Fiduciary responsibility of directors of deposit-taking financial institutions

Timely regulatory intervention to put things right is profound, particularly in view of the track record of FI failures where the ultimate loser is the public who have reposed their trust in these institutions

A corporate responsibility like no other

This is a responsibility of trust that is reposed in directors of licensed deposit-taking financial institutions (FIs) which makes them the custodians of public deposits. This responsibility is therefore sacrosanct and requires the highest calibre of persons, who are deemed to be fit and proper (F&P) by the regulatory authority, to be appointed as directors on the boards of these FIs. Accordingly, the (F&P) assessment of these persons, is the primary responsibility of the regulator, to ensure that they are, indeed, suitable to discharge this responsibility to the public. 

In simple language, what the licensing authority is saying to the public is – we have found these persons who we have approved to be directors of these FIs, to be persons in whom you can repose your trust. So go ahead and deposit your money with them. This is not a guarantee but it automatically puts a huge burden of responsibility on the licensing authority (LA) to ensure that they have put the necessary checks and balances in place and used their best judgement, to preserve this public trust in these FIs.

What are the key attributes that would naturally go into such an assessment by the LA? Naturally, the track record of the persons whose probity and integrity are required, inter alia, to be impeccable and where there is not the slightest doubt that they will be able to discharge their primary responsibility of trust to the depositors. The LA thus has a very onerous responsibility here and in approving the appointment of persons as directors of these FIs, it is imperative that they must be seen to have exercised the highest level of prudence in such selections. It naturally follows therefore that the following minimum criteria are deemed to be used for this purpose:

• Their track record of integrity and honour is undoubted
• They possess the capabilities to contribute to the wellbeing of the FI
• Are able to devote the time required to make an effective contribution to the FI’s growth and stability and are not otherwise engaged in numerous other responsibilities that would detract from, or constrain them in their responsibilities to the FI.
• Have no vested interests in finance and business ventures, which would encroach upon, cause a conflict of interests, or threaten, their relationship with the FI.

The above criteria represent the absolute minimum that must be ensured in the best interests of good corporate governance which is vital in steering the FIs towards good financial health and wellbeing.

The licensing authority: In the case of deposit taking financial institutions – the Central Bank of Sri Lanka(CBSL) – must recognise that , if the above minimum criteria are ensured; that their decisions in this regard are independent and not subject to extraneous influences; and that any person not satisfying these criteria are rejected outright, they have then set the stage for the prudent and efficient management of the FI from the outset and that, as a result of the highest quality of good corporate management, they can rest assured that the FI is in good hands and that their fiduciary responsibility to the public will in no way be compromised.

Accordingly the primary responsibility for the highest standards of corporate governance at these FIs, is with the CBSL. If this fiduciary responsibility is threatened in any way by directors who have been appointed who do not meet these criteria, primary accountability lies with the CBSL or the LA and in the interests of the stability and integrity of the financial system, every effort must be made to have these persons removed and replaced without any further procrastination. 

Primary Dealers: In the background of the recent failure and unethical transactions of certain primary dealers, the Fit and Proper assessment of directors becomes an imperative even in financial institutions which have custody of public investments. From what has emerged in this sector as well, it is evident that the licensing authority has failed in its responsibility in this regard. If one cares to look at the track record of the key management personnel at some of these institutions their relationship with failed finance companies where fraudulent, intercompany transactions were the norm, were not taken into the reckoning in granting them a PD licence. 

Arm’s length transactions and Related Parties (RP) in FIs

Directors of FIs who are on boards of banks and other FIs, for the privileges they can give themselves, serve no useful purpose. How much at ‘arm’s length’ these related party transactions may be, it does not remove the vested interest the directors obviously have in concerns in which they have a substantial interest by way of equity ownership or by representation on the boards of these concerns. The prudential measures formulated to prevent significant related party transactions in FIs, commence with the prohibition of RP transactions by directors having a substantial interest (SI) in the FI and with a comprehensive definition of what constitutes a substantial interest. 

Such RP transactions can, however, be undertaken if they are against approved securities to ensure that they are adequately collateralised in case of default. In effect these measures ensure that these RP transactions are subject to the same, or more stringent, criteria that are used in the normal course of business with non-related parties.

However, the gilt-edged nature of these securities originally approved, have been greatly compromised over the years as a result of pressure brought on the CBSL by the industry to make it easier for directors to conduct these RP transactions, to the extent that even a percentage of movables like stocks have been admitted as approved securities! 

The argument brought by these directors was that they would prefer to give their business to the banks on which they are directors and not to any other bank. However, in upholding the highest tenets of good corporate governance, such an argument is clearly untenable and has severely compromised good credit risk management as well, as a result of credit officers feeling intimidated in exercising sound credit assessment of related party transactions. 

There is ample testimony to this in the many failures we have experienced in this country, primarily in the finance companies in the 1980s. During 1988 to 1990, 13 registered finance companies failed. The most common problem being the parties having controlling stakes misusing power and position to obtain large advances on very favourable terms (L.S. Randeniya – bank failures). This was the time most corporates thought it more opportune to have a finance company arm through which depositors’ funds were used, largely to serve their diverse business interests. This was much cheaper than borrowing from the banks.

We saw a recurrence of this malaise in 2004 with the failure of Mercantile Credit, The Finance and several other FCs where the RP transactions were so significant, that they led to the failure of these institutions, and due to the obvious regulatory failure of the CBSL, had to be recapitalised or merged with stronger FIs. Sadly, several depositors are still without their legitimate deposits. 

In 2009, eight Ceylinco Group related companies had liquidity problems when Golden Key, an illegal Ceylinco-owned deposit taking firm, collapsed. None of these finance company failures were a result of difficult economic times. They were due to, predominantly, blatantly bad, self-serving, fraudulent governance, weak internal controls, and weak regulatory oversight. 

The most recent incident of significant RP transactions is the ETI and Swarnamahal as a result of heavy inter-group transactions. 

So it is evident that not much has changed to tighten the controls over RP transactions and to enhance corporate governance standards in these FIs.

If these RP transactions as claimed are above board, are at “arm’s length” and not on preferential terms, directors who value their reputation for integrity and good governance, would do well to take their business to any other bank where, based on their perceived creditworthiness, they could be easily accommodated. It is strongly recommended therefore that in promoting good corporate governance in financial institutions, consideration be given to a general prohibition on related party transactions by the boards of management of FIs. On the other hand, if indeed such RP transactions are accommodated, stronger regulatory measures such as deductions of these exposures from capital and ensuring the highest quality of approved securities to deter their proliferation would be worthy of consideration. 

Market discipline: Corporate governance of the banking sector is inherently different from governance in non-financial entities. This is where market discipline through transparency and adequate disclosure, which is what the third pillar of Basel II stands for, can effectively enhance and strengthen corporate governance. The auditing standards too require the disclosure of RP transactions to ensure that they are indeed at “arm’s length”. 

However, is the disclosure made adequate to conclude that these transactions are not on preferential terms? Do the numerous awarding agencies for the best published accounts of banks, etc., give good corporate governance the importance it deserves? 

Sadly, apart from tick-box compliance of so-called GRI standards, the criteria used to make these awards is not disclosed to be able to discern if indeed good corporate governance has received top priority as it should rightly be the case, a bank or FI which is seen to be governed by a board of management that has a vested interest in the bank is certainly not deserving of any recognition, regardless of these RP transactions being at “arm’s length” and within the regulatory framework. Such a board of management just cannot have the best interests of the FI they serve on at heart. Their own interests just have to take precedence besides creating a clear conflict of interests.

Regulatory discipline: It becomes imperative therefore that the regulatory authority must do everything in its power to promote the highest standards of corporate governance in deposit-taking financial institutions. The fit and proper assessment is where such regulatory authority should be exercised, to ensure that directors of these FIs are not shackled by their numerous private and personal corporate interests in the business world, which could possible give rise to a conflict of interests and an unhealthy relationship with the FI, which would be to its detriment. They could not, by any token, serve the larger interests of the FI they hope to govern. They have to be able to give the FI their prime time and attention to be able to honestly discharge their fiduciary responsibility to the depositors. 

The current regulations that permit bank directors to be directors on as many as 20 other corporates is far too excessive and goes against the very essence of good corporate governance. If indeed directors have to serve on 20 other boards, where would they have the time to give of their best to the deposit-taking FI? This is common sense surely and the CBSL just cannot be serious about corporate governance at FIs with such accommodative and compromising regulations. 

These are provisions that must, perforce, be revised and no amount of pressure brought by the industry should be succumbed to. The FIs must be forced into identifying young blood to the boards of management who are not so encumbered – looking at the corporate and business community today, there is surely no shortage of potential for these management positions so that the cronies of the shareholders can be weeded out. The CBSL just has to assert itself in this regard

Whilst it is incumbent upon all other stakeholders in the financial system to contribute to improving the standards of corporate governance in our financial system – the Accounting and Auditing Standards Board, the external auditors and the numerous awarding agencies, the Governor and members of the Monetary Board must use every public forum at their disposal to send the message of good corporate governance and their expectations of the industry in this regard, loud and clear. 

It is incumbent that the regulatory departments review the present composition of the boards of management of all FIs and make appropriate recommendations to the FIs for their re-composition wherever it is felt that any current members could compromise the standards of good corporate governance at these FIs. The on-site reports of examination should give particular emphasis to findings in this regard – particularly where it is found that directors are not making an effective contribution to the welfare of the FI or where they are seen to have significant vested interests in the FI. 

This becomes an imperative for the regulatory departments and a thematic examination on CG will be timely to be commissioned by the Monetary Board for this purpose, together with the strengthening of the corporate governance provisions and the Fit & Proper criteria, currently applicable. 

Timely regulatory intervention to put things right is profound, particularly in view of the track record of FI failures where the ultimate loser is the public who have reposed their trust in these institutions. 

(The writer is ex-Director of Bank Supervision and Advisor to the Governor of the Central Bank, an independent consultant on financial regulation and a freelance writer.)