These have been difficult times, we all know. Raising funds through either debt or equity is harder than it was only a few years ago. On way to improve our positioning and thus, access to funding is through building credibility by enhancing governance. Our traditions have generally been built around entities controlled by individuals and with minimal disclosure but that is going to have to change if we are to attract in meaningful levels of capital – foreign or even domestic.
The bigger and deeper stock markets – including the UK, Singapore, Hong Kong, Australia and India – generally have market capitalisation that exceeds their GDPs. Most, if not all, have high governance standards/codes and these have been further strengthened after the global financial crisis of 2008. However, many countries, including ours, have market capitalisation below 20-25% of the GDP. Upgrading governance in our stock exchanges could have a major impact on both market size and sustainability and this should flow through into increased investment flows.
In approaching this, we need to consider two areas upon which to focus, namely:
1) building the governance of companies listed in the stock exchanges, and
2) enhancing the governance of the stock exchanges themselves.
Here, I want to talk primarily about the reforms/upgrading needed within our stock exchanges as such. These exchanges are especially significant as they not only serve as trading platforms but also carry the responsibility of being frontline regulators. The independence and thus, effectiveness of such a regulatory role naturally impacts the confidence investors will place in the exchanges and markets they cover.
The exchanges are owned by the brokers and thus have not yet been demutualised. Both, as owners and with their domination of the boards of the exchanges, brokers can therefore influence the regulations affecting their own businesses as well as the implementation of these regulations. In such situations, how are the interests of small investors to be protected? In many markets, it has been seen as necessary to construct firewalls to protect such investors against the conflicts of interest that inevitably arise in such situations. These can relate to policies or to transactions and they can also extend into subsidiaries and affiliates and into dealing with the management at the exchanges. The regulatory role of the exchanges in Karachi and Lahore becomes particularly significant as the apex regulator, the SECP, is headquartered away from the main markets and this distance may impact supervision.
The most direct way, of course, is through demutualisation whereby ownership of the exchanges is transferred partly or wholly to independent investors and the exchanges are thereafter run by independent professionals. Demutualisation is a relatively straightforward solution to dealing with the conflicts of interest.
Usually, demutualisation involves two steps, i.e. corporatisation and then demutualisation. Many issues surface in developing a framework for demutualisation including whether the brokers should retain a shareholding, and if so, then at what level; what representation, if any, they should have on the boards of the exchanges thereafter and how resulting conflicts of interest should be addressed. Often under broker lobbying pressures the debates and negotiations on these terms of demutualisation stretch out over many years.
In Pakistan’s case, the process was started almost six years ago and now, even after the lower house of parliament has approved the relevant bill, it has been awaiting further consideration for almost a year. However, even before demutualisation, there are a number of steps we can take to build governance in our stock exchanges.
Over the last 2-3 years, following the lessons of the global financial crisis, corporate governance codes have been strengthened in a number of major markets, including the US, UK, South Africa and Australia. The central principles and the recommendations adopted don’t vary much.
The UK corporate governance code highlights the following key principles relating to the boards of stock exchanges:
— The leadership role of the chairman of the board
— The “challenge” role that non-executive directors are required to play
— The need for appropriate skill sets among board members
— The responsibility of the boards for defining risk appetite
— The reporting needed and the actual business model for the entity
Within this framework, the key elements involve:
— Having a board that is effective and independent
— Ensuring accountability in reporting/risk and audit
— Providing oversight of compensation (amounts/processes and policies)
— Communicating with both the wider market and with shareholders including via the annual general meetings
The role of board committees is mentioned as a critical supervisory function and the primary committees are expected to be either limited to independent directors or at least being dominated by them.
This is far from the reality on the boards of our exchanges though their value is unquestioned. Our exchanges have demonstrated their interest in driving both hiring and compensation and even being able to influence management when required. This does not alleviate issues relating to conflicts of interest. To do that effectively, we should consider adopting the kind of measures taken at major stock exchanges as above. In fact, we should consider this not only for the boards of our stock exchanges, but also for the boards of any subsidiaries and affiliates of the exchanges so they meet the same standards and are also appropriately shielded. Such entities are mostly engaged in the payments, custody or commodity businesses and enhanced governance there can also undoubtedly help the standing and growth of our exchanges.
So far, we have talked about dealing with conflicts of interest and of the role of chairmen and primarily, board committees. But even within the boards, the culture would have to change to raise their level of professionalism. There has to be encouragement of open discussions and toleration of dissent. Issues on which there are varying opinions can be addresses through discussions within the board or even voted upon where necessary but stifling dissent or taking it outside the board where it becomes the subject of lobbying and pressure groups only detracts from the standing of the exchanges. To go in such directions though is not easy as it means ceding dominance of the current small exchanges in order to build much larger ones. But then, that is the trade-off if you want them five or six times bigger than they are today.
— Speech delivered at Institute of Business Management (IoBM), Karachi
