Corporate governance: An incentive to improve checks and balances

21 December 2007
The global credit crunch should act as a catalyst to increase transparency and raise standards in the region's banking sector.

Charles Prince of Citigroup and Stan O'Neal of Merrill Lynch are two of the first executives to be forced out of their jobs following the credit crunch. The two institutions lost $19bn combined, related to investments in defaulting mortgage securities.

The two men have more in common than bad investments. They held the duel role of chairman and chief executive officer, allowing them even greater leeway to force through their own views on the type of business their bank should be doing, according to Charles Freeland, former deputy secretary general of the Basel Committee on banking supervision. Freeland has also spent time assessing the standards of corporate governance in Middle East banks.

The resulting losses should serve as a reminder of how important it is that banks have proper checks and balances in place, says Freeland, to ensure that any one person is not exerting undue influence, or forcing out other staff members who may have a more prudent viewpoint.

Regional lack

Good corporate governance should stop individuals from simply overriding the concerns of others. So far, the Middle East is lacking in this area. Mark Beer, vice-president of Mastercard for South Asia, Middle East and Africa, says good standards of governance will be increasingly important for the region.

“Effective corporate governance will give the region's banks access to cheaper sources of funding through improving their reputation with ratings agencies, customers and investors,” he says.

“By international standards, GCC corporate governance provisions are lacking in a number of key areas,” says Rupert Copeman-Hill, partner at law firm Trowers & Hamlins in Abu Dhabi. “But this is changing fast.”

The Union of Arab Banks (UAB), a body that promotes co-operation between banks in the Middle East and North Africa region, is drafting a series of guidelines on corporate governance.

Fouad Shaker, secretary general of the UAB, says he hopes to get the guidelines finalised and enforced by early 2008.

“The development of strong corporate governance standards is crucial to the growth of the Middle East banking sector,” he says.

The UAB code would be the first region-wide initiative to instil transparency and accountability guidelines, but as it is not a legal requirement it will still lack the ability to enforce compliance.

One of the factors that has so far hampered the development of corporate governance in the region is the lack of an institutional investor base that can lobby companies to change their behaviour.

In other markets, institutional investors pay advisory firms to make recommendations based on corporate governance standards. In the Gulf, a sizeable institutional investor base is yet to develop, let alone one that is interested in using its shareholdings proactively to vote against the status quo at annual general meetings.

In addition, a substantial chunk of the owner-ship of the majority of banks is still in private or government hands. This makes transparency an even more difficult issue to promote.

Ownership sensitivities

Ownership is a sensitive issue for most regional banks, as they tend to be dominated by a single shareholder, often linked to the government and with a senior position on the management board.

“A founding principle of any good governance standards is a clear distinction between the ownership of a business and its management,” says Freeland. “It has to be ensured that there is not a dominant figure who can railroad through their own views.”

The difficulty in the Middle East will be ensuring that the views of minority shareholders, which often comprise retail investors, are also heard.

Corporate governance is not just about pleasing investors. Jonathan David Lyon, chief executive officer at Burgan Bank, which recently received the UAB's inaugural Corporate Governance Award, says there have been additional internal benefits from implementing a strong corporate governance culture.

“Because our managers now feel more empowered since we started promoting accountability and transparency, our staff turnover has dropped from about 40 per cent in 2004 to about 6 per cent,” he says.

Human capital still represents a significant challenge to implementing good standards of governance. “The human resources in the region are so limited that if you are a person who could be deemed fit and proper to sit on the board of a bank, then you probably already sit on the board of a number of competitors,” says Beer.

Another area that will remain a challenge for some time is that however much whistleblowing procedures may be supported, there are still significant cultural impediments to employees actually using the systems in place to accuse more senior staff members of wrongdoing. Coupled with this are fears over how anonymous complaints will be treated.

Potential gains

However, institutions that do try to improve have much to gain. “Those institutions that adopt best practices will get the most interest from international investors, and performance will diverge from those banks that do not reform,” says Beer. “In the end, those that are not interested will only go one way.”

Another issue that needs to be addressed is aligning management incentives to companies' long-term performance. Instances of directors being rewarded with shares that pay out based on long-term performance criteria are rare, but are a useful tool in promoting management to think beyond merely hitting profit targets, which can sometimes be manipulated.

The more Middle East banks reach out to global investors, the greater the pressure will be to fit into modern standards. Adopting greater disclosure and firmly separating ownership from management will be essential as the Middle East develops. Several regional banks have seen that implementing best practice may sometimes be problematic, but brings rewards in the long run.

FACT FILE: Corporate Governance

Corporate governance became a major issue for investors and businesses after the collapse of US energy company Enron in 2001, when directors were found to have misled shareholders over the true extent of the company’s $18bn debt. It led to the creation of a corporate governance law in the US, called Sarbanes-Oxley, which imposed stricter rules on auditors and made corporate directors criminally liable for lying about their accounts.

Traditional areas covered by corporate governance include:

  • Structure of the management board - a clear separation of powers between the
    chief executive officer and chairman

  • A balance and separation of powers between executive and non-executive

  • Treatment of minority shareholders

  • Protection of basic shareholder rights

  • Implementation of sound risk management systems

  • Requirements for stringent internal and external auditing procedures

  • Establishment of whistleblowing procedures to allow staff to report potential wrongdoing

Oman was the first country in the region to adopt a corporate governance code. Now codes have been implemented in most countries, including Jordan, Saudi Arabia, the UAE, Bahrain and Qatar. Most of the codes, however, are voluntary and companies are under no obligation to follow the code, or even to explain to shareholders why they choose not to.

Oman’s code is perhaps the most robust. But across the region, areas such as internal auditing, accounting regulations and disclosure of directors’ remuneration still have some way to develop before they approach international standards.

Despite having one of the region’s most developed equity cultures, Kuwait still lacks a corporate governance code. Corporate governance guidelines have also been drawn up by the Basel Committee on Banking Supervision, and the OECD, to give every bank a steer on inter-national best practice.

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