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Corporate governance changes must cut deep

Over recent months, much has been made of the review done by Lord Turner with regard to the banking industry. However, just on the horizon is the publication of the review of the state of corporate governance within the financial services industry by Sir David Walker.

A review of corporate governance after an economy-changing event is not uncommon. Those with reasonably good memories will recall the scandal that followed WorldCom and Enron collapsing. From these ashes was born the Sarbanes Oxley legislation in the US which was largely followed in the UK by the single-biggest piece of legislation in the history of Parliament, the Companies Act 2006.

Therefore, from the smouldering remains of our once-admired financial services sector, there will need to be change. Such change needs to address the many issues that gave rise to the collapse of Lehman Bros, the nationalisation of Northern Rock and virtual Government takeover of RBS, together with the merged Lloyds and HBOS. It will need to be wide-sweeping and cut deep into the corporate irregularities of the industry.

Walker’s review will look at a number of areas, including risk management at board level, the inefficiencies within board practice and the effectiveness of the various committees, including remuneration and risk. It will also ask if the UK approach is consistent with intern-ational practice.

Finally, following on from Lord Myners’ statement on April 22, 2009, the review will look at whether its recommendations will be applicable to institutions other than the banking sector.

Will this all be enough?

The answer will depend on the review’s final outcome, which recommendations are taken forward and how they are enforced. Of course, we cannot see into the future but maybe the recommendations should include the following.

It is a combination of the lack of awareness and/or appreciation of the fundamentals of risk and risk management that have placed a number of institutions into the current situation. However, it is almost unacceptable for this failing on behalf of key individuals to then be rewarded with pay increases, bonuses and pension payouts.

One of the key areas will be to find a balance in making sure that board-level executives are both aware of the fundamentals of risk and of the importance of following a set performance criteria, whether set by the FSA or by the company. Only then can there be a potential reclaim on bonuses.

Conversely, where a board meets or exceeds risk appreciation indicators this should then form part of the bonus structure.

The failing point here will be who decides the criteria. The FSA will say the company is too subjective and the company will say the FSA does not understand its business therefore an objective test cannot apply.

For me, a middle-of-the-road approach is required whereby both tests should be applied. The FSA should offer a recommended requirement for appreciation in the confirmation of completion of training, and correct capital adequacy being held by the company will show an objective understanding of risk.

In return, the company resolves to a subjective view to where it can pay the bonus so long as other key perfor-mance criteria are met.

The make-up of the board of directors and the numbers of both executive and non-executive members has long been discussed by corporate governance practitioners. This may be the time to recommend companies have a set ratio of non-executives to executives.

The difficulty would be in confirming their indep-endence from the board.

A more important role will be the design and creation of the various committees within companies as well as the documentation of their meetings, investigation and findings/recommendations.

It is clear from this ordeal that either the advice from these oversight committees was not being followed or their recommend- ations were not reaching the board.

International standards are a hard measure to compare against due to jurisdictional inconsistencies, but the maintenance of certain institutions (for example, those listed) should perhaps look at complying with a cross-border standard of requirements.

This could be an EU standard which may expand to include the US and other continents. The key for coverage could be that the international guidance rules must cover a core set of values and the companies should be able to demonstrate that their policies and procedures are standardised in every aspect, enabling it to comply with all the jurisdictions within which it operates.

No matter what the recommendations say, there are two by-products of the outcome.

First is enforcement, in that the FSA will now be charged into reviewing through the external and internal audits if the institution complies with the requirements being proposed here.

This begs the question as to what to do if companies do not come up to scratch. What sanctions would be set upon the company and would these sanctions include personal liability to the board members themselves?

The second issue is one of costs, not only to the FSA but also to the company. Someone (both management and external) will have to take time to review a company’s current procedures and policies and make them compliant. This cost, along with that of complying with the recommendations flowing from the Turner review, could put further strain on an already weakened market.

But even if the recommendations are unclear, the spirit behind such a review is not. Companies need to rebuild confidence both internally and externally. They should lead by example and start their own independent internal wholesale review of their corporate governance, risk analysis, compliance procedures and policies in anticipation of the forthcoming review.

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