Holding autonomous central banks accountable

Dhaka,  Fri,  28 April 2017
Published : 17 Mar 2017, 21:06:02
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Holding autonomous central banks accountable

Jamaluddin Ahmed
Effective disclosure and integrity help central banks strike a balance between autonomy and accountability. An effective system of central bank reporting, backed up by demonstrably good governance, is instrumental in proper functioning of an autonomous central bank. The challenge is how to hold central bankers accountable since they are unelected public officials, managing public resources and implementing policies that affect society at large. The demonstration of appropriate oversight of internal control and financial reporting provides central banks with strong grounds to defend themselves against unwarranted external influence.

The focus on governance and accountability provides strong incentives for a central bank to adopt an audit committee, drawing on the experience of other sectors. For a central bank entrusted with banking supervision, establishing an audit committee would actually be a 'practice-what-you-preach' approach since corporate governance principles are applied in commercial banks.

The core function of an audit committee in a central bank remains similar to that of other sectors to oversee the integrity of internal control and the transparency of financial reporting. Depending on the governance structure specified in the law, the audit committee functions may be discharged by a body acting as a sub-committee of the governing board or as the body with direct responsibility for discharge of the functions. The audit committee is not involved in management or operational duties; its focus remains on the board's discharge of fiduciary obligations.

Several challenges arise in central banks' application of accounting standards which could distinguish their audit committees from those in other sectors. The trend towards harmonisation of central bank accounting under International Financial Reporting Standards (IFRS) facilitates comparability, transparency, and helps avoid that central banks 'cherrypick' their accounting treatment. It also increases the responsibilities of boards and audit committees in reviewing accounting policy and disclosures. Difficulties may arise from the central banks' not-for-profit focus, a move to an expanded use of fair-value accounting, and the best practice of only including realised gains in central bank transfers of profits to governments. While striving towards compliance with prevailing accounting standards, a central bank must ensure that financial reporting neither conflicts with its objectives and law, nor exposes its capital base. Disclosure requirements, in the area of liquidity support for commercial banks or the composition of foreign reserves portfolios for instance, may conflict with the bank's policy functions. IFRS requirements to report foreign currency revaluation gains and losses through the profit and loss account can generate significant volatility in the central bank's profit due to the specific structure of its balance sheet. These issues require care when preparing financial statements to ensure that the statements reflect reality, do not generate perverse incentives and still comply with the IFRS requirements. This may necessitate some education of stakeholders.

EMERGING CHALLENGES FOR CENTRAL BANKS: Supplementary disclosures beyond areas prescribed by the accounting framework may help boards better fulfill their fiduciary responsibilities. Both public-and private sector entities have found that the growing complexity of financial statements makes it difficult for readers with limited financial literacy to understand them. Central banks may draw on the experience of codes in the US, Canada, and the UK for such supplemental disclosures elaborated. For central banks to maximise the benefits of communicating with financial markets, better, rather than more, transparency is required. In financial reporting, this may entail providing further explanations to help interpret the central bank's balance sheet, since the absence of a profit maximization objective makes it more difficult to assess a central bank's performance. An independent audit committee may facilitate this process for central banks.

The diversity of stakeholders with an interest in central bank disclosures underscores the need for carefully crafting their communication strategy. Politicians, financial institutions, economists, and the public at large all form part of the central bank's audience, with varying interests in operational details and levels of financial literacy. Yet, the technical nature of modern financial statements requires their readers to be financially literate. Central banks may, therefore, base their disclosures on a non-technical summary of the balance sheet and profit and loss statements, written in a form that all readers can understand. If these disclosures are mandatory and have to be audited by the external auditor, the audit committee would either oversee these additional disclosures as part of its oversight of the external audit function, or include the preparation of disclosures within its own responsibilities.

Applying the corporate sector's experience with audit committees to central banks is a challenge, as institutional objective and governing incentives differ. Reliable and transparent financial statements are crucial for central bank credibility and effectiveness, but the overriding objectives-typically price stability and financial sector stability-differ from those of shareholder wealth maximisation. A Governor's incentives are also fundamentally different to those of a commercial corporation's CEO and performance is measured against a range of indicators other than the 'bottom line'. Their objective function is broader than salaries and pensions, as it also includes such incentives as reputation and stature and may explain why well-qualified individuals opt for public sector or central bank employment in spite of lower pay. The focus of central bank financial disclosure and the functions of its audit committee will, therefore, tend to differ from that of a private sector entity.

HOW AUDIT COMMITTEE FITS IN A CENTRAL BANK: Notwithstanding functional demarcations within a central bank, it is the complementarities between them that support the thrust toward good governance. The audit committee is a subset of the governance function, neither replacing internal or external audit functions, nor interfering in management's operational responsibilities. Rather, its role is to ensure the existence of effective systems of internal controls, risk management, and financial reporting. To do so, it relies on the management, internal audit, accounting and risk management and external audit functions.

Only through a process of iterative interaction with key governance functions of the central bank will an audit committee be able to fulfill its duties. Cooperation and open lines of communication should be established across the organisation for the audit committee to effectively discharge its functions. It is important to view the audit committee within the broader governance framework.

The key to oversight effectiveness is a carefully designed organisational structure which removes the possibility for any gaps or overlaps in responsibilities. This entails a clear understanding of what each of the central bank's functional areas is required to oversee, and the manner in which it should report back to the board and interact with its counterparts. Regardless of the way the central bank is configured, it is important that its audit committee function integrates seamlessly into the overall governance framework.  

The form and extent of delegation should balance the advantages of supporting the board's execution of fiduciary duties against the danger of diluting its responsibilities. The ultimate responsibility for financial integrity remains vested in the board of directors, even though the authority to discharge this responsibility may be delegated to the audit committee. The board is obligated to find the time and have the expertise to fully interpret and explain its financial statements, which can be facilitated by the audit committee. Yet, a potential for reputational risk may emerge if the public fails to understand the true financial condition of the central bank. This provides a key role for an audit committee (or a similar body) to carefully design and execute the central bank's financial disclosure strategy.

ISSUES TO CONSIDER WHEN DESIGNING AN AUDIT COMMITTEE: Fiduciary governance duties require quality and transparency of the financial reporting process and adequacy of internal control environment. Authority refers to delegated authority from the board, but ultimate responsibilities remain with the board. An Audit Committee reports to the board, but must keep in mind its fiduciary responsibilities. Minutes of meetings should be also circulated to the board. There must be special statement in annual financial statements or in the annual report. The committee must be independent to remain credible. It has difficult issues to handle: prior employment at the bank, receipt of compensation, close familiar ties with the management team, representation of a major shareholder, a significant customer or supplier. It is ideally composed of non-executive directors or at minimum the majority. One or more of these may be a board member. The committee should be able to co-opt independent technical experts. Other participants can be invited to meetings, including the CEO, chief financial officer (CFO), internal auditor, external auditor, and, when necessary, the legal counsel. The size of an Audit Committee depends on extent of responsibilities, not less than 3, typically 3-6 members. The committee is generally aligned with board membership with typically 2-3 years with the possibility for reappointment with a view to balancing continuity. Continuity can also be ensured with staggered terms, in which case a larger committee can alleviate shorter terms. Shorter terms, however, may also contribute with freshness (new members bring in a different perspective). At least one member of the Audit Committee should have accounting or related financial management expertise. S/he should be a senior financial officer with oversight responsibilities, and should have experience in risk management and must be able to commit sufficient time and resources to the assignment. Depending on the composition, a non-executive board member may function as chairman, hence acting as a focal point for reporting to the board. The Audit Committee should have regular meetings with adequate time to review various reports and financial statements. Meetings should correspond with major phases of financial reporting and audit cycles. Agenda and supporting material should be distributed early enough before the meetings to allow proper consideration. Four to six meetings a year are common. An Audit Committee should have resources-administrative and secretarial support- necessary to fulfill its functions. New members should be provided with adequate background information and training. Although establishing an oversight body such as an Audit Committee is increasingly accepted as a means of strengthening governance, it is important to maintain realistic expectations. An Audit Committee adds value by contributing to enhanced objectivity of financial reporting and internal controls, thus providing further assurances of integrity in the conduct of business. The advantage of a set-up based on delegated authority is that there is an independent check on internal audit, and through its role as focal point for the organization's relations with external auditors, it facilitates the external audit process. The strength of an audit committee is its ability to seek out information until completely satisfied with the explanation provided.

The board of directors should ensure that the members of its audit committee have sufficient time to devote to their allocated task, and are not overburdened by other responsibilities. While serving on several boards may provide valuable experience and reputational benefits, external directors may also have other obligations that impede their effective oversight. Hence, the empirical evidence is mixed.

In designing oversight mechanisms, central banks may wish to consider the dangers of overloading audit committee members with too many responsibilities and ignoring the 'expectation gap' (Koh and Woo, 1998) that may emerge from placing undue emphasis on audit committees to uphold accountability and integrity. Another important factor to keep in mind is that the emphasis on audit committee expertise and authority may have an unintended consequence of creating confusion over liability, unless it is made very clear that the board of directors is ultimately responsible.  Given the protection that many central bank laws afford to their staff in the conduct of their official duties, it may be helpful to delineate the extent to which non-executive members of their audit committees may be held liable for breach of duty or lack of due diligence.

For an Audit Committee to be effective, its precise configuration within the governance structure of the central bank should be in line with the country's legal tradition. The audit committee as a non-executive subcommittee of a unitary governing board is a reflection of the Anglo-Saxon model, while in the continental European dual board structure (distinguishing management from supervision), the supervisory board would usually be responsible for the functions of an audit committee. Audit Committee members will need to have a good understanding of their position in the central bank's governance structure and the broader legal framework within which the central bank operates. Regardless of the precise configuration, management structures always include a separate internal audit department. So it is important that the modalities for delegating oversight duties are unambiguous to avoid any duplication of efforts.

Since the scope of financial disclosure also depends on the complexity of financial operations, some central banks may opt for more limited audit committee functions. Indeed, it is simpler to draft a non-technical summary of the balance sheet and profit and loss statements if the central bank does not engage in complex financial transactions. In such cases, the oversight function may not require additional resources or special expertise, and may be effectively discharged through an advisory committee to the board, rather than a more formal supervisory body which is established separate to the latter. A pragmatic approach that balances the type of central bank activities with the preferred format for their oversight is therefore recommended.

Some organisations may be too small for the practicable establishment of a separate Audit Committee with non-executive members. This is acknowledged in the UK Treasury guidelines on Audit Committees, and may apply to some of the smaller central bank boards, or less developed countries where the pool of qualified and truly independent individuals is quite limited. In such cases, the suggestion is for the board-or a subgroup of the board comprising external members-to act as the audit committee, although this would be at a different sitting from its regular meetings. However, the guidelines are very emphatic in stating that 'this [configuration] should not be the 'default' option for smaller organisations; before deciding to take this course of action careful consideration should be given to other options.' The board (in lieu of an Audit Committee) could develop a different mindset from that of its role is day-to-day operations but it would need to demonstrate that it safeguards objectivity by other means, such as chairmanship by a non-executive member.

Jamaluddin Ahmed PhD, FCA is General Secretary, Bangladesh Economic Association and Member, Board of Directors, Bangladesh Bank.

 jamal@emergingrating.com

 
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