Key corporate governance lessons from financial crisis

Mats Isaksson, OECD head of corporate affairs, highlights the need to put in place effective pay for performance systems at every level of a company’s pay structure, not just at CEO level

June 17, 2009

Following moves by US government last week to set pay limits at firms that have received TARP assistance, Mats Isaksson, OECD head of corporate affairs, highlights the need to put in place effective pay for performance systems at every level of a company’s pay structure, not just at CEO level, and talks about urgency of strengthening corporate standards of risk management and board director performances, essential to avoiding a repeat of the corporate governance failures that played a part in the financial crisis.

What are the key corporate governance lessons from the financial crisis?

The most obvious lesson is that corporate governance matters. Company executives, policy makers, regulators and shareholders need to pay more attention to corporate governance. When times were good, it seems that many took their eye off the ball and now we see the consequences.  A firm’s rising  share price is not necessarily a sign of good corporate governance.  History tells us that it could actually be the opposite.

What issues need the most urgent attention?

There are four key areas: corporate risk management, pay and bonuses, the performance of board directors, and the need for shareholders to be more proactive in their role as owners.

Let’s start with remuneration. There’s a lot of public anger over executive pay in many countries. Is this a sign of poor corporate governance within firms? How can corporate governance principles help?

I am not surprised by the public outcry. And when there is a very weak link between pay and performance it is obviously a case of poor governance. Recent surveys have shown that four out of five financiers believe that compensation practices played a role in promoting the accumulation of risk that led to the crisis. There are clearly big problems with the “pay for performance” system.

But to get it right we need to look at pay structures across whole companies, not just at their high-profile CEOs. Our work has shown that it is equally important to come to grips with how bonuses are designed and paid among traders and portfolio managers throughout the company. We have seen too many examples of employees being given short term incentives that are not in line with the long term sustainability of the company. This contributed to the build-up of unmanageable risks that eventually brought the companies down. Corporate governance principles can be of great help by providing a structure for deciding on remuneration.  Here the board will play an important role. When looking at various models for compensation, boards should explicitly ask themselves if the company’s compensation model is aligned with prudent risk taking and the long term objectives of the company.

If pay for performance doesn’t work, what will?

Pay for performance does work but need to be better managed and more transparent. The governance of remuneration systems has often failed because decisions and negotiations are not carried out at arm’s length. Managers and other insiders  often have had too much influence over the level and conditions for performance-based pay with the board unable or incapable of exercising objective, independent judgment. In many cases it is even hard to establish the link between performance and remuneration in such schemes. For example, companies have often used general measures of stock price rather than the relative performance of an individual firm. Often, the pay schemes are also described in a way that makes it hard for shareholders and others to understand their implications in terms of risk, cost, etc. Hard to value pensions schemes is a good example.

The crisis has thrown up some massive failures in risk management. While many companies had internal controls on financial reporting, it’s clear that their executives did not fully grasp or communicate the financial risks of many of the instruments they were betting on. Can the OECD’s principles address this issue?

Yes. Our message is that risk management must be seen in a corporate wide perspective where the risk management system is continuously adjusted to corporate strategy and risk appetite.  We also need to improve the exposure to risk management among board members and make sure that they get all the necessary information to make informed decisions. We have therefore suggested that corporations have a special risk officer.  We believe that this person should report directly to the Board of Directors and not via the CEO. Surveys of audit committee members have shown that they are not too satisfied with the current state of reporting. Only four out of ten said that the risk reporting reports they received were very good.

What about the boards? After all, these are charged with overseeing the risk management systems of firms. Is this their failure too and what must be done?

As I said, they have not always received high quality information. But the question is also if they actually demand high quality information? And if they received it, would they be able to understand and interpret it in any meaningful way? Being a board member in a large complex organization is extremely demanding. And it would not be realistic to expect all board members to have detailed knowledge of all aspects of the business. But particularly in financial firms, a good understanding of risk management is vital.  This is why the OECD has suggested that the  “fit and proper person” test (deleted could) be expanded to  include also their technical and professional competence in areas like risk management. It might also be worth looking at strengthening the legal duties of board members – and enforcement of those duties.

Have you seen any sign that the private sector is taking greater interest in improving their corporate governance since the crisis?

Yes. I think this is on everybody’s mind right now.  And large parts of the private sector realize that they need to re-gain credibility.  We believe private sector initiatives to improve corporate governance are very important and encouraging and we have therefore established a standing forum for dialogue and exchange of experiences with the private sector and other stakeholders.

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