Corporate Governance:Lessons Learned in the Financial Crisis

Sao PauloSeptember 24, 2009

Background

How can the international financial community explain the events of 2007–2008? Were these failures the result of poor application of sound

governance practices? Should the blame be placed at the feet of regulators who allowed a

systemic wave to wash over otherwise well-run banks?

We argue that: Corporate governance matters Serious problems of implementation were revealed during the crisis Many problems prompted by increasingly short term performance

horizons – by markets, shareholders, boards, and therefore management

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Four broad areas of concern

Risk governance Remuneration and alignment of

incentive structures Board independence, qualifications, and

composition Shareholder engagement

Risk Governance: Definitions

Risk governance is generally defined as board and management oversight of risk, including identification, measurement, and reporting systems.

The board that is ultimately responsible for ensuring that all risks to the bank are identified, evaluated, and suitably managed.

Understanding the bank’s risk composition and market position is key to the board’s ability to set strategic direction and risk policy provide oversight respond to developing challenges and opportunities effectively measure institution performance based on the

return on those risks and allocated capital. 4

Risk Governance:Board Level Weaknesses

A lack of effective risk governance is generally found at the top of the list of recent failures

Frequent board level weaknesses in failed institutions: Lack of a comprehensive understanding of their

institutions’ risk profile or its appropriateness : Lack of information transmitted to the board, leading to

a false sense of security. A fundamental lack of expertise at the board level

among nonexecutive directors (NEDs) Use of the board by executives as a “group think”

function rather than a real forum An “autopilot” risk mentality

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Risk Governance:Management Level Weaknesses

Failure to adopt and integrate the necessary systems to identify, manage, and report risk

To much focus on already recognized risks and not enough on less obvious and higher level risks

Risk management isolated along product and organizational lines

Risk management units did not have sufficient visibility or stature to stand up to management

Banks with good risk governance systems were able to respond with more flexibility

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Remuneration and Alignment of Incentive Structures

Good practice: boards should align executive and board remuneration with the longer-term interests of the company and its shareholders

Over the past 10 to 20 years this general goal was interpreted in the US and elsewhere to mean increased use of equity-based compensation.

The financial crisis has increased skepticism over the structure and use of incentive-based compensation.

In banks (particularly failed ones), executives were seen to “reach for short-term yield” at the expense of long-term firm stability and value. This problem was compounded by the short term nature of incentive

structures (as well as the nature and risk of growth, new products, etc.). A related issue is that high proportions of bonuses relative to the level of

fixed salaries adequate to support a minimum living standard, required companies to pay them even when the company was loss-making.

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Board Professionalism

The key to aligning the interests of the company and its shareholders is to establish the objectivity of the board: solid leadership by the board chairman and the CEO appointing experienced nonexecutive directors (NEDs) assigning key tasks to board committees composed of a majority of non-

executive directors.

A closer look at boards of six distressed investment banks: Combination of chairman and CEO (especially in US) Too few executives on the board. As a result, technical and institutional

expertise may have been concentrated in the hands of a few, been shallow or had no voice in the boardroom.

Boards may have been less independent than they appeared.

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Shareholder Engagement

Shareholders have a number of basic rights and obligations: Right to appoint directors Right to make key corporate decisions Right to obtain information about the company Institutional investors should play an active and informed role.

However, not always the case: In the US, dissident shareholders face substantial obstacles, and cannot always pass

a non-binding resolution on compensation (Bebchuk and Fried 2004). At the same time, institutional investors in many countries are passive, do not vote,

and have conflicts of interest with the companies in their portfolio.  As a result, boards are insulated from investors, especially in the US, and

shareholders are forced to rely on board independence requirements to oversee management and mitigate conflicts of interest.

But board independence alone does not appear to have been able to control excessive risk taking during the crisis.

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Policy Responses

Direct intervention (ownership) International standard setters (OECD / BIS) Regulatory responses

Much of the current discussion around the world has addressed the specific issue of executive compensation.

Board professionalism (e.g. Walker review UK)

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Relevance of Failures for Emerging Market Countries

The same general topics (risk governance, remuneration, board professionalism, and shareholder roles and rights) are important

World Bank diagnostics (CG ROSC and bank governance reviews) suggest that a great deal has been accomplished

However, the specific issues and their relative importance are different, because many of the financial crisis issues are specific to the unique ownership structure in the US and the UK where ownership of large companies and financial institutions is relatively dispersed.

In most other countries ownership is concentrated. This means that some problems present in developed markets (especially issues of executive pay) are less prominent.

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A comparison of developed and emerging markets

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Developed Markets (Crisis-related findings) Emerging Markets

Risk Governance Risk management systems were frequently deficient. Boards did not understand their risk profile. Strategies were not accompanied by a corresponding

consideration of the risks involved. Risk management functions have inadequate stature.

Major area of concern in emerging countries. Boards may not understand their role or set appropriate

risk taking strategies. Rapid growth in many institutions not matched by

improvements in risk governance. Risk management systems are only now evolving.

Remuneration and Alignment of Incentive Structures

Increased skepticism over the use of incentive-based compensation.

Executives were seen to reach for short-term yield at the expense of long term firm stability and value.

Focus on design of compensation

Direct remuneration is less of a policy concern. The opposite problem (low-paid executives and boards)

is sometimes identified. Lack of adequate disclosure is a major issue. Indirect compensation may be a larger problem.

Board professionalism

Studies of failed institutions suggest erosion in independent / objective oversight role of boards.

Combined chairman / CEO (US) Boards were less independent than they appeared.

There may have been too few executives on the board. Technical expertise may have been inadequate.

Large but different problem in emerging countries Boards tend to be passive and insular. Board and executive capacity a key concern. Family ownership prevalent, leading to lack of

separation of roles of ownership, board, management. “Independent” boards is particular challenge

Disclosure and transparency

Significant financial and non-financial disclosure Variety of problems and debates over accounting

standards (e.g. mark-to-market / fair value). Concerns over disclosure of risks.

Major concern, key problem. Many countries moving toward adopting International

Financial Reporting Standards (IFRS). Weak enforcement mechanisms. Ownership is often opaque.

Shareholder roles and rights

Debates over shareholder engagement and passivity during run-up to crisis

In US: weakness in ability of shareholders to appoint board members.

Shareholder rights have also improved, but problems remain with the application of rules designed to protect small shareholders against expropriation.

The State (major owner of FIs in many countries) typically a poor owner.

Conclusions

Different financial institutions have had different outcomes during recent periods of stress, depending in part on the strength of boards and their overall corporate governance framework and culture.

Much of the existing governance framework already existing is generally adequate and should remain intact.

However, the devil is in the detail of implementation. It is clear that more work will need to be done on standards to attempt

to address the weaknesses identified above. Future reforms are likely to attempt to address:

Executive remuneration Independence More explicit guidance and public disclosure on risk governance

structures (including the establishment of board risk committees). Financial sector regulators must improve their ability and political

willingness to evaluate the configuration and effectiveness of banks’ governance platforms.

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Thank you!

Alex Bergaberg2@worldbank.org

Corporate Governance GroupWorld Bank

Washington, DC202-473-3687202-522-1604