Annex 10.C Financial Sector Governance—Selected Issues
Financial sector governance refers to (a) corporate governance of financial institutions and other market participants (e. g., issuers, service providers), as well as governance arrangements for financial sector regulatory agencies, and (b) the nexus of relationships among institutions whereby quality of governance of one institutional segment affects the other. Although quality of financial sector governance will ultimately be conditioned by the overall public sector governance, several key issues arise in assessing and strengthening financial sector governance. First, how well have the components of existing supervisory standards that deal with regulatory governance been implemented in practice? And what is the effect of regulatory governance on the overall effectiveness of supervision and soundness of the financial system? Second, has the governance of financial institutions (particularly banks) required additional controls and safeguards over and above the normal corporate governance practices and standards that apply to non-financial firms? Third, how should regulatory governance and regulatory policies in individual sectors be adjusted to help strengthen and reinforce corporate governance of financial institutions? This last issue has been given prominence in a recent research (see Barth, Caprio, and Levine 2004). Finally, how should policy makers encourage regulated financial institutions to exercise greater focus on the quality of governance of their counterparties (financial and non-financial firms, household, and government)?
Regulatory agency governance can be defined, similar to the definition of public sector governance in Kaufman (2002), as (a) the capacity of the agency to manage resources efficiently and to formulate, implement, and enforce sound policies and regulations and (b) its ability to carry on its mandate consistent with the broader goals and policies of the government and legislature. Regulatory agency governance can be assessed in terms of four key attributes that determine its “capacity” and “ability” to carry out its objectives effectively. Those attributes are independence, accountability, transparency, and integrity.
In the presence of several regulatory agencies and oversight bodies, the overall regulatory governance (not simply the internal governance of a single agency) will also depend on interagency governance arrangements, including division of responsibilities among oversight agencies, as well as information exchange and communication arrangements. The existing supervisory standards cover those elements in varying degrees of depth. The clarity of its mandate, the ability to carry out its mandate through appropriately designed instruments without undue interference, and the legal identity of the agency are among the factors that govern independence. Accountability of the agency to the body that had delegated the responsibility—the government or the legislature—and to the courts and the public (stakeholders) helps to add credibility and reinforce independence.
Transparency means that the agency’s objectives, frameworks, regulatory processes and accountability arrangements, and internal processes to ensure integrity are all disclosed to the public in a comprehensive, accessible, and timely manner. Integrity of the agency is ensured by mechanisms such as procedures for appointment and removal of management, internal audit arrangements, standards for the conduct of staff members’ personal affairs to prevent conflicts of interest, and the legal protection for staff members in discharging their official duties in good faith. Finally, the combination of information exchange and coordination arrangements among various sectoral supervisors and oversight bodies raises issues relating to the optimal design of institutional arrangements for supervision, as discussed in appendix F, Institutional Structure of Financial Regulation and Supervision.
Recent experience with assessments of observance of the core principles relating to regulatory governance across sectors shows that, in most countries, the principles are well implemented, except in the case of the insurance sector, where compliance was relatively low compared with other sectors (banking and securities). Main weaknesses observed were related to regulators’ independence; lack of clarity of regulators’ objectives and accountability arrangements; regulatory forbearance, sometimes reflecting lack of legal protection for the regulator; and lack of clarity with respect to the responsibilities of the regulatory body and self-regulatory organizations (see IMF 2004). Also, quality of regulatory governance affects financial system soundness, as illustrated in Das, Quintyn, and Chenard (2004).
In light of the systemic stability concerns associated with the commercial banking functions, supervisory authorities typically place emphasis on additional safeguards to enhance corporate governance of banks. For example, the Basel Committee on Banking Supervision has issued a range of guidance documents, including “Enhancing Corporate Governance for Banking Organizations” (Basel Committee on Banking Supervision 1999b), that bear directly on various aspects of internal governance of banks. The relative emphasis on official regulation and supervision, on the one hand, and corporate governance and market discipline aspects of supervised institutions, on the other hand, varies among countries, in part, reflecting the structure and state of the financial system and, sometimes, the level of systemic stress in the system. Thus, the supervisory approach toward enhanced corporate governance of banks varies over time and across countries. Similarly, the appropriate approach to strengthening governance of non-bank financial institutions is a recurring theme in the design of regulatory policies for non-bank financial sectors, including securities markets and their institutions (see Litan, Pomerleano, and Sundararajan, 2002). In addition, emphasis on disclosure standards for banks under Pillar
III of the New Basel Capital Accord is designed to strengthen governance of, and market discipline on, banks.
Several regulatory authorities, notably the Reserve Bank of New Zealand, place great emphasis on adjusting their supervisory approaches to ensure that corporate governance of banks and market discipline are strong. Those adjustments have been achieved through the following means:
• Holding directors responsible and requiring them to attest to accuracy of disclosures and to quality of regulatory compliance
• Ensuring adequate representation of non-executive independent directors, with a separation of board chairman and chief executive
• Requiring directors to avoid individual and collective conflicts of interests
• Ensuring rigorous internal and external audit arrangements, with external auditors having a measure of independence
• Enforcing regular, timely, comprehensive, meaningful, and reliable financial and governance disclosure
• Promoting incentives for market scrutiny of banks through contestable banking; equal competition between banks and non-banks; limited (or absence of) deposit insurance; and equitable loss sharing among all creditors, depositors, and shareholders
The extent to which financial institutions exercise influence on corporate governance of counterparty institutions, particularly non-financial corporations, also will vary a great deal across countries, but certain policies can make a difference. First, sound principles of risk management and asset selection promoted by the regulator could include adequate attention to corporate governance of counterparties. Second, corporate governance policy that is used by major institutional investors in guiding their asset allocation could be highly effective. Finally, the insolvency and creditor rights regime and other supporting institutional arrangements for bad debt resolution and asset management could provide powerful incentives for banks to exercise due diligence on counterparty credit risk and for debtor institutions to exercise good governance. The governance arrangements and governance nexus would, of course, change in times of crises, with relative roles of regulatory and oversight agencies, as well as the intrusiveness of official supervision and regulation changing rapidly to ensure stability.
7. The IASB is an independent, privately funded organization that is based in London and that sets accounting standards. The board members come from nine countries and have a variety of functional backgrounds. The IASB is committed to developing—in the public interest—a single set of high-quality, understandable, and enforceable global accounting standards that require transparent and comparable information in general - purpose financial statements. For additional information, see http://www. iasb. org.
8. The IFAC is an international organization for the accountancy profession. It works with 157 member organizations that represent 2.5 million accountants in public practice, industry and commerce, government, and academia. Its stated overall mission is to serve the public interest, to strengthen the worldwide accounting profession, and to contribute to sound economies by establishing and promoting adherence to high-quality professional standards, thereby furthering the international convergence of such standards, and by speaking out on public interest issues where its expertise is relevant. International Standards for Auditing (ISAs) are issued by the International Auditing and Assurance Board (IAASB), which functions as an independent setter of standards under the auspices of IFAC (see http://www. ifac. org).
9. See IASB (2004) for a list of IASs with summary descriptions of each standard.
10. See IFAC (2004) for a full listing of code of ethics ISAs and other engagement standards.
11. 
The ROSC Web site posts details of the accounting and auditing assessment tools and published country modules and these are available at http://www. worldbank. org/ifa/ rosc. html.
12. Currently, no international regulatory standards exist for A&A, although efforts to address this gap are under way. In the absence of regulatory standards, Bank staff members draw on their own experiences and international best practices.
13. This section is based on Artigas (2004), a paper from Financial Stability Institute.
14. For example, Standard & Poors may put a country on “credit watch,” whereas Moody’s puts a country “on review for possible upgrade/downgrade,” and Fitch issues “alerts.”
15. For a recent example of corporate governance assessment undertaken as part of FSAP, see IMF (2003c).
16. This governance nexus—whereby the broader governance arrangements, financial supervisory policies (affecting governance of supervised financial entities), and policies of supervised financial entities themselves (affecting nonfinancial firm governance) interact with one another—is explored in Litan, Pomerleano, and Sundararajan (2002).
17. Fremont and Capaul (2002); for empirical evidence that investors would be prepared to pay a premium for companies exhibiting high governance standards, see Newell and Wilson (2002) and Bhojraj and Sengupta (2003).
18. When ROSCs are prepared in the context of an FSAP, they may also be published—at the initiative of the authorities—as part of the FSSA report of the IMF.
19. See, for example, Nier and Baumann (2003).
20. See section 10.5.2 for a discussion of disclosure standards in the new capital accord.
21. Compliance with Basel Core Principle 21 requires that the supervisor has the authority to hold management responsible for ensuring that the financial statements issued annually to the public receive proper external verification. However, it does not
indicate that the supervisor has the authority to require that the financial statements be disclosed. An additional criterion indicates that the supervisor promotes periodic public disclosures of information that are timely, accurate, and sufficiently comprehensive to provide a basis for effective market discipline. Therefore, at most, if financial statements are not disclosed, assessors would note it in the comments to the principle. See Basel Committee on Banking Supervision (1999a).
22. See “New Zealand: Financial System Stability Assessment” (IMF 2004b).
23. See, for example, Basel Committee on Banking Supervision (1998), Basel Committee on Banking Supervision (1999c), and Basel Committee on Banking Supervision (1999d).
24. See Basel Committee on Banking Supervision (2003b).
25. For example, compliance with Core Principle 21 may be affected, even when the supervisors exercise comprehensive powers to enforce wide-ranging disclosures, if the underlying accounting standards were to deviate from international norms.
26. See United States Securities and Exchange Commission (2001) and United States Securities and Exchange Commission (1997).
27. 
See Section 10.1 on MFP transparency code of good practices for a discussion of transparency of aggregate information. The Financial Stability Reports published by various central banks (see, e. g., http://www. bankofengland. co. uk/financialstability/index. htm) include aggregate information on regulated financial firms.
28. See Basel Committee on Banking Supervision (2003a).
Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI). 2000. Accounting, Auditing and Governance Standards for Islamic Financial Institutions. AAOFI, Manama, Bahrain.
Artigas, Carlos Truchartem. 2004. “A Review of Credit Registers and Their Use for Basel II.” A Report for the Financial Stability Institute Bank for International Settlements, Basel, Switzerland.
Barron, John M., and Michael Staten. 2003. “The Value of Comprehensive Credit Reports: Lessons from the U. S. Experience.” In Credit Reporting Systems and the International Economy, ed. M. J. Miller, 273-310. Cambridge, Massachusetts: MIT Press.
Barth, James, Gerard Caprio, and Ross Levine. 2004. “Bank Supervision and Regulation: What Works Best?” Journal of Financial Intermediation 13 (2): 205-48.
Basel Committee on Banking Supervision. 1998. “Enhancing Bank Transparency.” Basel Committee Publications 41, Bank For International Settlements, Basel, Switzerland.
---- . 1999a. “The Core Principles Methodology.” Basel Committee Publications 61,
Bank For International Settlements, Basel, Switzerland. Available at http://www. bis. org/publ/bcbs61.htm.
---- . 1999b. “Enhancing Corporate Governance for Banking Organisations.” Bank For
International Settlements, Basel, Switzerland. Available at http://www. bis. org/publ/ bcbs56.pdf.
---- . 1999c. “Sound Practices for Loan Accounting and Disclosure.” Basel Committee
Publications 55, Bank For International Settlements, Basel, Switzerland. Available at http://www. bis. org/publ/bcbs55.htm.
---- . 1999d. “Recommendations for Public Disclosure of Trading and Derivatives
Activities of Banks and Securities Firms.” Basel Committee Publications 60, Bank for International Settlements, Basel, Switzerland. Available at http://www. bis. org/publ/ bcbs60.htm.
---- . 2003a. “The New Basel Capital Accord.” Third Consultative Paper, Bank For
International Settlements, Basel, Switzerland.
---- . 2003b. “Public Disclosures by Banks: Results of the 2001 Disclosure Survey.” Basel
Committee Publications 97, Bank For International Settlements, Basel Switzerland. Available at http://www. bis. org/publ/bcbs97.htm.
---- . 2004. “International Convergence of Capital Measurement and Capital
Standards—A Revised Framework,” June 2004, Bank For International Settlements, Basel, Switzerland.
Beers, David T., Marie Cavanaugh, and Takahira Ogawa. 2002. “Sovereign Credit Ratings: A Primer.” Available at the Standard and Poors Web site: www. standardandpoors. com (reprinted from Ratings Direct).
Bhatia, Ashok V. 2002. “Sovereign Credit Ratings Methodology and Evaluation.” IMF Working Paper 02/170, International Monetary Fund, Washington, DC.
Bhojraj, Sanjeev, and Partha Sengupta. 2003. “Effect of Corporate Governance on Bond Ratings and Yields: The Role of Institutional Investors and Outside Directors.” Journal Of Business, Volume 76, Issue 3, pp. 455-476, University Of Chicago Press, Chicago, Illinois)
Das, Udaibir S., Marc Quintyn, and Kina Chenard. 2004. “Does Regulatory Governance Matter for Financial System Stability? An Empirical Analysis.” IMF Working Paper 04/89, International Monetary Fund, Washington, DC.
El Daher, 1999. “Credit Ratings: An Introduction and the Case of Subsovereign Ratings.” Infrastructure Notes, Urban FM.8c, World Bank, Washington, DC.
Fremont, Olivier, and Mierta Capaul. 2002. “The State of Corporate Governance: Experience from Country Assessments.” World Bank Policy Research Working Paper 2858, World Bank, Washington, DC.
Galindo, A., and M. J. Miller. 2001. “Can Credit Registries Reduce Credit Constraints? Empirical Evidence on the Role of Credit Registries in Firm Investment Decisions.” In Annual Meeting, Inter-American Development Bank, 1-26, Inter-American Development Bank, Washington DC.
International Accounting Standard Board (IASB). 2004. “Summaries of International Financial Reporting Accounting Standards.”
International Federation of Accountants (IFAC). 2004. “Handbook of International Auditing, Assurance, and Ethics Pronouncement.”
International Monetary Fund (IMF). 1999. Code of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles. Washington, DC: International Monetary Fund.
---- . 2000a. “Guidance Note for Assessing the Code of Good Practices on
Transparency in Monetary and Financial Policies.” Washington, DC: International Monetary Fund.
--- . 2000b. Supporting Document to the Code of Good Practices on Transparency in
Monetary and Financial Policies. Washington, DC: International Monetary Fund.
---- . 2002. “Safeguards Assessments—Review of Experience and Next Steps,” February
15, International Monetary Fund Washington DC.
---- . 2003a, “Fifth Review of the Fund’s Data Standards Initiative,” June 18, 2003,
International Monetary Fund, Washington DC.
---- . 2003b. “Access to International Capital Markets for First Time Sovereign
Issuers.” Washington, DC: International Monetary Fund.
---- . 2003 c. “Assessments of the IMF Code of Good Practices on Transparency
in Monetary and Financial Policies—Review of Experience.” Paper prepared by the Monetary and Financial Systems Department, International Monetary Fund, Washington, DC.
---- . 2003d. “Financial System Stability Assessment on the People’s Republic of
China-Hong Kong Special Administrative Region.” IMF Country Report 03/191, International Monetary Fund, Washington, DC.
---- . 2004. “New Zealand: Financial System Stability Assessment, Including Reports
on the Observance of Standards and Codes.” Country Report 04/126, International Monetary Fund, Washington, DC.
Jappelli, T., and M. Pagano. 2001. “Information Sharing, Lending, and Defaults: CrossCountry Evidence.” Journal of Banking and Finance 26 (10):2023-54.
Joint Forum. 2004. “Financial Disclosure in the Banking, Insurance and Securities Sectors: Issues and Analysis.” Basel, Switzerland: Joint Forum.
Kallberg, Jarl G., and Gregory F. Udell. 2003. “Private Business Information Exchange in the United States.” In Credit Reporting Systems and the International Economy, ed. M. J. Miller, 203-28. Cambridge, Massachusetts: MIT Press.
Kaminsky, Graciela, and Sergio Schmuckler. 2002. “Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?” World Bank Economic Review 16 (2):171-95.
Kaufman, D. 2002. “Public and Private Misgovernance in Finance: Perverse Links, Capture, and their Empirics.” In Financial Sector Governance: The Roles of the Public and Private Sectors, ed. R. E. Litan, M. Pomerleano, and V. Sundararajan, Washington, DC: Brookings Institution Press.
Litan, Robert E., Michael Pomerleano, and V. Sundararajan, eds. 2002. Financial Sector Governance: The Roles of the Public and Private Sectors. Washington, DC: Brookings Institution Press.
Miller, M. J. 2003. “Credit Reporting Systems around the Globe: The State of the Art in Public Credit Registries and Private Credit Reporting Firms.” In Credit Reporting Systems and the International Economy, ed. M. J. Miller, 25-81. Cambridge, Massachusetts: MIT Press.
Mishkin, Frederick. 2001. Financial Policies and the Prevention of Financial Crises in Emerging Market Economies. World Bank Policy Research Working Paper No. 2683, World Bank, Washington, DC.
Nier, Erlend, and Ursel Baumann. 2003. “Market Discipline, Disclosure and Moral Hazard in Banking.” Paper presented at BIS workshop Banking and Financial Stability: A Workshop on Applied Banking Research, Rome, March 20-21, Basel, Switzerland. Organisation for Economic Co-operation and Development (OECD). 2003. “Experiences from the Regional Corporate Governance Round Tables.”
---- . 2004. “The OECD Principles of Corporate Governance.” OECD Policy Brief,
Organisation for Economic Co-operation and Development, Paris.
United States Securities and Exchange Commission (SEC). 1997. “Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments.” SEC Final Rules, Release 33-7386, January 31, Securities and Exchange Commission, Washington, DC.
--- . 2001. Securities Act Industry Guide 3: Statistical Disclosure by Bank Holding
Companies. Washington, DC: Securities and Exchange Commission.
