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CORPORATE GOVERNANCE AND THE 2008 FINANCIAL CRISIS

PRESENTED BY

JOEL WOLPERT CA (SA) FCMA FCIS

September 2009

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INDEX

1) Context2) Introduction: Overview of the Global Financial Crisis3) Four Horsemen of the Financial Apocalypse4) Governance of the Remuneration Process5) Board Practices6) Risk Management7) Shareholder (In) Activism8) Conclusion

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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-30’s were doing”

– Johann Rupert, Remgro Chairman3

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 4

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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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 businessrecession. Global imbalances and housing bubbles – a disregard for systemic risk – excessive market-based, backward-looking riskmanagement 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.

INTRODUCTION- OVERVIEW OF GLOBAL FINANCIAL CRISIS

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2. The banking crisis was triggered by largely unregulated trading of complex financial instruments, including mortgaged-backed securities, which dragged down some of the USA’s 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.

INTRODUCTION- OVERVIEW OF GLOBAL FINANCIAL CRISIS - Continue

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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.

INTRODUCTION- OVERVIEW OF GLOBAL FINANCIAL CRISIS - Continue

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There were four major areas of Governance Weakness:

1. Remuneration Process

2. Board practices

3. Risk management

4. Shareholder (In)Activism

FOUR HORSEMEN OF THE FINANCIAL APOCALYPSE

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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 company’s 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.

GOVERNANCE OF THE REMUNERATION PROCESS

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GOVERNANCE OF THE REMUNERATION PROCESS - Continue

3. 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 KPI’s - 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/NED’s) - 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 government’s interest in the stability of the financial system, intervention in pay structures is as legitimate as the traditional forms of financial regulation. Government’s 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. 13

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.

BOARD PRACTICES

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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.

BOARD PRACTICES - Continue

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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

BOARD PRACTICES - Continue

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“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 management’s decision making for both risk-taking and risk-avoiding decisions;

RISK MANAGEMENT

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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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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.

RISK MANAGEMENT - Continue

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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

RISK MANAGEMENT - Continue

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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 if”questions have been asked and understood from the business model perspective rather than focusing on scenarios based solely on historical quantitative data.

RISK MANAGEMENT - Continue

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“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

SHAREHOLDER (IN)ACTIVISM

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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

SHAREHOLDER (IN)ACTIVISM – Continue

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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.

SHAREHOLDER (IN)ACTIVISM – Continue

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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

SHAREHOLDER (IN)ACTIVISM – Continue

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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.

CONCLUSION

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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 everyone’s 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

CONCLUSION - Continue

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CONCLUSION - Continue

6. Features of Fit for Purpose Governance:

Governance Soccer Team

Culture Vision Values

Transparency Accountability Disclosure

Trust Confidence

Integrity Independence Competence

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“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

CONCLUSION - Continue

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