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Naïveté of directors and regulators revealed by GFC

By Shann Turnbull - posted Friday, 17 September 2010


The Global Financial Crisis (GFC) revealed the naïveté and irresponsibility of governments, regulators and company directors being involved in firms “too big to fail”.

The GFC also revealed the irrelevance of corporate governance codes and risk management practices. As noted by the Association of Chartered Certified Accounts (in Risk and reward: tempering the pursuit of profit (PDF 993KB), June 2010): “During the banking crisis, organisations failed which were previously thought to have had leading-edge risk management functions.”

Another bleeding obvious insight, not generally reported, is that firms in their present form that are “too big to fail” are also too big to be reliably managed or regulated. This insight means that the most experienced, gifted and dedicated directors, regulators, promoters of governance codes, risk management professionals and their expertise are impotent to avoid further failures.

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It is only human nature for this observation to be vigorously denied by those involved. Denial will ensure future failures.

The really bad news is that governments of the US, UK and other leading nations now have little capacity to finance further bailouts of firms too big to fail. The only good news is that a breakdown of the current system could accelerate a breakthrough to a more resilient system with the spread of cloud banking. How this can occur is described in my forthcoming article “How might cell phone money change the financial system” (forthcoming in November, issue number 30, The Journal of Financial Transformations. Based on a working paper available here).

The denial by leading company directors, regulators, governance experts and other thought leaders of the bleeding obvious can be compared with the story of the Emperor who did not wear clothes. No one except a small child who did know better was prepared to state the bleeding obvious. It is the uninformed today that can see through the hubris of the great and the good and understand how the intellectually naked company directors, regulators, policy advisers and governance professionals are profoundly misleading themselves.

One exception was the head of the Australian Treasury, the most senior financial advisor to the Australian Government - Ken Henry. During a speech at the National Press Club in November 2008 he stated:

The array of financial instruments deployed within the global financial system has become so complex that it defies understanding. For decades to come, policy makers around the world are going to be asking why those with sufficient authority didn't, at some point, stand above the buzz of the financial markets and declare, in simple language, that all of this simply doesn't make sense. (Ramsey 2008).

However, this statement is self-incriminating as it means that regulators under his watch were irresponsible in allowing financial instruments to be used that were not understood.

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Young children understand very well how information about very simple things can get grossly distorted, misleading and wrong. They learn this from the party game of trying to transmit a simple message through a chain of people. Invariably the message gets mangled even with the very best intentions. It seems that when children grow up to become company directors, risk managers, regulators and governance advisers the lesson is not applied.

However, responsible journalists and courts of law recognise the problem of biased, incomplete or wrong information. They routinely seek the other side of a story and/or collaborating independent evidence. But such practices are not built into the Anglo system of corporate governance. As a result, senior management, company directors and regulators who they report to have no systemic basis for obtaining feedback information independently of management. This is not only naïve and irresponsible but dangerous for firms, investors and the capitalist system.

An additional way in which stock exchanges, regulators and governments are naïve and irresponsible is allowing firms to be publicly traded with their directors having absolute power to manage their own conflicts of interests. Power is widely accepted as being a source of hubris and corruption with absolute power being able to corrupt absolutely.

Company directors of firms governed with a single board obtain absolute power to determine: (i) how they remunerate themselves; (ii) their own nomination for board reappointment; (iii) the remuneration of the auditors that judge their accounts; and (iv) how they manage other conflicts of interest. In other words directors have absolute power to corrupt themselves and/or the business! A result revealed by the GFC.

A core function of banks is to manage the risks of insolvency and illiquidity. The introduction of new types of financial assets provided no basis for financiers to neglect their core risk analysis functions. According to Fligstein and Goldstein (PDF 570KB), details of each traded US prime or sub-prime mortgage and their sliced and diced components were registered with the SEC. This made the information readily available for anyone to evaluate the risk with two or three clicks of a mouse to access the SEC database. Fligstein and Goldstein went on to say: “Even more disturbing, the actions of the regulators betrayed a deep ignorance of what was actually going on.” A point supported by the statement cited above by the head of the Australian Treasury.

Transparency is a necessary but insufficient condition for self-regulation. Transparency becomes useless and dangerous by providing false comfort when people lack the incentive, ability and power to make use of available information.

There were only 25 giant US financial firms involved in writing 90 per cent of both the prime and sub-prime mortgages in 2007. There were a number of people who understand firm specific or systemic risks as detailed by my co-author Michael Pirson and I in our joint paper (“Can Network Governance Reduce Risks for Financial Firms Too Big to Fail?”, working paper available here) that this article is based on. There were at least 12 individuals who predicted in writing when, how and why the financial system would fail.

The problem with the Anglo system of corporate governance is that is that there is no systemic way that those who are aware of risks are to be connected to those with the incentive, will and power to take action to mitigate them. The bleeding obvious solution is to systemically connect those with knowledge of risks and opportunities with those who have the incentive and power to take corrective action. Network governance provides a way to make the necessary connections. The connections not only mitigate risks but also provide competitive advantages as identified by Professor Michael Porter (1992, Capital choices: Changing the way America invests in Industry, Council on Competitiveness and Harvard Business School).

However, the solution is not that as proposed by Porter who recommended that employees, customers, suppliers and community representatives be appointed to a unitary board. This approach does not address the excessive and many “inappropriate” powers of directors as identified by Bob Monks and Allen Sykes (2002, Capital without owners will fail: A policymaker’s guide to reform (PDF 200KB), New York: Centre for the Study of Financial Innovation). Neither do the “reforms” proposed by Monks and Sykes that involved greater shareholder engagement solve the problems of directors possessing excessive power or their inability to identify business risks and opportunities independently of management.

Any solution requires a division of powers through the establishment of multiple boards. No board would possess absolute power as originally existed in the US based VISA International before it became publicly traded. A similar situation exists for the multiple boards found in the most successful large stakeholder controlled firms like the John Lewis Partnership in the UK. These examples illustrate how multiple boards can be introduced to create checks and balances on the powers of directors in either the US or the UK under existing laws.

A division of powers creates Network Governance (Turnbull, S. 2002, A New Way to Govern: Organisations and society after Enron, Pocket Book No. 6, London: New Economics Foundation, available here) that allows the decomposition of decision-making labour to a degree that ordinary humans can cope with in firms considered to be too big to fail. Network governance also facilitates stakeholder engagement in a manner that manages their conflicts of interests in a constructive way that introduces distributed intelligence to mitigate risks and identify opportunities. The opposing interests and views of stakeholders become available to cross check the information reported by management. In this way network governance empowers and so legitimis es the role of non-management directors. It also integrates governance into management.

Most importantly, network governance facilitates the ability of stakeholders to protect their own interests in a much more responsive, economical, appropriate and efficient manner. Network governance introduces self-regulation and self-governance to reduce the need for many laws, regulations, regulators, and governance codes. Stakeholders become co-regulators to take over many functions of regulators. In this way network governance provides a basis to reduce the size, cost and role of government while increasing stakeholder protection and economic efficiency.

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About the Author

Dr Shann Turnbull BSc (Melb); MBA (Harvard) is the Principal of the International Institute for Self-governance based in Sydney and a co-founding member of the Sustainable Money Working Group established in the UK. He is a founding life Fellow of the Australian Institute of Company Directors, Senior Fellow of the Financial Services Institute of Australasia, Fellow of the Governance Institute of Australia and Fellow of the Australian Institute of Management. He co-authored in 1975 the first course in the world to provide company directors an educational qualification and wrote Democratising the Wealth of Nations. His bibliography reveals he is a prolific author on reforming the theories and practices of capitalism.

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