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CORPORATE GOVERNANCE AND THE 2008 FINANCIAL CRISIS

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Title: CORPORATE GOVERNANCE AND THE 2008 FINANCIAL CRISIS


1
CORPORATE GOVERNANCE AND THE 2008
FINANCIAL CRISIS
  • PRESENTED BY
  • JOEL WOLPERT
  • CA (SA) FCMA FCIS
  • September 2009

1
2
INDEX
  • 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

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3
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-30s 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
    sub-prime 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 USAs
    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 long- term 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
  • Remuneration Process
  • Board practices
  • Risk management
  • 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 companys 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
  • 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 KPIs
    - 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/NEDs) - 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 governments interest in the stability
of the financial system, intervention in pay
structures is as legitimate as the traditional
forms of financial regulation. Governments
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 managements 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
  • Greater awareness and improved implementation of
    risk management
  • Improved disclosure of risk management processes
    and practices
  • Risk management must be integrated with internal
    control
  • 6. 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 ifquestions 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
    non-executive 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 socio- economic
    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 everyones 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 Govern
ance Soccer Team Culture Vision Values
Transparency Accountability Disclosure
Trust Confidence Integrity 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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