Improving the Corporate Governance of Chinese Financial Institutions Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)

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1 China Forum: Capital Markets and Corporate Governance Beijing, 1 December, lawrencelau@cuhk.edu.hk; WebPages: Improving the Corporate Governance of Chinese Financial Institutions Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Vice-Chancellor The Chinese University of Hong Kong and Kwoh-Ting Li Professor of Economic Development Stanford University

2 A Preview The objectives of corporate governance The prerequisites of good corporate governance Obstacles to good corporate governance--asymmetric information, incentive incompatibility and moral hazard What is special about financial institutions? The importance of enforcement of the applicable laws and regulations by the government Concluding remarks Lawrence J. Lau, The Chinese University of Hong Kong 2

3 The Objectives of Corporate Governance Adopting and implementing corporate policies and directions that optimize the interests of the shareholders and enhance corporate performance Aligning the interests (including the risk preference and the time horizon) of the shareholders/owners and the managers Aligning the interests of the managers and the employees The enterprise acting in unity Ensuring compliance with applicable laws and regulations Protection of minority shareholders Lawrence J. Lau, The Chinese University of Hong Kong 3

4 The Pre-Requisites of Good Corporate Governance--Information Information--Accurate, reliable and timely information for the management and the Board of Directors is critical to good corporate governance Real-time management information and communication system Internal audit and external audit Use of advanced information and communication technology Lawrence J. Lau, The Chinese University of Hong Kong 4

5 The Pre-Requisites of Good Corporate Governance Hierarchical Organization Giving the CEO full executive authority over the operations of the entire enterprise, including over personnel. Only key personnel (e.g., the Deputy CEO, the Chief Financial Officer, the Chief Auditor and the Chief Compliance Officer) should require the approval of the Board of Directors; other executive appointments and promotions should be up to the CEO. Lawrence J. Lau, The Chinese University of Hong Kong 5

6 System of Monitoring and Internal Control Institution of internal controls and risk control and management. Systematic randomization is a good, cost-effective technique for monitoring. Lawrence J. Lau, The Chinese University of Hong Kong 6

7 The Pre-Requisites of Good Corporate Governance--Incentives Providing incentives for desirable behavior Is there enough interest for the board of directors and the management to act in the best interests of the shareholders/enterprise? Lawrence J. Lau, The Chinese University of Hong Kong 7

8 Obstacles to Good Corporate Governance Asymmetric information the senior management of the enterprises has the most information and the shareholders the least information. It is therefore difficult for the shareholders and even the board of directors to be sufficiently well-informed so as to evaluate the management s strategy and performance. Incentive incompatibility even if information is perfect, the rewards for success and penalties for failure for the management and the owner (shareholders) as well as the respective risk preference and time horizons may be different, leading to possible non-alignment of interests between the shareholders and the management. Moral hazard because information is asymmetric, and monitoring is difficult and costly, senior management of enterprises may undertake hidden actions that are in their interests but not in the interests of the shareholders. Lawrence J. Lau, The Chinese University of Hong Kong 8

9 Reform of the Microeconomic Process of Loan Approval and Disbursement Reform of the microeconomic process of loan approval and disbursement can greatly discourage hidden action. Equity requirement--in order to reduce the moral hazard of borrowers and potential borrowers, there must be a significant equity requirement up front. On investment projects, the equity requirement should be no less than 30 percent. The equity requirement must be fully paid in and retained by the commercial bank financing the project before the project can be initiated. Lawrence J. Lau, The Chinese University of Hong Kong 9

10 Reform of the Microeconomic Process of Loan Approval and Disbursement Progress method of loan disbursement in order to prevent diversion of funds to other, non-project-related purposes, funds should be disbursed first from the initial equity deposit, and only then from the loan proceeds, and in any case only in accordance with actual progress made on the project and only to third-party contractors and sub-contractors upon independent verification of progress (e.g., payments for turbines for electricity generation should be made directly to the supplier and not to the borrower and only upon properly verified installation and acceptance). In addition to preventing diversion of loan proceeds, this also provides additional protection for the lender. In the event of a failure of the project, at least all the loan funds were spent on the project itself. Lawrence J. Lau, The Chinese University of Hong Kong 10

11 Reform of the Microeconomic Process of Loan Approval and Disbursement Since the equity requirement is expressed as a percent of the value of the entire project, reliable appraisals prior to the approval of the loans are absolutely necessary. This is especially the case if the equity consists in whole or in part of the value of the land or long-term lease contributed to the project. Trained professional appraisers are urgently needed in China. All of the above practices are actually common international lending practices. Use of techniques to reduce opportunities for corrupt influences mandatory rotation/vacation, dual loan approval process, randomization of the membership of the loan committee. Lawrence J. Lau, The Chinese University of Hong Kong 11

12 Reform of the Microeconomic Process of Loan Approval and Disbursement Differential treatment, including pricing, of borrowers based on their debt to equity ratios. The higher the debt to equity ratio, the higher the interest rate. At the extreme no loans should be extended to firms with debt to equity ratio beyond a certain level. Firms with high debt to equity ratio have nothing more to lose and will tend to become reckless. Borrowers who are willing to pay high rates of interest are not the borrowers that you want to lend your own money. Lawrence J. Lau, The Chinese University of Hong Kong 12

13 Incentive Incompatibility between Owners (Shareholders) and Managers This is a problem present in many countries in not only publicly owned enterprises, but also privately owned enterprises. The incentives of the senior executives are not necessarily the same as those of the shareholders and hence the policies adopted and the actions taken may not be in the best interests of the shareholders. Senior management would like to invest regardless of whether the times are good or bad. Owners (shareholders) may want to hold off for a while. Stock options do not solve the problem because they are one-sided. They encourage moral hazard and recklessness. Employee-owned shares financed with loans with recourse can be a solution. There should also be distributed disposal upon retirement. Requirement of senior management to own shares and participate in both the ups and the downs. The possibility of mutual self-monitoring by senior executives. Is the presence of an active controlling shareholder good or bad possible conflict of interest, piggy-backing and transparency? Lawrence J. Lau, The Chinese University of Hong Kong 13

14 Reducing Moral Hazard Providing Incentives for Employees Use of higher compensation and long-term career advancement as incentives--employees should be paid well enough and be provided sufficient opportunities for advancement and growth so that they do not want to leave the firm. Once employees decide they do not want to leave, they will begin to develop a loyalty and sense of belonging to the firm. The interests of the firm and the employees are then much better aligned what is good for the firm is good for the employees; what is good for the employees is good for the firm. The employee should have the incentives to treat the funds of the financial institution as carefully as his or her own money. Inadequate compensation creates temptation for employees with authority and/or opportunities for self-enrichment at the expense of the firm. Only with long-term employees can one begin to inculcate a Lawrence J. Lau, The Chinese University of Hong Kong 14 corporate culture.

15 Monitoring by the Board of Directors Audit Committee hiring and firing of and direct reporting by external and internal auditors. Approval of the appointment of senior management, including, in particular, the second and third in command, as well as the Chief Financial Officer. Lawrence J. Lau, The Chinese University of Hong Kong 15

16 Incentives for Independent Directors For independent directors owning little or no shares of stock in the enterprise, if the compensation is too low, they are unlikely to make a real effort; if the compensation is too high, they are likely to support whatever the management proposes, since they are often selected and compensated by the management. In addition, if there is inadequate directors and officers insurance, one is unlikely to be able to find good individuals willing to serve as independent directors; however, if the insurance is too good, there is no real downside if the directors shirk their responsibility. Ultimately good corporate governance depends on having on the Board of Directors individual members with a genuine financial interest a stake financially important enough for the members themselves. Lawrence J. Lau, The Chinese University of Hong Kong 16

17 What is Special about Financial Institutions? A major source of moral hazard is a financial institution lending to its own direct or indirect subsidiaries or to its parent the financial institution is a source of low-cost and high-leverage funds. Financial institutions have unusually high leverage the capital requirement is only 8 percent, leading to a liabilities to equity ratio of 12.5 times. Additional moral hazard on the part of the management as well as the depositors of the financial institution due to explicit or implicit deposit insurance--financial institutions may also be considered too big to fail! A more sophisticated way of tapping into the resources of a financial institution is through reciprocal lending practices I lend to your subsidiary and you lend to my subsidiary. Thus, the separation of ownership of financial institutions from industrial enterprises as well as the separation of different lines of Lawrence J. Lau, The Chinese University of Hong Kong 17 financial businesses do have their merits.

18 What is Special about Financial Institutions? There is enormous room for hidden actions (e.g., lending to related parties, approval of loans in return for bribes, excess valuation of assets, too high a deposit rate, too low a lending rate) that are difficult to monitor and especially not in a timely manner. Incentives, appropriately structured, can counter information asymmetry and reduce moral hazard. However, incentives currently available for management and employees in Chinese financial institutions cannot be considered adequate. There is less inhibition in defrauding or defaulting on impersonal formal financial institutions as opposed to family, relatives, friends and colleagues. Lawrence J. Lau, The Chinese University of Hong Kong 18

19 The Importance of Conscientious Enforcement of Applicable Laws Enforcement should be consistent, uniform and fair over both space and time enforcement of the applicable laws and regulations. Tolerance of scoff-laws and/or slack, sporadic and arbitrarily discriminatory enforcement foster opportunistic behavior, breeds contempt for the laws and regulations and penalizes the law-abiding enterprises. Unenforced or inadequately or inconsistently enforced laws eventually become unenforceable laws. Enterprises must be given incentives for good behavior (and disincentives for bad behavior). Lawrence J. Lau, The Chinese University of Hong Kong 19

20 Concluding Remarks Ultimately corporate governance can improve only if there is such demand on the part of shareholders and their agents. Having more shareholders with a long-term interest in the enterprises is also essential for improving the corporate governance and hence corporate performance. It also depends on the reduction of information asymmetry and moral hazard and the environment of legal enforcement. Lawrence J. Lau, The Chinese University of Hong Kong 20