Why Corporate Governance is Important in Financial Industry Finance Essay

Corporate governance is most often viewed as both the structure and the relationships which determine corporate direction and performance. The board of directors is typically central to corporate governance. Its relationship to the other primary participants, typically shareholders and management, is critical. Additional participants include employees, customers, suppliers, and creditors. The corporate governance framework also depends on the legal, regulatory, institutional and ethical environment of the community. Whereas the 20th century might be viewed as the age of management, the early 21st century is predicted to be more focused on governance. Both terms address control of corporations but governance has always required an examination of underlying purpose and legitimacy. (James McRitchie, 1999) Corporate governance is important for all organization not only today but has and will always be. However, it is specifically very important for the financial industry due to various reasons which will be discussed subsequently. The Organization for Economic Cooperation and Development (OECD) suggests sound corporate governance of financial institutions need to be in place in order for banking and financial supervision to operate effectively. Consequently, banking supervisors have a strong interest in ensuring that there is effective corporate governance at every bank. Supervisory experience underscores the necessity of having appropriate levels of accountability and managerial competence within each bank. Essentially, the effective supervision of the international banking system requires sound governance structures within each bank, especially with respect to multifunctional banks that operate on a transnational basis. A sound governance system can contribute to a collaborative working relationship between bank supervisors and management. The following are some of the factors that deem it necessary to have very good corporate governance in financial institutions: Financial firms are "opaque" in nature and gives rise to significant information asymmetries. This makes it difficult to assess management performance. Current deregulated nature of financial institutions have made the nature of the activities of employees and managers moved from traditional activities toward decision-making activities. This has created greater potential for risk and results not expected or desired by shareholders and other stakeholders. Governance is an activity in which communal benefits resultant from private supervisory in the finance industry plays a dominant role. Limitations such as on takeovers, ownership concentration, prudent supervision, etc. could weaken product market discipline. This could further lead to weakening of the private sector's undertaking other governance functions. Financial firms hold equity stakes, grant credit and, hence, examine performance, which facilitates them to make a strong impact on governance of other institutions. Financial innovations potentiality weakens traditional governance processes. The role of banks is integral in any economy. They provide financing for commercial enterprises, access to payment systems and a host of a variety of retail financial services for the economy as a whole. Some banks even have a broader impact on the macro sector of the economy by facilitating the transmission of monetary policy by making credit and liquidity available in different market conditions. The integral role that banks play in the national economy is demonstrated by the almost universal practices of states in regulating the banking industry and providing, in many cases, a government safety net to compensate depositors when banks fail. Financial regulation is necessary because of the multiplier effect that banking activities have on the rest of the economy. The large number of stakeholders, whose economic well-being depends on the health of the banking sector, further depends on the appropriate regulatory practices and supervision. Indeed, in a healthy banking system, the supervisors and regulators themselves are stakeholders acting on behalf of society at large. The primary function is to develop substantive and other risk management procedures for financial institutions in which regulatory risk measures correspond to overall economic and operational risks faced by a bank. Accordingly, it is imperative that financial regulators ensure that banking and other financial institutions have strong governance structures, specially, in light of the pervasive changes in the nature and structure of both the banking industry and the regulation which governs them. In this respect, the role of legal issues is crucial for determining ways to improve corporate governance for financial institutions, such as, the enforceability of contracts, including those with service providers, clarifying governance roles of supervisors and senior management, ensuring that corporations operate in an environment that is free from corruption and bribery and laws/regulations, etc. aligning the interests of managers, employees and shareholders, all help to promote a strong business and legal environments that support corporate governance and related supervisory activities. Further, corporate governance is very important to financial institutions in the present context is post-crises situations. The financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements. When they were put to a test, corporate governance routines did not serve their purpose to safeguard against excessive risk taking in a number of financial companies. A number of weaknesses have been apparent. The risk management systems have failed in many cases due to corporate governance procedures rather than the inadequacy of computer models alone: information about exposures in a number of cases did not reach the board and even senior levels of management, while risk management was often activity rather than enterprise-based. These are board responsibilities. In other cases, boards had approved strategy but then did not establish suitable metrics to monitor its implementation. Company disclosures about foreseeable risk factors and about the systems in place for monitoring and managing risk have also left a lot to be desired even though this is a key element of the Principles. Accounting standards and regulatory requirements have also proved insufficient in some areas leading the relevant standard setters to undertake a review. Last but not least, remuneration systems have in a number of cases not been closely related to the strategy and risk appetite of the company and its longer term interests.

Question - 02

Why do Islamic banks need to give special care to corporate governance and what advantages does it provide to them?

Answer - 02

Very little is written on governance structures in Islamic banking, despite the rapid growth of Islamic banks since the mid 1970s and their increasing presence on world financial markets. There are now over 180 financial institutions world-wide which adhere to Islamic banking and financing principles. These banks operate in 45 countries encompassing most of the Muslim world, along with Europe, North America and various offshore locations. Islamic financing increasingly is a market segment of interest of Western banks and the latest addition to the list of Islamic banks in October 1996 in the City Islamic Investment Bank, Bahrain a wholly owned subsidiary of Citicorp. Islamic banking represents a radical departure from conventional banking and from the viewpoint of corporate governance, it embodies a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements from the basis of Islamic financing. Due to the bank dealing in Riba, an Islamic bank cannot charge any fixed return in advance, but rather participates in the yield resulting from the use of funds. The depositors also share in the profits according to predetermined ratio, and are rewarded with profit returns for assuming risk. Unlike a conventional bank which is basically a borrower and lender of funds, an Islamic bank is essentially a partner with its depositors, on the one side, and also a partner with entrepreneurs, on the other side, when employing depositors' funds in productive direct investment. These financial arrangements imply quite different stockholder relationships, and by corollary governance structures, from the conventional model since depositors have a direct financial stake in the bank's investment and equity participations. In addition, the Islamic bank is subject to an additional layer of governance since the suitability of its investment and financing must be in strict conformity with Shari'ah and expectations of the Muslim community at large. Islamic financial institutions display key distinguishing features requiring special care when it comes to the corporate governance mechanisms. They are as follows: Stakeholders include large number of depositors and their deposits are not guaranteed. Islamic banks operate on the model of universal banking. This is very close to the deregulated banking system. Financial activities are spread over a large spectrum from the usual customary traditional finance. Islamic financial institutions holding equity would enable them to sit on various companies Board of Directors. Thereby they could influence corporate governance mechanisms of the latter. Corporate governance and ethical standards provides many an advantage to Islamic banks. If an Islamic financial institution practices very good corporate governance, it helps them to build a good and strong brand image. Through this good and strong brand image they are able to attract a higher customer base leading to higher and greater customer loyalty. Once they have captured the customers' loyalty, there is greater commitment towards the employees. Once the employees are given greater commitment they become passionate and drive with a lot of creativity. Having large amounts of creativity in a very competitive and volatile environment can drive an organization to have immense competitive advantage.

Question - 03

Why do banks need to be regulated and supervised? What are the key tasks facing regulators for creating a level playing field for Islamic banks within a country's overall regulatory framework that includes the operations of conventional banks?

Answer - 03

A logical first reason is that a strong and adaptable banking system helps the monetary authorities to carry out monetary policy, that is, to implement decisions about money supply and interest rates. In this sense, regulation is a "public good", because everyone benefits from an effective monetary policy. A second more practical reason relates to the unique nature of the business of a bank. The business of a bank can for argument's sake be reduced to, on the one hand, the taking of deposits from the public and, on the other hand, the lending of those same funds to others at a profit. The liabilities of banks, namely the deposits held on behalf of clients, are generally short term and certain in amount - the bank must repay the full amount from its resources. The assets of a bank, namely the loans made, are generally longer term in nature, but actually uncertain in value - the bank can never be sure that the debtor will repay the loan over the specified period. The nature of a bank's business is therefore inherently highly risky, and poor decisions can easily lead to the demise of a bank and the loss of depositors' funds. When this happens, often the confidence in the banking system is harmed, and, in order to avoid this, public funds are sometimes used to save an ailing bank. Either way, the cost of a bank failure to society as a whole is often higher than the private cost (that is, shareholder losses), which is a compelling reason for supervising banks to ensure that they are always prudently managed by competent, experienced and ethical individuals. Another reason why banks are usually regulated is the asymmetry of information - that is, the unequal availability of information to all interested parties. Depositors do not have sufficient information about the true risks that a particular bank faces, and whether the risk they take in placing their money with the bank is commensurate with the interest to be earned on the deposit. A final reason for the regulation and supervision of banks is to protect depositors against unscrupulous organizations that misrepresent themselves as banks and unlawfully collect "deposits" before absconding. All developed countries, and less developed countries, have a banking supervisory authority. Although the principles are largely the same, supervisory authorities may differ regarding their degree of autonomy, relationships with other financial regulators, and supervisory approaches or methods employed. Central Banks and Regulators could play a crucial role in the development of a framework for Shari'ah compliant monetary policy instruments to operate within a level-playing field. Supervisors are faced with a dual challenge. One hand, they promote financial diversification and consolidation to achieve market development and on the other side they have to position themselves to recognize new dimensions and new types of risks and encourage appropriate risk mitigation plans. Regulators need to practice flexibility and work with Islamic banks such as to become well acquainted with needs of the industry and subsequently develop successful and acceptable regulatory frameworks. Further, regulatory authorities and market participants should be very well-versed with the nature and implications of the rules adopted in jurisdictions where there are heavy constraints on Islamic finance operations. This would facilitate greater market discipline and no undue burden on the Islamic financial institutions. Therefore, regulatory and supervisory authorities operating in dual banking systems, i.e. conventional as well as Islamic, should be mindful of setting up regulatory frameworks, since they should be pragmatic and flexible in internationally accepted prudential and supervisory requirements. According to Shari'ah principles, Islamic banks cannot guarantee repayment of full amount of deposits, in Western countries requiring that deposits have to be returned in full. In Muslim countries separate regulations have been developed to allow banks to share the risk of loss on investments with their clients. The final solution was to structure a Mudharabah agreement whereby savings and deposit/investment accounts in such a manner that FSA was satisfied that the risk of loss of amount deposited by the depositors was minimal. Key features included a bank setting aside reserves earned from investment in special reserve accounts before the distributing of profits to the depositors. This reserve was further to be used to cover any losses that arose from investments. Another feature was allowing depositors decide if they wanted capital losses to be made good. A depositor complying with Shari'ah principles would not require such losses to be made good. The Islamic Financial Services Board (IFSB) was established with the aim to promote the development of a prudent and transparent Islamic financial services industry and provides guidance on the effective supervision and regulation of institutions offering Islamic financial products. The IFSB has produced international standards on capital adequacy and risk management for Islamic Financial Institutions, and has made progress in developing standards on corporate governance. These international standards are intended to assist regulators and supervisors in pursuing soundness, stability, and integrity in the world of Islamic finance.

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