RegionsMiddle EastThe Role of Compliance in Strengthening Corporate Governance

The Role of Compliance in Strengthening Corporate Governance

Over the past two months, the United Arab Emirates (UAE) has been reeling with one wave of bad news after another. Apart from the contagion effect of global bearishness on capital markets and the credit crisis, the Dubai Financial Market and the Abu Dhabi Exchanges have been traumatised by a string of high profile investigations into alleged financial irregularities by senior executives of public and private entities from the real estate sector. Yet another investment firm, Shuaa Capital, was fined by the Dubai Financial Services Authority (DFSA) for marking up the book value of its proprietary portfolio by quoting bid prices at off market rates during the closing minutes of trading on 31 March.

The questions that come to mind are: where were the internal control processes of these companies that rendered their governance practices so ineffective? Was there adherence to the principles of dual control and segregation of duties that is the foundation of good banking? Do members of the board of directors and senior management meet the fit and proper guidelines recommended by regulators to demonstrate integrity and competence? As the details slowly become public, it is clear that greed and ego caused individuals to abandon the ‘ethical compass’ and indulge in activities that are detrimental to their company’s interest.

It takes a series of frauds or fine-based scandals to reiterate the importance of a financial institution’s governance, risk and compliance framework. Whether it is liquidity risk or operational risk, the onus is on the board of directors to ensure that the various risks affecting the firm are identified, monitored and controlled. One cannot expect directors to micromanage each line of business or oversee all transactions – it is, however, their responsibility to ensure that they hire individuals who have integrity, who can exercise sound judgment and are competent to advise them proactively on the high risk and emerging risk areas, while ensuring that there are effective preventive and detective controls over the lower risk activities.

In today’s credit crunch, it is clear that financial institutions can accrue benefits ranging from tangible cost efficiencies (in terms of borrowing costs) to improved reputation, if they have a strong internal controls and compliance culture. By the same token, an increased perception of risk due to poor controls can see the share price plummet, as was the case in Enron and World Comm. This has been substantiated in a recent study conducted by Lord & Benoit, which revealed that companies that had ongoing violations saw their share drop by 6%.

Following the recent credit crisis, Norton Rose surveyed 195 respondents (comprising financial institutions and other mainstream corporate entities) to seek the opinion of financial services professionals on the impact of the latest phase of the credit crunch and its effect on corporate behaviour. One of the results of the survey is indicated in the graph below:

Figure 1: Has Corporate Behaviour in the Following Areas Changed Since the Credit Crunch?

Source: Norton Rose LLP Survey, September 2008

There is no doubt that increased regulation and a strengthening of processes is called for to mitigate risks irrespective of whether they pertain to credit, market, operational or liquidity conditions. What is required is enhanced corporate governance, where there is a clear understanding and delegation of responsibilities right from the board of directors to the officials who are responsible for day-to-day management. A robust compliance framework goes a long way in achieving this.

Elements of an Effective Compliance Framework

Senior management responsibilities

Compliance risk management is most effective when it is implemented across the organisation in close co-ordination with the risk management and the internal audit departments. Ideally, all three departments should be kept updated by line managers in terms of strategic and new product development efforts to ensure that there is an independent view of potential conflicts, identification of underlying risk and the assurance of adequately trained systems and back office staff to support the new product/s. It is not uncommon that in the race to launch a new feature, procedures and controls are glossed over to be introduced ‘at a later stage’. The net impact is that post-launch, there could be ambiguity in terms of undocumented back office processes and a lack of understanding among staff, which in turn lead to errors and enhanced operational risk.

Structure

The structure of the compliance function varies based on the size and complexity of the financial institution. The ability to access all operational areas of the firm helps compliance to cut across business lines, and identify weaknesses or violations of internal or external regulations that may not be effectively managed. The next step involves plugging the gaps, which requires prioritisation of resources with adequate participation from the relevant business and support units. This is best achieved in organisations where there is complete support from the CEO for corporate governance and where the compliance function in turn is proactive in addressing issues before exceptions occur. This helps protect the reputation of the firm, as well as builds credibility internally and externally.

Scope

New regulations and prudential reporting requirements are being introduced by regulators each year to improve transparency and accuracy. It is easy to lose track of what needs to be reported and when. An up-to-date checklist as indicated by the box below goes a long way in recording requirements and ensuring that no deadlines are inadvertently missed.

# Description of Reporting Deadline Rule Reference # Current Status

 

The new and changed regulations also have to be analysed to determine the impact on relevant internal processes. These may have to be modified appropriately to ensure adherence to prudential reporting. This is a task that can be efficiently conducted by compliance.

Improved training

Another survey by Lord and Benoit revealed that the top 10 threats to Sarbanes-Oxley (SOX) compliance for smaller public companies in the US appear to be:

  1. Control environment.
  2. Design of controls or lack of effective compensating controls.
  3. Accounting and disclosure controls.
  4. Competency and training of accounting personnel.
  5. Revenue recognition.
  6. Financial closing process.
  7. Treasury related back office controls.
  8. Inadequate account reconciliations.
  9. Information technology.
  10. Consolidations, mergers, and intercompany accounts.

While the governance of a bank’s compliance and risk management programme is invariably ‘top down’, a successful framework involves the training of staff at all levels and across departments. It is the responsibility of senior management to keep front and back office employees trained to keep up with the changes in regulations and best practices in internal controls. The culture of compliance has to be built systematically across the organisation from grass roots through a series of familiarisation programmes. Training can be centralised within the human resources (HR) department, or can rest with the individual departments, depending on the size of the institution.

Robust MIS tools

There is always scope for improvement when it comes to using management information systems (MIS) effectively. It is a common feature among banks that different data is maintained and processed in different architectures. For example, a commercial bank may have a separate treasury system, lending system, credit card system, trade finance system, asset management system and risk management system, etc. In such a scenario, determining a simple key risk indicator, such as classified loans to total loans, or the aging profile of receivables, typically involves intense manual computations – invariably on Excel. The more efficient way of ensuring timely and accurate MIS, is to use ETL (Extract, Transform, Load) tools to bring data from the myriad of systems to a common platform, and then build information queries and reports accordingly from this staging area. In the long run, the benefits of accuracy and elimination of manual effort/excessive dependence on people, far outweigh the pain of dealing with missing fields and data cleanup.

Conclusion

The events of the past two months have determined the need to improve trust and market confidence between customers of financial institutions, interbank counterparties and the regulators. Improved compliance and corporate governance go a long way in strengthening these ties and enhancing market perception.

The views expressed by the author are hers alone and need not necessarily represent those of the organisation.

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