By Gian Piero Cigna, Milot Ahma & Pavle Djuri – Gian Piero is Associate Director, Senior Counsel, Milot is an Associate and Pavle is Counsel at the European Bank for Reconstruction and Development
The existing stock of non-performing loans (NPLs) in Europe – estimated at more than €1trillion – remains a serious concern for European regulators and national authorities. NPLs impact banks’ profitability, divert banks’ resources from ordinary lending activities and reduce new lending into the economy. This ultimately holds back the country’s potential for growth and, in high NPL countries, can even pose a threat to the stability of the financial system as a whole.
The roots of the NPL crisis are largely derived from the economic and financial crisis – i.e. retail and corporate borrowers in dire straits because of the crisis – but in some cases or jurisdictions the high level of NPLs might have been exacerbated by poor corporate governance practices in banks, including the (lack of) oversight capacity of boards. The link between poor corporate governance and high NPL ratio has not yet been clearly demonstrated, but there are undoubtedly a number of factors suggesting a strong causal relationship.
Some illuminating stories are now starting to appear in the media. Take Veneto Banca and Banca Popolare di Vicenza, both Italian unlisted mutual banks with a very high NPL ratio, as case studies. These banks received media attention because of a practice nicknamed ‘kissing shares’ – borrowers were granted loans that otherwise would not have been granted or would be granted on less favourable terms under the condition that they would buy shares in the banks. In this way, both banks were simultaneously expanding their capitalisation, shareholding base and their loan portfolio, which allowed ‘extravagant remuneration for directors and sweet financing deals for some on the board’.
Because the banks were not listed, the price of their shares was determined on an annual basis by management, endorsed by the board, validated by auditors and submitted for approval to the shareholders’ meeting, including those shareholders that took the loans, all happy to see the share price increasing. Shares prices were calculated at 1.5 times the banks’ net assets, while other banks were usually pricing their shares at 0.5 times. In the course of five years, shareholders’ equity halved and the net-NPLs/shareholders’ equity ratio rocketed. Few questions were asked on the sustainability and soundness of the lending practices associated with the kissing shares until it was too late.
“The shift in board composition away from insiders towards independent directors has been one of the most important developments in international corporate governance over the past few decades”
At Veneto Banca, the numbers tell the story. In 2011, it made a profit of €160million. In June 2012, it had 54,000 shareholders. But its losses began to mount – and so did the number of shareholders. In 2014, Veneto Banca had 88,000 shareholders and made €2.4billion of new loans. It also made a €650million loss for the year, the worst in its history. In 2016, the share prices of both banks crashed to 10 Euro cents from their highest value of €62.50 and €40.75 a few years before.
Is there a ‘corporate governance story’ behind all this? Well, clearly kissing shares practices were not sustainable and the lesson that can be learned from it is not much different from what was learned in the aftermath of the financial crisis. In particular, we could argue that not enough attention was paid to the oversight of credit risk, including the creditworthiness of borrowers and the value (and depreciation) of collaterals.
Banking is an inherently risky business and ensuring a sound risk management system within banks is a key board responsibility. However, this now universally accepted truth became apparent only after the financial crisis. As a matter of example, in the 2006 Basel Committee’s eight principles for good corporate governance of banks – the key benchmark for corporate governance of banks at that time – the word ‘risk’ does not appear at all. In Europe, only in 2013 did the Capital Requirements Directive IV (so-called CRD IV) provide for the first time some mandatory regulation of different governance aspects for banks, including the need for independent and qualified directors on the board and its committees. For many European banks, this came too late.
Lessons to be learned
So, taking inspiration from the story above, we asked ourselves if there are any corporate governance lessons that can be drawn. To answer the question, we looked at the disclosure offered by those two Italian banks mentioned above. On paper, both banks appear to have sound governance in place with various committees, clearly articulated ‘lines of defence’ and charters requiring boards to be staffed with independent directors.
However, there are a number of unanswered questions as to who was sitting in these committees, whether those sitting at the board – in both banks pretty much ‘male, pale and stale’ – and in the committees had the right mix of skills to direct the banks and keep management accountable. And, last but not least, who the ‘independent’ directors were. These are key questions, as those people were supposed to ensure the soundness of the banking practices and operations, including the sustainability of the business. Having an appropriate number of qualified and independent directors was especially important in these banks as they both had an executive board chair and a substantial presence of executive committee members in the board.
The shift in board composition away from insiders towards independent directors has been one of the most important developments in international corporate governance over the past few decades. Indeed, we could not find a single corporate governance code in the world that does not emphasise the need for independent directors on the board. However, independence must be coupled with proper qualification to be meaningful – how can somebody be objective if he/she does not understand what they are talking about? It’s a correlation that has been historically largely ignored.
Introduction of requirements
The CRD IV was the first mandatory European act that emphasised the need for diversified boards in banks so to avoid ‘group thinking’. The same directive required members of the audit and risk committees to be non-executives and ‘have the knowledge, skills and expertise required for the committees’. This requirement was then complemented by the new wording of the audit directive, which now requires the audit committee to be made up by a majority of independent directors and that the ‘committee members as a whole have competence relevant to the sector in which the audited entity is operating’ with ‘at least one member to have competence in accounting and/or auditing’.
The CRD IV also makes a specific reference to integrity and ‘independence of mind’ that all board members should possess, another important cornerstone of the reform. Thanks to the supervisory work by the European Central Bank (ECB) over banks in the Euro area, this is now becoming a standard, but it is still largely overlooked: by looking at the definition of independence in most legislation and corporate governance codes, what is generally meant as ‘independence’ is largely confused with ‘non-affiliation’.
This is misleading as the two concepts are profoundly different. While ‘non-affiliation’ can be defined in negative terms only (e.g. not being an employee of the company or not having a material business relationship with the company, etc), independence is a positive characteristic – the ‘objectivity of mind’ – which should be demonstrated and explained in practice – hence the need for proper disclosure. In practical terms, this translates to the ‘challenging attitude’ that all board members – and especially independent directors – must have. The same attitude that could have saved many banks from entering into toxic practices. The same attitude that external auditors must have and that can be undermined if the auditor becomes too entrenched with the institution being audited.
As a matter of fact, it appears that in both banks the same audit firms performed statutory audits for many years while also providing other non-auditing services in the same period.
It is not our intention – and we do not have any grounds – to provide any allegation of auditors’ misconduct, but it has been often argued that auditors that have become too close to the company or that have over-relied on income from a single source might have their objectivity challenged and independence compromised. In fact, in 2014 new European legislation entered into force to restrict the non-audit services that auditors can provide to EU public interest entities, which include banks. The same directive requires public-interest entities to have an audit committee, in charge – among others – to ‘review and monitor the independence of the statutory auditors or the audit firms… and in particular the appropriateness of the provision of non-audit services to the audited entity’.
In the two banks, the audit committee – which in Italy is called the ‘collegio sindacale’ – is composed of non-board members only. This is a common practice in a number of countries, but we are not convinced this is the right solution, especially when the functions delegated to the committee are typical board functions. We think instead that it is essential that audit committee members who are recommending specific actions to the board are then able to follow up on them when they are discussed and voted at the board. This would reinforce their positions and the board’s ‘objective judgement’ – to the extent that, of course, those sitting in the audit committee are truly independent and qualified board members. It’s worth noting that there is no mention of qualification and independence of those sitting at the board and at the collegio sindacale in the annual report of either bank.
Further, we believe that committees’ members should have a thorough understanding of the bank’s business when performing their duties, while ‘outsiders’ – as they do not sit at the board – might only have a partial vision and understanding of the bank’s activities. While it is legitimate that committees might need external advice or expertise on specific issues, they should be able to request such advice but without allowing outsiders to take the place of board members in their determinations.
Finally, committees that include outsiders might have confidentiality and accountability issues, since outsiders might not be bound by the same duties of loyalty and care required to be board members. In some countries where this practice is allowed, audit committee members are accountable to the board but only on a contractual, not fiduciary basis. This might create perverse incentives. In other countries – as we believe it is the case in Italy – the accountability of the audit committee is directly to the shareholders. Interestingly, in Italy ‘foundations’ are major shareholders in banks and foundations are subject to political influence.
“Outside the EU, efforts seem mostly dedicated to NPLs workout strategies while
little attention is focussed on governance of banks”
Similar characteristics can be found in the Spanish cajas, which accounted for a vast majority of NPLs in Spain. Some authors suggest that in state-owned banks, the public authorities could have influenced their lending decisions towards excessive risks relative to expected returns. A recent study found that cajas whose chairmen were previously political appointees had significantly worse loan performance. This toxic relationship seems also confirmed by a recent OECD study on Slovenia which points out that ‘the bust has not affected all banks equally. The quality of the loan portfolio has deteriorated the most for large state-controlled banks…. For these banks, the ratio of NPLs to private corporations increased from two per cent in 2007 to 30 per cent in October 2012. In comparison, the corresponding ratio for foreign banks amounted to 11 per cent and for small domestic banks to 23 per cent. This suggests that the increase in bad loans of state-controlled banks is not driven just by the business cycle’.
Reform progress inches forward
The good news is that substantial reforms are currently ongoing. Cajas in Spain and banche popolari in Italy are being restructured – even if in Italy the reform is moving slowly – and governance issues are being tackled and improvements are visible in the most recent banks’ disclosures. In Slovenia, the largest bank in the country is planning to go public during 2017 and this should also help to improve its governance. The ECB – through the Single Supervisory Mechanism – working closely with the national supervisory authorities, is leading the supervision of systemically important banks in the Eurozone. The ECB has also recently published the new Guidance to Banks on NPLs, which includes some important corporate governance elements. A major development, one of the ECB key priorities of 2017, that it is expected to enter into force in January 2018, is the introduction of a new IFRS 9, which should help tackling the delayed recognition of credit losses associated with loans and contribute to a better assessment and disclosure of banks’ credit portfolio quality.
However, most of the corporate governance reform seems to stay within the European Union. Outside the EU, efforts seem mostly dedicated to NPLs workout strategies while little attention is focussed on governance of banks. A recent review of the disclosure by some banks affected by high NPL ratio in countries neighbouring the EU, reveals that the issues mentioned above are still present. Information about the qualifications and independence of board members is vague or non-existent, audit committees are staffed with outsiders and the role of the banking regulator in overseeing governance of banks is still limited to a quantitative approach, not appropriate to oversee governance practices. Clearly a lesson not yet learned.
The opinions expressed are of the authors only and do not necessarily reflect the views of the European Bank for Reconstruction and Development (EBRD).
About the Authors:
Gian Piero, who is an Italian qualified attorney, is the corporate governance specialist in the EBRD Legal Transition Team. Prior to joining the EBRD, he worked on company law, corporate governance and capital markets related issues at the European Commission and at the Italian Ministry of Economy. He practiced law in an international law firm in Italy, Albania and Romania and acted as consultant to international organizations and various state institutions and ministries in Eastern Europe. In Albania he was advisor at the Ministry of Economy for the privatization of state owned enterprises in strategic sectors. In the Czech Republic he worked as “Pre Accession Advisor” at the Ministry of Justice and the Securities Commission for the approximation of the Czech legislation with EU standards.
He graduated in law in Italy and attended postgraduate studies in the Netherlands and US focusing on European and International business law. He has been responsible for the EBRD Corporate Governance Legal Reform Projects since 2004, and led projects in a number of jurisdictions (Albania, Armenia, Kazakhstan, Kyrgyz Republic, Romania, Russia, Slovenia, Serbia, Turkey and Ukraine) especially on corporate governance code and company law development and implementation as well as a number of research and standard-setting projects.
Milot Ahma is an Associate in the EBRD’s Legal Transition Team (Financial Law Unit) primarily focused in corporate governance, insolvency, debt restructuring and access to finance matters. Prior to joining the EBRD, Milot was a Senior Associate at Pallaska&Associates in Kosovo where he was focused in contract law, mergers and acquisitions, banking law and property law. In addition to this, Milot was also engaged in several legal reform-related projects in Kosovo. Milot graduated at the top of his class in the University of Prishtina, Faculty of Law. In 2014 he was awarded a full scholarship, which enabled him to complete his LL.M. degree at Duke University, School of Law. Before this, in 2011 he was the recipient of another scholarship, which facilitated his one semester of studying international commercial law at the University of Groningen, Faculty of Law in Netherlands.
Pavle Djurić is a counsel in the Legal Transition Team (LTT) of the European Bank for Reconstruction and Development, the EBRD’s initiative to contribute to the improvement of the investment climate in the Bank’s countries of operations by helping create an investor-friendly, transparent and predictable legal environment. Pavle is actively involved in the EBRD’s work on corporate governance in the Bank’s countries of operations, which encompasses both working directly with investee companies in order to strengthen their governance arrangements and policy dialogue with country authorities to assist development of effective legal and regulatory frameworks that support sound corporate governance. He also participated in the 2016 Assessment of Corporate Governance Legislation and Practices in the EBRD Countries of Operations, the results of which are published on the EBRD website. A citizen of the Republic of Serbia, Pavle graduated from the Faculty of Law, University of Belgrade, where he also obtained a master’s degree in business law.
1. Financial Times, November 24 2016: https://www.ft.com/content/04869eca-b15e-11e6-9c37-5787335499a0
2. Il Sole 24 Ore, 3 August 2016: http://www.ilsole24ore.com/art/finanza-e-mercati/2016-08-02/veneto-banca-gioco-prestigio-prestiti-baciati-231514.shtml?uuid=AD8LoE1 and
3. Financial Times, November 24 2016: https://www.ft.com/content/04869eca-b15e-11e6-9c37-5787335499a0
4. In particular, OECD, Corporate Governance and the Financial Crisis: Key Findings and Main Messages, June 2009. Available at: http://www.oecd.org/corporate/ca/corporategovernanceprinciples/43056196.pdf
5. Basel Committee, Enhancing Corporate Governance for Banking Organisations, February 2006. Available at: http://www.bis.org/publ/bcbs122.pdf. The word ‘risk’ is recurrent in the text, but not in the eight Principles.
6. Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC.
7. The Annual Report of Banca Popolare di Vicenza 2009 states that changes were made in order to have ‘at least two directors to be independent and at least four to be non-executive directors’, while Section 17.6 of the statute of Veneto Banca requires that at least ¼ of board members must be independent.
8. Directive 2014/56/EU of the European Parliament and of the Council of 16 April 2014 amending Directive 2006/43/EC on statutory audits of annual accounts and consolidated accounts.
9. Foundations are major shareholders in 23 percent of Italian banking assets through participations in 20 percent or more of bank capital. Moreover, in several large banks, they control bank Boards with an even smaller share of ownership, often through shareholders’ agreements. In the large cooperative banks (Banca Popolare), restrictions on ownership and voting rights (one member-one vote) weaken market diligence and the bank’s capacity to raise capital from outside sources.
10. IMF Working Paper, Reforming the Corporate governance of Italian banks, by Nadege Jassaud, September 2014.
11. See: Illueca, M., L. Norden, L. and Udell, G.F., 2013. Liberalization and risk taking: Evidence from government-controlled banks. R.Financ, 1217-1257.
12. See: Did Good Cajas Extend Bad Loans? Governance, Human Capital and Loan Portfolios. Vicente Cuñat and Luis Garicano, London School of Economics and Political Science and CEPR https://mpra.ub.uni-muenchen.de/42434/1/
13. See: OECD, Banks’ Restructuring and Smooth Deleveraging of the Private Sector in Slovenia. Economic Department Working papers No. 1059, by Olena Havrylchyk, page 8 (http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=ECO/WKP(2013)51&docLanguage=En)