After the recent financial and economic crisis more transparency, accountability, regulation, and alignment of interests of directors

with long-term objectives are considered necessary to restore confidence in the financial markets, to reformulate the role of CEOs and to reformulate the existing corporate governance structures that have been inadequate. Discuss this statement, supporting your answer with reference to the literature and empirical research on corporate governance.

The recent financial and economic crisis can supremely (but not completely) be attributed to failures and weaknesses in corporate governance mechanisms. This discussion heavily relies on The Corporate Governance Lessons from the Financial Crisis compiled by Grant Kirkpatrick,1 which identifies the requirements of increased transparency, accountability, regulation and alignment of interests of directors with long-term objectives in order to restore confidence in the financial markets and the need to reformulate the role of CEOs. Kirkpatricks findings are supported by literature and empirical research from a wide array of sources, with the resulting conclusions stressing the imperative need for the OECD, governments and regulators, to re-examine the adequacy of its corporate governance principles in these key areas (Kirkpatrick, 2009). In mid-2008, the global financial economy began to experience the onset of the crisis in the US subprime market, which had spread to a number of other advanced economies through a combination of direct exposures (Merrouche and Nier, 2010). The worst crisis since the great depression (UN, 2010) had a major impact on financial institutions and banks in many economies; with the largest and most significant financial reverberations experienced in the US and Europe. The worst affected companies in the US included AIG, Bear Stearns, Citibank and Merrill Lynch while in Europe, the list included Barclays, Credit Suisse, Socit Gnrale and UBS. Many financial institutions realised major losses in assets whilst others required significant government rescuing. The impact of the GFC continued into 2009, and was still an issue leading into 2010 (Eves, 2010), resulting in a number of collapses. The impact of the crisis resulted in a worldwide loss of confidence which affected all financial institutions, the aftermath realised the failing of several banks in Europe and the recapitalisation of many more. On a macroeconomic scale, the impact of the GFC was greatest in developing economies which relied heavily on foreign capital assistance or were heavily geared (Eves, 2009). Due to the small global economic standing of these developing nations, the combined impact on the US, Japan and developed western European economies dominated the worlds attention; as financial liquidity dried up. Summarised succinctly, it can be concluded that Capital

The report was prepared for the OECD Steering Group on Corporate Governance by Grant Kirkpatrick under the supervision of Mats Isaksson (2009).

flows provided the fuel which the developed worldss inadequately designed and regulated financial system then ignited to produce the firestorm that engulfed us all. (King, 2010). Merrouche and Nier (2010) explore the causes which resulted in the build-up of financial imbalances globally. Their findings establish, that a combination of poor supervision and lacking regulation allowed overly accommodative monetary policies to help fuel the build-up (White, 2009), and widening global imbalances and associated capital flows were the root cause across advanced economies. Amongst these causes, it can be established that to a very important extent, the financial crisis can be attributed to failures and weaknesses in corporate governance approaches. The decade leading up to the GFC saw major progress in the standards and application of corporate governance on a global scale. The mid 90s saw the hi-tech bubble burst and the late 90s brought on the Asian financial crisis. Furthermore, large corporate scandals including Enron and Worldcom failures all highlighted significant flaws, which resulted in the improving refinement of corporate governance standards. In each case, the corporate governance deficiencies, while not strictly causal, were certainly facilitators of the resultant failures; if not also deficient in preventing poor performance. Leading into the GFC, many regulators took comfort in the fact that once companies and banks met basic corporate governance standards, they were in effect stable (CeFiMS, 2012b). However, when put to the test during the GFC, the corporate governance countermeasures to protect against excessive risk taking, failed miserably. The most evident system failures resulted from, poor transference of exposure information, corporate strategies with poor performance indicators to measure implementation and substandard company disclosures about foreseeable risk factors. Summarised neatly, Erik Berglof; Chief Economist of the European Bank for Reconstruction and Development, found banks with dominant corporate governance systems, also ran into difficulty during the crisis. Leading on from this observation, Berglof poses the question Was corporate governance really not important or is it that the way we conceptualise and measure corporate governance does not capture its relevance? (Berglof, 2011). Globally, the corporate governance standards implemented across countries are really very unique in both composition and application. While most international systems of governance refer to the OECD Principles of Corporate Governance (OECD, 2004) to set the required standards, there are many leading international codes defining specific relevance to individual countries See Table 1. Some of these codes have regulatory clout and others might be purely advisory. However, the aim is the same: to raise governance standards in the market as a means of attracting capital. (CeFiMS, 2012d).

Table 1 Leading International Codes Source: (CeFiMS, 2012d)

The World Bank has established a program to assist its member countries in strengthening their corporate governance frameworks (World Bank, 2012) under the Reports on the Observance of Standards and Codes (ROSC) initiative. The primary differences between corporate governance systems across countries which can be established from the ROSC reports are well reflected in the findings of the OECD; acknowledging that one size fits all is not an effective approach to corporate governance, The balance between law, regulation and voluntary principles varies widely in the OECD area depending in part on history, legal traditions, efficiency of the courts, the political structure of the country and the stage of enterprise development. (OECD, 2004) a summary of different codes and principles in operation across OECD member countries is summarised in Table 2. In present day evidence; highlighting the differences between corporate governance systems, a United Nations investigation; seeking the views of members on global economic governance and development, found overwhelming support for a global system of governance with an emerging consensus that a stronger system of global economic governance must be more transparent inclusive and efficient. (United Nations, 2011). Referring back to the question Berglof poses, the summary of corporate governance systems across countries established by the OECD as well as the opinions expressed by the member nations of the UN, a decisive conclusion can be established. During the GFC, the growth rate countries with various corporate governance systems; from a heavily dispersed locality around the world, experienced a slowdown, with many countries falling into recession; see Figure 1 (Nanto, 2009). From this it can be deduced that the failures and weaknesses in corporate governance which can be attributed to the GFC, more specifically resulted from the actions of the financial institutions at the heart of the financial crisis; the responsibility of which, is held by the board of directors.

In the post-2000 market, boards had to be clear about the strategy and associated risk management systems of the company. Accordingly, performance was required to be displayed in efficient reporting systems indicating the achievement of objectives. During the GFC it appears that there was a severe mismatch between the incentive systems, risk management and internal control systems in many cases (Kirkpatrick, 2009). A review of eleven major banks by the Senior Supervisors Group (2008), established that while all were impacted on by the GFC, there was a significant variance in the levels of impact which correlated strongly with the structure of senior management and the nature or risk management systems. Frederick Tung and Xue Wang (2011) establish that bank executives compensation to be a culprit during the GFC. Empirical evidence evidences their analysis, hypothesizing that bank CEOs inside debt incentives correlate with bank risk taking and bank performance in the Financial Crisis (Wang and Tung, 2011). The board itself is responsible for the day-to-day operation of a company, and in 2004 the average board comprised of 11 members, established by Spencer Stuart (2004). Boards tend to be comprised of inside (employee) and outside (independent) directors, with varying degrees of diversity and interlocking directorships amongst companies. The board itself is managed by two critical and very distinctive positions, the CEO and the chairman. The role of the CEO is to run the company, and the role of the Chairman is to supervise the operation of the board. However, in 2004 74% of all S&P 500 boards had a combined chairman and CEO role. During the GFC, the position of company CEO became a highly controversial figure. Extending the hypothesis that Tung and Wang devised, the GFC with the near collapse of

major international banks, the need of many others for unprecedented levels of state support and revelations that their CEOs were well paid regardless of performance, brought into sharp focus their remuneration policies. (CeFiMS, 2012b). Arguably, pay should reflect performance; structured in a manner to create incentive for improved performance. From a theoretical perspective, the purpose of an incentivised remuneration package is to align the interests of the CEO with all stakeholders. However, within this theory lies an inherent flaw, which during the GFC left investors isolated from many CEOs. Kirkpatrick, found that during the GFC agency theory directly resulted in the poor performance of many financial institutions. Agency theory explains the relationship whereby the board of directors supervises company managers on behalf of shareholder and investors. During the GFC; as a direct result of chasing improved performance, many banks had taken on high levels of risk by following the letter rather than the intent of regulations For example, credit lines extended to conduits needed to be supported by banks capital (under Basel I) if it is for a period longer than a year. Banks therefore started writing credit lines for 364 days as opposed to 365 days thereby opening the bank to major potential risks. (Kirkpatrick, 2009). The CEO as supervisor of the boards and accordingly company managers, as in this instance, did not provide the capital adequacy reports with the transparency, accountability and regulation expected of the position. If the CEO does not share information or is dishonest, then it is very difficult for a board (who are often appointed by the CEO) to carry out a full due diligence. (CeFiMS, 2012a) to paraphrase, Even if risk management systems in the technical sense are functioning, it will not impact the company unless the transmission of information is through effective channels (Kirkpatrick, 2009). Leading up to the GFC, as the global economy was weakening, an Associated Press Study revealed the median CEO salary for S&P 500 companies was US$8.4 million. Post GFC, average director salaries rose by 3.2%; however bonuses rose by 23%. And while bonuses are purportedly reflections of positive performance, instances of the contrary continue to defy logic (CeFiMS, 2012b), illustrated below in Table 2 comparing CEO remuneration with company performance.

Table 2 CEO remuneration comparisons. Source: (IDS Executive compensation Review)

Joseph Stiglitz, a former Nobel Prize winner for Economics, suggests several critical reasons which prove the incentive (bonuses) system to be flawed, which in combination with the

Agency theory provides correlation to the failure and weaknesses in corporate governance systems during the GFC. Stiglitz argues that exorbitant incentives encourage excessive risk taking and short sighted behaviour. This behaviour in turn leads to creative accounting and can distort the provision of information (Stiglitz, 2010). Stock options are a recent and controversial aspect of CEO remuneration. The theory behind options allows the right to purchase stock at present day prices in the future. If stock prices increase during the time period, options may be exercised to realise available profits. If stock prices reduce, options need not be exercised, and no loss is incurred by the holder. While options have been used as incentive to align stakeholder and CEO objectives, several reasons; in addition to the Stiglitz argument, prove that the intention of share options do not align with the theoretical logic, the most prominent being that rarely is the relationship between a companys performance and share price well defined. During and post GFC, confidence in financial markets plummeted, in part this can be attributed to the simple observation that The directors of such [joint stock] companies, however, being the managers of other peoples money than their own, it cannot well be expected, that they would watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Like the stewards of rich men, they are apt to consider attention to small matters as not for their masters honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. (Adam Smith, 1776). The resulting separation of ownership gave rise to the fundamental underpinnings of corporate governance, and it was this delegated power; which when abused, facilitated the onset of the financial crisis. Financial confidence was at an all-time low, and shareholder disillusionment was unprecedentedly high. In stark contrast to the poor financial performance of financial institutions and the negative growth rate of economies, the poor performance of company CEOs was rewarded with lavish compensation, incentives, and stock options. The GFC, like many previous occurrences of corporate governance failures, highlighted the need to review, refine and develop corporate governance standards. Post-GFC, shareholders now demand, complete transparency, accountability and regulation of company performance and the board. The code of the OECD Principles is a remarkable achievement (CeFiMS, 2012d) and in conjunction World Bank ROSC process and the United Nations continue to interact with countries to develop corporate governance standards in a continual process.

References Berglof, E. 2011. A European Perspective on the Global Financial Crisis [online]: Abstract, Corporate Governence and International Review, Vol 19 (5): 497-501. Available from: <http://onlinelibrary.wiley.com/doi/10.1111/j.1467-8683.2011.00872.x/abstract>. CeFiMS, 2012a. Unit 6: Board Composition and Control, University of London. CeFiMS, 2012b. Unit 6: CEO Compensation, University of London. CeFiMS, 2012c. Unit 7: International Governance, University of London. CeFiMS, 2012d. Unit 8: Overview of Corporate Governance Codes, University of London. Eves, C. 2010. Reviewing the Impact of the 2008/2009 Global Financial Crisis (GFC) on International Property Markets and Property Professions, The International Real Estate Research Symposium, Kuala Lumpur (April 27-29): 1-23. King, M., 2010. Speech at University of Exeter, January 19th 2010 Kirkpatrick, G. 2009. The Corporate Governance Lessons from the Financial Crisis [online],OECD. Available from: <http://www.oecd.org/dataoecd/32/1/42229620.pdf>. Nanto, D. K. 2009. The Global Financial Crisis: Analysis and Policy Implications, Congressional Research Service. Available from: <http://www.fas.org/sgp/crs/misc/RL34742.pdf>. OECD, 2004. OECD Principles of Corporate Governance [online]:Preamble, OECD. Available from: <http://www.oecd.org/dataoecd/32/18/31557724.pdf>. Ouarda Merrouche and Erlend Nier. 2010. What Caused the Global Financial Crisis? Evidence on the Drivers of Financial Imbalances 1999-2007 [online], IMF: Working Paper Series. Available from: <http://www.imf.org/external/pubs/ft/wp/2010/wp10265.pdf>. Smith, A. 1990. An Inquiry into the Nature and Causes of the Wealth of Nations (originally published 1776), London: Encyclopedia Britannica. Stiglitz, J. 2010. Incentives and the performance of Americas Financial Sector, testimony to House Committee on Financial Services (Hearing on Compensation in the Financial Industry), January 22nd 2010. Tung, F and Wang, X. 2011. Bank CEOs, Inside Debt Compensation, and the Global Financial Crisis [online], Boston University School of Law Working Paper. No. 11-49. Available from: <http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1943711_code355514.pdf?abstractid=1 570161&mirid=2>.

United Nations, 2009. The Global Financial Crisis: Impact and Response of the Regional Commissions [online], United Nations. Available from: < http://www.un.org/esa/ffd/economicgovernance/InformalSummaryBySecretariat.pdf>. United Nations, 2011. Views provided by Member States on global economic governance and development. [online], United Nations. Available from: <http://www.un.org/regionalcommissions/crisis/global.pdf>. White, W. R. 2009. Should Monetary Policy Lean or Clean?, Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Working Paper: No.3. World Bank, 2005. Reports on the Observance of Standards & Codes, World Bank Group. Website: < http://www.worldbank.org/ifa/rosc_cg.html>. Accessed: March 25th 2012.

Table 3 - Summary of codes and principles in operation. Source: (OECD, 2004)