THE ROLE OF COMMERCIAL BANKS IN PROMOTING CORPORATE GOVERNANCE OF THEIR CLIENTS THE SMALL AND MEDIUM ENTERPRISE PERSPECTIVE BASSAM AZAB SENIOR MANAGER SMALL AND MEDIUM ENTERPRISE BANKING SERVICES HSBC BANK EGYPT May 2007 Disclaimer This working paper was prepared for the Conference: "Corporate Governance and Reform: Paving the Way towards Financial Stability and Development" that was held in Cairo, Egypt on May 7-8, 2007. The views and opinions presented in this paper are those of the author and may not necessarily coincide with those of HSBC Bank Egypt.
TABLE OF CONTENTS Acknowledgment 3 About the Author 4 Abstract 5 Introduction 6 Corporate Governance in Commercial Banks 7 A. Corporate Governance for Commercial Bank Clients 8 B. Corporate Governance for Bank SME Clients 9 Conclusion 11 References 12 Appendix 13 2
ACKNOWLEDGEMENT The author would like to thank the Egyptian Institute of Directors for the valuable assistance during the preparation and publishing of this paper, which is aspired to add value to the area of research in Corporate Governance in Egypt. 3
ABOUT THE AUTHOR Bassam Azab, born in 1973 and graduated from the Faculty of Commerce and Business Administration, Helwan University in 1995. Bassam holds an MBA degree in International Banking and Finance from the University of Birmingham, The United Kingdom and a Banking Certificate from the Chartered Institute of Bankers, UK In 1996 Bassam Joined HSBC Bank Egypt (Former Egyptian British Bank) and has covered several position in retail banking and custody operations. In 2003, he Headed the Custody Operation of HSBC Bank Egypt and was elected the Head of Custodians' Committee in Egyptian Capital Market Association (ECMA). In 2006, Bassam joined the Egyptian Corporate Governance Project at the International Finance Corporation, The World Bank Group in the capacity of a Financial Expert. In 2007, Bassam rejoined HSBC Bank Egypt to Head the Small and Medium Enterprise Banking Services. 4
ABSTRACT The author in this paper presents the corporate governance of banks. As the Traditional role of banks is to efficiently mobilize and allocate funds, the application of corporate governance is argued to lowers the cost of capital to firms, improve capital formation, and further encourage productivity growth. In the contrary, weak application of corporate governance is considered to be a bad indicator of how the company is run. After reviewing the major governance concepts for corporations in general, the author discusses two special attributes of banks, first, corporate governance for commercial banks clients and second, the paper discusses the corporate governance for bank SME clients emphasizing that corporate governance evaluation for lending medium-size and small- size companies is very important as The CAPMAS has published a census which showed that 85 per cent of the Egyptian companies were small and 9 per cent were medium size and only 5 per cent are large companies. 5
INTRODUCTION B anks are vital institutions in any economy as they form an important source for providing finance to businesses. Their role becomes more important in emerging markets, where the majority of finance to new and existing businesses comes from the banking sector, as opposed to finance through the stock market. The figures show that this is particularly true for Egypt that despite the recent revival of the stock market, most of the activity was in secondary trading with very few private sector companies exposing themselves to primary stock market issues. Having this vital role, it is important to ensure that banks are properly governed internally and to ensure sound governance structures to their customers externally in order to protect the interests of the various stakeholders and to sustain the healthy functioning of the monetary system in the Economy. Egyptian banks differ in size, complexity and sophistication and, hence, the Corporate Governance model adopted for themselves and for assessing their customers may vary from one bank to another and from one customer category to another. The key message is that Corporate Governance is important to banks and their clients and the extent of application should be flexible to offer the best model for each bank/customer according to their differing size and structure. 6
CORPORATE GOVERNANCE IN COMMERCIAL BANKS C orporate Governance is the system by which an organisation is directed and controlled. In a public-held company, the board of directors acts on behalf of the shareholders (owners) in overseeing management to ensure that their activities ensure maximisation of the value and sustainability of the company. Due to this key role of the board of directors, the main focus of corporate governance is to provide the framework and tools for board members to help them carry out their responsibility of management oversight. Within this scope, the duty of the board members to ensure that shareholders' rights are exercised and that all categories of shareholders (minority versus majority) are receiving equitable treatment is essential. The scope in corporate governance also extends beyond the direct owners of the company to other stakeholders that have interest in the company's operations, including creditors, regulators and employees. The heavily geared nature of banks makes the attention to stakeholders' interest very essential to the survival and success of a bank. From this perspective, corporate governance should not be confused with the narrower focus on risk management, which is governed by the Basel II recommendations and which is only one component of a complete corporate governance framework, but the view for corporate governance should be more of a strategic role of the board of directors to ensure that management of a bank, when performing their duties, are aiming at achieving the bank's strategic objectives, within the strategic risk appetite, to maximize the value of the bank to its owners, taking into consideration the interests of the relevant stakeholders. This perspective should render the expected rewards to the bank applying a sound framework of corporate governance in achieving the target results, managing the risks associated (and hence, reducing the costs of doing business) and gaining the confidence and trust of the bank's owners, depositors and regulators. 7
Needless to say that the implementation of a sound corporate governance framework requires a great effort form both the management and the board, and this requires a great commitment form both to ensure sound application. This commitment should come form the understanding of the rewards that corporate governance promise to the bank. The Basel Committee on Banking Supervision paper "Enhancing Corporate Governance for Banking Organisations", published in February 2006 is based on the Principles of Corporate Governance set by the Organisation for Economic Cooperation and Development (OECD). The paper provides eight principles of sound Corporate Governance and explains the role of supervisors and the supportive environment needed to form a sound governance framework for a bank. Appendix I provides a copy of the full paper. A. Corporate Governance for Commercial Bank Clients Commercial banks, in their traditional banking role, try to assess the capability of the borrower to operate successfully, thereby try to assess their client's ability to repay both the principal and interest of the loan as they fall due. The traditional focus of banks on mere financial risk measures has changed in the past few years to encompass other non-financial risk aspects (e.g. Operational, Reputational, Environmental and compliance risk) of the client. Operational Risk, arguably in this context, has two folds: The risk of loss or damage that may result from staff or management being erroneously interpreting and/or executing the rules and procedures laid down by the organization; And more importantly, The risk of setting the wrong rules and procedures to be followed by the members of the organization. 8
Here, the role of Corporate Governance of looking at the company's Board Practices comes to the picture. The Egyptian commercial banks should start giving more attention to Corporate Governance as part of the non-financial risk assessment when evaluating the lending proposition to a company as the structure, qualifications, background, track record of strategic decisions of the board would not only affect the interests of shareholders, but would also affect the company's ability of repaying its debts to the debt holders, mainly banks. B. Corporate Governance for Bank SME Clients According to the census published by the Central Agency for Public Mobilization and Statistics (CAPMAS) in 1996, out of a total 109,337 companies, 85 per cent were small and 9 per cent were medium size while only 5 per cent represented large companies. Two important observations can be drawn from these figures. First, in a country like Egypt, a very good number of the 94 per cent of the small-medium sized companies would have a legal form of Joint-stock or Limited Liability by Stock. This legal form mandates the existence of a board for the company. As such, Corporate Governance evaluation would be very important, at least, when lending to medium-size and the upper tear of small-size companies. Second, the fact that in so many cases, the Small and Medium size companies may not have a separation of ownership from management. In this respect, the claim that Corporate Governance should be of no relevance as the owners bear the consequences of their deeds is, in effect, a fallacy. In fact, taken collectively, the improper strategic management and practices of the owners/managers of such companies would cause a systematic failure that would harm the banking sector and the economy as a whole. This may become very clear in a down-turn phase of an economy when badly-run companies would start suffering the symptoms of debt deflation 9
causing difficulties to banks to recover their loans and the economy as a whole to suffer from severe recession. The above observation shows the importance of considering Corporate Governance when lending to such companies. However, the governance focus here should shift from the risk to shareholders as the primary concern to the risk to stakeholders (debt holders and the economy at large). This shift should represent what the author wishes to coin as "Corporate Economic Responsibility". CER should be understood as the company's responsibility, through the actions of its owners/managers to achieve not only its business and profitability objectives but also the wider objective of developing the economy in which it operates. Traditionally, commercial banks used to apply the classical "Judgemental" evaluation approach of credit granting proposals. The large number of small and medium size companies and the varying size of those companies make judgemental evaluation both time consuming and cost inefficient. To overcome this hurdle, many commercial banks in the world, that have exposed themselves to the SME finance world have opted to mix the classical judgemental approach with the new technique in retail banking finance known as "credit scoring". The resulting hybrid approach can best be described as "Criteria-based" Lending, where banks try to use the expertise gained through the history of credit granting to large corporates and retail individuals to come up with a list of criteria that a bank believes, if fulfilled by the applying company, should make it eligible for the credit. In that respect, having certain elements of Corporate Governance, adapted to the size and complexity of the borrowing company, as part of the lending criteria to such small and medium size companies would effectively enhance the assessment of credit to such companies. 10
CONCLUSION The paper focuses on the vital role played by banking sector in financing new and existing businesses in the emerging markets. It shows the importance of applying sound corporate governance for banks specially the commercial banks. As the traditional focus of commercial banks has been changed to include not only financial risks but also nonfinancial risks (e.g. operational, Reputational, environmental and compliance risk) of the client. Finally, the paper shows that having certain elements of corporate governance adapted to the size and complexity of the borrowing company would effectively enhance the assessment of credit to such companies. The scope of corporate governance has been extended to include not only the direct owners of the company but also other stakeholders that have interest in the company s operation ( creditors, regulators and employees). Eliminating the confusion between corporate governance and risk management governed by Basel II. The view for corporate governance should be more of strategic role of the board of directors to maximize the value of the bank to its owners. Commercial banks should go beyond its traditional focus on financial risk measures to encompasses other non- financial risk aspects when evaluating the lending proposition to a company. Corporate governance evaluation is an important aspect when lending medium-size and small-size companies. The improper strategic management and practices of the owners and managers would cause a systematic failure that would harm both the banking sector and the economy. The small and medium enterprise governance should shift its focus from the risk to shareholders to the risk to stakeholders represented by the Corporate Economic Responsibility as the company not only achieving its business and profitability objectives but wider objective in developing the economy. Mixing the classical judgmental approach with the new retail banking finance ( credit scoring) may be an effective tool for medium-size and small-size companies. 11
Empirical evidence shows that the good application of corporate governance principles adds value, reduces risk and increases returns. This makes it more convenient for banks to look at the extent to which their clients are applying these principles. The Key Challenges banks are facing now are if we assume that banks includes Corporate Governance as on of the criteria in its decision-making process, then, the question what are the tools used to assess corporate governance application, should this be used for all corporate clients or just for key accounts, and finally what would the bank offer as an advantage for those who apply good corporate governance. 12
REFERENCES 1. OECD Principles of Corporate Governance. (http/www.oecd.org) 2. The Bank for International Settlements. The Basel Committee on Banking Supervision. Enhancing Corporate Governance for Banking Organisations (http://www.bis.org/publ/bcbs122.htm) 3. Ministry of Finance. "Profile of M/SMEs in Egypt" Update Report. October 2005 4. Mishkin, F. S., The Economics of Money, Banking and Financial Markets Addison-Wesley, Fifth ed., 1998 5. International Finance Corporation, World Bank Group, Corporate Governance Newsletter, Several issues. 13
APPENDIX I 14