Corporate Governance in the Financial Sector - Coursework Example

Chapter Corporate governance has became one of the widely debated topics in recent times as the large scale corporate failures as well as current financial meltdown has raised certain important questions regarding the fair practices of the businesses. The capitalism, in its essence, is a system which advocates the competition as the basis of exploiting the economic resources of a country. However, this competition faces organizations to often engage themselves into activities which may be rather illegal or detrimental to the interests of the stakeholders. Corporate governance therefore ensures that the firms and managers do not engage into activities which can be detrimental to the interests of the shareholders. The modern history of corporate governance starts after the 1970s as there was general increase in the awareness of the shareholders for their right to have more roles in the overall affairs of the businesses in which they invested. The issue became more critical during 1990s owing to the firing of the CEOs of the major firms including IBM thus giving rise to the question of how well the firms are managed. The Bankruptcies of the organizations like Enron and WorldCom further renewed the interest and also resulted into the promulgation of the regulations such as Sarbanes Oxley. BASEL Accords as well as other regulations like SOX are also applied to Banking sector. Chapter#2 The recent economic meltdown has raised certain important questions over the state of corporate governance in the financial sector. The failure of the organizations such as JP Morgan and AIG indicates that the corporate governance mechanism was not entirely effective in preventing such large scale failure of the financial institutions. The compensation issues that emerged as a result of the failure of the firms like RBS as what was revealed was nothing more than extraordinary as for as the corporate governance was concerned in the financial sector. A brief historical look at the history of corporate failure in the banking industry in general would indicate that the banking is more prone to the external shocks and as such if prudent lending practices are not applied, there are chances that the banks may fail. Similarly, in case of investment banking, there are greater chances that the firms offering such services may be prone to the cyclical behavior of the activity as investment banking activity is believed to be picking up when the economic conditions are improving and tend to show the decline when economic activity decline. Such cyclical nature of the activity therefore requires that the managers must act with prudence and device their strategies in such a manner that strategies can significantly insulate the firm from the external shocks. Given the overall nature of the industry, it is also critical to note that there are different styles and models of corporate governance that can be applied to the investment banking industry in general. Market centric as well as relationship based models of corporate governance therefore can be appropriately applied to the firms operating in the investment banking industry. The relationship centric models of the corporate governance however may not be suitable for the investment banking industry because relationship based model of corporate governance requires that other stakeholders including labor and employees shall also be considered. As such the market centric corporate governance model may be more suitable for the investment banking as it allow the firms to develop its corporate governance strategies by considering the market practices and norms. What is also significant to note that this model of corporate governance may not result into restricting the managers to take the excessive risk as the managers may be more tempted to take excessive risks due to higher short term compensation? The importance of corporate governance in investment banking is critical from the perspective of the risk taking. The compensation structures in the industry are designed in such a manner that it allows the risk taking which can have negative consequences. By linking the pay structure with the short term performance, investment banking industry specifically can increase the overall riskiness of the business they are in and executives may be tempted to take actions which can be potentially detrimental to the interest of the shareholders. Corporate governance in investment banking becomes more critical given the fact that Investment banking itself is a very risky business. The inherent risks in the business therefore require that the managers must be prudent enough to clearly cull the right projects and finance them through funding. However, there is an agency cost involved here as the managers, out of acting in their own self interests, may finance those projects which may prove detrimental to the overall interests of the shareholders. The Cadbury Report was one of the initial efforts to integrate the corporate governance mechanism into institutions regardless of the industry and strengthened the role of the Board of Directors in managing the overall affairs of the institutions. Though investment banking services are offered by the wholesale banks therefore the board of directors of such firms often oversees other activities of the financial institution also. This therefore requires that the investment banking as a whole shall also be included in the larger context and the board shall have the vigilant role in overseeing the risk taking patterns of the managers and monitor their performance. Evidence also indicated that managers in investment banks often tend to get higher salaries and there are widespread variances in the salaries of the managers in investment banking profession. Such high salaries, as discussed above, may be due to the focus on the short term success i.e. there has been a trend in the recent past wherein managers are focusing more on achieving the quarterly returns rather than focusing on achieving and maximizing the returns for the long run. This tendency of the managers therefore require that there must be an effective corporate governance mechanism within the investment banking sector and the role of board of directors as well as the regulators shall be strengthened to ensure better governance. Ch#3 As discussed above that the market based corporate governance mechanism may be more appropriate for the investment banking sector given the fact that it is largely market driven and most of its activities are cyclical in nature. What is however, also important to understand that the corporate governance is a continuous process and must be continuously evolved within the organization so as to achieve better organizational structure. Traditionally, the corporate governance within the financial institutions were overseen by the regulatory authorities such as FSA which has the regulatory mandate to check the compliance with the rules and regulations besides ensuring that the financial institutions are performing in accordance with the acceptable standards. Apart from that the financial institutions like building societies were also governed by the rules and regulations which specifically set the parameters which need to be addressed by the financial institutions. For example, The Building Societies Act 1986 set forth many important regulatory requirements which building societies have to follow. This act was one of the earliest efforts to bring in some positive changes to the way building societies were managing their affairs and how their actions can affect the shareholders. A revised code of corporate governance was issued in 2008 which set forth the new requirements for the building societies to follow. This new and revised corporate governance code was issued after considering the changes that took place with the advances that happened in the industry as a whole. This revised code of corporate governance however, was applicable only to the public entities. The recently concluded Walker Review, though is not considered to be applied directly to the Building societies however, FSA has made it clear that its implications will be wider and can be extended to any financial institution as for as the implementation of the corporate governance is concerned. Corporate governance mechanism in building societies is therefore now focuses mostly on the role of compensation as well as the role of Board of Directors to vigilantly monitor the business activities of the building societies. The role of the Board is enhanced to ensure that the building societies put their resources in a manner where they are best utilized and utilized to achieve the intended objectives of the firm. Thus the corporate governance in building societies is also relatively similar as for as the role of board of directors is concerned. Further, Board is also required to delegate the execution of various strategies to the senior management of the building societies however; there is an in-built mechanism which allows the Board to continuously evaluate the performance of the senior management. Further there is segregation between the roles of the Chairman of the Board as well as the Chief Executive which give more credibility to the role of the board of directors as well as ensure that there is a balance of power between the two important positions in the firm. It is also critical to understand that the building societies are often formed on more informal basis and as such this degree of oversight ensures that they perform according to their intended objectives. On the other hand, corporate governance in the traditional investment banks offering mortgages only may not be as different as it may seem. It is critical to note that despite the basic differences between the natures of the functionality of both the firms, the corporate governance mechanism is relatively the same. The focus on the investment banks offering mortgages may be more penetrating in the current context of the subprime mortgage drama however, still the basic principles are same and same prudence principles are applied. Investment banks offering mortgages however, are prone to more risks given the fact that they may engage themselves into the activities such as securitization. Thus the most fundamental difference between the approaches adapted in the two types of the firms may differ in their ability to affect the market. Investment banks have the capability to affect the market through the development of products and services which may provide short term benefits however, this may result into the more risk for the firm. In such scenario, the role of the board of the directors becomes more significant and a there may be added vigilance from the board members to ensure that the firm is following its intended objectives. As discussed above that there are relatively similar sets of corporate governance codes for both types of business however, investment banks offering mortgages may have relatively more stringent requirements to meet because of their nature of business and overall risk. Since investment banks offering mortgages are also involved in the issuance of the securities it is therefore critical for them to ensure that they follow the principles of transparency, objectivity as well as the equity. This therefore requires them to put in place more stringent internal controls as well as strengthen the role of the board of directors in overseeing the affairs of the firms. It is also important to note that some investment banks have two tier- management system wherein the managing board as well as the supervisory boards are different thus giving more transparency and equity to the whole process of conducting the business. The separation of the supervisory role and management role therefore also further strengthen the role of the supervisory members of the board to become impartial and remain unaffected from the influence of the management. It is however, critical to note that there is a growing debate regarding setting the scope and limitations of both the types of the boards as one may transgress the authority of the others. Finally, the constitution of the various committees especially the audit committee is considered as more powerful as compared to the audit committee of a building society. Since the scope of the audit committee of an investment bank is much higher it is therefore often assumed that the audit committee has the more role and power while overseeing the audit functions in the investment banks offering mortgages. Read More