Corporate governance has to be one of the most dreary of all topics.  Do you remember Monty Python's jokes about chartered accountants?  These are the guys, along with lawyers, who manage corporate governance.

But as the financial crisis shows once again, corporate governance is one of the most important issues in the global economy.  Good corporate governance should be an effective line of defense against some of the madness that led to the current crisis.

To tell the story, we need to start with the basics.  When you see these corporate golden boys and cowboys, it's difficult to remember that the real owners of corporations are the shareholders, often just regular folks like you and me.  Of course, sometimes shareholders can be so-called institutional investors like insurance companies or pension funds, and others too.  But even the institutional investors are just managing our savings.

Because it's too hard for you and me to direct our companies, we appoint a board of directors to do this for us.  In theory, they are competent to do this.  Also, there is only a small group of them which makes it all manageable.

The directors' job is to oversee the management of a company.  They should set and enforce clear lines of responsibility and accountability within an organisation.  They appoint senior management who create a whole raft of systems for management, finance, marketing, production, etc.  And within that, one key issue is risk management, which managers should manage and directors should oversee and control. 

All of these systems and relationships are what they call corporate governance.  And corporate governance is "good" when it is consistent with the strategy of the company and the interests of the shareholdes.  Sure, we have to pay attention to stakeholders like workers, customers and local communities.  But at the end of the day, it's you and me, the shareholders who are the bosses.

This brings us to the crisis.  At the bottom of any financial crisis is a whole bunch of bad loans -- today, we call them "toxic assets".  They came about because young turks in the financial markets went on a reckless lending spree without paying sufficient attention to risk.  Lots of poor people also borrowed money which they had no hope of repaying.  And these loans were packaged into fancy products ("securitised") which no-one understood, but which everyone invested in because the ratings agencies gave them a rubber stamp. 

So the question is if we have all the above systems of corporate governance in place, how did we manage to end up with all these bad loans.  The simple answer is that the corporate governance lines of defense did not work.  Risk management systems that should have nipped all this in the bud fell asleep at the wheel.

Risk management systems should define a company's level of risk appetite, identify emerging risk areas and ensure that the risk appetite is a coherent reflection of the company's strategic objectives.  It should have a system of metrics for evaluating the level of risk that a corporation is carrying at the corporate level.  There should be a system for reporting this level of risk from operational levels to senior management and then to the board which is ultimately responsible. 

Looking across all the corporations involved in this financial crisis, every corporate governance sin was committed, particularly in the area of risk management.  Some companies had strategies, but no metrics for monitoring risk.  Some companies started taking on new sub-prime risk without informing the board.  Growing levels of risk were not reported to boards or in some cases to even senior managers.  In some cases, remuneration systems rewarded excessive risk taking.  In some banks, the traders were the kingpins, while risk management staff had lower prestige and status which basically impaired their ability to do their job.

What is even more worrying is that questions are being raised about the ability of some boards to oversee management, and understand and monitor businesses.  It is often said that corporate boards are a "retirement home for the great and the good".  Apparently, four of the ten board members at Lehman Brothers were over 75 years old and had very little current financial knowledge.

Corporate governance is certainly one of the most thorny issues in the financial crisis.  Here we enter into what British author Graham Greene called the "Human Factor".  Risk management and internal control systems require human beings checking up on their fellow colleagues, colleagues they may have a drink with on Friday evenings.  And when things are sailing smoothly, risk management may not seem so urgent or important.

This crisis, like others before it, will surely lead to improvements in the design of corporate governance systems.  Implementation, which is the most important issue, will no doubt improve too. 

But the danger is that we will ultimately be lulled into complacency and a false sense of security once again.  We need to avoid this danger like the plague, because good corporate governance can save a company against its own excesses and even madness.  And given that companies increasingly behave like herds, good corporate governance nationally and globally can help us avoid these crises.

Reference:

"Corporate governance lessons from the financial crisis" -- www.oecd.org/daf/corporateaffairs/