Corporate Governance in Financial Services - Essay Example

Corporate Governance in Financial Services Introduction Corporate governance is undoubtedly fundamental in the organizational setting. Practices of corporate governance influence and inform the interactions and relations between various stakeholders within and across an organization or industry. This was well observed during the global financial crisis that led to failure of banks in the UK. Banks’ failings subject to the financial crisis triggered the need to assess and evaluate corporate governance in the banking sector, the key concern being the efficiency and effectiveness of corporate governance practices. This paper presents agency and other related issues which explain banks’ governance failings in the UK. It further looks into stakeholders’ responsibility as far as the identified failings are concerned. In conclusion, the paper highlights several recommendations that could essentially enhance corporate governance in the UK’s banking sector. Bank Governance Failings in the UK The effectiveness and efficiency of corporate governance influences almost all operations undertaken by a business enterprise. Just like any other business enterprise, banks in the UK are profit-driven. This means that the set organizational goals and objectives are designed on a profit-motive platform. All the stakeholders involved relate and interact in a way that fosters business continuity. Whilst this process may be marred with operational and functional challenges, supervision and control relative to stewardship, fiduciary duties, and accountability define the corporate governance pursuit (Gordon & Roe, 2004, p.168). Board of Directors The board of directors stands at the top of organizational hierarchy. The role and responsibility played by the board acts in the best interest of all stakeholders. This means that the board is the highest body that represents the interests of all the stakeholders in an organization. In the banking sector, board of directors plays more or less the same role and responsibility. Specifically, the board supervises, monitors, and controls corporate officers, and also handles major decisions that relate to organizational operations (Ryan & Wiggins, 2004, p.511). In the light of corporate governance, board effectiveness is critical both in the short run and long run. The subject of board effectiveness in corporate governance is provided for by the Combined Code on Corporate governance (Edmonds, 2011). Bank failure and subsequent financial crisis in the UK can be explained through boards’ failure to be effective and efficient. Monitoring of executives in the banking sector was poor in the period preceding banking crisis in the UK. Many boards in the sector failed to discharge their duties and responsibilities accordingly. The implication was that banks were caught unaware of the underlying risks of poor board management. The board of directors sets strategic aims, provides entrepreneurial leadership, ensure understanding and realization of organizational obligations to stakeholders, and reviews/manages organizational performance (Adams, 2003, p.723). These aspects of the board’s role were poorly discharged and managed, resulting in failed corporate governance practices. UK banks were adversely affected by this failure due to the fact that they failed to realize the underlying risks of poorly managed and governed corporates. The relationship and interaction between Chief Executive Officers, non-executive directors, and board of directors further influenced governance failings in UK banks. Corporate structuring had failed to streamline and clearly distinguish the governance role of each of the said parties. Moreover, the integral role of chairmanship in banking further complicated governance practices. In the UK banking context, there existed conflict of interest between board chairman and the CEO. In his review, David Walker (2009) reported that majority of firms were yet to separate chairman and CEO positions. Notably, this had rendered many boards in the banking sector ineffective. The non-executive directors can also be put on the spot as far as governance failings are concerned. Most often than not, non-executive directors exhibit passivity within and across the organizational setting. Their inactivity in organizational operations downplayed the importance of monitoring organizational performance. In this respect, potential risks remained unseen, and so did the underlying implications on banks’ performance. The broken connection between the identified parties bound to the board of directors created operational ineffectiveness and inefficiencies. As a result, a vital component of corporate governance in the banking system collapsed. Management of Risks Business enterprise encounter risks on a daily basis. Whilst risks are more or less inevitable in the business setting, determining and managing these risks influence business continuity over time. Corporate governance essentially accounts for risk determination and handling, aspects that are provided for by a number of codes and laws, namely: UK Combined Code, 1999 Trunbull Report, and 2007 Basel II agreements (Boone, et al. 2007, p.97). The idea is to get firms to strategize on risk measurement and pursue policies that foster business value. The practice of short-termism by UK banks translated to corporate governance failure and subsequent financial crisis. It is important to note that financial institutions were at the heart of the financial crisis that hit UK hard alongside the rest of the world. This resulted in a banking crisis that saw the collapse of big bank names in the UK. Governance failings that befell UK banks can be explained by their excessive practice of short-termism that adversely affected risk management. Securitization schemes and contracts that involved derivatives paved way for banks to make high short-term profits, but the banks overlooked the underlying long term risks. Moreover, short-termism led banks to engage in financial transactions that were highly unpredictable and complex, which notably involved illiquid financial instruments (Hudson, 2009). Counterparty risks that emanated from credit default swaps (CDS) protection issued by American International Group (AIG) to UK banks eventually led to their collapse (Joel, 2010). The persistent increase of CDS contracts in the UK financial system had seen many financial institutions become heavily reliant on AIG’s CDS protection. Amid the underlying counterparty risks realized from the process, corporate governance in the banking sector failed to warn banks on the implications of excessive counterpartying. When AIG collapsed, systemic failures were transferred to the banking sector and the entire financial system. The CDS contracts that banks once relied on caused their failure. Once again, bank governance was put on the spot for failing to act accordingly at the time when banks were becoming heavily reliant on AIG’s CDS protection. Shareholder Engagement Shares represent the level of ownership that an individual has in the firm. The spread of shares vary from one organization to another, but the common denominator is that shares carry rights that shareholders can practice in the firm setting. Essentially, shareholders can monitor and control organizational operations subject to the rights provided by the shares owned (Arthur, 2005, p.3). However, this is not always the case as shareholders are often not engaged by the executive in decision making. The executive-forced shareholder passivity constituted a free rider problem in corporate governance, consequently leading to bank failure in the UK. The disconnection between executives and shareholders in the corporate world poses governance challenges and implications, some of which are associated with the bank governance failings in the UK. Rewards and Remuneration UK banking crisis can also be explained in terms of rewards offered to directors and remunerations directed to top management. Compensation of high ranking officers was option and performance based (Jingchen, 2011, p.9). Moreover, directors were given bonus incentives in order to deliver. All these factors combined complicated rewards and remuneration schemes in the banking sector. In order to fetch huge bonuses, directors excessively became risk takers. This was done at the expense of firm and shareholder interests. The result was a failed corporate governance system, which subsequently plunged the UK banking sector into a financial crisis. Where does the Solution to the Governance Failings Lie? The discussed governance failings in the UK banking system put both the banks and their institutional shareholders on the spot. The board of directors failed to execute their roles, duties, and responsibilities effectively and efficiently (Kenneth, 2010, p.241). For this reason, the supervision and control of the banks failed to account for the business environment that prevailed before and during the banking crisis. The executive was marred with operational and functional challenges that further complicated the bid to avoid or salvage banks out of the crisis. On the other hand, shareholders overlooked their importance in governance. For many years prior to the UK financial crisis, shareholders exhibited passivity and allowed the free rider problem to thrive among the executives. After the financial crisis had already hit the UK, and more especially the financial sector, the need to engage shareholders in governance even more emerged. Notably, many institutions persistently pursued strategies and policies that would foster shareholder engagement. Looking into the role, duties, and responsibilities played by the board of directors and the shareholders, the solution to UK banks’ governance failings leans more towards the board of directors than it does towards the shareholders. This directly implies that the board of directors or the banks themselves were ultimately to blame for the realized failings. The banks were at a better position to foresee the underlying risks in the banking sector. Being the focal point of organizational operations, the board of directors was supposed to monitor and control every aspect of organizational operations (Tomasic, 2011). However, risk assessment and evaluation practices seem to have been taken lightly given the happenings that were prevalent at the time. The executives in the financial sector seem not to have matched competitive qualifications that could have warranted effective decision making relative to risk management. On the same note, the codes and laws of risk determination were to some extent not fully operationalized. For these reasons, risks of failure intensified. Worth to note is that the banks were essentially at the forefront of enforcing risk determination and management strategies and policies, but the pursuit either failed or was highly ineffective and inefficient. The burden of responsibility points to the executives. Directors constitute the primary beneficiaries of high-risk transactions through rewards and remuneration incentives. However, in the event of failure, even the shareholders are not spared. Whilst blame on shareholders still holds, though at a lesser extent, the ultimate blame goes to the banks’ boards of directors. Therefore, solutions to the governance failings in the UK banking sector lie with the board of directors or the banks themselves. In resolving these governance failings, institutional shareholders could be used to enhance the process by treating them as complementary factors in the pursuit of effective and efficient corporate governance (Bruner, 2011). Conclusion and Recommendations Policies for Rewarding, Remuneration, and Incentives Remuneration and rewarding of directors remains a contentious issue in today’s corporate governance practices (Tricker, 2009). This is a critical area that is in dire need for reform, improvement, alignment, and streamlining. Huge proceeds from high-risk financial transactions have made directors shift attention to their personal benefits while putting shareholder interests at stake. Policies should be formulated and implemented to balance governance issues relative to rewarding, remuneration, and giving of incentives to senior officers in the organizational hierarchy. Corporate Social Responsibility Financial institutions should persistently embrace socially responsible business practices. Continued engagement in corporate social responsibility will likely minimize future social and economic adverse effects on businesses while fostering corporate reputation (Argandona, 2009). Concern for stakeholders and the society at large will proof that financial institutions do not only prioritize their own interests, but also those of the larger society. Board Monitoring Executive and non-executive boards should be strictly monitored. This will allow timely determination of inefficiencies and ineffectiveness in discharging their roles, duties, and representation of shareholder/stakeholder interests. Shareholder Rights Shareholders have the right to actively take part in corporate governance. This right has seemingly been downplayed when it comes to corporate monitoring and control. There is need to engage shareholders even more in corporate decision making subject to the right(s) bestowed to them by the share they own. Regulation and Risk Management Regulation of governance practices, and especially risk management, should be intensified. The applicable codes and laws that have been designed purposely for corporate governance should be enforced to the letter. Violators should consequently be subjected to the legal framework. Reference List Adams, E. D. (2003). “Corporate Governance after Enron and Global Crossing: Comparative Lessons for Cross-National Improvement”, Indiana Law Journal, Vol.78:723. Argandona, A. (2009). Can Corporate Social Responsibility help us understand the Credit Crisis? 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