This article deals with some of the key issues related to audit committees in central banks. Among the issues to consider, when designing an appropriate governance structure, are the prevailing legal tradition and the type and complexity of the central bank's financial operations. It examines the implications of these issues on central bank legislation and recommends more explicit references to an audit committee (whether in statutes or in by-laws) for countries that lack strong corporate law traditions. It also suggests supplementary disclosures beyond the areas prescribed by the accounting framework, when central banks are active in complex financial operations, highlighting the key role for audit committees in this area.
An audit committee is considered as a means through which central banks may address principal-agent issues and effectively discharge their fiduciary duties, primarily regarding financial reporting. To avoid a configuration where management would be overseeing itself, and thereby limit conflicts of interest, several options are indicated, depending on the prevailing legal tradition: (i) ensuring a majority of external members without conflicts of interest in a one-tier board structure; (ii) stipulating that the non-executive directors have special oversight responsibilities for the financial condition without establishing a separate audit committee; (iii) setting up a special sub-committee of the board, which may or may not include additional members with special expertise; or (iv) the establishment of a separate supervisory board.
As a result of the growing complexity of central bank operations and their accounting frameworks, central bank boards may increasingly require specialised financial expertise. To address the need for special financial literacy, there are several options: (i) regulating the complexity of permitted operations, specifying the policy on derivative transactions for instance; (ii) requiring that a minimum of board members have special expertise in interpreting financial statements; or (iii) establishing a special body performing the functions of an audit committee. The article recommends pragmatism in balancing the type and complexity of central bank operations with the preferred format for their oversight. The effectiveness of an audit committee's oversight of internal controls and financial disclosure may provide a strong safeguard against the emergence of reputational risk. The potential for reputational risk partly stems from public uncertainty as to the true financial condition of the central bank and from the difficult interpretation of financial statements in the light of differences between central bank objectives of monetary or financial stability and the standard commercial objective of maximising shareholder wealth.
An audit committee, or a similar body, could assist in designing and executing the central bank's financial disclosure strategy. Increasingly complex central bank operations and adherence to international financial reporting standards raise the stakes for the scope of central banks' financial disclosure. In this context, an audit committee can help provide further assurances of financial integrity and demonstrate high standards of good governance in central banks.
AUDIT COMMITTEES IN CENTRAL BANKS: Good governance principles are fairly well developed for commercial corporations, and public sector organisations, but less so for central banks. In 1999 and revised in 2004, the Organisation for Economic Co-operation and Development (OECD) issued the OECD's Principles of Corporate Governance for commercial corporations. The Principles cover five main areas: protection of the rights of shareholders, equitable treatment of the latter, the role of stakeholders, transparency and timely disclosure, accountability of the board toward the company, its shareholders and its stakeholders. The recommendations included in these codes may not always be mandatory, but they tend to be implemented as a result of the requirement to either comply or explain. Complementing its Principles, the OECD also issued in 2004 the OECD Guidelines on Corporate Governance of State-owned Enterprises, which recommend, inter alia, a strict separation between the state's role as owner and regulator.
The term fiduciary is derived from Roman law, according to Black's Law Dictionary (1990), and designates a person holding the character analogous to a trustee. A fiduciary duty entails that the highest standard of care is imposed at either equity or law, which suggests that there cannot be a conflict of interest. Fiduciary responsibilities of a board and an audit committee typically imply responsibilities to all stakeholders in addition to the immediate shareholders/owners, but the extent to which they are explicitly mentioned in corporate law varies across countries.
The objective of a central bank is usually effective and efficient policy implementation of its designated objective(s), functions, and tasks rather than maximisation of shareholder wealth. The financial reporting framework for a central bank should thus, in principle, be more focused on stewardship of public funds, i.e., its efficient use of resources. However, applying internationally recognised accounting frameworks for central banks performing a broad range of commercial transactions is very useful from a transparency perspective.
This article thus starts by referring to corporate governance practices in the private sector before discussing efforts to enhance transparency and accountability in government organisations. Company law is increasingly converging on the recognition of good governance principles, generally interpreted as the organisational configuration and procedures that will most effectively and efficiently help achieve the objectives, tasks, and functions of an organisation. Weil, Gotshal and Manges (2002) survey how the term 'corporate governance' is defined in national corporate governance codes across European Union member-states, illustrating differences in details and breadth of the definition and distinctions in emphasis on control and supervision. This paper uses the definition of the OECD (OECD, 2004, page 11): "Corporate governance involves a set of relationships between a company's management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined."
According to OECD, "…good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring.
"The presence of an effective corporate governance system, within an individual company and across an economy as a whole, helps provide a degree of confidence that is necessary for the proper functioning of a market economy. As a result, the cost of capital is lower and firms are encouraged to use resources more efficiently, thereby underpinning growth."
Since this is still an evolving process, these principles are even less explicit for central banks. Only recently have studies (among others Frisell, Roszback and Spagnolo, Foster, Lybek and Morris, Schiffman and Mooij) been focusing more explicitly on the governance of central banks. The focus is on the substantive functions of an audit committee, audit board, supervisory board, or similar body, rather than its form.
A CORPORATE PERSPECTIVE: An audit committee may be envisaged as a mechanism to address principal-agent challenges and fulfil fiduciary duties. The challenge is how owners (the principal) can monitor and ensure that the employee (the agent or management) pursue the owner's objective. The principal-agent theory and its implicit assumptions-that maximisation of simple material returns is pursued by rational individuals-have dominated the discussion on how to improve governance. The real-world complexity has often forced company legislators to instead consider 'maximising stakeholder wealth' by elaborating the fiduciary responsibilities of the various governing bodies and management. Smallman (2004) examines three theoretical paradigms in corporate governance: shareholder theory, stakeholder theory, and stewardship theory. He argues that stewardship provides the future direction for corporate governance practice "if organisations are to deliver benefits to both their owners and other beneficiaries whilst not significantly harming the interests of other groups."
The audit committee may either perform its duties as principal whereby the legislation would hold it directly accountable, or it may be acting as the agent of the board, which would retain ultimate responsibility. It is, therefore, essential that the committee fully understands the capacity under which it operates. Fiduciary duties discharged by audit committees and, in some countries, the emergence of legal liability also stem from the separation of management and owners. They entail that the highest standards of care be taken by truly independent members and imply that the focus on maximising 'shareholder wealth' be broadened to encompass 'stakeholder wealth.'
Underlying the interest in oversight effectiveness is the recognition that businesses may lose as much value from weak internal control and financial reporting as from poor strategic decisions. The oversight function may be strengthened by either attributing specific functions (e.g., oversight and strategic decisions) to different boards, depending on the prevailing legal framework, or by adjusting an existing unitary board structure, altering its composition to increase its independence (e.g., the number of external members and their qualification requirements), or resorting to subcommittees. These subcommittees may either have explicit legal authority to perform certain functions, or act in a purely advisory capacity. If they have formal legal authority, their mandate must be clearly stipulated to guard against the dilution of their responsibilities from a subsequent addition of other subcommittees. Regardless of the structure of oversight, it is important to state upfront that audit committees, like external auditors, are not a panacea to prevent instances of reporting malpractices or fraud.
The impetus for strengthening oversight through audit committees in the private sector is partly market-driven, and partly a response to regulatory developments. Tighter statutory disclosure requirements from regulators have led to development of the audit committee function, even if the frameworks are not prescriptive as to the form of such an oversight body. In the financial sector, the Basel Committee on Banking Supervision issued Core Principles for Effective Banking Supervision. They require the internal audit function to report to an audit committee, or an equivalent structure, and request the audit committee to include experienced non-executive directors in organisations with a unicameral Board structure. Capital markets and the emergence of private pension funds may have contributed to de-linking management and the ultimate shareholder, thereby increasing the importance of high quality reliable financial disclosure for honouring a company's fiduciary responsibilities. Additional controls may also have stemmed from the complexity of financial reporting standards, key accounting issues (e.g., the treatment of pension obligations and stock options and the application of fair-value accounting), and the increased use of earnings management, which require special financial expertise. For a discussion of these accounting issues, see OECD (2004) Caruana et al. (2002), using Enron as a focal point to explore the challenges posed by failures of financial reporting also address some fundamental concerns about future accounting. Although fair-value accounting is a sound principle in a market economy, it may be manipulated, particularly in the way future-envisaged revenues are discounted. Accordingly, the stakeholders must hold boards responsible for developing better processes to ensure the existence and operation of appropriate control and reporting frameworks.
Notwithstanding diversity in corporate approaches across legal systems, the discharge of fiduciary duties by the body entrusted with audit committee functions is remarkably similar. The main features of audit committees in three legal traditions are: a) Within the single board configuration of Anglo-Saxon countries, the emphasis has varied from initially strengthening either the external representation on the board (UK) or to establish an audit committee, which seems to have began earlier in the US. In the UK, in July 2003, 'The Combined Code on Corporate Governance' superseded the recommendations on corporate governance from June 1998 by the Hampel Committee. The Combined Code covers both the recommendations of the Higgs group's review of the role and effectiveness of non-executive directors and the Smith group's review of audit committees. For a review of the literature on audit committees in the US, see for instance DeZoort (2002).
b) The German corporate structure is an example of a two-tier board structure. A similar approach is used in several other European countries. According to Ugeux (2004, page 345 and footnote 22), French law, for example, does not allow the board to delegate decision-making authority to a committee. A structure similar to that of the German corporate sector is adopted by some companies in France, which choose to establish a Directoire as the management board and a Conseil de Surveillance as the supervisory board. It is important to bear in mind that company laws in the European Union still differ significantly (See Weil, Gotshal and Manges, 2002 and, for a comparison of the UK and Germany, Davies, 2000). Companies registering under the new European company law (Societas Europaea) may elect a one- or a two-tier board system. See Title III Article 38 of the European Council Regulation (EC) No.2157/2001. Although the oversight role may, in principle, be more clearly delineated, audit committees seem to begin to play a more explicit role. Also note the 'comply or explain' approach dominating in the European countries, including the UK and the more regulatory approach in the US with Sarbanes-Oxley.
c) In the original Japanese corporate model, a statutory board of auditors is hierarchically equivalent to the board of directors, reporting directly to the shareholders, although it manages the external audit process and reviews audit findings in much the same way as in the two other models. Japanese law is more prescriptive, and requires the board of auditors to attach their audit opinion to the financial statements. Accordingly, the Financial Service Agency of Japan persuaded the US SEC to exempt Japanese issuers listed in the US from the Sarbanes-Oxley Act.
Jamaluddin Ahmed PhD, FCA is General Secretary, Bangladesh Economic Association and Member, Board of Directors,