[CORPORATE GOVERNANCE IN INDIA]

While recent high-profile corporate governance failures in developed countries have brought
the subject to media attention, the issue has always been central to finance and economics.
The issue is particularly important for developing countries since it is central to financial and
economic development. Recent research has established that financial development is largely
dependent on investor protection in a country – de jure and de facto. With the legacy of the
English legal system, India has one of the best corporate governance laws but poor
implementation together with socialistic policies of the pre reform era has affected corporate
governance. Concentrated ownership of shares, pyramiding and tunneling of funds among
group companies mark the Indian corporate landscape. Boards of directors have frequently
been silent spectators with the DFI nominee directors unable or unwilling to carry out their
monitoring functions. Since liberalization, however, serious efforts have been directed at
overhauling the system with the SEBI instituting the Clause 49 of the Listing Agreements
dealing with corporate governance. Corporate governance of Indian banks is also undergoing
a process of change with a move towards more market-based governance.
 Chapter 1
Introduction

The subject of corporate governance leapt to global business limelight from

relative obscurity after a string of collapses of high profile companies. Enron, the
Houston, Texas based energy giant, and WorldCom, the telecom behemoth, shocked the
business world with both the scale and age of their unethical and illegal operations.
Worse, they seemed to indicate only the tip of a dangerous iceberg. While corporate
practices in the US companies came under attack, it appeared that the problem was far
more widespread. Large and trusted companies from Parmalat in Italy to the
multinational newspaper group Hollinger Inc., revealed significant and deep-rooted
problems in their corporate governance. Even the prestigious New York Stock Exchange
had to remove its director, Dick Grasso, amidst public outcry over excessive
compensation. It was clear that something was amiss in the area of corporate
governance all over the world.

Corporate governance has, of course, been an important field of query within the
finance discipline for decades. Researchers in finance have actively investigated the
topic for at least a quarter century and the father of modern economics, Adam Smith,
himself had recognized the problem over two centuries ago. There have been debates
about whether the Anglo-Saxon market- model of corporate governance is better than
the bank based models of Germany and Japan. However, the differences in the quality
of corporate governance in these developed countries fade in comparison to the chasm
that exists between corporate governance standards and practices in these countries as a
group and those in the developing world.

Corporate governance has been a central issue in developing countries long before
the recent spate of corporate scandals in advanced economies made headlines. Indeed
corporate governance and economic development are intrinsically linked. Effective
corporate governance systems promote the development of strong financial systems –
irrespective of whether they are largely bank-based or market-based – which, in turn,
have an unmistakably positive effect on economic growth and poverty reduction.

There are several channels through which the causality works. Effective corporate
governance enhances access to external financing by firms, leading to greater investment,
as well as higher growth and employment. The proportion of private credit to GDP in
countries in the highest quartile of creditor right enactment and enforcement is more than
double that in the countries in the lowest quartile. As for equity financing, the ratio of
stock market capitalization to GDP in the countries in the highest quartile of shareholder
right enactment and enforcement is about four times as large as that for countries in the
lowest quartile. Poor corporate governance also hinders the creation and development of
new firms.

Good corporate governance also lowers of the cost of capital by reducing risk and
creates higher firm valuation once again boosting real investments. There is a variation of
a factor of in the “control premium” (transaction price of shares in block transfers
signifying control transfer less the ordinary share price) between countries with the
highest level of equity rights protection and those with the lowest.

Effective corporate governance mechanisms ensure better resource allocation and

management raising the return to capital. The return on assets (ROA) is about twice as
high in the countries with the highest level of equity rights protection as in countries with
the lowest protection. Good corporate governance can significantly reduce the risk of
nation-wide financial crises. There is a strong inverse relationship between the quality of
corporate governance and currency depreciation. Indeed poor transparency and corporate
governance norms are believed to be the key reasons behind the Asian Crisis of 1997.
Such financial crises have massive economic and social costs and can set a country
several years back in its path to development.
 Finally, good corporate governance can remove mistrust between different
stakeholders, reduce legal costs and improve social and labor relationships and external
economies like environmental protection.

Making sure that the managers actually act on behalf of the owners of the
company – the stockholders – and pass on the profits to them are the key issues in
corporate governance. Limited liability and dispersed ownership – essential features that
the joint-stock company form of organization thrives on – inevitably lead to a distance
and inefficient monitoring of management by the actual owners of the business.
Managers enjoy actual control of business and may not serve in the best interests of the
shareholders. These potential problems of corporate governance are universal. In
addition, the Indian financial sector is marked with a relatively unsophisticated equity
market vulnerable to manipulation and with rudimentary analyst activity; a dominance of
family firms; a history of managing agency system; and a generally high level of
corruption. All these features make corporate governance a particularly important issue in
India.

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 Chapter 2
Central issues in Corporate Governance

The basic power structure of the joint-stock company form of business, in

principle, is as follows. The numerous shareholders who contribute to the capital of the
company are the actual owners of business. They elect a Board of Directors to monitor
the running of the company on their behalf. The Board, in turn, appoints a team of
managers who actually handle the day-to-day functioning of the company and report
periodically to the Board. Thus mangers are the agents of shareholders and function
with the objective of maximizing shareholders’ wealth.

Even if this power pattern held in reality, it would still be a challenge for the
Board to effectively monitor management. The central issue is the nature of the
contract between shareholder representatives and managers telling the latter what to
do with the funds contributed by the former. The main challenge comes from the fact
that such contracts are necessarily “incomplete”. It is not possible for the Board to fully
instruct management on the desired course of action under every possible business
situation. The list of possible situations is infinitely long. Consequently, no contract can
be written between representatives of shareholders and the management that specifies
the right course of action in every situation, so that the management can be held for
violation of such a contract in the event it does something else under the circumstances.
Because of this “incomplete contracts” situation, some “residual powers” over the funds
of the company must be vested with either the financiers or the management. Clearly
the former does not have the expertise or the inclination to run the business in the
situations unspecified in the contract, so these residual powers must go to
management. The efficient limits to these powers constitute much of the subject of
corporate governance.
 The reality is even more complicated and biased in favor of management. In real
life, managers wield an enormous amount of power in joint-stock companies and the
common shareholder has very little say in the way his or her money is used in the
company. In companies with highly dispersed ownership, the manager (the CEO in the
American setting, the Managing Director in British-style organizations) functions with
negligible accountability. Most shareholders do not care to attend the General Meetings
to elect or change the Board of Directors and often grant their “proxies” to the
management. Even those that attend the meeting find it difficult to have a say in the
selection of directors as only the management gets to propose a slate of directors for
voting. On his part the CEO frequently packs the board with his friends and allies who
rarely differ with him. Often the CEO himself is the Chairman of the Board of Directors
as well. Consequently the supervisory role of the Board is often severely compromised
and the management, who really has the keys to the business, can potentially use
corporate resources to further their own self- interests rather than the interests of the
shareholders.

The inefficacy of the Board of Directors in monitoring the activities of

management is particularly marked in the Anglo-Saxon corporate structure where real
monitoring is expected to come from financial markets. The underlying premise is that
shareholders dissatisfied with a particular management would simply dispose of their
shares in the company. As this would drive down the share price, the company would
become a takeover target. If and when the acquisition actually happens, the acquiring
company would get rid of the existing management. It is thus the fear of a takeover
rather than shareholder action that is supposed to keep the management honest and on
its toes.

This mechanism, however, presupposes the existence of a deep and liquid stock
market with considerable informational efficiency as well as a legal and financial system
conducive to M&A activity. More often than not, these features do not exist in
developing countries like India. An alternative corporate governance model is that
provided by the bank-based economies like Germany where the main bank (“Hausbank”
in Germany) lending to the company exerts considerable influence and carries out
continuous project-level supervision of the management and the supervisory board has
representatives of multiple stakeholders of the firm. Annexure at end gives a brief
comparison of the two systems.

Common areas of management action that may be sub-optimal or contrary to

shareholders’ interests (other than outright stealing) involve excessive executive
compensation; transfer pricing, that is transacting with privately owned companies at
other-than- market rates to siphon off funds; managerial entrenchment (i.e. managers
resisting replacement by a superior management) and sub-optimal use of free cash
flows. This last refers to the use that managers put the retained earnings of the
company. In the absence of profitable investment opportunities, these funds are
frequently squandered on questionable empire-building investments and acquisitions
when their best use is to be returned to the shareholders. Keeping a professional
management in line is only one, though perhaps the most important, of the issues in
corporate governance. Essentially corporate governance deals with effective
safeguarding of the investors’ and creditors’ rights and these rights can be threatened in
several other ways. For instance, family businesses and corporate groups are common in
many countries including India. These range from Keiretsus in Japan and Chaebols in
Korea to the several family business groups in India like Birlas and Ambanis. Inter-
locking and “pyramiding” of corporate control within these groups make it difficult for
outsiders to track the business realities of individual companies in these behemoths. In
addition, managerial control of these businesses are often in the hands of a small group
of people, commonly a family, who either own the majority stake, or maintain control
through the aid of other block holders like financial institutions. Their own interests,
even when they are the majority shareholders, need not coincide with those of the
other – minority – shareholders. This often leads to expropriation of minority
shareholder value through actions like “tunneling” of corporate gains or funds to other
corporate entities within the group. Such violations of minority shareholders’ rights also
comprise an important issue for corporate governance.

One way to solve the corporate governance problem is to align the interests of
the managers with that of the shareholders. The recent rise in stock and option related
compensation for top managers in companies around the world is a reflection of this
effort. A more traditional manifestation of this idea is the fact that family business
empires are usually headed by a family member. Managerial ownership of corporate
equity, however, has interesting implications for firm value. As managerial ownership
(as a percentage of total shares) keeps on rising, firm value is seen to increase for a
while (till ownership reaches about 5% for Fortune 500 companies), then falling for a
while (when the ownership is in the 5%-25% range, again for Fortune 500 companies) till
it begins to rise again. The rationale for the decline in the intermediate range is that in
that range, managers own enough to ensure that they keep their jobs come what may
and can also find ways to make more money through uses of corporate funds that are
sub-optimal for shareholders.

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 Chapter 3

Legal environment, ownership patterns and Corporate Governance

The legal system of a country plays a crucial role in creating an effective corporate
governance mechanism in a country and protecting the rights of investors and creditors.
The legal environment encompasses two important aspects – the protection offered in
the laws (de jure protection) and to what extent the laws are enforced in real life (de
facto protection). Both these aspects play important roles in determining the nature of
corporate governance in the country in question.

Recent research has forcefully connected the origins of the legal system of a
country to the very structure of its financial and economic architecture arguing that the
connection works through the protection given to external financiers of companies –
creditors and shareholders. Legal systems in most countries have their roots in one of
the four distinct legal systems – the English common law, French civil law, German civil
law and Scandinavian civil law. The Indian legal system is obviously built on the English
common law system. Researchers have used two indices for all these countries – a
shareholder rights index ranging from 0 (lowest) to 6 (highest) and a rule of law index
ranging 0 (lowest) to 10 (highest) – to measure the effective protection of shareholder
rights provided in the different countries studied. The first index captures the extent to
which the written law protected shareholders while the latter reflects to what extent
the law is enforced in reality.

The English common law countries lead the four systems in the shareholder
rights index with an average of 4 (out of a maximum possible 6) followed by
Scandinavian origin countries with an average score of 3 with the French-origin and
German-origin countries coming last with average scores of 2.33 each. Thus, English-
origin legal systems provide the best protection to shareholder rights. India, for instance
has a shareholder rights index of 5, highest in the sample examined – equal to that of
the USA, UK, Canada, Hong Kong, Pakistan and South Africa (all English-origin- law
countries) and better than all the other 42 countries in the study including countries like
France, Germany, Japan and Switzerland.

The Rule of law index is another story. Here the Scandinavian-origin countries have an
average score of 10 – the maximum possible – followed by the German-origin countries
(8.68), English-origin countries (6.46) and French-origin countries (6.05). Most advanced
countries have very high scores on this index while developing countries typically have
low scores. India, for instance has a score of 4.17 on this index – ranking 41st out of 49
countries studied – ahead only of Nigeria, Sri Lanka, Pakistan, Zimbabwe, Colombia,
Indonesia, Peru and Philippines. Thus it appears that Indian laws provide great
protection of shareholders’ rights on paper while the application and enforcement of
those laws are lamentable.

This difference in protection of shareholders’ rights has led to completely

different trajectories of financial and economic developments in the different countries.
The English-origin systems spawn the highest number of firms per capita (on average
35.45 companies per million citizens as compared to 27.26 for Scandinavian-origin
countries and 16.79 and 10.00 for German and French-origin countries respectively).
They are also the best performers in mobilizing external finance. The ratio of the stock
market capitalization held by minority shareholders (i.e. shareholders other than the
three largest shareholders in each company) to the GNP of a country averages a
remarkable 0.60 for the English-origin countries, substantially higher than the average
ratio for German, Scandinavian and French-origin countries of 0.46, 0.30 and 0.21
respectively. India has 7.79 companies per million citizens, one of the lowest for English-
origin countries but higher than many French-origin countries and Germany. As for the
ratio of external capital to GNP, India has a score of 0.31 which puts it in the upper half
of the sample.

The primary difference between the legal systems in advanced countries and
those in developing countries lies in enforcement rather than in the nature of laws- in
books. Enforcement of laws play a much more important role than the quality of the
laws on books in determining events like CEO turnover and developing security markets
by eliminating insider trading. In an environment marked by weak enforcement of
property rights and contracts, entrepreneurs and managers find it difficult to signal their
commitment to the potential investors, leading to limited external financing and
ownership concentration. This particularly hurts the development of new firms and the
small and medium enterprises (SMEs). In such a situation many of the standard methods
of corporate governance – market for corporate controls, board activity, proxy fights
and executive compensation – lose their effectiveness. Large block-holding emerges as
the most important corporate governance mechanism with some potential roles for
bank monitoring, shareholder activism, employee monitoring and social control.

Apart from the universal features of corporate governance, Asian economies as a

group share certain common features that affect the nature of corporate governance in
the region. In spite of their substantial variation in economic conditions and politico-
legal backgrounds, most Asian countries are marked with concentrated stock ownership
and a preponderance of family-controlled businesses while state-controlled enterprises
form an important segment of the corporate sector in many of these countries.
Corporate governance issues have been of critical importance in Asian countries
particularly since the Asian crisis which is believed to have been partly caused by lack of
transparency and poor corporate governance in East Asian countries.

Research has established the evidence of pyramiding and family control of businesses in
Asian countries, particularly East Asia, though this feature is prevalent in India as well.
Even in 2002, the average shareholding of promoters in all Indian companies was as high
as 48.1%. It is believed that this is a result of the ineffectiveness of the legal system in
protecting property rights. Concentrated ownership and family control are important in
countries where legal protection of property rights is relatively weak. Weak property
rights are also behind the prevalence of family-owned businesses – organizational forms
that reduce transaction costs and asymmetric information problems. Poor development
of external financial markets also contributes to these ownership patterns. The effect of
this concentrated ownership by management in Asian countries is not straightforward.
Similar to the effects for US companies, in several East Asian countries, firm value rises
with largest owner’s stake but declines as the excess of the largest owner’s
management control over his equity stake increases. In Taiwan, family run companies
with lower control by the family perform better than those with higher control.

Recent research has also investigated the nature and extent of “tunneling” of
funds within business groups in India. During the 90’s Indian business groups’ evidently
tunneled considerable amount of funds up the ownership pyramid thereby depriving
the minority shareholders of companies at lower levels of the pyramid of their rightful
gains.

Empirical analyses of the effects of ownership by other (non- family) groups in

Asia are relatively scarce. The state is an important party in some countries in Asia,
notably India and China. The corporate governance mechanism and efficiency in state
controlled companies are generally deemed to inferior. Several studies show that
accounting performance is lower for state-owned enterprises in China. The non- linear
effects of entrenchment are also present with state ownership. Institutional investors
fulfill an important certification role in emerging markets, but there is little evidence of
their effectiveness in corporate governance in Asia. Equity ownership by institutional
investors like mutual funds has limited impact of performance in India. Ownership by
other groups like directors, foreigners and lending institutions, on the other hand,
appear to improve performance. In post-liberalization India, foreign ownership helps
performance only if the foreigners constitute the majority shareholders. Hostile
takeovers are all but absent in Asian countries. The premium for control is significant in
most Asian countries and as high as 10% of the share price in Korea. External and
minority representation in boards as well as participation by professionals are rare
though increasing in Asian companies. Nevertheless, corporate governance is not
entirely ineffective in Asia. In many Asian countries, including India, CEOs are more likely
to lose their jobs when corporate performance is poorer. Annexure shows a discussion
of a few typical features of Asian companies and their implications for corporate
governance.

In India, enforcement of corporate laws remains the soft underbelly of the legal
and corporate governance system. The World Bank’s Reports on the Observance of
Standards and Codes (ROSC) publishes a country-by-country analysis of the observance
of OECD’s corporate governance codes. In its 2004 report on India, the ROSC found that
while India observed or largely observed most of the principles, it could do better in
certain areas. The contribution of nominee directors from financial institutions to
monitoring and supervising management is one such area. Improvements are also
necessary in the enforcement of certain laws and regulations like those pertaining to
stock listing in major exchanges and insider trading as well as in dealing with violations
of the Companies Act – the backbone of corporate governance system in India. Some of
the problems arise because of unsettled questions about jurisdiction issues and powers
of the SEBI. As an extreme example, there have been cases of outright theft of investors’
funds with companies vanishing overnight. The joint efforts of the Department of
Company Affairs and SEBI to nail down the culprits have proved to be largely ineffective.
As for complaints about transfer of shares and non-receipt of dividends while the
redress rate has been an impressive 95%, there were still over 135,000 complaints
pending with the SEBI. Thus there is considerable room for improvement on the
enforcement side of the Indian legal system to help develop the corporate governance
mechanism in the country.

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 Chapter 4

Corporate Governance in India – a background

The history of the development of Indian corporate laws has been marked by
interesting contrasts. At independence, India inherited one of the world’s poorest
economies but one which had a factory sector accounting for a tenth of the national
product; four functioning stock markets (predating the Tokyo Stock Exchange) with
clearly defined rules governing listing, trading and settlements; a well-developed equity
culture if only among the urban rich; and a banking system replete with well-developed
lending norms and recovery procedures. In terms of corporate laws and financial
system, therefore, India emerged far better endowed than most other colonies. The
1956 Companies Act as well as other laws governing the functioning of joint-stock
companies and protecting the investors’ rights built on this foundation.

The beginning of corporate developments in India were marked by the managing

agency system that contributed to the birth of dispersed equity ownership but also gave
rise to the practice of management enjoying control rights disproportionately greater
than their stock ownership. The turn towards socialism in the decades after
independence marked by the 1951 Industries (Development and Regulation) Act as well
as the 1956 Industrial Policy Resolution put in place a regime and culture of licensing,
protection and widespread red-tape that bred corruption and stilted the growth of the
corporate sector. The situation grew from bad to worse in the following decades and
corruption, nepotism and inefficiency became the hallmarks of the Indian corporate
sector. Exorbitant tax rates encouraged creative accounting practices and complicated
emolument structures to beat the system.

In the absence of a developed stock market, the three all-India development

finance institutions (DFIs)– the Industrial Finance Corporation of India, the Industrial
Development Bank of India and the Industrial Credit and Investment Corporation of
India – together with the state financial corporation’s became the main providers of
long-term credit to companies. Along with the government owned mutual fund, the
Unit Trust of India, they also held large blocks of shares in the companies they lent to
and invariably had representations in their boards. In this respect, the corporate
governance system resembled the bank-based German model where these institutions
could have played a big role in keeping their clients on the right track. Unfortunately,
they were themselves evaluated on the quantity rather than quality of their lending and
thus had little incentive for either proper credit appraisal or effective follow-up and
monitoring. Their nominee directors routinely served as rubber-stamps of the
management of the day. With their support, promoters of businesses in India could
actually enjoy managerial control with very little equity investment of their own.
Borrowers therefore routinely recouped their investment in a short period and then had
little incentive to either repay the loans or run the business. Frequently they bled the
company with impunity, siphoning off funds with the DFI nominee directors mute
spectators in their boards.

This sordid but increasingly familiar process usually continued till the company’s
net worth was completely eroded. This stage would come after the company has
defaulted on its loan obligations for a while, but this would be the stage where India’s
bankruptcy reorganization system driven by the 1985 Sick Industrial Companies Act
(SICA) would consider it “sick” and refer it to the Board for Industrial and Financial
Reconstruction (BIFR). As soon as a company is registered with the BIFR it wins
immediate protection from the creditors’ claims for at least four years. Between 1987
and 1992 BIFR took well over two years on an average to reach a decision, after which
period the delay has roughly doubled. Very few companies have emerged successfully
from the BIFR and even for those that needed to be liquidated, the legal process takes
over 10 years on average, by which time the assets of the company are practically
worthless. Protection of creditors’ rights has therefore existed only on paper in India.
Given this situation, it is hardly surprising that banks, flush with depositors’ funds
routinely decide to lend only to blue chip companies and park their funds in government
securities.

Financial disclosure norms in India have traditionally been superior to most Asian
countries though fell short of those in the USA and other advanced countries.
Noncompliance with disclosure norms and even the failure of auditor’s reports to
conform to the law attract nominal fines with hardly any punitive action. The Institute of
Chartered Accountants in India has not been known to take action against erring
auditors.

While the Companies Act provides clear instructions for maintaining and
updating share registers, in reality minority shareholders have often suffered from
irregularities in share transfers and registrations – deliberate or unintentional.
Sometimes non-voting preferential shares have been used by promoters to channel
funds and deprive minority shareholders of their dues. Minority shareholders have
sometimes been defrauded by the management undertaking clandestine side deals with
the acquirers in the relatively scarce event of corporate takeovers and mergers.

Boards of directors have been largely ineffective in India in monitoring the

actions of management. They are routinely packed with friends and allies of the
promoters and managers, in flagrant violation of the spirit of corporate law. The
nominee directors from the DFIs, who could and should have played a particularly
important role, have usually been incompetent or unwilling to step up to the act.
Consequently, the boards of directors have largely functioned as rubber stamps of the
management.
 For most of the post-Independence era the Indian equity markets were not liquid
or sophisticated enough to exert effective control over the companies. Listing
requirements of exchanges enforced some transparency, but non-compliance was
neither rare nor acted upon. All in all therefore, minority shareholders and creditors in
India remained effectively unprotected in spite of a plethora of laws in the books.

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 Chapter 5
Changes since liberalization

The years since liberalization have witnessed wide-ranging changes in both laws
and regulations driving corporate governance as well as general consciousness about it.
Perhaps the single most important development in the field of corporate governance
and investor protection in India has been the establishment of the Securities and
Exchange Board of India (SEBI) in 1992 and its gradual empowerment since then.
Established primarily to regulate and monitor stock trading, it has played a crucial role in
establishing the basic minimum ground rules of corporate conduct in the country.
Concerns about corporate governance in India were, however, largely triggered by a
spate of crises in the early 90’s – the Harshad Mehta stock market scam of 1992
followed by incidents of companies allotting preferential shares to their promoters at
deeply discounted prices as well as those of companies simply disappearing with
investors’ money.

These concerns about corporate governance stemming from the corporate

scandals as well as opening up to the forces of competition and globalization gave rise
to several investigations into the ways to fix the corporate governance situation in India.
One of the first among such endeavors was the CII Code for Desirable Corporate
Governance developed by a committee chaired by Rahul Bajaj. The committee was
formed in 1996 and submitted its code in April 1998. Later SEBI constituted two
committees to look into the issue of corporate governance – the first chaired by Kumar
Mangalam Birla that submitted its report in early 2000 and the second by Narayana
Murthy three years later. Table 1 provides a comparative view of the recommendations
of these important efforts at improving corporate governance in India. The SEBI
committee recommendations have had the maximum impact on changing the corporate
governance situation in India. The Advisory Group on Corporate Governance of RBI’s
Standing Committee on International Financial Standards and Codes also submitted its
own recommendations in 2001.

A comparison of the three sets of recommendations in Table 1 reveals the

progress in the thinking on the subject of corporate governance in India over the years.
An outline provided by the CII was given concrete shape in the Birla Committee report
of SEBI. SEBI implemented the recommendations of the Birla Committee through the
enactment of Clause 49 of the Listing Agreements. They were applied to companies in
the BSE 200 and S&P C&X Nifty indices, and all newly listed companies, on March 31,
2001; to companies with a paid up capital of Rs. 10 crore or with a net worth of Rs. 25
crore at any time in the past five years, as of March 31, 2002; to other listed companies
with a paid up capital of over Rs. 3 crore on March 31, 2003. The Narayana Murthy
committee worked on further refining the rules.

The recommendations also show that much of the thrust in Indian corporate
governance reform has been on the role and composition of the board of directors and
the disclosure laws. The Birla Committee, however, paid much-needed attention to the
subject of share transfers which is the Achilles’ heel of shareholders’ right in India.

Annexure shows the frequency of compliance of companies to the different

aspects of the corporate governance regulation. Clearly much more needs to be
accomplished in the area of compliance. Besides in the area of corporate governance,
the spirit of the laws and principles is much more important than the letter.
Consequently, developing a positive culture and atmosphere of corporate governance is
essential is obtaining the desired goals. Corporate governance norms should not become
just another legal item to be checked off by managers at the time of filing regulatory
papers.

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 Chapter 6
Corporate Governance of Banks

Nowhere is proper corporate governance more crucial than for banks and
financial institutions. Given the pivotal role that banks play in the financial and
economic system of a developing country, bank failure owing to unethical or
incompetent management action poses a threat not just to the shareholders but to the
depositing public and the economy at large. Two main features set banks apart from
other business – the level of opaqueness in their functioning and the relatively greater
role of government and regulatory agencies in their activities.

The opaqueness in banking creates considerable information asymmetries

between the “insiders” – management – and “outsiders” – owners and creditors. The
very nature of the business makes it extremely easy and tempting for management to
alter the risk profile of banks as well as siphon off funds. It is, therefore, much more
difficult for the owners to effectively monitor the functioning of bank management.
Existence of explicit or implicit deposit insurance also reduces the interest of depositors
in monitoring bank management activities.

It is partly for these reasons that prudential norms of banking and close
monitoring by the central bank of commercial bank activities are essential for smooth
functioning of the banking sector. Government control or monitoring of banks, on the
other hand, brings in its wake, the possibility of corruption and diversion of credit of
political purposes which may, in the long run, jeopardize the financial health of the bank
as well as the economy itself.

The reforms have marked a shift from hands-on government control interference
to market forces as the dominant paradigm of corporate governance in Indian banks.
Competition has been encouraged with the issue of licenses to new private banks and
more power and flexibility have been granted to the bank management both in directing
credit as well as in setting prices. The RBI has moved to a model of governance by
prudential norms rather from that of direct interference, even allowing debate about
appropriateness of specific regulations among banks. Along with these changes, market
institutions have been strengthened by government with attempts to infuse greater
transparency and liquidity in markets for government securities and other asset
markets.

This market orientation of governance disciplining in banking has been

accompanied by a stronger disclosure norms and stress on periodic RBI surveillance.
From 1994, the Board for Financial Supervision (BFS) inspects and monitors banks using
the “CAMELS” (Capital adequacy, Asset quality, Management, Earnings, Liquidity and
Systems and controls) approach. Audit committees in banks have been stipulated since
1995.

Greater independence of public sector banks has also been a key feature of the
reforms. Nominee directors – from government as well as RBIs – are being gradually
phased off with a stress on Boards being more often elected than “appointed from
above”. There is increasing emphasis on greater professional representation on bank
boards with the expectation that the boards will have the authority and competence to
properly manage the banks within the broad prudential norms set by RBI. Rules like non
lending to companies who have one or more of a bank’s directors on their boards are
being softened or removed altogether, thus allowing for “related party” transactions for
banks. The need for professional advice in the election of executive directors is
increasingly realized.

As for old private banks, concentrated ownership remains a widespread

characteristic, limiting the possibilities of professional excellence and opening the
possibility of misdirecting credit. Corporate governance in co-operative banks and
NBFCs perhaps need the greatest attention from regulators. Rural co-operative banks
are frequently run by politically powerful families as their personal fiefdoms with little
professional involvement and considerable channeling of credit to family businesses. It
is generally believed that the “new” private banks have better and more professional
corporate governance systems in place. However, the recent collapse of the Global Trust
Bank has seriously challenged that view and spurred serious thinking on the topic.

_______________
 Chapter 7
Conclusion

With the recent spate of corporate scandals and the subsequent interest in
corporate governance, a plethora of corporate governance norms and standards have
sprouted around the globe. The Sarbanes-Oxley legislation in the USA, the Cadbury
Committee recommendations for European companies and the OECD principles of
corporate governance are perhaps the best known among these. But developing
countries have not fallen behind either. Well over a hundred different codes and norms
have been identified in recent surveys and their number is steadily increasing. India has
been no exception to the rule. Several committees and groups have looked into this
issue that undoubtedly deserves all the attention it can get.

In the last few years the thinking on the topic in India has gradually crystallized
into the development of norms for listed companies. The problem for private
companies, that form a vast majority of Indian corporate entities, remains largely
unaddressed. The agency problem is likely to be less marked there as ownership and
control are generally not separated. Minority shareholder exploitation, however, can
very well be an important issue in many cases.

Development of norms and guidelines are an important first step in a serious

effort to improve corporate governance. The bigger challenge in India, however, lies in
the proper implementation of those rules at the ground level. More and more it appears
that outside agencies like analysts and stock markets (particularly foreign markets for
companies making GDR issues) have the most influence on the actions of managers in
the leading companies of the country. But their influence is restricted to the few top
(albeit largest) companies. More needs to be done to ensure adequate corporate
governance in the average Indian company.

Even the most prudent norms can be hoodwinked in a system plagued with
widespread corruption. Nevertheless, with industry organizations and chambers of
commerce themselves pushing for an improved corporate governance system, the
future of corporate governance in India promises to be distinctly better than the past.

_______________
 Annexure

Alternative corporate governance mechanisms

While corporate governance mechanisms differ from country to country, there are two broad
categories of financial systems which differ in their very basic structure. These are the market-
based system exemplified by the British and American systems and the bank based system
typified by Japan and Germany. Varying paths of financial evolution situate countries at different
points in this market-institution spectrum with their positions determined by the nature of their
economic endowments and the historical and political forces that shape their societies.

The market-based system or the Anglo-Saxon system, marked with effective distancing of
ownership and control, trusts financial markets with the ultimate role of corporate governance. It
is characterized by effective an all-powerful CEO, frequently also the chairman of the board of
directors that barely accountable to a highly dispersed group of shareholders who generally find
selling shares an easier way to express their dissatisfaction with inefficient management than
creating a stir against it. Good performance and high share price are essential to keep future cost
of equity capital low. The market for management control and the concomitant takeover threat
then works to make sure that management does not lower shareholder interests. Block
shareholders have relatively less power though financial institutions like pension funds do hold
big chunks of stocks. Banks have practically no control over management.

Corporations in the bank based systems in Germany and Japan function quite differently. In
Germany for instance, share ownership is less diffuse and banks play a much more important
role as providers of finance and monitors of day-to-day activity. The board structure is
substantially different with corporations being run by giant sized supervisory boards,
Aufstichtsrat, about half of whose members are labor representatives. Management is carried out
by another board, the Vorstand, appointed by and answerable to the supervisory board. The
company has a very close relationship with its Hausbank, a universal bank that owns shares in
the company and usually has board representation. The company can rarely take a major step
without the consent of its Hausbank. The power (as well as salaries) of the top management is far
less than that in the Anglo- American model.

The Indian situation may be thought of as a combination of these two conflicting models.
Though the basic corporate legal structure is Anglo-Saxon, share ownership is far less dispersed
and financial institutions play a much bigger role in financing corporate activity. Share
ownership and board representation of financial institutions give these bodies the abilities to
serve as important monitors of management activities though the relationship. The powers,
however, are considerably limited as compared to those in typical bank-based systems and
universal banking is not widespread. Nevertheless, financial institutions, have, in general, failed
to fulfill even their limited role in corporate.

Recommendations of various committees on Corporate Governance in India

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