The Role of Audit Committees in Central Banks

Introduction:

The concept of audit committee was brought into light after the constitution of the Cadbury
Committee in 1992. The committee recommended this concept as one of the Code of Best
Practices in good corporate governance. The significance of audit committee in the context of
good corporate control mechanism was also highlighted in the Armstrong Corporate Governance
Principles. The same was given prominence in the OECD Principles of Corporate Governance
and Basel Committee paper on Enhancing Corporate Governance for Banking Organizations.

For the purpose of enhancing the structure of corporate governance, the audit committee needs a
good acquaintance of the underlying accounting framework, the organizational relationships
upholding governance and the process of its financial reporting. However, the scope of audit
committee varies depending upon the prevalent practices, mandatory and regulatory provision
and nature of governance framework exercised by an entity.

Commercial corporations and public sector undertakings are brought under the purview of a
fairly well developed good governance principles as compared to the central banks. However, in
the recent years, to constitute an audit committee is increasingly being considered as best
practice for central banks as well. The International Monetary Fund (IMF) also frequently
recommends the formation of an audit committee in the Fund’s Safeguard Assessments.

As compared to the commercial undertakings for which accounting frameworks are typically
designed, the objective of a central bank is usually the effective and efficient policy
implementation of its designated objectives and functions rather than maximization of
shareholders’ net worth. The financial reporting framework for a central bank should, hence, in
principle, be more concerned with stewardship of public funds, i.e., efficient utilization of
resources. However, adopting internationally recognized accounting frameworks for central
banks dealing with a broad range of commercial transactions is very useful from a transparency
perspective.

Effective disclosure and assurance of integrity help a central bank to strike a balance between
autonomy and accountability. The transformation of traditionally functioning central bank in the
era of economic deregulation has shifted the attention towards transparency, holding the

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autonomous central bank accountable for attaining clearly identified and prioritized objectives.
An effective system of financial reporting in the central bank supported by consummate good
governance is instrumental in the proper performance of an autonomous central bank. The focus
on governance and accountability provides strong incentive for a central bank to formulate an
audit committee. This mechanism for adopting the audit committee concept in a central bank
functioning as a supervisory authority as well will give an opportunity to the central bank to
throw the demonstration effect of adopting the approach of “Practice What You Preach” in the
financial system. The core function of the audit committee in the central bank remains similar to
that of other sector, i.e., to oversee the integrity of the internal controls and the transparency of
financial reporting. The committee is not involved in executive or operational functions. Its focus
sticks around the discharge of the fiduciary responsibilities of the board.

Challenges for Central Banks:

The institutional objective and the governing incentive of a central bank are quite different from
that of a commercial corporate sector. Hence, applying corporate sector’s experience with the
audit committee in the central bank is a challenge. The reliability of and transparency in the
superseding objectives of price stability and financial sector stability differ from those of
shareholders’ wealth maximization. The focus of central bank financial disclosure and the
functions of its audit committee will obviously be different from that of a corporate sector entity.

Several challenges crop up while applying accounting standards in a central bank which could
distinguish its audit committee from those of other corporate entities. The trend towards
harmonization of International Financial Reporting Standards in the context of central bank
accounting facilitates comparability, transparency, and helps avoid “Cherry Pick” accounting
treatment concept being exercised by some central banks. It also enhances the accountability of
the board as well as audit committee in reviewing accounting policy and disclosure requirements.
While striving towards compliance with prevailing accounting standards, a central bank needs to
ensure that financial reporting neither conflicts with its objectives and law, nor exposes its
capital base. IFRS requirements to report foreign currency revaluation gains and losses through
the profit and loss account can generate significant precariousness in the central bank’s
profitability due to the specific structure of its balance sheet. These issues need to be paid due

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attention while preparing financial statements to ensure that the statements disclose reality, do
not generate obstinate incentives and do not indicate non compliance of IFRS requirements.

Similarly, supplementary disclosures beyond areas prescribed by the accounting framework may
help the board better perform its fiduciary obligations. Better transparency is necessary on the
part of the central bank to maximize the benefits of communicating with financial market better.
For this purpose, better and additional explanations may be required to help interpret the central
bank’s balance sheet so as to facilitate better assessment of its performance and to cater the need
of information dissemination to the interest of different stakeholders of central bank with varying
interests in operational details and financial literacy like politicians, financial institutions,
economists, and public at large.

An independent audit committee can play a pivotal role in meeting these challenges. Part of the
role of an audit committee in such circumstances may be to assess the substantive transparency
of the disclosures, and the extent to which they are correct, complete and consistent with the
financial statements. In this context an audit committee can help assure the level of financial
integrity and demonstrate high standards of good governance in the central bank.

Acclimatization of Audit Committee in a Central Bank:

The main objective of an audit committee is to oversee fiduciary duties on behalf of the board
and in accordance with the prevailing internal regulations. These duties consist of the duty to
ensure the existence and operation of effective internal control system, mechanism of risk
management and transparent financial reporting. The scope of the committee may depend upon
country specific factors, like the degree of autonomy of the central bank, and accompanying need
of accountability. The charter of audit committee is a significant vehicle against which the
committee may be held accountable and it provides its members with a clear glimpse of their
precise role within the committee’s overall objectives.

An audit committee will be able to convene its duties and responsibilities in a central bank only
through a process of frequent and iterative interaction with key governance functions of the
central bank. Open communication and interactive cooperation should be established across the
entity for the audit committee to perform its functions effectively.

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The full hearted support of the governor is also necessary in this process, without which it may
not be able to carry out its duties effectively since it will need cooperation from management and
staff. The audit committee is supposed to be composed entirely of non executive members with
specialized expertise. Hence, it might have both open and confidential meetings with the
governor, deputy governors, other pertinent representatives of management, the external auditor,
internal auditor, the financial controller, the heads of strategic planning, regulation/supervision
and the head of risk management, if any, separately or jointly. The committee may require
specific private discussion with the internal auditor or other pertinent management
representatives regarding the governor’s performance with regards to the effective operation of
internal control mechanism or the external auditor’s report on effectiveness of the internal audit
functions. The audit committee relies on the management, internal audit, accounting and risk
management and audit functions so as to perform its duties towards ensuring the existence of
effective system of internal controls and risk management. It plays a complementary role in
establishing good governance in the central bank. It neither replaces internal auditor or external
audit functions nor interferes in management’s operational responsibilities.

However, the key to oversight effectiveness is a circumspectly designed organizational structure

which does not leave any scope for any gaps or overlaps in responsibilities. Irrespective of any
manner the central bank is configured, it is of paramount significance that its audit committee
functions assimilate into the overall governance framework. There should not be any scope of
duplication of efforts or any breach of coverage. A proper balance should be maintained between
the execution of board’s fiduciary functions and the danger of diluting its responsibilities. The
ultimate responsibility for financial integrity remains vested with the board of directors, even
though the authority to discharge this responsibility may have been delegated to the audit
committee. The board of directors should exercise its authority diligently while authorizing the
audit committee to function its fiduciary duties so that it may carefully design and execute the
central bank’s financial disclosure strategy so as to avoid potential reputational risk that may
arise if the public fail to understand the true financial position of the central bank.

Designing Audit Committees for Central Banks

While constituting an audit committee, the central bank should learn from the experience of the
private and public sector. Various issues need to be considered while designing an audit

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committee. The issues like the very objectives of its formation, delegation of authority, reporting
mechanisms, level of autonomy the committee expected to exercise, the composition, terms and
qualifications of the members and the frequency of meetings expected for the committee need to
be considered. Similarly, the resources, administrative and secretarial support necessary to
perform its functions should also be given due consideration. Although constituting an audit
committee is increasingly accepted as a tool for strengthening governance framework, it is highly
important to maintain realistic expectations. It is the fact that an audit committee adds value by
contributing to enhanced objectivity of financial reporting and internal controls and adding
assurance of integrity of the operations of the business. However, the expectations from the audit
committee need to be realistic. The audit committee operates on a part time basis, and it has to
rely on reports compiled by the management, internal audit or external auditor. The board of
directors should ensure that the members of its audit committee have sufficient time to devote to
their allocated task and are not over burdened by other responsibilities.

Basically three main factors need to be considered while forming an audit committee in a central
bank so as to optimize its effective role in good governance framework.

a) Appropriateness in terms of country-specific factors.

b) Independence in terms of appointment, composition and professionalism.

c) Interaction with the board.

a) Appropriateness:

The effectiveness of the audit committee depends upon its configuration within the
governance structure of the central bank in line with the country’s legal system. The
members should have a good understanding of their position in the central bank’s governance
structure and the broader legal framework within which the central bank operates. Due care
also need to be given to the fact that the modalities for delegating oversight duties are
unambiguous so as to avoid any duplication of efforts.

Some central banks may opt for more limited audit committee functions and some opt for
expanded functions based upon the complexities of the financial operations being undertaken
by them. Banks which do not engage in complex financial transactions opt for the former

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 since the oversight functions may not require special expertise and may be effectively
discharged through an advisory committee of the board rather than a more formal
supervisory body which is formed separately in the latter case.

In some other circumstances, the size of the central bank may be so small that it may not be
practicable for a separate audit committee with non-executive members. It normally happens
in case of smaller central bank boards or in less developed countries where the pool of
qualified and truly independent persons are quite limited. In such circumstances, it is
preferable to opt for a sub group of the board comprising of external members to act as the
audit committee subject to the provision that their charter could ensure that the external
members have an open access to the entity similar to that of their executive counterparts and
that their presence be explicitly required for the quorum for the meeting.

b) Independence:

The independence of the members as well as the committee itself is very important for
effective audit committee. The audit committee should be constituted and chaired by a non-
executive member so as to enable it to exercise objective judgment and ask the awkward and
critical questions. The independence as to the duration of the members of the audit
committee as well as independence as to the strict qualification criteria to ensure that
members have the required skills and expertise to exercise good judgment is very necessary
for the formation of an independent committee.

As regarding the duration of the term of a member of an audit committee, the term must
strike a balance between building institutional acclimatization and bringing in valuable
external expertise. Frequent rotation should be discouraged since it will not be supportive to
the consistency and the building of institutional acclimatization. For a smooth transition,
there should be an arrangement that both outgoing and incoming members attend the
committee meeting for a certain predetermined handover period.

Similarly, it is necessary to ensure that members are competent though not necessarily
experts in the areas that comes under the purview of the committee’s responsibility. It is
preferable that the audit committee members be nominated by the board subject to specific
criteria to reflect multiplicity in technical backgrounds. The basic requirement for all

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 members is to be adequately financial literate to be able to put pertinent questions and form
objective opinions on internal controls, financial reporting and risk management.

The audit committee may also require access to external expertise in certain complex
situations. A training budget may be envisaged so as to enhance the professional competence
of the members resulting into effectiveness of the audit committee.

C. Interaction

The interaction of the audit committee with the board from which it derives authority also has
a significant bearing on the effectiveness of the audit committee. An interactive dialogue
between the board, management and the audit committee and a more formal reporting at a
predetermined schedule are important elements for effectiveness of the audit committee. The
chairman of the committee shall play an instrumental role in maintaining a cohesive dialogue
with its counterparts in the central bank. He can play a role of a focal point for communicating
with board and coordinating with the internal and external auditors.

Similarly, overlapping membership and the exchange of minutes between the audit committee
and the board of directors also enhances the relationship between the two bodies. The common
membership in the board as well as audit committee consisting of non-executive members
may tighten the relationship between the board and the audit committee and would also help
the committee to better understand the board’s priorities, thereby adding value to the
governance system and finally resulting into enhanced effectiveness of the audit committee.

Audit committee in the Central bank in Nepal’s Context

The concept of an audit committee in the Nepalese history was initiated by the Nepal Rastra
Bank Act, 2058. Under section 34 of the Act, it has made the audit committee a mandatory
requirement in Nepal Rastra Bank, the central bank of Nepal. The section provides that the board
of directors of NRB shall constitute an audit committee comprising of one director as convener,
Chief of Internal Audit Department of NRB as a member and one senior officer of NRB
designated by the board as another member.

Section 35 of the same Act prescribes about the functions, duties and powers of the audit
committee. This includes submission of its report to the Board on accounts, budget and audit
procedures and control system of the bank, supervision of implementation of the appropriate risk

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management strategies adopted by the bank, and performance and management audit of the
bank.

Based on the above provisions, NRB has constituted one audit committee under the
chairmanship of one non-executive director. However, the terms of reference are not specified
and the business of the committee is regularized by the subsequent activities of the committee
itself. The committee has designed some TOR for itself and working smoothly under this charter
till date.

However, there is no provision regarding the term of the members of audit committee. The
qualification is also not specified and it is at the discretion of the board itself. The Act does not
spell out anything about the independence of the members. One of the members being the chief
of the Internal Audit Department itself, the duration of this member has been at the mercy of the
governor since he can transfer or switch over any department Chief from one department to
another at any time. Similarly, being the staff of the bank two of the members of the audit
committee cannot be expected to play an independent members role full heartedly since they are
accountable to the governor.

In the above circumstances, the effective and independent role of audit committee in Nepal
Rastra Bank is only an imaginary concept. Considering the aforementioned concepts and
requirements for enhancing effectiveness in the functioning of the audit committee and also to
foster independent role of the audit committee in NRB, the provisions made in section 34 of the
NRB Act need to be revised so as to accommodate and attract external experts from outside the
bank itself and also the duration and qualifications for the audit committee members need to be
spelled out. If these provisions could be accommodated, then we can expect that the audit
committee in the central bank will be fully independent and the service of external experts could
be mobilized specifically for the benefit of the bank itself and the economy of the country at
large, resulting into positive support in the governance framework of NRB through effective role
of the audit committee.

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References:

Nepal Rastra Bank, 2058.

Basel Committee on Banking Supervision, 2006, Core Principles Methodology.

Basel on banking supervision, 2006, Enhancing Corporate Governance for Banking

Organisations.

Browmilow, Catherin L., Barbara L. Berlin, 2006, Audit Committee Effectiveness – What works
best, prepared by Price WaterHouse Coopers and sponsored by The Institute of Internal
Auditors Research Foundation, Florida.

Dalton, John, and Hilbers Paul “The Role of Internal Control and Audit System in Supporting
Central Bank Governance and Transparency”, Monetary and Exchange Affairs
Department operational Paper No. 99’/1 , International Monetary Fund, Washington.

OECD, 2005, OECD Guidelines on Corporate Governance of State Owned Enterprises, OECD,
Paris.