BUSINESS STANDARD
Colin Mayer
In October 2008, the worlds financial system stopped. From what had only a year before seemed like an unassailable position of strength, the once proud heart of capitalism found itself bought and owned by government.
In many countries there was an outcry about immoral bankers, the greed and self-interest of traders and the ineffectiveness of regulators. There were demands for more regulation, more government, and more restraint upon the worlds financial institutions. This week in the UK the country is again decrying the bonuses proposed by some banks, including those bailed out by the government as part of a rescue package.
In the intervening months since the scale of the financial crisis became clear, there has been much reflection upon what has gone wrong and considerable comment on what should be done about it? There are clearly many lessons that can be learnt from the current crisis and many policy responses that are being suggested. There is one that I would like to emphasize and that is caution.
In many countries around the world, we are witnessing a rash of political initiatives. If there is a crisis, leaders must act and above all be seen to act. Indeed had they not acted recently the financial system would have collapsed in a state of chronic paralysis. It was only the decisive action of governments acting in concert that saved the day.
Governments deserve credit for taking decisive action when faced with a deepening and international financial crisis. But it is also true that most governments failed to take appropriate action when it was needed much earlier — not just when the financial crisis began to unfold, but long before this when the circumstances which led to this downturn were becoming entrenched.
So what now? Is further government action and intervention in the markets required and, if so, in what form? Rushing a neglected patient to the accident and emergency room is a correct response to previous misdiagnosis and complacency. But that does not mean that the subsequent cure requires similar dramatic responses. Instead, caution is much more appropriate at the current time.
The history of past financial crises is littered with cases of governments acting in haste and repenting at leisure. The response to the stock market crash of 1929 and the Great Depression is a case in point. In the US, the Glass-Steagall Act separating commercial and investment banking took the best part of 60 years to unravel and in the process created serious inefficiencies in the US banking system which, amongst other things, encouraged an unduereliance on bond rather than bank finance.
The pressures on governments to be seen to do something in the face of financial crisis, destruction of wealth and economic recession are overwhelming. To do nothing appears negligent at best and criminal to many. It is therefore inconceivable that we will not observe a rash of hastily constructed policy initiatives.
Most of these initiatives will focus on tightening regulation. In the old days we used to lay the blame for moral corruption at the feet of religious leaders and institutions.
Today the custodian of economic morality is the regulator, and if there is a breakdown, it is to the regulator that we point the finger of blame.Regulators claim that they merely responded to the political and economic pressures of the time. After all who would have thanked a British Financial Services Authority that undermined the competitiveness of London as a financial centre by imposing tougher regulatory standards than their counterparts in other financial centres? Just look at the reports emanating out of numerous studies pointing out the dangers of excessively stringent regulation.
It is, however, the case that regulation was blatantly inadequate and therefore needs to become much tougher — and tougher it will indeed become. That is far easier to predict than the crash that prompted it. While it is inevitable that regulation will tighten, it will not necessarily be appropriate across the board.
The first stage to sustained financial and economic recovery is a far better understanding of the root cause of the problems. One aspect of the current malaise is clear. No one really understands it. We all have our own opinions and some have voiced them louder than others. The first stage is to understand not just what happened but also where the underlying problem lies.
The next stage is even tougher. There are many policy prescriptions on the table, of which tightening the regulatory screw is the most commonplace. In fact it is quite likely that the most appropriate responses are not even being contemplated at present. Certainly there has been nothing in the debate to date to suggest that a coherent or well designed strategy is waiting in the wings. If anyone is looking for a response that is both quick and appropriate they are mistaken. The most useful action that we can urge on our policy leaders is caution — do
not repeat the mistakes of history and instead resist the temptation to score political points by being decisive in the presence of ignorance.
The issue is not just one of financial regulation. Corporate governance is now too subject to closer scrutiny than at any time since the days of the collapse of Enron. Instances such as the Madoff case in the US and Satyam in India have increased calls for tighter regulation in this sphere too. Countries with very different types of corporate governance systems, laws for protecting minority investors and different patterns of ownership of their companies, are facing similar crises of confidence. The pressure upon their governments to act is considerable and comes for many quarters, not least the press, the public, and company shareholders.
In recent months we have seen a great deal of discussion in India about corporate governance— the role of boards, of independent directors, of the auditors, of investors and analysts. The discussion will continue for some time, but here too, we should be cautious before we rush to conclusions about what needs to be done.
We have already seen an extensive tightening of corporate governance standards in the US in the face of the Enron and Worldcom scandals. The Sarbanes-Oxley Act was designed to plug the loopholes in accounting and governance standards that previously existed. It is clear, however, that the legislation has not prevented major failures from occurring in financial institutions across the US.
The board of directors is frequently regarded as being central to good governance and the role of the board has featured prominently in discussions about Satyam. The board is the body charged with having oversight of the operations of the firm and setting its strategy. The board should ensure that the company is upholding high standards of integrity and conduct, and provide a probing analysis of the activities of
management.
In particular, non-executive directors are supposed to give an independent assessment of the quality of management. But repeated failures of corporate governance suggest that they do not. There are several reasons. First, it is difficult to appoint truly independent directors. Such independence is particularly hard to achieve, in countries, such as India, where family ownership is widespread and there is a close knit group of corporate leaders. Even in countries where family ownership is less prevalent, such as the UK, there are serious doubts about the independence of directors.
Non-executive directors are also supposed to perform an equally important function in guiding and advising management and clearly there is a tension between this and acting as external assessors of the quality of management. Many countries have sought to separate the roles of chairman and chief executive to militate against the weaknesses inherent in the system, but this too has not prevented some of the most prominent failures of financial institutions over the last few months.
Can the role of the board be strengthened? The answer is yes. Tighter rules regarding the appointment and rotation of independent directors can be introduced. There can be rules relating to the credentials, experience and training of members of the board. The requirements on members of the board to provide oversight can be clarified. Reporting by the independent members to external investors can be strengthened, and attention can be given to the remuneration and incentives of non-executive as well as executive directors.
All of this is important. But will it solve the problem? The answer is almost certainly not. Many countries have experimented with these rules to limited effect. Boards are a focus of much discussion about corporate governance but they are not a solution. Effective corporate governance requires the direct involvement of investors and attention is being increasingly focused on investor activism as an alternative to a reliance on boards.