Why corporate governance reforms make business sense?

Today, it may no longer be possible to view one economy in the East Asian region without factoring in the influence of other economies in and out of the region. Similarly, it is becoming impossible to face up to macroeconomic vulnerability without, at the same time, securing the strength of the financial sector and reforming the governance of the corporate sector.

For instance, when exchange rates are forced to make big and sudden adjustments, the banking sector is also forced to go through a very tight squeeze. Collections become difficult. Sales plummet. Margins narrow. Profits disappear. Books weaken considerably. Bankruptcies spread. A vicious cycle then worsens the havoc within the economy.

As several corporations totter and more than a few collapse, the banks themselves become weaker as they are unable to collect from their borrowers. Saddled with non-performing loans and real as well as other properties they would much rather not own or keep in their books, many banks are forced to go hat in hand to the monetary authorities or to the public treasury.

The task of rehabilitating banks that fail and of strengthening banks that weaken carries a heavy macro-economic cost for the entire economy.

Best practices

Global best practices in corporate governance have evolved in a context of arms-length, mainly professional relationships between different parties in relatively open markets, more particularly in relatively well developed capital markets.

In such a context, there has been a much clearer delineation between owners or shareholders (whose number have increased significantly in the past five decades), directors and managers.

Owners expect return on their equity investments. Managers are expected to bring those returns. And directors are expected to advise and oversee the managers so that, in the process of bringing in those returns, all parties with legitimate interests in the corporation are treated fairly.

Oversight calls for reports that are transparent and are, therefore, accurate, timely and prepared according to generally accepted principles and practices. Fairness calls for a system of checks and balances as well as of accountability, internally within the corporation and externally to all stakeholders and shareholders. To ensure that this system works properly and effectively, a rule of law must be made to prevail. Among others, this requires that courts must function and accounts must be reported and independently audited.

The challenge to corporate governance reforms in East Asia stems from the context in which business and industry have grown and developed historically and particularly in the past few decades.

Challenges

In much of East Asia, governments and family patriarchs founded and nurtured several businesses and industries. In the rush to catch up and compete successfully with the more advanced businesses and industries in more developed economies, lines were often blurred and responsibilities often mixed.

Owners were often in absolute control and they generally took on the responsibilities of management. Directors were often elected to the board merely to give pro forma approval to decisions already taken by government or the controlling patriarch. Reports had to be functional and, since there was no need for a system of checks and balances, nor of accountability, in many instances, transparency and fairness were given a relative meaning different from that in the Anglo-American context.

Relationships and networking have been counted upon as much more important to get business done, rather than the rule of law, where courts have been far less effectively, efficient and fair.

Moreover, the reputational agents, such as lawyers, auditors, financial analysts and financial reporters, whose duty includes having to make financial markets work with transparency, accountability and fairness, have been far fewer and less independent in much of East Asia.

Within the context of concentrated, nearly absolute power, many businesses and industries have succeeded. Rapid growth was achieved. Development was rapid. Enormous fortunes were made. In head-to-head competition in export markets, market shares were won and, in a few industries, a commanding position was achieved.

In some respects, an economic miracle was wrought. A few "development paradigm" was proposed, modeled after the clearly apparent successes of many East Asian economies.

Against this background, the conviction has spread and deepened that, in many ways, East Asia is different. Our culture is different. Our way of doing business are different. Thus, our corporate governance practices also must take into account these very real differences from those observed in the Anglo-American setting.

The 1997-1999 Asian financial crisis may have only dented the great economic successes already achieved in the region. But it did bring very important reminders about the dangers of corporate governance practices with no operative systems of checks and balances or accountability.

Owners, even if majority or controlling, are not the only parties with a stake in the corporation. Thus, decisions about the use of the resources of the corporations cannot be reserved to the majority or controlling owners. These must be reserved for a collegial board of directors, several of whom must be functionally independent of the controlling shareholders and of top management.

Independently audited reports, prepared according to internally accepted standards, must be issued regularly and on schedule.

Thus, while the cultural differences need to be continually taken into account, the fundamental demands of corporate governance for fairness, accountability and transparency need to be fully met, sooner rather than later.

Two broad alternatives, which can be mutually reinforcing, are open to meeting these challenges. The first is through the development of capital markets. The second is through the banking sector itself.

Market reforms

Capital market development has become the vogue in much of East Asia. The Securities and Exchange Commissions are in the process of being strengthened, empowered, professionalized and made independent of political interference. Many stock exchanges are being demutualized, and the rules for their operation are being reviewed and gradually put in line with the rules that prevail in more advanced exchanges.

Codes of corporate governance are being copied from those already inspired by the Overseas Economic Cooperation and Development (OECD) principles and these are being adopted to serve as models for publicly listed corporations being encouraged to formulate their own codes.

Accounting and auditing practices are also being reviewed and these, too, are in the process of being made fully consistent with internally accepted standards.

New rules are being imposed, indeed often by mandate of new laws. These rules require a minimum number or percentage of independent directors in the board of directors of banks and publicly listed companies. They spell out more clearly the role of the board of directors.

There can no longer be any doubt about the seriousness of the board’s fiduciary responsibilities as a collegial body, where each member is expected to participate in the collective decision-making with due diligence, interest and competence.

The new rules also specify ‘fit and proper" tests for directors. They further require all directors of banks and publicly listed companies to undergo an orientation and learning program on corporate governance within a certain time frame.

Finally, in some jurisdictions, a capital market development council has been tasked to coordinate initiatives between government departments and concerned institutions from the business sector to fast track measures aimed at strengthening, enlarging and developing the capital market.

All this activism should, in time, make corporate governance reforms effective. It may help attract portfolio investors back to several of the emerging capital markets in East Asia. It may force the pace of reforms in corporations actively gearing themselves up for listing in other stock markets with higher corporate governance standards.

However, there is a limit to which the pace of corporate governance reforms through the capital markets can be speeded up in several east Asian economies. The relative importance of capital markets, as the source of external finance for corporations is small relative to the importance of banks. And the control over the majority shares by either government or family makes oversight by an independent board of directors either merely cosmetic or downright embarrassing in many instances.

Minority shareholders are not organized. Their voices are not heard. And the few attempts on the part of those that have become litigious have largely proven to be heroic (and in only very few instance successful as in South Korea), but for the most part futile.

Banking reforms

Reforms through the banking system appears more promising in several Asian economies.

These reforms are linked to the broader set of reforms aimed at tightening financial supervision, in line with the core principles adopted and propagated by the Bank for International Settlement.

In adherence with these principles, banks are required to maintain new capital adequacy ratios and to arrive at those ratios on a risk-weighted basis. Banks are called upon to install new risk management systems, which classify the risk of different types of accounts.

Among the risk factors that are increasingly taken into account are the corporate governance practices of the borrowers. The more modern and the more closely aligned with the OECD principles these practices are, all other things being equal, presumably the lower the risks to the banks from lending to such borrowers.

The steps actually taken in this direction are still the initial ones, such as imposing modern corporate governances practices in the banks themselves and calling upon them to install a risk management system that assigns different risk weights to different borrowing accounts. Moreover, the new capital adequacy ratios have just come into force.

In the foreseeable future, the banks would be treating different borrowers differently on the basis of the risks they bear. They would provide a premium for borrowers with lower risk of defaults. They would then provide pragmatic incentives and financial advantages to solid and strong corporate borrowers.

From here, it would be a short step to including modern corporate governance practice of corporate borrowers among the bank criteria for solidity and strength.