Futile reform

The Korea Federation of Banks (KFB) announced new rules over the outside director system for banks on January 25. As the guidelines are not drawn by a regulatory body, they may carry no legal binding force. But since they are proposed by the industry association, they will urge voluntary compliance. The move may open a new chapter in financial regulations but it contains elements of state control over the finance industry, revealing the limitations of the current banking regulations.

Korean banks have no controlling owners in tradition as the government put a strict restraint on one's ownership. Financial authorities such as the finance ministry and bank supervisory commission had the right to appoint top managers of local banks until the nation received the emergency loan from the International Monetary Fund to avert a sovereign default in the late 1990s. After the financial crisis, the government has exercised its influence over the selection of banks' board members and presidents through a recruitment committee in the name of better governance. As the recent meltdown of the global financial system sparked by the U.S. sub-prime loan crisis has stirred up debates over the governance problems, the government has shown its strong will to improve the banks' ownership structure through the new guidelines, including the restraint on the terms of outside board members.

But the proposed reform is unlikely to avert criticism that it contains little substance, as seen in the scheme to overhaul the governance structure of state-owned companies.

Rubber stamp

Corporate governance is a means to secure management efficiency. In other words, we can say the star performers in business have the best governance structure.  

However, the guidelines proposed by the KFB appear to be intended to stop the practices that outside board members serve merely as a rubber stamp and make them effectively supervise the management executives. In short, the reform is aimed at check and balance, rather than management efficiency. 

The outside director system has stirred up much controversy over its effectiveness at the initial stage. The majority believed that an independent outside board would improve transparency and guarantee management efficiency. The opponents pointed out the limitations of the system as seen in the U.S. case as outside board members failed to gain a full independence from the executives and turned into a rubber stamp. They predicted that the corporate governance reform would be ineffective and only add costs.

In conclusion, the KFB's guidelines remind us of the debates seen years ago when the outside director system was first introduced. They believe that outside directors lack expertise and fail to act independently only to serve as a rubber stamp, falling far short of their original functions to check and supervise top managers. Therefore, the KFB aims to prevent incompetent outside directors from staying in office too long. 

But there are only few arguments supported with empirical data that a long term for outside directors weakens their authority as a supervisor and bars from building up expertise. The outside board member system was introduced 12 years ago in Korea but no researchers have ever since proved an improvement in a company's competitiveness as a result. In contrast, criticism has been growing that the arrangement led to a decrease in registered board members, putting the legal status of executive officers at risk. To resolve the problem, some proposed to revise the law to allow executive officers to register themselves as a board member. Other efforts to improve the system have been made consistently. 

In conclusion, the outside director system is still seen as playing little positive role for the corporate governance structure in Korea. 

Reform focused on limited terms of outside directors

The underlying objective of the KFB's new standards is known to ban chief executive officers at some financial companies from taking the helm too long. To this end, the rules slashed the term of outside board members to 2 years from the current 3 years and put a restriction to ban any directors from serving more than 5 years. A fifth of board members should be replaced with new directors every year. They have to quit after five years in office, regardless of their contribution to banks' management efficiency. 

As such, there are many elements in the new standards that could raise criticism that they are not really aimed at banks' management efficiency but rather a move for the financial watchdogs to expel the defiant and enhance their own power.

The KFB should have come up with more compelling reforms in order to get away with the suspicious view. A proposal to ensure the bank's autonomy over selecting outside directors would have received warmer welcome. 

The problem with our current system is to force banks to hire outside directors by law. Not only banks but also all other financial institutions and listed companies are required to have outsiders in their boardroom. For example, the current rules require banks to have half of their board as outsiders while the latest proposal urges them to hire outsiders for even more than half of the board. Under the new rules, the board of a bank should be chaired by an outside director, not an incumbent president. In other words, the board should hire one more outside director if the board has even number of members and one of the outsiders should be at the helm. Accordingly, a bank with even number of board members should begin in March to add one outside director and appoint one of outsiders to the chairmanship.

In conclusion, the new guidelines are a means to infuse the banking industry with a new stream of experts by creating more seats for outside directors.

The guidelines need to be reviewed and reconsidered

The government has put restraints on bank ownership in a bid to keep its grip on financial industry. Many people blame that the state control is responsible for making banks the weakest industry in terms of global competitiveness even after injecting the biggest amount of taxpayers' money. The criticism is not entirely correct but has many points that we can empathize. But it's hard to find how to break through the long-standing practices of state control. As long as the taboo to prohibit industrial capital from financial industry stays in place, the state control over the financial companies would not disappear forever. But the KFB's guidelines have shown again how much harm the state control can do to the financial industry. In short, their proposal for corporate governance reform has failed to address how to improve the banks' management efficiency but focused on limiting the terms of outside directors.

Enterprises are an entity that can earn money only when their creativity of management is respected. As such, when the government imposes a forceful governance overhaul irrelevant to the management efficiency in an indirect way through an industry association, it would hamper the development of the banking industry. Furthermore, the state-run National Pension Service announced that it would withdraw their investment from a bank who fails to comply with the new rules. Korean banks really got in a fix. Although I have no sympathy for the top managers, the business environment for local banks is too grim.

Samsung Electronics has recently posted the world's biggest revenue and profit. Korean shipbuilders and carmakers have risen to global players while sports stars in figure skating and golf swept victories in international games. But we haven't heard any similar success from domestic financial institutions. Rather, they have shown disappointing performance with financial distress and public fund injections. The future of the banks and other financial companies who are regarded as ugly ducklings depends on the government. It will be more efficient when the government retrains its influence over them and instead grants more autonomy. In this sense, the KFB's guidelines need more review and reconsideration.

By Cheon Sam-hyun / Professor at Soongsil University