COVID-19 and Corporate Governance in Banks and Financial Institutions: What the RBI Needs to Do to Ensure Financial Stability
Like our own Reserve Bank of India (RBI), central banks worldwide are worried about the impact of COVID-19, as it is an extremely severe and unprecedented health and economic crisis impacting the world. COVID-19 perhaps represents the most serious test of the global financial system after the 2008 (global) financial crisis. Without a doubt, it represents a huge fundamental threat to financial stability in many ways. That said, what can central banks like RBI do to ensure that financial stability is not seriously threatened?
As noted in a previous article
, one key action by the RBI especially during the COVID-19 crisis and thereafter is, to ensure that there are clear regulatory (and supervisory) standards with regard to appointments, roles, compensation and evaluation of boards of directors and that these are followed at the implementation level, which are essential components of good corporate governance.
That said, what exactly does the RBI need to do to ensure this, both during and after the COVID-19 crisis? Here are some basic suggestions:
First, the RBI must ensure that the functions of the chairmen of the boards of directors and managing directors (or chief executive officer or equivalent) in banks and FIs—where they are together—are separated. But that alone is not enough. The RBI must also mandate that qualified outsiders occupy at least one of these posts—and this rarely happens.
This is critical to the regulatory and supervisory framework, and when implemented it should result in dispersed power, especially when the founder-promoter is the chairman and/or managing director. Much of the excessive risk-taking that occurred during the lead up to the past crises happened primarily because there was no one on the board to seriously question the enthusiastic and entrepreneurial promoters and CEOs occupying one or both of these positions.
Second, the RBI must ensure that there is a transparent board recruitment (or appointment) policy that clearly specifies the duties and profiles of the bank and FI directors, including the chairman. The RBI must also mandate that directors have adequate skills and experience (apart from the availability of time to do their job).
Additionally, the overall composition of the board of directors of the banks and FIs must be suitably diverse to include more women, youth, clients (or their interest groups), and individuals with the requisite skills (but possibly different backgrounds) in the board. This is perhaps a way to improve the board’s overall functioning and effectiveness.
Most importantly, the RBI must ensure that conflict of interest issues are taken into account with regard to board appointments through a formal conflicts of interest disclosure policy, so that the independence of the directors is not compromised.
Accordingly, third, the RBI must ensure that bank and FI boards develop a formal conflict of interest policy and implement the same as part of their functioning. Such a policy should ideally include: (a) a director’s duty to avoid (if possible) all activities and transactions that could either create a conflict of interest or even the appearance of a conflict of interest; (b) a transparent set of processes and procedures for directors to follow before they engage in certain types of activities (such as agreeing to serve on the board of another bank/FI or that of a lender or an investor, etc.) so as to ensure that such activities will not create a conflict of interest; (c) a director’s duty to disclose any activity and issue that may result, or has already resulted, in a conflict of interest; (d) a director’s (voluntary) responsibility to abstain from voting on any matter where the director may have a conflict of interest or where the director’s objectivity/ability to properly fulfill duties to the bank/FI may be compromised; (e) adequate procedures and clear norms for transactions and activities conducted with related parties on an arms-length basis; and (f) transparent procedures by which the bank/FI board will deal with the issue of any noncompliance with the conflict of interest policy.
Ideally, it would be good for the conflict of interest policy to provide specific examples of where and how conflicts of interest can arise when serving as a board member of the bank/FI. This should facilitate greater understanding of conflict of interest issues, with regard to financial services delivery in general and the bank/FI in particular.
Fourth, the RBI should provide a clear definition of who is an independent director. There is lack of clarity on who is an independent director in terms of objective criteria such as age, expertise, and experience, as well as having had past relationships with the same bank/FI (which can result in significant conflicts of interest). Therefore, regulatory guidelines from the RBI regarding the definition of independent directors would be very useful and these guidelines must be implemented in real time on the ground.
Fifth, transparent RBI guidelines regarding the appointment of independent directors mustbe formulated. It seems appropriate to vest the powers of appointment of new, independent and executive directors in accountable board nomination (and remuneration) committees (at banks/FIs), which must be a mandatory requirement for all types of banks/FIs. These committees should follow a transparent process and lay down clear steps and criteria for selecting board members.
Further, an independent director must chair the board nomination committee so that truly independent candidates are hired to the bank/FI board, and the climate for their real independent functioning is ensured. Promoters (founder chairman, managing director etc) and CEOs should not be allowed to be part of the board nomination committees—this clearly needs to be mandated by the RBI.
Sixth, the practice of the CEO (or (founder chairman, managing director etc) hiring board/independent directors in many banks/FIs must be discontinued by the RBI. In many banks/FIs, the promoter who is (often) also the CEO hires the board and this practice needs to be questioned from the perspective of implementing corporate governance directives on the ground.
The key question here is whether a board hired by the promoter/CEO (of a bank/FI) can really be independent in terms of its functioning? The related issue is how such boards can be expected to perform the roles they are supposed to in terms of safeguarding the interests of various stakeholders, including minority shareholders? So, this is an aspect worthy of RBI’s attention.
Seventh, the RBI must mandate time to be spent by independent directors on work at banks/FIs. Independent directors should be required to spend a certain minimum time working at the bank/FI and especially in the field at the operational level. As an industry observer argues, “independent directors should be made to devote a certain minimum number of hours every quarter (or regular period) so as to understand the business and gain insights about the bank/FI in which they are serving as directors.
This will enable them to examine the risks being taken and the appetite of their bank/FI to take such risks as well as understand and provide guidance on other strategic aspects, as may be required.” This again should be specified by RBI which must also strive to educate the boards and senior management of banks/FIs to follow this in practice.
Eighth, the RBI should also specify the number of bank/FI boards on which an independent director can serve concurrently. When there are people who, at any one point in time, serve as independent directors on several bank/FI boards, the quality of directorship is likely to suffer. Furthermore, having the same set of people serve as independent directors across bank/FI boards could also result in cabal like behaviour as well as create significant conflicts of interest.
It may therefore be appropriate for RBI’s regulatory framework to recommend a threshold level for the number of banks/FIs in which people (professionals) could serve as independent directors and supervisors must ensure this in real time during implementation. This is a critical aspect. Specifically, limiting the number of bank/FI boards on which a director may sit to not more than three at any given point in time appears prudent from a regulatory standpoint. This will hopefully afford directors the time and space to understand how the banks/FIs, on whose boards they serve, are actually performing on the ground.
Ninth, peer appraisal of independent directors must be made mandatory by the RBI. Peer appraisal should enhance the effectiveness of independent directors (in their work). While such an appraisal process would need to be managed with associated sensitivities, board members should also view this as an opportunity for continuous learning and improvement.
Traditional methods of evaluation (in terms of share valuations/prices and strategy initiatives) would perhaps need to be augmented by a formal and objective appraisal of the independent directors’ performance with regard to governance (in terms of various parameters). Such an appraisal should enable identification of gaps in governance, enhance the decision-making process and improve the effectiveness of board meetings and various processes at the banks/FI. This is also an aspect that could be looked at in the context of banks/FIs by the RBI.
Tenth, the regulatory framework must ensure a compulsory formal evaluation of the functioning of the bank’s/FI’s board of directors by an external independent evaluator, at least once in two years. This is a critical issue and the results of this evaluation should be made available to shareholders and regulatory and supervisory authorities—officially publishing this evaluation (on their website) is an aspect that could also be considered by the banks/FIs concerned.
This formal evaluation of the board should preferably be done in the absence of the CEO (or found chairman or promoter) or managing director, so as to ensure that the exercise is a free, fair, and independent one. The services of independent evaluators—individuals and/or institutions who have not had (or do not have) a material relationship (as defined in common parlance) with the bank/FI—could be taken in this regard. Reputable management schools and institutes could also be actively involved in these (evaluation) processes.
Eleventh, the RBI must also facilitate capacity building of first-time (independent) directors. This is another critical area often ignored. There is the need for continuous education programmes for independent directors, especially for entry or first-time (independent) directors. The RBI must use its developmental role to create an environment for such capacity building.
Twelfth, the RBI must allow for suitable compensation of bank/FI board members for their time but should not permit their working on the basis of award of stock options or other such mechanisms that invariably encourage undue or excessive ‘risk’ taking, as was witnessed during the past crises.
Even if the law permits this, it seems prudent not to remunerate board members through stock options and the like, as the independence of (independent) directors may be seriously compromised. Past crises clearly demonstrate the fact that independent directors who had been so compensated had not performed their fiduciary and other duties appropriately.
The key issue to note here is that many of the crises occurred because board members and senior management were compensated heavily (in the short term through stock options and the like), whereas the risks of their strategies could be known only in the medium/long term. This mismatch created a huge incentive for excessive risk taking, which, in turn, led to the crises. Furthermore, the RBI must ensure that compensation of independent directors be entrusted to the board nomination and remuneration committee.
The framework must also mandate that promoters/CEOs (or promoters or founders) do not interfere in setting and implementing norms of compensation for independent directors as well as the senior management. Such regulatory guidelines in this regard will ensure that the real independence of the independent directors is not compromised under any circumstances.
Thirteenth, the RBI must make it mandatory for bank/FI boards to set up a risk management committee and establish clear rules regarding the composition and functioning of this committee, including the number of meetings to be held in a year. In addition, it must make it compulsory for one or more members of the audit committee to be a part of the risk management committee and vice versa.
Further, the chairman of the risk management committee should always report to the annual general meeting (AGM) and outline the role that directors have played in shaping the bank’s/FI’s risk profile and strategy. Also, the risk management committee should frame a ‘risk control declaration’, which should also be published to ensure its wider dissemination and use—both within and outside the organization.
The promoter or CEO or founder should not be part of the risk management committee, which should be primarily comprised of independent directors. The recent 2018 case of IL&FS—where despite a five-star board and high profile risk management committee, no meeting of the committee had been held for over three years from 23 July 2015—again makes it necessary for regulators and supervisors to closely monitor the accountable functioning of the risk management committee in bank/FI boards.
Fourteenth, the RBI must protect client interests on the bank/FI board. Thus, it should mandate that there need to be specially designated independent directors, representing client interests. We have directors in banks representing staff interests and the same could be done to safeguard client interests. Similar to compensation, this is an important issue in bank/FI governance.
Thus, the RBI must ensure that banks/FIs carry an obligation for a specific duty (‘duty of care’) to be established for the board of directors so that they take into explicit account the interests of various stakeholders (including shareholders and clients) during the decision-making procedure. This is especially critical, and the past crises would perhaps not have occurred, if only boards of banks/FIs had exercised such a duty of care that explicitly looked after the interests of shareholders and clients. Therefore, there is a clear need to incorporate a duty of care—especially with regard to shareholders and clients—among bank/FI boards and this is very, very essential during this COVID-19 crisis.
And RBI’s supervisory authorities must ensure that these are implemented on the ground.
Thus, while enhancing the integrity of independent directors would surely sanitise governance and thereby bring about financial stability, especially during the stressed times of COVID-19, there is also a right mindset aspect that we should not forget. The RBI and the regulatory ecosystem must encourage and incentivize people to have the right governance mindset. Here, the least we can do is incentivize good governance and, perhaps, penalize bad governance, and do this consistently and without fear or favour.
For this, we need a practical guiding (regulatory and supervisory) framework pertaining to the points noted earlier. This is something that the financial service sector in many countries including India needs desperately as it is rather low on its governance quotient, because of the repeatedly occurring past crises and events. The RBI needs to keep this in mind as well.
You may wonder why I have dwelt so much on the topic of independent directors. One of the most critical reasons for the importance attached to the topic of independent directors in any organization (including banks/FIs) relates to conflicts of interest.
There are several issues here: (i) Conflicts of interest hinder judgment and affect decision-making; (ii) judgment and decision-making are what directors are asked to do; and (iii) directors must feel free to think, express, question, and decide in the interest of those they represent.
All of these apply very much to banks/FIs as well, who, during the past few years, have received a lot of negative publicity with regard to corporate governance, conflicts of interest and the role of independent directors on their boards.
In fact, the debate has now widened to encompass not only the roles of independent directors but also that of nominee directors from FIs, and several questions continue to be raised regarding real and potential conflicts of interest on the ground. The IL&FS case of 2018 is an appropriate example here, as governance and the roles of independent and nominee directors on its board have come under strong focus and continue to be debated and discussed.
To summarize, for the financial services sector that has experienced many a crisis, corporate governance has never been more important than now, especially in times of COVID-19. Corporate governance is not just the responsibility of an individual bank/FI. Rather, it is the collective responsibility of all the individuals who become directors on the boards of a bank/FI and serve together and this applies to all banks/FIs in the wider financial sector.
While we can have norms and guidelines for corporate governance, unfortunately, they cannot be effectively enforced through regulation alone. They need to be practised at all times (including difficult circumstances) and that is where the individual initiative of directors (serving on bank/FI boards) does really matter. I sincerely hope that directors on bank/FI boards ensure that this happens in real time on the ground—by enabling and facilitating their boards to reorient their functioning in the light of the suggestions made.
In the Indian scenario, if this happens, many of the ills plaguing the financial services sector and banks/FIs will slowly but surely start to vanish and we will begin a purposeful journey towards a stable, accountable and inclusive financial sector. Along with good governance, good practices in the governance of compensation, risk management and audits are also critical for the traditional and new age FIs (especially FinTech entities) and these are discussed in subsequent articles—all of these are extremely important at a time like this when COVID-19 is ravaging our economy. All these, again, should, go a long way in helping to promote a vibrant and stable financial sector that is not only healthy in a financial sense but also accountable and inclusive in the real senses of the word. Only such a financial sector can safeguard India’s financial system during the COVID-19 era and help drive India’s growth story towards the much needed double digits in the short, medium and long-term.
(Ramesh S Arunachalam is author of 12 critically acclaimed books. His latest release in January 2020 is titled, “Powering India to Double Digit Growth: Five Key Steps To A Robust Economy”. Apart from being an author, Ramesh provides strategic advice on a wide variety of financial sector/economic development issues. He has worked on over 311 assignments with multi-laterals, governments, private sector, banks, NBFCs, regulators, supervisors, MFIs and other stakeholders in 31 countries globally in five continents and 640 districts of India during the last 31 years.