Internal Governance for Financial Institutions
Internal Governance for Financial Institutions
--Peter Lo
Chief Country Officer
Hong Kong, Deutsche Bank
Good morning,
I am pleased to be part of this important forum and to be speaking on the topic of internal corporate governance in financial institutions today.
With businesses in 74 markets globally, Deutsche Bank operates in an environment of wide cultural diversity, broad ranging regulatory regimes and countries at varying stages of economic development. Yet the internal governance programme we operate in each of those markets is the same across the globe. It is this central commitment to one best practice internal governance model, which binds all our business units together in these disparate jurisdictions, and gives our shareholders, staff and many regulators– full confidence in our institution. Importantly it is one of the reasons that gives Stand & Poors the confidence to rate Deutsche Bank a AA+ credit, which is vitally important to our funding cost.
So as you can see best practice in internal governance is critically important to us in operating as a unified entity to all our stakeholders as well as being good for business.
But what is good internal governance? Actually the origin of the word ‘governance’ that provides a useful metaphor. The word ‘governance originates from the latin word gubernare, which refer to steering a ship.
Put simply, good internal governance binds the elements of business regulation, law, codes of conduct, process guidelines, competitive practice and ethics together. However too often good internal governance can be confused with simply taking measures to satisfy regulators and government or as a compliance exercise.
True internal governance, at best practice, can only be achieved through a transparent process of rigorous independent checks and balances, robust systems and expert review, all implemented in an environment of strict integrity, where all aspects are open for rigorous debate and scrutiny. Thus good internal corporate governance is not simply a way of achieving a paperwork trial, or systems to focus on financial performance or compliance with local regulation - but rather a culture focused on overall success. Success in delivering commercial and financial stability, profitability and in attracting customers, quality staff and investors.
The market environment
The complexity of the task in achieving a culture of good internal governance in a competitive global environment is significant. The main issues in relation to internal governance for institutions who are expanding their footprint, is because of global macro management strategic outlooks, a tendency to emphasize top down rather than bottom up corporate governance models and the challenge of fundamental corporate governance differences in many jurisdictions.
Since the 1988 Basel Committee’s Capital Accord the regulatory environment for corporate governance has significantly changed for the better and financial institutions operate in an environment that has never been more demanding and well defined – both in the external and internal processes of governance. This is particularly the case because of the high level of adoption of these standards by global regulators in developed and developing countries for the Banks under their control. The Basel accord set the stage for an alignment of the capital requirements for Banks that competed across national boundaries. As a result guidelines for internal controls and procedures had to become far more closely defined.
Since the first Accord, the environment in which financial services organizations operate has changed significantly. Markets have opened up, such as China, products such as derivatives and structured product have developed that have increased the complexity of measuring and managing market risk. To meet these changing situations international banks have also made progressed significantly in developing sophisticated internal controls to measuring, managing this risk. I think it is true to say that following the corporate governance issues that were highlighted in recent years in America, there is a far higher level of acceptance of public and corporate acceptance of the value of high levels of good governance.
Efforts by regulators to meet the changing market environment resulted in The Basel II framework and it is this framework which has had the greatest impact on the process to internal governance. This second accord sought to harness, into the supervisory process, best practices in risk management and market discipline. Being more sensitive to risk in approach the latest framework rewards stronger and more accurate risk management, while aligning the capital requirements of banks to their risk appetite. For many Banks the implementation of internal governance measures to meet the second accord has proved to be a significant challenge and placed heavy demands on internal resources and tests to systems. However the resulting disciplines reward through greater stability, higher ratings, lower cost of funds and an increase in market valuation.
Management responsibility
Ultimately of course, the greatest weight of responsibility for a company’s internal governance structure and implementation is on management. The legal responsibility falls to them to guide the most important elements of successful internal governance – namely to ensure that the following key elements are present in making the system and review process robust.; Firstly -
· Independence and perspective
Independent impartial input, review and perspective are vital when reviewing internal controls. In many organizations divisional management, dominant personalities and commercial interests can often cloud decision making. Only strong impartial independent review by those empowered to accept, reject or demand changes can achieve a meet the challenge of implementing appropriate internal governance practices.
· Transparency
Clear documentation of processes and responsibilities for accountability, reporting and escalation procedures is critical. Decisions and actions must be clearly visible to those charged with review both internally and externally such as auditors and regulators.
· Prudence
Financial and strategic goals must be achieved in an environment where risk and reward are carefully evaluated, quantified and monitored. Returns generated in an environment of prudent risk management procedures and controls, and sound capital management practices.
· Due diligence
Management must spend time to closely question and rigorously ‘test’ established and proposed internal processes. Independent experts should be consulted and a genuine level of review with a ‘skeptical’ and challenging of systems and procedures.
.. and finally
· Appropriate expertise
There is little value in having a world class system in place without the expertise to oversee it. In the world of finance this can be a problem for independent directors. The business of finance has become increasingly complex, derivatives trading and structured products put layer upon layer of additional complexity into the system requiring very specialist expertise to be brought to bear in evaluating internal systems and procedure – particularly in the area of risk management.
The human element
The one element that in my view overrides all others in the successful implementation of internal good governance is the integrity of staff. It is the most important component of any internal governance programme and yet it is easiest to underestimate and the hardest to control. Recruitment of quality staff, that have strong values and integrity, and investment in training those staff to understand the importance and relevance of core values in their daily business is the glue that binds all other elements of a successful process together.
One only has to read the media reports of rogue traders, or sharp practice within organizations that has led to not only financial loss but tough punitive action from regulators. Many of these situations have not occurred in small organizations or in organizations with poor overall practices, they have occurred through a lack of personal integrity for an employee or group of employees.
Training in ethics and the consequences of the personal actions of employees is an important part of modern corporate governance. Many companies including Deutsche Bank heavily promote the ‘values’ of the company to their employees and make ‘living the values‘ and important part of daily work life. In the case of Deutsche Bank it is embedded into the Bank’s human resources system and process of ongoing employee evaluation.
In some developing countries, corruption and sharp practice still remains a problem making it a real issue for global organization looking to conduct business in these countries. This is particularly the case for those subject to global regulatory supervision, with the onerous penalties that can bring for misconduct through inadequate controls. We have found that the single most critical aspect to mitigating risk in countries where this remains a problem lies beyond merely installing and closely monitoring world class systems. It is in the management of our human resources – from very stringent and thorough hiring processes, to ongoing staff training and development.
Comment on India and China
Before I sum up today I will touch on the two big developing markets - India and China. In these markets the issues of strong internal governance in the financial services sectors will play a critical role in how fast the markets continue to develop and prosper, what extent foreign investors will participate and how the global markets will value them.
Both India and China have recognized the need to rationalize their non performing loans in the banking sector and are making significant progress toward reducing these. In both cases the issue of non performing assets has a strong connection with internal governance practices.
In opening up to foreign competition and seeking to compete at international best practice, there is a huge amount of work to be done in changing the culture within major public sector banks in both countries, to one of greater accountability and transparency. International banks seeking direct investment in domestic financial institutions in China and India will play a very positive role in lifting internal compliance and governance practices in both countries in the medium term. This will be through management experience, the application of systems, training and also through improved technology.
Banks in both countries will benefit from the process of engagement with Banks at best practice level through;
· Improved loan diversification
· Better quality lending and processes of risk scoring
· Improved credit monitoring
· Reduced operating costs through the upgrading of technology
· Improved market risk management
· Reduced impact of operational risk through systems of measurement, mitigation and insurance
The level of involvement of international banks, increasing competition and the will of regulators to make internationally competitive and robust markets has already seen levels of governance improve dramatically.
Conclusion
In conclusion - As the financial services marketplace effectively becomes globalised in practice rather than in principle, the pressure on financial services institutions to compete in every respect has led to a significant improvement in global internal governance standards. This combined with more stringent approach to regulatory management through the Basel accords and other local improvements in Asia following the Asia crisis, has changed the expectation of governance practice of all key constituents.
The broad level of awareness from depositors, investors and regulators about the potential issues arising from lax practices in internal governance has never been higher.
Investors are more international looking and have in recent years brought their demands and expectations to the Asian region.
Banks is Asia and globally can clearly see that good corporate governance can only be achieved through the recognition that that the culture of governance, risk management and internal controls is not one that can be paid lip service to, either internally or with regulators. Good international governance practices have become an economic imperative which local and international shareholders demand, and where directors and managers are becoming more and more directly accountable. In an environment of increasing complexity and competition, where financial transparency and integrity is prized, financial institutions who do not embrace internal corporate governance at global best practice level will simply not survive.
