CORPORATE GOVERNANCE OF BANKS IN PAKISTAN: A PROFILE* By Ahmed M.

Khalid, Bond University, Australia & Muhammad Nadeem Hanif, PIDE May 2004
Abstract: Corporate governance of banks received immense importance in the aftermath of several episodes of banking crises in 1990s, some of which resulted into banking sector collapses. In an emerging economy like Pakistan, this issue becomes even more important. In view of rapidly developing market but slow pace of information dissemination, it is important to reduce the adverse selection and moral hazard problems that may arise due to new entrants in the business of banking. It is in this perspective that the State Bank of Pakistan issued some guidelines detailing the code of corporate governance of banks. This study attempts to provide a profile on corporate governance of banks in Pakistan. Besides providing a theoretical discussion on this issue, we also provide an overview of the banking sector restructuring in Pakistan and highlight the important features of the codes of corporate governance established by the SBP.

* This paper was written with the financial support of LUMS-Citigroup Corporate Governance Initiative at Centre for Management and Economic Research, Lahore University of Management Sciences, Lahore. Corresponding Author: Ahmed M. Khalid, Associate Professor of Economics and Finance, School of Business, Bond University, Australia, Fax: (61 7) 5595-1429; E-mail: ahmed_khalid@bond.edu.au

Corporate Governance of Banks in Pakistan: A Profile

1. INTRODUCTION The term corporate governance essentially refers to the relationships among management, the board of directors, shareholders, and other stakeholders in a company. These relationships provide a framework within which corporate objectives are set and performance is monitored (Mehran, 2003). The Organization for Economic Co-operation and Development (OECD) generally defines corporate governance as a set of relationships between a companys management, its board, 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 are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently (OECD, 1999). Corporate governance is of course not just important for banks. It is something that needs to be addressed in relation to all companies. However, sound corporate governance is particularly important for banks. The rapid changes brought about by globalization, deregulation and technological advances are increasing the risks in banking systems. Moreover, unlike other companies, most of the funds used by banks to conduct their business belong to their creditors, in particular to their depositors. Linked to this is the fact that the failure of a bank affects not only its own stakeholders, but may have a systemic impact on the stability of other banks. Theoretically, informational asymmetries give rise to agency problems and conflicts of interest between ownership and management which is the basis of corporate governance problems. These problems are more relevant to banks due to their nature of operations. Moreover, government regulations and frequent interventions reduce the incentive for effective monitoring and at the same time make supervision (or supervisors) less effective. In this perspective, corporate governance of banks becomes more important than the other firms/corporations.

Internationally the issue of corporate governance has been recognized as on of the most important issue of corporate sector. The OECD has produced a set of corporate governance principles that have become the core template for assessing countries' corporate governance arrangements. Similarly, the Basel Committee on Banking Supervision - the international standard-setting body responsible for establishing international banking supervision principles - has distilled principles for corporate governance in banks. More recently, United Kingdom has published corporate governance reviews and many in the world are now reflecting on the implications of the recently enacted Sarbanes-Oxley legislation in the United States. In Australia, there has also been considerable interest in corporate governance issues, including the role of non-executive directors. And, of course, many countries have their own national codes of good corporate governance, either developed by government or by the private sector. New Zealand, with its Institute of Directors has issued a draft of guidance material to directors (Bollard, 2003). Pakistan is no exception and State Bank of Pakistan has recently issued Handbook of Corporate Governance with the objective in order to provide guidance to the Board of Directors and the Management of the banks for promoting corporate governance in their respective institutions. Banks in Pakistan are well governed by best international standards as SBP is fully or largely compliant in almost all the core principles of effective supervision of banks. Sometimes banking supervision and regulation can go some way towards countering the effects of poor governance but is not a substitute for sound corporate governance practices for which internal governance arrangements has substantial effects (Carse, 2000). As discussed elsewhere in this study, the issue of corporate governance in Pakistan is a new phenomenon, especially, given that major denationalization and privatization of banks in Pakistan took place very recently and the code of corporate governance issued only a year ago, there is nothing much to assess on the implementation and implication of these policies on banking sector efficiency. Nevertheless, the main objective of this study is to provide a profile (or perspective) of the theoretical issues related to corporate governance of banks and the developments that have taken place in Pakistan. The remainder of this study is organized as follows. Section 2 discusses the importance of corporate governance for bank in a theoretical perspective. Section 3 describes some sort of mechanism for corporate governance in banks. Section 4 focuses on two issues. In section 4.1 we provide 3

an overview of the banking sector restructuring in Pakistan. Section 4.2 summarizes the main features of the SBPs recently issued code of corporate governance of banks. Some concluding remarks are made in section 5.

2. CORPORATE GOVERNANCE FOR BANKS Banks play an important role in the corporate governance system. Their role varies from one model to another. This is due to the banks function as credit issuers, as banks still remain primary providers of credit to almost all of the economies in the world, to their borrower monitoring function, as well as to their ownership functions performed within companies. Banks are also business entities, and as such they rank among some of the largest corporations on a global, regional and local scale. The interest in corporate governance in banking has been growing in recent years, primarily because of the sustained high share of debt financing of the economy, systemic transformations taking place in many countries, and the role of banks in ensuring financial stability. In Pakistan, we have been witnessing significant changes in the banking sector over the last decade or so, following start of the liberalization of the financial system and privatization of the nationalized banks (except NBP) and emergence of a few new private banks. As a result, the ownership structure of some banks and the entire banking system has changed. The purpose of the study is to make an assessment of the corporate governance of banks in Pakistan.

2.1. Why Corporate Governance for Banks is so important? 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 payment systems. In addition, some banks are expected to make credit and liquidity available in difficult market conditions. The importance of banks to national economies is underscored by the fact that banking is, almost universally, a regulated industry and that banks have access to government safety nets. It is of crucial importance therefore that banks have strong corporate governance.

Banking crises serves as an indicator of poor governance of banks. The episodes of banking crises in 1980s in Europe and 1990s in Latin America and Asia suggest that such crisis may lead to major bankruptcies, recession, and economic and political instability. The recent pressures on crisis-hit economies to establish certain norms of corporate governance are also linked to the same. Although, banks are similar to other firms in terms of the composition of shareholders, debt holders, board of directors, competitors, etc, there in one important distinction between banks and other firms. The nature of transaction banks are involved in suggest that banks are expected utility maximizer (sometimes, it takes more than 20 years to complete a transaction). As a result, the risk factor increases substantially and hence risk management becomes important. In an emerging economy where banks are the main source of generating savings and investment, these concerns are even more important. Therefore, the issue of corporate governance of banks takes a center stage in an economy. Macey and Hara (2003), Adams and Mehran (2003), and Levine (2003) have focused on why corporate governance of banks is special to be focused separately. Macey and Hara (2003), argue that commercial banks pose special corporate governance problems not only to managers and regulators, but also to claimants on the banks cash flows. The authors contend that bank officers and directors should be held to a broader, if not higher, set of standards than their counterparts at unregulated, nonfinancial firms. Moreover, they recommend that the scope of the fiduciary duties and obligations of bank officers and directors be broadened to address the interests of fixed as well as equity claimants. Top bank executives, in view of Macey and Hara (2003), should take solvency risk explicitly and systematically into account when making decisions. Adams and Mehran (2003) argue that the governance of banking firms may be different from that of unregulated, nonfinancial firms for several reasons. For one, the number of parties with a stake in an institutions activity complicates the governance of financial institutions. In addition to investors, depositors and regulators have a direct interest in bank performance. On a more aggregate level, regulators are concerned with the effect governance has on the performance of financial institutions because the health of the overall economy depends upon their performance. They focus on the differences between

the corporate governance of banking firms and manufacturing firms and find that the most significant differences relate to board size, board makeup, CEO ownership and compensation structure, and block ownership. These differences across banks and manufacturing firms support the theory that governance structures are industry-specific. Levine (2003) argues that when banks efficiently mobilize and allocate funds, this lowers the cost of capital to firms, boosts capital formation, and stimulates productivity growth. Thus, weak governance of banks reverberates throughout the economy with negative ramifications for economic development. After reviewing the major governance concepts for corporations in general, Levine (2003) discusses two special attributes of banks that make them special in practice: greater opaqueness than other industries and greater government regulation. These attributes weaken many traditional governance mechanisms. Existing work suggests that it is important to strengthen the ability and incentives of private investors to exert governance over banks rather than relying excessively on government regulators. Levine (2003) argues that banks have two related characteristics that inspire a separate analysis of the corporate governance of banks. First, banks are generally more opaque than nonfinancial firms. Although information asymmetries plague all sectors, evidence suggests that these informational asymmetries are larger with banks (Furfine, 2001). In banking, loan quality is not readily observable and can be hidden for long periods. Moreover, banks can alter the risk composition of their assets more quickly than most nonfinancial industries, and banks can readily hide problems by extending loans to clients that cannot service previous debt obligations. Not surprisingly, therefore, Morgan (2002) finds that bond analysts disagree more over the bonds issued by banks than by nonfinancial firms. The comparatively severe difficulties in acquiring information about bank behavior and monitoring ongoing bank activities hinder traditional corporate governance mechanisms. The opacity of banks can weaken competitive forces that, in other industries, help discipline managers through the threat of takeover as well as through competitive product markets. Product market competition is frequently less intense in banking. Bankers typically form long-run relationships with clients to ameliorate the informational problems associated with making loans and these relationships represent barriers to competition (Levine, 2003). Takeovers are likely to be less effective when insiders have 6

much better information than potential purchasers. Even in industrialized countries, hostile takeovers tend to be rare in banking (Prowse, 1997). Furthermore, the absence of an efficient securities market hinders takeover and hence corporate governance. If potential corporate raiders cannot raise capital quickly, this will reduce the effectiveness of the takeover threat. Similarly, if bank shares do not trade actively in efficient equity markets, this will further hinder takeovers as an effective governance mechanism. Second, banks are frequently very heavily regulated. Because of the importance of banks in the economy, because of the opacity of bank assets and activities, and because banks are a ready source of fiscal revenue, governments impose an elaborate array of regulations on banks. At the extreme, governments own banks. Of course, banking is not the only regulated industry and governments own other types of firms. Nevertheless, even countries that intervene little in other sectors tend to impose extensive regulations on the commercial banking industry. 2.2. Corporate Governance of Banks, Financial Development and Economic Growth The law and finance theory focuses on the role of legal institutions in explaining international differences in financial development (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1997, 1998, 2000, henceforth LLSV). The law and finance view follows naturally from the evolution of corporate finance theory during the past half century (Beck and Levine, 2004). Modigliani and Miller (1958) view debt and equity as legal claims on cash flows of the firm. Jenson and Meckling (1976) stress that statutory laws and the degree to which courts enforce those laws shape the types of contracts that are used to address agency problems. Beck and Levine (2004) asserts that a countrys contract company, bankruptcy, securities laws, and the enforcement of these laws fundamentally determine the rights of securities holders and the operation of financial system. At the firm level, Shleifer and Vishny (1997) note both that inside managers and controlling shareholders are frequently in a position to expropriate minority shareholders and creditors and the legal institutions play a crucial role in determining the degree of expropriation. Expropriation may include theft, as well as transfer pricing, asset stripping, the hiring of family members, and other perquisites that benefit insiders at the expense of minority shareholders and creditors (LLSV, 2000). The law and finance theory emphasis

that cross country differences in (i) contract, company, bankruptcy, and securities laws; (ii) the legal systems emphasis on private property rights; and (iii) the efficiency of enforcement influence the degree of expropriation and hence confidence with which people purchase securities and participate in financial markets. A growing body of evidence indicates that the development of a countrys financial sector facilitates its growth (See Levine, [1997] for detailed survey). Levine (1997) presents a framework whereby a well-developed financial sector facilitates the allocation of resources by serving five functions: to mobilize savings, facilitate risk management, identify investment opportunities, monitor and discipline managers, and facilitate the exchange of goods and services. At the heart of these theories is the role of the financial sector in reducing information costs and transaction costs in an economy. In spite of the central role of information in these theories, until recently little attention has been given by empirical researchers to the information environment per se in explaining cross-country differences in economic growth and efficiency. (Bushman and Smith, 2003) discuss research that explicitly examines the role of a countrys corporate disclosure regime in the efficient allocation of capital. There is a positive relation between the quality of financial accounting information and economic performance (Bushman and Smith, 2003).

2.3. Corporate Governance and Financial Stability Financial stability is responsibility of central bank of a country. Corporate governance is now a topic of considerable interest to a large and expanding cross-section of the community. It is also of interest to the central bank, in its capacity as supervisor of the banking system. Here we will discuss a number of themes relating to corporate governance, with particular emphasis on the important role it plays in promoting a sound financial system. In the financial system, corporate governance is one of the key factors that determine the health of the system and its ability to survive economic shocks. The health of the financial system much depends on the underlying soundness of its individual components and the connections between them - such as the banks, the non-bank financial institutions and the

payment systems. In turn, their soundness largely depends on their capacity to identify, measure, monitor, and control their risks (Bollard, 2003). In any modern economy the two core components of the financial system are the banks which represent the vast bulk of financial system assets - and the payment system - which processes millions of transactions each day. Banks face a wide range of complex risks in their day-to-day business, including risks relating to credit, liquidity, exposure concentration, interest rates, exchange rates, settlement, and internal operations. The nature of banks' business - particularly the maturity mismatch between their assets and liabilities, their relatively high gearing and their reliance on creditor confidence - creates particular vulnerabilities. The consequences of mismanaging their risks can be severe indeed - not only for the individual bank, but also for the system as a whole. This reflects the fact that the failure of one bank can rapidly affect another through inter-institutional exposures and confidence effects. And any prolonged and significant disruption to the financial system can have potentially severe effects on the wider economy. The health of the financial system depends, to a significant extent, on an efficient, reliable, and rapid payments system. Payments system comprises rules, standards, instruments, institutions, and technical means of exchanging financial values between two parties. 1 The payment system involves many different components, including systems for settling large, inter-bank and inter-corporate payment transactions, and systems for handling myriads of smaller transactions, such as cheques, credit cards, direct debits etc. Each system is managed by a payment operator. Although these operators do not face risks of the nature that banks face - such as credit risk, for example - they do have major operational risks. In particular, they need to ensure that the systems for processing payments, the back-up arrangements, and the internal governance structures are robust. A major operational failure in the payment system has the potential to cause severe disruption to the financial system and wider economy. At its worst, a major payment system failure would bring countless commercial transactions to an abrupt halt, impede the operation of business in virtually all parts of the economy and fundamentally undermine investor and business confidence. The stakes are indeed high - hence the need for banks, other financial institutions and the payment system operators to maintain systems to enable them to identify, monitor and
1

In Pakistan over thirty million cheques are presented every year for clearing (Hanif, 2003).

control their risks. And sound corporate governance is the foundation for effective risk management.

3. CORPORATE GOVERNANCE MECHANISM FOR BANKS The availability of mechanisms which ensures that banks are soundly governed, and that both technical and moral mismanagements are avoided, is the decisive prerequisite for quality corporate governance of banks. From a banking industry perspective, corporate governance involves the manner in which the business and affairs of individual institutions are governed by their respective Boards affecting how banks: (i) set corporate objectives to generate sustainable economic returns to owners; (ii) get run the day-to-day operations of the business by the management; (iii) consider the interests of recognized stakeholders, including depositors; and (iv) align corporate activities and behaviors with the expectation that banks will operate in a sound manner and in compliance with laws of the land and regulations. Thus Bank directors have specific responsibilities to manage the risks at their respective financial institutions and effectively oversee the systems of internal controls. Bank directors are not expected to understand every nuance of banking or to oversee each transaction. They can look to management for that. They do, however, have the responsibility to set the tone regarding their institutions risk-taking and to oversee the internal-control processes so that they can reasonably expect that their directives will be followed. They also have the responsibility to hire individuals who they believe have integrity and can exercise a high level of judgment and competence. They have further responsibility to periodically consider whether their initial assessment of managements integrity remains correct. Boards of directors are responsible for ensuring that their organizations have an effective audit process and internal controls that are adequate for the nature and scope of their businesses. The reporting lines of the internal audit function should be such that the information that directors receive is impartial and not unduly influenced by management. Internal audit is a key element of managements responsibility to validate the strength of a banks internal controls (Bies, 2002).

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Indeed, beyond legal requirements, boards of directors and managers of all firms should periodically test where they stand on ethical business practices. They should ask themselves, for example, Are we getting by on technicalities, adhering to the letter but not the spirit of the law? Are we compensating ourselves and others on the basis of contribution, or are we taking advantage of our positions? (Bies, 2002).

4. CORPORATE GOVERNANCE OF BANKS IN PAKISTAN State Bank of Pakistan, during the last decade has implemented policies to reform the banking sector in Pakistan, as part of the overall financial sector reform package initiated in early 1990s. Although, slow in pace until recently, the reforms have been consistent and continuous. As a result of these reforms, the commercial banking industry in Pakistan has taken a new shape and is working on a new vision. Part of these reforms is also related to the issue of corporate governance of banks in Pakistan. This is the main focus of the remainder of this study. It is, however, imperative to have a brief discussion of the banking sector restructuring before we embark on the issue of corporate governance. This is accomplished in the next sub-section. 4.1 Banking Sector Restructuring in Pakistan

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Commercial banking experienced drastic changes over 50 years since the country started its banking sector from point zero. At the time of independence, out of 99 commercial banks only one, Habib Bank, had its head office located in the area that was to become the new country. The other 98 banks were located in India and were under the jurisdiction of the Reserve Bank of India. Pakistan did not have its own central bank until 1948, a year after independence.2 From 1947 to 1974, the banking sector grew very well. The private sector invested in establishing commercial banks with a network of branches in the country. At the same time, the authorities granted licenses to some foreign banks to operate in Pakistan. The domestic banks got nationalized 30 years ago. The 13 commercial banks were then merged to become five nationalized Commercial Banks (NCBs). The deposits in the NCBs were fully insured and their activities were supervised by the Pakistan Banking Council (PCB), also established 30 years ago, but abolished later.3 These NCBs enjoyed rapid expansion in terms of staff, which increased by 55 per cent, and the number of branches, by 82 per cent in just a few years. High and increasing inflation resulted in reduced deposits, about 20 per cent. Increasing economic uncertainties brought the real deposits down by about 23 per cent.4 The banking sector reforms introduced in the 1980s had three objectives: (1) to implement policies to gradually change the financial sector from a controlled one to market signal based operation; (2) to introduce Islamic banking in Pakistan; and (3) to create an environment for competitive banking to take roots by easing entry barriers on foreign banks. To achieve these goals, policies of a partial deregulation of interest rates were implemented, slow down the expansion of NCBs and allowing entry to foreign banks branches. Downsizing and privatization became the buzz words during the 1990s to deal with the inefficiencies of the public sector including NCBs. The process of privatization was accelerated during 2000 and at the time of this writing, over 80 per cent of the NCBs have
2 3

Pakistan did not have any formal stock exchange, merchant or investment bank. In January 1997, PBC was merged with the SBP. 4 See Klein (19__) for a detailed discussion on these events.

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already been privatized. At the same time, government encouraged private sector to invest in banking which added a large number of private commercial banks in the country which are essential for a competitive market structure. The present regime also took necessary measures to deal with a very high level of Nonperforming loans (NPLs) and loan defaults (as of 1997, outstanding balance from these defaulted loans stands at R126.15 billion.5). Recovery laws have been strengthened through the Banking Companies (Recovery of Loans, Advances, Credit and Finances) Act 1997. However, there is a need to provide the bank management and operators in the finance sector more independence and powers of prosecution against political pressures. Foreign banks provide a very competitive environment to the domestic commercial banks and have become an important part of the banking industry. Although, foreign banks are not allowed to open more than four branches, they have better managerial skills and more access to the international financial markets. As a result, they receive the bulk of the foreign currency deposits. This rapid development of banking industry in Pakistan increased the informational asymmetry and agency cost problems and necessitated the need for corporate governance. 4.2 Corporate Governance Measures As discussed earlier, corporate governance is a new phenomenon not only in Pakistan but in general. The major reason of corporate governance is the recent episodes of banks failures in different parts of the world especially in the aftermath of the 1997 Asian financial crisis. The issue of corporate governance of banks in Pakistan received special attention because Pakistan embarked on measures of banking sector restructuring and privatization at the same time when deliberations were underway to devise some code of ethics for corporate governance of the financial and corporate sector including banks. A major step towards this was a joint project by the Securities and Exchange Commission of Pakistan and the UNDP (SECP-UNDP) in collaboration with the Economic Affairs Division (EAD) of the Ministry of Finance. The project was launched in August 2002 with the objective to design, develop and implement a Code of Corporate Governance. Though this project had some discussion on corporate governance for banks but its main focus was
5

This is equivalent to US$ 2.66 billion; good enough to meet Pakistan immediate need to service and pay back some of the foreign loans.

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the corporate sector in Pakistan and issued measures to create stakeholder awareness, capacity building and networking with other emerging economies. To address the problems of banking sector, the State Bank of Pakistan (SBP) issued a Handbook of Corporate Governance in 2003. The objective of this handbook is to provide guidelines for Board of Directors, managers and shareholders. Most of the recommendations and guidelines stated in the handbook are directly drawn from the recommendations made by Basel Committee on corporate governance and OECD. These guidelines cover four important areas, namely, Board of Directors, Management, Financial Disclosure, and Auditors. It is to be noted that this is the only document available at this point. Some important features of this Handbook are highlighted here: a. The Board of Directors Basel committee places major responsibility on the board of directors and senior bank management to fully understand the risk exposure. As such, it is recommended that the composition of the board of directors and senior management in a bank should include individuals who are highly skilled and experienced in determining the risk exposure given the size and nature of the banks activities and should be able to take certain steps if a need arise to reduce a high risk exposure. Regulators and supervisors have an important responsibility to determine the adequacy of the internal control measures including the responsibilities of the board of directors in dealing with organizational structure, accounting principles, checks and balances and safety of investment and compliance of abiding by the given laws and required disclosure.6 Another important part of the recommendations issued by different committees such as Basel and OECD deals with the Business ethics, specifically to make sure that the rights of shareholders stakeholders are well protected. Accordingly, these shareholders and stakeholders have a right to adequate and timely information and appropriate forms of participation in the decision making process of the bank. Appoint of Board of Director Prior clearance of the SBP is needed for the appointment of BOD. The potential

nominee/appointee for the post of a Director should have substantial interest (no less than
6

See SBP: Handbook on Corporate Governance (2003), pages: 16-19 for details.

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20 per cent shares) and should be working in a management capacity for the bank. Anyone holding at least 10 per cent shares can become Director subject to SBPs approval. SBP requires that the incumbent should also qualify the standard fit and proper test for appointment. A minimum of 5 years of senior business/management level experience for the post of directors while potential candidate for Presidents or CEO of banks need to have spent 15 years in banking career with a minimum of 3 years in senior level. These individuals should also have impeccable record in the their professional capacities, should not have been involved in any bank insolvency or should not be a defaulter of any kind and should not be a director in any other financial institutions creating a conflict of interest. The SBP may also ask any banking company to call a general meeting of the shareholders to elect a new director. Banking Companies Ordinance (BCO), 1962 and Companies Ordinance (CO), 1984 specify the procedure for the election of a director. According to the Companies Act, 1913 the SBP may also appoint no more than one person to be a director of a banking company. In either case, the total number of directors should not be less than seven and the tenure of a director is restricted to be no more than six consecutive years. Responsibilities of the Board of Directors The responsibilities of the BOD are specified in the SBP code of corporate governance. Some important ones are highlighted here:7 The Board shall approve and monitor the objectives, strategies and overall business plans of the institution and will ensure that all activities are carried out prudently within the framework of existing laws and regulations. The Board shall clearly define the authorities and key responsibilities of both the Directors and the senior management without delegating its policymaking power to the management. The Board shall approve and ensure the implementation of all policies related to audit and internal management of risk and resources and will be responsible for the review and update of existing policies.
7

SBP, Code of Corporate Governance, 2003: 37-39.

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The Board will ensure an effective Management information system to cater to the needs of changing market conditions.

The Board should meet frequently (preferably on a monthly basis but at least quarterly), and the individuals directors should attend at least half of the meetings held in a financial year. The SBP requires that all Pakistani scheduled banks in Pakistan should not hold their ordinary BOD meetings outside the country. Holding such meeting abroad leads to wastage of resources without any benefit to depositors/customers.

The Board is required to prepare a formal summary of the proceedings of the general meetings and meeting of its directors and committee of directors for inspection duly signed by the chairman and makes it available for inspection by members free of charge. Under an amendment to the BCO, 1962, the SBP starting January 2000, required all banks incorporated in Pakistan to furnish copies of the minutes of the meeting of their respective BODs within seven days of the meeting to the Director, BPRD, SBP.

The activities of the Board should be transparent to the external auditors and supervisors to form a judgment on its working and decision-making performance.

The Board will ensure that appropriate actions are taken, in consultation with the audit committee of the Board, to rectify any weaknesses and lack of controls with a copy of the letter submitted to the SBP for monitoring purposes.

Further Guidelines for the Functions of the Board of Directors The Companies Ordinance, 1984 also details the power of Directors which empowers the Director to make important decisions on investment and human resource management as well as capital expenditure. The SBP directive also require that member of the BOD of a banking company should not hold any more 5 per cent of the paid-up capital of the banking company in individual capacity or in the name of family members. The Directors should not appointed in the bank in any capacity, shall not be paid other than traveling and dialing allowances to attend meeting and no more than 25% of the total directors can be paid executives of the bank.

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In order to reduce the monopoly of the same family in a banking company, the SBP, in November 2001 issued a circular to restrict the number of directors on the board from the same family no more than 25% (as compared to 50% allowed earlier). The BCO, 1962 also restrict a person to be a director of two companies simultaneously. To reduce political influence, any Federal, or Provincial Minister or the Minister of State or a civil servant cannot be appointed as the director of the banking company. Under prudential regulation guidelines of the SBP, the banking is not allowed to make loans or advances to any of its directors, chief executive, individuals, or their family members or firms or companies which the banking company or any of its director is interested as partner holding more than 5 per cent of the share capital or make loans and advances on the guarantee of the above individuals. The banking company is also not allowed to make loans and advances against the security of its own share. The prudential regulation circular issued in 1992 also forbids banks to enter, without a prior approval of the SBP, into a lease, rent or sale/purchase agreement with their directors, officers, employees or any individual (or their family member) with ownership of 10 percent or more of the equity of the bank Whenever deemed necessary, the SBP has the authority to supersede the Board of directors and may continue to do so for period determined by the SBP. The SP guidelines also detail the procedure for the removal, retirement or prosecution of director(s) or chief executive officers. b. Management The appointment criterion of the Chief Executive Officer (CEO) is the same as the Director of the BOD. No prior approval of the SBP is required for such appointments. However, the banks are required to adhere to the SBPs guidelines containing the Fit and Proper Test for the appointment of key executives, especially very senior level officials non compliance to which will result into punitive actions against the banking company. The key criterions of the Fit and Proper test include: the incumbent should have a track record of Honesty, integrity and reputation, not convicted of any criminal offence including fraud or financial crime.

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should be competent and capable of fulfilling his/her duties, having adequate qualification and experience.

should not have been removed/dismissed from service in the capacity of an employee, director or chairman on account of financial crime or moral conduct.

should not be defaulter of payment(s) due to any financial institutions or tax office. should not supervise more than one functional areas that give rise to conflict of interest within the banking company and should not hold directorship of a company that is a client to the bank.

c. Financial Disclosure Under the BCO, 1962, all banking companies incorporated in Pakistan or foreign banks with branches in Pakistan are required to furnish a balance sheet and profit and loss account to the SBP at the end of the calendar year. The CO, 1984 requires that the directors shall attach a report with the balance sheet to report the state of the companys affairs, the details of dividend distribution, and details of any reserve accounts Disclose any material changes and commitments affecting the financial position of the company. Disclosure of any observations or negative remarks made in the auditors report. State details of holding of share, earning per share, reasons for incurring loss (if any) and any defaults (if any). Noncompliance to the above will result in to punitive actions by the relevant authorities. d. Auditors Another principal of effective bank supervision is the effective internal audit. Internal audit helps to identify the problem areas and to avoid a major collapse. However, to have

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an effective internal audit, it is important that the bank should have sufficient resources and qualified and an appropriate methodology to undertake this task. Again, supervisors have to make sure that banks have an appropriate audit function and satisfy the above criterion. Reporting of these reports in an accurate and timely manner is essential for evaluation of the banks status and need for any necessary strategy. Supervisors have the authority to hold management responsible for the release of all such information and reports and that these reports are accurate and produced in a timely manner. Some recommendations from the SBPs handbook are stated here: Under CO, 1984, the banking company is required to appoint an auditor in its annual general meeting for a period of one year. The first auditor of a newly incorporated company should be appointed within 60 days of the incorporation of the company. All banking companies are required to appoint auditors from the panel of auditors maintained by the SBP. This panel consists of auditors who satisfy certain minimum criteria based on their qualification and experience. Any individual who is a director of the company or has any kind of employment with the company or any of his/her family member is employed by the company cannot be appointed as the auditor of the same company. Any individual or his/her family member who is appointed the external auditor is not allowed to hold, purchase, or sale shares of the company. The BCO, 1962 states that the balance sheet and profit and loss account prepared by the company shall be audited by the banking companys auditor. The auditor is required to furnish an audit report stating the authenticity of the information and extend of cooperation provided by the banking company while conducting the company audit. These will include verification of the sources of funds generated and investments made by the banking company during the audit period. The auditor shall adhere to the guidelines or any amendments to the guidelines issued by the SBP for the audit of the banking company. The auditors will furnish

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a special report to the Director, Banking Supervision Department (BSD) of the SBP and a copy to the concerned bank.

Further General Developments on Corporate Governance The State Bank of Pakistan has recently issued Guidelines on Internal Controls further explaining the policies, plans and processes as affected by the decion-manking process of the BODs and senior management. As it is well established elsewhere and effective risk management is strongly influenced by effective internal control mechanism helps reduce the risk and probability of banking crisis. Hence, the SBP has put special emphasis to these guidelines for internal control as part of effective risk management. The system of internal controls includes financial, operational and compliance controls and risk management. The guidelines ensure efficiency and effectiveness of operations, reliability, completeness and timeliness of financial and management information and compliance with policies, procedures, regulations and laws. An important aspect of risk management is risk recognition and assessment as well as correcting deficiencies. Self assessment requires certain level of expertise and experience. It is, therefore important that senior management and internal auditors of the banking industry are qualified to perform these tasks. In an emerging but rapidly developing financial system such as Pakistan, regulators can be very useful by organizing certain workshops to the senior management to understand the mechanism to fully understand and assess different categories of risk bank is expected to face in the changing market conditions. One can learn important lessons from the policies implemented by the Southeast and East Asian economies in the aftermath of the 1997 Asian financial crisis and under the new financial architecture. Organizing workshops and courses for senior banks management and sharing information dealing with a bank-specific problem are two important aspects of this new financial architecture.

5. CONCLUSION Due to a very high cost of banking crisis on the economy and taxpayers, it is important to develop a mechanism to prevent the occurrence of a banking crisis or collapse of a banking

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system.

Academic literature has developed some theoretical models and empirical

methodologies to predict and prevent a forthcoming crisis.8 However, not much attention was paid until recently on corporate governance to be used as an effective risk management tool. Even a good banking supervision cannot function well without wound governance in place (Tirapat; 2003). The recent trends of internationalization and globalization, changing market conditions, and deregulation as well as episodes of some of the worst banking crises in 1990s further emphasize the need for a proper self-discipline management, efficient internal control system and effective supervision. Hence good governance. It was in this perspective that in late 1990s and early 2000, some international organizations such as IMF, OECD, Basel Committee, etc embarked on establishing some guidelines for good governance practices in the banking sector and made some formal recommendations. Pakistan s banking sector experienced significant changes during the last few years moving from nationalized commercial banks to private banks. Given that the banking sector is the most important channel of resource allocation and mobilization in an emerging economy like Pakistan, a bank failure or banking sector collapse may have devastating effects on the economy. Therefore it is important for supervisors to take necessary steps to provide a safe banking sector and ensure its stability. Besides some organizational changes in the SBP itself which makes the supervision and monitoring more effective, it also issued some guidelines for corporate governance of banks in Pakistan. These guidelines, in general, are drawn from the recommendations made by the above stated international agencies but modified according to domestic economic environment and rules and regulations. As the process of corporate governance of banks in Pakistan is new, it is difficult to make an assessment of these policies such as evaluation of improvement in bank efficiency or reduction in bank defaults. This study, however, serves the purpose of presenting a profile (or a state-of-the-art report) on what has been done so far. It will take some time and to assess the impact of these policies. Given the relatively more autonomy and independence in decision-making that the SBP enjoys now, major improvements in information technology and a very competitive market, it is hoped that banks will use these guidelines for self-discipline and risk management. These trends are expected to establish
8

See Davis (1991), Demirguc-Kunt and Detragiache (1997), Garcia (1997), Goldstein, Morris, and Philip Turner (1996), Khalid and Irawati (2004) and Sachs, Tornell, and Velasco (1996) for further details on this issue.

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a sound banking system in Pakistan which is essential to achieve a high and a sustainable economic growth.

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