«Although debates still rage over the causes of the financial crisis of 2007 - 2009, most analysts agree that faulty corporate governance of risk was ...»
16. Incentives to Improve the Corporate Governance of Risk in
Richard J. Herring
Jacob Safra Professor of International Banking
The Wharton School, University of Pennsylvania
Although debates still rage over the causes of the financial crisis of 2007 - 2009, most
analysts agree that faulty corporate governance of risk was a major contributing factor, if not the
principal cause. Examples of failures in the governance of risk abound. An apparent lack of effective firm-wide oversight plagued many of the institutions that failed or required massive government intervention. Chief executive officers and boards appeared to have lacked an effective framework for imposing a consistent risk-appetite to constrain aggregate risk within acceptable limits.
This defect took many forms: an over reliance on risk decisions taken at a low-level in many product lines and trading desks without consideration of how such exposures might interact under various macro-economic conditions; a failure to question the risks of particular strategies and, instead, a tendency to follow the herd in an attempt to grow revenues and market share with minimal attention to risk; a reluctance to question fundamental assumptions about basis risks and hedges; an astonishing disregard for the centuries-old challenge of funding long- term assets with short-term liabilities and for liquidity risk more generally; a tendency to override limits when they conflicted with revenue goals; an astonishing inability to track aggregate exposures over complex legal structures and product silos; and a failure to risk-adjust 1 the price of internal transfers of funds and compensation more generally. As a result, the bonuses and compensation were real, but the profits were not.
Examples of these problems may be found in the bankruptcy of Lehman Brothers (Valukas 2010), the losses sustained by UBS (UBS 2008) and AIG (Special Inspector General for TARP 2009), the collapse of Northern Rock (Kirkpatrick 2009), the forced merger of Bear Stearns (Kirkpatrick 2009, SEC 2008), the collapse of Indy-Mac, WAMU (Office of the Inspector General 2010, Kelly 2008) and Wachovia (Corston 2010) as well as the string of losses reported by Citibank (Special Inspector General for TARP 2011), Merrill Lynch, and Bank of America (SEC 2010), which raised questions about whether corporate boards and senior management comprehended their exposures to sub-prime mortgage risks.1 These failures in the corporate governance of risk are all the more remarkable because supervisors have focused on this problem for more than a decade (BCBS1997, BCBS 1999a, BCBS 1999b, BCBS 2005, BCBS 2006, BCBS 2008, BCBS 2010a, BCBS 2010b, Joint Forum 1998, Davies 2003). “The Core Principles of Banking Supervision” (BCBS 1997) even embed good corporate governance of risk as a key principle. Nonetheless, most of these efforts have focused on processes and procedures to ensure good corporate governance–largely a matter of getting the right information to the right decision-makers at the right time–as well as the structure of boards, usually emphasizing the role of non-Executive directors on Audit Committees, Risk Committees and, more controversially in the United States, splitting the role of CEO and Chairman. Most of these recommendations for enhancing corporate governance seem sensible, although they seldom have drawn on lessons of what has actually gone wrong and, more generally, lack any empirical support.
1 Of course, too much emphasis may be placed on faulty governance. No principles of corporate governance can be expected to protect an institution fully against strategic errors or simply paying too much for an acquisition.
The press has often attributed good corporate governance to corporate culture, an elusive, but important factor. The Economist (2010a) noted that two American institutions which appeared to come through the crisis better than their peers did so based on some very simple principles. JP Morgan Chase was said to hold to two basic principles: (1) don’t hold too much of anything and (2) only keep what you are sure will generate a decent risk-adjusted return.
Goldman Sachs, which did require government assistance, but less than the other bulge bracket investment banks, encouraged greater attention to risk by promoting senior traders to risk positions and, indeed, making such positions a stepping stone to the top echelons of management. This may not have cultivated prowess in public relations, but it did enable the firm to cut its losses and hedge its remaining risks while some of its competitors continued to build even larger exposures. Numerous other examples can be found contrasting, for example, the strong leadership at Credit Suisse with the disastrous performance of UBS or the severe losses at Citigroup with the relative success of JPMorgan Chase. Strong leadership and a sound corporate culture undoubtedly matter, but it remains to be seen how these factors can be replicated, much less ensured by regulation or supervision. Moreover, the evidence remains largely anecdotal.
Recently Erkens, Hund and Matos (2010) have attempted to fill the gap in our empirical knowledge of the impact of presumed good corporate governance principles on outcomes during the global financial crisis. Since the 1990s, a series of official commissions, often formed in the wake of a shocking lapse in corporate governance, transformed the rules for good corporate governance by placing much greater stress on transparency and accountability and on
management (Committee on Corporate Governance 2000). The Economist (2010b) reports that the annual Booz & Company survey of the world’s biggest public companies show firms now routinely separate the jobs of Chairman and Chief Executive Officer. In 2009, less than 12% of incoming CEOs were also made Chairman of the Board, compared with 48% in 2002. And CEOs are dismissed more frequently for poor performance with the average tenure dropping from 8.1 years in 2000 to 6.3 years in 2009. Independent directors, too, have become more professional, at least in part because the Sarbanes-Oxley Act makes them personally liable for the statements they sign.
Yet we have no empirical evidence that these seemingly sensible changes have positively influenced the quality of decision-making. The financial crisis that engulfed America and Western Europe presents an opportunity to see whether financial institutions that adopted good practices of corporate governance fared better than those that did not.
Erkens, Hund and Matos (2010) conduct a comprehensive study of the performance during the crisis of 296 financial institutions from 30 countries with assets of more than $10 billion. They regress cumulative stock returns during the crisis on measures of corporate governance and control variables. They include three corporate governance factors: (1) board independence; (2) institutional ownership; and (3) the presence of large shareholders measured as of December 2006. They control for whether a firm is cross-listed on U.S. stock exchanges, leverage, firm size, dummy variables indicating a firm’s industry, home country, and the firm’s stock return during 2006 in case performance during the crisis period reflects a reversal of precrisis performance.
share ownership experienced worse stock returns during the crisis period. They note that one potential explanation for the result is that boards and shareholders encouraged managers to increase shareholder returns through greater risk-taking before the crisis In further testing, however, they find that greater institutional ownership is consistent with greater pre-crisis risktaking, but a higher proportion of independent directors is not. They test an alternative hypothesis about the negative role of the proportion of independent directors on stock performance based on the theory that independent directors, out of concern for their own reputations, pressured managers to raise additional equity capital to ensure capital adequacy and reduce bankruptcy risk.2 This leads to a transfer of wealth from existing shareholders to debt holders (and, potentially protects taxpayers). Erkens et al (2010) found that the amount of capital raised during the crisis (scaled by total assets) did depend on corporate governance factors. Firms with a larger proportion of independent directors did, indeed, raise more equity capital. Moreover, they found that the relation between stock returns and the proportion of independent directors becomes insignificant once firms that raised equity capital were excluded from the sample.
The authors also explored the relation between firm performance during the crisis and country level governance, measured as the quality of legal institutions and the extent of laws protecting shareholder rights. These factors proved insignificant indicating that firm-level, not 2 It should be noted that a decline in shareholder returns does not necessarily imply that the issuance of equity results in a destruction of the total value of the firm. Below I will suggest an alternative rationale for the pressure from independent directors to raise equity capital. As a firm approaches bankruptcy, the role of the directors shifts from representing the shareholders to protecting the assets of the firm for creditors who will become the new owners. In short, the independent directors have a fiduciary duty to protect the value of the bankruptcy estate. This will certainly not be rewarded by a rise in share prices because shareholders at that stage place a high value on the option that they may be saved by a high-risk high-return investment and they will resist a transfer of wealth to creditors, but it will reduce the costs of financial distress that would otherwise diminish the value of the firm and possibly cause losses to taxpayers.
crisis, which may be indirect confirmation of the popular view that strong leadership and corporate culture matter most.
Erkuns, Hund and Matos then tried to determine whether additional corporate governance variables could explain stock returns. They tested the existence of a risk committee, the financial expertise of the board, and separation between the role of CEO and Chairman, as well as the percentage of shares owned by insiders. None of these additional variables proved significant or altered the explanatory power of the original two corporate governance measures – the percentage of ownership by institutional investors and the proportion of independent directors.
These results raise troubling questions about the presumptions underlying most recommendations for enhancing corporate governance. But more fundamentally, the results imply that good corporate governance of risk is much more than a box-checking exercise. A board may conform to all of the hallmarks of good corporate governance, yet may lack the incentives to adopt the risk management framework necessary to control and coordinate the activities of complex, cross-border financial institutions. In the next section, we turn to the question of incentives.
III. The role of incentives in good corporate governance of risk III.A. Compensation In general, the many suggestions for enhancing corporate governance of financial institutions seem sensible, but usually ignore the role of incentives. The one exception is the recent attention focused on compensation (European Commission 2010, Turner 2009, BCBS 2011). Until the crisis, little attention was paid to the structure of remuneration either by the
competitive incentives to attract and retain top talent). The crisis provided an abundance of examples that the structure of remuneration can create incentives for excessive risk-taking. As Turner notes, “[P]ast remuneration policies, acting in combination with capital requirements and accounting rules, have created incentives for some executives and traders to take excessive risks and have resulted in large payments in reward for activities which seemed profit making at the time but subsequently proved harmful to the institution, and in some cases to the entire system.” Indeed, the consensus among regulators that badly designed compensation contributed to the crisis was echoed in the communiqué from the first meeting of the Group of 20 (2008). which pledged that “[A]ction needs to be taken, through voluntary effort or regulatory action, to avoid compensation schemes which reward excessive short-term returns or risk taking.” This was reinforced in the following Group of 20 (2009) Summit in Pittsburgh where the leaders announced “We committed to act together…to implement strong international compensation standards aimed at ending practices that lead to excessive risk-taking….” The Financial Stability Forum (2009) published Principles for Sound Compensation Practices that placed heavy emphasis on the role of the board in the effective governance of compensation. Principle I required that: (1) The firm’s board of directors must actively oversee the compensation system’s design and operation; (2) The firm’s board of directors must monitor and review the compensation system to ensure the system operates as intended; (3) Staff engaged in financial and risk control must be independent, have appropriate authority, and be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the firm. In the U.S., regulators have just announced a joint proposed rulemaking to implement Section 956 of the Dodd-Frank Act that prohibits incentive
excessive or that may lead to material losses.3 The European Commission (2010) has made a similar proposal.