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Implicit impact of corporate governance and financial sector development

Abstract This paper investigates the relationship between corporate governance and financial sector development. It nds that better corporate frameworks benet rm through greater access to nancing, lower cost of capital, better rm performance, and more favorable treatment of all stakeholders. Numerous studies agree that these channels operate not only at the level of the rm, but in sectors and countries as wellalthough causality is not always clear. There is also evidence that when a countrys overall corporate governance and property rights system are weak, voluntary and market corporate governance mechanisms have limited effectiveness. Less evidence is available on the direct links between corporate governance and poverty. There are also some specic corporate governance issues in various regions and countries that have not yet been analyzed in detail. In particular, the special corporate governance issues of banks, family-owned rms, and state-owned rms are not well understood, nor are the nature and of determinants of enforcement. Importantly, the dynamic aspects of corporate governancethat is, how corporate governance regimes change over timehave only recently received attention.

Corporate governance, a phrase that not long ago meant little to all but a handful of scholars and shareholders, has now become a mainstream concerna staple of discussion in corporate boardrooms, academic meetings, and policy circles around the globe. Two events are responsible for the heightened interest in corporate governance. During the wave of nancial crises in 1998 in Russia, Asia, and Brazil, the behavior of the corporate sector affected entire economies, and reference (Presented at the Global Corporate Governance Forum Donors Meeting, held in the Hague, The Netherlands, March 13, 2003. I would like to thank the participants for their useful comments. I would also like to thank Florencio Lopez de Silanes for useful suggestions.) deciencies in corporate governance endangered the stability of the global nancial system. Just three years later condence in the corporate sector was sapped by corporate governance scandals in the United States and Europe that triggered some of the largest insolvencies in history. In the aftermath, not only has the phrase corporate governance become nearly a household term, but economists, the corporate world, and policymakers everywhere began to recognize the potential macroeconomic consequences of weak corporate governance systems. The scandals and crises, however, are just manifestations of a number of structural reasons why corporate governance has become more important for economic development and well-being (Becht, Bolton, and Rell 2003). The private, market based investment process is now much more important for most economies than it used to be, and that process is underpinned by better corporate governance. With the size of rm increasing and the role of nancial intermediaries and institutional investors growing, the mobilization of capital has increasingly become one step removed from the principal-owner. At the same time, the allocation of capital has become more complex as investment choices have widened with the opening up and liberalization of nancial and real markets, and as structural reforms, including price deregulation and increased competition, have increased companies exposure to

market forces risks. These developments have made the monitoring of the use of capital more complex in certain ways, enhancing the need for good corporate governance. To do so, it reviews the extensive literature on the subjectand identies areas where more study is needed. A well-established body of research has for some time acknowledged the increased importance of legal foundations, including the quality of the corporate governance framework, for economic development and well-being. Research has started to address the links between law and economics, highlighting the role of legal foundations and well-dene property rights for the functioning of market economies. This literature has also started to address the importance and impact of corporate governance. Some of this material is not easily accessible to the nonacademic. Importantly, much of it refers to situations in developed countries, in particular the United States, and less so to developing countries. The paper is structured as follows. It starts with a denition of corporate governance, as that determines the scope of the issues. It reviews how corporate governance can and has been dened. It describes why more attention is been paid to corporate governance in particular. The paper next explores why corporate governance may matter. It also provides some background on the ownership patterns around the world that determine and affect the scope and nature of corporate governance problems. After analyzing what the literature has to say about the various channels through which corporate governance affects economic development and wellbeing, the paper reviews the empirical facts about some of these relationships. It explores recent research documenting how legal aspects can affect rm valuation, inuence the degree of corporate governance problems, and more broadly affect rm performance and nancial structure.

OVERVIEW OF CORPORATE GOVERNANCE IN PAKISTAN Corporate governance matters for the financial development by increasing the flow of capital to the capital market. East Asian financial crisis attract serious attention to importance of corporate governance in developing countries. The OECD has established a set of corporate governance principles in 1999 that have become the core template for assessing a countrys corporate governance arrangements. La Porta, et al. (2000) Defined, Corporate governance is, to a certain extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders. They define the insiders as both managers and controlling shareholders. Corporate governance comprises the private and public institutions (both formal and informal) which together govern the relationship between those who manage corporations and those who invest resources in corporations. These institutions typically include a countrys corporate laws, securities regulations, stock-market listing requirements, accepted business practices and prevailing business ethics [Omran (2004)]. Thus, changes in Pakistani system of corporate governance are likely to have important consequences for the structure and conduct of country business. The issue of Corporate Governance of banks has also fundamental importance for emerging Economies. SBP restructured the regulatory framework governing the commercial banking industry and issued some guidelines for corporate governance. The study of Kalid and Hanif (2005) provides an overview of development in the banking sector and measures of corporate governance in Pakistan. Their study observes that SBP organized its role as a regulator and supervisor and make the central bank relatively more effectively in recent years. Moreover, the legal and regulatory structure governing the role and functions of commercial banks has been restructured. However, as the process of corporate governance of banks in Pakistan is very recent, not enough information is available to make an assessment of the impact of these policies such as an evaluation of the improvement in bank efficiency or reduction in bank defaults. Securities and Exchange Commission of Pakistan issued Code of Corporate Governance in March 2002 in order to strengthen the regulatory mechanism and its enforcement. The code of corporate governance is the major step in corporate governance reforms in Pakistan. The code includes many recommendations in line with international good practice. The major areas of enforcement include reforms of board of directors in order to make it accountable to all shareholders and better disclosure including improved internal and external audits for listed companies. However, the codes limited provisions on directors independence remain voluntary and provide no guidance on internal controls, risk management and board compensation policies

Corporate governance is particularly important for banks, given the banks important role in the financial sector. The rapid changes brought about by globalization, deregulation and technological advances are increasing risks in the banking systems. Moreover, unlike other companies, most of the funds used by banks to conduct their business belong to their creditors, in particular their depositors. Linked to this is the fact that the failure of a bank affects not only its own stakeholders, but may have a systemic impact on the stability of other banks. Theoretically, information asymmetry gives rise to agency problems and conflicts of interest between owners and managers. Good corporate governance is designed to address this problem. Further, government regulations and frequent interventions reduce the incentive for effective monitoring and at the same time make supervision (or supervisors) less effective. In this context, the corporate governance of banks becomes a more important challenge as compared to other firms. reference (Ahmed M. Khalid and Muhammad Nadeem Hanif* *An earlier version of this paper was presented at the LUMS-SEC Conference on Corporate Governance in Pakistan: Regulation, Supervision and performance, held at LUMS, Lahore, Pakistan, May 29-30, 2004. Internationally, the issue of corporate governance for banks has been recognized as one of the most important issues of the corporate sector. The OECD has produced a set of corporate governance principles that have become the core template for assessing a countrys corporate governance arrangements. Similarly, the Basel Committee on Banking Supervision has made recommendations for the corporate governance of banks. Following the recommendations of the Basel Committee, OECD and the IMF, many developed countries have designed policies to implement best practice bank management. (Reference Examples are United Kingdom, Sarbanes-Oxley legislation in the United States, Australia and the New Zealand (Bollard, 2003). Also see Macey and Miller (1995).) Developing countries, especially emerging economies in the South Asian region followed the same recommendations and introduced certain guidelines for corporate governance. In Pakistan (as well as other South Asian countries), the banking sector restructuring took place only in the early 1990s and some steps towards good governance were initiated in late 1990s and early 2000. As such, not enough time has passed to conduct a meaningful assessment of the impact of these policies on bank efficiency

Corporate Governance for Banks Banks are critical elements in any economy. They provide financing for commercial enterprises, basic financial services to a broad segment of the population and access to payment systems. Banks are also the major credit providers and, as such, must deal with the problem of information asymmetry. Although, banks are similar to other firms in terms of the composition of shareholders, debt holders, board of directors, competitors, etc. However, there is one important decision between banks and other firms. Rather than any firm, which is a profit-maximize, the nature of transactions that banks are involved in makes them an expected utility (or expected profit-maximize). The short-term liabilities (such as demand deposits) are invested in long-term risky assets (such as mortgage loans) and may take several years to mature (20 to 30 years). As a result, the risk factor increases substantially and risk management becomes important. Another related issue is the role of the central bank in providing financial stability through efficient risk management, essential for sustainable growth. The central bank performs three important functions for the stability of the banking system. It acts as a lender of last resort, to help any short to medium-term liquidity problems of a bank and thus helps to avoid a bank run. Central banks also develop and implement a good regulatory authority

WHAT IS CORPORATE GOVERNANCE AND WHY IS IT RECEIVING MORE ATTENTION?

What is corporate governance? Denition of corporate governance vary widely. They tend to fall into two categories. The rst set of denition concerns itself with a set of behavioral patterns: that is, the actual behavior of corporations, in terms of such measures as performance, efficiency, growth, nancial structure, and treatment of shareholders and other stakeholders. The second set concerns itself with the normative framework: that is, the rules under which firm are operatingwith the rules coming from such sources as the legal system, the judicial system, nancial markets, and factor (labor) markets. For studies of single countries or rm within a country, the rst type of denition is the most logical choice. It considers such matters as how boards of directors operate the role of executive compensation in determining rm performance, the relationship between labor policies and rm performance, and the role of multiple shareholders. For comparative studies, the second type of denition is the more logical one. It investigates how differences in the normative framework affect the behavioral patterns of rm, investors, and others. In a comparative review, the question arises how broadly to dene the framework for corporate governance. Under a narrow denition, the focus would be only on the rules in capital markets governing equity investments in publicly listed rm. This would include listing requirements, insider dealing arrangements, disclosure and accounting rules, and protections of minority shareholder rights. Under a denition more specic to the provision of nance, the focus would be on how outside investors protect themselves against expropriation by the insiders. This would include minority right protections and the strength of creditor rights, as reected in collateral and bankruptcy laws. It could also include such issues as the composition and the rights of the executive directors and the ability to pursue class-action suits. This denition is close to the one advanced by economists. Andrei Shleifer and Robert Vishny in their seminal 1997 review: Corporate governance deals with the ways in which suppliers of nance to corporations assure themselves of getting a return on their investment (1997, p. 737). This denition can be expanded to dene corporate governance as being concerned with the resolution of collective action problems among dispersed investors and the reconciliation ofconicts of interest between various corporate claimholders. A somewhat broader

denition would be to dene corporate governance as a set of mechanisms through which rms operate when ownership is separated from management. This is close to the denition used by Sir Adrian Cadbury, head of the Committee on the Financial Aspects of Corporate Governance in the United Kingdom: Corporate governance is the system by which companies are directed and controlled (Cadbury Committee, 1992, introduction). An even broader denition is to dene a governance system as the complex set of constraints that shape the ex post bargaining over the quasi rents generated by the rm (Zingales, 1998, p. 499). This denition focuses on the division of claims and can be somewhat expanded to dene corporate governance as the complex set of constraints that determine the quasi-rents (prots) generated by the rm in the course of relationships and shape the ex post bargaining over them. This denition refers to both the determination of value-added by rm and the allocation of it among stakeholders that have relationships with the rm. It can be read to refer to a set of rules, as well as to institutions. Corresponding to this broad denition, the objective of a good corporate governance framework would be to maximize the contribution of rm to the overall economythat is, including all stakeholders. Under this denition, corporate governance would include the relationship between shareholders, creditors, and corporations; between nancial markets, institutions, and corporations; and between employees and corporations. Corporate governance would also encompass the issue of corporate social responsibility, including such aspects as the dealings of the rm with respect to culture and the environment. When analyzing corporate governance in a cross-country perspective, the question arises whether the framework extends to rules or institutions. Here, two views have been advanced. One is the view that the framework is determined by rules, and related to that, to markets and outsiders. This has been considered a view prevailing in or applying to Anglo-Saxon countries. In much of the rest of the world, institutionsspecically banks and insidersare thought to determine the actual corporate governance framework. In reality, both institutions and rules matter, and the distinction, while often used, can be misleading. Moreover, both institutions and rules evolve over time. Institutions do not arise in a vacuum and are affected by the rules in the country or the world. Similarly, laws and rules are affected by the countrys institutional setup. In the end, both institutions and rules are endogenous to other

factors and conditions in the country. Among these, ownership structures and the role of the state matter for the evolution of institutions and rules through the political economy process. Shleifer and Vishny (1997, p. 738) take a dynamic perspective by stating: Corporate governance mechanisms are economic and legal institutions that can be altered through political process. This dynamic aspect is very relevant in a crosscountry review, but has received much less attention from researchers to date. When considering both institutions and rules, it is easy to become bewildered by the scope of institutions and rules that can be thought to matter. An easier way to ask the question of what corporate governance means is to take the functional approach. This approach recognizes that nancial services come in many forms, but that if the services are unbundled, most, if not all, key elements are similar (Bodie and Merton 1995). This line of analysis of the functionsrather than the specic products provided by nancial institutions, and marketshas distinguished six types of functions: pooling resources and subdividing shares; transferring resources across time and space; managing risk; generating and providing information; dealing with incentive problems; and resolving competing claims on the wealth generated by the corporation. One cans dene corporate governance as the range of institutions and policies that are involved in these functions as they relate to corporations. Both markets and institutions will, for example, affect the way the corporate governance function of generating and providing high-quality and transparent information is performed. were previously in the hands of the state. Firms have gone to public markets to seek capital, and mutual societies and partnerships have converted themselves into listed corporations. Second, due to technological progress, liberalization and opening up of nancial markets, trade liberalization, and other structural reformsnotably, price deregulation and the removal of restrictions on products and ownershipthe allocation within and across countries of capital among competing purposes has become more complex, as has monitoring of the use of capital. This makes good governance more important, but also more difficult. Third, the mobilization of capital is increasingly one step removed from the principalowner, given the increasing size of rm and the growing role of nancial

intermediaries. The role of institutional investors is growing in many countries, with many economies moving away from pay as you go retirement systems. This increased delegation of investment has raised the need for good corporate governance arrangements. Fourth, programs of deregulation and reform have reshaped the local and global nancial landscape. Long-standing institutional corporate governance arrangements are being replaced with new institutional arrangements, but in the meantime, inconsistencies and gaps have emerged. Fifth, international nancial integration has increased, and trade and investment ows are increasing. This has led to many cross-border issues in corporate governance. Cross-border investment has been increasing, for example, resulting in meetings of corporate governance cultures that are at times uneasy. Literature review The research on the subject for the Balkan area is limited enough and there are only a few working papers performing several analyses. OEDC, Organization for Economic Co-Operation and Development has been the most active in publishing frequently topics and raising discussions through different panels considering as very important the role of Banks in corporate governance system; however such studies are in general for all companies and do not focus on the Corporate Governance of banks specifically. (OEDC publications, 2004, Corporate Governance A survey of OEDC countries) There are other reviews in the field regarding Basel II implementation as a strong tool for enhancing corporate governance in banks. The Basel Committee on Banking. Supervision though their meeting on Sept1999 took important decision in order to support government, especially the ones of developing countries like Balkan Countries, to improve the regulatory environment for corporate governance. Such guidelines were addressed to different fields like suggestions for stock exchanges operations, investors, corporations, and other parties that have a role in the process of developing good corporate governance (Enhancing Corporate Governance for Banking Organizations, Basel Committee, Basel, September 1999)

The recommendations of the Basel Committee towards the supervisory authorities of banks as well as to second tier banks concern to establishment of proper accountability and clear definition of reporting lines. This will improve at a great extent the internal controls of banks and moreover the banking supervision itself. The recommendations of Basel Committee include as well general guidelines on the structure of the bank in terms of board of directors and senior management, considering them as two decision making authorities separated from each other. (Enhancing Corporate Governance for Banking Organizations, Basel Committee,Basel, September 1999) In February 2006, the Basel Committee on Banking Supervision published the principles for sound corporate governance (Enhancing corporate governance for banking organizations, February 2006) giving emphasis mainly to the important role of the board of directors in the decision making process regarding banks strategies, in the proper implementation of the corporate governance policy, oversight of the daily banks management, transparency, defining the proper operational structure of the banks, etc. Another working paper, referring to corporate governance in banks in developing countries emphasizes the importance of corporate governance implementation in banks of the developing countries for the following reasons The important role of banks in financing the local economy through the lending activity to the private companies but even through the soft term loans given to the government for the public works. Banks plays a decisive role in decreasing the informal economy and increasing the transparent operations of the companies through bank accounts Banks serves as saving institutions by collecting the deposits of the market and by increasing the confidentiality of the consumer. However, the foreign banks supports the economy by injecting funds borrowed by the mother companies as well; however, such phenomenon was limited during the last year derived from the liquidity problems in general banks faced. Banks in the Balkan were forced to limit the lending activity since the source of funding from both sides consumer (though deposits) and group (through borrowings) was limited. From the other side, the fact that the regulatory framework in the Balkan countries is not at the proper levels, the internal control levels should be enhanced through the corporate governance policy. The tendency of top managers of banks in these

countries is to act in a more free way in governing the banks activities. Therefore, the government role should be strong in the way of restricting bank managers behavior. (Corporate Governance of Banks in Developing Economies: Concepts and Issues, Arun & Turner) In the same paper, it is mentioned that in the empirical studies performed by Demirguc-Kunt (1998) and Levine (1999) is suggested that the presence of foreign banks reduces the likelihood of banking crises and may result in banks becoming more prudentially sound. In addition, new legal and regulatory reforms should be obligatory implemented in the regional economies and banks structure as well. The existence of the audit committee is a must for all banks and the composition should be the adequate one, with at least one member with thorough knowledge on financials and accountings. The financial independence of the members is of much importance as well. The establishment of other committees in the bank providing for risk prevention and compliance with internal and external regulations is becoming the issue of the day for banks in developing countries. Addition, the board of directors should ensure the proper definition of clear lines of responsibilities and accountabilities in order to avoid the creation of vacuum in which nobody is in charge of the decisions made. (Corporate Governance of Banks in Euroasia - A policy brief) The yearly assessments that EBRD performs on evaluating improvements of the corporate governance legislation were strong basis for the dissertation since involve all countries of the Central Eastern Europe. The assessment is based comparing the improvements on the subject per country to the OEDC corporate governance principles and Basel Committee CG guidelines. (Corporate Governance Legislation Assessment Project for Albania, Serbia, Romania, Bulgaria, year 2007) The literature used gives and overall view of the importance of the corporate governance in the banks performance as well as the important role of international groups in improving the corporate governance of the banking systems in the Balkan countries. There is a positive correlation between strong corporate governance and

banks market share and expansion. The definition of corporate governance differs from country to country. For the case of Continental European countries such as Germany, the term refers to all the stakeholders of a firm while for Anglo-American countries corporate governance focuses on generating a fair return for investors (see Goergen, Manjon and Renneboog, 2005). The corporate governance devices utilized to ensure economic efficiency include among others shareholder monitoring, creditor monitoring, executive remuneration contracts, dividend policy and the regulatory framework of the corporate law regime and the stock exchanges. The increasing international integration, deregulation and technological development and the resulting challenges are calling for a review of national corporate governance systems. Countries that are in dire need of external financing require stronger and effective corporate governance systems. Pakistans failure to attract external finance some of it from foreign investors may be largely attributed to weak investor protection. Improved corporate governance practices increase firm share prices; hence, bettergoverned firms appear to enjoy a lower cost of capital. Operational performance is higher in better corporate governance countries, although the evidence is less strong. Well governed companies have less volatile stock prices in times of crisis. Companies with boards composed of a higher fraction of outsider or independent directors usually have a higher market valuation. Improvements in corporate governance quality lead to higher GDP growth, productivity growth, and the increased ratio of investment to GDP. The effect is particularly pronounced for industries that are most dependent on external finance. When a countrys overall corporate governance and property rights systems are weak, voluntary and market corporate governance mechanisms have limited effectiveness. Proper regulatory framework and enforcement mechanisms are crucial to promote good CG practices. Large, more concentrated ownership can be beneficial, unless there is a disparity of control and cash flow rights. The quality of shareholder protection positively correlates with the development of countries capital markets. Better corporate governance leads to a better developed financial system, which, in turn, is associated with greater access to financial services for small and medium enterprises and poorer people. Corporate governance measures in Pakistan The literature regarding corporate governance in Pakistan is enormously thin, given the lack of research culture in Pakistani academic and institutional areas.

International literature, reviewed in the earlier subsections has focused on East Asian countries like China, Malaysia, Thailand, Korea, and Japan to name a few. Among the South Asian countries, there is relatively much more literature on India than any other country (Khanna et al., 1996, 1997, 1998, 1999; Pankaj, 1996; Goswami et al., 1996; Singh et al., 2000, 2002, 2003). Cheema et al. (2003) sum up the corporate growth history of Pakistan, providing an overview of the ownership structures, state of financial market, and market dynamics. Cheema et al. (2003) contribute to the sparse literature in Pakistan by studying the various determinants of corporate structure in the same pattern that important corporate governance studies (Claessens et al., 1999; LaPorta et al., 1999) have. These researchers observed the concentration of ownership and control to determine the ownership structure and capital market structure of Pakistan. Culture may change as corporate structures change, however if a particular set of cultural traits is too deeply embedded in the society, that it fits many institutions, then it will not change if it is impeding the objectives of one institution (Roe, 2002). In Pakistan, a change in cultural traits cannot occur if the regulatory institutions desire the change only. Corporate governance and performance Numerous studies have investigated the connection between corporate governance and firm performance (Yermack, 1996; Claessens et al., 2000; Klapper and Love, 2002; Gompers et al., 2003; Black et al., 2003; Anda et al., 2005), with mixed results. Adjaoud et al. (2007) concluded that there is little evidence of a systematic relationship between the characteristics of the board. Bhagat et al. (2000) and Weir et al. (1999) observed a positive relationship between corporate governance and firm performance. Corporate governance contains various aspects of complex regimes as Zingales (1998) also examines it as a comprehensively broad, multifaceted notion that is enormously relevant, while difficult to define, due to the variety of scope that it encompasses. Friend and Lang (1998) examine that shareholders, having high concentration in firms, play an important role to control and direct the management to take keen interest in benefit of the concentration group. However, corporate governance command also allows shareholders to direct the management for betterment of their investment. Shleifer et al. (1997) urged that concentration groups

with large shareholdings; check the managers activities better. However, only the check and balance not only causes to reduce the agency cost but as well resolves the issues between managers and owners. Furthermore, Williamson (1988) examined the relationship between corporate governance and securities. Jensen (1986) seems to be quite keen to analyze how corporate governance directly or indirectly influences the capital structure and firm value. Driffield et al. (2007) stated that higher ownership concentration has a positive impact on capital structure and firm value. In the other case, lower ownership concentration, the relationship depends upon the strictness of managerial decision making which enforce to bring change in the capital structure. Gompers et al. (2003) analyzed the relationship between corporate governance, long-term equity returns, firm value and accounting measures of performance, while Rob et al. (2004) found combined relationship between corporate governance, firm value and equity returns. The Code of Corporate Governance (2002) issued by Securities and Exchange Commission of Pakistan describes the following benchmarks for international best practices. Corporate Governance in the Banking sector By examining 49 countries, La Porta et al. (1997) confirm the hypothesis that countries with poor investor protection have smaller capital markets. Their results provide support for the link between the legal environment and economic development. In particular, they find that countries with common law provide better shareholder protection than countries with civil law. Common law is case-based law and it is essentially the judges who make law by setting precedents in court. Civil law is codified law and the role of the judges is limited to interpreting the law texts in court. La Porta et al. report that common law countries that is, countries of English law provide the highest investor protection, followed by the Scandinavian civil law countries. Civil law countries of French origin provide the worst investor protection. Countries whose law system is based on German civil law are somewhere between the Scandinavian and French law countries. Shleifer and Vishny (1997) argue that greater investor protection increases investors willingness to provide financing. In turn, the greater availability of financing will lead to a lower cost of capital. For countries with emerging capital markets, such as

Pakistan, corporate governance holds even more significance for both individual companies and the national economy as a whole. Since the quality of corporate governance is an important factor to investors when choosing their investment targets, the introduction of international corporate governance practices in Pakistan may help improve the national investment climate and stimulate economic growth. If corporate governance improves e.g., in the sense of increased investor protection, this will attract more investment and external resources which will strengthen the national economy. The corporate landscape is changing dramatically all over the world. In developed countries, legal experts, practitioners and policy makers are not only striving to appraise corporate activity in better ways, but are also helping to design rules that are intended to improve the way companies are managed. In these countries, major corporate governance reforms are now under way (see e.g., Goergen, Martynova and Renneboog(2005) for a review of the ongoing reform on takeover regulation in the European Union). Leora and Love (2002) document evidence that, for the case of 14 emerging economies, the quality of corporate governance is important to investors when choosing their investment targets. They find that the quality of corporate governance is highly correlated with market valuation as measured by Tobins Q. Similarly, if market value is measured by the return on assets (ROA), there is a positive correlation between corporate governance and firm performance.CLSA (2001) calculate an index with corporate governance rankings (CGR). CLSA provide a CGR for 495 companies from 18 sectors in 25 emerging markets. They also assign rankings to the 25 markets according to factors such as overall market valuation, accounting and stock price performance. The study investigates whether firm level differences in terms of corporate governance have an impact on future performance, market valuation and access to external finance. CLSA (2001) assign Pakistan a weighted score of just 3.1 out of 10 in their ranking; only the Czech Republic (2.8) and Russia They find a significant relationship between corporate governance on one side and financial ratios, valuation and share price performance on the other side in emerging markets. Gompers et al. (2003) study whether variations in firm-specific corporate governance are associated with differences in firm value. Their results are consistent

with those of Leora and Love (2002) and CLSA (2001). They use Tobins Q as a measure of firm value and construct their own corporate governance index. They report a strong positive relationship between their corporate governance index on one side, and stock returns and firm valuation on the other side. There are scores of studies that touch upon various issues of corporate governance in emerging markets. Nevertheless, corporate governance within the financial sector has as yet not been explored extensively, particularly not for the case of developing economies (Arun and Turner, 2004). Ciancanelli and Gonzalez (2003) document that almost three quarters of the member countries of the International Monetary Fund (IMF) experienced significant episodes of a systemic crisis and associated bank failures due to agency hazards. They further argue that commercial banks differ from other types of firms because of a more intricate structure of information asymmetry arising from the presence of regulation. Further, they show how regulation limits the power of markets to discipline the banks, their owners and managers. They argue that regulation must be seen as an external force, which alters the parameters of governance in banks. They believe that, agency theory is unsuitable for analyzing governance in commercial banks for two reasons. First, the assumptions made by agency theory are not satisfied. In particular, banks are unique in the sense as the principal-agent relationship is subject to regulation. Second, bank regulation, intended to prevent risk, limits the disciplinary power of market forces. Doidge, Karolyi, and Stulz (2004) develop a model to examine the relationship between country-specific characteristics (such as the financial and economic development and investment opportunities) and the cost and benefits from improving the national corporate governance system. The model outlines the distinguishing features between investor protection granted by the countrys legal system and that offered by the firm. They report that a countrys economic and financial stability as well as its investment climate are an integral part of its corporate governance environment. They observe that a firms decision of whether to offer better investor protection than that granted by the legal system is largely dependent on the costs and benefits of doing so. These costs and benefits in turn depend mainly on countryspecific characteristics such as economic and financial development and openness. Crespi, Carcia-Cestona and Salas (2003) examine the governance of Spanish banks. They investigate whether poor economic performance triggers corporate

governance interventions such as changes to the board of directors and takeovers. They find that financial performance triggers corporate governance interventions. However, the type of governance intervention varies with the form of ownership. They distinguish between independent commercial banks, dependent commercial banks (which are wholly owned by another bank), and savings banks. For example, takeovers and the replacement of the chairman are more frequent in badly performing savings banks whereas the replacement of the CEO is more frequent in independent commercial banks. Barro and Barro (1990), who study a sample of large US commercial banks over the period of 1982-1987, explain CEO dismissals in banks as the result of poor economic performance. Prowse (1995) analyzes a sample of US bank holding companies from 1987 to 1992 to determine how many of these companies used corporate governance interventions. He finds that overall the market-based corporate governance mechanisms in banks are not as efficient at disciplining managers as they are in other firms. In most of the developing countries, banks make up most of the financial sector. Hussain (2005a) reports that banks account for 95% of the financial sector of Pakistan. Arun and Turner (2004) discuss corporate governance in the banking sector of developing economies. They argue that the distinctive characteristics of banks call for regulation to protect depositors interests. They further suggest that the market value of a banking institution will increase once it introduces corporate governance mechanisms. In particular, improved corporate governance yields better proceeds from the privatization of public sector banks. Arun and Turner also recommend a broader approach to corporate governance for banks to protect the interests of depositors and shareholders alike. Corporate Governance Reforms in Pakistan One of the rationales behind the recent corporate governance reforms aimed at Pakistans financial sector is to minimize risk. As mentioned above, banks in Pakistan account for 95 percent of the financial sector and hence their good health is essential to ensure sustained economic growth and the development of Pakistan (Hussain, 2004).However, banks in Pakistan have been catering largely for the

needs of the government. The government has been pressurizing banks to meet its financial needs, and to issue loans to corporations benefiting from favoritism. As a result, banks have ended up with bad loans and financing has not been channeled to the most efficient firms in the economy. Hussain (2005a) describes the banking sector over the past decades. The government used the banks deposits to finance its fiscal deficit. Lending to the government was considered to be safe and profitable. Moreover, the government owned most of the banks and their employees had little incentive to work hard and absenteeism was high. The banking sector was characterized by low levels of competition, unnecessary bureaucracy, overstaffing, loss-making branches and poor customer service. Further, favoritism at the time of lending resulted in huge amounts of debt defaulting subsequently. The corporate tax rate in the banking sector was 58 percent compared to only 35 percent in other sectors. As a result there was a continuous trend for lending rates to increase at the detriment of depositors who earned lower and lower returns. Over the last decade, the banking sector has been undergoing a tremendous transformation, which has been recognized by the IMF and the World Bank. IMF (2005) observes that credit to the private sector has been increasingly steady over the last few years. It further reports that credit to the corporate sector has been generally stable and is declining in the case of public sector owned enterprises. The Financial Sector Assessment Report (2004) distinguishes between domestic private financial institutions and foreign financial institutions. According to the Report, domestic private financial institutions have attracted almost 86 percent of credit by end of the 2004 financial year compared to 67.2 percent at the end of 2000. The government has undertaken some of the muchneeded corporate governance reforms, such as the privatization of banks, the appointment of individuals of standing and integrity as chief executive officers (CEOs) and changes to the boards of directors. Hussain (2005b) believes that good corporate governance is vital for bringing about improvements in the internal controls and the organizational culture. A summary of achievements and initiatives taken by the government is outlined below (Hussain 2005b): Regulation defining the responsibilities of the board of directors.

Applicants for the posts of CEO, other board members and key executives have to fulfill certain criteria. Banks have to adhere to minimum (quarterly and annual) disclosure requirements. Family representation on the boards has been limited to 25 percent of the seats and the remaining directors have to be independent non-executives and not related to the controlling family. Stockbrokers and all others who may suffer from conflicts of interests are barred from getting involved in the management and oversight of banks. A Handbook on Corporate Governance for banks/development financial institutions (DFIs) containing international best practice and State Bank of Pakistan (SBP) guidelines on the subject have been compiled, published and disseminated. The Handbook also refers to OECD practices and the Cadbury (1992) code. The main objective of publishing this document is to reinforce the significance of corporate governance as an effective business tool for bankers, auditors and the general public. Members of banks/DFIs were organized to train them. An institute namely, Pakistan Institute of Corporate Governance has been established in Karachi and the SBP is among its founder members. Corporate governance requirements for banks/DFIs are continually reviewed to keep them in line with internationally recognized best practice. External audit firms are screened, categorized and rated for the purpose of auditing financial institutions. Whenever they are found deficient, they are delisted or even black-listed. SBP claims that these steps have resulted in better market discipline and conduct, improved risk management, better-qualified board members and CEOs, and better self regulation. To set good examples, the regulatory agencies such as SBP and SECP have themselves subjected to higher standards of disclosure and transparency. Hussain (2005a) reports that both the SBP and SECP have undertaken a number of measures, including an open consultative process and the dissemination of information. As part of its accountability strategy, SBP now issues an annual corporate performance report.

CORPORATE GOVERNANCE REFORM The analysis so far suggests that better corporate governance generally pays for firms, markets, and countries. The question then arises why firms, markets, and countries do not adjust and adopt voluntarily better corporate governance measures. The answer is that firms, markets, and countries do adjust to some extent, but that these steps fail to provide the full impact, work only imperfectly, and involve considerable costs. The main reasons for lack of sufficient reform are entrenched owners and managers at the level of firms and political economy factors at the level of markets and countries. Both issues are considered below. The role of entrenched owners and managers Evidence shows that firms adapt to weaker environments by adopting voluntary corporate governance measures. A firm may adjust its ownership structure, for example, by having more secondary, large block holders, which can serve as effective monitors of the primary controlling shareholders. This may convince minority shareholders of the firms willingness to respect their rights. Or a firm may adjust its dividend behavior if it has difficulty convincing shareholders that it will reinvest properly and for their benefit. These voluntary mechanisms can include hiring more reputable auditors. Since auditors have some reputation at stake as well, they may agree to conduct an audit only if the firm itself is making sufficient efforts to enhance its own corporate governance. The more reputable the auditor, the more the firm needs to adjust its own corporate governance. A firm can also issue capital abroad or list abroad, thereby subjecting itself to higher level of corporate governance and disclosure. Empirical evidence shows that these mechanisms can add value and are appreciated by investors in a variety of countries. A study of a sample of U.S. firms found that the more firms adopt voluntary corporate governance mechanisms, the higher their valuation and the lower their cost of capital (Gompers, Ishii, and Metrick 2003). Similar evidence exists for Korea (Black, Jang, and Kim 2002), Russia (Black 2001), and the top 300 European firms (Bauer and Guenster 2003).13 Gompers, Ishii, and Metrick (2003) also report that these firms have higher profitability and sales growth, and lower their capital expenditures and acquisitions to levels that are presumably more efficient. There is also evidence that the voluntary corporate governance adopted by firms matter more in weak corporate governance environments. Two studies compared

indexes of firm-specific corporate governance measures with countries corporate governance indexes to analyze the effects on firm valuation and firm performance (Klapper and Love 2002; Durnev and Kim 2002). They found that firm-level corporate governance matters more to firm value in countries with weaker investor protection. Markets can adapt as well, partly in response to competition, as listing and trading migrate to competing exchanges, for example. While there can be races to the bottom, with firms and markets seeking lower standards, markets can and will set their own, higher corporate governance standards. One example is the Novo Mercado in Brazil, which has different levels of corporate governance standards, all higher than the main stock exchange. Firms can choose the level they want, and the system is backed by private arbitration measures to settle corporate governance disputes. Efforts like these can help corporations improve corporate governance at low(err) costs as they can list locally. There is evidence, however, that these alternative corporate governance mechanisms, apart from being costly, have their limits. In a context of weak institutions and poor property rights, firm measures cannot and do not fully compensate for deficiencies. The work of Klapper and Love (2002) and Durnev and Kim (2002) shows that voluntary corporate governance adopted by firms only partially compensates for weak corporate governance environments. There are also elements of self-selection, with worse firms choosing to list in worse environments. Competition between stock exchanges takes many forms, including not only listing standards, but also the direct cost of trading. This suggests that firms consider several dimensions in selecting where to list. One study, for example, has argued that family-owned firms prefer to choose to list in weak corporate governance environments (with perhaps higher trading costs). These markets would have little incentives to improve their corporate governance standards. By contrast, (large) firms with diversified ownership structures prefer to list in international markets (Coffee 1999 and 2001). Nevertheless, there are many other reasons why firms do not adjust their corporate governance or list in the environment optimal from a cost of capital point of view, including entrenched owners. The role of political economy factors Importantly, countries do not always reform their corporate governance frameworks to achieve the best possible outcomes. In some sense, this is shown by the pervasive importance of the origin of the legal system in a particular country in many analyses and dimensions. Whether a country started with or acquired as a result of colonization a certain legal system some century or more ago still has systematic impact on the features of its legal system today, the performance of its judicial system, the regulation of labor markets, entry by new firms, the development of its financial sector, state ownership, and other important characteristics (Djankov and others 2003). Evidently, countries do not adjust that easily and move to some better standards to fit their own circumstances and meet their own needs. Partly this is because reforms are multifaceted and require a mixture of legal, regulatory, and market measures, making for difficult and slow progress. Efforts may have to be coordinated among many constituents, including foreign parties. Legal and regulatory changes must take into account enforcement capacity, often a binding constraint. While markets face competition and can adapt themselves, they must operate within the limits given by a countrys legal framework. The Nova

Mercado in Brazil is a notable exception where the local market has attempted to improve corporate governance standards using voluntary mechanisms. But it needs to rely on mechanisms such as arbitration to settle corporate governance disputes as an alternative to the poorly functioning judicial system in Brazil. Experiments with self-regulation in corporate governance, as in the Netherlands, have often not been successful.14 The ability of corporations to borrow the framework from other jurisdictions by listing or raising capital abroad, or even incorporating, is limited to the extent that some local enforcement of rules is needed, particularly concerning minority rights protection (see Seigel 2002 for the case of Mexico). Causality is unclear, as weak corporate governance standards could have led to more concentrated corporate sector wealth. Conversely, a higher concentration of wealth could have impeded improvements in corporate governance. For example, in Indonesia, there are direct relationships between the government and the corporate sector. The sample is too small to make any statistical inference. Nevertheless, it does suggest that wealth structures may need to change in order to bring about significant corporate governance reform. This can happen through legal changes (over time), and also as a result of direct interventions (such as privatizations and nationalizations, as during financial crises). Reforms can also be impeded by a lack of understanding. Partly this will be linked to political economy factors, perhaps directly related to ownership structures, as when the media is tightly controlled. To date, the relationships between institutional features and countries more permanent characteristics, including culture, history, and physical endowments, has not been widely researched. Institutional characteristics (such as the risk of expropriation of private property) can be long-lasting and relate to a countrys physical endowments (Acemoglu and others 2003 show this for a cross-section of countries). Both the origin of its legal systems and a countrys initial endowments are important determinants of the degree of private property rights protection (Beck, Demirg-Kunt, and Levine 2003). The role of culture and openness in finance, including in corporate governance, is also important (Stulz and Williamson 2003). More generally, the dynamic aspects of corporate governance reform are not yet well understood. The underlying political economy factor that may drive changes in the legal frameworks over time is the subject of a study by Raghuram Rajan and Luigi Zingales (2003a). They highlight the fact that many European countries had more developed capital markets in the early twentieth century (in 1913) than for a long period after the Second World War. Importantly, many of these countries capital markets in 1913 were more developed than the U.S. market at that time. A review of ownership structures at the end of the nineteenth century in the United Kingdom (Franks, Mayer, and Rosi 2003) shows that most UK firms had widely dispersed ownership before they were floated on the stock exchanges. And in 1940 in Italy, the ownership structures were more diffused than in the 1980s (Aganin and Volpin 2003).

The Code of Corporate Governance

In March 2002, the SECP issued the Code of Corporate Governance (the Code). The Code is a code of best practice and all listed companies have to include a statement in their annual report as to the level of compliance with the best practices detailed in the Code. This statement must be reviewed and certified by the companys auditors. The Code specifies best practice in terms of: The composition and the duties of the board of directors; The appointment, qualification requirements and the responsibilities of the chief financial officer (CFO) and the company secretary; Corporate and financial reporting including the disclosure of directors interests and trades; The required free float at the time of the flotation; Takeovers; The need for an audit committee and its duties; Internal auditing; Corporate Governance as a Legitimizing Force From an institutional perspective, legitimacy is not a commodity to be possessed or exchanged but a condition reflecting cultural alignment, normative support, or consonance with relevant rules or laws (Scott, 2001: 45). As such, corporate governance practices mediate between corporate sovereignty and social legitimacy (Bonnafous-Bouchler, 2005). As Kostova and Zaheer (1999) point out, traditional institutional theory examines legitimacy at two levels of analysis: (1) the organizational field level, and (2) the organizational level.

In this study, we examine legitimacy at the societal level within the context of corporate governance practices. This extension of institutional theory to the societal level is not only interesting to institutional scholars, but also relevant and useful to practitioners. In our increasingly

global economy, nation-states are often viewed a potential investment locations (Friedman, 2000). If governance practices are viewed as in general as legitimate or improving in legitimacy, then multinational enterprises (MNEs) would be more likely to invest in those locations. Alternatively, if governance practices are generally viewed as illegitimate or declining in legitimacy, then MNEs might not invest or might even divest operations. Consistent with institutional theory at this level, we focus on the institutionally-based practices underlying Denis and McConnells definition of corporate governance as those mechanisms that induce the self-interested controllers of a company to make decisions that maximize the value of the company to its owners (2003: 2). In sum, nation-states tend to acquire reputations for the acceptability and legitimacy of its corporate governance practices. Since neo-institutional theory is concerned with social legitimization processes and outcomes and since corporate governance practices tend to vary systematically by nation-state, an empirical study of the institutional predictors of corporate governance legitimacy seems appropriate. The term corporate governance refers to the relationships among management, the board of directors, shareholders, and other stakeholders in a company. These relationships provide a framework within which corporate objectives are set and performance is monitored (Mehran, 2003). Corporate governance also provides a structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently (OECD, 1999). Empirical findings Findings on Corporate governance issues after financial crisis, corporate scandals and market manipulation First of all, we found out that the internal and external committee audit showed disadvantages and weak points during the audit process which lead to rooms for managers using manipulation tools to create an unreal financial picture of scandal

companies. The reasons might be including: there still exists an insufficient information system or database which contribute to ineffective business decision making in those companies. The second important corporate governance issue is that the corporate governance mechanisms is not complete and perfect in the aspect that controlling shareholders and group of minority shareholders participate into internal business issues of top management over the acceptable necessary requirements and therefore, it puts a lot of pressure on the efficiency, the effectiveness of the business , also the higher ROI commitment on the shoulder of the board of directors and CEO without considering to the current business context. This leads to negative manipulation and unstable changes in the businesss security market. Third, among important covered issues is the timing issue of corporate annual reports announcement to the public is another corporate governance issue. It includes issues such as: a) Common delays in delivering on-time annual financial statements to the public; and b) Insufficient data or information announced to the public on company website at certain points in the fiscal year, especially during and after financial crisis or suddenly changing in the management board. So, this also relates to the validity and control of regulations in information management on the company website. We can point it out another CG, corporate governance, and issue. That is, the appraisal of following code of ethics of the company and industry in specific markets is not done with full of responsibility or is done just on the business surface. Or in another word, there still lacks of the appraisal of the role of the legal or compliance division in the company which contributes to the bad results on the corporate performance and scandals. Last but not least, one major corporate governance issue existing as the main cause to corporate scandals of these companies is that there is a question on the quality of the management skill and talent of companies CEO and his or her colleagues in the board of management. Or in another way, it is the issue of evaluating and appraising the efficiency and effectiveness of their management and governance capacity during both business growing stage and recession stage

Findings on Construction of a Limited Common Asian Pacific Corporate Governance standards Asia Corporate governance standards analysis In Japan One of major different features in the Japan 2009 revised principles is that it views the Company or Corporation as the whole entity in constructing its corporate governance standards. Therefore, it, the company, has a responsibility in developing and improving an internal check and balance system for the Auditors, Board and other groups make their business judgments. And it also guarantees necessary facilities such as human resources and infrastructures to support the audits. Besides, the 2009 Code expands the interests from the corporations shareholders to its stakeholders, in order to create a harmony relationship between the company and its stakeholders and to create corporate value and jobs. Here we can see the role of the corporation when it is looked at as the whole entity and take into consideration of building a corporate culture in favor of its stakeholders. Additionally, The Japan Corporate governance principles have an ambiguous point when it describes the other relevant groups in supervising Management. And also, it still does not pay more attention to the supervisory roles and structure in favor of the CEO and Board. In conclusion, the Japan principles cover a variety of issues which is based on a shareholders- oriented point of view. In Philippines In the Philippines, the general corporate governance guide is called the Code of Corporate Governance which has a good foundation on reference criteria of corporate governance guidelines from World Bank and OECD principles of Corporate Governance. It is established in 2002 by SEC and revised in 2009 after the World Bank issuing the ROSC in 2006 (ROSC stands for Report on the Observance of standards and Code). It aims to strengthen the investor confidence, develop the capital market and help the corporate sector and Philippines economy to achieve the sustainable growth. Within the appropriate timeline and research objectives, this paper cannot cover the changing features of the old 2002 Code, compared to the new 2009 Code, so this is its limitation. Below analysis is focusing on the Code that took effect on July 15th, 2009 in Philippines. According to the revised 2009 Code, Corporate governance is understood as a framework of rules, systems and processes that govern performance by the Board of Directors and Management of their respective duties and responsibilities to the stockholders. This

formed a general legal system governing the corporation and also provides good understanding for the authorities and auditors while still exclude the emphasis of CEO roles. Besides, the internal control functions are separated from the internal audits ones, with the goals covering the accomplishment of the companys goals, efficient operation, reliability of financial reports, and faithful; compliance with applicable laws and internal rules. The Code has a good point when it mentions the internal audit department in this revised 2009 version with an emphasis on objective assurance to add value to the company itself. Next, the Board of Director is classified in 2 groups: executive and non-executive directors which involve the independent directors. Non-executive directors are appointed not to be Head of Department and not performing any work related to the companys operation. So, the co-existence of both independent and non-executive directors probably causes a misunderstanding or difficulty in separating and clarifying their duties. Additionally, while The 2009 Code allow the unify of CEO and The Chair, it also describes clearly the roles of the Chair in the Corporation which still has points misleading the CEO in many cases of decision -making in the Company. The reason is that the CEOs qualification and responsibilities are not well and clearly defined, in regarding to the Chairs duties. Another point is the organization of the Audit committee in the company. Though it provides a good definition on the composition of the board committee, it still had an overlap or might probably cause confusion between the roles of compliance and the roles of the audit division. One of the point show the importance of this body is the obligation to ensure that the internal and external auditors have unrestricted access to the companys records, properties and personnel. Therefore, it will be better if the Code clarify more on the responsibilities of the Internal Auditor and the difference between them and the External Auditor when it mention the independent internal auditor in the appointment and organization of Internal audit department. Moreover, in the light of the Code, we can see the detailed role of the Audit committee in the evaluation of non-audit work of external auditors which are difficult to some corporations, but we have to define the clear boundary again between a so-called non-audit versus audit works and the evaluation process as well. Last but not least, the Secretary of the Corporation is pointed either its legal counsel or the one aware of laws and rules. After the financial crisis, it is necessary to conclude that this criteria should be updated for him or her as the sub quality factor in the below table. And it is quite helpful to suggest that he should ensure that the meeting members have accurate information, before, that facilitates an intelligent decision. Finally, the 2009 Code highlight the role of the Compliance Officer in giving recommendation and measures to avoid the repetition of the Code or Rules violation. In general, the Philippine Code 2009 built a good standard for the Internal Audit department and mechanisms. It clarifies the duty of the Internal Auditor in delivering an annual report on its activities, duties and audit plan covering risk and control issues. Besides, it, the Code, still has some more works to do with constructing a good standard for the CEO of the company, and the procedures for separating the Chair and the CEO in case they are different people.

Also, it still has to clarify terms such as other matters or issues which cause ambiguous understanding for the Internal Auditors responsibilities. To be better in transferring the Code message to the Companys Top management team, it should focus more on describing the separate functions between the Board of Directors and The CEO. Based on the revised 2009 Code, each corporation can build its own corporate governance system including rules, procedures and principles in accordance to the Code

CONCLUSION In efforts to prevent and control the above analyzed corporate governance issues after crisis, scandals and negative manipulation, each country in this research paper is on the way to modify and revised their suitable Code of Corporate Governance and achieve important and different levels of corporate governance system, structure, mechanisms and positions. Philippines Code is mainly allocating the corporate governance system to the corporations Board of Directors while Japan Code uses a shareholder-oriented philosophy and considers the company as the whole entity in establishing and maintaining its governance relationships La Porta et al. (1998) assign Pakistan, a common-law country, a maximum score of 5 for their anti-director rights index. Pakistan should therefore be a country with good investor protection attracting large amounts of investments. However, the reality could not be more different. Pakistan has been lagging behind other, comparable Asian economies in terms of incoming foreign direct investment as well as GDP-percapita growth. Given the crucial role that the finance industry plays in promoting and sustaining economic growth in emerging markets, this paper focuses on Pakistans banks. The paper reviews some of the recent reforms of corporate governance, such as the introduction of the Corporate Governance Code (2002). It also comments on reforms that target the banking industry such as the privatization of financial institutions and the strengthening of its financial structure. To conclude, Pakistan has made major steps in improving the governance of its corporations in general and that of banks in particular. However, more efforts need to be made in terms of improving levels of compliance with the Code. Given its crucial role in promoting and sustaining economic development, Pakistans banking industry needs to be aware of its role as a leader in high corporate governance standards. It has been seen that owing to the opacity of banks and the relatively high degree of regulation, corporate governance measures are often faced with a hindrance. While this is generally true for all banking institutions, the governance issues become more difficult in government owned banks or public sector banks because the government typically owns, manages and regulates such banks

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