There has been a great deal of attention given recently to the issue of corporate governance in various national and international forums and publications. In particular, the Organization for Economic Cooperation and Development (OECD) has issued a set of corporate governance standards and guidelines to help governments “in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries, and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance.”

Sound corporate governance practices emphasize the need for banks to set strategies for their operations and establish accountability for executing these strategies. In addition, transparency of information related to existing conditions, decisions and actions is integrally related to accountability in that it gives market participants sufficient information with which to judge the Supervisory Council of a bank.

The OECD defines corporate governance as involving “…a set of relationships between a company’s management, its Supervisory Council, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the bank and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently.”

Banks are a critical component of any economy. They provide financing for commercial enterprises, basic financial services to a broad segment of the population and access to payments systems. In addition, some banks are expected to make credit and liquidity available in difficult market conditions. The importance of banks to the economy is underscored by the fact that banking is virtually universally a regulated industry and banks have access to government safety nets. It is of crucial importance therefore that banks have strong corporate governance.

However, the Presidential Decree “On the Measures with Regard to Development of Corporate Governance in Joint Stock Companies” signed in March 2002 made a considerable step forward on the way to best corporate governance practice.

The Decree stipulates that it is necessary to recognize further improvement of the legal foundations of corporate governance in joint stock companies, which would ensure:

efficient protection of the rights and lawful interests of shareholders,

improvement of the system of filing, content and structure of the information about activities of joint stock companies,

regulation of relations between the management bodies of a joint stock company with a precise definition of competence of each of them, and

implementation of generally accepted civilized fair norms of business relations in the process of carrying out corporate governance.

Also, the Decree entrusted the Cabinet of Ministers with drafting and submitting for review by the Verkhovna Rada of Ukraine draft laws aimed at regulation of the issues of corporate governance and joint stock companies, and it charged the Stock Market State Commission with ensuring development and implementation of national principles (code) of corporate governance in joint stock companies.

Following the signing of the Presidential Decree a number of further steps has been made to address the tasks set by the President in his Decree, and in particular:

In March 2003, the Cabinet of Ministers adopted the “Program of Development of Corporate Governance In Ukraine in 2002-2005″;

In June 2002, the Securities and Stock Market State Commission issued “Recommendations for Best Practices of Corporate Governance for Joint Stock Companies in Ukraine”;

NBU Governor has issued the “Comprehensive Program for the Development of the Banking System in 20032005″. The entire section of the Program is devoted to corporate governance issues, in particular, to improving the soundness of the banking system and ensuring the transparency of its operations;

NBU is studying the best international business practices on corporate governance to identify the possibilities of increasing the role and responsibilities of the Supervisory Councils in Ukrainian banks;

In March and April 2003, two new drafts of the Law “On joint stock companies” have been submitted to Verhovna Rada. One was initiated by a Rada member and the other by the Cabinet of Ministers. These draft Laws are focused on strengthening the legislation requirements on the principles of corporate governance of joint stock companies in Ukraine.

In April 2003, the Verhovna Rada passed in the first reading the changes to the Law on Banks and Banking activity that relate to the internal audit of banks; it proposed to have the internal audit office report directly to the Supervisory Council.

In April 2003, the Association of Ukrainian banks established the “Banking Ethics Committee” which has held its first meeting in April. The goals set by the Committee are aimed to promote the principles of sound business practices and elements of corporate governance in Ukrainian banks.

In his speech to the Verhovna Rada on 15 april 2003, the President Kuchma has once again emphasized that…” Urgent Reform of the corporate governance system must become part and parcel of the policy of economic growth…The crisis of the corporate governance system has

become one of the most acute problems, which impedes economic growth, effective restructuring of companies, development of up-to-date mechanisms of sale of private property, stock market development, attraction of citizens’ savings for investment purposes, increase of investment attractiveness of the Ukrainian economy for both domestic and foreign investors ”

Areas that should be strengthen by implementing best international corporate governance practices and principles include the following:

Members of the Supervisory Council should have a broader responsibility for the bank’s operations;

Supervisory Council should be completely independent from the Management Board of the Bank;

Protection of rights of the minority shareholders by representation of at least one member in the Supervisory Council of a bank from the minority shareholder;

Supervisory Council is proposed to receive wider range of authorities and responsibilities on approval of strategic and operational issues of a bank’s activities as well as on risk management issues;

the rights to approve or remove members of Supervisory Council if they do not meet requirements for directing a safe and sound bank; and

Appointment of an external auditor should be the sole competence of the Supervisory Council of a bank.

International best practices for banks

All these initiatives indicate the growing awareness and recognition by the legislators, bank supervision and other regulatory authorities of the importance of the corporate governance issues.

From a banking industry perspective, corporate governance involves the manner in which the business and affairs of individual institutions are governed by their Supervisory boards and Management boards, affecting how banks.

set corporate objectives (including generating economic returns to owners);

run the day-to-day operations of the bank; consider the interests of recognized stakeholders

align corporate activities and behaviors with the expectation that banks will operate in a safe and sound manner, and in compliance with applicable laws and regulations.

Basel paper defines key practices that are critical elements of any corporate governance process in banks. These are as follows:

Sound corporate governance practices

1. Establishing strategic objectives and a set of corporate values

It is difficult to conduct the activities of an organization when there are no strategic objectives or guiding corporate values. Therefore, the Supervisory Council should establish the strategies that will direct the ongoing activities of the bank. It should also take the lead in establishing the “tone at the top” and approving corporate values for itself, senior management and other employees. The values should recognize the critical importance of having timely and frank discussions of problems. In particular, it is important that the values prohibit corruption and bribery in bank activities, both in internal dealings and external transactions.

The Supervisory Council should ensure that the Management Board implements policies that prohibit (or strictly limit) activities and relationships that diminish the quality of corporate governance, such as:

conflicts of interest;

lending to officers and employees and other forms of self-dealing (e.g., internal lending should be limited to lending consistent with market terms and to certain types of loans, and reports of insider lending should be approved by the Council, and be subject to review by internal and external auditors and disclosure in the financial statements); and

providing preferential treatment to related parties and other favored entities (e.g., lending on highly favorable terms, covering trading losses, waiving commissions).

Processes should be established that allow the Supervisory Council to monitor compliance with these policies, ensure that deviations are reported to them on a regular basis corrective action taken and noted in the minutes of the meetings.

Such overall strategic objectives and corporate values should not only be set by the Supervisory Council but also more importantly, should be communicated to the public, shareholders and stakeholders.

Example:

As a good example of the formulated mission strategy and overall business principles one can refer to extract from the annual report of ING Group. In a very concise manner it describes the overall mission of the Group, business objectives and social principles of its activity.

Mission, profile, strategy

Mission

ING’s mission is to be a leading, global, client-focused, innovative and low-cost provider of financial services through the distribution channels of the client’s preference in markets where ING can create value.

Profile

ING Group is a global financial institution of Dutch origin offering banking, insurance and asset management to over 50 million private, corporate and institutional clients in 65 countries. With a diverse workforce of over 110,000 people, ING comprises a broad spectrum of prominent companies that increasingly serve their clients under the ING brand.

Key to ING is its distribution philosophy: ‘click-call-face’. This is a flexible mix of internet, call centres, intermediaries and branches with which ING can fully deliver what today’s clients expect: unlimited access, maximum convenience, immediate and accurate execution, personal advice, tailor-made solutions and competitive rates.

Strategy

ING’s strategy is to achieve stable growth while maintaining healthy profitability. The Group’s financial strength, its broad range of products and services, the wide diversity of its profit sources and the good spread of risks form the basis for ING’s continuity and growth potential. More than 70% of ING’s shares are held by investors outside the Netherlands.

ING seeks a careful balance between the interests of its stake-holders: its customers, shareholders, employees and society at large. It expects all its employees to act in accordance with the Group’s Business Principles. These principles are based on ING’s core values: responsiveness to the needs of customers, intrepreneurship, professionalism, teamwork and integrity.

ING aims to be a top-10 global financial institution. Through a variety of ING companies – managed by the Executive Centres ING Europe, ING Americas, ING Asia/Pacific and ING Asset Management -ING wants to deliver added value to clients in banking, insurance and asset management. ING wants to ensure operational excellence, achieve synergies and emphasize cost control within one ING culture. The long-term financial targets are an average annual growth of operational net profit per share of at least 12%, an average annual operational net return on shareholders’ equity (ROE) of at least 18% and improving efficiency ratios.

2. Setting and enforcing clear lines of responsibility and accountability

Effective Supervisory Councils clearly define the authorities and key responsibilities for themselves, as well as members of the Management Board. They also recognize that unspecified lines of accountability or confusing, multiple lines of responsibility may cause a problem through slow or diluted responses. Management Board is responsible for creating an accountability hierarchy for the staff, but must be cognizant of the fact that they are ultimately responsible to the Supervisory Council for the performance of the bank.

Example:

The provisions of the draft Law on Joint Stock Companies can be used to illustrate the example of some authorities and responsibilities for which the Supervisory Council has responsibility. This list is not comprehensive and may be used as a guideline for much broader spectrum of authorities and responsibilities.

Approve policies and procedures that regulate the internal issues of the company’s activity.

Approval of procedural aspects of general meeting of shareholders (date, agenda etc).

Approval of procedural aspects of transactions with own securities.

Approval of market valuation of properties.

Approintment of members of Management Board, approval of their compensations.

Appointment of external auditor, approval of an independent property appraiser.

Approval of establishment and closure of branches.

Approval of issues on business combinations.

Approval of significant transactions and contracts.

Approval of methods of disclosure of information.

3. Ensuring that Supervisory Council members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to undue influence from Management Board or outside concerns.

The Supervisory Council is ultimately responsible for the operations and financial soundness of the bank. The Supervisory Council must receive on a timely basis sufficient information to judge the performance of Management Board. All members of Supervisory Council should be capable of exercising judgement, independent of the views of Management Board, large shareholders or government.

Including on the Supervisory Council qualified individuals that are not members of the bank’s Management Board, or having a Supervisory Council separate from a Management board, enhance independence and objectivity. Moreover, such members can bring new perspectives from other businesses that may improve the strategic direction given to Management board, such as insight into local conditions.

Qualified members of the Supervisory Council can also become significant sources of management expertise in times of corporate stress. The Supervisory Council should periodically assess its own performance, determine where weaknesses exist and, take appropriate corrective actions.

This concept is very close to the requirements of the Anglo-Saxon corporate governance model where the Supervisory Council (Board of Directors) consists of outside members. It is believed that unaffiliated or outside directors are expected to contribute the fresh and broader perspectives of those who are not involved in daily operations. Retired executives and those who serve other corporations in other capacities, such as lawyers or investment bankers, can make a valuable contributions to the Council. Senior executives of other companies or those who have distinguished themselves in other fields are especially valuable as outside directors because they serve two important functions: they enrich the discussions of the Council and they qualify as independent directors in situations where that distinction becomes important.

Example:

The Supervisory Council of HSBC Holding consists of 21 individuals. It includes a number of prominent and respectful individuals such as:

Sir Mark Moody-Stuart – Chairman of Anglo American plc. Director and former Chairman of The ‘Shell’ Transport and Trading Company, plc and former Chairman of the Committee of Managing Directors of the Royal Dutch/Shell Group of Companies. A Director of Accenture Limited, a Governor of Nuffield Hospitals and President of the Liverpool School of Tropical Medicine. Member of the UN Secretary General’s Advisory Council for the Global Compact. A non-executive Director since 2001.

The Baroness Dunn – Executive Director of John Swire & Limited and a Director of Swire Pacific Limited.. A non-executive Director of The Hongkong and Shanghai Banking Corporation Limited from 1981 to 1996. Former Senior Member of the Hong Kong Executive Council and Legislative Council.

The Lord Butler – Educator, Master, University College, Oxford and a nonexecutive Director of Imperial Chemical Industries plc. A non-executive Director since 1998. Responsible for the policy overview of HSBC in the Community and Chairman of HSBC Education Trust. Secretary of the Cabinet and Head of the Home Civil Service in the United Kingdom from 1988 to 1998.

Other members of the Council have long years experience in various business fields ranging from the highest corporate levels of banking and industrial corporations to key positions in legal and accounting firms.

4. Ensuring that there is appropriate oversight function by Supervisory Council and Management board.

The Supervisory Council may choose to delegate some of its responsibilities to committees that comprise a smaller number of its members. Many Councils of western banks have established an executive committee, one or more oversight committees, and various special purpose committees.

However, all decisions and considerations of the committees should be approved by all Council members.

The original intent of the executive committee is to act on a standby basis to deal with matters that arise between Council meetings and that require prompt attention. The executive committee should report to the full Council on a regular basis and minutes of its meetings should be made available to other members of Council.

The specific roles of the major oversight committees are still evolving. Usually, these committees concentrate their attention on a particular aspect of governance issues devoting time to study of issues in detail and developing recommendations. The most common oversight committees are the audit, compensation and nominating committees.

Audit committee – provides oversight of the bank’s internal and external auditors, approving their appointment and dismissal, reviews and approves audit scope and frequency, receives their reports and ensures that Management Board is taking appropriate corrective actions in a timely manner to address control weaknesses, non-compliance with policies, laws and regulations, and other problems identified by auditors. Because of the technical nature of the questions the audit committee is likely to deal with, the committee should include among its members at least one member who is reasonably well familiar with accounting principles and practices.

Example

The New York Stock Exchange rules state that at leas one member of the audit committee must have accounting or related financial management expertise, as the Supervisory Council interprets such qualification in its business judgement.

KPMG’s Audit Committee Institute in conjunction with Corporate Board magazine conducted a survey of 5,000 audit committee members. When asked how many of the audit committee members meet the financial expertise rules, the following responses were given:

Compensation committee – provides oversight of remuneration of Management Board and other key personnel and ensures that compensation is consistent with the bank’s culture, objectives, strategy and control environment.

The committee’s goals are to devise compensation policies and arrangements that are sufficient to recruit, retain, and encourage a talented management teams; reward individual managers in accordance with their respective contributions; to ensure that the bank’s total compensation expense is reasonable in relation to the bank’s competition and resources. The committee therefore, should have access to information (from disclosures and other reports) concerning compensation practices of competitor banks. The committee should stay well informed of new trends in executives compensation and should periodically review the bank’s policy in light of new developments.

Nomination committee – provides an important assessment of Supervisory Council effectiveness and directs the process of renewal and replacement of the Supervisory Council members.

The principal responsibility of the committee is to develop criteria for the Council membership and to identify specific individuals for nomination. The nominating committee may also be asked to devise methods for evaluating the performance of individual Council members and to periodically review and make recommendations regarding the size of the Council, committee structure and assignments, and frequency of regular Council meetings.

Special Purpose committee – The Council can create as many ad hoc committees as it needs but such committees are typically used to develop the factual basis when the matter to be decided by the Council needs a comprehensive and sustained study. In these circumstances, the special committee’s role is to gather and evaluate information and to report relevant facts to the Council. The report may or may not include recommendations but final action is left to the full Council.

Special committees are also used to exercise the authority of the council in circumstances where the Council itself can not act because of real or apparent conflicts of interest (e.g. litigation committee is formed to evaluated litigation claims by shareholders against the Council members).

Oversight by Management Board

Management Board is a key component of corporate governance. While the Supervisory Council provides oversight to the Management Board, similarly, Management Board should assume that oversight role with respect to line managers in specific business areas and activities. Even in very small banks, key management decisions should be made by more than one person (”four eyes principle”).

Management board should consist of a core group of officers responsible for the bank’s operations. These individuals must have the necessary skills to manage the business under their supervision as well as have appropriate control over the key individuals in these areas.

5. Conducting corporate governance in a transparent manner

It is difficult to hold the Supervisory Council and Management Board properly accountable for their actions and performance when there is a lack of transparency. This happens in situations where the shareholders, market participants and general public do not receive sufficient information on the structure and objectives of the bank with which to judge the effectiveness of the Supervisory Council and Management Board in governing the bank.

Transparency reinforces sound corporate governance. Therefore, public disclosure is necessary in the following areas:

Supervisory Council structure (size, membership, qualifications and committees);

Management board structure (responsibilities, reporting lines, qualifications and experience);

Basic organizational structure (line of business structure, legal entity structure);

Information about the incentive structure of the bank (remuneration policies, executive compensation, bonuses, stock options);

Nature and extent of transactions with affiliates and related parties.

Example:

As an example of the overall approach to the transparency of the corporate governance process we will illustrate the structure of the disclosure made by the ING Group in its annual report. In particular, the report contains the following sections of disclosures:

- Recent legal developments in the area corporate governance Meetings of shareholders and providers of capital (issue of shares in the form of depositary receipts, cumulative preference shares, agenda for the meeting of shareholders)

- Executive board (rules, compensation, granted option rights and holding of securities)Supervisory board (profile of the supervisory board,  rules, reappointment of supervisory board members, other offices held/independence of Supervisory board members, remuneration and holding of securities)

- Information on members and experience of the Supervisory Board

- Information on members of the Executive Board

- Remuneration – executive board (general policy, base salary, short-term performance-related bonus, long-term incentive, pensions, options, ING Group shares held by members of the Executive Board) Remuneration of the Supervisory Board

- Details of the stock option plan, granted and exercised options.

6. Ensuring an environment supportive of sound corporate governance

Primary responsibility for good corporate governance rests with Supervisory Council and as implemented by Management Board of banks; however, there are many other ways that corporate governance can be promoted, including by:

government – through laws;

securities regulators, stock exchanges – through disclosure and listing requirements;

auditors – through audit standards on communications to Supervisory Council, Management Board and bank supervision; and

banking industry associations – through initiatives related to voluntary industry principles and agreement on and publication of sound practices.

Corporate governance can be improved by addressing a number of legal issues, such as the protection of

shareholder rights; the enforceability of contracts; clarifying governance roles; ensuring that corporations function in an environment that is free from corruption and bribery; and laws/regulations (and other measures) aligning the interests of managers, employees and shareholders. All of these can help promote healthy business and legal environments that support sound corporate governance and related supervisory initiatives.

Example:

McKinsey Global Investor Survey on Corporate Governance listed the following factors chosen by the investors as top four priorities in corporate governance area for policy makers:

strengthen shareholder rights (33% of respondents)

improve accounting standards (32% of respondents)

more effective disclosure (31% of respondents)

stronger enforcement of fiduciary duties (27% of respondents)

Members of Supervisory Council are fiduciaries – people in     Fiduciary

whom others place a special trust and confidence. As such      Duties

members of Council owe to these “others” (shareholders, stakeholders etc) the duty of care and duty of loyalty.

Bearing in mind the fact specific nature of duty of care and understanding that high risk transactions require special attention, individual members of Supervisory Council can be reasonable assured of meeting the duty of care by observing the following guidelines:

Each member of Council should have working knowledge of bank’s business, its services, its human resources, and particular problems effecting the bank. For the new members of Council this means committing a considerable amount of time to acquiring information about bank. Management Board can play a key role in helping Council members meet their duty of care by assembling packages of information that include analysts’ reports, articles, relevant information concerning the bank and its competitors, shows advantages and disadvantages of each proposal.

Being nominated to serve as a member of Council is an honor but it requires a continuing commitment of time. No one should assume this responsibility unless he or she is confident of having sufficient time to do the best job possible. Thus, members of Council should attend all meetings; should attend these meetings fully prepared. This involves study, reflection and formulation of any questions concerning the reports, proposals or other documents to be considered at the meeting.

Each member of Council should actively participate in the work and resolve relevant questions before voting            participant on an issue. If members genuinely feel that something has not been resolved to their satisfaction, they should not hesitate to press the point and insist on a satisfactory answer or delay until they get the information.

Members of Council must always be conscious of the fact       Honor the office that they have been chosen for a position of special trust and confidence. Council is a cooperative and collegial body in which the ultimate goal is to advance the collective interest. Individual egos and interests must be subordinated to the interests of the Council, the shareholders, and interests of other stakeholders. Accordingly, members of Council should approach all matters with an open mind and be receptive to the opinions and ideas of others, in the end they must rely on their own sense of what is fair, equitable and in the best interests of the bank.

Example:

This is example illustrates an extremely bad negligence of the duty of care by the Supervisory Council member.

Mr. Ivan Petrenko is a member of the Supervisory Council of a large bank. He was appointed to this position 3 months ago. He is the general director of textile factory and his financial and banking experience is very limited. He is to attend his first meeting of the Supervisory Council. Because of his work load at the plant he was able to devote only half a day to read the materials provided to him for the Council meeting. While quickly reading the materials, he skipped the parts that appeared complex or too technical.

At the Supervisory Council meeting the back of his mind was constantly thinking about the negotiations with the key customer of the textile plant that had to be conducted in his absence. He often had to step out of the Meeting room to answer the call on his mobile phone and as a result, missed parts of the discussion. He preferred to listen rather to speak at the Meeting and therefore, was not actively involved in discussions. He thought that he will vote on decisions in the same way as his fellow member that he met during the lunch.

Here is another real life example how the breach of duty of reasonable care resulted in holding the Chairman of Supervisory council liable for many millions of dollars.

This was a legal action brought in 1991 by the Commonwealth Bank to recover moneys advanced to the National Safety Council of Australia (NSCA).

The Chief Executive Officer (CEO) of the NSCA built an empire upon lies and deceit.

In the course of the action, the role of the Chairman of the Board of NSCA came under scrutiny. The Chairman, who was not a young man, was found by the Court to have failed to have exercised acceptable standards of care and diligence with respect to the Council’s interests. It appeared that he had been a mere ‘rubber stamp’ for CEO’s activities and had taken no steps to seek verification of equipment purchases and no, or insufficient interest in proposals that CEO brought to the Council.

It was held that the Chairman was personally liable for a part of the moneys owed to the bank.

Duty of Care Guidelines for the Council as a whole

No individual Council member can fulfill the duty of care all alone. The Council’s effectiveness is determined by the aggregate performance of its individual members. To ensure the adequacy of this performance, Council should establish and preserve certain processes and prerogatives. These include the following:

Complete and timely information – The Council has a right to expect that it will be kept fully advised of all material corporate developments and that such information will be provided as promptly as possible. The Council should expect that full documentation on all proposals submitted for its consideration.

Adequate time for deliberation – The Council should expect the Management Board to give as much advance notice as possible of any significant transaction submitted for its consideration. The Council can and should decline to decide any matter that it has not had the opportunity to consider thoroughly. The time required for consideration can be shortened significantly if the Council members are routinely kept informed of pending developments.

Maintain adequate records of Council discussions – Some banks record in their minutes provide only the actual resolutions adopted by the Council. However, for all significant transactions it is better to summarize fully the actual deliberations of the Council, including questions asked and answers given, the vote taken by each member and the well reasoned basis for his vote. The corporate secretary (or other individual taking notes) should file with the minutes copies of all reports, memos, financial records and other considered by the Council. A complete record is the best evidence that the Council acted with due care.

Example:

This is example illustrates a good practice of the duty of care by the Supervisory Council.

The Supervisory Council of the “Uniqum Bank” consist of 10 individuals. Meeting of the full Council is held every month. The Management Board of the Bank assigned one of its members to ensure that Supervisory Council receives all information needed for the meeting on time. His duty is to ensure that all Supervisory Council members obtain detailed agenda and information packages at least 15 days in advance of the next meeting.

Reports requested by the Council are very specific and detailed. The information package for the Council were always of high quality and reliable. The Council has never set the deadline for the end of the meeting in its belief that the meeting will not be closed until all issues are thoroughly discussed and agreed. It is a usual practice of the Council that every member should provide his opinion or comment on every issue of the agenda. All discussions and deliberations are documented in the form of tape records and detailed notes. The final minutes of Council meetings are signed by its members shortly after the end of the meeting.

This duty extends beyond refraining from taking advantage of the bank: loyalty also commands that members of Council not take advantage of their position even though no demonstrable harm may result to the bank from their actions.

Members of Council are not permitted to use information gained in their capacity for personal gain or to extract a personal benefit from a third party by promising to grant or threatening to withhold corporate business.

Compensation

Excessive compensation violates the duty of loyalty. As a practical matter, the most troublesome questions in this area are likely to involve allegations of excessive consumption of perquisites or other forms of implicit compensation.

Conflicts of Interest

Loyalty issues are also involved whenever a member of Supervisory Council has a personal interest in a transaction to which the bank is also a party.

The most prudent course of action for all members of Supervisory Council is to confine their relations with the bank to service on the Council.

Members of Supervisory Council have a legal conflict of interest whenever they, a family member, or any entity in which they have a significant financial interest or role enter into a material transaction with the bank. In conflict situations, the conflicted member and the Council should be concerned about the substantive fairness of the transaction and the manner in which it is effected. The price and terms of the transaction must be at least as favorable to the bank as it would have been in an arm’s-length transaction with a stranger. The conflict of interest matter should be sufficiently documented in the minutes, the conflicted member should withdraw from the meeting and not vote as well as should not pressure other members of Council to vote in his favor.

All members of Supervisory Council should take an especially hard look at any conflict situation, treat their colleague as though he or she were a stranger, and resolve all doubts against the conflicted member.

More difficult questions arise when a member wishes to invest in something that the bank would be likely to pursue for itself if aware of the opportunity.

Example:

This is example illustrates a bad practice of the duty of loyalty by the Supervisory Council members:

IEQ PLC is suing its former directors and one adviser (IEQ PLC, formerly Intermediate Equity PLC, provides ’specialty finance’; short term finance or equity bridging to commodity based ventures )

IEQ’s claim seeks to recover more than £3 million, in respect of questionable loans and bogus investments authorised by the former directors. IEQ says the former directors breached their fiduciary obligations as directors in two respects. First, the former directors should have given proper consideration to the monies advanced and investments made, having regard for the rights of IEQ’s shareholders, the expectation of a reasonable return, and likelihood for success.

In making these investments, some of the former directors failed to disclose their personal involvement or interests in the recipients of IEQ’s money. The investments were improper because these former directors thereby intentionally placed themselves in a position whereby they had a conflict of interest or, at the very least, a potential conflict of interest. This made it difficult for them to make future decisions on strategic investment choices, as a director, free of their own personal interests.

Adding to the conflict is the fact the director’s own shares (in some cases) were obtained at a discount from the amount paid by IEQ. This brings into play a profit motive, accentuating the former director’s personal interests and places too much strain upon the loyalties of the director.

The size of the investments being made by the former directors represented a considerable undertaking for IEQ, when compared to the available funds. IEQ’s weak financial condition made it all the more important that its directors should have no conflicting personal interest in any dealings on behalf of the corporation.

The relationship between government (bank supervision) and banks is different compared with commercial companies. Central Bank can determine the types of services that banks may offer; bank supervision have authority to examine the operations of banks; Central Bank requires disclosures by banks that are not required from other companies; Central Bank constrain decisions of banks on their capital structure; Central Bank exercise a great deal of authority over the operation of troubled banks etc.

Bank supervision cannot function well if sound corporate governance is not in place and, consequently, bank supervision has a strong interest in ensuring that there is effective corporate governance at every banking organization.

Sound corporate governance makes the work of bank supervision easier. Sound corporate governance should contribute to a collaborative working relationship between bank management and bank supervision.

A bank’s Supervisory Council and Management Board are ultimately responsible for the performance of the bank. As such, bank supervision typically check to ensure that a bank is being properly governed and bring to management’s attention any problems that they detect through their supervision efforts. When the bank takes risks that it cannot measure or control, bank supervision must hold the Supervisory Council accountable and require that corrective measures be taken in a timely manner.

Sound corporate governance considers the interests of all stakeholders, including depositors, whose interests may not always be recognized. Therefore, it is necessary for bank supervision to determine that individual banks are conducting their business in such a way as to protect depositors.

Bank supervision examiners usually deal with bank management during the examination to obtain information or to discuss issues. When the examination is complete, the examiners prepare a report of examination and should conduct a meeting with the bank’s Supervisory Council to discuss the results of the examination.

An environment in which examiners and Supervisory Council members openly and honestly communicate benefits a bank. The Central Bank examiners and office personnel have experience with a broad range of banking activities and can provide independent, objective advice on safe and sound banking principles and compliance with laws and regulations.

Supervisory Council members should be encouraged to meet with the Central Bank examiners to discuss the condition of the bank and the results of the examinations. They should ask questions and raise issues of concern. They also should create an environment in which examiners and supervisory council members openly and honestly assure themselves that the bank completes any specific follow-up actions in a timely manner.

The activities of the Central Bank examiners, however, do not diminish the Supervisory Council’s responsibilities to oversee the Management board and operation of the bank. Supervisory Council members are independently responsible for knowing the condition of the bank and should not rely on the bank supervision examiners as their sole source of information to identify or correct problems. Instead, the Supervisory Council should look to its Management board, its auditors, and other outside experts to identify and correct any problems.

Example:

This example illustrates the importance that the bank supervision in the US devotes to the corporate governance issues of commercial banks:

Every quarter Supervision and Regulation’s Risk Committee of the Federal Reserve Bank of Chicago meets to determine the top banking risks facing Seventh District banks in the upcoming months and develop appropriate supervisory responses. Here is the latest listing of the top risks, arranged alphabetically:

Accounting

Chasing Yield

Corporate Governance

Home equity lending

Internal controls and fraud

Liberal Extensions on Loans Masking Delinquency

Loan Rating Systems

Overdraft-Protection Products

Risks of Rising Interest Rates (Community Banks

Trust Departments Investing in their Own Proprietary Mutual Funds

USA PATRIOT Act Compliance (Anti Money

In recent years, Corporate Governance has moved to the center of attention all over the world.

Ukraine is gradually making the considerable progress in recognition of issues and importance of corporate governance.

Key elements of corporate governance in bank are:

Establishment of strategic goals and corporate values;

Setting clear lines of responsibility and accountability;

Adequate independence and professional competence of Supervisory Council members;

Appropriate oversight functions;

Transparency in corporate governance matters; and

Support of outside environment of sound corporate governance.

Members of Supervisory Council are responsible for proper fulfillment of its the fiduciary duties: duty of care and duty of loyalty.

Bank supervision should have a strong interest in ensuring that there is effective corporate governance in every banking organization

Risk management is an interactive process and corporate governance and controls should work around this interactive model. Identifying risks and simply reporting them, or reporting them incompletely does not help the bank and is likely to be considered unsatisfactory by bank supervision.

Corporate governance also implies the design, implementation and monitoring of the process of risk management and ensuring that it is integrated into the day to day activities of the bank.

It is the responsibility of the Supervisory Council of a Bank to:

- Set the risk strategy policies in liaison with Management Board.

- Ensure that the bank has implemented an effective ongoing process to identify risk and its potential impact on the business of the bank.

- Activate what is necessary to proactively manage these risks.

- Maintain a sound system of internal control to protect depositors, safeguard shareholders investment, the bank’s assets and the bank’s ongoing sustainability.

- Make disclosures to shareholders on the bank’s risk and management thereof.

By maintaining a sound system of risk management and internal control, Supervisory Council ensure that:

- Operations are run effectively and efficiently.

- The bank’s assets are safeguarded.

- Applicable laws, regulations and codes are being complied with.

- The processes and procedures are regularly reviewed to ensure the effectiveness of the bank’s internal systems of control and reliable reporting, so that the decision making and accuracy of reporting to shareholders is maintained at a high level.

- There is a system of checks and balances and reporting mechanisms in place that meet good corporate governance practices.

While some banks are implementing a bottom-up approach to governance and risk management (unless the Supervisory Council understands and participates in the monitoring, review and control processes) it is likely that eventually a glaring, big-picture omission will result in embarrassment, financial loss or worse – collapse of a bank.

There are three aspects to risk that Supervisory Council should be aware. It not only needs to decide on what to do with the inherent risk (the risk before any controls or actions). Residual risk (the risk that remains after the implementation of the risk management activity) and retained risk (the risk that the Supervisory Council decides to live with) must also be taken into consideration.

Example

As a good demonstration of interrelation between the corporate governance and risk management process one can refer to the 2002 annual report of ABN AMRO Bank (page 50 of annual report).

Risk governance organizational structure

The Managing Board establishes the strategic risk philosophy and policies for ABN AMRO under the supervision of the Supervisory Board. The Supervisory Board, as part of its oversight responsibilities, regularly monitors the risk of the bank’s portfolio Responsibility for the overall implementation of risk policy lies with the Chief Financial Officer, who is a member of the Managing Board.

Because market conditions and bank structures vary, no single risk management system works for all banks. Each bank should develop its own risk management program tailored to its needs and circumstances. The sophistication of the risk management system will increase with the size, complexity, and geographic diversity of each bank. All sound risk management systems, however, have several common fundamentals.

All sound risk management systems have several common fundamentals.

For example, bank staff responsible for implementing sound risk management systems should perform those duties independently of the bank’s risk-taking activities.

Regardless of the risk management program’s design, it should include mechanisms for identifying, measuring, controlling, and monitoring risks.

The focus is the view of whether the risk causes a negative deviation from desired or planned outcome or whether the negative effects are the risk itself. Sometimes a mixture of cause and effect (or so called Risk Identification Matrix) is used by banks for identification of risk.

For example:

In 1995, Nick Leeson, a 28 year old derivatives trader in the Barings Singapore office lost over $1.4b betting on Nikkei futures, wiping out the bank’s equity capital and making it technically bankrupt.

The conventional view that Barings’ derivatives losses were actually not market risks but operational risks, because no oversight was placed on transactions performed by the dealer.

It is not a matter of “either-or” but “cause and effect”. The causes were doubtless operational: the grossly negligent breach of recognized internal control principles. But it is just as clear that the effect was an unexpected loss of market value, that is, market risk.

For example: many western banks use internal models for measuring exposure to market risks. It is based on the following general conceptual framework: price and position data arising from the bank’s trading activities, together with certain measurement parameters, are entered into a computer model that generates a measure of the bank’s market risk exposure, typically expressed in terms of value-at-risk. This measure represents an estimate of the likely maximum amount that could be lost on a bank’s portfolio with a certain degree of statistical confidence.