It is now believed that the contagion of optimism that grew the speculative bubble in the US real estate market in 2007 and 2008, and the consequent financial crisis are to an important extent attributable to the failures and weaknesses in corporate governance arrangements. It demonstrated that governance lessons learnt from the earlier crisis and corporate governance failures in 2000 were short-lived and the bulwarks raised were unpredictably weak.
While computer models and technical assumptions for risk management proved inadequate in 2008, the corporate-governance drills also did not serve to safeguard against excessive risk-taking by financial services companies. The sensitivity of financial institutions to shocks was weakened by the remuneration and incentive systems, and these contributed to the development of unsustainable balance sheet positions and deficiency in board oversight. The incentive systems remain a highly controversial issue in the US and OECD countries. The information about exposures did not often reach the boards. Some companies took high levels of risk by following the letter rather than the intent of regulations. The boards were in many cases neither clear about their responsibilities, nor paid enough attention to their duties. Many boards became “retirement homes for the great and the good”. The boards often approved the strategy but did not establish suitable metrics to monitor its implementation. Accounting standards and regulatory requirements also proved insufficient in some areas, leading the relevant standard setters to undertake a review.
When systemic failures of astronomical proportions occur in any country or industry, more so in the financial services industry, the immediate response is to re-examine the prevailing regulatory paradigms. The attempt, then, is to work out an omnipotent, omniscient and omnipresent solution within the present limitations of the human mind. The US did that. A complex piece of legislation – the Dodd-Frank Act – has been enacted, the implementation of which is likely to become an equally complex story of epic dimensions. While this was the position in the US, the position in Europe became complicated by waves of financial crisis threatening the existence of the 17-nation Eurozone. Herman Van Rompuy, president of the European Council, admirably summed up Europe’s predicament in his speech last Thursday at the London School of Economics when he candidly admitted that “when the crisis erupted, we had to start from scratch. There was a complete absence of appropriate instruments. There was even an interdiction to take certain types of action (no bail-out clause). Politically, it was also difficult to act, both in the debtor countries, which had to accept reform programmes with strict conditionality, and in the creditor countries, who guarantee the loans”.
The changes in the regulatory paradigm in the US and the Dodd-Frank Act have introduced a few new concepts, given birth to new fads and refined some of the existing concepts.
Stress testing is a common term in medicine and material management that found its way into the finance and governance lexicon after the financial crisis. In 2009 and 2010, under the US Supervisory Capital Assessment Program, the US Federal Reserve System and supervisors assessed if the largest US financial organisations had sufficient capital buffers to withstand recession and the financial market turmoil. The Committee of European Banking Supervisors has mandated stress tests for banks in Europe since 2009. Stress testing and related scenario analyses have now become important risk-management tools for any board in its oversight of management and reviewing and guiding strategy.
Risk intelligence is a reincarnation of the old term risk management. The term implies the capability to learn about risk and uncertainty, think about risks and to estimate probabilities accurately. Successful companies have been using a risk-management framework that focuses not only on risk avoidance but “risk intelligence” — viewing all challenges and opportunities through the lens of risk and integrating risk into the overall governance process. It is like viewing the brake in a car as a mechanism to drive faster.
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Funeral plans and living wills are very new concepts. In plain English, they mean nothing but enhanced planning for the risk of failure. The Dodd-Frank Act talks of funeral plans, intended to end “too big to fail bailouts”. It requires large, complex financial companies to periodically submit rational plans for their rapid and orderly shutdown should the company go under. Regulators hope that they will then be in a better position to understand the structure of the companies they oversee and a roadmap for shutting them when they fail. As future regulatory and industry standards and best practices emerge, a wide range of financial companies may be required or simply find it prudent to prepare some form of a living will.
These new thoughts, however, have not given way to some of the prevailing governance processes. Indeed the financial crisis, the Galleon insider trading case and the News of the World phone-hacking scandal have highlighted the need to strengthen these. The overarching principle is increasing the boards’ professionalism and the need to have effective chairmen. The boards are now focusing their attention on:
- Reassessing roles through the development of board charters;
- Making the boards more engaged and assertive;
- Positioning risk management as a key board responsibility;
- Giving due importance to the board’s composition and focusing on the competencies of improving the nomination process to induct independent and competent directors;
- Encouraging remuneration practices that balance risk and long-term performance;
- Conducting board evaluation using formal and rigorous methods on a regular basis.
How many of these new thoughts and ideas will be implemented and how many will turn into fads and invade the “consultant speak dictionary” remains to be seen.
The author is former executive director of Sebi and is currently associated with the IFC’s Global Corporate Governance Forum of the International Finance Corporation and the World Bank. These views are personal