bank corporate governance

8/2/2019 Bank Corporate Governance

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Introduction to Banks

The bulk of all money transactions today involve the transfer of

bank deposits. Depository institutions, which we normally callbanks, are at the very center of our monetary system. Thus a

basic knowledge of the banking system is essential to an

understanding of how money works.

Bank Deposits and Reserves

The monetary base is created by the Fed when it buys securities

for its own portfolio. Bank deposits themselves are not base

money, rather they are claims on base money. A bank must hold

reserves of base money in order to meet its depositors' cash

withdrawals and to cover the checks written against their

accounts. Reserves comprise a bank's vault cash and what itholds on deposit at the Fed, known as Fed funds. The Fed

requires banks to maintain reserves of at least 10% of their

demand deposits, averaged over successive 14-day periods.

The Movement of Bank Reserves

When a depositor writes a check against his account, his bank

must surrender that amount in reserves to the payees bank for

the check to clear. Reserves are constantly moving from one

bank to another as checks are written and cleared. At the end of

the day, some banks will be short of reserves and others long.


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Banks redistribute reserves among themselves by trading in the

Fed funds market. Those long on reserves will normally lend to

those short. The annualized interest rate on interbank loans is

known as the Fed funds rate, and varies with supply and demand.

The reserve requirement applies only to the bank's demand

deposits, not its term or savings deposits. Thus when a bank

depositor converts funds in a demand deposit into a term or

savings deposit, he frees up the reserves that were held against

the demand deposit. The bank can then use those reserves in

several ways. For example, it can hold them to back further

lending, buy interest-earning Treasury securities, or lend them toother banks in the Fed funds market.

Controlling the Fed Funds Rate

The supply of reserves changes whenever base money enters or

leaves the banking system. This occurs when the Fed buys or

sells securities or when the public deposits or withdraws cash

from banks. The demand for reserves changes whenever total

demand deposits change, which occurs when banks increase or

decrease aggregate lending. The Fed controls the Fed funds rate

by adjusting the supply of reserves to meet the demand at its

target interest rate. It does so by adding or draining reservesthrough its open market operations.

The Fed funds rate effectively sets the upper limit on the cost of

reserves to banks, and thus determines the interest rates that


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banks must charge the public for loans. Bank interest rates

influence the demand for loans, and thereby the net amount of

bank lending. That in turn determines the liquidity of the private

sector, which is important in terms of aggregate demand and

inflationary pressures. The selection and control of the Fed fundsrate is the key monetary policy instrument of the Fed.

The Effects of Government

SpendingThe Fed acts as a depository for the Treasury as well as member

banks. All government spending is paid out of the Treasury's

account at the Fed. Whenever the government spends, the Fed

debits the Treasury's account and credits the Fed account of the

payees bank. The Treasury replenishes its Fed account with

transfers from its commercial bank accounts where it deposits the

receipts from taxes, and the sale of its securities.

In order to minimize variations in aggregate banking system

reserves, the Treasury maintains a nearly constant balance in its

Fed account. In effect, Treasury payments are simply transfers

from its commercial bank accounts to the bank accounts of the

public. Funds move in the reverse direction when the public pays

taxes or buys securities from the Treasury. The Treasury must

maintain a positive balance in its commercial bank accounts to

avoid having to borrow directly from the Fed. However it has no

need for, and does not accumulate, balances in excess of its near-

term payment obligations.


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On average, government spending does not affect the aggregate

bank deposits of the private sector. The Treasury sells or

redeems securities as required to balance its inflows against

outflows. However short-term variations occur because receipts

cannot be synchronized with spending. Banking system reservesremain essentially unaffected by government spending because

the Treasury transfers funds from its commercial bank accounts

to replace the funds spent out of its Fed account.

History of Banking

Safe in the temple: 18th century BC

Wealth compressed into the convenient form of gold brings one

disadvantage. Unless well hidden or protected, it is easily stolen.

In early civilizations a temple is considered the safest refuge; it is

a solid building, constantly attended, with a sacred character

which itself may deter thieves. In Egypt and Mesopotamia gold is

deposited in temples for safe-keeping. But it lies idle there, while

others in the trading community or in government have desperate

need of it. In Babylon at the time of Hammurabi, in the 18th

century BC, there are records of loans made by the priests of thetemple. The concept of banking has arrived.


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Greek and Roman financiers: from the 4th

century BC

Banking activities in Greece are more varied and sophisticated

than in any previous society. Private entrepreneurs, as well as

temples and public bodies, now undertake financial transactions.

They take deposits, make loans, change money from one

currency to another and test coins for weight and purity.

They even engage in book transactions. Moneylenders can be

found who will accept payment in one Greek city and arrange for

credit in another, avoiding the need for the customer to transport

or transfer large numbers of coins.

Rome, with its genius for administration, adopts and regularizes

the banking practices of Greece. By the 2nd century AD a debtcan officially be discharged by paying the appropriate sum into a

bank, and public notaries are appointed to register such

transactions.

The collapse of trade after the fall of the Roman empire makes

bankers less necessary than before, and their demise is hastened

by the hostility of the Christian church to the charging of interest.

Usury comes to seem morally offensive. One anonymous

medieval author declares vividly that 'a usurer is a bawd to his

own money bags, taking a fee that they may engender together'.


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Functions of a Bank

1. Recognition of Right to Credit

The view thus given of bank credit in general furnishes the key to

the view which should be taken of the bank itself. It is, as we havealready seen, a credit institution - an institution for the

investigation, discussion, and recording of credits. It is not, in this

aspect, what some have described it, an enterprise for

"manufacturing" credit. The "manufacture" of credit, as clearly

appears from what has already been said, is impossible. A basis of

credit is automatically created whenever real buying' power or

value is in process of being brought into existence. Such power is

created during the expenditure of labor and capital, but the realworth or value is often intimately associated with the other

elements that appear in the general operations of his concern.

The basis only appears when it is dissociated from the other

elements in the aggregate of goods and expert means are needed

to recognize it. The first function of a bank, then, is that of


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recognizing through scientific analysis the real nature and amount

of the values which are presented. Fundamentally, therefore, the

credit department of a bank is the basic element in its

organization. It is true that in the past many banks have been

able to do without credit departments and that at the presenttime there are not a few of them - chiefly the smaller and less

advanced types of institution - which have no credit departments,

or only very rudimentary organizations of the sort. These,

however, usually accept the work of credit departments operated

by their city correspondents. The true work of a bank credit

department is done whenever any loan is made. It may be that

the work of credit analysis is incidentally performed by the

president or a vice-president of the bank or by some other officerwho happens to have charge of the work of lending, but the

function is there.

2. Guaranteeing of Values

Secondly, the bank, after recognizing or analyzing credit,

guarantees it. It does this by substituting its own credit for that of

the "borrower" or owner of wealth. If A, for example, is producing

steel from pig iron, the bank ascertains the value of the products

which he has in process, which, we may say, is $25 per ton. It

undertakes to loan, say, $10 per ton, and in order to carry out its

part of the agreement it obligates itself to pay $10 on demand to

anyone who may be designated by the owner of the plant. The

owner leaves with the bank his own note, which may be secured

or may be simply a claim upon his general assets. In either case,

however, the loan is made on the strength of existing value. It

represents that part of the value of the product which the bank iswilling to guarantee. The bank does not expect to be called upon

to meet this obligation for $10 per ton. On the contrary, it expects

to offset the obligation against other claims, and as a net result it

believes that it will not be called upon to reduce its holding of

specie. That, however, is to be determined at a later time. The


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bargain which the bank makes when it enters into relationships

with the borrower involves the substitution of its own obligation

for that of the owner of the goods, and this is the essential point

in the whole operation.

3. Transferring of Titles

Thirdly, the bank not only undertakes to put its obligation in place

of that of the borrower, but it undertakes to keep this obligation

steadily redeemable on demand in money, or in lieu of such

redemption, to shift the "credit" from A to B and from B to any

other that the latter may indicate, through a process ofbookkeeping which involves the receiving, recording, and paying

of claims drawn against the total credit which has been allowed.

Closely connected with this function are the subordinate duties of

exchange and remittance, which, as will be seen at a later point,

are variants of the same general function.

Corporate Governance of Banks

Introduction

The concept of corporate governance, which emerged as a

response to corporate failures and widespread dissatisfaction with


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the way many corporates function, has become one of the wide

and deep discussions across the globe recently. It primarily

hinges on complete transparency, integrity and accountability of

the management. There is also an increasingly greater focus on

investor protection and public interest. Corporate governance isconcerned with the values, vision and visibility. It is about the

value orientation of the organisation, ethical norms for its

performance, the direction of development and social

accomplishment of the organisation and the visibility of its

performance and practices.

Indian Banking Industry

Indian banking has around 200 years of history and has

undergone many transformations since independence. But,

Liberalisation, Privatisation and Globalisation and Information

Technology are currently changing the Indian banking radically.

Earlier, banking was virtually a monopoly of the public sector

banks with full protection from the State. But the process of

reforms in the Indian banking system has thrown them out to

more liberal and free market forces. Now the banks, more

particularly the public sector ones, feel the real heat of the

competition. The interest rate cuts, dwindling margins and more

number of players to serve a reduced number of bankable clientshave all added to the worries of the banks. The customer has

finally come to hold the center stage and all banking products are

tailor-made to suit his tastes and preferences. This sudden

change in the banking environment has bereaved the banks of all


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their comforts and many of them are finding it extremely difficult

to cope with the change.

Need for Corporate Governance in Banks

1. Since banks are important players in the Indian financial

system, special focus on the Corporate Governance in the

banking sector becomes critical.

2. The Reserve Bank of India, as a regulator, has the responsibility

on the nature of Corporate Governance in the banking sector.

3. To the extent that banks have systemic implications, Corporate

Governance in the banks is of critical importance.

4.Given the dominance of public ownership in the banking system

in India, corporate practices in the banking sector would also set

the standards for Corporate Governance in the private sector.

5. With a view to reducing the possible fiscal burden ofrecapitalising the PSBs, attention towards Corporate Governance

in the banking sector assumes added importance.


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Prerequisites for Good Governance

There are some pre-requisites for good corporate governance.They are:

1. A proper system consisting of clearly defined and adequate

structure of roles, authority and responsibility.

2. Vision, principles and norms which indicate development path,normative considerations and guidelines and norms for

performance.

3. A proper system for guiding, monitoring, reporting and control.

Recommendations by the BirlaCommittee

The report of the Committee on Corporate Governance, set up by

the Securities and Exchange board of India, under the

Chairmanship of Kumar Mangalam Birla, is the first formal and

comprehensive attempt to evolve a Code of CorporateGovernance, in the context of prevailing conditions of governance

in Indian companies, as well as the state of capital markets. The

committee has identified the three key constituents of corporate

governance.


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Shareholders' Role

The role of shareholders in corporate governance is to appoint thedirectors and the auditors and to hold the board accountable for

the proper governance of the company by requiring the board to

provide them periodically with the requisite information, in

transparent fashion, of the activities and progress of the

company.

Board of Directors' Role

The board of directors performs the pivotal role in any system of

corporate governance. It is accountable to the stakeholders and

directs and controls the management. It stewards the company,

sets its strategic aim and financial goals, and oversees their

implementation, puts in place adequate internal controls and

periodically reports the activities and progress of the company ina transparent manner to the stakeholders.

Management's Role

The responsibility of the management is to undertake the

management of the company in terms of the direction provided

by the board, to put in place adequate control systems and to

ensure their operation and to provide information to the board on

a timely basis and in a transparent manner to enable the board to

monitor the accountability of management to it.


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The Basel Committee Recommendations

The Basel Committee published a paper for banking organisations

in September 1999. The Committee suggested that it is the

responsibility of the banking supervisors to ensure that there is an

effective corporate governance in the banking industry. It also

highlighted the need for having appropriate accountability and

checks and balances within each bank to ensure sound corporate

governance, which in turn would lead to effective and more

meaningful supervision.

Efforts were taken for several years to remedy the deficiencies of

Basel I norm and Basel committee came out with modified

approach in June 2004. The final version of the Accord titled "

International Convergence of Capital Measurement And Capital

Standards-A- Revised Framework" was released by BIS. This is

popularly known as New Basel Accord of simply Basel ll. Base llseeks to rectify most of the defects of Basel l Accord. The

objectives of Basel ll are the following:

1. To promote adequate capitalisation of banks.

2. To ensure better risk management and

3. To strengthen the stability of banking system.


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Essentials of Accord of Basel ll

1. Capital Adequacy: Basel ll intends to replace the existing

approach by a system that would use external credit assessments

for determining risk weights. It is intended that such an approach

will also apply either directly or indirectly and in varying degrees

to the risk weighting of exposure of banks to corporate and

securities firms. The result will be reduced risk weights for highquality corporate credits and introduction of more than 100% risk

weight for low quality exposures.

2. Risk Based Supervision This ensures that a bank's capital

position is consistent with overall risk profile and strategy thus

encouraging early supervisory intervention. The new framework

lays accent on bank managements developing internal

assessment processes and setting targets for capital that are

commensurate with bank' particular risk profile and control

environment. This internal assessment then would be subjected

to supervisory review and intervention by RBI.

3. Market Disclosures The strategy of market disclosure will

encourage high disclosure standards and enhance the role of

market participants in encouraging banks to hold and maintain

adequate capital.

Steps to be taken


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To overcome from these challenges, banks are required to

emphasize on certain factors, which will increase their

transparency and lead to higher foreign investment.

1. Self- Appraisal System: Good governance is like trusteeship. It

is not just a matter of creating checks and balance but it

emphasizes on customer satisfaction and shareholders value. The

law regulates certain responsible areas on borrowing, lending,

investigating, transparency in accounts etc. The directors, there

fore, evaluate themselves through self-introspection.

2. The Board's Committees: It will be difficult for a board, with all

the members acting together on some issues, to achieve its

objectives effectively and with apt independence. The board,

therefore, needs to be assisted by the some committee.

3. Transparency: Transparency can reinforce sound corporate

governance. Therefore, public disclosure is desirable in BoardStructure, Senior management, Basic organisational structure and

incentive structure of the bank.

Prudential norms on Capital

Adequacy, Income Recognition.

1. Risk Weight on Securities Guaranteed by

State Governments


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In terms of instructions contained in item 4 of paragraph 2 (d) of

our Circular DBOD No BP

BC 103/21.01.002/98 dated October 31, 1998, banks are required

to assign risk weight of 2.5per cent for market risk for their investment in securities where

payment of interest and

repayment of principal are guaranteed by State Governments.

However, in case of default in

interest/principal by the State Government banks are required to

assign 100 per cent risk

weight on investment in all the securities issued or guaranteed by

that State Government.

The position has since been reviewed and it has been decided

that banks need to assign risk

weight of 100 per cent only on those State Government

guaranteed securities issued by

the defaulting entities and not on all the securities issued orguaranteed by that State Government.

Banks are further advised to pay due regard to the record of

particular State Government in

honouring their guarantees while processing any further requests

for loans to PSUs in that

State on the strength of State Government guarantee.


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2. Sick SSI Units under rehabilitationIn terms of paragraph 3 of Circular DBOD No. BP BC

36/21.04.048/95 dated April 3, 1995,

advances granted to units which are placed under rehabilitation

package approved by

BIFR/Term Lending Institutions (TLIs) are treated as NPAs and

provisions are required to

be made. However, for additional credit facilities sanctioned to

units under rehabilitation

package approved by BIFR/TLI, provision need not be made for a

period of one year from

the date of disbursement. In other words, our guidelines on

income recognition, asset

classification and provisioning will apply to such additional credit

facilities only after a

period of one year from the date of disbursement.

Banks have been representing that the above relaxation is not

available in respect of

additional credit facilities granted under the rehabilitationpackage/nursing programme

prepared by banks themselves or under consortium

arrangements. On a review of the matter,


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it has been decided that no provision need be made for a period

of one year in respect of

additional credit facilities granted to SSI units which are identified

as sick (as defined inpara 5 (a) of RPCD Circular No. PFNFS. BC. 99/ 06.02.031/92-93

dated April 17, 1993)

and where rehabilitation packages/nursing programmes have

been drawn by the banks

themselves or under consortium arrangements .

3. Provision on Standard Assets

A reference is invited to para 3 of our Circular DBOD No.

BP.BC.101/ 21.04.048/99 dated

18 October 1999 regarding provision on Standard Assets. In the

light of suggestions received

from banks in regard to treatment and accounting of provision on

Standard Assets, our

instructions are partially modified as under:

The general provision of 0.25 per cent on Standard Assets

should be made on global

portfolio basis and not on domestic advances alone.

Provisions towards Standard Assets need not be netted from

gross advances as


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advised earlier but shown separately as Contingent Provisions

against Standard

Assets, under Other Liabilities and Provisions - Others in

Schedule No. 5 of thebalance sheet.

The above contingent provision will not be eligible for inclusion

in Tier II Capital.

4. Advances against Book Debt

In terms of instructions contained in para 4 of our Circular DBOD

No. BP.

BC.24/21.04.048/99 dated 30 March 1999, banks are required to

show advances against

Book Debt under item B (i)- Secured by tangible assets of

Schedule 9. Although such

advances are secured, it is likely that they may not be fully

secured by tangible assets.

Hence, banks may now indicate separately in Schedule 9 that

item B (i) includes Advances

against Book Debts as shown below:

Advances (Schedule 9)

B (i) Secured by tangible assets *

(* includes advances against Book Debt)


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5. Investment Fluctuation Reserve Account

In terms of instructions contained in paragraph 1 of our circular

DBOD No.

BP.BC.24/21.04.048/99 dated 30 March 1999 the amount held in

Investment Fluctuation

Reserve Account could be utilised to meet, in future, the

depreciation requirement on

investment in securities. In this connection, it is clarified that the

extra provision needed in

the event of a depreciation in the value of the investments should

be debited to the Profit and

Loss Account and if required, an equivalent amount may be

transferred from the Investment

Fluctuation Reserve Account to the Profit and Loss Account as a

below the line item after

determining the profit for the year.

In recent years we have across the term 'prudential norms' too

often particularly in relation to the non-performing assets of the

commercial banks. In the light of the existence of huge non-

performing asset in the balance sheets of the commercial banks

leading to the erosion of their capital base the relevance of these

prudential has acquired particular significance.

The main elements of prudential norms are income recognition,

assets classification , provisioning for loans and advances and

capital adequacy. In keeping with latest practices at the

international levels, commercial banks are not supposed to


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recognize their incomes from non-performing assets on an accrual

basis and these are to be booked only when these are actually

received.

If the balance sheet of a bank is to reflect the factual and true

financial state of affairs of the bank it is pragmatic and desirable

to have a system of recognition of income, classification of assets

and provisioning for sticky debts on a prudential basis. Banks

have been directed not to charge and take interest on non-

performing assets to the income account and classify their assets

under three broad categories of Standard Assets, Sub-standard

Assets, Doubtful Assets and Loss Assets. Taking into account thetime-lag between an account becoming doubtful of recovery, its

recognition as such, the realisation of the security and the erosion

over time in value of security charged to the banks, banks are

required to make provision against sub-standard assets, doubtful

assets and loss assets.

The prudential accounting norms which were put into place in1992-93, have been further strengthened over the years. In

respect of accounts where there are potential threats of recovery

on account of erosion in the value of the security or absence of

security and other factorssuch as fraud committed by the

borrowers exist, such accounts are to be classified as doubtful or

loss assets irrespective of the period to which these remained as

non-performing. All the members banks in a consortium are

required to classify their advances according to each bank's ownrecord of recovery. Depreciation on securities transferred from

the current category to the permanent category has to be

immediately provided for. Banks should value the specified

government securities under ready forward transactions at

market rates on the balance date.


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In recent years we have across the term 'prudential norms' too

often particularly in relation to the non-performing assets of thecommercial banks. In the light of the existence of huge non-

performing asset in the balance sheets of the commercial banks

leading to the erosion of their capital base the relevance of these

prudential has acquired particular significance.

The main elements of prudential norms are income recognition,

assets classification , provisioning for loans and advances andcapital adequacy. In keeping with latest practices at the

international levels, commercial banks are not supposed to

recognize their incomes from non-performing assets on an accrual

basis and these are to be booked only when these are actually

received.

If the balance sheet of a bank is to reflect the factual and truefinancial state of affairs of the bank it is pragmatic and desirable

to have a system of recognition of income, classification of assets

and provisioning for sticky debts on a prudential basis. Banks

have been directed not to charge and take interest on non-

performing assets to the income account and classify their assets

under three broad categories of Standard Assets, Sub-standard

Assets, Doubtful Assets and Loss Assets. Taking into account the

time-lag between an account becoming doubtful of recovery, itsrecognition as such, the realisation of the security and the erosion

over time in value of security charged to the banks, banks are

required to make provision against sub-standard assets, doubtful

assets and loss assets.


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The prudential accounting norms which were put into place in

1992-93, have been further strengthened over the years. In

respect of accounts where there are potential threats of recovery

on account of erosion in the value of the security or absence of

security and other factorssuch as fraud committed by theborrowers exist, such accounts are to be classified as doubtful or

loss assets irrespective of the period to which these remained as

non-performing. All the members banks in a consortium are

required to classify their advances according to each bank's own

record of recovery. Depreciation on securities transferred from

the current category to the permanent category has to be

immediately provided for. Banks should value the specified

government securities under ready forward transactions atmarket rates on the balance date.

Conclusion

Corporate governance has assumed vital role and significance

due to globalisation and liberalisation. With the opening of

economy and to be in line with WTO requirements, if the Indiancorporates have to survive and succeed amidst increasing

competition globally, it can only be through transparency in

operations. The excellence in terms of customer satisfaction, in

terms of return, in terms of product and service, in terms of

return to promoters and in terms of social responsibilities towards

society and people cannot be achieved without practicing good

corporate governance.


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bank corporate governance

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