The next regulatory challenge: corporate governance rules that actually work
Thursday, October 21, 2010
By Michael Prowse, Senior Visiting Fellow
There were multiple causes of the global financial crisis of 2007-09. But one insufficiently investigated explanation of the crash is the weakness of corporate governance in the financial sector.
The proximate cause of the failure of most of the world’s largest banks was senior executives’ unrestrained appetite for risk. The biggest losses occurred in proprietary trading: the sale and purchase of complex securities, such as credit default swaps. Yet who, in a limited liability company, is supposed to monitor and control risk taking by employees? The answer, of course, is the board of directors acting on behalf of the companies’ owners, its shareholders.
If shareholders of major banks, acting through their boards of directors, had exercised responsible oversight, there would have been no financial meltdown. Senior executives – traders in particular – would not have earned sky-high bonuses for taking unjustified risks that threatened the stability of their institutions. At the height of the boom in 2006, they would instead have been disciplined. Some would have lost their jobs.
Why, then, did shareholders not act responsibly? And what can be done, by the Financial Stability Board (FSB), and other regulatory bodies, to ensure that oversight is more prudent in the future?
So far, regulators have addressed only narrow aspects of corporate governance. In 2009 the FSB (in its former incarnation of the Financial Stability Forum) published principles for “sound compensation practices”. Looking at financial market behaviour prior to the 2007-09 crisis, it found employees who generated high short-term profits were paid generous bonuses without regard to the longer-term risks they imposed on their firms – without regard, in other words, for the true underlying profitability of their trades. It concluded that such “perverse incentives amplified the excessive risk taking that severely threatened the global financial system and left firms with fewer resources to absorb losses as risks materialised”.
The root problem, it argued, was that most boards of directors saw compensation systems “as being largely unrelated to risk management and risk governance”. This was an astonishing finding: prior to 2007 (and perhaps again today) the boards of the world’s major banks were paying out enormous bonuses for trading strategies that could potentially (and in practice often did) impose unacceptable risks on their institutions.
The FSB’s proposed solution was simply that pay, like capital requirements, should be “risk-adjusted”. If two employees generate the same short-term profits they should not automatically receive the same compensation. The trader who earns the profit via a riskier strategy should instead earn a smaller bonus. The recommendation (which has no legal force) was better than nothing, but only just. It left two questions unanswered. First, why were boards not taking such elementary factors into account anyway? And, second, who determines levels of risk, and according to what metric?
This month European Union regulators proposed more specific controls on bank compensation. They said there should be a maximum (but as yet unspecified) multiple of salary that can be paid in bonus to bankers with a significant risk-taking role. In addition up to 60 per cent of bonuses should be deferred for as much as five years, with half of upfront and deferred portions paid in shares. In the UK, the Financial Services Authority has argued that the total bonus should be share-based.
But again, the EU proposals beg the question as to why boards of directors and shareholders are not already imposing suitable controls on senior employees. What is wrong with financial services? Why will these firms act prudently only if ordered to do so by government regulators?
The financial services sector is not unique in suffering from weak corporate governance. To a great or lesser degree it is a problem common to all large companies owned by a multitude of dispersed shareholders. In fact modern compensation systems, such as share options and bonuses for senior executives, were intended to help cure, rather than exacerbate, governance problems.
The theory was that if senior managers’ pay was linked more closely to a company’s share price, their interests would be more closely aligned with those of shareholders. Managers and shareholders would be united in pursuing policies aimed at maximising the company’s profitability and longer-term share price.
In practice, though, share options and bonuses played into the hands of senior executives, who proceeded to transfer wealth from shareholders to themselves on a scale that would have astonished previous generations. It is one of the reasons why the compensation of chief executives has soared relative to that of regular employees throughout the economy. Wall Street simply carried the process to its logical extreme: the crash left traders with vast personal fortunes and investors holding nearly worthless bank shares.
The underlying problem is that the limited liability company –still the most popular corporate structure - was flawed from its inception in the mid-19th century. It was a brilliant innovation because it offered a legal structure through which an unlimited number of investors could contribute funds to a permanent corporate body, without fearing loss of their personal fortunes. It made possible accumulations of capital on a hitherto unimagined scale, and helped provide the motive power for 150 years of rapid economic growth.
But governance issues have never been satisfactorily resolved. There is no way that hundreds of thousands of shareholders can exercise proper control over boards of directors. Most do not attend shareholder meetings, and if they do, they are easily manipulated by directors. Shareholders are often “rationally apathetic” because it is not financially worth their while to involve themselves deeply in management issues. If they are unhappy the best strategy is just to sell their shares.
Since companies are hierarchical organisations, directors and senior executives are not answerable to rank-and-file employees either. So this great Victorian institution has created pools of unaccountable power in society: small groups of individuals at the top of corporations are able to pay themselves more or less what they please. And, as Wall Street has illustrated most vividly, compensation for these privileged elites is often unrelated to productivity or long-term profitability.
My suspicion is that top down control of senior managers by shareholders will never be practical. If it were possible it would have happened by now. Reformers, therefore, ought to consider the only other option: making corporations more equitable and democratic institutions in which the body of employees exercise greater power over boards of directors. This could be achieved by giving employees seats on supervisory boards that set remuneration and establish ethical guidelines.
Before dismissing such proposals as unworkable socialism, critics should ask themselves a question. If Citigroup’s rank-and file employees (who do not earn vast salaries) had been involved in the group’s governance prior to 2007 would they have sanctioned either the extremely risky strategies of top traders or their wildly excessive remuneration? My guess is that ordinary employees would have acted more responsibly than the elites that wrecked the company and then shamelessly accepted a tax-payer financed bailout.
It would be naïve, of course, to expect the FSB and other regulatory bodies to propose meaningful reforms of corporate governance in the financial sector, or elsewhere. The division of power within the modern corporation is an intensely political issue that can be addressed only at the highest levels of government. But if the present economic malaise continues long enough, and if levels of inequality continue to grow, it might just form part of the agenda of a future Democratic administration.
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