Corporate Governance Failure in Financial Serivices in the Uk

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Corporate Governance in Financial Services

The 2008 financial crisis is often addressed as the most serious economic crisis since the Great Depression^[1].  Although the origin of this crisis, that led to the collapse and subsequent government ‘bail-out’ of the banking giants Northern Rock, RBS and HBOS, has been related to a melange of macro-instabilities, micro-regulatory failures and growing financial innovations (Van Den Berghe, 2009) added to low interest rates causing rapid credit-growth and explosion of asset prices (Turner, 2009) it can be argued that governance failures aggravated the financial meltdown (Kirkpatrick, 2009; Yeoh, 2010; Fetisov, 2010). This paper discusses the corporate governance failures that can (partly) explain the UK financial crisis and provides possible remedies and recommendations.  

Challenging competitive conditions in an accommodating regulatory environment and low interest rates drove banks into developing new sources of income to fight revenue erosion.  New and sophisticated financial products were created such as CDOS^[2] and CDOs-Squared.  Housing finance markets were very profitable as banks adopted the “originate-to-distribute” model, aided by regulatory framework and high investor demand.   Volumes of securitised credit increased as entities that moved such assets off-balance-sheet gained competitive advantage and economised on core capital (Blundell-Wignall, 2007). Risk appreciation was deteriorated due to the complexity of such products, increasing scale of investment banking activities and shadow banking, as most of the maturity transformation took place off-balance-sheet, out of the regulators supervision.  It was safe to profit from holding long term maturity assets funded by short-term liabilities in liquid markets, however there was no appropriate management of liquidity risk, in case of a liquidity stress.  (Kirkpatrick, 2009)

Turner (2009) explains that the complexities of mathematics used to measure and manage risk made it very difficult for top management and boards to assess and exercise judgement over risks being taken.   The underestimation of counterparty risk generated by the increasing usage of CDS can serve as another example of failure of risk management.   Lang and Jagtiani (2010) reported that some firms abstained from the mortgage-related CDOs due to the lack of transparency of these products as they found it impossible to reach back to the underlying assets.  They concluded that “financial firms lacked effective internal controls, accurate and timely financial and risk reporting to the right management level, and an enterprise-wide risk management program”.   An example of information-transmission failure is that the UBS senior management only appreciated the severity of the potential subprime losses in late July-2007 despite the alert of their risk management department in Q1-2007.  

Principal-agent problems in the role of rating agencies aggravated the situation. As agencies’ revenue streams are a function of the number of ratings they provide, this created an incentive to sacrifice accuracy for speed.  Furthermore the oligopolistic nature of the ratings market permitted issuers to engage in “ratings-shopping”.  (Shah, 2014)  

Badly designed remuneration policies incentivised failures of risk management systems as they rewarded short-termism and excessive risk-taking without adequate regard for long-term global performance (Berrone, 2008; C.E.C., 2009; Kirkpatrick, 2009; Kay 2012).  Executives, which were motivated to increase short term profitability due to their performance based incentive structure^[3] (bonuses), often chose products like CDOs and MBS which generated huge revenue upfront without disclosing risk position.  This increased opaqueness in financial reporting to shareholders (Laeven et al. 2010), exposure to liquidity risk (Jean, 2011) and contributed to systemic risk (Yeoh, 2010).  Furthermore, there was limited cooperation between remuneration and risk committees for specific risk adjustments to performance objectives (Walker, 2009).

External directors are criticised for failing to restrain or at least raise more concerns over the perverse compensation incentive systems and excesses of the executive board commonly associated with many of the failed banks (Bickster, 2008; Williams, 2009).  The failure of this first line of defence in relation to their own institution can be attributed to deficiencies in board composition structure, their limited commitment and knowledge on complex financial products (Walker, 2009). Larger size of boards in UK-listed banks compared to the average of FTSE-100 listed companies and inadequate balance of executive-nonexecutive and internal-external directors might have contributed to reduction of board effectiveness in terms of manageability and ability of individual directors to contribute, increasing the risk of ‘single-voice’ dominated board decisions (Walker 2009).  Moreover, many NEDs did not have strong character and competent financial expertise^[4], to influence on strategy (Guerra and Thal-Larsen, 2008).  Walker (2009) pointed out that 25 days’ time commitment of NEDs on major UK BOFI boards was too short given the need for more intensive work related on areas of audit and risk.  

As banks are becoming larger and shareholding is getting more dispersed, individual shareholders power and incentives to influence long term corporate strategy is diminishing (Kay, 2012), in benefit of large institutional investors.  As retribution structure of active fund managers and other investment companies is often based on short-term performance of their holdings, earnings disappointments often induce heavy stock selling.   Therefore plenty of evidence^[5] shows that they fail to serve as monitors in correcting CEO overcompensation and short-termism.  This reduced engagement, and increased complacency leading to ‘managerial capitalism’.