A new era for corporate governance in banking and financial services

Citation

Kirkbride, J., Letza, S. and Smallman, C. (2010), "A new era for corporate governance in banking and financial services", International Journal of Law and Management, Vol. 52 No. 1. https://doi.org/10.1108/ijlma.2010.01052aaa.002

A new era for corporate governance in banking and financial services

Article Type: Viewpoint From: International Journal of Law and Management, Volume 52, Issue 1.

Over the past 30 years the developed part of the world has witnessed a shift away from government regulation and control towards a laissez-faire or free-market economy. Evidence of this shift is provided by the numerous privatisation programmes of government control industries across the EU. For example, in the United Kingdom industries which have been privatised include air travel, munitions manufacturing, nuclear weapons manufacturing, railways, water, gas and electricity generation and distribution. In Eastern Europe we have seen the collapse of Russian communism resulting in the former USSR and its satellite economies moving to free-market economies. The purpose of this essay is to take stock this shift by asking whether the pendulum has swung too far towards laissez-faire resulting in the current banking crisis. Global society is feeling vulnerable to both a potential melt down in global financial structures and long term economic instability.

Financial services and the banking industry have been subject to criticism in recent months by many commentators. The issue of regulatory oversight and internal corporate governance are at the centre of the current debate. It would seem that regulation is on the increasing for the individuals at the bottom of the banking chain while simultaneously being relaxed at the industry level. On the one hand, individuals have witnessed an increasing amount of bureaucracy in dealing with banks and other financial services companies. The simple task of opening a bank account requires a plethora of documents and various forms of identification and a significant amount of time needs to be set aside by the individual to complete the process. Similarly, when attempting to move funds from one location to another there are numerous hurdles to overcome. In essence both of these activities should be transacted with ease, so why are individuals facing these hurdles? The reason presented by banks and governments alike, i.e. the threat of terrorism and money laundering, is in tune with the general tightening up of control by the police and other security services. However, perhaps there is an alternative explanation and perhaps a more sinister reason lies behind this convenient façade? It is no coincidence that these barriers also act in favour of the banks and other financial institutions by enabling these bodies to retain precious liquidity for a longer period. On the other hand, and alongside this misdirection of oversight, the banking industry and financial services have managed to secure a massive reduction in regulation with regulators apparently mesmerised by the axiom “the market always knows best”. For many commentators the regulators now appear to act as facilitators and not enforcers and are being accused of constructing complicit governance structures. An apparent cosy relationship exists between bankers and regulators where bankers move seamlessly to regulators is one example note for example the case of the former CEO of the failed HBOS bank who was appointed deputy director of the FSA. The close proximity between regulator and regulated is of major concern. The old adage “if you want to drain the pond don't ask the frogs” is of relevance here.

Derivatives have been criticised over the past few months and for many are the root cause of the current banking crisis. While it is difficult to estimate the total global value of derivatives, the bank of international settlements writing in July 2008 present an estimated total global value of derivatives of $1.14 quadrillion. Made up of $548 trillion in credit derivatives plus a further $596 trillion of notional/OTC derivatives. These mind boggling amounts are beyond the comprehension of most people and to put things in perspective a sensible comparison can be drawn against the GDP of the US economy for 2009, estimated at $13 trillion, or approximately one-ninetieth of the estimated global value of derivatives. The critical question is how much of these derivatives are “toxic”? A 25 per cent estimate would amount to $280 trillion or well over 20 times the US economy, clearly a potentially lethal amount of write off. In 2002, Warren Buffett warned “We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralised receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.

Having painted a picture of gloom, if not Armageddon, it is now appropriated to ask whether there is anything that can be done to take the global economy forward into recovery and to ensure stability in the banking and financial services industry. As with all crises, it is true to say that at some point lessons will be learned and a corner will be turned. However, it is only when deep-seated learning takes place and a full cultural readjustment is embraced that the isomorphic tendency to further crisis will be broken. However, will the banking and financial services industry be able to make this meteoric cultural shift? It is acknowledged that the industry is deeply entrenched in a culture of large cash bonuses and consequently will executives and senior managers be prepared to accept the requisite level of cultural readjustment? This hinge point has not as yet emerged nor is it yet in sight; however, early signalling suggests movements in the direction of learning, albeit not full cultural readjustment learning, by several interested players in the UK by, notably, the British government and the Financial Services Authority (the UK's regulator). Mixed messages from the British government are not helping to stabilise the crisis, for example when questioned at the recent Treasury Select Committee inquiry the Prime Minister commented that HBOS had not been taking risks but rather their business model was faulty which was the cause of HBOS' demise. Clearly, HBOS' business model was faulty; however, the underpinning reason held by many commentators is that HBOS was pursuing very high risks, as identified for example by the head of Group Risk at HBOS, seemingly a matter on which the Prime Minister would prefer not to dwell. Within a week of these comments the Prime Minister commented that the UK banking industry should adopt a more prudent approach to banking and that regulation needs to be introduced to compel the bank industry to be prudent, a statement met by the banking industry with deep suspicious and with one banking executive describing this idea as “humbug”.

Parallels can be drawn with the depression of the 1930s. During this decade several significant studies were undertaken and published which are acknowledged as seminal in nature and fundamental to the development of the modern understanding of the nature of the firm and corporate governance. Berle and Mean, writing in 1932 on the Modern Corporation and private property, laid the foundations for the modern understanding of corporate governance. Coase's 1937 paper on transaction cost economics is of similar seminal standing. Together with other studies, these two great works brought about a quantum leap in thinking about the nature of corporate bodies and the manner in which they should be governed and organised. Perhaps the current banking and financial services crisis may instigate a similar quantum leap in thinking and understanding of corporate entities, their governance and purpose. Perhaps Milton Friedman's notion of the fundamental purpose of a corporate as “the Business of Business is Business” may be reconsidered and in its place an understanding of long-term stability for all stakeholders, including society as well as shareholders will become the norm. Is it too much to ask that society instils in its corporate boards a deep sense of responsibility towards society and the long-term sustainability? Surely this is not too much to ask especially in an era where society is being asked to pick up the tab for failed corporate bodies perceived as vital to society.

James Kirkbride and Steve LetzaLiverpool John Moores University, Liverpool, UK

Clive SmallmanLincoln University, Lincoln, New Zealand