Corporate Governance lessons from financial crisis

Abstract

This paper analyzes the influence of weaknesses and failures in corporate governance on the

recent financial crisis. It determines that the financial crisis played a significant role, which

attributed to weaknesses and failures in corporate governance arrangements that did not help

their objective to safeguard against enormous risk taking in several financial service companies.

The financial crisis was undoubtedly a global crisis. There were several reasons of failures, and

corporate governance was one of them. This proposal reviews the literature on corporate

governance critically and analyzes the causes of failure in global financial crisis. The literature

brings into the limelight by observing that there was substantially lacking in board practices, risk

management, remuneration system, and disclosure and transparency norms in many aspects. The

paper further reflects key lessons learnt on these deficient areas of corporate governance. The

study is crucial from the perspective that new corporate governance reformations emerge from

this analysis that may be common for all the organizations, and not limited only to financial

institutions and banks.

Table of Contents

Introduction…………………………………………………………………………………

Literature Review……………………………………………………………………………

Research Methodology…………………………………………………………………………………………………………….

Data Collection………………………………………………………………………………

Findings and Analysis of Secondary Research……………………………………………..

Findings and Analysis of Primary Research…………………………………………………

Conclusion…………………………………………………………………………………...

References…………………………………………………………………………………….

Introduction

The financial crisis occurred recently has been the most severe financial crisis since the Great

Depression of 1930s. Several reports and researchers reviewed the reasons of this global

financial crisis. Many scholars reasoned accused corporate governance as one the key reasons for

past global crisis while other aspects perform only a supplementary role. Several shortfalls in the

corporate governance processes and structure led to the failure of several financials firms and

triggering the crisis. Several financial and banking firms did not pay due consideration to

corporate governance before and during the crunch. This paper makes an endeavor to determine

what the several aspects relate to corporate governance failure and the lessons learnt in the

aftermath of the global financial crisis. It is significant to examine several aspects of corporate

governance failures during the crisis because it will aid in highlighting the normative

implications for future reforms. This paper conducts primary and secondary research by review

of literature and questionnaire method to some banking and insurance firms. Further, it

determines the lessons that can be learnt from crisis and suggests recommendations for future

reforms.

Literature Review

Many scholars continue to study financial crisis form the view of corporate governance (Clarke,

2010; Fetisov, 2009 Lang and Jagtiani, 2010). Several deficiencies in corporate governance

procedures and arrangement contributed to the failure of financial institutions that led to the

financial crisis (Clarke 2010). (Kirkpatrick), (2009) Yeoh, (2010) recommends that systematic crisis

occurred because of the collapse of international financial market was also the corporate

governance crisis and regulation. Before and at the time of the financial crisis, corporate

governance issues did not receive deserved attention, and that led to the collapse of several

financial firms. UNCTAD (United Nations Conference on Trade and Development) in its findings

(UNCTAD report, 2010) on corporate governance failure blamed poor practices in corporate

governance as a prime cause of global financial crunch implicated through the inferior and fragile

risk management system in several collapsed financial firms. Kirkpatrick (2009) argued on OCED

report that the financial crisis can be to a significant extent assigned to weaknesses and failures in

corporate governance arrangements. At the time of subjecting them to test, routines of corporate

governance did not serve the objective to protect against excessive risk taking in several financial

services institutions. Whereas Festiov (2009) asserted that the decline and worsening of corporate

standards evolved before crisis resulted in this global financial crisis. A brief literature in this review

further implicates corporate governance failures in the wake of the crisis. In the year 2008,

Blundell-Wignall et. al. (2008) by following Union Bank of Switzerland as an example established

that corporate governance played a critical role in financial crisis. Several Banks and their boards

could not understand the risk that associated with a large number of complex financial products.

The investment boards miserably collapsed in the guiding of strategy and adopting risk control

procedures. Moreover, remuneration incentives permitted managers to invest in inferior quality

mortgage products. Berrone (2008) and Van Den Berghe (2009) supported this factor and observed

faulty system of incentives for executives of financial firms as one of the prime reasons for the

financial crunch. Berrone (2008) proposed that designing of exit packages and stock options for

senior executives were extremely poor. Stock options permitted the executives to higher risk

whereas exit packages rewarded board directors even for their failures. Kirkpatrick (2009) agreed

that there were certainly inherent lapses in the system. Deficiencies in corporate governance

processes assigned the failures of risk management in several collapsed banks. Boards of collapsed

banks did not account the risk factors before implementing the company strategy. Bank’s

disclosures regarding the foreseeable risk aspects and systems for managing and monitoring risk

were certainly lacking in these institutions and even the regulatory, and the accounting

environment was not effective. Again Kirkpatrick (2009) highlighted that remuneration methods did

not possess effective alignment to the firm’s risk appetite, strategies and long term sustainability of

the institution. Buiter (2009) viewed a little transparency on off-balance sheet items of several

complex financial products and the subsequent risk, which financial firms were adopting for their

shareholders. Besides, the author also consented that the remuneration mechanism of banking

executives allowed them to initiate extreme risk with emphasis on short term gains. Sahlman(2009)

while studying the impacts of the financial crisis, determined that several firms suffered from a

deadly combination of powerful, misguided incentives; insufficient control and risk management

systems; and inferior human capital in terms of competence and integrity, all packed in a culture,

which failed to offer a sensible direction for managerial behavior. The UNCATD (2010) report also

determines that pervasive risk involvement by financial firms resulted in the global crisis. The

involvement of excessive risk in financial firms ultimately links to failure in board decisions of

delivering the suitable strategies and setting risk appetite. The report highlighted that remuneration

systems offered substantial incentives for taking extreme risks, while, Clarke (2020) consented that

designing of remuneration strategies for executives were in such a way that offer incentives for

taking higher risk. Finally, he concluded that involvement in extreme risk coupled with faulty

remuneration systems in financial and banking firms led to these crises. Appropriate risk

management structure did not apply to tackle with complex financial product in financial firms.

Bonuses for top executives were also related with upfront incomes from operations instead of their

actual accomplishment. Besides, deficiency in universal accounting and valuation caused a lack of

transparencies and misinterpreted disclosures to shareholders.

Research Methodology

This exploratory study uses qualitative research methodology. The study employs a mix of

secondary and primary data to answer the research questions. The researcher collects primary data

through the application of self-administered questionnaires. This research extensively involves

secondary data from several previous researches, company annual reports, economic reports as

well as articles from working papers, journals and books. This study uses panel data framework that

follows the similar used by Abor and Biekpe (2007) and includes the pool of observations on

cross section of units over various periods and offers results, which are not detectable in pure

time series or pure, cross section studies. Further, this research also conducts analysis with the

use of Black Box Model by Blair (1995) that explains the functioning of corporate governance.

Data Collection

Questionnaires on corporate governance systems were addressed to a diversified cross section of

ten prime listed insurance firms and banks established in the European Union. Few of them

received a severe impact than others by financial crunch. The follow up interviews with thirty

board members, chief risk officers, financial and internal auditors also supplemented this

questionnaire. A similar questionnaire addressed to the securities markets supervisors and

European insurance and banking firms approached about their opinion and role of corporate

governance of financial firms.

Findings and Analysis of Secondary Research

The existing literatures on failures of corporate governance during the global crisis provide many

insights, where lessons derived from crisis can be implemented to formulate new policy

guidelines. The literature review reflected areas of corporate governance concerns in the

financial crunch were remuneration systems, risk management, transparency and disclosure, the

board and director’s role, and protection of rights of shareholders. The OECD report

distinguished four key areas for corporate governance reforms. In an earlier analysis, OECD

confirmed the prime area of weaknesses in risk management, remuneration system, shareholders

rights and board practices and accordingly made suggestions for best practices and reforms

related to those areas. The banking sector of EU identified four prime areas for future reforms

that included better direction to strengthen banks’ risk management processes; reevaluation of

models of risk management to protect against unpredictable events; a structure of compensation

to avoid extreme risk or short duration returns; and efficient risk management over complex

financial products. Several researchers and academicians identified deficiencies in remuneration

systems as the significant lesson learnt from the crisis and recommended appropriate measures

for rectifying the deficiencies. The remuneration system promoted high risk taking with

unguaranteed focus on short term revenue and surprisingly rewarded executives for their failures.

Scholars suggest linking the remuneration systems of executives with firm long term

performance with suitable adjustment for risk. Lang and Jagtiani (2010) implicated that the

remuneration system should connect to risk appetite and must be within the limits of internal

control and risk management structure of the company. Fetisov (2009) and Van Den Berghe

(2009) strongly proposed using clawback policy for senior executives with an objective to

control high risk taking behavior. This policy for senior executives will enable them more

accountable towards investor’s and shareholders wealth, and further discourage board approval

of unrealistic compensation policies and magnanimous executive remuneration. The financial

crisis has much to deal with the monitoring of risk appetite of a company by the board and

establishment of efficient risk management systems. Muelbert (2009) determined that prime

lesson for banks in this financial crunch was to establish a separate board risk management

control to function under the guidance of chief risk officer. Another area of concern in the global

crisis pointed out to board practices and composition. Many scholars called upon in the

composition of the board and competence of a director to be based on the learning obtained from

the financial crunch. Muelbert (2009) proposed that individual should possess financial

knowledge and related expertise to tackle with risk control management of the company. Adams

(2009) also proposed director of financial institutions should have enough financial expertise and

knowledge. This may be possible with sufficient education and training support or including

those directors who possess this knowledge. Muelbert (2009) further suggested for defining the

qualifications and role of non executives so that they could better command the management.

Finally, certain lessons require to be derived on the reforming of the transparency, disclosure

norms and accounting standards. Laeven et. al. (2010) stressed on collection of information and

availability of that information to the shareholders for transparency.

Findings and Analysis of Primary Research

The senior executives of banks and insurance firms in an open questionnaire confirmed that

recent financial crisis disclosed serious deficiencies, and shortfalls in board performance at a

number of financial institutions. Significantly, for several reasons, some non-executive directors

were unable to form independent judgments and objective on decision of management and as a

consequence, at several instances they ceased to perform effective check, and challenge to

executive directors. Besides, duties of the board are critical and include arbitrating between

constituencies. Shareholders possess broadly diverging views and opinions of actions in the best

interests of the firm are not clear. The crisis reveals that interests of boards and shareholders may

not match with the long term interests of the financial firms. Principally, the interests of

stakeholders, for example, employees and depositors have not been considered into account by

the board and shareholders. Moreover, the financial crisis exposed serious restrictions in the

current supervisory framework internationally, both in a cross border and national context.

Supervisors never enjoyed adequate resources and sufficient mix of skills that lead to deficiency

in understanding and effective monitoring of financial firms’ activities. Besides, the procedures

of different systems of supervision further led to inconsistent powers of supervisors across

regulatory competition and supervisory capture, which further limited the senior executives from

exercising effective supervision with regard to expansion of investment bank business model.

Overall, the evidence shows that crisis prevention process of supervisors did not perform well

during the financial crisis.

Conclusion

The current financial crunch was a global crisis in terms of its approach and scale of impact. It

impacted almost all the economies and losses incurred by investors and shareholders were

enormous. The prime reason for this crisis attributed to corporate governance failure. The review

of literature conducted in this paper revealed various aspects of corporate governance, which

collapsed during the global crisis in financial firms and banks, because of board oversight,

transparency and disclosure, risk management system, and remuneration system. Several

researchers and academicians have derived key lessons, which relate to deficient features of

corporate governance emphasized by outcomes of the crisis. The study is captivating from the

view of policy makers and regulators. Lessons from the failure of corporate governance in

financial institutions and banking sector may be utilized for the development of new guidelines

not only for financial firms, but non financial firms can also derive its benefits. The lessons and

implications learnt from this financial crunch can trigger new horizons in corporate governance

reforms and new appropriate practices and policies may emerge, which can be applied to

different jurisdictions. It is a high time for corporate governance regulators to keep in touch with

contemporary scenarios, and increase the standard of corporate governance so as to safeguard the

wealth of millions of stakeholders, and shareholders.

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