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Related party transactions: A blind spot in banking supervision?

Within the intricate world of banking, activities captured under the term related party transactions often fly under the radar; seemingly innocuous and appearing perfectly legal on the surface. However, if we peel back the layers, a different narrative unfolds—one that reveals a breeding ground for potential abuse and financial crises.

What are Related Party Transactions?

Related Party Transactions (RPTs) encompass a wide spectrum of financial dealings between a bank and entities or individuals closely linked to it through ownership, control, or substantial influence. These include major shareholders, board members, senior management, key staff, their direct and related interests, their close family members, and corresponding persons in affiliated companies. These transactions are a standard practice in banking and can help optimize capital and liquidity allocation within banking groups.

Yet, without proper regulation and oversight, they can become a backdoor to malfeasance.

RPTs are particularly exposed to conflicts of interest and can potentially be unfair or fraudulent. In extreme cases, they can precipitate the downfall of financial institutions. This could occur when dealings are conducted under preferential conditions (for example, breaching the arm’s-length rule), or when they serve to advance the interests of individuals connected to the bank, such as shareholders treating the institution as their “pocket bank”.

Equally concerning is the practice of extending credit to financially unstable related parties, leading to a surge in non-performing loans and jeopardizing the bank’s financial soundness. Despite the accounting framework requiring transparency (IAS 24), RPTs are not always disclosed, concealing the true extent of associated risks.

It’s a Global Issue

In the past, malignant RPTs have not just rocked banks but entire economies. In Ukraine, the banking crisis of 2014-16 saw nearly half of the country’s banking institutions collapse. Moldova suffered staggering losses of around USD one billion in 2014, equivalent to about 12 percent of its GDP. Iceland’s 2008 crisis, partly caused by RPTs, led to the collapse of major banks due to undetected large exposures to connected businesses. More recently in Ghana, abusive RPTs prompted the revocation of licenses for several banks in 2017. Bulgaria, Brazil, Turkey, Ireland, and Portugal also experienced problems due to RPTs and this is a non-exhaustive list.

Diagnostics conducted by the World Bank and the International Monetary Fund as part of their Financial Sector Assessment Programs (FSAPs) paint a grim picture of the current scenario. Many countries are failing to meet international standards governing RPTs (Basel Core Principle #20 for Effective Banking Supervision), suggesting that risks associated with RPTs are not always being looked at sufficiently rigorously or consistently in either developed or emerging countries. These findings echo the observations during our fieldwork in various countries.

Unpacking the Root Causes

RPT abuse is fueled by weak legal frameworks, lax corporate governance, and a lack of supervisory teeth. Weaknesses in bank governance systems lead to failures across multiple fronts. Narrow definitions by law or regulation often fail to capture all the insiders (‘related parties’) capable of abusing a bank; the concept of ‘transaction’ is frequently confined to lending operations, while also service contracts or asset purchases could be done at no commercial terms, with related parties extracting private benefits from banks.

Major shareholders may prioritize personal gain, while board members neglect their oversight duties; internal control functions might not be able to detect all deviations from a bank’s decision-making process and mismanagement of conflict of interests; external auditors might perceive RPTs as a disclosures issue only, rather than an area where material inaccuracies of financial statements could occur because of fraud.

The opacity of ownership structures, sometimes poorly understood during a bank’s licensing stage, complicates the oversight of RPTs. Insufficient supervisory resources and independence further compound these challenges, while political pressure and interference impede effective oversight and enforcement of prudential standards. This might particularly occur in state-owned banks lending to state-owned enterprises.

Reforms and the Path Forward

Safeguarding the integrity of the banking sector lies in robust regulatory reforms, enhanced supervisory mechanisms, and strengthened governance frameworks.

Granting supervisors and executive authorities independence and legal protection is pivotal to ensure they carry out their functions without fear of retaliation. Broadening legal definitions of related parties and their transactions, along with empowering supervisors to exercise discretion in applying these definitions on a case-by-case basis are vital.  Enforcing penalties for RPT infringements will encourage adherence and deter malpractice.

National supervisors should step up their efforts to better oversee RPTs. Implementing prudential limits, accessing to beneficial ownership registry (when thy exist) especially during the licensing process, enforcing disclosure requirements, intensifying RPT scrutiny during on-site examinations, and seeking independent third-party opinions are key recommendations.

For banks, strengthening board approval and oversight mechanisms for RPTs is imperative, including more robust internal controls and IT systems that can map related parties at each stage of the relationship. Enhancing the role of independent directors and proactively using beneficial ownership information to vet shareholders and clients and developing robust whistleblower mechanisms is recommended.

Improving RPT reporting mechanisms is critical. In cases of RPT abuses, the lack of detailed and timely reporting obscured the scale of the problem, hindering early intervention.  In this regard, we very much welcome the revised iteration of CP20 on RPTs endorsed by the BCBS on February 29, 2024, as part of the new Basel Core Principles. This revision mandates banks to not only report aggregate exposures to related parties but also individual RPTs deemed material.

Lastly, we advocate for the Basel Committee on Banking Supervision to issue explicit guidance on designing and implementing an RPT framework. The lack of a separate set of supervisory guidance from the regulatory community leaves room for ambiguity and inconsistency.

Without decisive action, the exploitation of RPTs will persist, amplifying risks to financial stability and diminishing public trust. The solutions are within reach; the time for action is now.

(Pierre-Laurent Chatain is the Lead Financial Sector Specialist in the Finance, Competitiveness & Innovation Global Practice at the World Bank Group. Ezio Caruso is a Senior Financial Sector Expert in the Financial Stability unit of the World Bank.)

Contributed by Pierre-Laurent Chatain & Ezio Caruso

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