Economy

Banking on Governance ?

By Chad Leechor

Banks fail with alarming frequency, resulting in large losses of taxpayer money. A key factor in the high failure rate is the flawed governance mechanism, which exacerbates the risks inherent in banking. Bankers control a lot of other people’s money and have discretion over the information they disclose. The temptation to engage in excessive risk taking is strong. Tightening banking supervision is seldom the solution. For their part, banking supervisors often face incentives at odds with those of taxpayers. At times they may prefer not to act to minimize taxpayer losses. These twin governance problems are further compounded by the common practice of disclosing banking information only to supervisors, not to markets. This Note explains the conflicts and proposes some solutions.

Modern banking has been characterized by frequent and widespread bank failures. Even advanced countries with sophisticated banking practices and supervision have periodically experienced large-scale banking distress. In the United States, for example, in a period of high interest rates in the early 1980s, a quarter of the savings and loan institutions failed. In the late 1980s the collapse of oil and real estate prices brought another wave of bank failures.

Virtually no country is immunemuch to banking crises. According to recent studies, more than 130 countries have suffered major bank failures in the past two decades. In many cases the impact on the economy has been devastating. In Argentina, Estonia, and Poland more than half the banks failed in recent banking turmoil. The amount of public money needed to resuscitate the failed banks is often staggering.

Banking is an inherently risky business. To begin with, banks have access to unusually high leverage. In non-bank firms a debt-equity ratio of 1 to 1 is considered high, and a ratio of 4 to 1 - as seen in East Asia - reckless. But in banking a debt-equity ratio of, say, 10 to 1 is considered prudent. Such leverage intensifies business risks. With fractional reserve requirements, banks may end up with no cash on hand to pay depositors. They can borrow from other banks or from the authorities, but only within limits. Bankers also face the risk of insolvency. If a bank loses a fifth of its asset value, it is technically insolvent and may be taken over by regulators. Wide swings in business conditions can wreak havoc on banks. Depressed cocoa prices, for example, may cause banking distress in Côte d’Ivoire and Ghana, while a fall in copper prices may hit Zambia and perhaps Chile.

This vulnerability is exacerbated by policy interventions. For example, public deposit guarantee limits depositors’ runs on banks, but also encourages excessive risk taking by bankers (moral hazard). And it may cause depositors to disregard the quality of banks. The restrictions on bank branching or on foreign ownership as applied by some countries limit diversification and amplify the impact of cyclical and price fluctuations. Prudential rules of advanced countries also are often problematic. The risk of cross-border inter bank lending, for example, is often understated in the metric of exposure (risk-weighted assets), leading to a cycle of excessive lending and destabilizing credit withdrawals.

These natural and man-made hazards are known or predictable. With good governance, a bank can be prudently managed to avoid the dangers. Then why are bank failures so frequent and widespread ? It may have to do with the incentives and constraints of the decision-makers in banks and supervisory agencies.

Heads I win, tails you lose

There is a conflict of interest between bankers (controlling shareholders and managers) and other stakeholders - outside investors, depositors, and taxpayers. It is often quite rational for bankers to take on risks that are not prudent from the perspective of the other stakeholders. Bankers can use devices that reduce their personal exposure. They also have an information advantage that can be used to conceal the risk exposure. In these circumstances bankers are often drawn to inefficient risk taking.

How a banker sees the risk is affected by the combination of high leverage and limited personal liability. Consider a project that has a 90% probability of making US$ 10 and a 10% probability of losing US$ 100. Socially, this project is unattractive, with a negative expected value of US$ 1. But if the banker’s maximum loss is only US$ 10 and the depositors are entitled to only US$ 5 of interest, the project has an expected value of US$ 4 to the banker. For some, it would appear rational to take the risk.

In developing countries especially, bankers can often reduce their risk exposure because weak banking rules and poor enforcement enable them to lend large amounts of money to themselves or to affiliates (related party lending). Such connected lending allows bankers to take risks with little or no exposure. This is banker’s escape - the flip side of a run on banks.

A bank’s risk exposure is generally confidential. Detailed characteristics of individual assets (the borrower’s identity and the status of each loan) are costly to monitor and verify. Many banks use historical cost accounting, which obscures their true financial condition. The use of new financial products, including derivatives and structured notes, has made risk exposure even more difficult to assess. Only bank management with a good information system and strong banking skills can effectively monitor portfolio quality.

In addition, bank management has much scope for discretion in valuing assets and in making provisions. Through small changes to individual loans, management can change the aggregate information it discloses by a wide margin. The use of independent auditors can help keep managers honest, but there are limits. Auditors generally certify financial statements on the basis of local standards, which may not be consistent with international standards. And auditors face a conflict of interest in their dual role as certified public accountants and bank consultants.

Who is watching the umpire ?

The bank governance problem is often compounded by a conflict of interest between banking supervisors and depositors or taxpayers. Unlike shareholders, who have an equity exposure, banking supervisors have no similar financial stake in public guarantee funds. Their compensation cannot be readily tied to performance through the tools of incentive contracts or equity ownership. Nor are banking supervisory agencies subject to the threat of takeover. As a result, there is little assurance that banking supervisors will use their best efforts in the interest of depositors and taxpayers. The widespread failures of public deposit guarantee funds stand in stark contrast to the well-governed - and profitable - business of private sureties, which provide credit guarantee on a commercial basis.

When confronted with banking trouble, supervisors may find it difficult to proceed if the bank is too big to fail or powerful politicians are trying to protect the banker. They may be reluctant to disclose the bad news, especially if the problem should have been discovered earlier. And supervisors may often find that friendly relations with bankers serve their long-term interests better than a strictly arm’s-length relationship.

Banking supervisors have much discretion - for example, with regard to the definition of insolvency or the valuation of assets. A bank that is insolvent by accepted accounting standards may not be by the supervisors’ rules. Supervisors may not recognize changes in the market value of assets or do so on a timely basis. And if it serves their interests, supervisors might delay the necessary regulatory action.

In the business of banking, time is literally money. Delayed corrective actions typically mean larger lo Xsses down the road. Troubled banks generally respond to losses by taking on more speculative investments in the hope of making up for them. But this "desperation" risk taking often only magnifies the losses.These strategic official behaviourare not theoretical possibilities. Court documents and legislative records show that official delay has allowed many troubled banks to gamble with depositors’ money. In the United States, for example, banking supervisors contributed to the collapse of many public guarantee funds, including the Federal Saving and Loan Insurance Corporation in 1989 and state funds. In these cases the supervisors involved had foreknowledge of the trouble, delayed corrective actions, and helped in the cover-up. Strategic behaviour by supervisory official is not confined to any particular country. In the 1990s financial scandals involving public officials have been uncovered in such countries as France, Mexico, and Russia and in many East Asian countries.

Three wishes for the genie

Good governance in banking relies on three key building blocks: proper incentives, adequate transparency, and clear accountability. Putting these building blocks into place may require unconventional reforms.

Aligning incentives

It is crucial that bank insiders have a significant equity stake in the banking business. But upholding this roles is very difficult. Banks’ accounting policies need to reflect market risks and borrowers’ credit risks. Bank directors need to be accountable. Connected lending and ownership of banks by commercial interests need to be prohibited. Also helpful is expanding the scope for market insight, for example, through market-based disclosure and by rolling back public deposit insurance.

Essential, too, is to protect the interests of minority shareholders, especially among banks that are closely held. In particular, the duty of loyalty should be imposed on banks’ controlling shareholders, who also serve as bank directors and executives. The presence of independent directors and the use of audit committees can also deter insider abuse.

The interests of the banking supervisors should be aligned with those of the taxpayers. As long as public deposit guarantee is provided, the rewards of the civil servants who manage the guarantee fund must be linked in some way to the underwriting results. But this is not easy. Bringing in private sureties as business partners of the public guarantee fund is a possible alternative. The sureties would take the lead in pricing and underwriting the risks, with the public funds serving as co-insurers.

Ensuring transparency

The coverage and standards of banks’ disclosure generally leave too much scope for discretion. Banks should be required to disclose not only their financial statements, but also their capital adequacy ratio, peak exposure concentration, lending to related parties, members of the board, and any conflicts of interest. The disclosure should follow marked-to-market procedures, which reflect the effects of exchange rates, interest rates, and commodity prices. And bank directors should be required to attest that their disclosures are not false or misleading.

Another problem is that bankers are often required to give essential banking information only to the authorities, not to the market. This practice places undue reliance on banking supervisors. In a break from conventional practice, Chile and New Zealand have started moving towards market-based disclosure. Their banks make full public disclosure on a quarterly basis to market participants (depositors, their agents, and outside shareholders). This disclosure requirement gives bankers an incentive to be prudent.

Banking supervisors should also be more transparent. They should be required to disclose regulatory opinions on official forbearance or corrective actions. Where public deposit guarantee is used, they should disclose the risk exposure of guarantee funds, along with the standards for measuring the exposure. And the supervisors should be required to attest that their disclosures are not false or misleading.

Clarifying accountability

Along with better disclosure, competition in the banking business can make bankers more accountable. Banks would have to rely more on investment merits, including good governance and creditworthiness, to attract funding. In addition, adequate sanctions against abusive practices are essential. For bank insiders, sanctions should include unlimited liability, particularly for a breach of disclosure rules. And when fraud is involved, criminal sanctions must be an option. Minority shareholders and taxpayers should have access to judicial remedies against insider abuse.

The performance of banking supervisors improves when they have clearly defined performance criteria and a governing body accountable to the taxpayers. The supervisors should set targets for the risk exposure of public funds, explain any deviations from the targets, and provide a clear plan of corrective actions. They should also face significant sanctions for breach of duty, including criminal sanctions for participation in fraud. But such rules are not easy to enforce. Independent and aggressive media can play a critical role. In addition, a government ethics office can help in investigating official misconduct.

(Reprinted from Partnership for Development, 2000, The Word Bank.) Rs. in million

Source: NRB

 Government Budget
(Year ending on July 15) Rs. in million

Source: NRB

Direction of Foreign Trade (Rs. in million)

Source: NRB

Export to Overseas (Rs. in million)

Source: NRB

Foreign Exahange Rate 
(As fixed by Nepal Rastra Bank)  

91 Days Treasury Bills Discount Rates

Source : Information published by Nepal Rastra Bank

Bullion Prices (Kathmandu)

Nepali ICD & Indian Railway

By R.B. Rauniar

The "dry port" in Birganj of Nepal is still "dry" without business, as Nepali and Indian Governments are still dillydallying to finalize modalities for operating railway services between the two countries. A Nepali expert in multi-modal transport suggests a procedural arrangement which may be quite practical as well as helpful to reduce the worries of both the countries.

The Birganj ICD should operate as a real ICD, not just a new terminal. Birganj ICD will be an ICD only if the cargo originates in or is destined to it. It requires the cargo movement between the sea port and the ICD to be undertaken by Indian Railways or its subsidiary.

In India, there is a system under which the Indian Railway or its subsidiary provides a bond to the Indian Customs for movement of cargo from/to the port and ICDs by rail under its guarantee. If the same system is extended to cargo destined to or originating in Nepal, all the parties involved - the Indian customs, the Nepali Customs and the Nepali importer/exporter - will be happy.

Both Indian Railways or its subsidiary and the Indian Customs are undertakings or parts of the Indian Government. The railway receipt or Inland Way Bill (IWB) can be issued showing Indian Customs, Gateway Port, as the consignor and Nepal Customs, ICD-Birganj, as the Consignee (and vice versa for Nepali exports). If the above arrangement is in place, it will automatically check deflection of cargo, thus removing the worries of India. This way, there is no interference in the movement of the cargo from its actual owner. As the carriage is under Indian Customs bond, the cargo is under the control of Indian customs till it is being handed over to the Nepal Customs.

There is a system of making CTD and passing the documents at Calcutta Customs for cargo destined to Nepal. This system should be discontinued for cargo destined to Nepali ICD. Instead, shipping lines will submit Import General Manifest (IGM) along with the sub-manifest of "cargo in transit to Nepal" for the removal of the cargo from the Customs at the port of landing. The name of importer/exporter need not appear in the railway receipt or transit IWB.

The shipping lines will be booking the cargo from origin to ICD in Nepal, not only up to gateway port in India. Thus, it will be the responsibility of the shipping lines to move the cargo to the ICDs under this procedure. The Indian Customs at gateway port will give the removal order for onward carriage of the cargo to the ICD in Nepal. Indian Railway or its subsidiary will carry the cargo by rail.

Similar operation should be applicable for export cargo from Nepal. Under this, the shipping lines will receive the cargo at ICD Nepal where they issue their Bill of Lading.

After getting the removal order from the customs, the shipping lines will submit the forwarding note for the issuance of the IWB for transfer of the cargo from and to Indian port/Nepali ICDs, and they will get a cargo receipt for taking delivery at Nepali ICD or at Indian Port of Loading.

This is not a new proposal, as it is already in practice by customs at various ICDs in India. The only difference is that, in this case, the cargo will be in transit to Nepal and a transit IWB shall be issued.

As a transit giving country India will have every right to check or stop any cargo which they suspect to be harmful to the Indian interests. The proposed arrangement will not undermine their rights. Consolidating the traffic through ICDs will give additional benefit: it will limit free movement of transit traffic as is allowed under the present arrangement. This will be a step toward minimizing the entry/exit points - something that India has always been grumbling for whenever there is any Nepal-India consultation about transit arrangement.

Moreover, as the consignor and consignee of the cargo in transit will be the customs of the respective countries, the actual owners/importers of the cargo will have no access to the cargo till it arrives at the ICD in Nepal and a delivery order is issued at the ICD by the respective shipping line.

Nepal at present is not in a position to handle any rail operation. Therefore, the operational part of the rail within Nepali territory should be taken up by Indian Railway personnel to arrange siding operation from and to Raxaul/Birganj.

It is also suggested that the transfer facility from Indian ports to Nepali ICDs may be provided in a phased manner: only containerized traffic enjoy this facility in the beginning, and if it is successful, then it can be extended also to other traffic.

The system may also include endorsement or acknowledgement or arrival report of the container or cargo by the destination customs to be transmitted to the dispatching customs for verification. Such transmission can be made time bound. Upon verification of the document, the bond submitted by the Indian railway or subsidiary should be released for that particular cargo.

Decline Continued

Reporting decelerated growth in most of the major monetary, fiscal and foreign trade indicators, the latest statistics from central bank call for a rethinking in the country’s macro-economic management.

"The fiscal year 2000/01 has been marked with a deceleration in both the monetary aggregates and inflations rate", declares Nepal Rastra Bank (NRB) in its latest report covering all the 12 months of the last fiscal year that ended on July 15, 2001. According to NRB report, broad money registered a decelerated growth of 14.9% as compared to 21.8% growth in the previous year. The inflation, measured by change in national urban consumer price index was 2.4% against 3.5% of last year.

Among the components of money supply, there was a mere 7.2% increase in net foreign assets this year as compared to 22.2% increase last year, thus reflecting the slow growth in export. As Nepali economy is increasingly becoming export-dependent, slow growth in export has also resulted in slow growth in the banking system’s credit to the private sector - 16.8% this year against 20.5% last year. The message: reduced interest rate is not enough to stimulate economic growth.

Neither does an increased government spending stimulate growth. As NRB has reported, though the government had 15.9% of more resources this year than in the last year, it borrowed this year more heavily: 24% more from banks and 85% more through Treasury Bills, Development Bonds, National Saving Bonds and Overdrafts together. The resultant 20% increase in government expenditure this year could not pull the economy up. In 1999/2000 too, the government spending had been 11% higher than in the previous year. And the effects of that increased spending should have reflected this year (2000/2001) making an allowance for lag effect.

About external trade, NRB reports 14.9% increase in exports (39.7% increase last year) and 4.5% increase in imports (24% increase last year). Imports from third countries have actually declined 3.1%, meaning whatever increase has been there in imports it is in imports from India. As a result, the trade deficit with India has grown 5% to Rs. 19 billion as compared to the previous year when it was Rs. 18 billion. As a result, the share of India in Nepal’s total foreign trade has now reached over 43% as compared to 25.9% in 1996/97 and 38.4% in 1999/2000.

Among the major six export items overseas listed by NRB, both the first and second largest - readymade garments and carpets - registered declines of 5.9% and 12.7% respectively. Similar was the fate of silverware and jewelries (10.9% decline). As the exporters, particularly the garment exporters, are complaining, the exports of these items are further declining during the recent months not covered in the NRB report.

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