Naïveté of directors and regulators revealed by GFC

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.