Theories and Practices of Corporate Governance: Case of Nepalese Banks and Financial Institute

Sabin Bikram Panta

Different theories in the past attempted to study the issue of corporate governance (hereinafter refereed as CG). However, two main problems have emerged in the existing theories. First, despite of regulation and CG codes, it is fair to claim that existing theories are unable to capture the changing dynamics and complexities of business to a large extent which is evident from the regular reoccurrence of the crisis and frauds. Second, the current concepts and theories of the CG lack contextual issues. According to Turnball (1997), most of the theories and concept of CG are developes by US scholars in the height privaion model. Unlike in US and advanced economies, comapnies in developing and underdeveloped markets are mostly held by the founding family, and have weak investor and transparency standards . In such context, the existing theories of the CG may have limited application in developing and underdeveloped countries. Therefore, the current review paper attempts to study the link between theories of CG with the practices in Nepalese Banks and Financial Institutions (BFIs).

Several literatures in the past have highlighted the unique nature of the firm called banks. For example. banks are highly levered with assets that are relatively opaque (Gornall and Strebulaev 2018), banks are exposed to maturity mismatch (Diamond and Dybvig 1983) and have more complex agency relationship (Ciancanelli aand Gonzalez, 2000). From the banks governance perspective, the agent seeks the behavior beneficial to the firm’s interest and does not compromise to the public interest (Ciancanelli and Gonzalez, 2000). This effectively establishes a unique CG system for banks, which is different from the traditional CG of non-bank firms. Most importantly, Nepali capital market is highly dominated by banks and fianancial institute with 78 percentage of total market captalization (Nepal Stock Exchange 2017). Against this backdrop, and the re occurrence of the fraud and failures of some of the BFIs in Nepal in the past, the likelihood of systematic risk is high, if the CG in the BFIs is not practices and maintained.

The debate of governance from theoretical prospective is as old as Berle and Means (1932). The main questons was; should the publicly held corporation serve only the interests of shareholders, and should directors and executives focus only on maximizing shareholders’ wealth through dividends and capital gains (Stout L, 2000)?  According to Stout, this notion is popularly known as Shareholder Primacy. Berle and Means supported the sahreholdelr the corporation so that they can work for the interest of shareholders. Around forty years later, in a famous essay, ‘The social responsibility of business is to increase its profits’ the Nobel laureate economist Milton Friedman defends the role of shareholders as the owners or principals of the firm (Friedman, 1970). Therefore, the primary obligation of managers as agents of shareholder owners is ‘to conduct the business in accordance with their desires and increase the wealth of its represents the other investors. Similarly, the managers are the agents hired by the principals to conduct the work for the best interest of the principals. Therefore, the key activity for the boards is monitoring management on behalf of shareholders and that effective monitoring can improve firm performance by reducing agency costs

However, in reality, principal cannot monitor the performance and activities of the agents all the time due to ‘adverse selection’ and the other ‘moral hazard’ (Eisenhardt, 1989: 58). According to Osterloh and Frey (2003), “corporate governance convention on which the agency theory is based, has run out of stream and its three main methods of counteracting management misuse of power have not only proven ineffective, but also, sometimes, even counterproductive” .

From the prespective of the governance, the relation and the interaction between board and the management is very limited according to the agency theory. But stakeholder theory extended the scope by proposing the relation and the interaction between firm and its stakeholders that must be considered before making any decision by the firm.According to Freeman (1984), organizations benefit from understanding the needs and concerns  of a broad set of stakeholders. Stakeholder theorists object to the sole focus on the shareholders as other groups may have a legitimate claim or “stake” in a corporation. Therefore, firms must consider the interest of all those who has a stake in the firms while taking decisions.

As a result of liberalization policy, numerous banks and fiancial institutions are established from 1990s in Nepal. However, the policy has failed to establish a proper mechanism to analyze if the promoters are fit and proper to establish the banks.  In Nepal, most of the prominent businessmen representing various sectors are the promoters of different banks. There is a saying in Nepal all businessmen are banker and all the bankers are the businessmen. This has created a unique situation of conflict of interest where instead of monitoring and controlling the performance of the management, board members established governance practices. According to the agency theory (Jenson and Meckling 1976) board should monitor and control the performance of the management and create a mechanism where the interest of board and management is aligned. However, principal cannot monitor the performance and activities of the agents all the time due to adverse selection and moal hazard.

Therefore, as opposed to other developed and developing countries, the agency relationship is very unique in Nepalese BFIs for two reasons. First, most of the empirical studies in agency theory primarily focused on the relation between board and management with extensive control mechanism. It is built on the notion that seperation of ownership and control, as is characteristic of the modern corporation, potentially leads to self- interested actions by those in control- managers (Jenson and Meckling, 1976). Similarly the theory also suggests that increased performance is the result of the principal implementing governance structures to curb the opportunistic behaviour of the agent, based on the assumed economic model of man. However, in the context of Nepalese BFIs, the conflict of interest in general, exists among the board members themselves rather than conflict of interest between board and management. Therefore, it is not that question of the conflict of interest between principals and agents; it is in fact an issue of the conflict of interest among the principals. Second, the moral hazard and adverse selection as envisaged by the agency theory largely applies to board members rather than to the management which is evident from the past incidents of loan greening attempt by some of the board of the BFIs in Nepal.

Besides, the composition of the board of the most of the banks in Nepal is not as per the international standard from the prospective of the CG. For example, it is observed that retired high ranking bureaucrats of thr government of Nepal are either the members or the chairman of the board in most of the banks who may not have required in-depth knowledge and understanding of the banking. In addition, most of the board members are businessmen. According to the resource dependency theory (Pfeffer and Salancik 1978) directirs play instrumental roles in providing or securing essential resources to an organization through their linkages to the external environment. Directors bring resources to the firm, such as information, skills, access to key constituents such as suppliers, buyers, public policy makers, social groups as well as legitimacy . Hence, the resource dependency that board can provide is virtually non-existent in Nepalese BFIs.

As per the regulation of the central bank of Nepal, all BFIs are required to appoint one independent member in their board within a criterion. In practice, however, bank management and majority shareholders select “friendly” member in the board as an independent member. The central bank does not carry out fit and proper analysis of the independent board member recommended by the banks. Directors, therefore, are expected to refrain from overt criticism of management’s behaviour in order not to jeopardize their board seat and its associated its ineffectiveness to the theory depicts the board as an ineffective governing institution and attributes its ineffectiveness to the outside directors’ lack of independence from the incumbent management. Moreover, in contrast to agaency theory which assumes greater interdependence of out-side directors, managerial hegemony highlights outside directors’ dependence upon top management for firm- specific information (Wolfun 1984). Such control over selection and flow of information is believed to severely compromise the independence of all board members.

The CG code for BFIs imposed by the central bank of Nepal requires board members to take care the interest of all the stakeholders and not only to the shareholders which is consistent with the stakeholder theory. According to Freeman (1984), organizations benefit from understanding the needs and concerns of a broad set of stakeholders. Stakeholder theorists object to the sole focus on the shareholders as other groups may have a legitimate claim or “stake” in a corporation. Therefore, firms must consider the interest of all those who has a stake in the firms while taking decisions. However, as opposed to non-bank firms, the relation among stakeholdelrs are much complex in the BFIs. The main reason of such complex relation among stakeholders are much complex in the BFIs. The main reason of such complex relation is due to asymmetric information between depositors, the bank and the regulator, between owner, managers and the regulators, and between borrowers, managers and the regulator (Ciancanelli and Gonzalez, 2000). Hence, the agency relation is much more complex in banks than nonfinancial firms.The reform of the board in Nepalese BFIs by making it more inclusive and accountable to stakeholders has not yielded any substantial result so far. It has been observed that the promoter shareholder or group of them with majority stake, generally dominate the management. They influence the decisions in daily operation of the banks which is the violation of the CG code of conduct imposed by the central bank of Nepal. Hence, there is a lack of check and balance in the Nepalese BFIs creating a severe governance problem. Morck and Sterier (2007) posit that elites are self-interested and cooperate to entrench themselves, even at considerable cost. They further advance conservative bias argument which suggests that the controlling owners prefer to lock-in status quo control and resist institutional reforms that might risk their current wealth. Therefore shareholders with majority stakes are more likely to oppose the board reforms as it threats their interest by surrendering certain degree of control to minority investors.

This paper has reviewed the literature on CG theories in the Nepalese BFIs setting. Consistent with Berglof (2011) who underline the differences among CG systems and argues that the same rules could have very different effects in different countries, this paper identify few potential research areas for the future. For example, future research should investigate the isswues of propose a new framework to understand their behaviour. Similarly, the managerial hegemony theory which is not much of the focus in the advanced economies with limited empirical evidences seems to have more prominent presence in the Nepalese BFIs which can be interesting area for the future research.