Financial Sector Governance:
The Role of the Public and Private Sector
Michael Pomerleano
Financial Sector Development Dept.
The World Bank
Strengthening Financial Sector Governance in Emerging Markets
Overview by Robert E. Litan, Michael Pomerleano, and V. Sundararajan
http://www.worldbank.org/wbi/banking/finsecpolicy/pillars/
The Public and the Private Roles are
Inextricably Linked
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Why Public Financial Sector
Governance? The multiple
and possibly conflicting
roles of the State as:
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Regulator of financial
institutions;
Owner of financial institutions;
Market participant;
Fiduciary agent;
Authority directly intervenes in
market operations.
Why Private Financial
Sector Governance?
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Public/Private Nexus
•Weak states captured by
powerful elite corporates
•Public misgovernance, state
exerts monopoly powers
The ability and effectiveness
of capital markets to improve
the governance of corporates
through private and public
legal rules; and equally, the
improvements in corporate
governance promote
development of the capital
markets.
Good governance of banks is
critical for fostering effective
corporate governance of
enterprises
The Governance Nexus
Public Sector Governance
Government
Regulatory Governance
Corporate Governance of Financial
Institutions
Corporate
Sector
Corporate Governance of Firms
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What is Governance?
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Institutions and practices by which authority is
exercised
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Arrangements by which incentives of managers,
owners, and other stakeholders are aligned:
Principal -
agent
Principal -
principal
Principal -
stakeholders
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Public sector governance
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Good regulatory governance is effective and sustainable only
with good public sector governance
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Good public sector governance implies respect of the state for
the institutions that govern economic and social interactions
among them:
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Absence of corruption
Approach to competition policy
Effective legal environment
Effective judicial system
Government ownership
As long as political interference in the regulatory process is not
costly for the politicians, regulatory governance can not be
effective
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Why Emphasize Financial Sector
Governance? Macro Evidence
Valuing Governance: The “Corruption Premium” in Global Capital Flows,
Shang-Jin Wei
Ln(Loan)-Ln(FDI)
The Cost of Weak Governance:
The main conclusions are: (i)
corruption affects the volume as
well as quality of FDI flows, and
(ii) corruption distorts the overall
structure of capital inflows, e.g.,
in favor of portfolio flows and
bank lending relative to FDI
flows, which makes the host
country more vulnerable to
financial crises.
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0
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-1
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Corruption: GCR/WDR
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Cost of corruption has been measured by deterred FDI, which ranges
from 37% deterred in China to 74% deterred in Azerbaijan
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Regulatory governance
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Good regulatory governance is important to provide
incentives to the sector in a credible manner
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Components of good regulatory governance are:
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Agency independence –WITH - accountability
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Transparency in actions and decisions
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Measures to ensure integrity of agency staff
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Through FSAPs, and the assessments of compliance with
financial sector standards and codes, the IMF and the World
Bank try to improve regulatory governance.
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A clinical approach to each specialized
industry in the financial sector
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Banks and in particular State Banks…blurred
distinction between private and public FS
Asset-Management Companies …blurred
distinction between private and public FS
Public Pension Fund Management …blurred
distinction between private and public FS
Mutual Funds / Collective Investment Vehicles
Capital markets: Effective measures in capital
markets to exert governance over corporates
Why does corporate governance in banks
warrant special attention?
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Banks are funded by depositors & their failure
may have systemic impact
Operating in an increasingly competitive, volatile
global environment
Facing major strategic crossroads (e.g., new
technology, consolidation, globalization,
deregulation)
Cases during the Asian financial crisis of boards
of directors under-performing
Bank Governance: The Basle Guidelines Issued in
1999
Intended complement The OECD’s Corporate Governance
Principles
 Focused on the unique issues related to corporate governance
of banks and set out the key elements of corporate governance
in banks
Objectives:
 To encourage practices which can strengthen corporate
governance under diverse structures -e.g. as regards the
relative role of the board of directors & management. Document
does not promote a particular governance structure (e.g., AngloSaxon vs. German models)
 To assist supervisors in promoting the adoption of sound
corporate governance practices by banking organizations in
their countries
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The Basle guidelines
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1: Strategic objectives & corporate values should be established
2: Clear lines of responsibility & accountability should be set &
enforced
3: Board members should be qualified, understand clearly their role
& not be subject to undue influence from management or outside
concerns
4: There should be appropriate oversight by senior management
5: Work conducted by internal & external auditors should be
effectively utilized
6: Compensation approaches should be consistent with the bank’s
ethical values, objectives, strategy & control environment
7: Corporate governance should be conducted in a transparent
manner
Issues in State Banking
Corporate Governance of Banks: Concepts and International Observations (Jerry
Caprio and Ross Levine)
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The situation. More than 40% of the world’s population live in countries in which most
bank assets are held by state-owned banks
What are the implications? Government ownership thwarts competitive forces, limits
effectiveness of government supervision; banking market suffers from opacity, need to
improve accounting, auditing, credit information
Illustrative solutions
 Contestability of markets lessens reliance on family or conglomerate relationships
 Incentives matter: legal and bankruptcy frameworks
Select countries solutions:
• U.S. has published a book with guidelines for the Board of Directors (The OCC guide for bank
directors). Thailand, Oman, and East Africa reported that they have recently released guides.
• Education/ training for corporate directors re their obligations by a local institute of corporate
directors. Switzerland reported that there is a local institute of corporate directors that offers
training. Thailand, Philippines and Fiji advised that they recently established local institutes of
directors
• HKMA issued a guideline on corporate governance in locally incorporated authorized
institutions in May 2000. HKMA recommendation 5 : The board of each bank should establish
an audit committee with written terms of reference specifying its authorities and duties; the
audit committee should be made up of non-executive directors, the majority of whom should
be independent
• MAS requires banks to separate financial and non-financial businesses; to change their audit
firms every five years
Asset-Management Companies
THE GOVERNANCE OF ASSET MANAGEMENT COMPANIES: SELECTED
OBSERVATIONS (David C. Cooke, Managing Director, Barents Group, KPMG)
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The situation.
Following the East Asia crisis, IBRA in Indonesia controlled 70% of financial
sector assets in Indonesia. Similarly Danaharta in Malaysia, Kamco in
Korea.
 Often mission statement has conflicting objectives: restore financial stability,
minimize taxpayer losses, etc.
 Governance of AMCs impacts pace of problem resolution; responsibilities
poorly defined; oversight committees not sufficiently separated from
management.
 Solutions: Provide for independent and informed oversight committee to
articulate policy objectives, review performance.
 Areas of Oversight authority typically include approval of: Operating
policies, Budget and funding proposals, Operating board members, Outside
auditor, May also include approval of significant NPL transactions.
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Provide an independent operating board with authority to manage AMC activities
Transparent reporting
Encourage stakeholders participation in corporate governance
Public Pension Fund Management and Governance
(Governance Issues In Public Pension Fund Management Gregorio Impavido)
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The situation. 81% of world labor force covered by partially funded or PAYG
public schemes; Pension spending can reach 15% of GDP; Implicit pension
debt up to 200% of GDP (Transition economies); Publicly managed pension
reserves up to 55% of GDP (Malaysia).
In numerous countries multiple objectives; governance structure is murky, and
performance of PPFM is poor
What are the implications? Identify good governance practices and distill into
governance guidelines aimed at reducing the political influence risks that are
associated with central, public pension fund management.
Solutions:
 Only one objective: portfolio investing and maximizing returns for retirees.
 Development of a satisfactory set of governance guidelines tailored to public
pension funds
• Governors independent and fit and proper; Governors' responsibility defined by
fiduciary law; accountable for fund performance (e.g.,- Ireland, Canada)
• Independent performance evaluations should be conducted by external and
independent entities on a regular basis.
• Internal controls should be established to avoid conflict of interests.
Mutual Funds
(Mark St. Giles and Sally Buxton, Cadogan Financial)
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The situation.
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In the US investment fund assets represent 50% of GDP, whereas in
Europe 25%. In the transitional economies funds have been used for
privatization. Collective investment schemes can become increasingly
important financial institutions in developed countries
Types of CIS governance structures
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Corporate style mutual funds are found mostly in the U.S. and a few
emerging markets, and dominate in terms of value of assets. Directors
have a fiduciary responsibility to look after the interests of investors.
75% of collective investment schemes by number are held in the trust or
the contractual form, and are found mostly in developing countries.
The trust: made by trust deed between a management company and a
trustee.The trustee has the fiduciary responsibility
The contractual fund: where investors contract with the management
company. Protected by a combination of contract law, regulation and the
actions of the depositary, which plays a quasi trustee role.
Mutual Funds II
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No empirical evidence that any one fund legal structure
provides improved fund governance .. but
…. probably
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Better governance structure when fund management is
separate from oversight with independent corporate directors
Regulation and enforcement are needed
Additional solutions.
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Ability to exit a fund creates competitive commercial pressure
 Transparency is critical to leveling the playing field, pressure funds
to perform
 Regulation for fair competition
How Effective are Capital Markets in Exerting
Governance on Corporates
Lessons of Recent Experience with Private and Public, Legal Rules Cally
Jordan, The World Bank and Mike Lubrano, IFC
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The vision is that Pressures of Capital Markets will Improve Governance of
Corporates and Improvements in Corporate Governance will Promote
Development of Capital Markets. How?
Legal Families” Matter “…legal families appear to shape legal rules, which
in turn influence financial markets” (La Porta, et al)
Changes designed to facilitate better governance are not a "silver bullet" .
Solutions are inextricably linked to a constellation of legal practices,
institutions, corporate governance structures and market conditions
E.g., Hostile takeovers are a strong disciplinary force in U.S. markets.
They rely on a well developed high-yield bond market, that was been a
source of funding for acquiring firms. However takeovers are not prevalent
in emerging markets.
Importance of private rules for governance. Adopted ex ante by contract,
often underpinned by voluntary codes of conduct, or through ex post
enforcement through contractual dispute resolution, including arbitration, or
through market discipline.
Key Messages
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The finance sector is sufficiently unique to warrant
specialized consideration
The costs of poor private and public sector governance in
the finance sector are substantial
Recurring themes in the recommendations offered by the
authors :
• Information asymmetry and the need for improved
transparency are recurring recommendations
• Regulatory ‘capture’ and incentives must be dealt with
• Lack of independence of policy and operations; difficulties
with certain mgt structures, government ownerships;
practical obstacles
• Inadequate skills and competency critical to boards of
directors as well as supporting roles (audit, legal,
accounting, etc)
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Overview was circulated, Book is available fromThe
Brookings Institution Press