DISCuSSIon pApER Corporate Governance and the Credit Crunch ABouT ACCA ACknowlEDGEmEnTS ACCA is the global body for professional accountants. ACCA is grateful to the many people who have We aim to offer business-relevant, first-choice contributed to the preparation of this paper. We can qualifications to people of application, ability and not name them all but particular thanks are due to ambition around the world who seek a rewarding Richard Aiken-Davies, President of ACCA, David career in accountancy, finance and management. We Clarke of LEBA, Alan Craft of Craft Financial Advice support our 122,000 members and 325,000 students Ltd, George Dallas of F&C Investments, Brandon throughout their careers, providing services through a Davies of the Global Association of Risk network of 80 offices and centres. Our global Professionals and Gatehouse Capital PLC, Robert infrastructure means that exams and support are Labuschagne of KPMG in the UK, Malcolm Lewis of delivered – and reputation and influence developed – Strategic Value Partners, Michael Mainelli of Z/Yen at a local level, directly benefiting stakeholders Group Limited, Alistair Milne of Cass Business wherever they are based, or plan to move to, in pursuit School, and Raj Thamotheram of Axa Investment of new career opportunities. Our focus is on Managers. The views reflected in this paper are, professional values, ethics, and governance, and we however, those of ACCA and should not be inferred deliver value-added services through our global as being the same as those of the people named. accountancy partnerships, working closely with multinational and small entities to promote global This paper was commissioned by the ACCA standards and support. We use our expertise and Corporate Governance and Risk Management experience to work with governments, donor agencies Committee, which considers it to be a worthwhile and professional bodies to develop the global contribution to discussion accountancy profession and to advance the public interest. Our reputation is grounded in over 100 years The ACCA Corporate Governance and Risk of providing world-class accounting and finance Management Committee exists to contribute to qualifications. We champion opportunity, diversity and improving knowledge and practice in corporate integrity, and our long traditions are complemented by governance and risk management and to guide and modern thinking, backed by a diverse, global shape ACCA’s global strategies and policies in these membership. By promoting our global standards, and areas. The Committee, chaired by Professor Andrew supporting our members wherever they work, we aim Chambers, comprises experts from business, the to meet the current and future needs of international public sector, academia and ACCA Council. business. For more on ACCA’s work in this area visit www.accaglobal.com/governance ABouT ThE AuThoRS Paul Moxey is head of corporate governance and risk management at ACCA. Paul is a leading contributor to ACCA’s responses to global developments in this area, and is an active participant in ACCA’s increasing influence on best governance practice. ConTACTS Adrian Berendt is vice-chair of For more information, please contact: ACCA’s Financial Services Network Panel and a member of ACCA’s paul Moxey, head of corporate governance and risk Research Committee. He is joint management, ACCA owner of LA Risk & Financial Ltd, a +44 (0)20 7059 5794 risk management and financial [email protected] control advisory business. Adrian has held several senior finance and Steve priddy, director of technical policy and operations roles in investment research, ACCA banking, both in the UK and +44 (0)20 7059 5971 internationally. [email protected] © The Association of Chartered Certified Accountants, November 2008 Contents executive summary 2 introduction 3 the root causes of the credit crunch 4 the need for good corporate governance 5 remuneration and incentives 7 risk management 8 accounting and reporting 10 regulation 12 Conclusion 13 aCCa’s corporate governance and risk management principles 14 Further reading 16 Arguably the credit crunch is an extreme phenomenon of the business cycle. Whether it is or not, ACCA is keen to consider what the accounting profession can do to enhance understanding of the issue and its implications and to learn lessons for the future. The overall aim of the present paper is to look at the wider picture and to examine how sound corporate governance, risk management and accounting can help. ACCA has been following developments in the credit crunch closely since mid 2007. It has run events to debate the issues and has contributed to consultations from regulators and standard-setters. This paper sets out ACCA’s thoughts on the subject, along with some recommendations. We are very grateful to the experts from the banking, investment and academic communities who have helped us in forming these views. Corporate GovernanCe and the Credit CrunCh 1 Executive summary The credit crunch poses a grave threat to the economies of than would a similar-sized profit from a more secure the developed and developing world. The global banking activity. Failure to address this challenge satisfactorily industry, which was by far the most profitable sector in could frustrate other reforms. 2006, is in severe difficulty and the threat that this poses to the real economy is profound. This paper sets out Risk should have been more fully taken into account when ACCA’s thoughts on what has happened and, looking to making decisions about strategy or operations. Risk the future, makes recommendations and considers how management tools have not always been fit for purpose. accountants can help. There has been too much reliance on models which were not properly stress tested and on credit ratings, and Many of the causal factors seem to be inextricably linked insufficient attention given to the big picture. More use to a failure in corporate governance. Regulatory boxes may should have been made of scenario planning as a risk tool. have been ticked but fundamental principles of good The risk management function needs to earn, and be governance were breached. There should be more accorded, higher status. emphasis in the performance of corporate governance than with its regulatory compliance. To help improve Bank boards need to be capable of being held to account, understanding about governance performance, ACCA is not just to shareholders but to other stakeholders. This is publishing a set of ten corporate governance and risk the job of shareholders but, in practice, it is difficult for management principles which we believe have to be them to do this for widely held companies. observed to achieve good corporate governance. This paper draws on these principles. There is much that needs to be addressed about accounting and reporting. This includes questions about Boards should ensure they set the direction of the fair value, whether reports need to give a better sense of company and the right moral tone and consider the effects the range of uncertainty underlying certain material of their decisions on society as well as their shareholders. valuations and whether the present accounting model Yet boards have failed in their responsibilities. Why have encourages pro-cyclicality. boards not asked the right questions? They have allowed inadequate risk management and sanctioned While some individuals may need to be held to account, it remuneration incentives that influenced behaviour without would be wrong to single out a single issue or culprit. The proper consideration of risk. As a result, companies which problems cannot be blamed simply on short sellers, should have been run prudently and sustainably, have government or greed. It would be a serious mistake for failed. This is particularly regrettable in view of the social regulators to fail to address systemic problems while function which retail banking has and the regulatory changing regulations that do nothing more than address protection that it therefore enjoys. the symptoms, in the hope that the problem will go away. We must learn the lessons from what is happening. Remuneration schemes should promote sustainable business performance. Risk should therefore be taken into This paper is issued as part of ACCA’s programme of account when considering performance-based pay, eg events, publications and research on addressing the credit profits from risky activities should attract a lower bonus crunch. 2 Introduction We are now in the second year of the ‘credit crunch’. A employee were 26 times higher than the average of other situation, which manifested itself with relatively minor industries. Some maintain that such profitability is due in problems in one sector of the US housing market, has large part to market imperfections arising from the unfolded into a widespread credit and liquidity crisis that regulatory system, such as lack of competition, information threatens a global economic slowdown. asymmetry, and externalities. Events have moved rapidly: we know a lot about what has Earlier governments in the US and UK ostensibly put an happened, but less about how or why. To the extent that end to state support of ailing industries. Many may be this is a business cycle phenomenon, it is unclear whether curious as to why the banking sector, seemingly awash it is possible or desirable to prevent such an event with liquidity in early 2007, now seems to rely on central recurring. If we want market forces to work we should not bank or government support and capital injections from be assuming a policy objective of abolishing the business other states’ sovereign wealth funds. cycle. Bear markets are probably needed to reveal inefficiencies and bad business and regulatory practice. This paper complements the ACCA policy paper Climbing We may need to live with the peaks and troughs that out of the Credit Crunch. It explores the issues in greater happen every ten years or so, but clearly no one wishes to detail and draws on the principles set out in ACCA’s tolerate the larger cycles that happen every few Corporate Governance and Risk Management Agenda (The generations. Agenda). The Agenda, developed by ACCA’s Corporate Governance and Risk Management Committee, sets out The last few years saw unprecedented growth in the size ten principles of good governance that are appropriate to and profitability of the global banking industry. According almost any organisation, regardless of size, sector or to McKinsey, global banking profits in 2006 were $788 location. The Agenda principles are appended to this billion; this was over $150 billion greater than the next paper (page 14), and the full Agenda is available at: most profitable sector: oil, gas and coal. Global banking www.accaglobal.com/governance. revenues were 6% of global GDP and its profits per Corporate GovernanCe and the Credit CrunCh 3 The root causes of the credit crunch The overall business cycle has been affected by a number • failure to appreciate cultural and motivational factors, a of specific circumstances which increased the cycle’s rigidity of thinking, a lack of desire to change, an intensity and length. The causes are many, but from a attitude of ‘it is not my problem’, inappropriate vision/ corporate governance perspective, the heart of the drivers and, not least, human greed problem seems to have been: • lack of training to enable senior management and • a failure in institutions to appreciate and manage the board members to understand underlying business interconnection between the inherent business risks models and products, leading to poor oversight by and remuneration incentives senior executives and a lack of rigorous challenge by independent non-executive directors • remuneration structures/bonuses that encouraged excessive short-termism. This neither supports prudent • complacency after a prolonged bull market. risk management nor works in the interests of long- term owners All these factors played a role; they are complex and interrelated. • risk management departments in banks that lacked influence or power Much discussion has centred on possible regulatory reforms. While we accept that changes to regulation may • weaknesses in reporting on risk and financial be part of the solution, other changes are needed as part transactions of a more systematic and sustainable solution. Given the breadth of the issues, ACCA’s role is to focus on its own • a lack of accountability generally within organisations area of expertise, particularly governance and disclosure. and between them and their owners. The temptation to make scapegoats of individual people or These factors, combined with information asymmetry groups should be resisted. While short selling may be, and between parties to transactions and imperfections in greed certainly is, part of the problem, there is little to be regulation and monetary policy, led to an excess of money gained from simply blaming short sellers or ‘greedy supply and, ultimately, to the market dislocation. bankers’. Banning short selling is simply masking the problem. There is a systemic problem and it is vital that Further contributory factors were: we learn the right lessons. • over-complexity of products and lack of understanding ACCA believes that the credit crunch can therefore be by management of the associated risks viewed, in large part, as a failure in corporate governance. This should come as no surprise: previous financial • excessive reliance on leverage in banks’ business episodes such as the savings and loans bank crisis in the models US in the late 1980s, the East Asian crisis in the late 1990s and, of course, the failure of Enron and WorldCom, • inter-connectedness of financial institutions taught us the importance of sound corporate governance and risk management. We did not learn the lessons in the • misalignment between the interests of originators of, past and must do so now. and investors in, complex financial products 4 The need for good corporate governance Principle 1 of The Agenda says: obligations of directors in this respect. It now confers on directors a duty to promote the success of the company Boards, shareholders and stakeholders share a common and, in the course of making their decisions to that end, understanding of the purpose and scope of corporate they are now required by law to ‘have regard’ to the governance. following: Good corporate governance is about boards directing and i. The likely consequences of any decision in the long controlling the organisations in the interests of long-term term. owners. It is also about boards being accountable to company owners and accounting properly for their stewardship to ii. The interests of the company’s employees. ensure sound internal control. Good corporate governance means much more than complying with the letter of iii. The need to foster the company’s business regulations and codes. Merely having the requisite proportion relationships with suppliers, customers and others. of independent non-executive directors on a board and separating the roles of chairman and chief executive is not iv. The impact of the company’s operations on the enough. It means complying with the broader spirit of community and the environment. good governance. Recent events are particularly noteworthy, because they indicate that good governance v. The desirability of the company maintaining a was lacking at the very financial institutions which both reputation for high standards of business conduct. complied with local corporate governance requirements and considered their governance model as best practice. vi. The need to act fairly as between members of the company. Principle 10 of The Agenda says: While there remains a lack of precision in the practical Corporate governance evolves and improves over time. application of ‘regard to’ and the scope is limited to UK companies, insufficient regard has been paid by some It is necessary to look beyond compliance and consider boards to points i, ii, iv and v. The new requirements under the quality, performance and behavioural aspects of the Companies Act came into effect in October 2007, corporate governance. These include remuneration, meaning that compliance with the new statutory incentives, risk management and financial reporting to requirements could not have been expected before that investors and others. Human nature is a common date. It may be helpful to recall that an argument widely denominator in each of these areas and is influenced by used by those lobbying against the introduction of the new incentives. Accountants must act as gatekeepers and must provisions was that they were unnecessary, since all provide reliable information which can reveal whether responsible boards took these matters into account anyway. incentives are working as intended. ACCA also believes that accountants, as finance professionals for whom ethics is of Principle 3 of The Agenda says: vital importance, should act as guardians of ethical business behaviour. Boards should set clear goals, accountabilities, appropriate structures and committees, delegated Principle 2 of The Agenda says: authorities and policies. They should provide sufficient resources to enable executive management to achieve Boards lead by example. Boards should set the right tone the goals of the organisation through effective and behave accordingly, paying particular attention to management of day-to-day operations and monitor ensuring the continuing ethical health of their management’s progress towards the achievement of organisations. these goals. It is a question of ethics as well as sound business for A fundamental role of the board is to provide direction and boards to ensure that neither their organisation’s loans, control. It was clear that the non-executive directors of nor those of intermediaries lower down the chain, are Enron and WorldCom did not provide sufficient challenge advanced to those with little realistic hope of repaying or oversight of executive management. Reforms, such as them. As a society, we rely on bankers to be professional the US Sarbanes–Oxley Act, those contained in the EC and we must be able to trust them. Bank boards should Corporate Governance Action Plan and in the Higgs and ensure that, whether they decide to sell or hold a particular Smith reports in the UK were intended to ensure that transaction, they maintain the same high standards of risk non-executives do provide the necessary challenge and appraisal and disclosure. oversight. Recent events suggest that this did not happen in some financial institutions. This may be partly owing to We should remember the impact on employees and on a lack of understanding of the complexities of the business wider society. While bank boards owe their primary duty to but more training is probably not the sole answer. Nor is their shareholders they also have obligations to other regulation a substitute for professional judgement or stakeholders. The UK Companies Act 2006 clarified the common sense. Corporate GovernanCe and the Credit CrunCh 5 Do banks use the best system for promotion? In 2007, the ex-CEO of Citi Group, Chuck Prince, famously said ‘when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. ‘We’re still dancing’1: this may be an appropriate attitude for a trader but it is not suitable for the CEO of a global financial institution. What else is it that inhibits boards from asking the right questions, from understanding the risks that are being run and from ensuring that these risks are effectively managed? Accountants have a vital role, using their knowledge, objectivity and professionalism to help ensure that good governance means good performance in the interests of an organisation’s long-term owners. It is not just ticking the boxes. 1. Financial Times, ‘Bullish Citigroup is ‘still dancing’ to the beat of the buy-out boom’, 10 July 2007. 6 Remuneration and incentives Principle 6 of The Agenda says that: transparency to decision-makers and their stakeholders. It is not about box ticking and regulatory bureaucracy. It is Executive remuneration promotes organisational about fundamental principles of ethics and professionalism performance and is transparent. Remuneration and the clear accountability of those charged with the arrangements should be aligned with individual important responsibility for running our businesses. performance in such a way as to promote organisational performance. It needs the support of boards to make this happen, but boards may need additional encouragement. Fortunately, Boards need to understand the risks faced by the some institutional investors are talking about these issues organisation, satisfy themselves that the level of risk is to their boards and we encourage them in their efforts. acceptable and challenge executive management when ACCA hopes that shareholders will play a more proactive appropriate. role in holding boards to account and that this will limit the need for additional regulation. Performance schemes must be based on sound principles and applied properly. Otherwise there is a risk that a The basis of charging for financial products and scheme will be used to justify an influential executive’s or remunerating those selling them means that there will trader’s pay claim. Human nature drives most of us to always be an incentive to mis-sell. Asymmetry of attempt to maximise our wealth. Existing incentive and information in the selling process means that buyers will career structure packages of banks mean enormous often be vulnerable. Boards should ensure that such rewards but have contributed to short-term thinking. This incentives are properly managed so that mis-selling does lack of long-term thinking neither supports prudent risk not occur. management nor works in the interests of other stakeholders in the global financial markets. Arguably this Principles 8 and 9 of The Agenda say that: presents a fundamental challenge which could frustrate any other attempts for reform. Boards account to shareholders and, where appropriate, other stakeholders for their stewardship [and that] It is a human behavioural challenge. Risk management and shareholders and other significant stakeholders hold remuneration and incentive systems must be linked. boards to account. Profits which involve high risk to an organisation should trigger a smaller bonus than a similar profit which involves It may be questioned whether the relative share of bank less risk. Payments should be avoided or delayed (eg held income paid as remuneration compared with dividends in an escrow account) until profits have been realised, cash has been in the best interest of shareholders. Shareholders received and ‘profits’ cannot reverse. On the brighter side, have limited ability to influence companies they own. Not human nature tends to abide by accepted societal ethics; all shareholders invest for the long term and not all recent events may mean that society will increasingly tend shareholders have an interest in holding boards to account to the view that there is an ethical dimension to for their stewardship. This has allowed executive performance schemes. This could lead to better-designed managements to extract increasingly larger proportions of performance schemes, where long-term financial and corporate earnings. This is a fundamental governance ethical performance is rewarded. challenge in capital markets where shares are widely held and is not confined to the banking sector. The emergence Linking risk management with remuneration incentives of new strategies (eg using derivatives) for participating in would make the risk management function more corporate profitability and new types of shareholder, such important in organisations. Risk managers ideally would as sovereign wealth funds, compound the challenge. be regarded as having equal seniority in an organisation to others in the ‘front office’ and be remunerated accordingly. One way to help address both challenges is to ensure that The risk management function should advise the boards and shareholders receive appropriate, clear and remuneration committee. We recognise that many risk reliable information on risk and financial results. Without managers may need to raise their game but an such information, shareholders stand little chance of environment where the risk management function is holding boards to account. Accountants clearly have a vital accorded higher status is necessary. This is not about role here. curbing enterprise and innovation but providing Corporate GovernanCe and the Credit CrunCh 7 Risk management Principle 4 of The Agenda says that: Such activity meant a huge demand for ‘AAA’-rated securities. Selling some derivatives of securities has been Boards ensure their strategy actively considers both risk likened to selling betting slips. Products were created, and reward over time. All organisations face risk: success packaged and marketed which were a ‘bet’ on the in achieving their objectives will usually require performance of the reference assets. Collateralised debt understanding, accepting, managing and taking risks. obligations (CDOs) were created, in part, because there Consideration of risk should therefore be a key part of was insufficient volume of underlying MBS origination to strategy formulation. Risk management should be meet investor demand – in many cases these CDOs did embedded within organisations so that risk is considered not have any direct claim on the underlying assets so were as part of decision making. To avoid creating a risk averse reliant for their existence on, and vulnerable to, grades culture, risk should be viewed in terms of both threats given by ratings agencies. and opportunities. Boards need to understand the risks faced by the organisation, satisfy themselves that the A low inflation environment stimulated a desire to look for level of risk is acceptable and challenge executive yield in new ways and encouraged derivative trading. management when appropriate. Derivative trading, however, is very different from traditional banking. Huge increases in computing power Risk management seems to have shaky foundations in added to complexity by creating the ability to generate some instances. Banks have highly sophisticated risk many transactions and, thereby, apparently deep markets. management functions yet recent events have tested them The chief executives of banks may not have had sufficient and found some of them wanting. The report from UBS in understanding of these new products which, combined April 2008 to its shareholders explaining the reasons for with this complexity, meant that traders were allowed to its write-downs provides a clear example of risk ‘get on with it’, with CEOs not knowing how to stop or management failings. control them. The yields which seemed to be created, aided by AAA ratings, may have mesmerised top The UBS report highlights the danger of having silos within management. There was not enough questioning about organisations. It follows that it is particularly important what ‘AAA’ meant. Perhaps there is a need to review that risk management itself does not occupy a silo but is training programmes, particularly to ensure that rising integrated with the organisation. Good risk management is executives, who may be skilled in a narrow range of the responsibility of the board, management and all the disciplines, are fully aware of the risk characteristics of all staff; it permeates through an organisation. The risk aspects of the business. management function should be to guide, inform and facilitate; it is not ‘responsible’ for risk. Recent events have highlighted the fact that bank staff had assumed that risks which they thought would net off (eg In early 2007, few bankers investing in mortgage-backed where A owes B and B owes A) did not actually net off in securities (MBSs) or their derivatives thought that they practice. Risk management procedures should pay more were betting on the viability of their banks. They did not attention to gross risk. understand the risks and may have believed what they wanted to believe. They were assessing risk with tools The way we account for risk is a primary driver of capital which were not entirely appropriate. Boards may not have value. Present prices, showing points, rather than ranges, been giving the necessary time, and may have lacked the are not always a good indicator of future asset values. expertise, to ask the right questions. Many of the risk management tools such as value at risk (VaR) assume that ‘efficient market theory’ works, There seems to have been widespread misunderstanding although it does not do so all the time. Efficient market about credit ratings. Some investors may have believed theory infers the existence of a normal distribution around that ‘AAA’ meant ‘safe’. Others were allowed by their a mean, it does not take proper account of the risks employers to buy ‘AAA’-rated instruments with little or no (particularly credit and operational risks) posed by market further due diligence or consideration of risk. The risks of variables which do not move in line with normal such activities were not matched to incentive systems. distributions. Many financial valuations also assume an efficient market. This either needs to be addressed or we In addition, as evidenced in the UBS report to its have to accept the imperfections and find ways to limit shareholders, employees were able to buy large volumes of them. MBSs and receive bonuses based on the difference between the yield on the security and the bank’s internally Arguably the root of this problem cannot be addressed in charged cost of funds. The pricing of such internal funds is a short period of time – efficient market theory has been normally subject to less rigorous checking than that the bedrock of economic theory for decades, and changing applied to external assets or liabilities and does not take it is not something that would be possible to achieve. It account of an organisation’s brand value or credit rating. may be best to point out that the theory, while working in There was very limited downside risk for staff individually, many respects, is not perfect and has shortcomings. Some yet the inherent risk to the bank from such a trade, which of these shortcomings have found their way into risk was enormous, was either ignored or not recognised. management systems (eg VaR). VaR is too narrow a 8