Article
COMMENT

How not to run a bank or banking industry

31 December, 2013 | Posted By: Petros Florides

How not to run a bank or banking industry
By Petros Florides

The Cyprus Central Bank must be commended for establishing the Independent Commission on the Future of the Cyprus Banking Sector. Chaired by Mr. David Lascelles, it has provided a refreshingly clear account of what went so horribly wrong with Cyprus’ banking sector. In its own words “…the Cyprus banking system has suffered a series of disasters which have transformed what was once a large and prosperous industry into a national catastrophe.”
The report could easily have been entitled ‘How Not to Run a Bank or Banking Industry’. In addition to recommendations for the future, it documents the actions (or inaction) of different actors and stakeholders who, collectively, determined the quality of internal and external governance that pertained to Cypriot banking.
As contained in the Commissions’ report: “As late as February 2011, the IMF’s Article IV report on Cyprus concluded that ‘The Cypriot banking system has weathered the economic difficulties well and appears to be in sound overall condition’…This striking conclusion gave the authorities considerable comfort at the time.” Although not mentioned, both the Bank of Cyprus and Cyprus Popular Bank also passed the European Banking Authority’s so-called ‘stress test’ providing, unfortunately, further comfort (if not wholly undeserved ‘bragging rights’ that were exploited at the time).
But before we lay blame for our current woes on international agencies for providing insufficient regulatory oversight, let us consider our own performance.
Despite financial services contributing an ever-increasing amount to Cyprus GDP, the report notes the absence of a coherent national financial services strategy. As quoted in the report by one respondent: “We have one for tourism, why not for banking?” This was despite the banking industry peaking at nine times GDP. The report goes on: “The most significant high level cause of the crisis was a failure at the national policy level to appreciate that running a big banking industry is about risk as well as reward.” Furthermore: “There may even have been a (possibly subconscious) inclination to ignore these risks in order to avoid ‘spoiling the party’. This set a political tone in which low priority was given to monitoring banking risks, and to supervising banks themselves.” To make matters worse: “the political establishment seems to have difficulty accepting that the banking system and its regulators need to be independent.”
Cyprus’ fragmented structure of financial supervision also gets mentioned. One of the recommendations is to consolidate the four responsible bodies into a single regulatory entity placed within the Central Bank. Unfortunately, its own governance has left much to be desired. As the report states: “Governance of the CBC has been deficient as regards to the effectiveness of checks and balances on the role and power of the Governor, the method of appointment of board directors, and the strength of internal audit.” The following case is cited by the report to illustrate: “A Financial Stability Unit in the CBC…was indeed putting out impressively accurate warnings about emerging risks, but these were treated as unwelcome higher up the line.” Suffice to say the Commission feels compelled to suggest: “The new governance arrangements at the CBC must ensure that unwelcome news cannot be suppressed or ignored.” Further failings of prudential supervision and regulation are noted including those relating to, inter alia, leadership, challenging bank strategies, restraining imprudent lending, follow through on regulatory concerns, credit origination and poor enforcement of supervisory decisions.
The relationship between external auditors and supervisors is identified as an area for improvement. For example: “The trilateral meetings between the CBC, external auditors and bank boards were allowed to lapse” Encouragingly, we are told these have since resumed. More worryingly, the report also states: “The Cyprus Securities and Exchange Commission is responsible for enforcing accounting standards in the reporting of listed companies. Studies which have already been undertaken raise a sufficient number of questions about the quality of accounting in banks for it to be important that these be properly investigated.” Specifically, reference is made to banks’ performance appearing, perversely, to improve as a result of judgments made by the directors of Cypriot banks related to non-performing loans and Greek government bonds! The report emphasises how the exercise of “…judgment is critical, as is the willingness of the auditors to test those judgments.” Another area of concern for the Commission is audit-partner rotation “taking place in name only and with considerable influence played by a relationship partner of long standing.” It is also noted how Cyprus is one of the last countries in the EU to adopt a system of direct inspections by the public oversight body of public interest entities.
The role shareholders played in the governance of the banks is notable by its absence. Despite their rights in the company, shareholders effectively rendered themselves irrelevant. The Commission “encourage[s] shareholders to play a more active role in holding the banks to account by means of greater transparency.”
Notwithstanding the above contributions to the external governance environment, the report opines “The failure of corporate governance was one of the most important reasons why Cyprus’ biggest banks brought disaster upon themselves.” The Commission’s description of governance within the banks includes “weak boards, with inappropriately qualified members”, “board procedures were flouted, reporting lines diverted, and necessary information did not reach the directors”, “board members were deliberately kept in the dark”, “little belief in the value of strong corporate governance”, and “culture was one of deference rather than challenge”. This allowed “powerful senior executives to pursue risky strategies that were strongly influenced by personal ambition, and to bypass internal controls and procedures.” Regarding internal audit, the fact the Commission considered it necessary to dedicate a whole section to explain its role within financial services speaks volumes. In summary of its opinion: “The Commission believes…that stronger internal audit functions in the banks could have played a significant role in averting the Cyprus banking crisis.”
In contrast to shareholders, bank employees are described as “highly unionised and powerfully organised”. The report goes on: “Collective agreements involving all banks means there is no wage competition between them. The union also effectively controls bank opening hours, manning levels, recruitment and promotion. This has resulted in a well-paid but relatively inflexible labour force which has raised banks’ operating costs and arguably held back innovation and discouraged new entrants into the banking market.”
So, what are some of the governance lessons that can be drawn? Firstly, every actor and stakeholder group has a valuable role to play regarding governance whose quality will suffer if that role is not fulfilled properly. Secondly, if only certain stakeholder groups are active whilst others passive, the necessary tension required to achieving a fair compromise between competing interests is lost. This reduces the quality of governance yet further. Thirdly, effective governance requires substantive engagement over and above superficial compliance. This requires demonstrable application of sound principles including, inter alia, transparency, accountability, honesty, fairness and sustainability within a robust framework of enterprise-wide risk management. Fourthly, non-negotiable corporate governance standards must replace the voluntary guidelines that currently exist. These proved no match against Cypriot cultural idiosyncrasies and our addiction to bad governance and poor practices. To focus the mind of those responsible, new corporate governance standards should be reinforced with personal liabilities on transgressors. This can be achieved through a combination of targeted law and regulation.
To avoid a repeat of the past, the ‘New Governance for a New Cyprus’ initiative aims to promote holistic governance for all systemically important public interest entities (whether publicly or privately owned). The aim is to ensure all actors and stakeholders fulfill their role in accordance with their rights and responsibilities. Anybody interested in contributing to the development of such an environment is invited to write to
petros.florides@wvi.org .

 

The views in this article represent those of the author and not any other individual or organisation.
Petros Florides is Regional Governance Advisor for World Vision International, and Executive Officer of World Vision Cyprus. Petros is also on the board of the Institute of Directors (Cyprus), co-founder of the Cyprus National Advisory Council for the Chartered Institute for Securities & Investments, co-founder of the Institute of Risk Management Cyprus Regional Group, and a Chartered Management Accountant.