The Observer (Kampala)

Uganda: Corporate Governance Shields Banking Sector

In his remarks during the recent Mubs 5th annual international leadership conference, Deputy Governor Bank of Uganda Dr Louis Kasekende decried conflict of interest in corporate firms.

Below is an abridged version of his speech.

The function of corporate governance is to ensure that business enterprises are managed in a way which is not destructive to the wider society. Inherent in the concept of corporate governance is the notion that there are potential conflicts of interest in the management of firms and that those with the power to control the management of firms might take decisions which benefit themselves at the expense of other stakeholders or the general public.

Financial services:

Such conflicts are most acute in large and complex enterprises operating in particular industries such as the extractive industries and the financial services. One way of analysing such conflicts is in terms of market failures, arising from monopoly power, negative externalities or imperfect information.

Hence corporate governance can be seen as a tool to try and mitigate market failures. I first want to explain why the financial sector is particularly vulnerable to market failures, which can give rise to potentially very damaging conflicts of interest, as was vividly demonstrated in the recent global financial crisis. I then want to discuss how we have sought to address these problems in Uganda through efforts to strengthen corporate governance in the banking sector.

The role of a bank's board of directors in providing oversight of bank management and ensuring that the bank implements proper risk-management policies is at the heart of the approach to corporate governance in banking in Uganda, as it is elsewhere in the world. Several intrinsic characteristics of the financial sector make it vulnerable to conflicts of interest.

The "insiders", who are those with the power to control the management of financial institutions, can exploit their power to profit at the expense of other stakeholders "outsiders", who include depositors, non-controlling shareholders and the general public.

Insiders are often better informed about the future prospects for financial assets which they control. As a result, the balance sheets of banks are inherently opaque [not clear], especially because a large share of their assets comprises loans whose true value is not directly observable by outsiders. Hence it is very difficult for outsiders to evaluate accurately the true value of a bank's assets and thus its true financial condition.

Informational asymmetries give incentives for participants in financial markets, such as the insiders, to act in ways which are not in the interest of outsiders and which give rise to market failures.

Bank liabilities:

Most of the liabilities of banks are owned by a very large number of atomised depositors. These depositors have most to lose from reckless or abusive bank management. But because of both lack of knowledge and "free rider" problems, depositors are not in a strong position to exert any restraining influence over bank management.

Also, the potential damage which the failures of large financial institutions can inflict on the economy is enormous. Economic recessions caused by financial crises are much deeper and last longer than is typical for recessions. In most market economies, including Uganda, the government provides some form of explicit bank deposit insurance.

Governments are also widely assumed to provide an implicit guarantee to bail out 'systemically important financial institutions' which are deemed to be too big to fail, because their failure would have disastrous consequences for the economy.

These guarantees for bank creditors - explicit and implicit - intensify moral hazard in the financial system, in that they switch the burden of bearing the costs of bank failure from bank creditors to taxpayers. This weakens further any restraining influences on reckless or abusive bank management which might be exerted by creditors.

The consequences of these intrinsic features of the financial system are twofold. The first is that management of financial institutions, and especially banks, have incentives to engage in much riskier business strategies than is socially optimal. Hence bank failures are more likely to occur, at the cost of their depositors and the taxpayers.

Secondly, insiders may have incentives to loot their own institutions, through for example, insider lending, at the expense of non-controlling shareholders as well as depositors and taxpayers.

Regulation:

You might wonder why we need to bother with corporate governance when we have public regulators, such as the Bank of Uganda, whose responsibility it is to prevent the reckless and abusive management of banks. Might this not be a case of the regulator trying to evade its own responsibility?

My answer to this question is that no financial regulator is omnipotent. Furthermore, the ability of the financial regulator to monitor and influence the behaviour of the management of financial institutions depends heavily on the business environment in which these institutions operate and thus the incentives which their managers face.

Uganda's approach to the reform of corporate governance in the financial sector has been shaped by the lessons which we drew from several bank failures more than a decade ago and by the evolution of international standards in this area. In the 1990s and early 2000s, Uganda's banking industry suffered a number of bank failures.

Eight banks failed, forcing the Bank of Uganda (BOU) to intervene and resolve them. In some cases the failed banks were closed, in others they were sold to new owners. The primary cause of most of these bank failures was poor corporate governance.

In many of the failed banks, a dominant shareholder or group of shareholders was able to exert undue influence over the management of the bank which resulted in abuses such as pervasive insider lending. The losses incurred on insider loans were the single most important contributor to the collapse of these banks. Poor and abusive management was allowed to flourish in banks because their boards of directors were usually weak.

The bank failures of the 1990s prompted the BOU and the government to strengthen banking regulation. The BOU and the government also recognised that statutory bank regulation and supervision by a public agency cannot be expected, on its own, to guarantee the sound management of banks.

Moreover, excessively heavy-handed regulation, although it might protect depositors, can also stifle innovation and risk taking in banks, which would be detrimental to economic development. In a market economy, the onus for sound management, including the proper management of risks, must lie with the banks themselves. Bank regulators cannot be a substitute for bad bank managers.

The board:

Uganda's corporate governance regulations place great emphasis on the fiduciary responsibilities which the board of directors [owes to] all stakeholders. The board collectively must take ultimate responsibility for the performance of the bank and for the manner in which it conducts its operations.

They must also ensure that the bank's policies prohibit corruption and conflicts of interest in the bank's operations. An important function of the board is to define clearly the duties and responsibilities of each member of the bank's senior management.

To exercise their responsibilities, the directors themselves must be of the highest integrity and have the professional expertise necessary to understand the nature of a banking operation and, in particular, how it differs from that of a non-bank company, and what that means for the fiduciary responsibilities of the directors.

Uganda's corporate governance regulations also stress that an individual director cannot hide behind collective board responsibility. Each director can be held individually responsible for any failings of the bank.

Conclusion:

Banks perform a unique role in a modern market-oriented economy. When banks work well, they contribute to economic growth by allocating scarce financial resources efficiently and allowing private companies and individuals to undertake productive investments which they could not fund fully from their own resources.

When banks work badly, which is not uncommon, they can inflict damage throughout the economy, causing losses to depositors, firms who need credit and taxpayers. The unique characteristics of banks provide the rationale for prudential regulation by public agencies, such as the Bank of Uganda.

But it is unrealistic to expect that bank regulation alone can guarantee the efficient and safe operations of the banking system. Good corporate governance is just as important for sound and efficient bank management as good bank regulation. Corporate governance must start with the board of directors, setting the overall strategic policies of the bank and providing independent oversight of bank management.

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