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28 Oct. 2010 | Comments (0)

As world leaders prepare for the G-20 Summit in Seoul, South Korea, Nov. 11-12, the Basel III capital reform plan will be a big part of the discussion as countries continue to figure out how to best deal with fallout from the 2008-2009 financial crisis. While those international banking reforms that were written by the Basel Committee on Banking Supervision primarily address capital ratios and transition arrangements, there is another report written by the same committee that should be on the reading list of all corporates worldwide. The committee’s Principles for Enhancing Corporate Governance, which came out earlier this month, can easily be applied to all public and private companies. The report is an update on 2006 guidance, which was derived from a 1999 report. In the new report, the committee focuses on six areas that are the core of every corporate governance program: board practices, senior management, risk management and internal controls, compensation, complex or opaque corporate structures and disclosure and transparency. The Basel III standards sets stricter standards for capital, leverage, and liquidity ratios. [Read Oct. 8 article here.] For example, by 2015 banks would have to have to have a minimum common equity capital ratio of 4.5 percent, up from the current 2 percent level, and four years later have to add a capital conservation buffer of 2.5 percent to the common equity capital ratio. The Basel committee also issued a report to the G-20 on its response to the financial crisis that addresses the causes of the liquidity crisis and what lessons were learned. [You can read it by clicking here.] When, and if, Basel III is adopted by the largest U.S. banks, the effect on non-financial companies will be minimal, according to Ernst & Young’s Adam Girling and Peter Davis, principals in the accounting firm’s financial services department. “The short answer is this won’t likely have a direct impact on corporates,” Girling told me in an interview earlier this month. “But if you think about higher counterparty charges, it could impact who they [corporates] do business with. It could increase the cost of doing business.” The way to think about the impact of stricter Basel III standards on corporates is a lot like how retailers pass along the higher supply costs to customers. In the case of banks, the requirements to hold more cash for reserves would affect charges related to derivatives and swaps they enter into with other banks and parties as a way to leverage capital risk. In turn, that would affect the investment costs of corporates that need access to liquid assets on a daily basis. As for when the new Basel standards would go into effect, the transition period could be quite lengthy, according to the CFO article. That has been the case with Basel II standards, which still have not been fully adopted by U.S. banks. While the new Basel standards are important and deemed necessary for banks to avoid the next financial crisis, the Basel committee’s work on its principles are worth taking a look at for all companies. “Corporate governance is thus of great relevance both to individual banking organizations and to the international financial system as a whole, and merits targeted supervisory guidance,” the report states. The principles are comprehensive in scope, are very risk-based and take into account the recent failures of all types of companies. Here are the 14 Principles for Enhancing Corporate Governance:
  1. The board has overall responsibility for the bank, including approving and overseeing the implementation of the bank’s strategic objectives, risk strategy, corporate governance and corporate values. The board is also responsible for providing oversight of senior management.
  2. Board members should be and remain qualified, including through training, for their positions. They should have a clear understanding of their role in corporate governance and be able to exercise sound and objective judgment about the affairs of the bank.
  3. The board should define appropriate governance practices for its own work and have in place the means to ensure that such practices are followed and periodically reviewed for ongoing improvement.
  4. In a group structure, the board of the parent company has the overall responsibility for adequate corporate governance across the group and ensuring that there are governance policies and mechanisms appropriate to the structure, business and risks of the group and its entities.
  5. Under the direction of the board, senior management should ensure that the bank’s activities are consistent with the business strategy, risk tolerance/appetite and policies approved by the board.
  6. Banks should have an effective internal controls system and a risk management function (including a chief risk officer or equivalent) with sufficient authority, stature, independence, resources and access to the board.
  7. Risks should be identified and monitored on an ongoing firm-wide and individual entity basis, and the sophistication of the bank’s risk management and internal control infrastructures should keep pace with any changes to the bank’s risk profile (including its growth), and to the external risk landscape.
  8. Effective risk management requires robust internal communication within the bank about risk, both across the organisation and through reporting to the board and senior management.
  9. The board and senior management should effectively utilise the work conducted by internal audit functions, external auditors and internal control functions.
  10. The board should actively oversee the compensation system’s design and operation, and should monitor and review the compensation system to ensure that it operates as intended.
  11. An employee’s compensation should be effectively aligned with prudent risk taking: compensation should be adjusted for all types of risk; compensation outcomes should be symmetric with risk outcomes; compensation payout schedules should be sensitive to the time horizon of risks; and the mix of cash, equity and other forms of compensation should be consistent with risk alignment.
  12. The board and senior management should know and understand the bank’s operational structure and the risks that it poses (i.e. “know your structure”).
  13. Where a bank operates through special-purpose or related structures or in jurisdictions that impede transparency or do not meet international banking standards, its board and senior management should understand the purpose, structure and unique risks of these operations. They should also seek to mitigate the risks identified (i.e. “understand your structure”).
  14. The governance of the bank should be adequately transparent to its shareholders, depositors, other relevant stakeholders and market participants.
  • About the Author:Gary Larkin

    Gary Larkin

    Gary Larkin is a research associate in the corporate leadership department at The Conference Board in New York. His research focuses on corporate governance, including succession planning, board compo…

    Full Bio | More from Gary Larkin


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