When the leaders of the G20 nations met in Washington in November to discuss the impact of the credit crunch, they made it clear that financial firms will face much tougher regulation in future. “We must lay the foundation for reform to help to ensure that a global crisis, such as this one, does not happen again,” their end of summit communiqué said. There was little detail about how they would actually achieve this; more plans are promised for the end of March. But the general point was clear: there had been a systematic failure, so “the system” needs to be fixed
Perhaps surprisingly, the G20 had very little to say about standards of corporate governance in the financial sector (see sidebar). There was much talk about the need for banks to improve their modelling and their risk management practices, to re-examine their internal controls, and to disclose more about risks. But there was only a fleeting mention of the need to improve governance. This is despite the fact that all of these specific criticisms of banking behaviour can be traced back to a failure of board-level corporate governance. Doesn’t that mean that the system of corporate governance has failed too, and therefore needs to be fixed?
The Financial Reporting Council, which is responsible for the UK’s Combined Code on Corporate Governance, the leading international benchmark, says not. Its chief executive, Paul Boyle, argued in a recent speech that “the primary questions should not be about the standards of corporate governance in these institutions but rather the practice of it. The focus should be on whether the existing standards have been observed in practice.”
The Code, for example, says that a company’s board should “provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed.” It goes on to say that non-executive directors “should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible.” Bank boards have failed to meet either of those principles. But that doesn’t mean the principles are wrong, Mr Boyle argued.
Asking the right questions
If it is the practice, rather than the code, of corporate governance that is at fault, what should be done? The governance consultancy Independent Audit recently convened a meeting of 120 chairmen, chief executives and directors from FTSE 100 and 250 companies to discuss that question. “There has been a failure of governance, and that really centres on non-executives,” concluded Ken Olisa, Chairman of Independent Audit. The UK government’s new City minister, Lord Myners, said that boards were “part of the problem” and need to be strengthened. Lord Myners called on investor groups, such as the Association of British Insurers and the National Association of Pension Funds, to provide better training and guidance for non-executives.
The UK’s corporate governance system is hinged on their effectiveness. They are meant to perform the role that Walter Bagehot described for the monarchy: to be consulted, to encourage and to warn. But too often, they ask the difficult questions only when things have started to go badly. Delegates at the Independent Audit event wanted to see the performance of non-executives improve. They called for clearer selection criteria, so that better directors are appointed in the first place. They wanted them to get more training. And they suggested some quick fixes, such as holding informal meetings outside the confines of the traditional boardroom – to make it easier for non-executives to raise a challenge – and a ban on PowerPoint presentations, so that people had to actually engage with each other.
But perhaps the corporate governance model asks too much of non-executives? They are on a hiding to nothing. If the business thrives, the executives make more money – in salaries, bonuses and on their share options. But the non-executives don’t. Yet if the business falters, they catch as much flack as the executive directors, sometimes even more. They get none of the upside and all of the downside. This wasn’t such a problem when holding a non-executive role at a bank or FTSE company was a cushy number. But increased regulation and corporate governance reform has massively increased the workload and responsibility burden of the typical non-executive. No wonder companies say it is becoming more difficult to find good candidates – a problem that the current crisis will only make worse.
Institutional shareholders also have a crucial role to play in corporate governance, yet their engagement with companies on governance issues tends to be poor. With a few notable exceptions, they have been unwilling to invest in developing their ability to monitor and challenge governance practices, lapsing instead into mindless box-ticking.
Remaining on radar
And what of senior executive and management performance? A recent report from an all-party parliamentary committee, established “to develop and enhance the understanding of corporate governance”, pointed to a “surprising lack of board level contact between senior managers and directors.” It argued that over the last decade, the proportion of the board composed of hands-on, executive directors had declined to the point where they now account for less than a third of all board members in the FTSE 350. Yet over the same period, many of these companies have witnessed a significant increase in the size and complexity of their businesses.
These two trends have increased the responsibilities of the senior managers who are just below board level, such as the directors responsible for human resources and information technology and the chief risk officer. In a typical FTSE 100 company, the members of parliament found, nearly half the executive committee is not represented on the main board. HR directors, for example, had a board seat at only six percent of FTSE 350 companies. The report concluded that these people, who slip below the governance radar, are the ones who really run UK plc. Non-executives needed to “get beneath the skin of the board”, said Philip Dunne, the Tory MP who chairs the all-party group, and companies need to “provide shareholders with more confidence in the capabilities and skills of key executives below board level.”
There is another reason why these executives need to be more involved in corporate governance. The Senior Supervisors Group, which represents financial sector regulators in France, Germany, Switzerland, the UK and the US, warned recently about the risk of companies fracturing into “organisational silos” based on highly technical management functions. Poorly run companies often “lacked an effective forum in which senior business managers and risk managers could meet to discuss emerging issues frequently; some lacked even the commitment to open such dialogue,” it said. The financial firms that had the best control over their balance sheet growth and liquidity needs were those that: “demonstrated a comprehensive approach to viewing firm-wide exposures and risk, sharing quantitative and qualitative information more effectively across the firm and engaging in more effective dialogue.” There was a risk of disconnect, the group said, between the people effectively running the company and the board-level directors to whom governance principles apply.
Jaap Winter, the Dutch law professor whose ideas are behind much of the European Union’s approach to corporate governance, has talked recently about the need to make senior managers – indeed, all employees – more accountable and responsible, rather than creating more board-level rules and regulations.
Mr Winter told the annual conference of the European Confederation of Institutes of Internal Audit (ECIIA), held recently in Berlin, that errant human behaviour caused financial crises, not flawed systems. “No system has ever generated a crisis,” he said. “The first reaction is that the system has failed so we need new rules. We ask for more rules and more enforcement, but we forget about our own behaviour: what is it in us that we continue to game the system?”
Mr Winter said increased regulation of financial firms and general corporates was leading to the “self-enforcement” of a compliance culture. There were already far too many rules for regulators to monitor and enforce, so they were outsourcing that work to companies themselves, he argued. This growth in corporate compliance was having a pernicious effect: crowding out personal responsibility. “It is not helping us, it makes things worse,” he argued. “What compliance is doing is making sure people follow rules. We forget about our own responsibility for our behaviour and replace it with responsibility for compliance.”
Never again?
Leaders of the G20 have pledged to reform the global financial system
The G20 leading nations met in Washington on November 15, 2008, amid serious challenges to the world economy and financial markets. The group said it was determined to enhance its cooperation and work together to restore global growth and achieve needed reforms in the world’s financial systems.
The powerful club of nations said that in the months it would lay the foundation for reform to help to ensure that a similar global crisis does not happen again. Specifically, there would be action to stabilise financial markets and support economic growth.
Regulation is high on the agenda. The G20 said first and foremost this is the responsibility of national regulators, who constitute the first line of defence against market instability. However, financial markets are global in scope, so “intensified international cooperation among regulators and strengthening of international standards” was necessary.
The group’s end of summit communiqué said that regulators must ensure that their actions “support market discipline, avoid potentially adverse impacts on other countries, including regulatory arbitrage, and support competition, dynamism and innovation in the marketplace.”
Financial institutions must also “bear their responsibility for the turmoil” and should do their part to overcome it, the G20 said. This included recognising losses, improving disclosure and strengthening their governance and risk management practices.
The group committed itself to strengthening financial market transparency, including by enhancing required disclosures on complex financial products and ensuring complete and accurate disclosures by firms of their financial conditions. It also wants clearer alignment between incentives and risk-taking.
