As Asia emerges from the crisis that began in 1997, governments across the region are reforming their financial sectors. One critical element of these reforms is the revamping of corporate governance.¹ Asian boards have traditionally been corporate symbols rather than management structures. Many people in the region are now beginning to realize that an independent board with management-oversight authority is critical to building a healthy financial system and economy.² Weak and ineffective boards failed to prevent Asian banks from accumulating excessively risky loan portfolios, which ultimately caused the crisis. Revamping corporate boards is now seen as a critical lever in reforming the financial sector.

But introducing sound corporate governance is no easy task (see sidebar, "Elements of good corporate governance"). Barriers stand in the way of implementation, and strong government support for change is often lacking. But McKinsey’s experience in South Korea has shown that policy makers can change corporate-governance practices by taking a series of concrete actions focusing on the composition and processes of boards. Although it will undoubtedly take some time for the newly created boards to become fully established, South Korea is now well on its way. Other countries reforming their financial sectors should follow suit.

Starting from ground zero

Before the recent crisis, the typical Asian bank board was stocked with company insiders, important customers, and friends of the chief executive officer. Outside directors, from academia and government, had little or no board governance experience or expertise. Formal committees and board responsibilities did not exist, so that boards tended to rubber-stamp management decisions.

South Korea’s Seoul Bank provides an example of these problems. In 1996, only 8 of its 20 directors came from outside the bank, and the outsiders were executives of its client companies or members of policy institutes. Turnover was high, with many board members leaving after less than a year. The board met monthly, usually for no more than an hour, and often no agenda was sent to outsiders. There were no board committees.

With so little oversight of management, it is no surprise that Seoul Bank fared poorly. During the four years leading up to the crisis, the bank made little or no profit, yet the management team remained in place until the end of 1997, when the Financial Supervisory Commission (FSC)—the government restructuring agency—seized control of the institution. By the following year, nonperforming loans had reached 17.9 percent of the total loan portfolio of the bank and its capital ratio had sunk to 0.97 percent, far below the 8 percent recommended by the Bank for International Settlements (BIS). The FSC is now divesting the bank.

Seoul Bank was not alone. On the eve of the crisis, 20 percent of all loans in South Korea were nonperforming, compared with less than 1 percent in the United States. Too much bank sector funding came from short-term foreign borrowing, almost all denominated in foreign currency. This practice exposed the banks to both a currency and a maturity mismatch on their balance sheets, violating one of the most basic tenets of risk management.

At the same time, borrowers were becoming more of a risk; South Korean chaebol (conglomerates) had average debt-to-equity ratios of 520 percent, compared with 171 percent for the United States. South Korea’s banks fell far short of the 8 percent capital ratio recommended by the BIS: the official BIS ratio for South Korea was 6.75 percent, but this was overstated because embedded losses weren’t recognized. While these problems can’t be attributed solely to poor board governance, South Korean bank boards clearly didn’t provide adequate management oversight. The same state of affairs prevailed in almost every other country affected by the crisis.

Why board governance matters

As Asian countries and other emerging markets restructure their financial systems, it is imperative that they create independent corporate boards that can oversee management. Once the insolvent banks are closed and bad loans disposed of, stronger boards are needed to guarantee that operational improvements at the remaining banks endure.

A strong corporate board performs four main roles: overseeing the risk profile of a company, monitoring the integrity of its business and control mechanisms, ensuring that expert management is in place, and maximizing stakeholder interests. Such a board has regular and close contact with the organization and can detect and correct aberrant behavior quickly. It also plays an essential role in hiring and keeping sound managers.

By the time the government’s bank supervisors could uncover a bad situation, it was usually too late

Board oversight is especially important in emerging markets because other sources of corporate monitoring are generally ineffective there. In South Korea, most government bank supervisors lacked adequate training. Staff shortages meant that on-site bank examinations were conducted only to investigate fraud or the misallocation of funds; random audits were rare. Lack of information was a further handicap: by the time supervisors uncovered a bad situation, it was usually too late to remedy it. Most South Korean companies aren’t rated by external agencies, so there was no outside monitoring of corporate performance. And both Standard & Poor’s Ratings Services and Moody’s Investors Service failed to downgrade South Korea’s government debt significantly until after the 1997 financial crisis had hit.

Even a moderately effective corporate board can improve the crucial business and risk-management operations of a financial institution in less time than it takes to pass laws, train financial regulatory examiners, and enforce new accounting and disclosure standards. In South Korea, just six weeks after the FSC mandated new corporate-governance standards, banks were in the process of complying with them. Some of the ingredients of good corporate governance were not in place: there was no pool of qualified and experienced directors and little or no understanding of board committee functions and responsibilities. The government rightly understood that it could be years before all these problems were solved but that to delay the start of the reforms might mean disaster for the country’s financial system.

Even more important, putting in place a good corporate board is a significant driver of investment from both foreign and local sources—something that is particularly important in countries (such as South Korea, Ecuador, Indonesia, and Jamaica) requiring significant recapitalization to rebuild their financial systems. In attracting overseas investment, one of the most effective tools of a company is the quality of its board governance. According to McKinsey research,³ global institutional investors believe that in evaluating Asian companies, the quality of their board governance is at least as important as, if not more important than, financial issues (Exhibit 1).

Indeed, the quality of board governance directly affects whether investors would put their money into a company and the amount they would pay for its securities (see "Three surveys on corporate governance"). Almost 95 percent of the investors surveyed said, for example, that they would pay a premium—ranging from 24 to 31 percent—for the equities and bonds of a South Korean company that had an effective board of directors (Exhibit 2). A well-governed company in Indonesia, Japan, Malaysia, Taiwan, or Thailand would command an average premium of 20 to 30 percent. The level of these premiums indicates that Asian companies have a huge opportunity to increase shareholder value by introducing more effective boards.⁴ In the case of the banks that survived the Asian crisis, sound governance was a prerequisite for much-needed infusions of cash.

Finally, strengthened bank boards have an important trickle-down effect in promoting good governance among corporations. In South Korea, board governance has become a factor in many banks’ credit assessment models. South Korean conglomerates, with their credit ratings and access to capital at stake, are beginning to pay attention to the banks’ demands for better internal controls and shareholder rights. One large bank recently notified four big corporate borrowers that unless they complied with specific corporate-governance reforms, their credit lines would be greatly reduced.

Getting from here to there the South Korean way

The creation of the FSC, which had strong support from Kim Dae Jung, South Korea’s president, was vital, since entrenched interests at the Bank of Korea and the Ministry of Finance and Economy were more inclined to perpetuate the status quo than to change it. By early 1999, the basic bank reforms—closing and consolidating the most troubled banks, reducing costs, and writing off assets—were well under way. The FSC, led by Lee Hun Jai, closed and sold five banks,⁵ encouraged the merger of six others, nationalized four, and bought about $70 billion of nonperforming loans from the banking system.⁶ The number of banks in South Korea was reduced from 27 to 17, and more than 40,000 bank employees (about 30 percent of the bank workforce) lost their jobs. These reforms were not enough to ensure that the remaining, newly restructured banks would be run as profit-maximizing businesses with prudent lending practices and effective risk-management controls. So the FSC turned its attention to "soft" issues, such as improving management skills, corporate controls, and corporate governance.

In February 1999, the FSC mandated specific changes in the composition, structure, and processes of boards, to take immediate effect. All banks are now required to have a majority of outside directors, independent of management. The FSC strongly encouraged the idea that the chair of the board and key members of committees should be outsiders. Boards ought to appoint committees to oversee the compensation of management, financial reporting and auditing, and the overall risk position of their banks. They should also hold an annual meeting of one or two days’ duration to review the banks’ performance and strategy. To help banks comply with the new regulations, the FSC ran a series of training seminars on corporate governance for executives of financial institutions.

South Korea’s Housing and Commercial Bank (H&CB) provides a good example of the sweeping changes in board structure and operations that have taken place in the country. Before the 1997 crisis, the board comprised six company insiders as well as six outsiders, drawn largely from the major conglomerate construction companies to which H&CB made loans. The new board is dominated by independent outsiders, including a retail-company CEO to help build the bank’s retail operations, financial experts to strengthen the audit and risk-management committees, and an overseas banker who provides insight into global banking practices and best-practice board governance. Outside directors have a majority of voting rights.

This new board’s impact on H&CB has been tangible: Jardine Fleming now rates it, alone among its peers, as having "very good" corporate governance.⁷ The bank’s handling of the Daewoo bankruptcy is a case in point. Whereas other South Korean banks chose to override the recommendations of internal credit-risk managers and continued to extend credit to the troubled chaebol, H&CB had cut its exposure to Daewoo by 75 percent over the three quarters that preceded the bankruptcy. The bank was among the first to set aside realistic provisions for losses from Daewoo.

Moving quickly on other fronts as well, H&CB has shown its commitment to transparency by introducing the government’s new "forward-looking criteria" (which focus on the future rather than the current or past ability of corporations to repay loans) a year ahead of the deadline. It has also replaced local auditors with US-based accountants. And the bank is considering a listing on the New York Stock Exchange, a move that would require it to comply with the even more stringent US generally accepted accounting principles (GAAP).

The compensation plans of most large South Korean banks now include big stock option grants

Finally, H&CB was the first bank to pay its CEO largely with stock options. Previously, CEOs had been paid a modest base salary and a sizable expense allowance but received no incentive pay in the form of options or a performance bonus. Most other major banks have now modified their compensation plans to include a base salary, a sizable performance bonus, and large stock option grants. As a result, the interests of a majority of the leaders of South Korea’s banking sector are now much more closely aligned with the interests of shareholders.

Thus, in just one year, the concept of board governance has become established in South Korea’s banking system. Although the quality of board governance varies among banks, the country’s corporate boards are now moving toward global standards.

Implementation: The challenges are real

Despite South Korea’s success in jump-starting the transition to improved board governance, a number of problems remain. The most important is the shortage of qualified directors, especially if the strictest guidelines on independence are followed. By definition, a country that is instituting sound corporate-governance practices for the first time won’t have many experienced directors. McKinsey and the Korea Development Institute estimate that only about 100 qualified directors would be available for more than 2,000 director positions if US corporate-governance standards were applied to the top 150 corporations and financial institutions. Other Asian countries are no doubt in a similar position.

To meet the shortfall, many South Korean banks have recruited foreign directors to their boards. H&CB appointed Bruce Willison, the dean of the Anderson School of Management at the University of California, Los Angeles, and a former vice chairman of First Interstate Bancorp. Hana Bank brought in Deepak Khanna, from the International Finance Corporation, to serve on its board. Meanwhile, Hanvit Bank recruited Frank Cahouet, the former chairman and CEO of Mellon Bank, to advise its board. The cost of foreign board directors can seem shocking: they typically receive a total compensation of $100,000 to $200,000, including options, while directors from South Korea receive only $20,000 to $25,000.

A second challenge has been getting new board directors to shape strategy and monitor performance without encroaching on management terrain and becoming too involved in daily operations. One bank CEO had trouble working with several new board members who felt it was their right to delve into detailed management activities, such as the layout of branches and the pricing of individual products. To overcome this problem, companies must clearly specify the role of management and of the board in their bylaws and internal board rules, making sure that day-to-day operations are squarely in the hands of management. This role differentiation should be openly discussed at the board level so that a consensus develops. Roles should then be clearly documented to prevent confusion on the part of the board or management. This process may seem pedantic, but it is essential in situations where effective boards have not existed previously.

Bank boards must also ensure transparency in financial reporting. Since last year, South Korean companies and banks have been required to comply more closely with international accounting standards, but compliance will take time, since both internal accounting staff and external auditors have not yet developed the requisite skills. In addition, to protect shareholder interests more closely, disclosure requirements for listed companies should fall into line with international standards. At present, for instance, the compensation of the CEO and of the members of the board often isn’t disclosed.

Finally, the chaebol families who own minority shares in many publicly listed companies must also be prepared to respect the rights of all shareholders and to permit the installation of high-quality boards. While progress in this area has occurred, there have been numerous instances where shareholders’ rights have not been respected. The government and a few foreign investors are pushing for change, although past bad practices will probably dissipate slowly.

Global investors continue to rate corporate governance in Asia as poor (Exhibit 3). Although Japan and Taiwan come out best, they each earn average ratings of only about 2.5 out of 5, compared with the US rating of about 4 to 4.5. The crisis-hit countries of Indonesia, Malaysia, South Korea, and Thailand come out much lower; Indonesia is rated at only 1.1. US and European investors, with their higher standards, give Asian corporate governance even lower ratings than Asian investors do.

As Asian countries seek to improve their showing, several lessons from South Korea will prove helpful. First, governments can promote better board governance to compensate for the absence of market checks on corporate behavior, such as those provided by deep capital markets with activist investors, rating agencies, and effective, well-trained regulatory examiners. Second, it is better to adopt a "do it/fix it" approach than to wait until all of the optimal conditions are in place. Third, governments need to understand that qualified board members are in short supply and to seek out best-practice examples and guidelines. Fourth, to make initial implementation easier, governments should start with the area in which they have greatest control. For South Korea, this was the financial sector; for other countries, it could be government-owned businesses and public works.