Failed Corporate Governance is of course only one of many interconnected and reinforcing contributing factors to the crisis. Other candidates include: greed, wishful thinking and linear extrapolation; an addiction to efficient capital markets and principal agent model thinking; belief in mathematical models replacing judgment; and, in general, regulatory capacity and appetite lagging the developments of global financial markets. Persistent shortcomings in corporate governance do however certainly belong on the list.
What is corporate governance?
Corporate governance for me is the system of rules, regulations and practices by which we hold managers and owners accountable and responsible for whatever performance society expects. Remark that I did not say “by which we hold managers accountable for shareholder value”. That shareholder value and social responsibility are twin brothers in a sustainable world should no longer need defending. That investors and owners should be an integral part of the corporate governance system however is often underestimated.
Corporate governance thus involves many aspects. For example we should have paid more attention to the rules and regulations that govern banks as lenders and as investors. We should also have done a better job of clarifying rights and responsibilities of investors as shareowners. Ultimately however the main instrument of corporate governance remains the role and responsibility of the Corporate Board.
Not that Boards will ever be able to be up to the job of holding management accountable. For that reason we need to add a process of active ownership, which requires investor governance, we also need to have active disclosure and transparency in several areas, and we need sound accounting and reporting. In fact we need al the help we can get to create a system of accountability within which free enterprise can flourish. Even then we will also need a measure of self-responsibility which requires managers to behave as professionals.
Based on my own interviews of directors of financial institutions, and examining recent studies by the OECD and others, it is clear a failure of corporate governance is at the basis of practically every financial institution’s downfall in this crisis, and is also separating those who came out relatively unscathed from those that ran completely aground. Basically, in case after case Boards were either unaware, ill informed, ill equipped or not proactive.
Yet all of this is barely eight years after the previous value meltdown resulted in Sarbanes Oxley, and a whole wave of corporate governance rules and revised codes across the globe.
Did we then not remedy things after 2001? Actually I am afraid not. Based on the primacy of shareholder value and belief in principal agent theory we added financial reporting, strengthened audit committees, assured independence of directors, required financial expertise of committee members, put mathematical risk models in place and moved to fair value accounting, whilst creating an ever greater reliance on variable remuneration to align executives both at the top and on the trading floor.
I would submit that whilst all the corporate governance effort and codes may have helped to bring unsophisticated companies or countries to the basic level of governance structure, it has blinded us for the fact that complex companies were literally out of control. Code compliance gave a false sense of security. As a result we have destroyed the credibility of business to mind its own shop for a while to come.
One problem with corporate governance , and this is a challenge to academics and code makers who want to understand causal relationships and develop structural prescriptions, is that it ultimately it is an issue which is to be dealt with company by company, board by board, as each individual board member steps up to the plate or doesn’t. Structural features of governance are a very poor indicator of real quality of checks and balances in practice.
I would like to suggest that many if not most boards are still struggling to fulfil the roles which are theirs, and also that the root cause of this failing are weaknesses in the Board’s process.
Roles of the board
1) Set direction and approve strategy
From working with Boards I would surmise that in this crisis they typically fell short in three key areas. One is goal setting. What are reasonable stretching objectives? How to look at internal objectives, peer based ambitions or market based expectations. Few Boards have a proper view, little theory is available, yet a lot of the disasters start from inappropriate goal setting and lemming effects. From this flows the next challenge: providing proper business focus. I would surmise that much of the problem is due to inappropriate business scope and product offering extension in search of satisfying these performance expectations. This brings us to the third strategic issue: what is the proper risk appetite for the organisation. This is something Boards failed to set appropriately.
2) Provide proper performance and risk oversight.
Here Boards have fallen equally short. Partly because they did not see both sides of the coin together, partly because they did not understand the risks, partly because they had incomplete information – which in turn is because the underlying processes of risk management were segmented, void of judgment and highly technical. Again, a lot of soul searching and process design will be required to tackle these issues.
3) The selection, development and rewarding of leadership.
Whereas the first two are the biggest challenge, it is the latter which gets all the attention. Only 22% of the compensation of the main European Bank managers and 6% of that of the six largest American Bank managers was fixed. This says a lot for the underlying assumptions about what we expect from these managers, and how we expect them to behave. The top manager’s job is multidimensional, has to deal with multiple time horizons and should be evaluated as such, using a combination of KPIs and judgment. Shareholder value even over an interval is a poor proxy.
4) Set the tone at the top, to shape the values and to ensure they are brought to the coalface.
Here too it is clear that in many financial institutions the fish was rotting from the head. Chuck Prince said: as long as the music plays you have to dance. Perhaps not. Perhaps leadership means leaving the floor when the rhythm is too hectic. What is clear is that in most banks the traders that brought in the dough were clearly put ahead of the risk managers that raised questions or proposed limits.
How then do we get Boards to do a better job?
By realizing that this is a very special group situation: we are dealing essentially with a high prestige group of people who are travelling in for occasional meetings, to do two very conflicting things: giving support and council to management on the one hand and providing oversight and questioning on the other hand. They have to do this largely in the presence of the managers they are supposed to oversee, and based on information provided by the very people they are supposed to monitor.
Improvements come first of all from creating a quality team. We should recognize that technical independence and diversity matter less than competence, character, experience and dedication. When ABN AMRO was in trouble, it did not help that the Chairman was a US based American and the senior director a Dutchman living in NY.
A quality team needs to spend quality time. It is hard to fulfil the roles I mentioned in the fifty to sixty hours an active Board meets a year. Committees and executive sessions help, but no executive would dare to spend as little time on fulfilling his duties in his own firm as he does as a Board member in another company.
A quality team also needs quality information: a board can only be as good as the processes inside the company that feed it. In most companies strategy dialogues, enterprise risk management systems, reward processes, and corporate responsibility practices at the coalface are still up for serious improvement.
Finally, the whole thing is about quality process. How the Board, under leadership of the Chair critically examines the essence of management’s proposition, acknowledges and builds on each others questions, holds of premature answers and ultimately converges and supports, s is what makes the real difference.
I believe there is plenty of scope for academic inquiry into board focus and board process. I also think there is merit in debunking the myth that board structure and code compliance suffice. Finally I submit that without experienced Board members individually acknowledging and communicating about the reality of the challenge they are facing, the gap between public expectations and reality will remain too big for trust to be redeemed.