CORPORATE GOVERNANCE
AND THE 2008 FINANCIAL
CRISIS
PRESENTED BY
JOEL WOLPERT
CA (SA) FCMA FCIS
September 2009
1
INDEX
1)
2)
3)
4)
5)
6)
7)
8)
Context
Introduction: Overview of the Global
Financial Crisis
Four Horsemen of the Financial
Apocalypse
Governance of the Remuneration
Process
Board Practices
Risk Management
Shareholder (In) Activism
Conclusion
2
CONTEXT
“Contrary to the vulgar belief that men are motivated primarily by
materialistic considerations, we now see the capitalist system being
discredited and destroyed all over the world, even though the
system has given men the greatest material comforts”
- AYN RAND
“In fact, there is ultimately a limit to how much regulation can do. In
the final analysis, you could write all the rules you want, but there
has to be a philosophy of ethical behaviour that comes from human
beings operating in a professional way”
– William H. Donaldson, CFA
“The global crisis was caused by “the over-50s not knowing what the
under-30’s were doing”
– Johann Rupert, Remgro Chairman
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CONTEXT
“The first casualty of a downturn is truth”
- Financial Times Columnist 30 Sept 2008
Definition of OVERSIGHT :
Watchful care of management, supervision
An unintentional omission or mistake
Boardroom joke:
Was it the banks that caused the financial crisis ?
NO – it was something called Corporate Governance
The business world is questioning whether Corporate
Governance has become a mere catchphrase, divorced from
the contentious problems it is supposed to solve
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INTRODUCTION- OVERVIEW OF
GLOBAL FINANCIAL CRISIS
“The modern banking system
manufactures money out of nothing.
The process is perhaps the most
astounding piece of sleight-of-hand
that was ever invented. Banking was
conceived in inequity and born in sin
… but if you want to continue to be
slaves of the bankers and pay the
cost of your own slavery, then let the
bankers continue to create money
and control credit”
Josiah Charles Stamp – former Bank of England president
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INTRODUCTION- OVERVIEW OF
GLOBAL FINANCIAL CRISIS
1. Crisis timeline –

Northern Hemisphere Spring 2007 – rumblings about subprime loans

August 2007 – BNP Paribas liquidity crisis (France)

September 2007 – run on Northern Rock (UK)

September 2008 – collapse of Lehman Brothers (USA)
The severity of the banking crisis triggered a severe global business
recession. Global imbalances and housing bubbles – a disregard for
systemic risk – excessive market-based, backward-looking risk
management methods predicated on historical data – destabilizing
incentives – public outrage at prodigal sums of bankers’ bonuses.
Audit process failed to highlight developing problems in banking
sector.
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INTRODUCTION- OVERVIEW OF
GLOBAL FINANCIAL CRISIS - Continue
2.
The banking crisis was triggered by largely unregulated
trading of complex financial instruments, including
mortgaged-backed securities, which dragged down
some of the USA’s largest banks and brokerages as
the housing bubble of the mid-2000s collapsed and
foreclosures soared. In addition, generous pay and
bonuses on Wall Street were tied to lucrative but
risky short-range trading strategies rather than longterm performance. Bankers, brokers and traders were
rewarded handsomely for doing risky deals without
being financially exposed if the deals went wrong.
3.
Government, Regulators, Rating Agencies, Investors
and Borrowers all succumbed to temptation of short
term profit at the expense of long term value
creation.
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INTRODUCTION- OVERVIEW OF
GLOBAL FINANCIAL CRISIS - Continue
4. Banks’ arrogance and greed nearly destroyed the
World Economic System. There was a decline
in trustworthiness in the banking sector.
5. Trust is central to the workings of the
Capitalist System. A sound governance culture
addresses many items including conflicts of
interest, risk management and fiduciary duties.
6. The current financial crisis can be best
understood as a crisis of governance rather
than an inherent failure of markets or capitalism
itself.
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FOUR HORSEMEN OF THE
FINANCIAL APOCALYPSE
There were four major areas of
Governance Weakness:
1.
Remuneration Process
2.
Board practices
3.
Risk management
4.
Shareholder (In)Activism
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GOVERNANCE OF THE
REMUNERATION PROCESS
1.
Most market commentators believe that remuneration
practices played a role in promoting the accumulation of
risk that lead to the crisis – the design, implementation
and supervision of remuneration schemes did have
systemic impact on the financial system. Boards must
enquire whether the company’s remuneration model is
aligned with prudent risk taking and the long term
objectives and strategy of the company.
2.
There were flaws in the remuneration practices in the
investment banking sector. Bonus driven remuneration
structures encouraged reckless/excessive risk taking.
The design of bonus schemes was not aligned with
shareholder interest or long term sustainability of banks.
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GOVERNANCE OF THE
REMUNERATION PROCESS - Continue
3. Remuneration policies and practices were not at arms’ length –
boards did not exercise objective judgment – conflict of interest –
dilemma of risk taking and remuneration structure - during boom,
the board was less independent in monitoring remuneration and
more accommodating in their bargaining.
4. Remuneration schemes were not transparent – they did not
measure consequences – transparency must be improved by
disclosure in non-technical terms.
5. Remuneration in many cases is only upwardly flexible - rewards
for failure are cause for concern. Senior remuneration levels were
ratcheted up with undemanding performance targets. Weak link
between performance and remuneration - need to determine long
term KPI’s - ensure that generous incentives must be matched by
strong risk management systems.
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GOVERNANCE OF THE
REMUNERATION PROCESS - Continue
6. Instruments should only reward executives after long
term performance has been realized – tail-end risk.
7. Remuneration structures must be flexible.
8. Governance process must be explicit
(consultants/NED’s) - Big problem is ratio of CEO
remuneration to that of average employee.
9. ‘Say on Pay’ must be implemented – shareholder
resolution in respect of directors’ remuneration.
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GOVERNANCE OF THE
REMUNERATION PROCESS - Continue
10.
The failures in the executive remuneration process
have caused governments to endeavour to
regulate the pay in financial institutions. Having
regard to the government’s interest in the stability
of the financial system, intervention in pay
structures is as legitimate as the traditional forms
of
financial regulation. Government’s goal is
to promote
the safety and soundness of the
financial system
rather than addressing
shareholder concerns about
excessive
levels of pay. Regulation of pay would
make the executives of financial companies work
for, rather than against, the goals of financial
regulation.
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BOARD PRACTICES
1. Corporate governance failed to foresee/mitigate the global financial
crisis. There was an absence of guidance of appropriate
boardroom behaviours – this was a structural weakness. There
is a need for the better articulation of the business case for best
practice corporate governance. Boards were captives of their
own histories - disclosure failed to inform shareholders
sufficiently.
2. Evidence from the financial crisis indicates that some NEDs have
not fulfilled their role of providing strong independent oversight
of the executive management. NEDs will need to raise their
technical skills in order to exercise rigorous oversight – they will
need to demonstrate competence with regard to risk
management, regulation and the business model of the firm.
This may require NEDs to work on a more fulltime basis and be
remunerated accordingly. NEDs need to be properly supported
to strengthen their technical expertise.
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BOARD PRACTICES
- Continue
3. Boards must be competent and capable of
independent judgment.
4. Board member duties must be formalized –
continuing technical training in the case of
financial companies boards is essential.
5. Governance and risk management skills of board
members must be augmented. Risk that adding
extra governance requirements is likely to lead to
more box-ticking and hamper effective scrutiny by
non-executive directors by occupying time with
form rather than looking at substance.
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BOARD PRACTICES - Continue
6. A robust board evaluation process is required.
Independence is critical – problem with board
members who have served for too long under
the same CEO/Chair
7. Boards/Audit Committees must critically
evaluate:




Going concern
Liquidity risks
Fair value estimates
Risk disclosures
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RISK MANAGEMENT
“All business proceeds on beliefs, or judgment of
probabilities, and not on certainties”
Charles W. Eliot – former president of Harvard University
1.
The greatest shock from the financial crisis was the
failure of risk management.
“Seven Bad Habits”:



Failure to embrace appropriate enterprise risk
management behaviours;
Failure to develop and reward internal risk management
competencies;
Failure to use enterprise risk management to inform
management’s decision making for both risk-taking and
risk-avoiding decisions;
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RISK MANAGEMENT - continue




There was an over-reliance on the use of financial models, with
the mistaken assumption that the “risk quantifications” (used as
predictions) based solely on financial modeling were both reliable
and sufficient tools to justify decisions to take risk in the pursuit of
profit.
There was an over-reliance on compliance and controls to
protect assets, with the mistaken assumption that historic controls
and monitoring a few key metrics are enough to change human
behaviour.
There was a failure to properly understand, define, articulate,
communicate and monitor risk tolerances, with the mistaken
assumption that everyone understands how much risk the
organisation is willing to take.
There was a failure to embed enterprise risk management
best practices from the top all the way down to the trading floor,
with the mistaken assumption that there is only one way to view a
particular risk
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RISK MANAGEMENT - Continue
2. Well run companies made catastrophic errors of
judgment. Risk management was not properly
overseen, monitored or reviewed at board level – it
did not address company risk appetite. Need
alignment between corporate strategy and risk
appetite.
3. Each category of risk is correlated – the banking
sector had specific risks with regulatory/systemic
impact. In the case of financial companies risk
volatility is greater – systemic risk requires
prudential oversight. Regulation cannot remove
risk – risks must be understood, managed and
communicated.
4. Board must oversee the risk management structure.
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RISK MANAGEMENT - Continue
5.
Risk Governance requires:



6.
Greater awareness and improved implementation
of risk management
Improved disclosure of risk management processes
and practices
Risk management must be integrated with internal
control
The financial crisis :





risk was not focused on the business context
risk was not properly defined
risk responses were not properly developed (no
recognition of the extended enterprise)
poor disclosure of foreseeable risks
no link with remuneration / incentives
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RISK MANAGEMENT - Continue
7. Necessary to have separate role of Chief Risk Officer. Effective risk
managers need a combination of technical competence, communication
skills and stature in the organization so as to provide genuine challenge to
business managers
8. Risk management must be seen in a corporate perspective where the risk
management system is continuously adjusted in line with corporate
strategy and the appetite for risk. Board oversight of risk
management must be improved and directors must be given all the
information they need to make informed decisions.
9. It is now understood that risk management is not only about
measurement, but rather about the quality of the decisions companies
make in the face of uncertainty. Therefore, a reliable risk process identifies
specific risk exposures (including model limitations) and ensures
continuous measurement of those exposures. Effective risk oversight is
more about ensuring that the correct “what if”questions have been asked
and understood from the business model perspective rather than focusing
on scenarios based solely on historical quantitative data.
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SHAREHOLDER (IN)ACTIVISM
“The choice of a common stock is a single act; its
ownership is a continuing process. Certainly,
there is just as much reason to exercise care
and judgment in being a shareholder as in
becoming one”
Benjamin Graham and David Dodd, “Security Analysis,”1934
1. Bull market automatically aligned interests of
some shareholders with management
2. Shareholders in general have not been proactive
in relation to the financial crisis. Institutional
shareholders were guilty of being too passive and
reactive
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SHAREHOLDER (IN)ACTIVISM –
Continue
3. There has been a disconnect between size of
shareholding and voting behaviour. Many key
decisions are made or approved by a small
number of shareholders. Separation between
asset ownership and asset management has
created a systemic governance problem
4. Strong view that shareholders are at fault for
boards lack of oversight over risk management
and remuneration systems. The lack of
involvement and action by institutional
shareholders reduced accountability of both
boards and management
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SHAREHOLDER (IN)ACTIVISM –
Continue
5. There is a need for stronger links between nonexecutive directors and institutional
shareholders. Institutional shareholders did not
scrutinize or monitor boards in the banking sector –
this encouraged risk taking. The non-executive
directors at banks were a ‘cozy club’ which lacked
expertise/diversities and lacked adequate time
commitment to their responsibilities
6. Companies must do more to support constructive
engagement with their shareholders. Shareholders
must take responsibility to be active individually and
collaboratively to engage with senior management
and NEDs and question the effectiveness and
structure of boards – they must also challenge
management to ensure that business plans are
credible.
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SHAREHOLDER (IN)ACTIVISM –
Continue
7. Capitalism without owners has been shown to
fail. Governance flaws indicate that stronger
shareholder oversight is required. The dawning
of shareowner democracy could be a significant
development in corporate governance.
Corporate governance framework should be
complemented by advice of analysts, brokers,
rating agencies and others that is relevant to
decisions by investors. Stakeholders need to
better understand financial statements and be
held to account in the way the information is
used
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CONCLUSION
1. The supreme goal of business should not be shareholder
wealth creation but rather profitable business which delivers
good value services to customers. The future philosophy
of capitalism requires a new morality – a socioeconomic approach which does not rely only on the
market. The value of business activity should not be
completely delineated by the market.
2. The value of business is dependent on values with which
we do business. The culture of moral values must
encompass corporate governance processes. Society
cannot regulate business behaviour only by legal
legitimacy.
3. All the organs of capitalism must take responsibility for their
actions. At the G8 Summit in July 2009, even the Pope
condemned the “grave deviations and failures” of capitalism
that have been exposed by the financial crisis, calling on
the eve of the G8 Summit for a “true world political
authority” to oversee a return to ethical values.
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CONCLUSION - Continue
4.
At the heart of the crisis was a terrible failure of
“tone at the top” The age-old debate about whether
higher standards of corporate governance can be
enforced by laws and rules or encouraged via
guidelines and market behavior has heated up
considerably since the crisis.
5.
The financial crisis has underlined that good
corporate governance is everyone’s business.
Governance is about behaviour – standards may
be effective but not followed or standards may be
imprecise/defective. Codes are the servants of
underlying principles, not their master
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CONCLUSION
- Continue
6. Features of Fit for Purpose Governance:
Governance Soccer Team
Culture
Vision
Values
Transparency
Accountability
Disclosure
Trust
Integrity
Confidence
Independence
Competence
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CONCLUSION - Continue
“The day is not far off when the
economic problem will take the back
seat where it belongs, and the arena of
the heart and the head will be occupied
or reoccupied, by our real problems /
the problems of life and of human
relations, of creation and behaviour
and religion”
Jonn Maynard Keynes
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