Annex 10.C Financial Sector Governance—Selected Issues
Financial sector governance refers to (a) corporate governance of financial institutions and other market participants (e. g., issuers, service providers), as well as governance arrangements for financial sector regulatory agencies, and (b) the nexus of relationships among institutions whereby quality of governance of one institutional segment affects the other. Although quality of financial sector governance will ultimately be conditioned by the overall public sector governance, several key issues arise in assessing and strengthening financial sector governance. First, how well have the components of existing supervisory standards that deal with regulatory governance been implemented in practice? And what is the effect of regulatory governance on the overall effectiveness of supervision and soundness of the financial system? Second, has the governance of financial institutions (particularly banks) required additional controls and safeguards over and above the normal corporate governance practices and standards that apply to non-financial firms? Third, how should regulatory governance and regulatory policies in individual sectors be adjusted to help strengthen and reinforce corporate governance of financial institutions? This last issue has been given prominence in a recent research (see Barth, Caprio, and Levine 2004). Finally, how should policy makers encourage regulated financial institutions to exercise greater focus on the quality of governance of their counterparties (financial and non-financial firms, household, and government)?
Regulatory agency governance can be defined, similar to the definition of public sector governance in Kaufman (2002), as (a) the capacity of the agency to manage resources efficiently and to formulate, implement, and enforce sound policies and regulations and (b) its ability to carry on its mandate consistent with the broader goals and policies of the government and legislature. Regulatory agency governance can be assessed in terms of four key attributes that determine its “capacity” and “ability” to carry out its objectives effectively. Those attributes are independence, accountability, transparency, and integrity.
In the presence of several regulatory agencies and oversight bodies, the overall regulatory governance (not simply the internal governance of a single agency) will also depend on interagency governance arrangements, including division of responsibilities among oversight agencies, as well as information exchange and communication arrangements. The existing supervisory standards cover those elements in varying degrees of depth. The clarity of its mandate, the ability to carry out its mandate through appropriately designed instruments without undue interference, and the legal identity of the agency are among the factors that govern independence. Accountability of the agency to the body that had delegated the responsibility—the government or the legislature—and to the courts and the public (stakeholders) helps to add credibility and reinforce independence.
Transparency means that the agency’s objectives, frameworks, regulatory processes and accountability arrangements, and internal processes to ensure integrity are all disclosed to the public in a comprehensive, accessible, and timely manner. Integrity of the agency is ensured by mechanisms such as procedures for appointment and removal of management, internal audit arrangements, standards for the conduct of staff members’ personal affairs to prevent conflicts of interest, and the legal protection for staff members in discharging their official duties in good faith. Finally, the combination of information exchange and coordination arrangements among various sectoral supervisors and oversight bodies raises issues relating to the optimal design of institutional arrangements for supervision, as discussed in appendix F, Institutional Structure of Financial Regulation and Supervision.
Recent experience with assessments of observance of the core principles relating to regulatory governance across sectors shows that, in most countries, the principles are well implemented, except in the case of the insurance sector, where compliance was relatively low compared with other sectors (banking and securities). Main weaknesses observed were related to regulators’ independence; lack of clarity of regulators’ objectives and accountability arrangements; regulatory forbearance, sometimes reflecting lack of legal protection for the regulator; and lack of clarity with respect to the responsibilities of the regulatory body and self-regulatory organizations (see IMF 2004). Also, quality of regulatory governance affects financial system soundness, as illustrated in Das, Quintyn, and Chenard (2004).
In light of the systemic stability concerns associated with the commercial banking functions, supervisory authorities typically place emphasis on additional safeguards to enhance corporate governance of banks. For example, the Basel Committee on Banking Supervision has issued a range of guidance documents, including “Enhancing Corporate Governance for Banking Organizations” (Basel Committee on Banking Supervision 1999b), that bear directly on various aspects of internal governance of banks. The relative emphasis on official regulation and supervision, on the one hand, and corporate governance and market discipline aspects of supervised institutions, on the other hand, varies among countries, in part, reflecting the structure and state of the financial system and, sometimes, the level of systemic stress in the system. Thus, the supervisory approach toward enhanced corporate governance of banks varies over time and across countries. Similarly, the appropriate approach to strengthening governance of non-bank financial institutions is a recurring theme in the design of regulatory policies for non-bank financial sectors, including securities markets and their institutions (see Litan, Pomerleano, and Sundararajan, 2002). In addition, emphasis on disclosure standards for banks under Pillar
III of the New Basel Capital Accord is designed to strengthen governance of, and market discipline on, banks.
Several regulatory authorities, notably the Reserve Bank of New Zealand, place great emphasis on adjusting their supervisory approaches to ensure that corporate governance of banks and market discipline are strong. Those adjustments have been achieved through the following means:
• Holding directors responsible and requiring them to attest to accuracy of disclosures and to quality of regulatory compliance
• Ensuring adequate representation of non-executive independent directors, with a separation of board chairman and chief executive
• Requiring directors to avoid individual and collective conflicts of interests
• Ensuring rigorous internal and external audit arrangements, with external auditors having a measure of independence
• Enforcing regular, timely, comprehensive, meaningful, and reliable financial and governance disclosure
• Promoting incentives for market scrutiny of banks through contestable banking; equal competition between banks and non-banks; limited (or absence of) deposit insurance; and equitable loss sharing among all creditors, depositors, and shareholders
The extent to which financial institutions exercise influence on corporate governance of counterparty institutions, particularly non-financial corporations, also will vary a great deal across countries, but certain policies can make a difference. First, sound principles of risk management and asset selection promoted by the regulator could include adequate attention to corporate governance of counterparties. Second, corporate governance policy that is used by major institutional investors in guiding their asset allocation could be highly effective. Finally, the insolvency and creditor rights regime and other supporting institutional arrangements for bad debt resolution and asset management could provide powerful incentives for banks to exercise due diligence on counterparty credit risk and for debtor institutions to exercise good governance. The governance arrangements and governance nexus would, of course, change in times of crises, with relative roles of regulatory and oversight agencies, as well as the intrusiveness of official supervision and regulation changing rapidly to ensure stability.
7. The IASB is an independent, privately funded organization that is based in London and that sets accounting standards. The board members come from nine countries and have a variety of functional backgrounds. The IASB is committed to developing—in the public interest—a single set of high-quality, understandable, and enforceable global accounting standards that require transparent and comparable information in general – purpose financial statements. For additional information, see http://www. iasb. org.
8. The IFAC is an international organization for the accountancy profession. It works with 157 member organizations that represent 2.5 million accountants in public practice, industry and commerce, government, and academia. Its stated overall mission is to serve the public interest, to strengthen the worldwide accounting profession, and to contribute to sound economies by establishing and promoting adherence to high-quality professional standards, thereby furthering the international convergence of such standards, and by speaking out on public interest issues where its expertise is relevant. International Standards for Auditing (ISAs) are issued by the International Auditing and Assurance Board (IAASB), which functions as an independent setter of standards under the auspices of IFAC (see http://www. ifac. org).
9. See IASB (2004) for a list of IASs with summary descriptions of each standard.
10. See IFAC (2004) for a full listing of code of ethics ISAs and other engagement standards.
11. The ROSC Web site posts details of the accounting and auditing assessment tools and published country modules and these are available at http://www. worldbank. org/ifa/ rosc. html.
12. Currently, no international regulatory standards exist for A&A, although efforts to address this gap are under way. In the absence of regulatory standards, Bank staff members draw on their own experiences and international best practices.
13. This section is based on Artigas (2004), a paper from Financial Stability Institute.
14. For example, Standard & Poors may put a country on “credit watch,” whereas Moody’s puts a country “on review for possible upgrade/downgrade,” and Fitch issues “alerts.”
15. For a recent example of corporate governance assessment undertaken as part of FSAP, see IMF (2003c).
16. This governance nexus—whereby the broader governance arrangements, financial supervisory policies (affecting governance of supervised financial entities), and policies of supervised financial entities themselves (affecting nonfinancial firm governance) interact with one another—is explored in Litan, Pomerleano, and Sundararajan (2002).
17. Fremont and Capaul (2002); for empirical evidence that investors would be prepared to pay a premium for companies exhibiting high governance standards, see Newell and Wilson (2002) and Bhojraj and Sengupta (2003).
18. When ROSCs are prepared in the context of an FSAP, they may also be published—at the initiative of the authorities—as part of the FSSA report of the IMF.
19. See, for example, Nier and Baumann (2003).
20. See section 10.5.2 for a discussion of disclosure standards in the new capital accord.
21. Compliance with Basel Core Principle 21 requires that the supervisor has the authority to hold management responsible for ensuring that the financial statements issued annually to the public receive proper external verification. However, it does not
indicate that the supervisor has the authority to require that the financial statements be disclosed. An additional criterion indicates that the supervisor promotes periodic public disclosures of information that are timely, accurate, and sufficiently comprehensive to provide a basis for effective market discipline. Therefore, at most, if financial statements are not disclosed, assessors would note it in the comments to the principle. See Basel Committee on Banking Supervision (1999a).
22. See “New Zealand: Financial System Stability Assessment” (IMF 2004b).
23. See, for example, Basel Committee on Banking Supervision (1998), Basel Committee on Banking Supervision (1999c), and Basel Committee on Banking Supervision (1999d).
24. See Basel Committee on Banking Supervision (2003b).
25. For example, compliance with Core Principle 21 may be affected, even when the supervisors exercise comprehensive powers to enforce wide-ranging disclosures, if the underlying accounting standards were to deviate from international norms.
26. See United States Securities and Exchange Commission (2001) and United States Securities and Exchange Commission (1997).
27. See Section 10.1 on MFP transparency code of good practices for a discussion of transparency of aggregate information. The Financial Stability Reports published by various central banks (see, e. g., http://www. bankofengland. co. uk/financialstability/index. htm) include aggregate information on regulated financial firms.
28. See Basel Committee on Banking Supervision (2003a).
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