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Public Enterprises Development Deputy Minister Eran Wickramaratne, who was previously a senior and professional banker, in this interview shares some key insights into corporate and boardroom governance issues in the financial services sector:
Public Enterprises Development Deputy Minister Eran Wickramaratne
A: John Exter in 1949 wrote in his Report on the Monetary Law Act of the Central Bank of Sri Lanka the following: “Banking is an economic activity which affects the public welfare to an unusual degree; it touches in one way or another, almost every phase of a country’s economic life. Sound banking is essential to healthy and vigorous economic development. Supervision of banks helps to protect the public against mismanagement, bank failures, and loss of confidence in the banking system. It helps to protect depositors and stock-holders against loss and frequently enables bank directors and officers to manage the affairs of their banks more wisely and intelligently.”
This statement clearly articulates the importance of regulation in the banking sector not only for financial stability but also for ensuring robust economic growth. The regulator, while encouraging banks to play a significant role in accelerating and sustaining the growth momentum, must also ensure that banks maintain adequate levels of capital to satisfy higher regulatory standards.
Corporate governance issues are also far more important in the banking sector than in other institutions, for two reasons. Firstly, it arises from the fundamental difference between banking institutions and other institutions, which is the intermediary role played by banks that depends primarily on public trust and confidence. Banks are typically highly leveraged on public deposits and unlike non-financial enterprises are funded mainly by depositors and not shareholders.
For example, in Sri Lanka, non-financial companies raise funds by borrowing from banks but this rarely exceeds one or two times the funds invested by shareholders. However, in the case of Sri Lankan banks that are privately owned, they borrow on average around 13 times the shareholder’s funds and mainly from depositors. This capital structure is also far riskier than that of non-financial institutions and the risks are mainly borne by depositors, while the rewards accrue to shareholders.
Secondly, banks play a vital role in money creation through the current accounts which they are permitted to operate. They also typically have a maturity mismatch between their assets and liabilities on their balance sheets. Consequently, they are vulnerable to various risks in their operations. For this reason, the banking industry is highly-regulated and is subject to a more stringent standard of integrity and professionalism in their operations.
A: Ensuring the quality and determining the degree of concentration of ownership structure in banks is an important element of ensuring high standards of corporate governance are maintained. Concentrated ownership is said to result in a better alignment of interest between shareholders, boards and management. However, this may be undesirable for two reasons. Firstly, there is a risk that a dominant shareholder will act in his own interests at the expense of both minority shareholders and depositors. This is especially risky if the owner has outside commercial interests which are funded by bank borrowings, as is usually the case.
The experience from the Asian financial crisis has taught us that having a few large shareholders representing a group of companies or a single family leads to them exerting control over the decision making and acting in their own interests at the expense of minority shareholders or other stakeholders. The risk could however, be mitigated if the dominant shareholder is an international institution or an investment fund with diversified investors. Secondly, where the bank needs more Tier 1 capital, a dominant shareholder may be reluctant either to infuse new capital or to dilute his/her own position by allowing others to do so. This reluctance can at best restrict the expansion of the bank and at worst, put its depositors at risk.
Consequently, in most banking legislation there are strict limits with respect to the ownership in banks. In Sri Lanka, according to the Banking Act Directions No. 1 2007 the maximum percentage of the share capital that can be held by a company, an incorporated body, or an individual in a licensed commercial bank incorporated in Sri Lanka is 10% of the issued capital of a licensed commercial bank carrying voting rights. However, in the case of a licensed commercial bank which requires restructuring to avoid inadequacy of capital, insolvency or potential failure, the upper limit may not be imposed, and the Monetary Board may grant permission for the acquisition of a material interest in excess of 15 per cent of the issued capital carrying voting rights in the licensed commercial bank, subject to the condition that the shareholding is reduced to 15% within a specified period as may be determined by the Monetary Board, on a case-by-case basis. [There was a restriction that required that the shareholding had to be reduced to the Monetary Board limit within five years but this was removed in an amendment to the Directions on Ownership of Issued Capital Carrying Voting Rights for Licenses Commercial Banks in 2009.]
It is therefore prudent, to maintain the single ownership limit at around 10% and to encourage banks to seek capital transparently on the markets. The regulator would need to exercise vigilance to ensure that these limits are adhered to by all entities, including the government and that parties are not allowed to act in concert to surreptitiously take control of ownership or boards.
A: The board of directors is mandated with the task of monitoring and providing strategic guidance to management and is the central governance mechanism in the banking sector. Appointment of competent boards with high standards of integrity is one precondition for a well-functioning, broad based banking system.
Recognising the enormous responsibility of directors on bank boards the Central Bank has laid down ‘fit and proper’ criteria in selecting directors to boards. There are exclusion criteria such as not having a conviction in a court of law, not being a defaulter, not having been removed or suspended by an order of a regulatory or supervisory authority from serving in a licensed bank or any other financial institution or corporate body, in Sri Lanka or abroad etc. But inclusion criteria are also imposed such as having relevant academic and/or professional qualifications and experience in banking, finance, business or administration or of any other relevant discipline, to ensure suitably qualified and experienced persons are appointed to boards.
In addition, Central Bank regulation requires that the board comprise at least three independent non-executive directors or one third of the total number of directors, whichever is higher. Further, the roles of chairman and chief executive officer are to be separate and should not be performed by the same individual. It is also expected that the chairman should be a non-executive director and preferably an independent director as well. Some private banks, such as the National Development Bank follow even stricter criteria requiring the chairman of the board to be an independent director as well. A few years ago there was an attempt to remove this requirement for the chairman to be an independent director, but it was opposed by the then government. The present government would go further an advocate that such a high level of criteria be adopted by other banks as well and also be included in the Directions issued by the regulator.
The appointments of directors to boards of banks should therefore, meet the minimum fit and proper criteria set by the CBSL at the least. These are not onerous and should be strengthened. However, banks seem unable to attract competent people in sufficient numbers to meet their needs. In Sri Lanka, there are around a dozen domestic banks and almost 50 non-bank financial institutions. If each board has an average of ten directors, you would need around six hundred competent professionals with no conflicts of interest to serve on these boards. Consequently, quality is compromised in the search for quantity. This is one more argument in favour of consolidation.
This also raises the issue of training for directors on bank boards. It is essential that training programmes on corporate governance practices be designed for directors of financial institutions. Through such programmes it would be possible to raise the quality of governance in financial institutions as directors become aware of their roles and responsibilities. These programmes would also be useful in fostering an environment where there is greater sharing and exchange of experiences and ideas among directors of financial institutions.
A: I must admit that we have fallen short in fulfilling all criteria in some appointments that have been made. The Central Bank has refused to approve a couple of appointments including the chairman of a small State-owned bank. The person concerned has appealed to the regulator to reconsider his suitability based on facts provided. In the event the Central Bank does not change its original position, be assured that we are committed to upholding the position of the regulator.
I must mention that during the period of the previous Government there were unfit and improper persons who were appointed to bank boards. One such appointment that comes to mind was made to the Commercial Bank Board, where an individual with a past judicial stricture was appointed. Today, the regulator can act independently. Things are certainly changing for the better. Any attempt by individuals, a shareholder or vested interest to circumvent regulation will not be tolerated.
A: Financial institutions play a vital role in the economy which requires them to balance between multiple objectives of growth and profitability as well as stability and innovation. The unique role played by financial institutions in the economy lends itself to excessive risk taking by these institutions in the expectation that they would be bailed out by the government (or the taxpayer) in the event of failure – a classic moral hazard problem. Corporate governance frameworks need to address these issues while paying attention to the challenges that may arise going forward from the greater role played by the banking sector in facilitating economic growth; continuous financial innovation and increasing complexity of financial systems; as well as tightening global regulations.
The evidence is overwhelming that the cost of dealing with failure in the financial system is much higher than the cost of prevention. However, the principles of good governance cannot be achieved only by regulation. These principles need to be embedded in the culture of institutions and societies. Only then will it be possible to see real and sustainable change.
