Thursday, November 23, 2017
Analysis & OpinionsBankingFeatured

BoU: How Banks Can Avoid Collapsing

Bank of Uganda (BoU) Deputy Governor, Dr Louis Kasekende has advised banks on how they can stay sound and strong.

Kasekende revealed corporate governance, external auditors and prudential regulation and supervision by the Central Bank are key in keeping banks sound and strong.

He said this while delivering a Keynote address to the 22nd Annual Seminar of Certified Public Accountants of Uganda held at Imperial Resort Beach Hotel, Entebbe on Wednesday 6th September, 2017.

He noted that the purpose of corporate governance in a bank is to ensure that those who control a bank – the controlling shareholders and senior managers – do not abuse their powers of control to manage the bank in manner which is detrimental to the interests of all other stakeholders; the minority shareholders, the depositors and other creditors, other customers of the bank and the broader public.

“The primary responsibility for ensuring good corporate governance in a bank lies with its Board of Directors. All directors must be approved by the BOU. They must be of the highest integrity and have professional expertise relevant to banking, such as accounting qualifications,” Kasekende said.

He added: “Each director of a bank is individually responsible for the conduct of the bank and can be held responsible for any misconduct by the bank. The corporate governance regulations also emphasise the importance of the internal audit function of a bank. Each bank must have an internal auditor who is independent of the bank management and who reports to the audit committee of the board of directors.”

He explained that the duties of the internal auditor include evaluating the accuracy of financial information prepared by the bank’s accounting and computer systems and monitoring the management’s compliance with the policies and procedures of the bank.

“Internal auditors must not only possess a very high degree of professional expertise and integrity, they must also have the strength of character to stand their ground against senior management and controlling shareholders when this is necessary,” he said.

He added that the external auditor must perform an audit of the annual financial statements of the bank in accordance with international accounting standards – the International Financial Reporting Standards (IFRS) – and give an opinion on these statements.

“The external auditor of a bank has responsibilities both to that bank’s board of directors and to the bank regulator, the BOU. The audited financial accounts of a bank must be published and this is intended to enhance transparency and thus strengthen public confidence in the banking system,” he said, adding that  each bank must appoint its external auditor from a list of accounting firms which have been pre-qualified by the BOU.

Bank Regulation And Supervision

Kasekende revealed that despite banks having to meet high standards of corporate governance and subject to external audit by accounting firms, the experience of the global financial crisis at the end of the last decade demonstrated that optimism about the efficacy of market forces alone to guarantee sound banking was misplaced.

In the run up to the crisis, market forces drove banks to maximise short run returns on equity at the expense of long run stability, with catastrophic results.

“The fundamental reasons why market forces are not sufficient to ensure a sound banking system are twofold. The first is the inherent divergence of interests between banks’ equity holders and their depositors, which I have already mentioned. This divergence circumscribes the effectiveness of a bank’s board of directors to fully protect the interests of its depositors, because directors are ultimately responsible to shareholders and if the shareholders are dissatisfied with the actions of their directors, they can replace them,” he said.

He added: “The shareholders themselves, especially institutional shareholders, are often under intense market pressure to maximise short term returns. This means that good corporate governance alone cannot be sufficient to guarantee the interests of a bank’s depositors.”

 

The second reason, he said, pertains to the capacities and incentives of depositors to enforce market discipline on banks. In theory, depositors could do this by only depositing money in banks which are soundly managed and very unlikely to fail.

“In reality, this is impractical, because most depositors lack the expertise to analyse the financial soundness of a bank, even when accurate financial statements are available, and they lack the optimal incentives to do this because of “free rider” problems. As a result, banking involves negative externalities which can only be mitigated by public regulation and supervision. The regulator must act on behalf of the depositors to curb the incentives facing banks to take excessive risks with depositors’ money,” he said.

He however noted that bank regulation and supervision is never a guarantee against bank failure.

“If banks are to fulfill their role as financial intermediaries – mobilising funds from savers and lending these funds to investors – they must take some form of risk; they cannot invest only in riskless assets. What is crucial is that banks understand the risks they incur and manage them properly, for example through appropriate diversification, so as to minimise the risk of bank failure. Nevertheless, in a world in which the future is inherently uncertain and which is subject to shocks, bank failures will sometimes occur, even in well regulated financial systems,” he said, adding that the primary objective of bank regulation and supervision is not to prevent all bank failures, as that is impossible, but to minimise the losses to deposits in the event that bank failures do occur, through prompt regulatory interventions in distressed banks, and to ensure that individual bank failures do not cause contagion which might lead to a systemic crisis in the banking system.

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