«They say things are happening at the border, but nobody knows which border» (Mark Strand)
by Deepankar Sharma
Abstract: The financial instability in the banking sector of any country marks a beginning of broader existential crisis for the maintenance of economic growth rate which may lead to plethora of problems viz. mounting bad loans, un-availability of finance, instable economic ecosystem causing unemployment etc. The backbone of the financial crisis is often adduced to the crucial factor of rising bad debts (Non- Performing Assests) which hamper the governance and management of fiscal stimulus at micro level i.e. within banks and at macro level as well. The root cause of this giant going beresk is the non-compliance of corporate governance mechanisms within the banking institutions as mandated by the government and Reserve Bank of India.
This paper discusses the key ingredients required for effective corporate governance in the banking sector and best practices. This paper highlights the corporate governance mechanisms followed largely in India in the banking institutions. In this backdrop this paper, refers to the arrangements that companies, including banks, have in place for their internal governance, including in respect of the identification, monitoring and management of their risks. Although the paper discusses corporate governance as it applies to any corporate entity, the principal focus of the article is on corporate governance within banks and other financial institutions thereby covering the major guidelines issued by Reserve Bank of India in this regards.
Summary: 1. Introduction. – 2. Types of Risk Involved in Banking Institution and ways to manage the Risk. – 3. Role of Regulator in Risk Management in Banking Sector. – 4. Mechanism of Corporate Governance Framework in Indian Banking Scenario. – 5. Analysis of Regulatory Framework of Corporate Governance in Indian Banks. – 6. Recommendations. – 7.Conclusion.
1. The main object of corporate governance in banks is to protect the interest of the stakeholders from risk. “Risk is effect of uncertainties on the objects which is followed by coordinated and economical application of resources to minimize, monitor and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities” .Effective corporate governance helps in proper allocation of responsibility and authority to board and senior management who carry affairs of business.
Board is responsible for identifying risk at early stage and thereby assess consequences of risk and ways in which it can be avoided and therefore selecting best measures for avoidance of identified risk. Risk management in banking institutions and thereby bringing good corporate governance culture in banks is also governed by OCED Principles which are followed in various regulations of government. Types of risk involved in banks and regulations governing risk management practice in India and obligation under OCED Principles are focused for assignment.
2. It follows the types of Risk Involved in Banking Institution and ways to manage the Risk.
1. Liquidity Risk: It occurs mainly in the scenarios when a bank fails to honour its commitment due to unavailability of funds or inability to mobilize resources for conducting day-to-day operations.
Management of the risk: The banks try to mitigate this risk by fixing a limit on inter-bank loans and through the Board supervision by having timely information on the liquidity prospects of the bank.
2. Interest Rate Risk: It occurs when the interest rate changes unexpectedly thereby collaterally affecting the market equity of the bank.
Management of the risk: This risk is mitigated by refering to BCBS Principle, where the earning prospect becomes the benchmark parameter. In economic prospective impact is analysed on expected cash flow. The role of board here would be to setup the mitigating alternatives through policy driven mechanism.
3. Market Risk: This risk is prominent in India as in recent times the forex value of Rupee has been fluctuating on dynamic basis.
Management of the risk: For managing market risk ALM framework is used. Under this three pillars are set i.e. ALM Information System which includes management information system and information availability system, accuracy adequacy etc. ALM Organisation in which top management and structure and responsibilities are involved and ALM Process includes risk parameters, identification, measurement and management.
4. Credit or Default Risk: Credit risk refers to the inability of the bank to meet its credit supply obligations. It refers to trading concerns where the borrower fails due to market restrictions beyond his control.
Management of the risk: Effective risk management framework will comprise of:
• Policy and Strategy: Board of directors of bank have to review and approve credit risk strategy and polices on periodical basis. Policy approved by board has to be communicated to branches of bank so that all officials of bank could understand approaches for sanctioning of credit and ensure accountability. Responsibility of credit risk polices will be on senior management of the bank.
• Organisational Structure: In sound structure there board of directors must have responsibility of management of risk. Risk management committee will be board level committee in which CEO, head of credit, operation and market committees will be there which will be working in coordination with each other. It will have to accept recommendation of committee and in case of denial rational for same is required and then served to internal and external auditors.
5. Operational Risk: It refers more to the behavioural approaches where either the people or the process in the setup itself has failed the system. The elements of frauds and non-adherence to guidelines are the triggers for the same.
Management of the risk: Impact assessment and constant review & supervision of internal control systems may help in mitigating such kinds of risks.
Role of Reserve Bank of India: Grown complexities of banking due to deregulation and changes in behaviours of consumer resulted in ineffectiveness of control system. In order to deal with increasing level of risk RBI set guidelines to bank on risk management in 1999 under which banks are required to distribute the out flow and inflow in different maturity periods.
Reserve Bank of India has put responsibility of management of risk on board of directors who are required to take active part in risk management polices and also in setting liquidity limits, foreign exchange rate, equity price risk and interest rate. Assets Liability Committee (ALCO) has been introduced by the RBI as top most committee to oversee implementation system by ALM system. It carries out function of considering product prices for advances and deposits, desire profile of maturity of incremental assets and liabilities along with monitoring level of risk in banks. It also carries out function of articulation of current rate of interest and to make it for decision making for future business strategies.
CAMLE Model is also adopted in which there are six components namely Capital Adequacy, Asset Quality, Management, Liquidity and Earnings Quality which are focused for effective risk management in banking company. RBI realigned entire supervisory mechanism to Board of Financial Supervision. Supervisory and regulatory supervision of RBI has also been widened in which financial institutions as well as non banking financial companies. Onsite supervision system is also developed in which assessment of core nature is carried on as per statutory mandate i.e., liquidity, solvency, management prudence and operational soundness. Due to recent trends of competition, financial integrations and globalisation one site supervisions is replaced by offsite supervisions by Board of financial institution so that risk can be identified at early stage. Offsite system involves asset quality, large credit and concentration, capital adequacy, earnings and risk exposures viz., currency, connected lending, liquidity and interest rate risks. Financial analysis of stock of bank in secondary market is useful source used for knowing financial performance of bank.
Basel Committee: It is a primary global standard settler for regulation of banks on supervisory matters and it has issues guidelines on the basis of OCED Principles for effective corporate governance in banks. Basel Committee on Banking Supervision is focused towards making banks more sensitive towards risk since most important reason of risk are breakdown of internal control and corporate governance. Committee has identified major breakdown like lack of control culture by management, inadequate risk assessment of certain banking activities, lack of communication between different levels of management and inadequate monitoring and audit programme. Use of internal system is allowed in order to measure risk and thereby allocating capital accordingly. Three pillars are developed with as view to maintain financial stability in banks. These include Minimum capital requirements, supervisory review process and market discipline. Under pillar of supervisory review process necessity of exercise of internal assessment is recognised in order to ensure that the management is exercising the strong judgment and has kept the capital for various identified risk in advance. Board has been entrusted with responsibility of business strategies and financial soundness and they must in exercise of these responsibilities have to adopt duty of care and diligence. They must be engaged in actively in affairs of bank and must monitor implementation of risk measures effectively. Board must also set up good corporate culture by setting corporate values and by promoting the risk awareness in a strong risk culture. Board should ensure that professional codes of conduct are duly followed.
3. Role of RBI is indispensible in current risk management of banking institutions in India. It is true that risk cannot be eliminated from banking activities but same can be eliminated and for effective elimination of risk in banking institution RBI has introduced various regulations which apply to both public and private banks equally. With help of RBI only entire Indian banking system is professionally managed and proper risk management are adopted at individual banks levels. Above discussed regulations of Basel and its committee’s role of board of directors have been explained clearly and they are put in centre of governance of banking system. There are various models that have been suggested for effective management of credit risk in bank like “Internal Rating Based” in which focus is to be drawn on various factors that causes threat of risk in banking system. So present in built risk control system are equally strong for both private sector banks and public sector banks.
4. RBI normally follows threefold mechanism of corporate governance in supervising the banks’ compliance, which is:
1. Disclosure and Transparency System:
The most emphasized mode of governance used in Indian legal system for regulating the banks is seeking timely, uniform and transparent disclosures. According to the standard operating procedures, the RBI vests with the power of imposing and levying heavy fines in case of non-compliance with the disclosure norms. Most recently RBI used such power to penalize a co-operative bank based out of Hyderabad, Telangana under the section 47A (1) (b) read with Section 46 (4) of the Banking Regulation Act, 1949 (As Applicable to Co-operative Societies), for violation of Reserve Bank of India directives and guidelines on loans and advances to directors and their relatives and in other similar matters.
2. Surveillance Based System (Off-Shore)
The main object to be achieved from such surveillance is to analyze the financial health and position of the target bank in between two on-site supervisions. Therefore the idea of off-shore inspection was initiated by RBI in the year 1995.
3. Prompt Action Based Sytem
As is the case with most sectoral regulators even RBI is involved in the process of taking prompt actions based upon breach of trigger points like issues of rising NPAs (Non- Performing Assets) in form of bad loans. This action include the issuance of mandatory action plan to the entire sector in form of guidelines and discretionary plans which are issued to the target bank or specific banks depending upon the financial deterioration and lapse of the existing internal control systems like failure of board etc.
Therefore, the special nature of banking institutions necessitates a broad view of corporate governance where regulation of banking activities is required to protect depositors. However, while maintain the effective supervisory role and compliance to internal control systems, excessive pressure on the banks would lead to slowdown of financial transactions and economic development. Hence the best way is to pull-up the responsibility ratio of the Board of such so that the internal autonomy and governance are simultaneously balanced.
5. The continuous breakout of frauds in banking sector in India has shown shabby nature of compliance with corporate governance mechanisms in Public Sector Banks (PSBs). The fraud patronage by PNB officials in irrational and fraudulent issue of Letter of Undertakings (LOUs) to companies controlled by Nirav Modi, has shaken investors’/depositor’ confidence. This makes it imperative for us to analyze the existing legal framework for governance and prevention of fraud/mis-management in banks in India.
Numerous committees have put forward the recommendations on this pertinent issue:
P.J. Nayak Committe Report (2014)
• Public Sector Banks (PSBs) are bound by the directions issued on timely basis by Ministry of Finance in India.
• Reserve Bank of India remains the only regulator of all banks including PSBs.
• The private banks and PSBs are ideally designed to be put at equal pedestal if the governance and reforms are concerned thereby granting more autonomy to the Board.
• A Banking Investment Company (BIC) is designated to be incorporated which will hold all the shares of Public Banks.
• Till the formation of BIC, an autonomous recommendatory body called Bank Board Bureau should assume the functions of BIC.
It is further to be informed that BBB started its operational activities from April 1, 2016.
Bank Board Bureau’s Compendium of Recommendations (2018)
• The concept of regulations without pertaining to ownership has to introduced where the government continues to have its holdings in the banks.
• The harmonious interpretation of banking statutes incorporating such banks with Companies Act, 2013 has to be drawn but in conflicting scenarios the Companies Act shall prevail.
• In the context of pure banking operations Banking Regulation Act, 1949 will remain the guiding force.
World Bank – Detailed Assessment of Observance—Basel Core Principles for Effective Banking Supervision (2018)
• RBI is the legal regulator as well for the PSBs.
• RBI has no say in removal of Board Directors.
• RBI continues to have little say over risk management, profile assessment and compensation procedures.
• RBI should be vested with full powers to act as effective regulator for PSBs which would in turn ensure parity between private and public banks.
The governor of RBI, Mr. Urjit Patel also emphasized upon the same in speech on the RBI’s perspective of PNB loan fraud. In order to advise it on the matters of high divergence observed in asset classification, various incidents of fraud, RBI appointed a committee under the chairmanship of Mr. Y.H. Malegam which is due to present its report till the date of the writing of present research paper.
6. Risk is indispensible in banking sector and timely and proper assessment of risk can only be helpful in making effective risk avoidance decisions by board. Board is using magnitude of risk and thereby making strategies for good corporate governance in banks.
Acceptance of Basel Accord II by the RBI is a move towards more effective risk management since it is focused on enhancing risk sensitivity of capital requirement, promoting coverage of comprehensive risk and more flexible approach by board members. Board must follow consistently various principles that are stated there in Basel to bring good corporate culture in bank and mitigating risk in effective and efficient manner.
In addition to this, in order to improve governance an ownership neutral law is supposed to be brought into place which brings both Public Sector Banks and Private Banks at equal footing which would inherently mean the application of stringent norms without exception which otherwise is granted to PSBs as a course of routine rather than exception.
The Government of India should necessarily take a strategic decision of transiting its holdings of PSBs into Banking Investment Company as proposed by P.J. Nayak Committee at a faster pace which would in turn be governed by Independent Board for which an exception may be added in the Companies Act, 2013.
The use of ‘Prescriptive Approach’ of corporate governance should be brought into the fold of banking sector which would require banking institutions, to prescribe as mandatory rule, the organizational structure, designated officers (which may help in fixing the criteria of Officer in Default as per the Companies Act, 2013) and secure the personal accountability of conduct and internal grievance redressal.
Under the framework of risk mitigation, RBI should aim to reinforce the Master Direction on Frauds whereby the regulation 8.3 consisting of Early Warning Signals (EWS) and Red Flagged Accounts (RFA) be made integral part of Board’s report and the loan accounts threshold for the same be lowered to Rs. 500 Million as the lower trenches of loan default make a huge chunk of NPAs in the current system.
7. The depositors should be made feel protected to sustain relation and rule based banking. The idea of prudential regulation may come to good rescue in this cause but all these criterias can be compromised in wake of ill-informed disclosures and mismanagement tendencies creating operational cartels. The nature of bank holdings and the strenuous relationship of the sector with the government also adds upon the existing conflicts and in such loomy scenario the RBI may come to its rescue by being the regulator and occasional mediator.
This paper in its length has targeted the aspects of continuous maintenance of high governance standards which was envisaged at the time of inception and referred by Mr. Rahul Bajaj Chairman of CII Task Force on Desirable Governance Norms. The plethora of problems are not present because of faulty system but the paper concludes by suggesting that they in fact remain in existence due to highly technical rule based process with equally less favourable compliance appreciation.
Deepankar Sharma is Assistant Professor of Law at School of Law, Manipal University Jaipur. He is also designated as Visiting Scholar at City University of London (UK) & Visiting Research Associate at University of Hong Kong (HKU). He is also the member of International Editorial Council of BRICS Law Journal (SCOPUS Indexed & UGC Approved). He is also an Arbitrator at Dubai International Arbitration Centre (DIAC).