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Governance Of Financial Institutions: Call For A Paradigm Shift

BloombergQuintOpinion

Every crisis has a silver lining: it spawns lessons that help forestall a reoccurrence. Much ink has already been spilt over various corporate governance failures in Infrastructure Leasing & Financial Services Ltd. that may have contributed to its financial implosion. These include excessive risk-taking, distorted managerial incentives, laxity on the part of the board of directors and possible lapses on the part of gatekeepers such as auditors and credit rating agencies.

Governance Of Financial Institutions: Call For A Paradigm Shift

The solutions proffered tend to follow the well-trodden path of tightening the already stringent corporate governance norms and their implementation. However, this time it’s different.

Involving a financial institution, the IL&FS episode has raised governance considerations that are specific to the financial sector, and they need to receive greater attention than in the past.

This Time It’s Different

Lessons from a previous wave of crises involving Satyam and Sahara have not been wasted. They were incorporated in the Companies Act, 2013 and regulations issued to listed companies by the Securities and Exchange Board of India. These norms are largely sector-agnostic and appear to have been designed keeping in mind non-financial firms. However, internationally the global financial crisis of 2007-2008 triggered a greater discourse surrounding governance of banks and financial institutions that did not gain much traction in India. The IL&FS case has brought to the fore the governance of financial institutions in the Indian context.

The essential lesson is that the conventional corporate governance regime is woefully inadequate to deal with financial institutions. 

Even though the Reserve Bank of India has stipulated governance frameworks for banks and non-banking finance companies (NBFCs), they have been found wanting in situations such as IL&FS. This calls for governance in financial institutions to be viewed through a different lens altogether, and it is so for a number of reasons.

Debt Governance

First, the traditional governance paradigm seeks to align the interests of the shareholders on the one hand and the management of a company on the other. In companies with concentrated shareholding, the alignment should extend to both controlling and minority shareholders. This framework falls flat in its application to financial institutions.

Enter another stakeholder, i.e., the creditors of these institutions, who seek “debt governance”. This generates a conflict between the interests of the shareholders and creditors. Such a conflict is exacerbated by the phenomenon of “leveraging” that such financial institutions undertake by which the debt borrowed by the financial institutions are of a substantially higher order of magnitude compared to equity.

Governance mechanisms that are shareholder-focused point us in the wrong direction when it comes to financial institutions. They encourage managements to engage in excessive risk-taking simply because creditors bear most of the risk (for a fixed return) while shareholders’ risk is limited to their investment (with boundless potential for upside). In these circumstances, the interests of the shareholders and creditors militate against each other.

Often, the management’s incentives are pegged to shareholder value rather than to creditor protection.

This has been evident from the global financial crisis when executive compensation skyrocketed in companies that collapsed, an accusation now levelled against the IL&FS management.

Second, the implications of a governance crisis in a systemically important financial institution can be catastrophic to the financial markets and the economy.

No longer is governance a private matter among the board, management and shareholders of the financial institution, but it has larger public repercussions.

This creates externalities because the consequences of the risk undertaken by a financial institution is borne by third parties.

For example, as in the case of IL&FS, an institution may take on short-term liabilities while in possession of long-term, often illiquid, assets that create a stark mismatch between assets and liabilities. If not addressed properly, this can leave a large number of creditors in the lurch and paralyse the financial system.

Governance norms premised on shareholder primacy suffer from a crucial shortcoming as they fail to recognise these wider costs of excessive risk-taking.

Third, managements of large (“too-big-to-fail”) financial institutions suffer from moral hazard problems. They assume excessive risks with the understanding that the government will bail them to avoid the negative ramifications of failure of such a financial institution. These risks flow to the shareholders as well, and they are deprived of any motivation to steady the ship as they have very little skin in the game by then.

The above factors present in financial institutions shed light on one aspect: excessive risk-taking.

Instead of curbing excessive risks, the shareholder-premised corporate governance frameworks enables further risk-taking, and hence poses inadequacies.

Risk Management Failure

On the other hand, governance of financial institutions must be premised on an effective risk management mechanism. To be sure, the Companies Act as well as the relevant SEBI regulations mention risk management as one of the functions of the board, although they are shorn of the details.

However, the financial sector needs to be held to a higher standard of risk management.

The RBI requires banks and certain types of financial institutions to establish a risk management committee to identify risks arising out of the business (such as asset-liability mismatch), assess them and to devise a strategy to resolve them.

The risk management function must be given greater teeth as a means to operate as a prophylaxis against crises involving financial institutions.

Such a committee is not meant to be ornamental but a functional part of the management of the financial institution. In such a scenario, it is ironical that the risk management committee of IL&FS met only once since 2015 despite the gloomy financial position.

Risk management must be an essential part of the board’s duties and the tone must be set from the top. At a more general level, the thinking must pervade across the entire financial institution as a shared responsibility and become part of the organisation’s DNA.

Thus far, while RBI has stipulated risk management as an inherent feature of the governance of banks and financial institutions, episodes such as IL&FS and the non-performing assets (NPA) crisis demonstrate that this feature has operated only in form and not in action.

As the IL&FS episode demonstrates, conventional corporate governance norms are not sufficient to address specific concerns involving financial institutions and a more targeted approach becomes necessary.

As a sector regulator, the RBI would carry the onus to supplement its prudential regulation with appropriate governance norms and structures. At the same time, risk management must not only form part of the governance structures of financial institutions, but also be imbibed as part of the corporate culture and ethos of such companies.

Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.