Why the crisis in the financial markets is about Corporate Governance not Executive Pay or Bonuses
by: Iain Greenwood, MA, MIoD, FIBC
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Summary:
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The media and politicians have over the last few weeks polarised a lot of the issues relating to the current crisis around risk and reward. In other words unacceptable risk taking was tolerated as it led to higher profits for the financial institutions and this then led to the insiders paying themselves obscene amounts of money in salary and bonuses.
This article aims to widen this issue (albeit it in a simplified way), leading to what the author believes is the more compelling debate. Are our financial institutions being governed in line with accepted standards of Corporate Governance and Prudential probity?
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In 1995 the world had to suffer the collapse of Barings Bank due to the dealings of one individual and in 2001 it had to deal with Enron amongst others. Well what is the significance to here and now? Both were failures of Corporate Governance, the former being manipulated by a low level individual who by passed a Board of Directors who did not understand how certain financial instruments worked, the later a number of Board Directors manipulating the financial probity of the company to enhance their remuneration. In both Britain and the US, Corporate Governance standards for all major organisations were strengthened to cover remuneration as part of the overall responsibilities of the board, the integrated approach to Corporate Governance is the key to the current issue not the single element of remuneration.
So why does this matter now and what is Corporate Governance?
Both of the above examples, Barings and Enron are part of the same issue, the Boards of Directors did not take on their responsibilities with the due care and diligence that they are required to do.
So what is Corporate Governance? Well it is very simple really, it is the framework that people at the top of an organisation use to ensure that they run the organisation in the most efficient, compliant and sustainable way, maximising returns within those given parameters.
To underpin this concept in the UK, elements of the Cadbury, Greenbury, Hample and Higgs reports were moulded together and named the Combined Code, listed company directors (including all the top banks) were made to adhere to this by the Stock Exchange and Investors.
Over and above this the Financial Services Authority (FSA), over a period of years has issued its Prudential Source Book, which sets out the responsibilities for banks including capital requirements and risk.
These are the main tenets of Corporate Governance for UK banks.
So what relevant elements are within these tracts of Corporate Governance?
There are a number of elements that are relevant to this current crisis, these include:-
• An audit and risk committee to oversee the organisations balance of risk and return (chaired by a Non-Executive director), its regulatory compliance and capital requirements
• A remuneration committee to set executive pay (chaired by a Non-Executive director) and also the committee should set the overall remuneration framework for the organisation
• An appointments committee to ensure appropriate directors are appointed to the board, both executive and non executive directors (Non-Executive directors adhering to specific elements of the Combined Code). This committee again needs to be chaired by a Non-Executive director.
Hopefully, it can be seen quite clearly from the above, the issue of executive pay is not the main issue that the board needs to consider. In fact, it is more about the dynamics between Executive and Non-Executive (Non-Execs) director’s roles and responsibilities than anything else. This is where the organisation will either be run compliantly and appropriately or not.
Of particular note here, is the issue of risk and how much is acceptable for that bank to carry. The Non-Execs role is to ensure that the executives and staff are running a sustainable, compliant and profitable organisation. They are also responsible for setting the remuneration framework to reward both senior and junior staff for managing the risk/reward balancing act.
The crux of the matter here is that if there is a failure in the risk/reward balance then it is a failure of Corporate Governance and oversight which is the more important issue that the regulators and government should be looking at.
So what are the implications of the government taking on a role as a major investor in stock market listed banks?
Firstly, the government needs to ensure that its involvement is seen by all parties as legal and compliant.
An important example of this is the appointment of 5 Non-Execs to two of the banks boards. Not only do these Non-Execs have to be credible, but also they need to be seen to be impartial, ensuring that they comply with Company Law, putting the best interests of the company and all shareholders before their own or any single shareholder. This is very similar to the situation that a Non-Exec is in when a Private Equity firm takes a stake and appoints a representative to the board. The Non-Execs legal responsibility is to the company and all shareholders not just one.
Secondly, whilst it is not known by the author what exactly is going on behind the scenes of government, it is important that there is co-ordination between all the different arms of government. At the moment it appears the different parts of government listed below are involved in some way or other either through direct input or legal responsibility:-
• The Treasury
• The Financial Services Authority
• The Bank of England
• Department for Business Enterprise and Regulatory Reform
• The Cabinet Office
• Companies House
• New Arms Length holding company
It is therefore important to ensure that the banks that either have been taken over or are having significant public money put into them are not hampered by separate guidance from different parts of government, there has to be a co-ordinated approach, hopefully this will be done via the New Arms Length holding company.
Thirdly, it is important to allow any bank that the government invests in to set its own transparent and sensible lending rules to ensure proper compliance within the framework set out by the Audit and Risk Committee as part of the bank’s Corporate Governance. This does not mean the current situation of the unacceptably low levels of lending should be allowed to continue, but it also means not being pushed down a route by government advisors to lend to certain targets. The dangers of target setting by government could come back to haunt the taxpayers by creating further toxic debt in future years and ultimately undermines the tenets of Corporate Governance .
Finally, it is also important for government to accept that there is already a Corporate Governance framework out there which if applied robustly and clearly will protect all owners of the business whether it be taxpayers, normal shareholders, money market investors or customers. It may need some revision but government needs to avoid creating a new framework to oversee these organisations.
Conclusion
It is hoped this article will spark debate about how to manage the current situation and move the discussions away from only one element, remuneration, to what is the crux of the matter true Corporate Governance, the running of complaint and sustainable financial institutions.
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Author Details:
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Iain Greenwood, MA, MIoD, FIBC
Managing Director
Forward Management & Consulting Limited
igreenwood@fwdmgmt.com
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