Corporate Governance Failure in Financial Serivices in the Uk

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Who is to blame for governance Failings? The author’s analysis and opinion

It is that it is clear that both the board of directors and the institutional shareholders of banks contributed to governance failings. Boards were incapable to respond to changing business models and adapt to increasing complexity of financial innovations. It is the board’s responsibility, as the principles state, to remain abreast of relevant laws, regulations and changing risk through in-house training and external courses. They failed to take into consideration the risk factors before approving company strategy. Disclosures of the foreseeable risk factors and about systems for monitoring and managing risk were minimum in many banks in an inefficacious accounting and regulatory environment (Kirkpatrick, 2009).

Although it is well known that governance literature argues that board is more efficient when directors hold fewer outside directorships and boards are more independent, i.e. contain more directors without social or business connections to management (Adams et al., 2009), initiatives to improve board structure and composition where not taken neither by the board or its shareholders in an atmosphere where everything seemed perfect, profits where high and no changes were needed.

Shareholders engagement and monitoring was clearly insufficient as companies were not regularly required to give a clearer and broader view of solvency liquidity, risk management and viability so that they could assess these statements thoroughly and engage accordingly. In addition, neither the shareholders nor the external directors did anything to ensure that executive remuneration was aligned to the firm’s risk-appetite and log-term success, contributing to the failure of corporate governance. It seems that those who did raise questions about overexposure to risk, where replaced by others with less technical experience.

Paul Moore, the former HBOS head of group regulatory risk, who claims that he was sacked after raising concerns about overexposure to risk to the bank's management, explained that "sales targets and bonuses were right at the heart of the bank's collapse and that the board appointed Carphone Warehouse founder Charles Dunstone as head of the retail bank's risk-control committee when he had no technical expertise" (The Guardian, 2009). This shows that even though the senior management in some banks were made aware of paying more attention to risk management, there was no interest[6] in the short-term as long as “the music was playing.” . Citigroup CEO Chuck Prince told the Financial Times in July-2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing” (FT, 2007)

There is some literature in defence of the CEOs. Fahlenbrach and Stulz (2011) found no evidence that excessive option compensation of CEOs encouraged excessive risk taking. From these findings, along with their finding that CEOs did not reduce or hedge their equity holdings during the crisis, they suggest that CEOs acted with shareholder interests in mind before the crisis, and that the poor ex post results, costly to both the CEOs and their banks, were not expected by CEOs. However in the author’s opinion, not anticipating losses and inadequate protection from situations of stress is not an example of good corporate governance. In addition the interests of dominant institutional shareholders may have differed from the interests of more passive individual shareholders, whose dispersed ownership incurs in high costs when attempting to gather and discuss corporate strategies. The fact that some banks weathered the storm better than others and did not require bail-outs during the crisis, ceteris paribus, remains a clear argument for management failure.

Analysis of what has happened shows that both board of directors and shareholders failed to self-police, independent of the existence of a strong and competent regulatory regime. Surely the disproportionate power in the hands of managers and higher exposure to the moral hazard caused by “to-big-to-fail” factor should bear them with greater share of responsibility, compared to the institutional shareholders.

Recommendations for improvement of corporate governance of banks

Recommendation 1

Remunerations structures of high-end employees and executive board members must be aligned with long-term performance with appropriate adjustment for risk appetite of the firm. (Walker, 2009; Laeven et al., 2010). Fixed remuneration should be increased to compensate for the deferral of payment of variable remuneration, which should be linked with performance assessments of actual income earned over at least three years (Van Den Berghe, 2009). At least three-quarters of variable incentives should not be paid before three years, from the end of the fiscal year. Claw-back policy should be used to control extreme risk taking behaviour as it will make executives to bear financial liability for the losses incurred by the companies for their mistakes (Fetisov, 2009; Sharfman et al., 2009; Walker, 2009)

Recommendation 2

Risk management is an important area of reform[7]. BOFIs should have a separate risk management control at board level under the authority of a CRO (Muelbert, 2009, Walker 2009) The CRO should be a knowledgeable person with the highest level of integrity, be under control of the board, and should have complete authority to implement a risk management system at the highest level on an enterprise-wide basis and have a status of total independence from individual business units. The CRO should report to the board risk committee, CEO, CFO and have direct access to the chairman of the committee if needed (Walker, 2009).

Recommendation 3

Accounting standards and transparency and disclosure norms should be reformed. BOFIs should collect, disclose and perform risk disclosure based cost benefit analysis and its extent in affecting the companies existence as suggested by Laeven et al. (2010). Universal accounting and valuation methods should be used to ensure fair reporting to shareholders and investors (Clarke 2010). The CRO should put special emphasis on promoting fair value accounting and transparency on off-balance sheet items to the shareholders, and other board members.

Recommendation 4

It is important to make reforms on board size, composition, qualification and practices. Empirical evidence suggests improvement of