Corporate Governance in the UK - Coursework Example

Corporate Governance in the UK Table of Contents Table of Contents 2 Introduction 3 Part 3 Part 2 6 Part 3 8 Reference 11 Introduction Corporate governance practices of the UK banks were governed by various international and domestic institutions, such as Financial Services Authority, Financial Reporting Council and Basel Committee on Banking Supervision, prior to the crisis. Although many of the corporate governance codes were developed on the basis of the Cadbury report and the Greenbury report during 1990’s and early 2000’s, these codes were not sufficient to prevent banking crisis in the UK. Therefore, it can be inferred that failure of corporate governance policies of banking sector in the UK was partially responsible for the financial crisis in the country. Economists have pointed out that banking sector failure in the UK was triggered by a chain of actions; for example, corporate governance malpractices like above average remuneration package for directors, lack of shareholders’ engagement, increase in transient ownership, absence of risk measurement mechanisms and misrepresentation of financial performance of the firm have contributed significantly to sub-prime mortgage crisis in the USA which was followed by a global financial crisis in 2008. The global financial crisis caused systematic risks for the UK banks which were linked with the USA and other global financial market. Northern Rock bank was the first victim of banking crisis in the UK, overreliance on wholesale funding and lack of regulatory control were the reasons behind the failure of Northern Rock bank. Part 1 Corporate Governance Failures in the UK Banks Industry analysts have pointed out that, the UK banking sector crisis was triggered by four types of corporate governance failures, such as inefficient risk management, above average remuneration for top level executives, lack of shareholder engagement and lack of board qualification. Next section will discuss the contribution of these four issues to the financial crisis in the UK. Risk Management Managing risk is an essential part of corporate governance policy of banks in the UK. Investors and shareholders decide on the investment strategy on the basis of the level of risk associated with a particular investment decision. Research scholars have proposed recommendations, in the form of Cadbury report, Greenbury report and Turnbul report, in order to address the risk management issues related to corporate governance policy of companies in the UK. Combined code and Basel II agreements were the guiding criteria for banks to formulate risk management strategies but these guidelines were not sufficient for them to avoid financial crisis which resulted from sovereign debt crisis. Although the UK banks created audit committees and risk management teams on the basis of recommendations made by combined code, operations of these committees were found ineffective as the board members of these UK banks were focusing more on swap market and securitization rather than decreasing risks (Association of Chartered Certified Accountants, 2009). Banks were relying on credit rating agencies excessively in order to assess risks associated with their business operation. Bank of England (2008) has stated that relying on share market based corporate governance model was the key contributor to increase financial threat for banks in the UK. Research scholars such as Hayes and Abernathy (1980), Shiller (1989) and Charkham (1994) have strongly criticized the tendency of companies to use stock market performance as the key indicator for measuring success of implemented corporate governance model. Relying on stock market based corporate governance model has created problems like inability to track market uncertainty, intentional misprice of assets etc., for the UK banks. Many of the banks in the UK got involved in complex financial transactions, securitization schemes and derivative financial contracts in order to earn fast money and short term profit for shareholders, on the other hand involving collateralized debt obligations (CDOs) increased the risk for UK banks Remuneration and Executive Incentives Research scholars have pointed out that excessive and impractical remuneration packages for board of directors of banks in the UK was one of the key contributor for corporate governance failure. According to these research scholars, excessive remuneration packages for directors were one of the key contributors for banking crisis in the UK. For example, bonus driven remuneration packages destabilized the payment structure in many banks and gave an opportunity to managers to ignore the interests of shareholders. Many of the banks in the UK did not introduce any significant penalty for managers when their firm was performing poorly in the market, hence managers of banks took excessive risks in order to fulfill personal interest fearlessly due to absence of any penalty code. Generally, two types of compensation schemes, namely performance based compensation and option based compensation were used by banks in the UK, in order to align interest of managers with the interest of shareholders. Relying heavily on option based compensation decreased the scope for banks to control the activity and performance of agents or managers. Subsequently malicious activities of managers increased the risk factors for banks and financial institutes. According to Coelho et al (2003) and Keasey et al (1997), malicious activities of managers can be viewed as an agency problem for organizations. Hence it can be said that agency problem was one of the key reasons behind the failure of banks in the UK. Shareholder Engagement Dispersed ownership model of banks in the UK, have created problems for them to maintain the same level of engagement with all the shareholders. Dispersed ownership model or separation of share ownership into multiple pieces, increased the threat for small shareholders due to the fact that holding small number of shares made them the minority among other shareholders. In most of the cases, banks in the UK did not feel the urgency to explain their financial performance, corporate strategy and other important issues to the minority shareholders, which subsequently increased the chances for lack of shareholder engagement and free rider problem. Due to genesis of free rider issue, managers completely ignored the interest of majority shareholders which increased financial crisis for the banks. Board Effectiveness Industry analysts have stated that lack of efficiency of board members was the key reason behind the failure of banks in the UK during 2007. Non-executive directors (NEDs) acted passively in order to monitor and control malicious activities of board members; board members influenced the decision of CEOs of the banks with the help of unrealistic stock market results and inflated financial projection. Lack of effectiveness of NEDs decreased the trust of shareholders on the business policy of banks; therefore, many investors withdrew their investments from these banks. Hence it is evident from the above discussion that corporate governance failure contributed significantly in financial crisis of banks in the UK. Part 2 According to my limited knowledge about the subject, I can assume that corporate governors need to take a holistic approach in order to address the above mentioned issues regarding corporate governance failure of banks in the UK. Relying on one particular issue, such as inefficiency of board of directors or lack of engagement with shareholders cannot solve the problem in a justifiable manner. Sir David Walker (2009) has given significant amount of importance to structure, composition and effectiveness of boards for banks in order to recommend codes to improve corporate governance practices in banks and other organizations in the UK, but the scholar has given slightly less importance on institutional shareholder engagement and communications. For the sake of addressing pertaining issues of this assignment, I have taken the help of assumptions of Sir David Walker and selected restructuring of board as a viable solution to address corporate governance failure. At first, corporate governors need to clarify the role of chief executive officer (CEO) and NEDs in the board in order to initiate the restructuring. Role of CEO Generally, CEO heads the board in a corporate world but prior to the crisis this situation was different in banks of the UK, it was found that CEOs of almost 60% of the banks were handling the job responsibility of a chairman. Dual responsibilities had given opportunities to the CEOs to act in order to fulfill personal interests and influence NEDs on critical management issues. Research scholars such as Allen (1992), Eisenhardt (1989) and Jensen and Mechling (1976) have stated that conflict of interests between principal and agent is bound to arise, where activity of agents cannot be controlled by monitoring, hence lack of control over CEOs activities in banks of the UK caused interests conflict between them and the shareholders. Another import facet of banking crisis in banking sector of the UK was the involvement of personal relationship between the CEOs and the board of directors, in many cases board members or NEDs of banks intentionally ignored malicious activities, such as short-termism, over relying credit rating agency of executives for the sake of personal relationship. Role of Non- Executive- Directors Lack of activities for NEDs contributed noticeably to financial crisis of banks in the UK; in many cases qualification of non-executive directors was not sufficient to analyze the critical aspects of corporate governance. According to the report published by Vickers Commission, many of the NEDs of banks did not have a proper understanding of the previous corporate governance codes, such as Combined Code, Greenbury recommendation, Turnbul recommendation etc (Edmonds, 2013). Industry analysts have pointed out those banks intentionally appointed those NEDs who did not have knowledge and time to measure irregularities in corporate governance practices in order to fulfill personal interest of board members. For example, Northern Rock bank appointed a NED who had doctorate in zoology and did not have any knowledge and experience about financial accounting or banking practices. Part 3 Research scholars such as Shleifer and Vishny (1997), La Porta et al. (1997) and Weimer and Pape (1999) have stated that corporate governors should take corporate governance as a holistic problem which comprises issues like board structure, shareholder issues, stakeholder issues, director’s remuneration and agency problem. Hence the study will suggest five recommendations which would cover all the pertinent issues of corporate governance in order to avoid situations like the UK banking crisis in future. Recommendation 1 According to the report published by Vickers Commission, banks should provide mandated services which can reduce the economic cost of operation, deposit and withdrawal facilities for customers and overdraft facilities for small and medium enterprises (SMEs). Banks should not involve in services which can increase cost of operation, decrease global financial market exposure, decrease scope for direct or channelized intermediation of funds between non-financial institutions. Banks should not involve in services such as purchase of derivatives or investment in sovereign bond in order to increase asset value in balance sheet. Recommendation 2 Research scholars such as La Porta et al (1999) and Manne (1965) have stated that board members are responsible for maintaining efficiency of market based corporate governance model. The study will take help of report published by Sir David Walker in order to make recommendations regarding board structure of companies. A supervisory board should be created by conjugating all the financial and non-financial institutions. The supervisory board will provide knowledge sessions related to business ethics and corporate governance to non-executive directors of all the member organizations; the process will decrease the knowledge gap and increase efficiency among NEDs. Recommendation 3 Chairman of financial and non-final institutions should devote substantial amount of time for reviewing business policy of the organization; chairman of bigger banks or other organizations need to devote at least 75% of time in order to understand the present and future aspect of existing financial activities. Organizations should select chairmen who have sufficient experience and industry expertise, in order to decrease inefficiency among board members. Recommendation 4 Companies need to provide information regarding change in share value or financial performance to institutional investors in a periodic manner. Traditional concepts like stewardship approach of managers should be abandoned by investors, who should review and question activities of board members on a periodic basis. Institutional shareholders should follow the code of responsibilities prepared by Institutional Shareholders’ Committee. Recommendation 5 FTSE 100 listed financial companies need to establish a board risk committee, which will work separately from audit committee. The risk committee should actively review the risk exposure or chance of finance crisis of companies and also advice the companies regarding risk management strategy. Risk committee should review risk management strategy of banks and insurance companies by taking into account all the financial, economic, macro and micro environmental factors. Risk committee should include CEO, CFO of companies in order to take decisions regarding risk management issue of corporate governance in a holistic manner. Reference Allen, W. T., 1992. Our Schizophrenic Conception of the Business Corporation. Cardozo Law Review, 14(2), pp. 261-281. Association of Chartered Certified Accountants., 2009. A Review of Corporate Governance in UK Banks and Other Financial Industry Entities. Comments from ACCA. [Online] Available at: [Accessed 12 February 2013]. Bank of England., 2008. Financial Stability Report. [Online] Available at: [Accessed 12 February 2013]. Charkham, J., 1994. Keeping Good Company: A Study of Corporate Governance in Five Countries. Oxford: Clarendon. Coelho, P. R. P., McClure, J. E. and Spry, J. A., 2003. The social responsibility of corporate management: A classical critique. Mid-American Journal of Business, 18, pp. 15-24. Edmonds, T., 2013. The Independent Commission on Banking: The Vickers Report. [pdf] Available at: [Accessed 12 February 2013]. Eisenhardt, K. M., 1989. Agency theory: An assessment and review. Academy of Management Review, 14, pp. 57-74. Hayes, R. H. and Abernathy W. J., 1980. Managing Our Way to Economic Decline. Harvard Business Review, 58, pp. 67-77. Jensen, M. C. and Mechling, W., 1976. Theory of the firm: Managerial behaviour, agency costs and capital structure. Journal of Financial Economics, 3, pp. 305-60. Keasey, K., Thompson, S. and Wright, M., 1997. Corporate Governance: Economic and Financial Issues. Oxford: Oxford University Press. La Porta, R., Lopez de Silanes, F. and Shleifer, A., 1999. Corporate ownership around the World. Journal of Finance, 54(2), pp. 471-517. La Porta, R., Lopez de Silanes, F., Shleifer, A. and Vishny, R., 1997. Legal determinants of external finance. Journal of Finance, 3, pp. 1131-50. Manne, H. G., 1965. Mergers and the Market for Corporate Control. Journal of Political Economy, 75, pp. 110-126. Shiller, R. J., 1989. Do Stock Prices Move too much to be Justified by Subsequent Changes in Dividends? Cambridge: The MIT Press. Shleifer, A. and Vishny, R., 1997. A survey of corporate governance. Journal of Finance, 52, pp. 737-83. Walker, D., 2009. A review of corporate governance in UK banks and other financial industry entities. [pdf] Available at: [Accessed 12 February 2013]. Weimer, J. and Pape, J., 1999. A taxonomy of systems of corporate governance. Corporate Governance: An International Review, 7(2), pp. 152-66. Read More