Insights into the corporate governance of Philippine rural banks′

1、 asia-link programmeeuro-philippines network in banking & financeenhancing teaching and researchasialink/asie/b7-3010/2005/105-139research conference oninsights into the corporate governance of philippine rural banks 27th august 2007this paper was prepared for the asia-link human resource develo

2、pment project: euro-philippines network on banking and finance, safety and soundness of the financial system (asialink/asie/b7-3010/2005/105-139), coordinated by the university of limoges (.ph/cba/asialink). asia-link is a programme of the european commission that seeks to promote regiona

3、l and multilateral networking among higher education institutions in europe and developing economies in asia.the contents of this paper are the sole responsibility of the authors and can under no circumstances be regarded as reflecting the position of the european commission.insights into the corpor

4、ate governance of philippine rural banksjoselito g. florendo university of the philippines, college of business administration introduction the philippine deposit insurance company (pdic) has placed around 395 rural banks under liquidation or receivership in the last 27 years (table 1). the highest

5、number of rural bank failures occurred in the 1980s when the number of rural banks that were closed reached 168. the rural banks that went out of business in the 1990s and during the period 2001-june 2007 has declined significantly but this occurrence remains a cause for concern. in 2006 alone, the

6、total deposit liabilities of six closed rural banks amounted to php 1.011 billion spread over 27,070 deposit accounts. the six rural banks are: rural bank of narra (palawan), rural bank of pilar (capiz), the center rural bank (metro manila), merchants rural bank of talavera, rural bank of tangalan (

7、aklan) and the rural bank of the 21st century (bulacan).table 1number of rural banks placed under liquidation or receivership1970 june 20071970-19801981-19901991-20002001- jun 2007total2616813962395source: philippine deposit insurance corporation while there are those who point to weak corporate gov

8、ernance as behind the failure of some philippine rural banks, the bangko sentral ng pilipinas (bsp) governor squarely identified corporate governance as the root of most bank failures that the country has experienced. he points out that the failure of these banks board of directors to exercise their

9、 oversight role in the face of insider abuse has, according to the governor, been a “recurring theme” (buenaventura, 2004).instability or failure in rural banks is a cause of concern due to the vital role that they play in the rural financial market. lim (1998) indicates that rural banks are the pro

10、per channels for financing and lending, both to non-agricultural and agricultural micro-enterprises. he believes that rural banks could provide cheaper credit than informal markets and uphold market discipline and monitoring that usually elude national government organizations (ngos). he argues furt

11、her that, compared to commercial banks; rural banks are more approachable and people-oriented, making them more attractive to small clients. thus they are perceived to be the most conducive instrument for channeling funds to viable and sustainable micro-enterprises. there are numerous causes for ban

12、k failures, among which are, political climate, regulatory framework, domestic and international competition. this paper will look into the significance of effective corporate governance in mitigating business failure in philippine rural banks. corporate governance in general the organization for ec

13、onomic co-operation and development oecd (2004) describes corporate governance as: “a set of relationships between a companys management, its board, its shareholders and other stakeholders. corporate governance also provides the structure to which the objectives of the company are set, and the means

14、 of attaining those objectives and monitoring performance are determined.” from this description, we identify some of the corporate governance issues that will be relevant in our discussion. they are the rights of shareholders, the interests of other stakeholders and the role and responsibilities of

15、 the board. shareholders and stakeholdersagency theory (jensen and meckling, 1976 and fama and jensen, 1983), which is often associated with the development of corporate governance, describes the typically problematic relationship between principals and agents. the problem in a principal-agent setup

16、 is brought about by the self-interested motives of agents and principals under conditions of incomplete and asymmetric information. in a game-theoretic sense, the agent whose task is to act on behalf of the principal (and in this sense, is more well-informed) is dictated by rational self-interested

17、 behavior to disregard the set of actions that will advance the benefits of the principal in order for him to obtain a better payoff. the challenge, therefore, is to develop a set of contracts and incentive mechanisms to align the motives of the agent with those of the principal. indeed, one way to

18、view every business organization is that it “represents nothing more than a particular standard form contract” (hart, 1989). since there is no single contract which can capture the complexities of a modern corporation, the challenge for corporate governance is to look for a set of structures that wi

19、ll minimize the differences between the principal and the agents motives that are simultaneously aligned with the corporations objectives.a corollary problem in relation to agency theory is the critical question: to whose motives should the agents set of motives be aligned with? should it, more or l

20、ess, be aligned with the shareholders, who are the ultimate beneficiary of a corporations residual cash flow? or should it be aligned with the motives of a wider group of stakeholders (e.g. employees, creditors, government)? the oecd (2004) addresses this issue by recognizing that a companys central

21、 mission is the long-term enhancement of shareholder value. it recognizes the importance of satisfying the long-term objectives of a wider group of stakeholders by prescribing that the “corporate governance framework shouldencourage active co-operation between corporations and stakeholders in creati

22、ng wealth, jobs, and the sustainability of financially sound enterprises.” jensen (2001) posits a balancing act by proposing an enlightened value maximization approach. he argues that “enlightened value maximization utilizes much of the structure of stakeholder theory but accepts maximization of the

23、 long run value of the firm as the criterion for making the requisite tradeoffs among its stakeholders.and therefore solves the problems that arise from multiple objectives that accompany traditional stakeholder theory.” it is this balancing act that makes corporate practitioners frown upon when the

24、y are reminded to consider the interests other than those of the shareholders. “when directors must not only decide what their duty of loyalty mandates, but also to whom their duty of loyalty runs (and in what proportions), poorer decisions can be expected” aba committee on corporate laws, “other co

25、nstituencies statutes: potential for confusion,” business law 45 (1990, pp. 2253, 2269). the hampel report (1998) summarizes their position in the following statement: “directors as a board are responsible for relations with stakeholders; but they are accountable to shareholders”.role and responsibi

26、lities of the board the combined code (2003) sums up the importance of the board by stating that “the boards role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed.” in addition, the board plays

27、a key role in harmonizing the competing interests of the various stakeholders of a corporation. having established the role the board plays in a corporation, the focus then turns to the question of whether there is an ideal board structure or composition. the united kingdom, united states, and the p

28、hilippines, for instance, operate under the unitary board structure while countries such as germany, denmark and austria operate under the dual structure. this paper is concerned with the board composition in general and the role of non-executives (neds) in particular. while corporate governance cod

29、es emphasize the key role of the chairman in the board, they also encourage that “boards should consider assigning a sufficient number of non-executive board members capable of exercising independent judgment to tasks where there is potential for conflict of interest” (oecd 2004). in recent years, t

30、here has been a marked recognition of the role of neds in bringing into companies a fresh, impartial view of how businesses should be run. the cadbury report (1992) believes that “the caliber of the non-executive members of the board is of special importance in setting and maintaining standards of c

31、orporate governance.” increasingly, non-executive directors are also expected to perform dominant roles in key board committees, such as, in audit, remuneration, nomination. however, additional issues related to having neds in the board must be addressed, particularly, the ideal number of neds, the

32、specific role/s that they are expected to perform and their qualifications/attributes that are necessary for effective corporate governance. corporate governance codes or prescriptions, in different regions, vary not only in terms of their prescribed number of neds but also in terms of the title use

33、d. in the uk, the term non-executive director is used while independent director is used in the philippines. in the uk, at least half of the board (except for smaller companies), excluding the chairman, should consist of neds while in the philippines, the existence of at least two independent direct

34、ors in the board already suffices. the specific role/s that neds are expected to perform, that is, whether they should be involved in control and/or strategic roles, remain an unsettled issue. as regards to the qualifications/attributes of neds, strictly defining specific attributes and/or qualifica

35、tions limits the corporations ability to comply with the prescribed number. on the other hand, coming up with a general describe provides too much room for misinterpretation and the possibility of appointing neds who do not possess exceptional skills to merit the position but merely satisfy the mini

36、mum requirements (and diluting the potential impact that they can play in the boardroom). corporate governance in banks for developing countries (such as the philippines), where the capital markets are not fully developed, banks serve as the dominant sources of external finance for businesses. mulli

37、neux (2006) points out that “in all countries, banks are by far the most important source of external finance for small and medium enterprises (smes), which are effectively dependent on banks for external finance.” their importance is highlighted when we consider that in the philippines, the sme sec

38、tor comprises 99.7% of all registered firms, employs 69.1% of the labor force and contributes around 30.0% to the economy. source: department of trade and industry (dti). due to their dominant role as providers of external finance, banks have the ability to exercise corporate governance over the fir

39、ms which they lend to. they are at the center of the financial system and any instability they experience may have a very serious systemic impact to the rest of the economy. several reasons have been identified to argue for the special treatment of banks in the study of corporate governance (i.e. wh

40、y they deserve a different treatment from other firms). they are as follows:1. banks are the dominant sources of external finance in several countries; 2. banks are generally more opaque than non-financial firms (levine, 2003);3. banks are frequently very heavily regulated (levine, 2003);4. banks te

41、nd to have very little equity than debt (macey and ohara, 2003);5. banks liabilities are largely in the form of deposits (which are mostly available on demand), while their assets take the form of loans that have longer maturities. hence, they have a fiduciary duty to depositors as well as sharehold

42、ers. “there is a public dimension to the banking firm that vitiates the exclusive claims that its shareholders bring to the attention of directors” (macey and ohara, 2003); 6. banks transactions and financial reporting accounts are more complicated; and7. in an environment where there is deposit ins

43、urance, moral hazard can arise and taxpayers need protecting against abuse of the system. mullineux (2006) indicates that the root of what makes banks special is due to information asymmetry. banks exist because one party (the saver/lender) has inadequate information about the other party (the borro

44、wer/investor) in a financial transaction. another way of looking at information asymmetry is that the borrower knows more about their credit worthiness than the lender (mullineux, 2006). moreover, banks become the dominant providers of external finance, especially in developing countries, because th

45、e quality of information that firms generate may not be adequate for them to access direct finance from the capital markets (mishkin, 2003). asymmetric information also explains why banks are heavily regulated. the government wishes to promote the provision of quality information for the efficient p

46、erformance of the financial markets. with adequate information, lenders will be able to weed out risky firms and those most likely to engage in risky activities. in addition, savers will be able to assess the soundness of the banks that are holding their money thereby preventing, at worse, a financi

47、al panic. there is also a need to protect depositors who are more risk-averse than the more risk-prone shareholders (mullineux 2006 and macey and ohara, 2003).it should be noted that asymmetric information (and the twin problems associated with it adverse selection and moral hazard) is key to unders

48、tanding the sequence of events that led to the asian currency crisis (almost ten years ago) and how insufficient or confusing information regarding the banking industry could result in the contraction of the economy as a whole. the international response was to move towards effective good governance

49、 by promoting the principles of fairness, accountability and transparency.the issue then moves on to developing corporate governance mechanisms to promote and balance the interests of shareholders and other stakeholders (depositors). corporate governance of philippine banks in this section, we use t

50、he framework given by echanis (2006) as a model for visualizing the factors which influence the corporate governance of banks in the philippines. in her model, there are four external influences which affect the practice of corporate governance, namely: (1) the legal system, (2) the regulatory syste

51、m, (3) the judiciary system and (4) the financial reporting standards (chart 1). chart 1external influences on philippine corporate governancelegal system§ the corporation code§ the securities regulation code§ the general banking act§ the central bank actphilippine corporate gove

52、rnanceinternal corporate governance risks & practicesregulatory system§ sec§ bsp§ psefinancial reporting standards§ frsc§ sec§ ifrsbjudiciary system§ regional trial courts§ court of appeals§ supreme courtlegend:sec securities and exchange commissionbs

53、p bangko sentral ng pilipinas (the central monetary authority)pse philippine stock exchangefrsc financial reporting standards councilifrsb international financial reporting standards boardsource: echanis (2006)our focus will be on the role played by the bsp as an external influence. to this, we will

54、 add the role played by the pdic as another external influence under the regulatory system in the practice of corporate governance of philippine banks. the central bank of the philippines was established on 03 january 1949. pursuant to the provisions to the 1987 philippine constitution and the new c

55、entral bank act of 10 june 1993 (republic act 7653), the bangko sentral ng pilipinas (bsp) took over from the central bank as the philippines central monetary authority. bsps mission is to promote and maintain price stability favorable to a balanced and sustainable economic growth in the philippines

56、. under republic act 7653, the bsp shall have supervision over the operation of banks and exercise such regulatory powers as provided for in the republic act.republic act 8791 was passed into law on 12 april 12, 2000 giving the bsp the power to supervise the operations and activities of banks in the

57、 philippines. some of the provisions of the act related to corporate governance are the following:1. definition and disclosure of family groups and related interest (section 12 and 13); 2. prescription on the profile of the board of directors. there shall be at least five (5), and a maximum of fifte

58、en (15) members of the board or directors of a bank, two (2) of whom shall be independent directors. an "independent director" shall mean a person other than an officer or employee of the bank, its subsidiaries or affiliates or related interests (section 15);3. prescription on the quality of bank management giving the monetary board the power to prescribe, pass upon and review the qualifications and disqualifications of individuals elected or appointed as bank directors or officers and disqualify those found unfit. towards this