Corporate governance in the Indian banking industry

Abstract

The paper makes a case for corporate governance as an internal mechanism in banks, and therefore influenced by cultural issues, to dovetail with the overriding compulsions of prudential regulation, that sets the boundaries for systemic stability. The dynamic changes in the structure of global financial markets and the blurring of boundaries between different players — banks, investment banks and hedge funds, pose new challenges for financial regulators. This is especially crucial in the context of structural mechanisms that are in place to run the new financial conglomerates. From a regulatory perspective, the key issue would be the presence of unregulated entities/holding companies in the structure. The presence of any unregulated entity within the Bank Holding Company/Financial Holding Company structure, especially an unregulated intermediate holding company, may prove to be a weak link in the entire structure, providing scope for regulatory arbitrage. As is evident from the recent sub-prime problems originating in the United States, all financial entities are interdependent and the collapse of any one, not necessarily a commercial bank, involves a systemic risk and may propel the financial regulator to save it. In the context of overriding compulsions of financial stability and the inherent limitations of any external regulation to anticipate all innovative, exotic derivative products and eliminate the propensity of excessive risk-taking by a bank/financial entity, regulators worldwide, and in India, are placing more and more responsibility on bank boards. This has entailed, on the part of the board, a better quantitative understanding of the risks inherent in specific lines of activity and a clear assessment of possible impact on the financials. In the Indian context, the Reserve Bank of India (RBI) has put in place detailed regulations related to the composition of bank boards, the ‘fit and proper’ criteria for appointment of directors, transparency and disclosure norms for derivative products, related-party transactions, risk-based internal audit and other crucial components of banks' corporate governance architecture. The systemic risk posed by such financial conglomerates (FC), because of possible regulatory arbitrage, is sought to be plugged by a system for all the identified FC whereby a designated entity within the conglomerate reports to its lead regulator. In order to monitor the intra-group transactions and exposures, information from the designated entities of each FC is obtained by the principal regulators and a system for exchange of information among the regulators has been put in place. Mixed ownership of government (as a majority shareholder) and private (almost all public sector banks are listed on the stock exchange) also poses a unique challenge of divergent objectives of shareholding and the issues of reconciling them. In the final analysis, corporate governance is a continuous process of evolving best practices in response to market developments. RBI cannot be complacent. This is the constant thrust of RBI's initiatives in ensuring a vibrant corporate governance framework.