Corporate Governance and Internal Control

Corporate Governance and Internal Control Banking Supervision Seminar Paris October 7-18, 2002 Alain Laurin Banque de France

Corporate Governance A System Composed of Key Players Management Internal control Board of Directors Audit Committee External auditors Supervisors Other players (market discipline)

Definitions • CORPORATE GOVERNANCE: “a system of checks and balances which promotes a healthy balancing of risk and return” • INTERNAL CONTROL: “systems established in order to provide reasonable assurance of effective and efficient operations, reliable financial information and reporting, and compliance with laws and regulations”

Is there a "One Model Fits All" for corporate governance? ? ? ? ? ?

Corporate Governance and Capital Structure I State-owned banks II Private-owned banks III Listed banks

I. Corporate Governance and State-owned Banks • Leading role assumed by management and to a lesser extent by shareholders • External auditors will have the tendency to overvalue the implicit/explicit guarantee of the State • Banking supervision as last line of defense

II. Corporate Governance and Close Capital Banks • Management has no autonomy vis-à-vis the shareholders • Bank supervisors must closely supervise those banks • External auditors • Market discipline might have a significant impact depending on circumstances

III. Corporate Governance and Listed Banks • All building blocks are likely to be in place: • Shareholders • Audit committee • Management • Market discipline • External auditors • Bank supervisors

“Checks and balances performed by several players should trigger more efficient operations which will result in healthier institutions”

We Can DistinguishFour Distinct Environments 1. Asia 2. Europe 3. Anglo-Saxon countries 4. Emerging economies

1. Asia • Large and small diversified shareholders • Close links, cronyism, corruption • Corporations/banks/governments • Tightly held and family control • Absence of minority protection leads to ….. • Lack of market discipline • Poor governance

2. Europe • Strong institutional framework • Swift enforcement and creditor protection • Weak capital market and limited disclosure • Strong role for banks and institutional investors leads to ….. • Reasonable control • Reasonable governance

3. Anglo-Saxon Countries • Strong equities markets • Generally good information • Good contractual enforcement • Effective boards • Take-over a real threat leads to ….. • Competitive markets • Good financial arbitrage • Really good governance

4. Emerging economies • Poor legal environment • Weak enforcement • Little transparency • Few financing alternatives leads to ….. • No checks and balances • Concentration of powers

Asian and Emerging Economies • Need substantial improvement to ensure: • Effective minority protection • More transparency and disclosure • Swift contractual enforcement • Efficient allocation or resources • Availability of finance for development

OECD Report on Corporate Governance The “wise men” reporting to OECD suggested 25 “desirable objectives” centered on: • Public policy improvements(Principles 1 to 20) • Self-improvements(Principles 21 to 25)

Public Policy Improvements (Principles 1 to 20) • P1: Flexible, adaptive governance • P2: Structures avoidance of undue interference • P3: Regulatory intervention limited to ensuring “fairness, transparency, accountability, responsibility” . . . . . continued

Public Policy Improvements (Principles 1 to 20) Fairness • P4: Clear, consistent, enforceable securities and capital markets regulations designed to protect shareholders rights • P5: Protection against litigation abuse • P6: Enforceable contractual relationship • P7: Eliminate impediments to active shareholder participation • P8: Elimination of corruption and bribery . . . . . continued

Public Policy Improvements (Principles 1 to 20) Transparency • P9: Accurate and timely disclosure • P10: Consistent, comparable disclosure • P11: Ownership disclosure • P12: Continuing disclosure improvement . . . . . continued

Public Policy Improvements (Principles 1 to 20) Accountability • P13: Corporate governance legal standards • P14: Shareholder protection • P15: Independent corporate boards • P16: Sound audit practices • P17: Investor competition . . . . . continued

Public Policy Improvements (Principles 1 to 20) Responsibility • P18: Law abiding corporation • P19: Individual welfare • P20: Income and opportunity divergence

Self-improvements(Principles 21 to 25) • P21: Clearly and honestly stating their true and sincere corporate objectives • P22: Recognizing and establishing the importance of governance and competition • P23: Articulating governance best practices as they apply in the local context . . . . . continued

Self-improvements(Principles 21 to 25) • P24: Ensuring competent and effective control by an independent board of directors • P25: Establishing voting as the effective and ultimate democratic right and asset of shareholders

How can bank supervisors contribute to enhancing corporate governance? Effective regulatory framework and market discipline will not emerge in a vacuum • Hence supervisors must : • Check internal checks and balance • Verify independence and professionalism of auditors • Ensure adequate disclosure of information by banks

Basel Committee Guidelines • Why focusing on internal control? • Principle 14 aimed at ensuring a sound and reliable internal control system

Corporate Governance and Lending Activities • Board of Directors: Sets strategy and policies, etc.; direct involvement of the board if deemed necessary in specific areas (large exposures) • Management: Compliance with and implementation of agreed strategy and policies • Audit Committee and Internal control: Check compliance and report to the Board on internal policies, compliance with laws and regulations, weaknesses and means to remedy them . . . . . continued

Corporate Governance and Lending Activities • Auditors: Financial statements, loan portfolio review • Supervisors: Design of regulatory framework, dissemination of best practices and review of all of the above

What Internal Control System Should Not Be: • Internal control functions exclusively performed by a special unit • Internal control essentially dealing with accounting issues • Internal control mainly focusing on compliance with laws and regulations • A “model”

What Is Internal Control? • A process • A culture • A concern shared by all players in and outside the bank • An instrument to capture evaluate and monitor risks • Customized to specific needs

Main Objectives of Internal Control • Efficiency and effectiveness of operations • Reliable financial reporting • Compliance with laws and regulations

Building Blocks • Management oversight • Risk assessment • Control of activities • Information and communication • Monitoring activities

Management Oversight • Board of Directors and senior management must promote an environment in which internal control is effective : • Codes of conduct (business practices, ethical values,etc) • Documented organizational structures • Job description

Risk Assessment • Senior management must assess the factors both internal and external that may affect the achievement of goals; the review should include the full range of risks incurred by the bank in the course of its activities, namely: • credit risk, • market risk, • liquidity risk, • interest rate risk, • operational risk, etc.

Control of Activities • A structure that fits the need of the organization: first degree, second degree, etc. (daily, weekly, or monthly) • Part of daily operations • Procedures set up for each business level, system of approval and authorization, verifications and reconciliation • Segregation of duties

Information and Communication • Information is the main raw material in banking activities; thus information is to be: • Relevant • Timely • Accessible • Provided in a consistent format • The quality of information requires adequate and reliable IT systems which need to be regularly tested

Monitoring Activities • The internal control should be under close scrutiny by competent and trained staff; in large organization this may lead to set up of special unit • This unit should report to the Audit Committee or the Board • This unit has to work closely with other departments and external auditors

Board of Directors • Regarding internal control the Board should : • Have periodic discussions with the senior management about the effectiveness of the system • Review assessment of internal control made by internal/external auditors • Ensure that management will follow-up on recommendations expressed by auditors

External Auditors Since external auditors must make a judgment on financial information disclosed by banks, they cannot overlook the effectiveness of the internal control system; even though their role may vary from a country to another, external auditors will: • Review the procedures for measuring and evaluating risks • Formulate an opinion on the quality of information • Will benefit from assessing the internal control in order to draw the most reliable conclusions, as examinations are made on a test basis

Banking Supervisors • Supervisors should ensure that all the five components are operating effectively • Supervisors should ensure that banks have an effective system of internal control that is consistent with the nature, complexity and risk of their activities . . . . . continued

Banking Supervisors • On-site examination should assess the internal control system; the testing should encompass: • adequacy of and adherence to procedures, limits • accuracy and completeness of management reports • If appropriate, this evaluation might trigger a more intense supervision

Costs vs. Benefits • Benefits will overweigh costs if: • Internal control is part of daily operations and not viewed as an administrative burden (bureaucracy) • Level of controls are properly combined (excess of controls is likely to result in inhibition of initiatives and innovation) • Internal control help managers mitigate risks and eventually boost profitability

Corporate Governance and Internal Control