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Enhancing and Reforming the way Banking is Governed

Abu Dhabi Center for Corporate Governance February 24, 2016

Prepared by:Philip Weights, Managing Director

Enhanced Banking Governance LLCBubikon, Zürich, Switzerland

weights@e-bkgov.com

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1. Introduction2. Corporate Governance Framework3. Corporate Governance Committee4. Chief Governance Officer5. Banking Conduct and Culture6. Remuneration of the Board and Key Executives7. Three Lines of Defence

Overview

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Introduction

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Introduction – Importance of Banking Governance

Corporate Governance for Banking Organisations is arguably of greater importance than for other companies given the crucial financial intermediation role of banks in the economy. It is essential to achieving and maintaining public trust and confidence in the banking system.The Basel Committee

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Introduction – Banks too Big?

Are global systemically important banks (G-SIBs) now too big to manage, too big to govern, and too big to regulate?

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Introduction – Failures of Corporate & Risk Governance

“We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis.”

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Introduction – Have Lessons been Learned?

Principles of good governance have been a major component of international financial standards and are seen as essential to the stability and integrity of financial systems. So, how to explain the events of 2007–08? What about the 2016 financial crisis?

Many problems can be traced to flawed implementation of good principles and to behavior prompted by increasingly short-term performance horizons.

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Introduction – Should the US & the UK be the Model?

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Introduction – Failures in Financial Regulation

Crisis avoidable - caused by: Widespread failures in financial regulation, incl. the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including many financial firms acting recklessly - taking on too much risk - with too little capital - and too much dependence on short-term funding.Breaches in accountability and ethics at all levels.

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Introduction – Women now running the financial world?

Christine Lagarde noted that there is still work to be done to address distorted incentives in the financial system given that actions precipitating the crisis were mostly driven by short-term profit motivation.

She suggests we need to build a financial system that is both more ethical and oriented more to the needs of the real economy, a financial system that serves society and not the other way round. Her view is that regulatory frameworks are not tight enough and oversight not strong enough.

Remarks made by Christine Lagarde, IMF managing director in Washington DC on May 6, 2015 in a conversation with Janet Yellen, chair of the Board of Governors of the Federal Reserve System. The topic was “Ethics and Finance - Aligning Financial Incentives with Societal Objectives”.

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Introduction – So What to Do?

“Enhancing banking governance is not only about the rules and regulations. It concerns the need for more robust implementation, to all levels of the organization, in all regions, with improved monitoring, auditing, and board oversight, enabled by assigned responsibility and accountability”. Philip J. Weights

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Introduction – What can go wrong today you might ask?Corporate Governance and the

U.A.E.

The USD 900 million Kabul Bank fraud ranks, at around 5% of the GDP of the Afghan economy, as one of history's biggest ever banking scandals. Former chairman Sherkhan Farnood, and the bank's CEO Khalilullah Ferozi, were jailed for 15 years on Dec 11, 2014 for money laundering and embezzlement. The court awarded a fine of $334 million to Farnood for the embezzlement of Kabul Bank funds, and a fine of s196 million to Ferozi. The assets of Mahmood Karzai, brother of former President Hamid Karzai, were also frozen by the court

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Introduction – Cash flown (laundered) to Dubai

The Financial Transactions and Reports Analysis Centre of Afghanistan was advised that Kabul Bank was moving money through food trays on Pamir Airway flights. This is supported by a Kabul Bank account used to pay 10 Pamir Airways pilots $320,000 for cash shipments between March 2008 and November 2010. The description “Pilots of Cash Delivery” is particularly suspicious given that Kabul Bank was laundering large amounts of cash through Kabul Airport to Dubai.

Pamir Airways operated a scheduled service to Dubai International airport until 2011.

Hundreds of millions of U.S. dollars were smuggled and flown out of Afghanistan secretly stashed in bags and airline food trays.

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Introduction – Money laundered to buy Dubai real estate.

Sherkhan Farnood, the bank Chairman, controlled the titles of prime Dubai real estate purchased with bank money but registered in his and his wife’s name. He had properties worth about $160 million.

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Corporate Governance Framework

It is recommended that the Board of Directors of all banks should formally adopt and implement the “Corporate Governance Principles for Banks” published by the Basel Committee on Banking Supervision.

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Corporate Governance Framework

Primary objectives of the 2015 revision are:• to explicitly reinforce the collective oversight and risk

governance responsibilities of the board. • to emphasize key components of risk governance such as

risk culture, risk appetite and their relationship to a bank’s risk capacity.

• to delineate the roles of the board, board committees, senior management, control functions, including the CRO and internal audit.

• to emphasize strengthening banks’ overall checks and balances.

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Corporate Governance Framework

Principle 1: Board’s overall responsibilities “The board has overall responsibility for the bank, including approving and overseeing management’s implementation of the bank’s strategic objectives, governance framework and corporate culture.” This Principle requires a combined approach, with approval and oversight at the board level, and implementation by management. Under the “duty of care” on Principle 1, the board should: “oversee implementation of the bank’s governance framework and periodically review that it remains appropriate in the light of material changes to the bank’s size, complexity, geographical footprint, business strategy, markets and regulatory requirements;”

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Corporate Governance Committee

The creation of a specialized board committees for governance and ethics is recommended in Principle 3 of the Basel Principles. Principle 3: Board’s own structure and practicesOther board committees 77. Other specialized committees that are recommended include: • Nomination / human resources / governance committee: • Ethics and compliance committee:Some banks have created a dedicated “Corporate Governance Committee”, others have established a combined “Corporate Governance and Business Ethics Committee”, or “Corporate Governance & Nomination Committee”.

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Corporate Governance Committee – Hong Kong Regulator

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Corporate Governance Committee

One example of a successful Corporate Governance Committee is the Abu Dhabi Commercial Bank (ADCB) in the UAE. The Bank’s ongoing achievements in corporate governance resulted in the Bank receiving the “Corporate Governance Award - UAE” from World Finance magazine in 2014. The Bank also received the Hawkamah Bank Corporate Governance Award.

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Chief Governance Officer – Different Approaches

Appointing a Chief Governance Officer sends a powerful message to investors and other stakeholders that integrity, transparency and accountability matter to your company.

“Policy Governance®” model, a system of organizational governance developed by Dr. John Carver PhD. Principles 1-3 an organization's ownership, the board's responsibility to it, and the board's authority. 4-7 the board defines in writing policies identifying the benefits from the organization, how the board conducts itself, and staff behavior. 8-10 board's delegation and monitoring. Describes the Chief Governance Officer as a “specially empowered member of the board who ensures the integrity of the board’s process and the completion of its products”

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Chief Governance Officer – CGO Role and Responsibility

Assess and monitor the governance framework - The CGO provides an ongoing evaluation of the company’s board structure and governance practices and recommends modifications as the company’s circumstances or regulatory environment changes. Ensure compliance - This involves coordination with various corporate departments, internal audit, compliance, risk, legal, human resources and investor relations, to ensure the company complies with laws and regulations related to corporate governance. Develop Policy - The CGO helps the company develop code of conduct / ethics / conflict-of-interest standards and other governance policies. Educate the Board - The CGO keeps the board of directors and management up to date with the latest corporate governance trends, regulations and best practices. Support the Governance Committee - The CGO should support the creation of a Governance Committee and assist in developing the Terms of Reference, and subsequently the activities of the Committee in supporting the Board fulfill its governance oversight responsibility.

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Chief Governance Officer – CGO Role and Responsibility

Validate External Governance Reporting - Review and recommend to the Board the Bank’s annual disclosure of its corporate governance practices; Assess Subsidiary Governance - Ensure the preparation of an annual report on Subsidiary Governance. In this regard, it is not sufficient for banks to only have good governance in H.O. and the main group board. The CGO is positioned to take a global and holistic view on governance at all levels, in all regions, where the bank operates. The CGO should be guided by Principle 5 “Governance of group structures” of the Basel “Corporate Governance Principles for Banks”.Oversight of the 3 Lines of Defense - Risk governance, and the related internal control systems, involves the business (front office) as the first line of defense, risk and compliance as the 2nd line of defense, and internal audit as the 3rd line of defense. In many instances there can be substandard coordination and communication between the different actors in the governance and control systems within banks. It is therefore critical for the CGO, as the governance central command, to maintain strong, effective and frequent contact with all 3 lines of defense.

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Banking Conduct and Culture – Need for Industry Reform

“Banking Conduct and Culture” published July 2015 should be read and adopted by every bank director and C-Suite executive.It highlights five areas where banks should focus their attention:1) Fundamental shift in the Mindset on Culture; 2) Senior Accountability and Governance; 3) Performance management and incentives; 4) Staff development and promotion; 5) An effective Three Lines of Defence.

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Banking Conduct and Culture – Not just Tone at the Top

Desired values and conduct should be reflected in the daily habits and practices of employees - how they work; how they are evaluated; who is hired, promoted, and rewarded; and how employees act when managers are not present and when matters of personal judgment arise.

The key takeaway is: “Tone at the Top – Echo at the Bottom”. Boards must ensure senior managers demonstrate the right "tone at the top". Desired values and conduct should be evident in the tone from the top. The voices of the middle manager should be heard in an echo from the bottom and should infuse the entire organization and its businesses.

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Remuneration of the Board and Key Executives

Boards of banks should adopt a rule, applicable globally, whereby the remuneration of the Board and the key executives is subject to an annual vote (preferably binding) by the shareholders. Switzerland and Italy have binding "say on pay" votes. Australia introduced the Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Act 2011 which says that if at two consecutive meetings over 25% of shareholders vote against the directors’ remuneration package, the directors have to stand for election again in 90 days. EU has not taken a position on this issue, however Germany passed reforming legislation to the Stock Corporation Act to introduce a non-binding say on pay. In the US and the UK there are also non-binding, or advisory votes on pay.

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Three Lines of Defence

A risk governance framework should include well defined organizational responsibilities for risk management, typically referred to as the three lines of defence. 1st line is comprised of the business units; 2nd line a risk management function and a compliance function independent from the first line of defence; 3rd line an internal audit function independent from the first and second lines of defence. Depending on the bank’s nature, size and complexity, and the risk profile of its activities, the specifics of how these 3 lines of defence are structured can vary. Regardless of the structure, responsibility for each line of defence should be well defined & communicated.

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Three Lines of Defence

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Three Lines of Defence

This is how the Board can meet the challenge of providing oversight of the “Three Lines of Defence” that is so critical for ensuring risk governance.

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Three Lines of Defence

Too Big to Manage: JP Morgan and the Mega BanksIn a complex organization like JP Morgan, with many separate entities and lines of business, an effective “control agenda” is a huge undertaking. “It means “process mapping” the myriad business functions; assessing business, legal and ethical risks at various points; mitigating that risk through education, checks and balances; and ensuring that problems are discovered early and handled promptly. It is a vexing, complicated task which requires both outstanding leadership and management. It also requires a significant investment of time and resources which, while sizeable, amounts to far less than the huge resource drain which scandal can cause. Ultimately, it means having an open, transparent performance-with-integrity culture that encourages but bounds business risk and that does not cut legal or ethical corners to make the numbers.”Harvard Business Review - Oct 3, 2013 - Ben W. Heineman, JrFrom https://hbr.org/2013/10/too-big-to-manage-jp-morgan-and-the-mega-banks/

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Banking Governance Consulting & AuditA Swiss Perspective

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