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The systemic changes to banking and insurance risk governance advocated in the Draft Report by Sir David Walker represent incremental, rather than seismic, shifts. With the possible exception of the proposals in the Draft Report on remuneration, he proposes refinements. The refinements are well reasoned and well argued. Particularly in the areas of encouraging increased executive and board-level concentration on risk and improving the focus on the stewardship of investment managers, his arguments are clear and persuasive.
In other areas, we would advocate a more noticeable departure from current practice: in relation to ‘comply or explain’; disclosure; the role of corporate secretaries; board evaluation; and cost, risk and capital allocation principles and systems.
On the topic of remuneration, the Draft Report has created a stick with which the industry can beat Sir David (which it has already used). The same result as that intended by the Draft Report can be achieved without providing such a weapon by focusing on issues of principle. Our suggestions are provided below.
In its tone and intent, the Draft Report establishes a very conservative bar for new product development: that it must be within the understanding of the board’s newly-proposed non-executive risk committee. We believe a less conservative approach is warranted and more practicable – suggestions are provided below.
Clarity of terminology of governance
The corporate world is awash with definitions of governance. The Draft Report does specify which definition it uses from among the competing sources. However, in interpreting the brief of the Review, the Draft Report focuses on the full range of aspects of governance covering relationships between the board and . . .
- executive management
- subsidiary boards
- assurance functions
We provide clarification on definitions in each of these areas and suggest a terminology which may help to disentangle the meaning and useage of ‘governance’ in the Final Report. In addition, in our work with clients, we find it useful to address different dimensions of governance for each of these relationships:
- structural (organisational) dimension
- analytical dimension, and
- behavioural dimension
We outline these and provide examples of governance and management issues which fall in each of the dimensions.
Comply or explain
The Draft Report makes frequent use of the term ‘best practice’. We believe strongly that such a concept is both illusory and potentially unhelpful. The logic of ‘comply or explain’ rests on the idea that practices suited in one firm’s context may not apply in another. However, the clear implication much of the governance provided on the Combined Code and in FSA Handbooks is that firms are ‘perfectible’ and that regulators (and other parties) can define ‘best practice’ from which firms deviate at their peril. This in unhelpful.
In corporate practice generally, and in risk management and internal control practice especially, there is a need for diversity and experimentation which ‘best practice’ guidance by regulators does not foster and may actively suppress. The Turnbull Guidance is a clear example of this, as is the guidance by the US PCAOB on SEC interpretation of the Sarbanes Oxley Act’s §404 on internal control. These have resulted in very limited innovation in these crucial areas and have impaired firms’ performance on internal control. The result has, emphatically, not been to provide enhancements in firms’ internal control, as extensive recent failures among SEC registrant banks demonstrate.
The approach taken to the review by Sir David Walker (consistent with his terms of reference) has been to investigate the issues of governance, risk, and related topics of internal control and assurance through discussions with senior executives and board members of banks and other financial institutions (BOFIs) and with consultants and regulators and to draw conclusions therefrom. This approach is consistent with most or all previous reviews of corporate governance and other aspects of governance in the UK.
There has been a startling lack of robust empirical work on what is effective and what is not in corporate and banking practice in governance in the UK (or elsewhere). Greater attention to empirical research on governance, risk, internal control and assurance is urgently required.
The current disclosure regime under which firms are required to disclose their governance, risk and internal control practices results in ‘boilerplate’ terminology which exposes very little of the underlying logic of governance in the firm. Indeed, if firms comply with the provisions of the Combined Code and related guidance, they are often not required to develop any such logic. We believe instead that regulation should require firms to disclose the logic and assumptions of their governance, risk & internal control approaches, with guidance relating only to the principles to be discussed; there should be no prescription on content.
The proposals for greater time commitment of NEDs risks increasing NEDs’ own perceptions of direct involvement in the business and reducing their objectivity and questioning of assumptions in the firm’s operating model, and its business models and proposals.
The role of company secretaries
We believe the role of company secretary is widely under-used and that greater emphasis on and reliance on secretaries could enhance the flow of information to the NEDs and performance of the board. In this regard, we endorse previous recommendations by Institute of Chartered Secretaries and Administrators (ICSA) to Financial Reporting Council (FRC).
Rather than focus on episodic, external evaluation which is fraught with problems, board evaluation should move to a continuous cycle of feedback between board members and between the board and executives on quality of chairmanship, agenda management, quality of meeting, debate and discussion, quality of papers and outcomes. This can and should be conducted online, supported by tools implemented by the company secretary. This will encourage a self-reinforcing behavioural change that no amount of external review or disclosure could accomplish.
The role of the CRO
We endorse the recommendations of the review in relation to the proposed role of Chief Risk Officers.
The key constraint in forming an ‘enterprise-wide’ view of risk (as advocated in the Draft Report) is not a lack of will or the presence or absence of a CRO; it is the common reality that he or she will face (i) disciplinary silos in credit, market, operational risk, as well as (ii) complexities in the firms’ structures and process and (iii) limitations in firms’ data infrastructures. These limitations often result from underinvestment or mis-investment in suitable technology platforms. To achieve a material improvement in firms’ management of risk at an enterprise level, these data infrastructure limitations will need to be addressed.
Complexity and uncertainty
In contrast with the views expressed in the Draft Report (and widely elsewhere), we do not concur that a major cause of product failure has been the complexity of the structure or mathematics of the instruments; it is the failure to grasp the limitations of the models used – the inevitable basis and model risk present – and of the operational risks in the structures, vehicle, documentation and exchange and settlement approaches used (or not used, as the case may be).
Also, effective management of risk in institutions will require far greater attention to the allocation of risk, cost and capital to business unit, desk, trader and trade level than is commonly the case at present.
The recommendations in the Draft Report on stewardship by fund managers rely on:
- demand for increased attentiveness by pension fund trustee
- improved supply of governance-related information from research houses
Neither of these can be assured. To satisfy the increased research requirement implied by the Draft Report’s recommendations, there will need to be a ‘retooling’ of equity research to enhance capability in and attention to analysis of governance practices. With these dependencies noted, we believe the changes to stewardship proposed represent a sound, systemically consistent set of recommendations.
The recommendations of the Draft Report mask a more fundamental issue of principle: that the current ‘bonus problem’ is a creation of accounting fictions – of reliance on accounting recognition of profit rather than economic profit. Focusing on earned or realised profit as the basis for bonus entitlement would eliminate many of the problems highlighted in the Draft Report (and widely elsewhere). The result would be similar to the intent of the Draft Report, but would have the advantage of returning the debate to a focus on principles.
The approach to risk and product innovation implied in the Draft Report is very conservative; essentially: if you don’t understand it at board level, don’t go in to the business. If rigorously applied (which is highly unlikely), it would limit innovation to an extraordinary degree. A far more useful approach would be to advocate clear and focused understanding of uncertainties in business models, business cases and mathematical risk analyses; that is, to understand more clearly model risks, basis risks and operational risks in the proposed operating model.