Corporate governance lessons from the financial crisis – oecd observer electricity in water pipes

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Directors, regulators and shareholders, but also policymakers and the general public, need to pay more attention to corporate governance. This tells us how firms operate, their motives and principles, their reporting lines, who they are accountable to, and how they manage profit, remuneration and, in the case of many financial firms, other people’s money. When times were good, too many people took their eye off the ball and now we see the consequences.

The public outcry has been loud and understandable, not least in relation to executive pay. And even some top executives have now admitted the lack of relationship between pay and performance and called for a salaries shake-up. We now realise that constantly rising share prices is not necessarily a sign of good corporate governance. In fact, as recent history shows, it could actually be the opposite.

The question is, what can be done to improve how financial firms operate? We have been examining the crisis closely and in particular seeing how the OECD Principles of Corporate Governance might help or, indeed, be improved in light of recent experiences.

Let’s start with remuneration. Recent surveys have shown that four out of five market participants believe that compensation practices played a role in promoting the accumulation of risk that led to the crisis. If they are right, the way that remuneration schemes are designed and supervised can have systemic impact on the financial system.

But to get it right we need to look at pay structures across whole companies, not just at their high-profile executives. It is equally important to come to grips with how bonuses are designed and paid among traders and portfolio managers throughout the company. We have seen too many examples of employees being given short-term incentives that are not in line with the long-term sustainability of the firm. This is what contributed to the build-up of unmanageable risks that eventually brought some companies down. By applying the corporate governance principles, companies can establish a proper structure for deciding on issues such as remuneration. And the board will clearly play an important role, since to leave it to executives themselves is inviting disaster. When looking at various models for compensation, boards should explicitly ask themselves if the company’s compensation model is aligned with prudent risk-taking and the long-term objectives and strategy of the company. Perhaps some firms asked this question and got the wrong answer, but it is also likely that too many firms ignored it. The crisis has also thrown up some massive failures in risk management. Even where companies had mandatory internal controls on reporting for the financial accounts, their executives did not fully grasp or clearly communicate the financial risks of many of the instruments they were betting on. Many of these were in fact off the balance sheet prior to the crisis. To fill this gap, risk management must be seen in a corporate-wide perspective where the risk management system is continuously adjusted in line with a corporate strategy and the appetite for risk. The oversight of risk management by board members must also be improved and they must also be given all the information they need to make informed decisions.

One way OECD believes this can be done is to encourage corporations to appoint a special risk officer. Moreover, to keep information clear, that person would report directly to the board of directors and not only via the CEO. Surveys of audit committee members have shown that they are not too satisfied with the current state of reporting. Only four out of ten said that the risk reporting they received was very good. Some boards have not only failed in the oversight of risk management systems but also in the remuneration practices of their firms, so the financial market collapse was their failure, too.

It is indeed true that boards have not always received high-quality information. But we must also ask if they had actually demanded the right information and in a suitable form. For example, knowing exposure to residential mortgages is not the same thing as also knowing what proportion is exposed to sub-prime. Being a board member in a large complex organisation is extremely demanding. And no board member can be expected to master all aspects of the business in detail.

But in financial firms, a good understanding of risk management is vital. This is why the OECD has suggested that the "fit and proper person" test-which assesses if somebody is trustworthy to be a bank director-could be expanded to include technical and professional competence in areas like risk management. It might also be worth looking at strengthening the legal duties of board members-and the enforcement of those duties.

The age-old debate about whether higher standards of corporate governance can be enforced by laws and rules or encouraged via guidelines and market behaviour has heated up considerably since the crisis. But the debate may be missing the point.

Consider the OECD Principles of Corporate Governance. In many cases the principles have been implemented through regulation and legislation. This creates a level playing field and is sometimes the preferred route for companies that may find it hard to "take the first step" among competitors. But even where there are rules and laws on the books, they simply cannot ensure good behaviour. We also need to do better in monitoring their implementation and their effectiveness. That is why the OECD will put in place a process of peer reviews based on the OECD principles. These peer reviews will obviously scrutinise implementation, though they will also encourage transparency, consistency and mutual learning.

Not that all companies are sitting on their laurels. Since the crisis, the private sector has been taking a greater interest in improving their corporate governance. Board composition is changing and shareholders are rediscovering their voices too.

Many firms now realise that they need to re-gain credibility. Private sector initiatives to improve corporate governance are vital for progress and OECD has established a forum for companies and broader stakeholders to exchange views and best practices. In 2009 we also launched a global consultation on the Internet to garner input and suggestions from the public on how to improve corporate governance. As the financial crisis has underlined, good corporate governance is everyone’s business.