Accountability to the shareholder - the failure of corporate governance

Wall Street 1987, Gordon Gekko Teldar Speech:

"The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right or you get eliminated."
...
"America, America has become a second-rate power. Its trade deficit and its fiscal deficit are at nightmare proportions. Now, in the days of the free market when our country was a top industrial power, there was accountability to the stockholder. The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake."

The former Chairman of the FSA made an interesting speech in 2003, in relation to Corporate Governance in Financial Intitutions. What is interesting is the content of his speech. I have pulled some extracts below. It is very interesting to look at the failure of corporate governance in the light of the recent financial crisis we have witnessed. Have we really learnt from it?

Corporate Governance in Financial Institutions:
Speech made by Howard Davies, former Chairman of the UK Financial Services Authority , 3rd of June 2003.

http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2003/sp132.shtml



"There is not as much systematic and useable analysis of the reasons for failure in financial institutions as one would like. But there are some helpful sources.

European banking supervisors studied a number of banking problems across the continent between 1988 and 1998. Their overall conclusion was that management and control weaknesses were underlying, fundamental and contributory in almost all of the cases they considered.

A very similar conclusion was reached by a group of European insurance supervisors who looked at 21 cases of failure or near failure in European insurance companies between 1996 and 2001. (One astonishing feature of the work was that there were, during that 5-year period, a total population of 270 cases to consider, from which that selection of 21 were made.)

That report shows that there were usually a number of contributory causes to the collapse of an insurer. Poor underwriting practice, or inadequate reserving, was often the proximate cause of failure. But in all the case studies underlying management or governance causes were identified, in many cases relating to significant systems and controls issues. The widespread underwriting or asset problems were able to arise because of these fundamental weaknesses, and the combination of poorly managed risks made firms particularly vulnerable to adverse external events.

•When the group compared problem cases with other firms who weathered similar circumstances better, a pattern emerged of the following four forms of management malfunction:
•Incompetence, with firms straying outside their field of expertise or uncritically following the herd instinct.
•Excessive risk appetite, or objectives that were at odds with the prudent management of the business;
•Lack of integrity, or
•Lack of autonomy and inappropriate pressure for short-term results from, perhaps, the parent company.

Following my distinction between management and governance problems, I see governance issues in at least 3 of these 4 cases. Certainly a Board should identify the risks involved in companies straying outside their field of expertise, should ensure that there are no incentive structures in place which promote excessive risk-taking, and should ensure that the business does not come under inappropriate pressure to maintain earnings or market share."

All the above points raised by Howard Davies seems to indicate what went wrong with regulators in trying to mitigate the risk appetites of some of the financial players they were supposed to regulate. The regulators failed.

Howard Davies also added the following:

"A third interesting source can be found in the New York Fed’s most recent economic policy review, published in April of this year. It was a special issue entitled "Corporate governance: what do we know and what is different about banks?"

The volume includes a series of interesting analytical pieces, by different hands. They all, from different perspectives, try to assess just how much relationship there is between good governance and corporate success. As that, after all, is what ought to interest shareholders, not elegant governance per se.

One of the papers concludes that Board composition does not seem to be a useful predictor of firm performance. That is an interesting conclusion given the focus on Board composition in some of the codes. On the other hand, they found that in the US, at least, Board size does have a negative relationship to performance. In other words, the bigger the Board, the poorer the results."

Howard Davies goes on:

"Some of the bankers among you might welcome this conclusion. But I ought to add that one of the pieces in the Fed’s report argues that "a clear case can be made for bank directors being held to a broader, if not higher standard of care than other directors". Essentially, their point is that there are important stakeholders in banks other than shareholders – including major creditors and other institutions, given the safety net. The same authors go on to argue that, as a result, they support "a hybrid approach to corporate governance in which most firms are governed according to the US model, while banks are governed according to a variant of the Franco-German paradigm"."

Howard Davies also make an interesting point in his speech:

"Our experience shows, for example, that a dominant chief executive, or indeed business head, who is not effectively challenged by the Board or his colleagues, is a danger sign. Similarly, a Board lacking in relevant experience is unlikely to act effectively as a constraint on excessive risk taking."

His final conclusions in his speech made in 2003, indicates how corporate governance failed in financial institutions. Most of Howard Davies recommendations were not followed.

The failure of appropriate corporate governance is leading to a sigificant welcomed shareholder activism:

http://www.investmentweek.co.uk/investment-week/news/1360340/f-c-highlights-corporate-governance-failures

From this article:
Karina Litvack, head of governance and sustainable investment at F&C, says: "We believe that a failure in governance lies at the heart of the banking crisis. The events of the last few months have confirmed that the soaring pay packages for top bank executives were driven by extraordinary risk-taking rather than real, sustainable profits. Investors can be part of the solution, by spotting red flags and using their influence as shareholders to press for better governance practices."

Corporate Governance failed mostly because regulators failed to do what they are paid for: regulate. In May 2009, Stephen Friedman resigned as Chairman of the New York Fed’s Board of Directors.
The reason of his resignation was the following:

http://inthesenewtimes.com/2009/05/04/new-york-fed-chairmans-ties-to-goldman-raise-questions/


"The Federal Reserve Bank of New York shaped Washington’s response to the financial crisis late last year, which buoyed Goldman Sachs Group Inc. and other Wall Street firms. Goldman received speedy approval to become a bank holding company in September and a $10 billion capital injection soon after.

During that time, the New York Fed’s chairman, Stephen Friedman, sat on Goldman’s board and had a large holding in Goldman stock, which because of Goldman’s new status as a bank holding company was a violation of Federal Reserve policy.

The New York Fed asked for a waiver, which, after about 2½ months, the Fed granted. While it was weighing the request, Mr. Friedman bought 37,300 more Goldman shares in December. They’ve since risen $1.7 million in value."

If the regulators cannot even regulate themselves and avoid conflict of interests, how are they supposed to do their job properly?

http://mostlyeconomics.wordpress.com/2009/05/08/new-york-fed-corporate-governance-failure/


The author of this blog raise an important point? How can an entity like the New-York Fed can properly regulate financial institutions when 6 of the members supposed to represent the public representatives are from the very same financial institutions?

In addition to corporate governance, disclosure of information, adds transparency and would alleviate concerns and restore trust in the system.
There is an ongoing legal battle of great interest currently happening in the US relating to the access of the financial institutions to the Fed Discount Window during the Financial crisis:

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aUQp2owUUueA


"The Federal Reserve won’t join a group of the largest commercial banks in asking the U.S. Supreme Court to let the government withhold details of emergency loans made to financial firms in 2008."
...

"The bank group is appealing a federal judge’s August 2009 ruling requiring the Fed to disclose records of its emergency lending. Bloomberg LP, the parent company of Bloomberg News, sued for the release of the documents under the Freedom of Information Act.

The central bank has never disclosed the identities of borrowers since the creation in 1914 of its Discount Window lending program, which provides short-term funding to financial institutions, the Clearing House said in its petition."

Would transparency do more harm than good? This is what the bank group thinks according to this Bloomberg article.

“Greater transparency results in more accountability, and the banks’ resistance continues to engender suspicion among taxpayers about the bailouts,” said Matthew Winkler, Bloomberg News editor-in-chief.

It is very important to track the results of this appeal. If it leads to full disclosure, it will give a great insight into the difficulties faced by many insititutions during the crisis.

It is indeed a very sensitive issue.