The Corporate Governance Lessons Learnt From the 2008 Global Financial Crisis

7/29/2019 The Corporate Governance Lessons Learnt From the 2008 Global Financial Crisis

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After the recent financial and economic crisis more transparency, accountability, regulation,

and alignment of interests of directors with long-term objectives are considered necessary to

restore confidence in the financial markets, to reformulate the role of CEOs and to

reformulate the existing corporate governance structures that have been inadequate.

Discuss this statement, supporting your answer with reference to the literature and empirical

research on corporate governance.

The recent financial and economic crisis can supremely (but not completely) be attributed to

failures and weaknesses in corporate governance mechanisms. This discussion heavily relies

on The Corporate Governance Lessons from the Financial Crisis compiled by Grant

Kirkpatrick,1 which identifies the requirements of increased transparency, accountability,

regulation and alignment of interests of directors with long-term objectives in order to restore

confidence in the financial markets and the need to reformulate the role of CEOs.

Kirkpatricks findings are supported by literature and empirical research from a wide array of

sources, with the resulting conclusions stressing the imperative need for the OECD,

governments and regulators, to re-examine the adequacy of its corporate governance

principles in these key areas (Kirkpatrick, 2009).

In mid-2008, the global financial economy began to experience the onset of the crisis in the

US subprime market, which had spread to a number of other advanced economies through a

combination of direct exposures (Merrouche and Nier, 2010). The worst crisis since the great

depression (UN, 2010) had a major impact on financial institutions and banks in many

economies; with the largest and most significant financial reverberations experienced in the

US and Europe.

The worst affected companies in the US included AIG, Bear Stearns, Citibank and Merrill

Lynch while in Europe, the list included Barclays, Credit Suisse, Socit Gnrale and UBS.

Many financial institutions realised major losses in assets whilst others required significant

government rescuing. The impact of the GFC continued into 2009, and was still an issue

leading into 2010 (Eves, 2010), resulting in a number of collapses. The impact of the crisis

resulted in a worldwide loss of confidence which affected all financial institutions, the

aftermath realised the failing of several banks in Europe and the recapitalisation of manymore.

On a macroeconomic scale, the impact of the GFC was greatest in developing economies

which relied heavily on foreign capital assistance or were heavily geared (Eves, 2009). Due

to the small global economic standing of these developing nations, the combined impact on

the US, Japan and developed western European economies dominated the worlds attention;

as financial liquidity dried up. Summarised succinctly, it can be concluded that Capital

1 The report was prepared for the OECD Steering Group on Corporate Governance by Grant Kirkpatrick underthe supervision of Mats Isaksson (2009).


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flows provided the fuel which the developed worldss inadequately designed and regulated

financial system then ignited to produce the firestorm that engulfed us all. (King, 2010).

Merrouche and Nier (2010) explore the causes which resulted in the build-up of financial

imbalances globally. Their findings establish, that a combination of poor supervision and

lacking regulation allowed overly accommodative monetary policies to help fuel the build-up

(White, 2009), and widening global imbalances and associated capital flows were the root

cause across advanced economies. Amongst these causes, it can be established that to a very

important extent, the financial crisis can be attributed to failures and weaknesses in corporate

governance approaches.

The decade leading up to the GFC saw major progress in the standards and application of

corporate governance on a global scale. The mid 90s saw the hi-tech bubble burst and the

late 90s brought on the Asian financial crisis. Furthermore, large corporate scandals

including Enron and Worldcom failures all highlighted significant flaws, which resulted in

the improving refinement of corporate governance standards. In each case, the corporate

governance deficiencies, while not strictly causal, were certainly facilitators of the resultant

failures; if not also deficient in preventing poor performance.

Leading into the GFC, many regulators took comfort in the fact that once companies and

banks met basic corporate governance standards, they were in effect stable (CeFiMS, 2012b).

However, when put to the test during the GFC, the corporate governance countermeasures to

protect against excessive risk taking, failed miserably. The most evident system failures

resulted from, poor transference of exposure information, corporate strategies with poor

performance indicators to measure implementation and substandard company disclosuresabout foreseeable risk factors. Summarised neatly, Erik Berglof; Chief Economist of the

European Bank for Reconstruction and Development, found banks with dominant corporate

governance systems, also ran into difficulty during the crisis. Leading on from this

observation, Berglof poses the question Was corporate governance really not important or

is it that the way we conceptualise and measure corporate governance does not capture its

relevance? (Berglof, 2011).

Globally, the corporate governance standards implemented across countries are really very

unique in both composition and application. While most international systems of governance

refer to the OECD Principles of Corporate Governance (OECD, 2004) to set the requiredstandards, there are many leading international codes defining specific relevance to individual

countries See Table 1. Some of these codes have regulatory clout and others might be

purely advisory. However, the aim is the same: to raise governance standards in the market

as a means of attracting capital. (CeFiMS, 2012d).


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The World Bank has established a program to assist its member countries in strengthening

their corporate governance frameworks (World Bank, 2012) under the Reports on the

Observance of Standards and Codes (ROSC) initiative. The primary differences between

corporate governance systems across countries which can be established from the ROSC

reports are well reflected in the findings of the OECD; acknowledging that one size fits all

is not an effective approach to corporate governance, The balance between law, regulation

and voluntary principles varies widely in the OECD area depending in part on history, legal

traditions, efficiency of the courts, the political structure of the country and the stage ofenterprise development. (OECD, 2004) a summary of different codes and principles in

operation across OECD member countries is summarised in Table 2.

In present day evidence; highlighting the differences between corporate governance systems,

a United Nations investigation; seeking the views of members on global economic

governance and development, found overwhelming support for a global system of

governance with an emerging consensus that a stronger system of global economic

governance must be more transparent inclusive and efficient. (United Nations, 2011).

Referring back to the question Berglof poses, the summary of corporate governance systemsacross countries established by the OECD as well as the opinions expressed by the member

nations of the UN, a decisive conclusion can be established. During the GFC, the growth rate

countries with various corporate governance systems; from a heavily dispersed locality

around the world, experienced a slowdown, with many countries falling into recession; see

Figure 1 (Nanto, 2009). From this it can be deduced that the failures and weaknesses in

corporate governance which can be attributed to the GFC, more specifically resulted from the

actions of the financial institutions at the heart of the financial crisis; the responsibility of

which, is held by the board of directors.

Table 1

Leading International CodesSource: (CeFiMS, 2012d)


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In the post-2000 market, boards had to be clear about the strategy and associated risk

management systems of the company. Accordingly, performance was required to be

displayed in efficient reporting systems indicating the achievement of objectives. During the

GFC it appears that there was a severe mismatch between the incentive systems, riskmanagement and internal control systems in many cases (Kirkpatrick, 2009). A review of

eleven major banks by the Senior Supervisors Group (2008), established that while all were

impacted on by the GFC, there was a significant variance in the levels of impact which

correlated strongly with the structure of senior management and the nature or risk

management systems. Frederick Tung and Xue Wang (2011) establish that bank executives

compensation to be a culprit during the GFC. Empirical evidence evidences their analysis,

hypothesizing that bank CEOs inside debt incentives correlate with bank risk taking

and bank performance in the Financial Crisis (Wang and Tung, 2011).

The board itself is responsible for the day-to-day operation of a company, and in 2004 the

average board comprised of 11 members, established by Spencer Stuart (2004). Boards tend

to be comprised of inside (employee) and outside (independent) directors, with varying

degrees of diversity and interlocking directorships amongst companies. The board itself is

managed by two critical and very distinctive positions, the CEO and the chairman. The role

of the CEO is to run the company, and the role of the Chairman is to supervise the operation

of the board. However, in 2004 74% of all S&P 500 boards had a combined chairman and

CEO role.

During the GFC, the position of company CEO became a highly controversial figure.

Extending the hypothesis that Tung and Wang devised, the GFC with the near collapse of


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major international banks, the need of many others for unprecedented levels of state support

and revelations that their CEOs were well paid regardless of performance, brought into

sharp focus their remuneration policies. (CeFiMS, 2012b). Arguably, pay should reflect

performance; structured in a manner to create incentive for improved performance. From a

theoretical perspective, the purpose of an incentivised remuneration package is to align theinterests of the CEO with all stakeholders. However, within this theory lies an inherent flaw,

which during the GFC left investors isolated from many CEOs.

Kirkpatrick, found that during the GFC agency theory directly resulted in the poor

performance of many financial institutions. Agency theory explains the relationship whereby

the board of directors supervises company managers on behalf of shareholder and investors.

During the GFC; as a direct result of chasing improved performance, many banks had taken

on high levels of risk by following the letter rather than the intent of regulations For

example, credit lines extended to conduits needed to be supported by bankscapital (under

Basel I) if it is for a period longer than a year. Banks therefore started writing credit lines for364 days as opposed to 365 days thereby opening the bank to major potential risks.

(Kirkpatrick, 2009).

The CEO as supervisor of the boards and accordingly company managers, as in this instance,

did not provide the capital adequacy reports with the transparency, accountability and

regulation expected of the position. If the CEO does not share information or is dishonest,

then it is very difficult for a board (who are often appointed by the CEO) to carry out a full

due diligence. (CeFiMS, 2012a) to paraphrase, Even if risk management systems in the

technical sense are functioning, it will not impact the company unless the transmission of

information is through effective channels (Kirkpatrick, 2009).

Leading up to the GFC, as the global economy was weakening, an Associated Press Study

revealed the median CEO salary for S&P 500 companies was US$8.4 million. Post GFC,

average director salaries rose by 3.2%; however bonuses rose by 23%. And while bonuses are

purportedly reflections of positive performance, instances of the contrary continue to defy

logic (CeFiMS, 2012b), illustrated below in Table 2 comparing CEO remuneration with

company performance.

Joseph Stiglitz, a former Nobel Prize winner for Economics, suggests several critical reasonswhich prove the incentive (bonuses) system to be flawed, which in combination with the

Table 2CEO remuneration comparisons.

Source: (IDS Executive compensation Review)


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Agency theory provides correlation to the failure and weaknesses in corporate governance

systems during the GFC. Stiglitz argues that exorbitant incentives encourage excessive risk

taking and short sighted behaviour. This behaviour in turn leads to creative accounting and

can distort the provision of information (Stiglitz, 2010).

Stock options are a recent and controversial aspect of CEO remuneration. The theory behind

options allows the right to purchase stock at present day prices in the future. If stock prices

increase during the time period, options may be exercised to realise available profits. If stock

prices reduce, options need not be exercised, and no loss is incurred by the holder. While

options have been used as incentive to align stakeholder and CEO objectives, several reasons;

in addition to the Stiglitz argument, prove that the intention of share options do not align with

the theoretical logic, the most prominent being that rarely is the relationship between a

companys performance and share price well defined.

During and post GFC, confidence in financial markets plummeted, in part this can be

attributed to the simple observation that The directors of such [joint stock] companies,

however, being the managers of other peoples money than their own, it cannot well be

expected, that they would watch over it with the same anxious vigilance with which the

partners in a private co-partnery frequently watch over their own. Like the stewards of rich

men, they are apt to consider attention to small matters as not for their masters honour, and

very easily give themselves a dispensation from having it. Negligence and profusion,

therefore, must always prevail, more or less, in the management of the affairs of such a

company. (Adam Smith, 1776). The resulting separation of ownership gave rise to the

fundamental underpinnings of corporate governance, and it was this delegated power; which

when abused, facilitated the onset of the financial crisis.

Financial confidence was at an all-time low, and shareholder disillusionment was

unprecedentedly high. In stark contrast to the poor financial performance of financial

institutions and the negative growth rate of economies, the poor performance of company

CEOs was rewarded with lavish compensation, incentives, and stock options. The GFC, like

many previous occurrences of corporate governance failures, highlighted the need to review,

refine and develop corporate governance standards. Post-GFC, shareholders now demand,

complete transparency, accountability and regulation of company performance and the board.

The code of the OECD Principles is a remarkable achievement (CeFiMS, 2012d) and in

conjunction World Bank ROSC process and the United Nations continue to interact with

countries to develop corporate governance standards in a continual process.


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References

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Table 3 - Summary of codes and principles in operation.Source: (OECD, 2004)

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The Corporate Governance Lessons Learnt From the 2008 Global Financial Crisis