Dr Devendra Kodwani of Open University Business School examines what went wrong for financial institutions in the lead up to the recession and how Lord Turner’s advice should be implemented by G20 leaders.

A corporate entity with limited liability where the owners delegate the responsibility of managing a business to professional managers is one of the most powerful social innovations of the past four centuries. It’s also at the heart of the current banking failures and consequent chaos in the global economy. This corporate entity embeds an innate conflict of interest between the managers and other stakeholders, in particular shareholders.

Since the 1970s, companies have aligned these competing interests by designing compensation deals for executives that link to shareholders’ interests. However, following corporate scandals like Enron, the UK and many European countries put in place principles-based governance mechanisms to monitor the executives, while the US chose to enact a law (Sarbanes Oxley Act) with similar objectives. Why and how did these two approaches to better align interests of managers and other stakeholders fail to stop bank executives from assuming astronomical risks?

Bonuses backfire
First, the idea of using performance based incentives which included bonuses, and in particular share options, has clearly backfired. Latest research from US academics suggests that the link between executive incentives and firm performance is tenuous in a best case scenario, and indeed negative in some cases. There is also disturbing evidence that when firms pay a very high level (90%) of CEO compensation in stock options, it increases the chances of questionable financial reporting in the following years.

Why did so many independent directors not scrutinise or provide sufficient challenge to put a check on what now seems to have been complete disregard of that simple principle of economics: reward and risk go hand in hand, particularly in the age old business of lending and borrowing?

Risk
The combined code of corporate governance in the UK is very clear that the role of non-executive directors is powerful and crucial in controlling risks. It is expected, for example, that members of a company’s audit committee will be competent enough to understand the nature of business and the financial reports of the business. It is that committee’s role to challenge management’s judgement on annual reports and, in the case of disagreement, issue a statement to shareholders in the annual report.

Similarly, the risk committee has the right to challenge management decisions upon seeing danger signs. Sadly the existing internal corporate governance mechanisms did not prove effective in protecting the interests of shareholders in affected banks and the wider public now affected by the economic crisis.

Post Turner
What could we do for the future in light of the failed practice of the past? While many of us may feel otherwise, for government to interfere with the freedom of companies to decide their remuneration policies is not practical. However, remuneration committees would be wise to consider academic evidence that puts a big question mark over the wisdom of incentive compensations for CEOs linked to the firm’s performance.

Lord Turner, in his review of the banking crisis published last week, goes some way towards addressing this by recommending executive compensation be linked to long term profits and more holistic yardsticks comprising non-financial indicators be introduced to explicitly recognise risk implications arising from remuneration schemes.

His recommendation for rigorous reporting and compliance systems and linking them with remuneration policy, however, is another matter. One need only look to the government’s targets based regulation of reducing waiting times for NHS patients to see how regulated entities may succeed in complying, but fail in delivering. What is needed is more transparency in remuneration determination policies, and remuneration and risk committees that are truly independent and accountable.

Perhaps the most positive recommendation from Lord Turner regards variable capital and better liquidity standards, requiring banks wanting to borrow more to bring in more capital to support it. This, if applied internationally, would be a positive, market-based check on the behaviour of banks, and should feature prominently in the plans of G20 leaders going forward.

Dr Devendra Kodwani is a lecturer in finance at Open University Business School.