RBI and Corporate governance

A third and an area of particular relevance to the Reserve Bank of India (RBI) relates to corporate governance in the financial sector. Today, therefore, the major focus of this presentation would relate to corporate governance in the financial sector itself.

It is possible to broadly identify different sets of players in the corporate governance system. For convenience they can be identified as law which is the legal system; regulators; the Board of Directors and Executive Directors on the Board; financial intermediaries; markets; and self regulatory organisations. There is a dynamic balance among them that determines the prevailing corporate governance system, and the balance varies from country to country. In some countries, self-regulatory organisations are well established and in others, as you are aware, the financial intermediaries play a greater part. These balances vary from country to country and, vary depending upon the stage of institutional development and the historical context. Since financial intermediaries are important players in corporate governance in India, special focus on the corporate governance in the financial sector itself becomes critical.

Secondly, the RBI, as regulator relevant to financial sector, has responsibility on the nature of corporate governance in the financial sector. Therefore, we, in the RBI, have to see how corporate governance is evolving, particularly in the context of the financial sector reforms that are being undertaken.

Third, banks are special and to the extent banks have systemic implications, corporate governance in the banks is of critical importance to the RBI.

Fourth, which is not peculiar, but certainly one of the important features of the Indian system, is the dominance of the Government or the public sector ownership in financial sector, whether it is the banking system or development financial institutions. In a way, Government, as a sole or significant owner of commercial, competitive, corporate entities in the financial sector would also set the standards for corporate governance in private sector.

Fifth, relates to the reform process initiated since 1991-92. In the pre-reform period, most decisions were externally, i.e., external to the financial intermediary determined including interest rates to be paid or charged and whom to lend. But recently, there has been a movement away from micro regulation by the RBI. There is thus, a shift from external regulation to the internal systems and therefore, the quality of the corporate governance within the bank or financial institution becomes critical in the performance of the financial sector and indeed the growth of financial sector.

In this perspective of the significance of corporate governance in the financial sector in India, the rest of the presentation is divided into three parts.

The first relates to corporate governance in Government owned financial intermediaries, i.e., the nature of the corporate governance in the context of the Government ownership.

The second set relates to corporate governance and regulatory issues in financial sector, especially relevant to the Reserve Bank of India.

The third part identifies the areas that require attention, taking into account not only the ownership and regulatory aspects but also the total systemic requirements. The areas requiring attention are simply listed for further attention.

Importance of Corporate Governance Under Government Ownership

The evolving corporate governance system in Government owned banks and financial institutions is very critical in India for a number of reasons.

First, public ownership is dominant in our financial sector and it is likely to be dominant for quite sometime in future in India. So, it sets a benchmark for the practices of corporate governance.

Second, the whole concept of competition in banking will have to be viewed in the light of the government ownership. If the regulator is trying to encourage competition, such encouragement of competition is possible if the market players i.e., banks concerned, are willing to respond to the competitive impulses that the regulator is trying to induce. It is possible that the nature of corporate arrangements and nature of incentive framework in the public sector banks are such the regulatory initiatives will not get the desired response or results. Consequently, the regulator’s inclination or pressure to create an incentive framework for introducing competition would also be determined by the extent to which the corporate governance in public sector financial intermediaries is conducive and responsive.

A third factor is diversified ownership in many public sector financial intermediaries, both the banks and financial institutions. The government is no longer 100 per cent owner in all public sector organisations. In organisations where there has been some divestment, it owns directly or indirectly about 55 to 70 per cent. The existence of private shareholders implies that issues like enhancing shareholders value, protecting shareholders value and protecting shareholders rights become extremely important. Such a situation did not exist in most of the public sector and financial sector until a few years back. The issue is whether this transformation in ownership pattern of the financial system has been captured in changing the framework of corporate governance.

A fourth factor is that if the financial sector, in particular banking system, has to develop in a healthy manner there is need for additional funding of these institutions. More so, when the central bank is justifiably prescribing better prudential requirements and capital adequacy norms. If some additional capital has to be raised by these institutions, they should be able to convince the capital market and shareholders that it is worth investing their money in. In the interest of ensuring that the institutions have adequate capital and that they continue to grow, they should be in a position to put in place and assure the market that their system of corporate governance is such that they can be trusted with shareholders money. The issue, therefore, is how our public sector financial institutions have been performing in terms of enhancing shareholder values. This is extremely important from system point of view because, additional funding has to be provided either by the Government or by the private shareholder. Given the fiscal position, the Government cannot be expected to invest significant funds in recapitalising public sector financial organisations. In brief, Government as an owner has to appreciate the importance of enhancing shareholder value, to reduce the possible fiscal burden of funding of banking or financial institutions in future and so attention to corporate governance in public sector is relevant from overall fiscal point of view also – whether for additional investment by Government or for successful divestment of its holdings.

Fifth, there is the issue of mixing up of regulatory, sovereign and, ownership functions and at the same time ensuring a viable system of corporate governance. A reference has been made to this in the Narasimham Committee Report on Banking Sector Reforms (Narasimham Committee II) Banking Sector Reforms and more recently in the Discussion Paper on Harmonising the Role and Operations of Development Financial Institutions and Banks (Discussion Paper on Universal Banking), circulated by the Reserve Bank of India. For instance, as the Narasimham Committee (II) has highlighted, in the case of the State Bank of India, the RBI is both regulator and owner. Also, ownership and regulatory functions are mixed up in the case of the Industrial Development Bank of India.