Principles of central banking 2: Governance of central bank boards

Monday, 19 August 2013 00:00 - - {{hitsCtrl.values.hits}}

Trust of people comes from good governance of bank boards In the principles of central banking 1 published two weeks ago, it was pointed out that central banks have been brought into existence by societies and not by governments or politicians with a single objective to attain. That objective is to preserve the value of the money which a central bank is mandated to issue for use by society’s members. It was mentioned that the value of money has to be preserved because any erosion of the value means that people would be losing the value of their wealth and therefore, it amounts to a betrayal of the trust which they have placed in central banks. This trust, it was further mentioned, is built not by the state ownership of central banks or the laws by which they have been established, but by the professionalism, integrity and adherence to good governance by those who run central banks. Of those who run central banks, the most important category is the board that manages central banks on behalf of societies. Monetary Board has to deal with monetary affairs In most cases, the governing board of a central bank is called ‘the Board’ as in a normal corporate body or ‘the Monetary Board’ as in the case of Sri Lanka which is rather an uncommon appellation. The term ‘monetary’ has been added to the name in the latter case to emphasise its role as the protector of the value of money. John Exter, Founder Governor and architect of Sri Lanka’s central bank, has elaborated on this in the report he submitted to the government on the establishment of a central bank in Ceylon, known as the Exter Report, as follows: “The word ‘monetary’ in its name emphasises again that the board is intended to be very much more than simply the board of directors of another bank. It is a governmental agency responsible for the determination of a particular kind of policy – monetary policy – and the regulation of a particular kind of economic activity – money, banking and credit.” (p 11). Even after the Central Bank’s mandate was expanded in 2002 to include financial system stability as a co-objective, it still carries its appellation ‘monetary’ before its name, somewhat a misnomer from its current range of activities. Boards should be made up of people with diverse knowledge The governing boards of central banks are normally made up of non-executive members drawn from a pool of experience in banking, economics, trade, commerce and industry. The objective is to draw on the rich experiences of each other to steer the policy of central banks towards the effective attainment of their goals and objectives. However, in some cases, deputy governors who are full-time executives of central banks have been made board members, but they are always outnumbered by the non-executive members appointed from outside. Hence, in banks, where the majority rule constitutes the decision making criterion, the appointment of deputy governors, who are a minority, does not add value to the policymaking of a central bank. Thus, in countries like Sri Lanka where deputy governors are not vote-carrying board members but are only in attendance at board meetings, an opportunity is provided for board members to consult them on important policy issues. However, for deputy governors to perform this job effectively, they should be well versed in all aspects of central banking and global developments, in addition to having a detailed institutional memory which the board can tap into whenever it has doubts about any policy action being contemplated. Big or small, all boards have to serve society There is no uniform practice with regard to the size of a board. It ranges from five members, as in Sri Lanka, to 14 members as in the newly established central bank in Croatia. A smaller board poses issues such as the non-availability of a sufficient number of members for appointment to board committees that look at auditing, risk management, remuneration and nomination aspects of central banks. A bigger board does not pose this issue but raises its costs and brings in inconvenience to its operations. The costs would become a crucial factor in countries where board members are handsomely remunerated: Kenya’s US$ 1,200 as against Sri Lanka’s about $ 100 per member per month. As for inconvenience, large boards have also posed the problem of assembling all the board members for meetings and getting them to contribute effectively during deliberations. Consensus is not the best at all times The general consensus is that the size of the board does not matter, as long as each member functions independently and casts his vote after making an objective and impartial analysis of the issues concerned to the best of his professional ability. What this means is that board members, while working as a team, should act as independent and individual defenders of the money they have issued. However, Sri Lanka does not follow the practice of majority decision making but endeavours to attain consensus on matters placed before the board. From the point of view of governance, this practice has strengths as well as weaknesses. The strength is that it makes all members equally accountable for the decisions of the board. Hence, even if a single member does not agree, it gives another chance for the board to reconsider the matter and review it in more detail before making a decision. The weakness is that it disregards the differences of opinion which members as human beings should naturally have when seeking to attain consensus on all matters. Treasury Secretary: Should or should not be on the board? In many countries, a Treasury official, usually its head, has been made a member of the board with voting power. In Sri Lanka, it is the Secretary to the Treasury who is also the Secretary to the Ministry of Finance who has been made a member of the board. This practice has been criticised widely on account of the conflict of interest it has brought to the central bank boards. The conflict is that the Treasury Secretary might seek to override the decisions of the board in order to compel a central bank to provide funds for the government budget when the bank is required to do the opposite to keep inflation low and thereby protect the value of wealth owned by people. John Exter: Treasury Secretary should be a conduit John Exter, who provided for this arrangement in Sri Lanka’s central bank, expected the Treasury Secretary to function as the conduit between the central bank and the government: The Treasury Secretary is expected to convey the views of the Minister of Finance to the other members of the board (p 13). Exter had thought that such an arrangement would establish effective cooperation and coordination between the central bank and the government based on the maturity of the people who occupy the top position in the Treasury as well as in the central bank. In other words, what he had expected was that the Treasury Secretary should appreciate and respect the job of the central bank and the other members of the board should appreciate and respect the plans and the goals of the government. Exter era permanent secretaries could demonstrate maturity This type of governance based on the maturity of people holding positions and not well defined demarcation of authority is not a satisfactory arrangement at all. At the time John Exter made his recommendation, the Treasury Secretary was called the Permanent Secretary to the Ministry of Finance and he enjoyed a fair degree of autonomy and independence from the political authorities. There are numerous examples of even prime ministers respectfully listening to the wise counsel made by permanent secretaries of those golden years. In one case, a prime minister bypassing the subject minister had requested a permanent secretary to forward a file concerning the award of a tender to him. When the Prime Minister was reminded that he did not have authority to see that file by the Permanent Secretary concerned, it is reported that the Prime Minister had thanked the Permanent Secretary for correctly guiding him and tendered an apology for unknowingly overstepping his authority. Thus, a Permanent Secretary at that time could function independently of the political authorities and could have demonstrated the maturity which Exter expected of a civil servant serving on the Monetary Board. Republican Constitution has made permanent secretaries impermanent However, in the 1972 Republican Constitution, secretaries were brought under the control of the Cabinet of Ministers and in 1978 Constitution, they were brought under the exclusive powers of the President. Thus, even if the secretaries do want to function independently like mature people, today’s constitutional provisions do not permit them to do so. As a consequence, the cherished principle of maturity which John Exter incorporated into the Monetary Board of Sri Lanka’s Central Bank has become irrelevant since even the most mature civil servant serving on the Monetary Board cannot act against the wishes of his political masters. If the political authorities do want to implement vote catching expenditure programs generating inflation, the Treasury Secretary or the other members of the Monetary Board could do a little to safeguard the value of money. Three pillars of independence of a central bank In order to serve the societies well, the governing boards of central banks have to function independently. There is a dilemma here because in a sovereign state there cannot be another sovereign body. However, the sovereign has to recognise the need for a central bank to function independently in the following three areas to build people’s confidence in the bank, its money and eventually in the whole economy:

Policy independence (often called operational independence) – that is to take policy without being influenced by the government.
Budget independence – that is to have its own budget independent and separate from the budget of the government.
Key person independence – that is, the governor, deputy governors, board members and other key personnel should have job security and could be removed only under specific circumstances and by following specific procedures.

A grey area of central bank independence The Central Bank of Sri Lanka enjoys a fair degree of all these three types of independence as per the provisions of the Monetary Law Act. However, with the establishment of an all-powerful executive presidency under the 1978 Republican Constitution, it has now become a grey area where political interferences cannot be kept out of the operations of a central bank. This writer recalls that during that golden era, a Governor of the Central Bank could remind the Minister of Finance that the latter did not have authority to review or approve the list of officers to be appointed to the Central Bank. To the credit of the Minister, when this communication was received, he accepted it with all humility and did not seek to contest it or bring in new laws to permit him to give directions to the Central Bank. In terms of the current Republican Constitution, the Secretary to the Treasury does not have job security; similarly, several incidents that have taken place since 1978 have posed serious questions about the job security of the other key personnel of the Central Bank though their jobs have been protected by law. Importance of governance of central bank boards The governance principles which a central bank should follow have been presented as follows:

The rules and practices that govern the relationship between the board of a central bank and its stakeholders should be clearly stipulated. The stakeholders are the public, financial institutions, foreign agencies, employees and the government and the opposition members.
The adoption of good governance principles by a central bank board underpins the market confidence, financial market integrity and economic efficiency.
It provides an objective measurement criterion for benchmarking of institutional structures, helping to improve legal, institutional and regulatory framework.

Governance requirements The following five areas would, therefore, fall on the governance framework of the board of a central bank:

Addressing failures – that is, taking action regarding the poor information flows, bad communications and inadequate understanding of risks.
Improving the quality of structures and management at all levels of the bank.
Making the best use of bank’s assets, resources and intellectual capital.
Understanding and managing risks faced by the bank.
Communicating with the stakeholders the performance of the bank through regular and pre-announced communication actions and taking stewardship of the operation of the bank.

The role of the board is therefore to oversee the main operations of a central bank and ensure that the bank is accountable to its stakeholders for all the actions it takes. Then, it follows that the board should have a proper disclosure policy and should also endeavour to maintain consistency and transparency in its actions. A board member should answer to ‘the call of his conscience’ In summary, the good governance means that the board should be guided by self-imposed principles that are based on an ethical and moral framework that could be well understood by all those concerned. Each board member, individually and collectively, should ask the question whether he or she does the right thing in the right manner to provide the service which the stakeholders expect of him or her to do. If he or she is satisfied that he or she has fulfilled this requirement, then, the board as a whole has followed good governance principles. ABC of a governance code It, therefore, requires a board to:

Communicate fully the true meaning of all its actions, their desirable consequences and any undesired side effect that may follow out of its actions.
Accept failure whenever such failure occurs and ensure the stakeholders that it would take the necessary corrective measures promptly to eliminate or minimize the damage.
Clarify all issues, answer all criticisms and maintain full transparency in all its actions.
Consider and treat critics, however illogical their criticisms may be, as beneficial factors rather than enemies.
Document every action clearly and comprehensively so that posterity could learn of the rationale and the process of such action without any ambiguity.
Practice what it preaches to its customers and stakeholders.
Put all board members on a continuous learning path in order to acquire the knowledge necessary for them to perform the duties which societies have entrusted to them.
Recognise that they serve the societies and not the political masters who have appointed them.
What this means is that a central bank board should be a leaning body and it should set an example for others to emulate by following good governance principles of its own.

(W.A Wijewardena can be reached at [email protected] )

Principles of central banking 2: Governance of central bank boards

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