Corporate Governance Issues in Cooperative Banking

Dr P A Kiriwandeniya, Leader/SANASA Movement, President/International

Cooperative Banking Association, distinguished delegates from the Regional
Cooperative Banking Association, other speakers, ladies and gentlemen. Good
morning to all of you. It gives me great pleasure to see so many participants at
this important conference on the Corporate Governance for Cooperative Banks.
The initiative to hold this conference itself shows that Corporate Governance is
no longer being ignored by this sector.

What is Corporate Governance?

The issues of Corporate Governance continue to attract considerable national and
international attention. Corporate Governance is about effective, transparent and accountable
governance of affairs of an institution by its management including the board conduct.
Governance of financial institutions should aim at protecting the interests of all stakeholders, i.e.
shareholders, creditors, regulators, depositors and the public. Corporate Governance is
particularly important in countries where a number of financial failures, frauds and questionable
business practices have adversely affected investor confidence. Investors as well as depositors
want safety of their investments, deposits and funds, which need to be ensured by the
management of a company, bank or financial organization entrusted with soliciting investments
or deposits. In short, Corporate Governance is really about process, in particular, a decision-
making process that (a) hold individuals accountable, (b) encourage stakeholder participation,
(c) facilitate the flow of information, and (d) rely on open and clear rules that are fairly and
uniformly enforced. It is not the policies and decisions themselves, but how polices and
decisions are implemented.

Recent Corporate Governance practices have evolved over time and different codes of
Corporate Governance have been developed. The OECD code of Corporate Governance, the
Commonwealth Association Code of Corporate Governance and the Basel Committee on Bank
Supervision BIS Corporate Governance Code for banks are some of the well recognized ones.
In recent years, the Basel Committee has described the role of the boards of directors and senior
management in managing risk in its latest code and it underscores the need for banking
organizations to set strategies for their operations and establish accountability for implementing
these strategies. Some of the common elements emphasized in these governance codes
indicate that the development of corporate values, codes of conduct and corporate strategy
would require the establishment of a mechanism for interaction and cooperation among the
board of directors, senior management and auditors; strong control systems including external
and internal audit functions; risk management policies and other checks and balances; and
special monitoring of risk exposures.

Corporate Governance cuts across all banking and financial institutions which solicit
funds from the public, be it a commercial bank, specialized bank, cooperative rural bank or a
finance company. It is of greater importance for banking organizations than other companies,
given the crucial financial intermediation role in an economy and the fiduciary responsibility of
safeguarding depositors funds. The high degree of sensitivity to potential difficulties arising
from ineffective Corporate Governance can cause problems of stability in the institution
concerned and also trigger a system-wide instability. The cooperative banking sector in Sri
Lanka and possibly in other countries may account for only a fraction of the countrys financial
sector and also it may not be significant in terms of posing a system-wide risk. However, a
failure of a few cooperative banks can bring in significant public costs and consequences in
terms of the public confidence in the financial sector.

The Evolution of Corporate Governance

Corporate Governance had its origins in the 19 th century arising in response to the
separation of ownership and control following the formation of joint stock companies. The
owners or shareholders of these companies, who were not involved in day-to-day operational
issues, required assurances that those in control of the company, in particular the directors and
managers, were safeguarding their investments and accurately reporting the financial outcome
of their business activities. Thus, shareholders were the original focus of Corporate Governance.
However, current thinking recognizes a companys or a banks obligations to society, which
includes all stakeholders. Since the latter part of 2001, the already lively debate on Corporate
Governance became a more focused topic due to big corporate scandals like Enron, WorldCom
and new laws like the Sarbane Oxley Act in the US were introduced to deal with such scandals
in future.

In recent times, Corporate Governance is treated as an essential element of financial

stability. The changes in the financial markets landscape since the early 1970s and the rapid
acceleration of changes in the 1990s and beyond have resulted in an unprecedented growth in
the financial services industry as well as challenges including the growing importance of
safeguarding financial systems. The evolution of Corporate Governance principles thus
establishes a conceptual foundation for understanding financial stability as a public good and
explains why both private and public policy involvement might be beneficial and even necessary
for achieving and maintaining financial stability. That is why Corporate Governance applies to
all institutions and embraces all stakeholders in the financial sector, be it banks, finance
companies, cooperative banks or body corporates and also governments and government
institutions.

The Applicability of Corporate Governance to Cooperative Banking

Let me now turn to the theme of the conference, which is the Corporate Governance for
the cooperative banks. My knowledge on different structures of cooperative banking in the Asia
Pacific region is limited. However, I believe that there are some common elements of such
structures and regulatory systems, which can be used to benchmark the applicability of
Corporate Governance to cooperative banking in most countries. For easy reference, I would
like to refer to the cooperative banking structure and its regulatory framework in Sri Lanka and
highlight the applicability of Corporate Governance to cooperative banking.

Sri Lanka has a layered structure for cooperative banking. The top layer is the
Cooperative Federation formed by 14 district unions. These unions form the second layer. The
third layer consists of the Multi-Purpose Cooperative Societies and their banking arms known as
the Cooperative Rural Banks. Almost all cooperative societies are registered under the Co-
operative Societies Law No.5 of 1972, by which they are authorized to accept deposits from
public and lend monies to their members. In addition, there are a large number of Thrift and
Credit Cooperative Societies, which are also categorized as cooperative banks as they perform
banking functions at grass root level. At present, co-operative banking operations account for
about 1.5% of the assets of the financial system in the country.

The regulatory structure of the cooperative banks in Sri Lanka is a complex one. All
cooperative societies, whether they mobilize public funds or not, should register with the
Cooperative Development Department, which is headed by the Commissioner of Cooperatives.
The Cooperative Development Department is also the national level regulatory body. Some
societies are registered with the Provincial Cooperative Commissioners. At the time of
registration, all societies are provided with the rules and regulations and by-laws applicable to
the cooperative sector.

As at mid 2004, there were 306 Multi-Purpose Cooperative Societies, which used 1,490
Co-operative Rural Banks as their banking arms. Their total deposits stood at Rs. 22 bn and
advances portfolio at Rs. 8 bn. Their deposits account for nearly 3% of total savings and time
deposits of all deposit taking institutions. The excess funds of the Co-operative Rural Banks are
deposited with the 14 unions.

The management of Multi-Purpose Cooperative Societies, Bank Unions and the

Cooperative Federation is vested with a Board of Directors appointed by members at an annual
general meeting. The General Manager of the Federation is the Chief Executive Officer. A
working committee appointed by members at an Annual General Meeting governs other credit
co-operative societies. The management structure including auditing and reporting
requirements is incorporated in by-laws of each society in line with the specimen of by-laws
issued by the Cooperative Development Department. In addition, the Cooperative Development
Department has issued prudential guidelines on operations of Co-operative Rural Banks. The
procedures cover deposit-taking, grating loans, financial controls, security arrangements and
some internal controls. These guidelines cover operational aspects and not necessarily

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Corporate Governance principles. I understand that under a cooperative sector reform project,
work is in progress to introduce Corporate Governance codes and working rules for co-operative
societies. Therefore, the cooperative sector is now making efforts to incorporate some of the
Corporate Governance principles into the by-laws guiding them.

Regulators/Supervisors and Corporate Governance

Corporate Governance promotes market discipline without calling for regulatory burden.
In most countries, the cooperative banks are not intensively regulated like in the case of banks.
Since most of these cooperative banks deal with deposits of lower income groups in rural areas,
enhanced risk management through Corporate Governance will greatly contribute to safeguard
the interest of depositors.

In this regard, three major governance issues that require regulatory attention can be
mentioned. They include: related party transactions, conflict of interest and creative
accounting. If there are dominant cooperative societies or members of boards who promote
related party transactions, that can lead to abuses and conflict of interest that will undermine
the role of small shareholders. Creative accounting can lead to small-scale scandals, as they
hide the true picture of financial transactions of any organization.

The supervisor has a specific role in ensuring that the banking organization has
appropriate Corporate Governance policies which are being satisfactorily complying with and
bringing to the board of directors and managements attention problems that they detect
through their supervisory efforts. When a commercial bank or a cooperative bank take risks that
it cannot control or measure, supervisors should hold the board of directors and senior
management accountable and require that corrective measures be taken in a timely manner.
Similarly, supervisors should assess the quality of banks internal controls. It is important that
effective controls, not only be set out in policy, but also be properly implemented and made
operational.

The licensing and supervisory processes also afford supervisors an important opportunity
to evaluate the expertise and integrity of proposed directors and management. The fit and
proper criteria typically include (a) the contributions that skilled and experienced individuals can
make to ensure the safety and soundness of operations of the bank; and (b) any record of
criminal activities or adverse regulatory judgment that, in the opinion of the supervisors, make a
person unfit to uphold important positions in a bank.

Sound Corporate Governance considers the interest of all stakeholders including

cooperative societies themselves and depositors in a balanced fashion. As long as individual
societies are conducting their businesses in such a way that they do not jeopardize the interests
of depositors, Corporate Governance may be viewed as one element of depositor protection.

In this effort, it is important to ensure that along with the introduction of standard
Corporate Governance principles, there exists a regulatory mechanism or mechanisms to
monitor progress and compliance. In that context, greater supervisory attention needs to be
paid to internal risk management and control systems for better understanding by the
management of risks and to consider market discipline as an effective tool in building
confidence among depositors and other stakeholders.

In introducing and inculcating Corporate Governance principles, the regulators and the
cooperative sector should work together. The efforts that are being made by the cooperative
community in Sri Lanka to reform the sector by establishing governance rules should be
commended. The new rules should broadly cover principles that require to improve internal
governance, in particular management of risk controls, covering the societies, the multipurpose
cooperatives, the cooperative banking arms, the membership and the board of directors. It is
also important to ensure that regulatory incentives are re-evaluated periodically, as there could
be inconsistencies at all levels. As a core element, wide ranging disclosures should be
encouraged for effective market discipline and improving cooperative/collective responsibility.
Similarly, legal consistency and clarity should be established to avoid ambiguity, especially in
dealing with equity holders obligations and depositors funds. These norms will strengthen the

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governance structure in the cooperative sector, which will result in enhanced transparency and
accountability, which are the key words in Corporate Governance.

Supportive Environment for Sound Corporate Governance

The primary responsibility for good Corporate Governance rests with boards of directors
and senior management of banking organizations. But, they should not be left alone. The
shareholders, auditors, banking industry associations, federations, cooperative societies,
governments, banking supervisors, securities regulators, stock exchanges and employees
should also contribute to uphold Corporate Governance. The participation of these stakeholders
need to ensure that Corporate Governance practices can be improved by addressing a number
of legal issues such as protecting and promoting shareholder rights and ensuring that banking
institutions function in a transparent manner through appropriate laws, regulations and other
measures.

Corporate Governance arrangements as well as legal and regulatory systems vary widely
between countries. Nevertheless, sound governance can be achieved regardless of the
corporate status of the banking organization so long as several essential governance codes are
in place. It may perhaps be important to concentrate on three important forms of oversight that
should be included in the organizational structure of any bank in order to ensure appropriate
checks and balances. They are (1) oversight by the Board of Directors; (2) oversight by
individuals, not involved in the day-to-day running of the various business areas; and (3)
independent risk management, compliance and audit functions. In addition, it is important to
ensure that key personnel in banking are fit and proper to hold their respective posts.

Modern Corporate Governance Principles

Modern Corporate Governance principles and guidelines can be applied appropriately to

any institution for better risk management. Corporate Governance researchers and regulators
have developed several Corporate Governance principles and guidelines for voluntary
compliance by companies. The Central Bank of Sri Lanka also has issued a code of Corporate
Governance for the banking industry for voluntary compliance. These guidelines relate to the
responsibilities of the Board, Directors, Chairman, CEO, other senior management and Board
appointed Committees and safeguard rights of minority shareholders. It may perhaps be worth
elaborating a few relevant guidelines to cooperative banking, although I am aware that separate
sessions will be held today by various speakers on these topics.

1. The Board
The Board should maintain a good balance of executive and independent or non-
executive directors such that no individual or small group of individuals can dominate
the boards decision-making. They should also be independent from any undue
influence and act in a manner that ensures the unbiased treatment of all shareholders
and stakeholders. The Board shall at all times safeguard the best interests of the bank
and shall not compromise its fiduciary responsibilities.
The board should have responsibility for the establishment of the vision, mission,
values and objectives of the institution, effective monitoring of management in
achieving the objectives, approving policies, strategies, budgets and organizational
structure of the bank, ensuring that senior management takes necessary steps to
identify, monitor, manage and control related risks, implement internal controls
effectively, comply with the applicable laws and regulations and initiate and
encourage the establishment of good Corporate Governance throughout the bank.

2. Directors
The directors should be persons whose abilities are widely acknowledged by the
shareholders and other stakeholders. They should have the experience, knowledge,
expertise and good judgment to make an effective contribution for the bank to
achieve its corporate objectives.
Directors should be fit and proper persons.
The directors should act in the best interest of the bank and its shareholders with due
regard to claims of other stakeholders.

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 The directors should undertake a formal and rigorous evaluation of the sub
committees, individual directors and of their own performances. Each director should
perform a self-evaluation of the contribution that he/she made during the year.

3. Chairman
The Chairmans position should be separated from that of the Chief Executive Officer.
On all important matters, the Chairman should obtain Board approval prior to
communicating with outside parties.
Chairman is expected to ensure that all directors, executive and non-executive
directors are encouraged to play a useful role within their respective capabilities in
order to secure the maximum benefit to the institution.
In the event of the Chairman exercising the casting vote, he/she shall ensure that the
best interests of the institution are held and achieved by his/her decision.

4. CEO and Senior Management

CEO should be accountable for the effective implementation of the Board policies and
collective decisions taken by the Board and the senior management is responsible for
the performance of the bank.
Senior management should ensure that the internal and external factors that could
adversely affect the achievement of the objectives of the company are being
identified and evaluated.
The Board shall be informed of all currently faced and foreseeable risks by the
institutions and of any adjustments of the corporate risk profile when necessary.

5. Board Committees
The Board should appoint committees to ensure its close oversight over the affairs of the
bank. The terms of reference, composition and operating procedures should be well
defined and laid down by the Board for the functioning of each Committee. The
cooperative banks should at least have Audit Committees in place to monitor the
integrity of the financial statements of the company and review significant financial
reporting judgments contained in them to play an important role in selecting the
accounting policies for the institution.

6. Training of Directors of Banking Organizations

Strengthening of the Boards of any banking organizations is a must as it relates to
governance. Education and training and the growing need for professionalism in
directorships would be essential to sustain the principles that have been established.
There are a number of institutes of directors in many countries including Sri Lanka which
provide training to the directors of companies including banking companies. To truly
professionalise directors, there is a licensing procedure in Hong Kong. Training of
director boards is part of the curriculum in USA, UK and many other European countries.
Sri Lanka has begun to pay attention to the training needs of director boards of banks
and financial institutions operating at grass root levels and to encourage them to get
training prior to being appointed as directors.

These are some of the Corporate Governance guidelines issued by the Central Bank of Sri
Lanka to the banking sector, which have some relevance to cooperative banking.

Let me conclude by thanking the organizers of this conference for focusing on an

important topic relevant to a grass root level banking organization. I hope the deliberations of
this conference would lead to preparation of an implementable set of proposals, which would
enhance Corporate Governance in the cooperative banking sector. I wish the seminar a success.

Thank you.