The objective of this paper is to detail the Indian experience in
meeting the governance challenge with special reference to public sector banks (PSBs) or
State-owned banks as they are described in some countries. The paper sets out the historical
context of the Indian experience since the governance challenge is significantly related to the
background in which state ownership emerged. This will be followed by an account of the
pre-reform status encompassing the policy, regulatory and structural environments. The measures
undertaken to tackle the governance issues during the reform follow. In the context of the recent
on-going exercise relating to India’s status, vis-à-vis the international standards
and codes, an assessment would be made on the governance issues with special reference to the
banking sector, based essentially on the assessment of independent advisory groups and current
proposals under consideration for enhancing corporate governance in the public sector banks are
discussed. An attempt would be made to highlight what may be termed as tentative issues and
lessons emerging from the Indian experience. By way of a summing up, some random thoughts are set
out to provoke analysis and debate on the subject.
Historical Context
India had a fairly well developed commercial banking system in
existence at the time of independence in 1947. The Reserve Bank of India (RBI) was established
in 1935. While the RBI became a state owned institution from January 1, 1949, the Banking
Regulation Act was enacted in 1949 providing a framework for regulation and supervision of
commercial banking activity. The first step towards the nationalisation of commercial banks was
the result of a report (under the aegis of RBI) by the Committee of Direction of All India
Rural Credit Survey (1951) which till today is the locus classicus on the
subject. The Committee recommended one strong integrated state partnered commercial banking
institution to stimulate banking development in general and rural credit in particular. Thus,
the Imperial Bank was taken over by the Government and renamed as the State Bank of India (SBI)
on July 1, 1955 with the RBI acquiring overriding substantial holding of shares. A number of
erstwhile banks owned by princely states were made subsidiaries of SBI in 1959. Thus, the
beginning of the Plan era also saw the emergence of public ownership of one of the most prominent
of the commercial banks. There was a feeling that though the Indian banking system had made
considerable progress in the ‘50s and ‘60s, it established close links between commercial and
industry houses, resulting in cornering of bank credit by these segments to the exclusion of
agriculture and small industries.
To meet these concerns, in 1967, the Government introduced the concept of
social control in the banking industry. The scheme of social control was aimed at
bringing some changes in the management and distribution of credit by the commercial banks. The
close link between big business houses and big banks was intended to be snapped or at least made
ineffective by the reconstitution of the Board of Directors to the effect that 51 per cent of the
directors were to have special knowledge or practical experience. Appointment of whole-time
Chairman with special knowledge and practical experience of working of commercial banks or
financial or economic or business administration was intended to professionalise the top
management. Imposition of restrictions on loans to be granted to the directors’ concerns was
another step towards avoiding undesirable flow of credit to the units in which the directors were
interested. The scheme also provided for the take-over of banks under certain circumstances.
Political compulsion then partially attributed to inadequacies of the
social control, led to the Government of India nationalising, in 1969, 14 major scheduled
commercial banks which had deposits above a cut-off size. The objective was to serve better the
needs of development of the economy in conformity with national priorities and objectives. In a
somewhat repeat of the same experience, eleven years after nationalisation, the Government
announced the nationalisation of six more scheduled commercial banks above the cut-off size. The
second round of nationalisation gave an impression that if a private sector bank grew to the
cut-off size it would be under the threat of nationalisation.
From the fifties a number of exclusively state-owned development financial
institutions (DFIs) were also set up both at the national and state level, with a lone exception
of Industrial Credit and Investment Corporation (ICICI) which had a minority private share
holding. The mutual fund activity was also a virtual monopoly of Government owned institution,
viz., the Unit Trust of India. Refinance institutions in agriculture and industry sectors were
also developed, similar in nature to the DFIs. Insurance, both Life and General, also became
state monopolies.
Pre-Reform Status
The regulatory framework for the banking industry under the Banking
Regulation Act was circumscribed by the special provisions of the Bank Nationalisation Act both
of which had elements of corporate governance incorporated with regard to composition of Board of
Directors in terms of representation of directors, etc. While technically there was competition
between banks and non-banks and among banks, substantively, competition was conditioned by policy
as well as regulatory environment, common ownership by the Government and agreement between the
Government of India as an owner and the workers represented by the Unions. Subsequent efforts
during the reform period in terms of hesitancy in permitting industrial houses as well as foreign
owned banks should be viewed in this historical context.
As regards the policy environment, it must be recognised that almost the
whole of financial intermediation was on account of public sector, with PSBs being the most
important source of mobilisation of financial savings. Resources for DFIs were also made
available either by banks or mostly created money and governmental support. The major thrust was
on expansion of banks’ branches, provision of banking services and mobilisation of deposits. The
interest rate regime was administered with interest rates fixed both on deposits and lending. At
the same time, there was large pre-emption of banks’ resources under the cash reserve ratio or in
the form of statutory liquidity ratio. The delivery of credit was also by and large directed
through an allocative mechanism or as an adjunct to the licencing regime. In the process, the
private sector banks tended to be confined to the local areas and were unable to expand in such
an environment. Banks, mainly public sector banks became the most dominant vehicle of the
financial intermediation in the country. To a large extent, entry was restricted and exit was
impossible and there was little or no scope for functions of risk assessment and pricing of
risks. The Government, thus combined in itself the role of owner, regulator and sovereign.
The legal as well as policy framework emphasised co-ordination in the interest
of national development as per Plan priorities with the result, the issue of corporate governance
became subsumed in the overall development framework. To the extent each bank, even after
nationalization, maintained its distinct identity, governance structure as incorporated in the
concerned legislations provided for a formal structure of relationship between the RBI,
Government, Board of Directors and management. The role of the RBI as a regulator became
essentially one of being an extended arm of the Government so far as highest priority was
accorded to ensuring coordinated actions in regard to activities particularly of PSBs. The SBI,
which was owned by the RBI, was in substance no different from the other banks owned by the
Government in terms of Board composition, appointment procedures of the executives and
non-executive members of the Board of Directors. Both Government and RBI were represented on the
Board of Directors of the PSBs. There has been significant cross representation in terms of
owner or lender and in other relationships between banks and all other major financial entities.
In other words, cross holdings and inter-relationships were more a rule than an exception in the
financial sector, since the basic objective was coordination for ensuring planned development,
with the result, the concepts of conflicts of interests among players, checks and balances etc.,
were subordinated to the social goals of the joint family headed by the
Government.
Reform Measures
The major challenge of the reform has been to introduce elements of
market incentive as a dominant factor gradually replacing the administratively coordinated
planned actions for development. Such a paradign shift has several dimensions, the corporate
governance being one of the important elements. The evolution of corporate governance in banks,
particularly, in PSBs, thus reflects changes in monetary policy, regulatory environment, and
structural transformations and to some extent, on the character of the self-regulatory
organizations functioning in the financial sector.
Policy Environment
During the reform period, the policy environment enhanced competition
and provided greater opportunity for exercise of what may be called genuine corporate element in
each bank to replace the elements of coordinated actions of all entities as a "joint
family" to fulfill predetermined Plan priorities. The measures taken so far can be
summarized as follows :
First, greater competition has been infused in the banking system by
permitting entry of private sector banks (9 licences since 1993), and liberal licensing of more
branches by foreign banks and the entry of new foreign banks. With the development of a
multi-institutional structure in the financial sector, emphasis is on efficiency through
competition irrespective of ownership. Since non-bank intermediation has increased, banks have
had to improve efficiency to ensure survival.
Second, the reforms accorded greater flexibility to the banking system to
manage both the pricing and quantity of resources. There has been a reduction in statutory
preemptions to less than a third of commercial banks resources. The mandatory component of
market financing of Government borrowing has decreased. While directed credit continues it is
now on near commercial terms. Valuation of banks' investments is also attuned to international
best practices so as to appropriately capture market risks.
Third, the RBI has moved away from micro-regulation to macro-management. RBI
has replaced detailed individual guidelines with general guidelines and now leaves it to
individual banks’ boards to set their guidelines on credit decisions. A Regulation Review
Authority was established in RBI, whereby any bank could challenge the need for any regulation or
guideline and the department had to justify the need and usefulness for such guideline relative
to costs of regulation and compliance.
Fourth, to strengthen the banking system to cope up with the changing
environment, prudential standards have been imposed in a progressive manner. Thus, while banks
have greater freedom to take credit decisions, prudential norms setting out capital adequacy
norms, asset classification, income recognition and provisioning rules, exposure norms, and asset
liability management systems have helped to identify and contain risks, thereby contributing to
greater financial stability.
Fifth, an appropriate legal, institutional, technological and regulatory
framework has been put in place for the development of financial markets. There is now increased
volumes and transparency in the primary and secondary market operations. Development of the
Government Securities, money and forex markets has improved the transmission mechanism of
monetary policy, facilitated the development of an yield curve and enabled greater integration of
markets. The interest rate channel of monetary policy transmission is acquiring greater
importance as compared with the credit channel.
Regulatory Environment
Prudential regulation and supervision have formed a critical component
of the financial sector reform programme since its inception, and India has endeavoured to
international prudential norms and practices. These norms have been progressively tightened over
the years, particularly against the backdrop of the Asian crisis. Bank exposures to sensitive
sectors such as equity and real estate have been curtailed. The Banking Regulation Act 1949
prevents connected lending (i.e. lending by banks to directors or companies in which Directors
are interested).
Periodical inspection of banks has been the main instrument of supervision,
though recently there has been a move toward supplementary 'on-site inspections' with 'off-site
surveillance'. The system of 'Annual Financial Inspection' was introduced in 1992, in place of
the earlier system of Annual Financial Review/Financial Inspections. The inspection objectives
and procedures, have been redefined to evaluate the bank’s safety and soundness; to appraise the
quality of the Board and management; to ensure compliance with banking laws & regulation; to
provide an appraisal of soundness of the bank's assets; to analyse the financial factors which
determine bank's solvency and to identify areas where corrective action is needed to strengthen
the institution and improve its performance. Inspection based upon the new guidelines have
started since 1997.
A high powered Board for Financial Supervision (BFS), comprising the Governor
of RBI as Chairman, one of the Deputy Governors as Vice-Chairman and four Directors of the
Central Board of RBI as members was constituted in 1994, with the mandate to exercise the powers
of supervision and inspection in relation to the banking companies, financial institutions and
non-banking companies.
A supervisory strategy comprising on-site inspection, off-site monitoring and
control systems internal to the banks, based on the CAMELS (capital adequacy, asset quality,
management, earnings, liquidity and systems and controls) methodology for banks have been
instituted. The RBI has instituted a mechanism for critical analysis of the balance sheet by the
banks themselves and the presentation of such analysis before their boards to provide an internal
assessment of the health of the bank. The analysis, which is also made available to the RBI,
forms a supplement to the system of off-site monitoring of banks.
Keeping in line with the merging regulatory and supervisory standards at
international level, the RBI has initiated certain macro level monitoring techniques to assess
the true health of the supervised institutions. The format of balance sheets of commercial banks
have now been prescribed by the RBI with disclosure standards on vital performance and growth
indicators, provisions, net NPAs, staff productivity, etc. appended as 'Notes of Accounts'. To
bring about greater transparency in banks' published accounts, the RBI has also directed the
banks to disclose data on movement of non-performing assets (NPAs) and provisions as well as
lending to sensitive sectors. These proposed additional disclosure norms would bring the
disclosure standards almost on par with the international best practice.
Structural Environment of Banking
The nationalized banks are enabled to dilute their equity of
Government of India to 51% following the amendment to the Banking Companies (Acquisition &
Transfer of Undertakings) Acts in 1994, bringing down the minimum Government's shareholdings to
51 per cent in PSBs. RBI's shareholding in SBI is subject to a minimum of 55 per cent. Ten banks
have already raised capital from the market. The Government proposed, in the Union Budget for
the financial year 2000-01 to reduce its holding in nationalised banks to a minimum of 33 per
cent, while maintaining the public sector character of these banks. The diversification of
ownership of PSBs has made a qualitative difference to the functioning of PSBs since there is
induction of private shareholding and attendant issues of shareholder’s value, as reflected by
the market cap, representation on board, and interests of minority shareholders. There is
representation of private shareholder when the banks raise capital from the market.
The governance of banks rests with the board of directors. In the light
of deregulation in interest rates and the greater autonomy given to banks in their operations,
the role of the board of directors has become more significant. During the years, Boards have
been required to lay down policies in critical areas such as investments, loans, asset-liability
management, and management and recovery of NPAs. As a part of this process, several Board level
committees including the Management Committee are required to be appointed by banks.
In 1995, the RBI directed banks to set up Audit Committees of their Boards,
with the responsibility of ensuring efficacy of the internal control and audit functions in the
bank besides compliance with the inspection report of the RBI, internal and concurrent auditors.
To ensure both professionalism and independence, the Chartered Accountant Directors on the boards
of banks are mandatory members, but the Chairman would not be part of the Audit Committee. Apart
from the above, Board level committees that are required to be set up are Risk Management
committee, Asset Liability Management committee (ALCO), etc. The Boards have also been given the
freedom to constitute any other committees, to render advice to it.
Government introduced a Bill in Parliament to omit the mandatory
provisions regarding appointment of RBI nominees on the Boards of public sector banks and instead
to add a clause to enable RBI to appoint its nominee on the boards of public sector banks if the
RBI is of the opinion that in the interest of the banking policy or in the public interest or in
the interest of the bank or depositors, it is necessary so to do.
As regards, appointment of Additional Directors on the Boards of private
sector banks, since December 1997, the RBI has been appointing such directors only in such of
those 'banks making losses for more than one year, having CRAR below 8%, NPAs exceeding 20% or
where there are disputes in the management.
Appointment of Chairman and Managing Directors and Executive Directors of
all PSBs is done by Government. The Narasimham Committee II had recommended that the appointment
of Chairman and Managing Director should be left to the Boards of banks and the Boards themselves
should be elected by shareholders. Government has set up an Appointment Board chaired by
Governor, Reserve Bank of India for these appointments. More recently, in case of appointment of
Chief Executive Officer of the PSBs identified as weak, the Government has formed a Search
Committee with two outside experts.
Appointment as well as removal of auditors in PSBs require prior approval
of the RBI. There is an elaborate procedure by which banks select auditors from an approved panel
circulated by the RBI. In respect of private sector banks, the statutory auditors are appointed
in the Annual General Meeting with the prior approval by the RBI.
Self Regulatory Organizations
India has had the distinction of experimenting with Self Regulatory
Organisations (SROs) in the financial system since the pre-independence days. At present, there
are four SROs in the financial system - Indian Banks Association (IBA), Foreign Exchange Dealers
Association of India (FEDAI), Primary Dealers Association of India (PDAI) and Fixed Income Money
Market Dealers Association of India (FIMMDAI).
The IBA established in 1946 as a voluntary association of banks, strove
towards strengthening the banking industry through consensus and co-ordination. Since
nationalisation of banks, PSBs tended to dominate IBA and developed close links with Government
and RBI. Often, the reactive and consensus and coordinated approach bordered on cartelisation.
To illustrate, IBA had worked out a schedule of benchmark service charges for the services
rendered by member banks, which were not mandatory in nature, but were being adopted by all
banks. The practice of fixing rates for services of banks was consistent with a regime of
administered interest rates but not consistent with the principle of competition. Hence, the IBA
was directed by the RBI to desist from working out a schedule of benchmark service charges for
the services rendered by member banks.
Responding to the imperatives caused by the changing scenario in the
reform era, the IBA has, over the years, refocused its vision, redefined its role, and modified
its operational modalities.
In the area of foreign exchange, FEDAI was established in 1958, and banks were
required to abide by terms and conditions prescribed by FEDAI for transacting foreign exchange
business. In the light of reforms, FEDAI has refocused its role by giving up fixing of rates,
but plays a multifarious role covering training of banks’ personnel, accounting standards,
evolving risk measurement models like the VaR and accrediting foreign exchange brokers.
In the financial markets, the two SROs, viz., the PDAI and the FIMMDAI are of
recent origin i.e. 1996 and 1997. These two SROs have been proactive and are closely involved in
contemporary issues relating to development of money and government securities markets. The
representatives of PDAI and FIMMDAI are members of important committees of the RBI, both on
policy and operational issues. To illustrate, the Chairmen of PDAI and FIMMDAI are members of
the Technical Advisory Group on Money and Government Securities market of the RBI. These two
SROs have been very proactive in mounting the technological infrastructure in the money and
Government Securities markets. The FIMMDAI has now taken over the responsibility of publishing
the yield curve in the debt markets. Currently, the FIMMDAI is working towards development of
uniform documentation and accounting principles in the repo market.
Assessment of Corporate Governance in PSBs
A Standing Committee on International Financial Standards and Codes
was constituted to, inter alia, assess the status in India vis-à-vis the
best global practices in regard to standards and codes. An Advisory Group on Corporate Governance
(Chairman: Dr. R. H. Patil) made detailed assessment and gave recommendations of which those
relating to PSBs is an important component. The Report provides the most comprehensive set of
recommendations on the subject, summarised in Box 1.
Box 1
Advisory Group on Corporate Governance
- Currently in India, about four-fifths of the banking business is under the
control of public sector banks (PSBs), comprising the SBI and its subsidiaries and the
nationalised banks. Corporate governance in PSBs is complicated by the fact that effective
management of these banks vests with the government and the top managements and the boards of
banks operate merely as functionaries. The ground reality is such that the government performs
simultaneously multiple functions vis-à-vis the PSBs, such as the owner, manager,
quasi-regulator, and sometimes even as the super-regulator. Unless the issues connected with
these multiple, and sometimes conflicting, functions are resolved and the boards of banks are
given the desired level of autonomy it would be difficult to improve the quality of corporate
governance in PSBs. One of the major factors that impinge directly on the quality of corporate
governance is the government ownership. It is desirable that all the banks are brought under a
single Act so that the corporate governance regimes do not have to be different just because the
entities are covered under multiple Acts of the Parliament or that their ownership is in the
private or public sector.
Box 1 (cont.)
Advisory Group on Corporate Governance
- Even when the government dilutes its holdings to bring them significantly
below the threshold limit of 51 per cent, efforts to institute good governance practices would
remain at superficial level unless the government seriously redefines its role de
novo. The changes proposed in the composition of the boards as per legislation under
contemplation would result in government directly appointing 9 out of the 15 directors including
the 4 whole time directors. Moreover, the voting rights of any of the other shareholders will
continue to be restricted, thereby negating the basic principle of equal rights to all the
shareholders. The rights of private shareholders’ of SBI/PSBs are abridged considerably, since
their approval is not required for paying dividend or adopting annual accounts. The subsidiaries
of the SBI enjoy very limited board autonomy as they have to get clearance on most of the
important matters from the parent even before putting them up to their boards. Further, as
things stand today, there is no equality among the various board members of the PSBs. Nominees of
RBI and Government are treated to be superior to other directors.
- Another major problem affecting banks has been the representation given to
the various interest groups on the boards of the banks. The main objective behind these
representations was to give voice to various sections of the society at the board level of the
banks. Hence, a major reform is needed in the area of constitution of the boards of the banks.
The Chairmen, Executive Directors and non-executive directors on the boards of the PSBs
(including the SBI and its subsidiaries) need to be appointed on the advice of an expert body set
up on the lines of the UPSC, with similar status and independence. Such a body may be set up
jointly by RBI and the Ministry of Finance. There is also no need to have directors that
represent narrow sectional and economic interests. All the objectives that the banks are
supposed to achieve should become an integral part of the corporate mission statements of these
institutions.
- Although RBI maintains a tight vigil and inspects these entities
thoroughly at regular time intervals, the quality of corporate level governance mechanism does
not appear to be satisfactory. In its role as the regulator, RBI need not have representation on
the bank boards, given the fact that it leads to conflicts of interests with its regulatory
functions. This should apply even in the case of SBI where RBI is the major shareholder.
Further, any policy measures to protect banks that are less careful in their lending policies at
the cost of tax payers’ money need to be tempered in such a way that they do not encourage
profligate lending by banks.
- Current regulatory provisions do not permit a bank to lend money to a
company if any of its board members is also a director on the board of that company. The negative
impact of this rule has been that the banks are not able to get good professionals for their
boards. This archaic rule should be modified immediately so that the professionals who are on the
boards of non-banking companies as professional or independent directors do not suffer from any
handicaps. The current rule may, however, be continued only in respect of directors of companies
who are their promoters and have a stake in their companies beyond being merely a director. In
the interest of good governance, it is desirable that government directors should not participate
in the discussion on such matters and also abstain from voting.
The Report of the Advisory Group on Banking Supervision (Chairman : Mr. M.S.
Verma) has also made some recommendations on corporate governance, which are summarised in Box
2.
Box 2
Advisory Group on Banking Supervision
- The quality of corporate governance should be the same in all types of
banking organisations irrespective of their ownership. The process of induction of directors
into banks’ boards and their initial orientation may be streamlined. Banks need to develop
mechanisms, which can help them ensure percolation of their strategic objectives and corporate
values throughout the organisation. Boards need to set and enforce clear lines of responsibility
and accountability for themselves as well as the senior management and throughout the
organisation. Linkage between contribution and remuneration/reward should be established.
Compensation Committees of the board could be set up for the purpose. Nomination Committees to
assess the effectiveness of the board and direct the process of renewing and replacing board
members are desirable. Disclosures in respect of committees of the board and qualifications of
the directors, incentive structure and the nature and extent of transactions with affiliated and
related parties need to be encouraged. Finally, a provision on the lines of Section 20 of the
Banking Regulation Act, 1949, which prohibits loans and advances to directors and their connected
parties, will have to be made in respect of large shareholders also. Information on transactions
with affiliated and related parties should be disclosed.
Current Proposal
It would be evident that the Reports of Advisory Groups contain far
reaching proposals to improve corporate governance and many, if not all, do require legislative
processes and they are necessarily time consuming and often realizable only in medium-term.
While proceeding with analysis and possible legislative actions, it may be necessary to consider
and adopt changes that could be brought about within the existing legislative framework.
To this end, Governor Jalan in his Monetary and Credit Policy Statement of
October 2001 constituted a Consultative Group of Directors of banks and financial institutions
(Chairman Dr. A.S. Ganguly) to review the supervisory role of Boards of banks and financial
institutions and to obtain feedback on the functioning of the Boards vis-à-vis compliance,
transparency, disclosures, audit committees etc. and make recommendations for making the role of
Board of Directors more effective. The Group made its recommendations very recently after a
comprehensive review of the existing framework as well as of current practices and benchmarked
its recommendations with international best practices as enunciated by the Basel Committee on
Banking Supervision, as well as of other committees and advisory bodies, to the extent applicable
in the Indian environment. The report has been put in public domain for a wider debate and its
major recommendations are summarized in Box 3 :
Box 3
Report of the Consultative Group of Directors
of Banks/Financial Institutions
- On appointment of Directors, due diligence of the directors of all banks –
be they in public or private sector, should be done in regard to their suitability for the post
by way of qualifications and technical expertise. Involvement of Nomination Committee of the
Board in such an exercise should be seriously considered as a formal process. Further, the
Government while nominating directors on the Boards of public sector banks should be guided by
certain broad "fit and proper" norms for the Directors. The criteria suggested by the
Bank for International Settlements (BIS) may be suitably adopted for considering "fit and
proper" test for bank directors.
- In the present context of banking becoming more complex and
knowledge-based, there is an urgent need for making the Boards of banks more contemporarily
professional by inducting technical and specially qualified individual. While continuing
regulation based representation of sectors like agriculture, SSI, cooperation, etc., the
appointment/nomination of independent/ non-executive directors to the Board of banks (both public
sector and private sector) should be from a pool of professional and talented people to be
prepared and maintained by RBI. Any deviation from this procedure by any bank should be with the
prior approval of RBI.
- On the functioning, the independent/non-executive directors should raise
in the meetings of the Board, critical questions relating to business strategy, important aspects
of the functioning of the bank and investor relations. In the case of private sector banks where
promoter directors may act in concert, the independent/non-executive directors should provide
effective checks and balances ensuring that the bank does not build up exposures to entities
connected with the promoters or their associates. The independent/non-executive directors should
provide effective checks and balances particularly, in widely held and closely controlled banking
organizations.
- As a step towards effective corporate governance, it would be desirable to
take an undertaking from every director to the effect that they have gone through the guidelines
defining the role and responsibilities of directors, and understood what is expected of them and
enter into a covenant to discharge their responsibilities to the best of their abilities,
individually and collectively.
- In order to attract quality professionals, the level of remuneration
payable to the directors should be commensurate with the time required to be devoted to the
bank’s work as well as to signal the appropriateness of remuneration to the quality of inputs
expected from a member. The statutory prohibition under section 20 of the Banking Regulation
Act, 1949 on lending to companies in which the director is interested, severely constricts
availability of quality professional directors on to the Boards of banks. This would require a
change in the existing legal framework. We need to move towards this goal.
- It would be desirable to separate the office of Chairman and Managing
Director in respect of large sized public sector banks. This functional separation will bring
about more focus on strategy and vision as also the needed thrust in the operational functioning
of the top management of the bank. The directors could be made more responsible to their
organization by exposing them to an induction briefing need-based training
programme/seminars/workshops to acquaint them with emerging developments/challenges facing the
banking sector. RBI as the regulator, could take the initiative to organizing such seminars.
RBI may bring out an updated charter indicating clear-cut, specific guidelines on the role
expected and the responsibilities of the individual directors. The whole-time directors should
have sufficiently long tenure to enable them to leave a mark of their leadership and business
acumen on the bank’s performance. All banks should consider appointing qualified Company
Secretary as the Secretary to the Board and have a Compliance Officer (reporting to the
Secretary) for monitoring and reporting compliance with various regulatory/accounting
requirements.
- The information furnished to the Board should be wholesome, complete and
adequate to take meaningful decisions. A distinction needs to be made between statutory items
and strategic issues in order to make the material for directors ‘manageable’. The Reviews
dealing with various performance areas could be put up the Supervisory Committee of Board and a
summary of each such review could be put up to the Main Board. The Board’s focus should be
devoted more on strategy issues, risk profile, internal control systems, overall performance,
etc. The procedure followed for recording of the minutes of the board meetings in banks and
financial institutions should be uniform and formalized. Banks and financial institutions may
adopt two methods for recording the proceedings viz., a summary of key observations and a more
detailed recording of the proceedings.
- It would be desirable if the exposures of a bank to stockbrokers and
market-makers as a group, as also exposures to other sensitive sectors, viz., real estate etc.
are reported to the Board regularly. The disclosures in respect of the progress made in putting
in place a progressive risk management system, the risk management policy, strategy followed by
the bank, exposures to related entities, the asset classification of such lendings/investments
etc. conformity with Corporate Governance Standards etc., be made by banks to the Board of
Directors at regular intervals as prescribed.
- As regards Committees, there could be a Supervisory Committee of the Board
in all banks, be the public or private sector, which will work on collective trust and at the
same time, without diluting the overall responsibility of the Board. Their role and
responsibilities could include monitoring of the exposures (credit and investment) review of the
adequacy of risk management process and upgradation thereof, internal control systems and
ensuring compliance with the statutory/regulatory framework. The Audit Committee should, ideally
be constituted with independent/non-executive directors and the Executive Director should only be
a permanent invitee. However, in respect of public sector banks, the existing arrangement of
including the Executive Director and nominee directors of Government and RBI in the Audit
Committee may continue. The Chairman and Audit Committee need not be confined to the Chartered
Accountant profession but can be a person with knowledge on ‘finance’ or ‘banking’ so as to
provide directions and guidance to the Audit Committee, since the Committee not only looks at
accounting issues, but also the overall management of the bank. It is desirable to have a
Nomination Committee for appointing independent/non-executive directors of banks. In the context
of a number of public sector banks issuing capital to the public, a Nomination Committee of the
Board may be formed for nomination of directors, representing shareholders. The formation and
operationalisation of the Risk Management Committees in pursuance of the guidelines issued by the
RBI should he speeded up and their role further strengthened. With a view of building up
credibility among the investor class, the Group recommends that a Committee of the Board may be
set up to look into the grievance of investors and shareholders, with the Company Secretary as a
nodal point.
- Finally the banks could be asked to come up with a strategy and plan for
implementation of the governance standards recommended and submit progress of implementation, for
review after twelve months and thereafter half yearly or annually, as deemed
appropriate.
Tentative Issues and Lessons
The Indian experience shows recognition of (a) the importance of
corporate governance and the challenges in redefining institutional relations in the financial
sector in respect of PSBs; (b) the need for a broader view of enhancing corporate governance to
take account of law and policy as well as the operating and institutional environment; and (c)
the desirable changes in the composition and functioning of the board. The processes by which
some progress has been made so far and actions contemplated are also instructive – needless to
add that these issues and lessons have to be viewed as tentative, and of course, contextual.
Corporate governance in PSBs is important, not only because PSBs happen to
dominate the banking industry, but also because, they are unlikely to exit from banking business
though they may get transformed. To the extent there is public ownership of PSBs, the multiple
objectives of the government as owner and the complex principal-agent relationships cannot be
wished away. PSBs cannot be expected to blindly mimic private corporate banks in governance
though general principles are equally valid. Complications arise when there is a widespread
feeling of uncertainty of the ownership and public ownership is treated as a transitional
phenomenon. The anticipation or threat of change in ownership has also some impact on
governance, since expected change is not merely of owner but the very nature of owner. Mixed
ownership where government has controlling interest is an institutional structure that poses
issues of significant difference between one set of owners who look for commercial return and
another who seeks something more and different, to justify ownership. Furthermore, the
expectations, the reputational risks and the implied even if not exercised authority in respect
of the part-ownership of government in the governance of such PSBs should be recognized. In
brief, the issue of corporate governance in PSBs is important and also complex.
The most important challenge faced in enhancing corporate governance and
in respect of which there has been significant though partial success relates to redefining the
interrelationships between institutions within the broadly defined public sector i.e.,
government, RBI and PSBs to move away from "joint family" approach originally designed
for a model of planned development. As part of reform the government had to differentiate,
conceptually and at the policy level, its role as sovereign, owner of banks and overarching
supervisor of regulators including RBI. The central bank also had to move away from sharing the
nitty gritty of developmental schemes with government involving micro regulation, to a more
equitable treatment of all banks as regulator and supervisor. Furthermore, the bureaucracy of
RBI is accountable to the RBI’s Board for Financial Supervision. The large publicly owned
non-financial enterprise had to recognize the need for a more commercial and competitive approach
with banks including PSBs in raising of and deployment of funds. Similarly, the PSBs had to
reorient their approach to each other also with intensified competition engineered by policy
while guarding against excessive risk taking as dictated by a supervisor seeking to meet
international standards.
Another noteworthy aspect of enhancing corporate governance is the
narrowing of gap between PSBs and other banks in terms of the policy, regulatory and operating
environment, apart from some changes in ownership structures with attendant consequences. The
PSBs as hundred per cent owned entities with no share value quoted in stock exchanges accounted
for over three quarters of banking business seven years ago, while they now account for less than
a quarter.
A third area where a few changes to enhance quality of governance have
been made or are contemplated relates to the manner in which chief executives are selected, the
board is composed in view of induction of some elected directors, and the constitution of
committees, including the Audit Committee. In this regard, it is noteworthy that recently, the
functioning of bank boards in the private sector seems to have attracted significant adverse
notice, both from market and supervisor. That the representation of RBI on the Boards is not
desirable has been conceded just as RBI has expressed interest in divesting all its ownership
functions.
The processes by which these changes have been and are being brought about
may also be of some interest. First, RBI has taken initiative in bringing about changes rather
than "keep aloof" from the regulated entities as pure theory may suggest. The
developmental role of RBI, which was in the nature of promoting and funding of institutions or
channeling credit to schemes under government approved plans has yielded place to the role of
developer of a more robust financial system, especially banking structure and system. Sometimes,
closer involvement of RBI in some transitional arrangements, such as in advising government on
appointment of Chief Executives of PSBs was needed to bring about changes. The professional
inputs as well as sensitising and creating opinion to enhance corporate governance was ensured by
RBI through the Advisory Groups and Consultative Group mentioned.
Second, as Governor Jalan in his National Institute of Bank Management
(NIBM) Annual Day Lecture articulated, markets are more free and more complex now; what happens
in banks is a concern for all since there is fear of contagion and above all we live in a more
volatile and interlinked world where effects are instantaneous. (Jalan 2002). Hence, in the
process of making markets more free as part of the reform, RBI had to discharge its
responsibility of equipping the participants, especially the most dominant segment viz., PSBs, to
manage the complexities or simply to cope. Hence, RBI had taken initiatives in improving the
competitive strengths as well as governance systems of PSBs while pursuing its objective of
distancing, as a regulator, from the operational closeness with both government which is an owner
of PSB, and PSBs which are the regulated.
Thirdly, the path of reform of which corporate governance is one element
had to be considered carefully and evolved through a consultation and participation process at
every step. Thus, the basic framework was provided by Narasimham Committees 1 and 2 in which all
stakeholders were represented followed by a series of Committees and Consultation Papers to
refine and redefine and apply the basic framework. The collaborative and consensual approach in
the path of reform was adopted while the goals of reforms were to the extent possible well
defined. The most recent example of this approach has been described in the Report of the
Advisory Groups on various International Standards and Codes.
Fourthly, there was need to resist the temptation of demoralising the PSBs
on presumed inefficiency, and make every effort to enable and empower them to meet the
challenges. There has been clear recognition that governance is not merely one of structures,
but also one of culture and this requires careful nurture. This has been made possible by a
variety of mechanisms and through a variety of fora. One illustration would suffice to reflect
the changing attitude of the RBI in this regard. The Governor, RBI who was the Chairman of
National Institute of Bank Management yielded the position to a former Chairman of a public
sector bank and the RBI distanced itself from the day to day running of the Institute without
withdrawing its interest and support.
Fifthly, the importance of SROs in bringing about change has been
recognised and the orientation of pre-existing institutions, in particular, Indian Banks’
Association, has changed to meet new challenges. Various mechanisms have been found to ensure an
environment supportive of sound corporate governance mentioned in BIS Document (BIS September
1999) by not only pursuing legal and policy changes with the Government, but also close
interaction with auditors and banking industry associations.
Random Thoughts
The Indian experience provokes some thoughts on a few fundamental
issues in regard to PSBs and corporate governance. First, is public ownership compatible with
sound corporate governance as generally understood? Since various corporate governance
structures exist in different countries, there are no universally correct parameters of sound
corporate governance. Government ownership of a bank, unless government happens to have such a
stake purely as a financial investment for return, necessarily has to have the effect of altering
the strategies and objectives as well as structure of governance. Government as an owner is
accountable to political institutions which may not necessarily be compatible with purely
economic incentives. The mixed ownership brings into sharper focus the divergent objectives of
shareholding and the issues of reconciling them, especially when one of the owners is government.
In such a situation, one can argue that as long as the private shareholder is aware of the
special nature of shareholding, there should be no conflict. In other words, the idea of
maintaining public sector character of a bank while government holds a minority shareholding is
an intensified and modified version of "golden share" experiment of U.K. The question
could still be as to whether such a mixed ownership is the most efficient form of organization,
particularly for banks which are in any case generally under intense regulation and
supervision.
Second, is corporate governance generally better in private sector, in
particular, private sector banks? In regard to old private sector banks (i.e. founded in
pre-reform era, almost all of them continue to be closely held and many of them resist broadening
their shareholder base and thus avoid deepening of corporate structures. More often than not,
takeover bids have been by equally closely held groups. As regards new private sector banks,
which have been licensed after close scrutiny in the reform period, the promotees were expected
to dilute their stakes to below 40 per cent within three years. In two of the cases, this is yet
to happen, while in most cases, the banks continue to be identified with effective controlled by
promoter institutions. Governor Jalan, made an interesting observation on this in a recent
lecture. "By and large, the structure is very weak in Co-operatives and NBFCs for
historical reasons, local practices, and multiplicity of regulators and laws. Old private sector
banks also have very poor auditing and accounting systems. New private banks – generally good on
accounting, but poor on accountability. More modern and computerized, but less risk conscious.
One thing which is common to all is that corporate governance is highly centralized with very
little real check on the CEO, who is generally also closely linked to the largest owner groups.
Boards or auditing systems are not very effective." (Jalan 2002)
Third, how do the dynamics of insider and outsider models in terms of
separation between ownership and management work in public vis-à-vis private sector banks?
One view is that there is not much difference between public and private sectors in India.
"The literature on the governance deals mostly with the financial disclosures and
restrictions on the managements that remain within the corporation and the influence that the
external stakeholder or shareholders can hold. But in developing countries, the problem is
slightly the other way round. In developing countries and more particularly in India, the major
corporate issue is not how outside financiers can control the actions of the managers but also
how outside stakeholders including the minority shareholders can exert control over the big
inside shareholders; and this does not apply only to the public sector, but it applies equally
strongly or probably more strongly to the private sector as well." (Bhide 2002).
There are, however, significant elements of subjectivity. Governor Jalan
feels that private sector has greater elements of insider model. "Public sector banks/FIs,
for example, are more akin to the ‘outsider’ model with separation of "Ownership" and
"Management". Private sector banks/NBFCs/Co-ops - much more "insider" models
with families, inter-connected entities or promoters running the management." (Jalan
2002)
The dominant view, backed by more recent research is that the issue in
India often relates to minority shareholder. "Rather than conflict between owners and
managers of firms, it is the conflict between the interests of minority shareholders and
promoters (say business groups) that is more relevant for India and that needs to be addressed.
" (NSE 2001). In other words, if the governance structures are weak, the risks of private
ownership of banks need to be assessed before embarking on large scale privatizations.
Fourth, is the performance of PSBs vis-à-vis private sector
demonstrably better? The evidence here is not conclusive, because comparison is beset with
several difficulties. Clearly, old private sector banks as a group do not perform well, while
new private sector banks show good performance as a group better than the PSBs as a group. Given
the size and variety of PSBs, it is possible to find banks that could equal the good private
sector banks as well as bad ones. In addition, PSBs have to reckon the "legacy"
problems, such as the non performing assets that they are saddled with. Some PSBs operate in
relatively backward areas with limited discretion for management to pull out from such areas.
The question still remains: whether there is a better pay off in enabling PSBs to improve their
performance while promoting private sector banks compared to transfer of ownership and control
from public to private sector? Will greater scope for mergers and acquisitions within and
between public and private sector add to greater efficiency than treating public and private in a
watertight manner?
Finally, what should be the most operationally relevant approach for
enhancing governance in PSBs recognizing that the extent of public ownership is determined
predominantly by considerations of political economy while the functioning of institutions could
possibly be influenced by techno-economic factors. The Indian experience so far, including
identified agenda for debtate, seems to indicate that, clear cut demarcation of responsibilities
of various institutions and participants is critical since "joint family approach"
needs to be ended with friendly but amicable "partition" of assets, liabilities and
activities. This needs to be accompanied by transparency in dealing with each other and proper
accounting of transactions which would be significantly in the areas of managerial reporting and
financial accounting. Simultaneously, checks and balances should be consciously put in place to
replace the tradition of all pervading bureaucratic coordination.
In brief, central bank has a developmental role even in the period of
reform but it is a different type of role, namely not directly financing development but help
develop systems, institutions and procedures to enable a paradigm shift in public policy and in
the process enhance corporate governance also in PSBs, in particular. While legislative changes
are necessary for an enduring improvement in corporate governance and such legislative changes
are not easy to effect in a democratic multi-party Parliamentary system, it is reassuring to
observe that significant improvements in corporate governance in the Indian financial sector are
being effected even within the existing legislative framework.
Select References
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Bhide, M.G. (January 6, 2002), Address at NIBM Annual Day on the theme of Corporate
Governance in Banks and Financial Institutions, Pune
Commonwealth Working Group on Corporate Governance in the Financial Sector, (November
2000), London.
Commonwealth Secretariat, (January 2001), Corporate Governance in the Financial Sector :
Checklist of Issues for Promoting Effective Corporate Governance, London.
Jalan, Bimal, (January 6, 2002), Inaugural Address at NIBM Annual Day on the theme of
Corporate a Governance in Banks and Financial Institutions,
Kakani, Ram Kumar, Biswatosh Saha and V.N. Reddy (November 2001),
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* Paper presented by Dr. Y.V. Reddy, Deputy Governor, Reserve Bank
of India, at World Bank, International Monetary Fund, and Brookings Institution Conference on
Financial Sector Governance: The Roles of the Public and Private Sectors, on April 18, 2001 at
New York City, USA. |