Corporate Governance Of Banks A Critical Appraisal Of Islamic Finance And Conventional Practices 2
the lack of corporate governance in banks which led to the financial crises from Asian crises in 1997 to the 2008 crises, and why Islamic banks are immune from such crises when they apply the true principal of Islamic financial system.
Ard, Islam, Mal, Sales
Ard, Islam, Mal, Sales
Transcription
- Corporate Governance of Banks : A Critical Appraisal of Islamic Finance and Conventional Financial Practices Introduction This chapter discusses the lack of corporate governance in banks which led to the financial crises from Asian crises in 1997 to the 2008 crises, and why Islamic banks are immune from such crises when they apply the true principal of Islamic financial system. A highlight on the paper ‘Corporate Governance of Banks after the Financial Crisis theory, Evidence, Reforms by Mülbert (2010), this paper states that poor corporate governance of banks has increasingly been recognized as an important cause of the recent world wide economic crisis. Research into banks’ corporate governance is evidenced by the publication of an increasing number of empirical studies and theoretical works into the causes of the crisis. What will be examined also is the context of how corporate governance and other regulatory matters pertaining to banks and financial institutions will be handled within the working framework of Islamic finance. It will examine the difference in working practices and in the ethical approach to the responsibilities that any banking system should have and will show how this is implemented within the Islamic banking system. Banks’ corporate governance became of greater interest during and after the Asian crisis in 1997. From then on, in line with a more general trend, listed banks and even non-listed institutions worldwide started to publicly emphasize that good corporate governance is of vital concern for the company and even adopted individualised corporate governance codices as a result. At the international level, the World Bank Group, due to a direct consequence of the experiences during the Asian crisis, had taken up the issue of banks’ corporate governance from several angles. More specifically, international standard setter BIS and the Basel Committee on Banking Supervision (BCBS) published the first edition of its guideline “Enhancing Corporate Governance for Banking Organisations” in 1999 and, building on the OECD’s thoroughly reviewed ‘Principles of Corporate Governance’ of 2004, produced a revised version of this guideline in 2006. During the second year of the financial crisis, the issue of banks’ corporate 1
- governance began to resurface with a vengeance , starting with the OECD. The OECD Steering Group on Corporate Governance, based on the premise that corporate governance problems of banks are not fundamentally different from those of generic corporations, commissioned a fact-finding study with respect to four areas of corporate governance: (1) remuneration; (2) risk-management; (3) board practices, and (4) exercise of shareholder rights. Based on those findings, the Steering Committee recently published a full report on the key results and main lessons inside and outside of the banking industry, finding, in particular, that there is no immediate call for a revision of the OECD Principles, but a need for a more effective implementation of standards already agreed. The G20, at its London summit in April 2009, acknowledged the importance of the issue as well, albeit somewhat indirectly. The economics and functions of banks differ from those of industrial firms. These differences mean that banks are subject to stringent prudent regulation of their capital and risk which are reflected in corporate authority practices observed in the banking sector and in theoretical works on “good corporate governance of banks.” Looking at corporate governance practices, a particularly striking feature of mostly large commercial and investment banks is the prevalence of remuneration schemes that provide high-powered incentives not only for executive directors (officers who are members of the management board in a two-tier system) but also for senior managers at lower levels, and even for more junior employees in some functions, particularly the trading and sales function. More recently, some elements, such as risk management and compliance have also started to become an important issue in the general corporate governance debate. At the heart of the matter however, is the fact that Banks differ substantially from generic companies in several important respects. Perhaps most prominent amongst the well-known differences is the liquidity-producing function of banks based on a maturity-mismatch between the two sides of a bank’s balance sheet. Strictly, a bank’s core business is to accept voluntarily a mismatch in the term structure of its assets and its liabilities. As a consequence, the existence of banks depends crucially on uninterrupted and continuous access to liquidity, albeit by way of deposits, short-term funding on the interbank market, funding on secured financing markets or funding from a central bank as the liquidity provider of last resort. 2
- Banks and Corporate Governance There is no generally accepted definition of corporate governance . Listed banks and even non-listed firms worldwide have publicly stressed that good corporate authority is vital for organisations. Many have adopted company-specific corporate governance texts. Moreover banking administrators have already taken up this weighty question, Mülbert (2010). The author cites in particular the Basel Committee on Banking Supervision that has already published two editions of guidelines on “Enhancing Corporate Governance for Banking Organisations.” This set of recommendations perfectly echoes the supervisors’ view of and approach to the subject. Traditional notions describe corporate governance as a complex set of constraints that shape the ex post bargaining over the quasi-rents generated by a firm or as every device, institution, or mechanism that exercises power over decision-making within a firm. Put in another way, corporate governance deals with decision-making at the level of the board of directors and top management (i.e., the management board in a two-tier system), and the different internal and external mechanisms that will ensure all decisions taken by directors and top management are in line with the objective(s) of a company and its shareholders, respectively. The OECD Principles of Corporate Governance11 take a slightly broader view: “Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. By contrast, a much broader definition describes corporate governance as encompassing the standards for decision-making within a company, the duties of board members and officers, the internal structure of the firm (enterprise) and the relationship between the corporation and its shareholders, and other stakeholders. 1LuigiZingales,“CorporateGovernance,”inTheNewPalgrave–DictionaryofEconomics, ed.StevenN.DurlaufandLawrenceE.Blume,2nded.(Basingstoke:Macmillan,2008),250. 3
- Such a concept of corporate governance goes beyond even the OECD ’s definition2. This much broader concept is very much in line with the banking supervisors’ understanding of corporate governance as embodied in the Basel Committee on Banking Supervision’s guidance entitled “Enhancing corporate governance for banking organisations” Bank’s implementation of Risk Management Due to their systemic prominence on the one hand and the susceptibility to runs on the other, banks are heavily controlled and supervised entities. Basically, banking regulation is designed to limit the amount of risk a bank may take by stipulating riskadjusted minimum capital requirements, i.e., by linking the required regulatory capital for a bank’s assets (loans, securities, and other assets) in a rather sophisticated approach to the adjusted risk-weight of the different assets. Regulation also limits a bank’s exposure to a single creditor or group of creditors, and addresses the risk from disruptions in the access to sufficient liquidity by setting standards for liquidity management3. The importance of banks’ access to liquidity was forcefully demonstrated during the financial crisis when all possible sources of liquidity dried up at the same time for all banks in (most) Western countries. Central banks had then to intervene to prevent a collapse of the banking systems in the affected countries. 1For regulators therefore, such as the Basel Committee on Banking Supervision1 one of the important lessons of the crisis has been to make provision for more demanding prudent regulation relating to banks’ liquidity risk and its management. Lessons learned from the market turmoil, have recently led regulators and supervisors to commit themselves to introduce an additional backstop-ceiling – similar to, but not identical with existing US regulations – to limit a bank’s non-risk-adjusted total exposure to an arbitrary multiple of its capital. Such a leverage quotient serves as a safety valve for the weaknesses and limitations of risk-weighted requirements, in particular for underestimation of risk. However, in order to prevent banks of some countries from being put at a competitive disadvantage, the accounting rules for measuring the capital base will have to be harmonised at international level. 2OECD,PrinciplesofCorporateGovernance(Paris:OECD,2004),11.Alsoavailableonlineat www.oecd.org/daf/corporateaffairs/principles/text. 3AlyKhorshid,EncyclopediaofIslamicFinance,EuromoneyBooks,2010 4
- Banks are highly leveraged institutions . Banks are compensated for accepting a maturity-mismatch by a premium charged to creditors, i.e., a bank’s creditors have to pay a higher interest rate than the bank pays for its refinancing. Hence, ceteris paribus, a bank’s profit increases directly in proportion with the volume of lending to creditors. The upper limit for an increase in lending is derived from the marginal cost of a bank’s refinancing, given that an increase of the bank’s leverage will increase its probability of default, and depositors as well as other debt holders will demand a higher risk premium as compensation for the higher risk of bankruptcy, and from minimum capital requirements provided for by prudent regulation. Banks do a substantial, even a major part of their business with other banks, i.e., more precisely; banks are highly interrelated among themselves. Important features of the interbank business are, amongst other things, undertakings on the interbank market, the OTC derivate market, and the foreign exchange market. So, from a bank’s perspective, competitors are also significant industry partners and, as such, pose a major counterparty risk. It is true, that even banks themselves find it difficult to assess the precariousness of other banks accurately. This theory is not only supported by recent financial instabilities but, for example, also by studies that have found that analysts disagree more in respect to the quality of bonds issued by banks than with the quality of bonds issued by other firms. The banking system is prone to infectivity - problems at one bank will spread to other banks and then to the whole system very quickly. In contrast to the typical nonfinancial firm, a bank holding a significant portfolio of derivatives and securities with embedded options is subject to sharp changes in its risk-profile even if the bank does not take new positions. The possibility arises from the fact that complex derivatives often have exposure to risk factors that are extremely sensitive to market conditions so therefore even incremental changes on the market may make a drastic change to the value of the derivative. As well as this because of the mismatch in the term structure of assets and liabilities banks are subject to creditor runs. Since, in the case of a run, readily available liquidity reserves will be exhausted very rapidly and most of a bank’s assets will not be readily liquidated, only the very first creditors to 5
- withdraw their money will receive a timely and complete pay-out4 . The run on the UK’s Northern Rock can be seen more as a “traditional” run of (small) depositors. In contrast, the downfall of Lehman Brothers and the takeover of Merrill Lynch were more the result of an (imminent) run by other banks within the inter-bank market. Of course, depository insurance can substantially mitigate the danger of bank runs. However effectiveness in this respect critically depends on the details of the protection afforded. Not only the maximum amount protected but also the kind of deposits protected can be of crucial importance. Prior to the events in autumn 2008, most mandatory depository insurance protection schemes worldwide were geared only to protect (small) depositors. The resulting “trust crisis” in the wake of Lehman Brothers’5 insolvency, however, caused a swift hike in the maximum coverage under existing deposit protection schemes and an even swifter move to establish additional insurance and guarantee schemes to enable banks to issue state-backed new debt. The well known stakeholders that may act as agents in the context of firms are: • Shareholders, owning a large stake (block owners) or small stakes (disperse shareholders); • Directors, i.e., members of the board performing the supervisory function (board of directors/supervisory board), fruitfully discriminated according to the two mutually non-exclusive qualifications inside/outside directors and non- independent/independent directors; • Officers/executive directors or managers/members of the management board, i.e., the persons performing the management function at top level; • Creditors, i.e., employees, bondholders, depositors, commercial creditors, the state. Critical, however, Ciancanelli and Reyes-Gonzalez, “Corporate Governance in Banking”. 4AlyKhorshid,BuildingBridgesacrossfinancialcommunities,Islamicfinanceproject, ThepresidentandfellowsofHarvardcollege,2012 5AlyKhorshid,CorporateGovernanceinIslamicFinance,WileyPLCpublications,2013 6
- The possible agency conflicts fall into three categories : 1. The conflict between shareholders and managers/directors resulting from the separation of ownership and control: (a) Managers show a higher degree of risk aversion than diversified shareholders since “pure” managers have most of their wealth tied up in the firm and, hence, are less diversified; (b) Managers are underperformers with respect to their managerial tasks because of a preference for empire building, shirking, and/or wasting the company’s assets for personal expenses. 2. The conflict between block owners and dispersed shareholders: Block owners will prefer to receive pay-outs from the firms in the form of private benefits instead of dividends since the latter payments would also benefit other (dispersed) shareholders; (Blockowners will very often show a comparatively higher degree of risk-aversion since, typically, a higher percentage of their wealth is tied up in the firm). 3. The conflict between shareholders and creditors (bondholders/depositors): Creditors in general, and bondholders/depositors in particular, are more riskaverse than shareholders given that the former are only interested in their claims being paid back in full on time and, hence, in the firm choosing the least-risky strategy possible, whereas shareholders are interested in a riskier business strategy with a higher expected return; (Specifically, shareholders benefit from ex post-opportunism on the part of the firm, i.e., from a firm’s subsequent shift to a riskier business strategy and/or from a subsequent distribution of company assets to its owner. Numerous solutions for mitigating these agency conflicts have been identified, as well as possible costs ensuing from each of these mechanisms). Banks hold a portfolio of financial assets, i.e. debt claims and securities. The composition of these and the corresponding risk-profile they can alter much faster than, for example, a television manufacturer can do, who will make much more firmspecific and, hence, less readily marketable investments in production equipment (machines) and property. Securitization even allows banks to effortlessly liquidate long-term debt claims, e.g., mortgages, and securities, lacking a viable secondary 7
- market by transforming them into tradable assets and investing the proceeds in new assets with a very different risk-profile . Citigroup had a rapidly growing investment in CDO’s following Charles O. Prince’s taking office as CEO in 2003 - a good example of a bank’s ability to rapidly change its risk profile. Many more banks followed the same pattern, in particular, the author points out, UBS and some of the German state-controlled public sector banks. Depending on the situation, the management or shareholders will benefit from the greater flexibility in risk shifting. Managers, whose remuneration is (partly) performance- based, will find it easier to change the bank’s risk-profile in order to meet the agreed performance targets. This holds true, in particular, for more immediate performance. This situation is to be distinguished from even sharper involuntary changes in a bank’s risk-profile that result from changes in the value of its portfolio of derivatives and securities with embedded options. Shareholders, on the other hand, will find it easier to exploit depositors and other debt holders by an opportunistic (ex post) switch to a riskier business strategy. The greater opaqueness of banks’ balance sheets and incentive contracts with managers will be less effective in aligning the interests of managers and shareholders. The board of directors will find it difficult to observe whether management did actually meet their performance targets and whether this resulted from the shift to a riskier business strategy than was expected or anticipated. By the same token, outside monitoring by shareholders, depositors, and other debt holders will be much more difficult and less effective. If a substantial part of any management’s total remuneration is equity-based in order to align managers and shareholder interests more closely, managers will focus on short-term results. In addition, they will have an excessively low risk aversion because a riskier business strategy will increase the stock price. Specifically, managers have an incentive to increase the bank’s leverage which, in turn, gives an incentive to increase the bank’s leverage even more, and so on. 8
- Dispersed shareholders have even stronger incentives than managers for a bank to operate with a high leverage and with equity-based remuneration . Prudential regulation stipulating minimum capital requirements acts as an upper bound to such tendencies. From a shareholder’s perspective, such regulation has the effect of exacting a higher investment in the bank than they would make otherwise and, hence, acts as an incentive to favour a riskier business strategy as compensation for the higher investment. Admittedly, this effect only holds true if minimum capital requirements are not risk- sensitive, i.e., if they only reflect the nominal value but not the riskiness of the bank’s assets. Deposit insurance is often said to weaken the incentives for outsider control and, as a consequence, to cause banks to take on more risk by pursuing a riskier business approach, e.g., by offering higher interest rates for deposits. Explicit deposit insurance, however, may well be of only limited importance in practice. Mandatory insurance coverage is often limited. In his summing up Mülbert points to the described particularities of banks that act to exacerbate the multiple agency conflicts present within banks and that also reduce the effectiveness of some of the mechanisms for mitigating these conflicts. The overall effect is for banks to take on substantially more risk than a generic firm would usually do. Looking at it from a shareholder’s perspective, the ‘holy grail of banks’ corporate governance is to check management’s short-term orientation without creating incentives for choosing a suboptimal low level of risk. With a view to that goal, remuneration should be structured to include a higher, not a lower amount of equity compensation, i.e., stock, not stock options, and to require managers to hold such stock on a long-term basis (restricted stock). The well-known downside of such a remuneration arrangement is that the company and, therefore the shareholders, will end up having to pay a higher total amount of remuneration. By accepting a higher amount of stock, (less diversified) managers take on an additional firm-specific risk, and they will require compensation in the form of an additional non-variable cash component: The more stock or stock options the company grants, the higher will be the amount of additional non-variable 9
- compensation demanded by managers – an economic logic supported indeed by some anecdotal evidence from the banking industry. Depositors and other debt holders are only interested in a bank’s ability to pay its debts when they fall due. Consequently, the management remuneration structure preferred by creditors is very different from the one favoured by shareholders. If remuneration includes performance-based elements at all, performance criteria should not be volume-based (e.g., not on sales volume) and should discourage taking on risk as much as possible. Specifically, compensation should not include any equity or any equity-related element or, at the very least, the fraction of equity-based compensation should be as small as possible. The presence of large shareholders and of powerful large shareholders in particular, is an equivocal mechanism for mitigating any conflicts between depositors/other debt holders and management. On the one hand, large shareholders will typically be more risk-averse and have higher incentives for monitoring management. On the other hand, large shareholders will be interested in extracting private benefits, thus reducing the value of their higher monitoring activities. Empowering large shareholders further increases the risk that a block owner will extract private benefits to the detriment of depositors and other debt holders, even though small shareholders are hurt more by such behaviour. As a consequence, with respect to directors’ qualifications, requiring some or even all directors to be independent from large shareholders is confusing too. Whether depositors and other debt holders benefit from the presence of directors that are independent from a large block owner depends largely on whether, on balance, the positive effects of a block owner’s more intense monitoring activities are greater than the costs associated with his extraction of private benefits. By contrast, the presence of financially independent directors, i.e., directors whose compensation is not equityrelated in any form, is beneficial to depositors and other debt holders since they lack the incentive to exercise their monitoring and controlling functions with a view to stock price development. A more general mechanism for mitigating the conflict between depositors/other debt holders and shareholders is to expand corporate governance with a view to including 10
- debt governance . The more sweeping approach is to substitute shareholder supremacy with stakeholder supremacy either by substituting the shareholder-only-oriented goal of value maximization by that of depositor-restrained value maximization, or, slightly less far-reaching, by requiring the (board of) directors – and possibly even officers/executive directors – to take the interests of depositors and other debt holders into account. Finally, depositors and other debt holders will favour the existence of a powerful supervisor with far-reaching powers to regulate, to monitor and to control a bank’s activities in the interest of financial stability. Looking at the supervisors’ take on the issue of banks’ corporate governance,1 sometimes referred to as a financial stability perspective. Indeed, supervisors, in pursuing their primary objective of maintaining and even enhancing the stability of the financial sector, are concerned with the financial soundness of all banks, even the smallest ones. Put differently, supervisors, with a view to financial stability, seek to prevent the collapse of even a single small bank, regardless of whether that event results from criminal or disloyal behaviour by directors or top managers, or from the bank taking on too much risk. With respect to the latter, the role of banking supervisors is sometimes said to complement regulations to further limit excessive risk-taking. However, the author points out, their primary responsibility is to enforce existing prudential regulation and, if the legislator assigns them the power to disseminate relevant binding rules, to circulate such practical regulation. The impact of banking regulation/supervision on equity governance is very different, since the interests of shareholders and supervisors are not fully aligned. Both shareholders and the supervisor want banks to have high-quality corporate governance mechanisms, structures and procedures in place. In particular, both are interested that banks design effective internal control systems and observe effective risk-management practices, that banks’ boards are staffed with members who boast pertinent experience and sufficient time for board-work, and that banks’ boards function effectively, e.g., by setting up an appropriate committee structure. However, one fundamental difference remains: The supervisor is interested in the long-term existence of the bank whereas shareholders are interested in high stock returns, and with well-diversified shareholders, the divergence is even more pronounced. As a 11
- consequence , with respect to corporate governance standards for substantive issues, i.e., a bank’s objective and the criteria for decisions taken by senior management or the board, a supervisor will favour rather different standards. Prudential regulation, e.g., arbitrary limits on leverage and requirements for liquidity, is a case in point; in addition, a supervisor’s notion of good corporate governance will be different with respect to corporate governance mechanisms that have an indirect bearing on the substantive standards for decision-making by the board or top management. The most important area in this respect is the structure of remuneration systems. Pay arrangements that would be preferred by shareholders are by no means identical to those that are preferred by the supervisor as a socially optimal solution. Tellingly, the restrictions for banks’ remuneration structures recently designed or even implemented by regulators/supervisors are much tougher than the incentive structures in place before the crisis, and which served the (short-term) interests of shareholders rather well. Corporate governance differs from that of generic firms. Given banks’ high leverage, debt holders (i.e., depositors and bondholders), as well as a bank’s management, will prefer the firm to take on substantially less risk than diversified shareholders. However, deposit insurance and prudential regulation, although aimed at compensating for deficits in the monitoring and control of banks, will also weaken debt holder monitoring and control. Highly incentive-based remuneration can neutralise management’s aversion to take on more risk, in particular if a substantial part is in the form of short-term cash bonuses. Banks Role in Monetary and Fiscal Policies To ensure that monetary growth is 'adequate' and not 'excessive' it would be important to monitor carefully all the three major sources of monetary expansion. Two of these are domestic areas of (a) financing of government budgetary deficits by borrowing from the central bank; and (b) expansion of deposits through commercial bank credit creation. The third source of monetary growth is external and is (c) monetization of the balance of payments surplus. Financing of Government’s Fiscal Deficit 12
- There is no controversy among economists about whether fiscal deficits can be , and have been, an important source of 'excessive' monetary expansion. Attempts by the government to extract real resources at a faster rate than is sustainable at a stable price level could lead to continually rising fiscal deficits and accelerated increases in money supply, thus contributing to an inflationary spiral. Even in major industrial countries, large fiscal deficits have been a primary cause of the failure to meet money supply targets. This has tended to shift a disproportionate burden of the fight against inflation onto monetary policy. But, as has been very well stated by the Economists Advisory Group Business Research Study, "the greater the dependence of the public sector on the banking system, the harder it is for the central bank to pursue a consistent monetary policy". For the monetary policy to become either ineffective or highly restrictive, it is imperative that there be coordination between monetary and fiscal policies for the realization of national goals. This underscores the need for a realistic and noninflationary fiscal policy in Muslim countries. Therefore, a conscientious Muslim government committed to the achievement of the goals of an Islamic economy should pursue a fiscal policy, which is consistent with its goals. This is all the more important because the money markets in Muslim countries are relatively underdeveloped and monetary policy cannot play as effective a role in regulating money supply as fiscal policy can. This does not necessarily rule out fiscal deficits but imposes the constraint that deficits be allowed only to the extent necessary to achieve sustainable long-run growth and broad- based well-being within the framework of stable prices. However, the removal of 'excessive' fiscal deficits could remain a pious hope in Muslim countries as long as the primary causes of deficits are not remedied. These are: firstly, the inability or unwillingness of governments to raise adequate finance through taxation and other non-inflationary sources to meet their essential and productive expenditures; and secondly, lack of willingness on the part of governments to eliminate or reduce substantially their unproductive and wasteful spending. Therefore, an Islamic government must, if it wishes to be true to its name, eliminate both the sources of deficits. The entire tax structure of Muslim countries needs to be impartially examined. There are certain sectors of Muslim economies, which are 13
- overtaxed . There are certain other sectors, which are under taxed, not because of rational socio-economic considerations, but because of the desire to please vested interests. If the tax system is rationalized, the inequities in the system are removed and the tax administration is streamlined, tax revenues can be substantially raised with a better economic impact on incentives, output and distribution. This is however an unpleasant task and the availability of the easy recourse to deficits through borrowing inhibit the governments from undertaking this necessary task. The need to eliminate unproductive and wasteful spending is a religious imperative for all Muslims. It is; however, particularly indispensable for governments because they use resources provided by the people as a trust, and using these wastefully or unproductively is a breach of this trust. Resources available to governments for financing their expenditures are limited in all countries, including the developing Muslim countries. They need therefore to be used efficiently and effectively with the acute consciousness of answerability before God. Such a conscientious use of funds cannot be achieved by merely whittling away at frills. It requires a careful review of the entire expenditure program in the light of Islamic teachings, concentrating not only on how much is spent but also on how it is spent. Unless this is done, an irresponsible Muslim government, finding its recourse to the market closed, may adopt the easy course of borrowing indiscriminately from the central bank, thus causing considerable damage to the economy in addition to frustrating the realization of Islamic goals. After all the wasteful and unnecessary spending has been eliminated the balance of government spending may be divided into three parts: • Normal recurring expenditures, • Project expenditures, • Emergency expenditures. Tax revenues as argued must finance all normal recurring government expenditures, including outlays on projects not amenable to profit-and-loss-sharing arrangements, earlier. The non-availability of debt-financing for such purposes should prove to be a hidden blessing and help introduce the needed discipline in government spending, the realization of which is frustrated by easy access to interest-based finance. In the case 14
- of projects costing vast amounts , the bulging may be avoided, as suggested earlier, through proper timing and dovetailing of all such projects in a perspective plan and the use, wherever feasible, of leasing and hire purchase. The government may undertake projects, which are amenable to equity financing, where this is necessary in the public interest, but the financing should be obtained by selling shares to financial institutions and the public. A commercially- oriented pricing system should be adopted without a general subsidy. All subsidies needed for the poor or low middle-class families should be arranged from Zakat revenues, donations or Qard-Hassan (interest free loan). Equity financing and commercial pricing should help eliminate some of the unnecessary and unproductive projects that governments sometimes undertake to satisfy vested interests. This would, no doubt, also necessitate the striking of a 'social balance' between public services and private production in the light of Islamic teachings. All emergency expenses like war, which cannot be financed in either one of the two ways indicated above, should be financed by compulsory borrowing as discussed earlier. Wars mean sacrifice and the sacrifice involved for the rich is only the interest foregone by them on such loans. Wars for which people are not willing to make such a sacrifice are not worth fighting and should be avoided. Nevertheless, the government may be constrained to borrow to finance some unavoidable deficits and arrangements must be made to enable the government to do so in a non-inflationary manner. This may be done partly, and to a limited extent, through borrowing from the central bank within a non-inflationary framework as discussed later, and partly, but also to a limited extent, from commercial banks as discussed earlier. Credit Creation Plan of Commercial Banks Commercial bank deposits constitute a significant part of money supply. These deposits may, for the sake of analysis, be divided into two parts: 15
- First primary deposits ' which provide the banking system with the base money (cashin-vault + deposits with the central bank) and 'derivative deposits' which, in a proportional reserve system, represent money created by commercial banks in the process of credit extension and constitute a major source of monetary expansion in economies with well-developed banking habits. Second The derivative deposits lead to an increase in money supply in the same manner as currency issued by the government or the central bank and since this expansion, just like government deficits, has the potential of being inflationary in the absence of an offsetting growth in output, the expansion in derivative deposits must be regulated if the desired monetary growth is to be achieved. This could be accomplished by regulating the availability of base money to commercial banks. For this purpose, the absence of interest as a regulating mechanism would not be a disadvantage. It will in fact be an advantage as it will remove the destabilizing effect of fluctuating interest rates, stabilize the demand for money and substantially reduce the amplitude of economic fluctuations. Monetisation of Balance of Payments Surplus Only a few Muslim countries have enjoyed a balance of payments surplus while most of them have experienced deficits. In the few that did have a surplus, the surplus did not originate in the private sector and did not lead to an automatic expansion in money supply. It did so only to the extent to which the government monetized the surplus by spending it domestically and the private sector balance of payments deficit did not offset this adequately. If, in countries with a surplus, government spending is regulated in accordance with the capacity of .the economy to generate real supplies, there should be no internally- generated inflation resulting from the balance of payments surplus. In the countries that have a deficit, it is unhealthy monetary expansion along with public and private sector conspicuous consumption, which generate the balance of payments disequilibrium through current account deficits and 'underground' capital outflows. These cannot be removed without socio-economic reform at a deeper level and healthy monetary and fiscal policies in the light of Islamic teachings, as has been, or will be, discussed in the appropriate section. Poor Corporate Governance of Banks is a Major Cause of the Crisis 16
- Whether and to what extent corporate governance failures can be considered to be a cause of the financial crisis seems easily answered by a resounding “Yes.” Banking supervisors, Sir David Walker and Nestor Advisors, are named who, he says, could point to numerous examples of unsound corporate governance practices before the crisis and undoubtedly, over time, even more anecdotal evidence will come to light. Still, even flagrant cases of unsound corporate governance practices do not support the claim that major governance failures were one important or even the most important cause for the crisis. More generally, no amount of anecdotal evidence will serve as proof. Proof of widespread corporate governance failure at banks can only come from empirical studies and arguably, these results should not serve as an all-out argument against any reforms designed to improve bank’s corporate governance even more. Some areas, most notably risk management, would indeed warrant substantial improvement, albeit to a widely varying degree with each different bank. On the other hand, the deficiencies highlighted by supervisors often relate to faulty management practices and not to the ways shareholders assure themselves of getting a return on their investment. A case in point is the over- reliance on VaR or other quantitative risk measures as a means to assess the firm’s current risk position. Even, the author says, if all banks had followed exemplary corporate governance practices, because of the incentives created by states (e.g., prudential regulation), central banks (e.g., very low interest rates), and supervisors in all probability, the crisis, perhaps on a different time scale, would have erupted anyway. For example, if boards were not involved in setting the risk appetite of a firm it does not follow that level of risk appetite would have been any different from the one chosen by the board if they were involved. Theory suggests that, depending on the situation, executive managers/officers were just as likely to choose a suboptimal low level of risk, as they were to choose a suboptimal high level of risk. Erkens, Hung, and Matos studying 296 financial firms from 30 countries arrive at the conclusion that their results obtained are inconsistent with the hypothesis that the firms losses suffered during the financial crisis were the result of lax oversight by boards and investors. Rather, firms with more independent boards and greater institutional ownership were not only more likely to replace their CEOs for poor performance, but also experienced worse stock returns and recognized 17
- larger write-downs during the crisis .1 Apart from remuneration, risk management has attracted most interest in the debate on lessons to be learned from the crisis with a view to improving banks ́ corporate governance. Chief Risk Officer at the highest level of top management (executive director/Mitglied des Vorstands) who has direct access (reporting) 97 to the board or, where a risk committee or a audit committee exists, to the committee, and who as an individual, possesses the authority and standing to impress the importance of sound risk management practices throughout the organization, thus vesting the risk function with the necessary authority and organizational powers. The list of causes advanced to explain the sometimes almost complete failure of risk management at some banks, is long: Risk management focused more on measuring instead of identifying risks, the riskiness of structured products such as CDOs, ABSs and others was not fully understood, areas of risk concentration were not properly identified below top management level (silo structures). Risk stress tests were performed using past events instead of identifying new risks and looking at possible new scenarios respectively. Another strategy is to assert that directors and officers also have a fiduciary duty towards depositors, and to require that banks’ (executive) directors pursue a less risky business strategy than their counterparts at other firms. Boards relied too much on quantitative risk models (daily value at risk (VaR) and similar techniques) and failed to see the “fat” risks that should be a board’s foremost concern. In some cases they even failed to understand the firm’s current risk position relative to its risk appetite. In particular, a key lesson from the crisis is said to be that the directors on bank boards should not take false comfort from their regulatory capital ratios. Whether the industry-wide remuneration structures creating highpowered incentives for short-term risk taking are an important or even the major cause for the financial crisis is still open to debate Mülbert contends1. However, regulators, politicians and society at large are united in favouring tough new rules on recompense issues at banks, in particular and, to a somewhat lesser extent, at large and/or listed companies in general. So far, empirical studies do not offer clear-cut support for the claim that the highpowered short-term remuneration structures were a major cause for the crisis. While some early studies found that high executive compensation was prevalent for the 18
- riskiest financial institutions , others did not find any correlation between remuneration structures and risk. Some observers claim that lack of alignment of bank CEO incentives with shareholder interests cannot be blamed for the credit crisis or the performance of banks during that crisis since CEOs did not sell shares ahead of the crisis. In response to this argument – which reflects a broader consensus among many observers – Bebchuck, Cohen and Spamann recently showed that the five top executives at Bear Stearns and Lehman Brothers, respectively derived cash flows from cash bonuses and equity sales during the period 2000-2008 that substantially exceeded the value of the executives’ initial holdings at the beginning of the period. The executives’ net payoffs for the period were, therefore, decidedly positive. Hence, they point out, the large paper losses that the executives suffered when their companies collapsed should not provide a basis for either dismissing or accepting the claim that the prevailing remuneration structures acted as an important cause of the financial crisis. Still more importantly, the top executives’ proven inability to foresee the crisis does not rule out the possibility that their decisions were, in fact, influenced by their heavily-incentivised short-term-oriented remuneration packages. At the European level, former EU Commissioner McGreevy declared his commitment to rethink the roles of directors, managers, and shareholders of financial institutions with a view to strengthening the role of non-executive directors and shareholders, and to prioritizing long-term shareholder value over short-term bonus payments, and the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, stated flatly in its report that banks corporate governance “is one of the most important failures in the present crisis.” At the level of EU Member States, very similar assessments are voiced in the UK, in particular. The Association of Chartered Certified Accountants (ACCA) “believes that the credit crunch can be viewed, in large part, as a failure in corporate governance.” Sir David Walker, charged with an independent review of corporate governance in the UK banking industry by the UK government, the “need is now to bring corporate governance issues to center stage” since serious deficiencies in prudential oversight and financial regulation in the period before the crisis were accompanied by major 19
- governance failures within banks . Even the Financial Services Authority (FSA), albeit somewhat reluctantly, probably due to its own track record. The changed perception of the interrelationship between the crisis and banks’ corporate governance is also reflected in recent empirical studies and theoretical works. Case Studies of Banks Failures: Lehman Brothers and the supreme crisis In November 2008, Richard Fuld was called to testify before a US Congressional committee investigating the sudden collapse of Lehman Brothers6, the investment bank he had headed for many years. Its deep involvement in the markets for assetbacked securities-bonds developed from what were called 'supreme' mortgages and derivatives contracts associated with them had brought the bank to a crisis two months before. When the US government refused to bail it out, credit markets around the world seized up, accelerating the growing slump of the world economy. The next day, perhaps realizing the mistake of allowing Lehman Brothers to fail, the US Treasury pumped money into the American Insurance Group (AlG), a company that had become the biggest player in a gigantic global market for credit default swaps tradable securities that initially served as insurance against corporate borrowers, individual mortgage-holders and the banks who lent to them being unable to meet their commitments. As credit dried up around the world, almost any credit default swap might have to payout. There was insufficient money to pay them all at once. The US Treasury saved AlG, but it proved too little and too late to prevent a string of calamities of varying degrees of severity in Italy, France, Japan, Thailand, Germany, the UK and even Switzerland. By the end of November, several major commercial banks in a variety of countries had, in effect, been nationalized. Citigroup, the world's largest bank, had been propped up with new equity supplied by US taxpayers, and the entire banking system of a whole country z Iceland -was on its knees. Investments made by Icelandic banks especially in the retail sector across Europe z were threatened as other banks refused 6AlyKhorshid,EncyclopediaofIslamicFinance,Euromoneypublication,2010 20
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