Failures in Corporate Governance as Revealed by the Financial Crisis and Subsequent Lessons - Coursework Example

Failures in Corporate Governance as Revealed by the Global Financial Crisis and Subsequent Lessons Introduction The Global Financial Crisis (GFC) not only revealed the failure of corporate governance systems but has also portrayed absolute simplicity and irresponsibility among involved company directors. The GFC almost ruled out risk management practices and corporate governance policies following their failure to cushion the effects of the crisis. By mid 2008, the subprime market crisis and the consequent liquidity crunch had caused untold instability in financial institutions. Big names including United State’s Bear Stearns, Freddie Mac, Fannie Mae, American Insurance Group (AIG) and UK’s Northern Rock were on the verge of collapse. While the state came to the rescue of most of these companies through nationalization, shareholders lost a great deal in the bargain. Furthermore, most of these companies have not come close to recovering what they lost following the GFC. Most importantly however, the debate on the underlying factor in the global crisis remains unresolved amidst claims that poor corporate governance is to blame for the whole scenario. According to studies on the financial crisis, there were inconsistencies in corporate board’s responsibilities to provide strategic direction and oversight towards the operations of their companies. Further, the existence of remuneration structures that promoted risk taking approaches among managers has been blamed for the crisis. Other factors include the poor accounting and disclosure standards, failure to study and predict trends in the market and existence of unregulated products in the market. Despite the fallout on what weaknesses contributed most to the financial crisis, it is evident that there is need to address the shortcomings that exist in corporate government systems so as to avoid another crisis in future. This paper forms a discussion to establish whether failure in corporate governance systems was revealed during the Global Finance Crisis. Further, the paper will assess the lessons that ought to be learned as far as corporate governance is concerned. GFC and failures in the corporate governance systems The importance of effective corporate governance systems cannot be underestimated. This is because the role played by corporate governance in any company is imperative; given that importance of efficient management. Corporate governance envisions the relations existing between directors, shareholders and managers in regard to constitutional provisions and legal rules (Clarke 2-4; Redmond and Brennan 5). The functions of corporate governance in regard to other stakeholders; more so in the balancing communal goals with economic goals is also emphasized (Redmond and Brennan 6). A company’s responsibility to shareholders, customers and the community therefore spell out the need for executives to aim at satisfying the needs and expectations of each group. The Global Financial Crisis revealed the existence of weak corporate governance trends among companies which lead to serious reverberations in the market and consequently caused the most serious crisis ever since the Great Depression. Inconsistencies in corporate governance can be explained as follows: Poor risk management practices Subsequent analyses of the Global Financial Crisis reveal that poor risk management played a significant role in the unfortunate occurrences. As noted by McDonald (65), efficient risk management safeguards a company from loss and protects it from possible dissolution. Failure to set risk mitigation practices could be highly detrimental to a company’s continuity prospects. Accordingly, risk assessment and evaluation are important in all company undertakings in order to avoid losses through unanticipated events. Gauging from the consequences of the GFC however, it can be established that most companies did not have well laid out risk management plans to counter the crisis (Kirkpatrick 2-3). The global financial crisis straightforwardly depicts failures that could emanate from poor risk management systems in companies around the world. Notably, the subprime mortgages and high risk lending among financial institutions were responsible for the GFC. In the real sense, these instruments carried high risks and financial institutions should have been able to predict such risks. This insinuates that effective risk assessment and vulnerability were not conducted to establish the probability of risks. Risk assessment involves the identification of potential threats and evaluation of the likelihood of them occurring (McDonald 10). In the case of subprime mortgages for example, financial institutions failed to take into account that poor credit worthiness among borrowers was a threat to the future of their businesses through defaulted loans. Further, they did not predict the effect of excessive money supply in the market which was likely to lead to inflation thus affecting the economy significantly. Instead, lenders continued to give out loans thus leading to the housing bubble and the eventual global financial crisis. Shah (1) makes note of how financial institutions created more risk in their bid to mitigate risk. He brings out the concept of securitization; which was often labeled the most innovative idea of the 20th century. It is a procedure in which banks sold their loans to larger financial institutions such that the risk of defaulted payments was transferred to these institutions. On the other hand, the banks benefited through obtaining more funds to lend and also reduced risks. Securitization led to increased greed for profits among banks since it eliminated risk. Banks kept borrowing money to lend and in turn sell the loans as securities. This meant that the banks did not have to rely so much on customer deposits for their upkeep. It is this elimination of risks that led banks into lending to the poor or the subprime; knowing that they would not incur any losses. It is also notable that the rising house prices encouraged the banks to continue lending since they figured out that bad loans would result in the repossession of high-value property; such that financial institutions did not have to worry about making losses (Shah 1). It was therefore shocking when the house prices suddenly went down and the number of defaulters rose. Financial institutions had not anticipated such a move and therefore they were hard hit by the turn of events. Besides being unable to control risks, managers of the organizations involved were not able to manage the consequences of the GFC since they did not have adequate systems to counteract the damage caused by the crisis (Fotouh 1). As a result, many firms ended up collapsing or seeking buyouts in order to survive. This can be blamed on the corporate governance policies and their narrow approach in forecasting and mitigating risk. The case of Northern Rock is a perfect example of unpreparedness among organizations. To begin with, the bank did not predict the bank run and therefore did not have a plan to mitigate the effects of the same (Shin 1). It was therefore unfortunate that the bank could no longer operate once the customers claimed their money. Consequently, the bank had to be nationalized; leading to major losses to the shareholders. Failure to study the market and forecast risk It is surprising how respectable financial institutions failed to predict the financial crisis despite the knowledge possessed by financial experts and the tell-tale signs that could easily give away the possibility of a financial crisis. This insinuates that companies did not invest much in studying the market and the effect of their activities. Instead, companies continued to operate as if their risk-taking endeavors would not have effect on the economy in the long-run thus affecting their stakeholders vehemently. The failure to predict the crisis denotes some form of ignorance on the part of the financial institutions given that various individuals and research groups had predicted the crisis as early as September 2006. An example is Nouriel Roubini who warned of a possible crisis and was supposedly ridiculed when he predicted a crumple in the housing market to an extent of being labeled “Dr. Doom” (Mihm, MM26). Nassim Taleb, a financial risk engineer also predicted that the high risk models undertaken by the banks could eventually lead to a collapse in the banking system. Other economists who predicted the global financial crisis included Wynne Godley from UK, Dean Baker from U.S, Steve Keen from Australia and Jakob Madsen from Denmark among other predictors (Financial Times 8). Failure to act on these predictions portrays a situation in which the organizations did not give regards to the interests of the shareholders and customers thus leading to serious losses. Such losses could have been avoided if the organizations heeded the advice given by various institutions and individuals who had predicted the crisis. Companies were also blamed for failure to disclose foreseeable risk which is often regarded a good practice in corporate governance (OECD 15). This could have warned the members of public on the impending risk and probably avoided heavy investment in the affected markets. This way, the effects of the crisis could have been minimized. Board practices and structures Effective corporate governance requires company boards to actively participate in an organization’s strategy formulation. It is also imperative for the board to create clear lines of accountability and responsibility among the executives such that their activities are in line with the shareholders’ interests (OECD 4). The professional competence of board members, governance and managerial skills are also very important. On the contrary however, it is notable that boards in most companies were either not actively involved in company activities or did not understand the implications of the actions of executives (Kirkpatrick 17-18). To begin with, the directors of financial institutions, where the crisis actually originated, did not take time to understand the risk implications of using intricate products and procedures derivatives and the process of securitization (Shah 1). Furthermore, it is highly possible that some of the board members involved in such decisions did not have adequate knowledge about the working of these products. At the same time, they did not question the decisions of the executives either because of inexistence of direct reporting channels or due to lack of enough knowledge to question the use of introduction of such services. In the same light, the existence of part-time boards or seasonal boards has been highly criticized based on the notion of independence and objectivity in decision making (OECD 4). This has to do with the fact that these boards may not hold the interests of the company as tightly as full-time boards would. It is also notable that they may not exercise full control in the running of the business such that they may lose accountability contact with the executives and consequently lose track of accountability. The existence of these loopholes in corporate governance made it possible for executives to involve themselves in high risk activities which later turned destructive. Exaggerated executive remuneration structures Remuneration is often considered a useful technique for motivating staff and managers with an aim of improving productivity. Improper use of this provision is however risky and could lead to the downfall of a company; more so where hefty remuneration packages offered to directors do not match the profitability of the company. The management of remuneration and other incentives has been put forth as one of the contributing factors in the GFC. This mostly has to do with the hefty packages paid to directors in the form of bonuses at the expense of the shareholders’ profitability (Fotouh 1). In the case of American Insurance Group (AIG) for example, directors were getting chunky bonuses, yet the company was quickly becoming dissolute. Reports indicate that while AIG was undergoing major financial problems and had even sought to be bailed out by the government, a $165 million bonus package was paid to the executives. 96 individuals had received 1 million dollars each or more despite the company’s ailing financial performance (Gang 1). Bonuses and incentives based on performance are said to be responsible for the poor risk controls that emerged within the banking sector. The remuneration packages given to top executives played a significant role in encouraging them to pursue short-term goals. According to Kirkpatrick (13), such incentives encourage executives to aim at closing as many deals as possible in order to get huge bonuses and thus losing focus on long-term objectives. The manner in which these benefits are designed raises questions about corporate governance and the ability of managers to forecast risks resulting from their policies and decisions. It also endangers the continuity of a company to a large extent because managers may disregard important strategies in order to maintain short-term profitability goals. The manner in which bonuses are given provides for a payout whenever the company makes outstanding profits. However, there is no mechanism of making directors to pay back the bonuses or to be disciplined in case the company does not perform well in the following period. Consequently, there is no sense of responsibility; which basically insinuates that the executives may not have the best interests of the company at heart. It is therefore possible for them to make risky decisions without regard to the outcomes and the effect they will have on the company’s profitability. This spells the need to come up with controls that encourage managers to be more accountable for their actions. Inconsistency in internal controls and accountability The global financial crisis has been pegged to the corporate governance systems’ failure to uphold accountability in organizations. Apparently, companies failed to make it through the financial crisis since their accounts had been mismanaged. This came at a time when the focus on internal controls has been intensified in a bid to ensure consistency in financial reporting and to enhance accountability among staff members. As a matter of fact, internal control is a risk management subset which is of great concern in the corporate governance systems. Evidence from the GFC indicates that most companies collapsed because of loose internal controls (Smith 10). Poor accountability has also been linked to the unaccounted amounts that were paid to directors in the form of annual benefits. These benefits in most circumstances outweighed the companies’ ability in terms of profitability. It therefore became difficult for these companies to salvage themselves from the crisis as. Disregard of customer welfare Corporate governance not only incorporates the interest of the company and the directors but also involves the management’s responsibilities towards the needs of customers. This is in relation to corporate governance’s function of maintaining a balance between economic and social goals in order to enhance peaceful co-existence between the business and the community (Redmond and Brennan 6; Plessis, McConvill and Bagaric 343-344). In the period preceding the global financial crisis, financial institutions engaged in dishonest lending practices which were not only risky to them but posed a serious threat to customers who unknowingly engaged in them. Notably, the financial institutions sought to take advantage of the rising prices of houses to convince members of the public to take mortgages which would in turn earn them profits once the houses were sold in future. What the institutions did not reveal is that while they took risk in lending to subprime customers, they were aware that it was highly possible for these customers to default in payment such that their houses would be repossessed at a higher value thus earning huge profits for the banks (Shah 1). Customers unknowingly took mortgages only to be disappointed when their housing bubble collapsed and their houses had to be repossessed. This in turn affected the financial institutions which had not anticipated the value of houses to fall thus subjecting them to major losses. In a bid to beat competition, financial institutions resorted to using any means to get money from the public through introducing complex products such as derivatives. Due to the fact that derivatives are generally unregulated, it was possible for originators to intentionally hide their vulnerabilities so as to lure people into using them thus exposing them to risk vulnerability (Shah 1). Notably, other companies other than banking institutions took advantage of the GFC to raise prices for goods and services such that within a short time, the effects of the global crisis could be felt as customers sought to reduce their spending due to the high prices of goods and little money available. If the real costing had been used to calculate selling prices for goods and services, the financial crisis could have been controlled significantly. Lessons from the GFC in relation to corporate governance It is apparent that failures in corporate governance contributed significantly to the Global Financial Crisis and that there is dire need to address these shortcomings in order to prevent a repeat of the same. In this respect, managers and directors must re-evaluate their strategies and become more focused on protecting the interests of their businesses and those of shareholders. The corporate governance dimension calls for boards to clearly state their strategy, establish efficient reporting systems, define the company’s risk appetite subject to remuneration and oversee risk management. The GFC clearly indicates that the effects of a crisis are bound to cause serious reverberations in the market such that it could cause permanent damage on a company’s profitability. It is notable that the GFC has greatly changed consumer behavior and that people are more cautious with their spending habits. This follows the increased prices of goods and the unavailability of credit. Accordingly, most businesses have suffered vehement losses and they may not be able to recover the profits lost during the recession. Improvement in corporate governance is therefore highly necessary in order to avoid putting the economy in such a situation again. Importance of risk management programs Special emphasis has been placed on corporations’ failure to foresee and counter risk thus leading to the financial crisis. While risk cannot be completely eliminated, the principles of risk management acknowledge that potential threats can be reduced through enhancing protection against potential threats that could occur (McDonald 42). Accordingly, every company must take adequate steps to come up with a workable risk management program to be used in the event of a financial crisis in the future. In particular, financial institutions should disclose the business and risk models used in their organizations since they are more likely to be affected by financial crises (OECD 15). These models should be well formulated such that they are able to counter possible risks and hence reduce the probability of financial crises in future. Further, they must include a recovery strategy to be taken following the occurrence of an undesirable event. Recovery from the global financial crisis has proved to be a challenging process for most companies; with a considerable number of businesses closing down in the past three years. This can easily be linked to the companies’ inability to plan for the mitigation of risks. According to McDonald (49), a company should have a recovery plan to enable it recuperate after an incident. In the banking sector for example, it is advisable for the banks to have a reserve for back-up finances just in case a crisis occurs. The government should also undertake the responsibility of ensuring that banks maintain a minimum reserve amount that can be used for the recovery process in the event of another financial crisis. When planning for risks, company directors must ensure that the major elements of risk management are incorporated. To begin with, an effective risk management plan should carefully assess the organization’s internal environment so as to establish how risk is seen and addressed by the people within the organization (Kirkpatrick 7). This is followed by objective setting where the management establishes the goals of the organization’s risk management program even before potential events can be identified. Once the events and possible risks are identified, the next step is to assess the risks in order to determine how they should be managed. This involves market research so as to establish potential risks in the market and within the sector in which the firm operates. The risk management must then come up with risk response methods. This is done in consideration to the company’s risk tolerance abilities (McDonald 61). Further, control activities such as policies and procedures for implementing risk responses are put in place in order to counter any risk that may come up. The establishment of control activities is followed by effective communication and transmission of information to the people in the organization. The relevant information should be well captured and should include details on how each person is supposed to carry out their obligations and the time frame for conducting these responsibilities (McDonald 62; Kirkpatrick 7). Finally, there must be an effective monitoring channel to ensure that the program is well implemented. This may involve regular tests to ascertain whether the employees can implement the processes effectively in case of a real event. Further, any modifications made on the risk management plan should be communicated to the right people accordingly. Risk management should be made part the company culture such that every employee is committed towards the elimination and control of risk. This involves ensuring that each employee knows the role he or she is expected to play whenever a risk occurs. Further, they must be in a position to report any risk indicators such that actions are taken early enough. It also encompasses the management’s commitment to review the risk management plan every now and then to ensure that it is effective in mitigating risks and thus incorporate any new advancement (McDonald 62). By constantly reminding employees that they are responsible for risk management in the organization, the management ensures that employees are always alert and that the occurrence of risk is highly minimized. Control of compensation structures In order to minimize the possibility of another financial crisis, compensation incentives should be such that they do not induce risk-taking attitudes among executives (Fotouh 1; IGCN 1). This is in line to what happened when banks risked their liquidity in a bid to lend out more and hence attract higher profits. This however failed when the number of defaulters rose and the banks could not control their deteriorating liquidity levels any longer. The promise of hefty benefits if the banks made huge profits definitely led to over-ambition among bank managers; a factor that led to the collapse of the banking sector. This is a good lesson to the banks’ management and it should be carefully implemented in order to eliminate the possibility of a new financial crisis. It is imperative for companies to ensure that executive bonus payments should only be paid once there is incontrovertible proof that profits have been taken in and that there is no possibility of reversal of transactions (Kirkpatrick 15). This would certainly avoid situations in which executives are paid for unrealized profits and therefore eliminates circumstances in which directors feign profits in order to get bonuses. In relation to risk, the board must strike a balance between the remuneration systems and risk management such that the interests of the company are protected (Ghosh 1). A company must be able to weigh its risk appetite when offering incentives so as to avoid encouraging short-term thinking which could easily ruin a company in the long-run. Furthermore, incentives linked to performance could encourage high risk-taking attitudes among the executive members at the expense of shareholders. In his study on the role of management, Younkins (155) notes that a sense of ownership creates motivation among directors and managers. He suggests that managers should be given a stake in the organization in order to properly align their interests with those of the shareholders. This way, managers are likely to work towards ensuring the success of the organization since they are assured of extra returns emanating from the company’s profitability. Enhancing board performance It is quite imperative for corporate boards to undertake the fundamental responsibility of providing strategic direction and oversight for the organizations so as to maintain strong control environments (Ghosh 3). They should also be in a position to challenge the executive concerning the business strategies adopted with a view of providing the best options as far as the company is concerned. It is highly important for boards to be strengthened so as to ensure integrity and the possession of proper skills to manage risks and oversee complex businesses (OECD 17). Studies in the banking sector for example indicate that most bank board members had little knowledge on banking if any. This limits their ability to assess risks that could be associated with various decisions that they make. In order to avoid poor decisions in future, this problem must be mitigated by ensuring that board members’ qualifications are thoroughly scrutinized during the hiring process (Kirkpatrick 18-19). Alternatively, financial experts and auditors could be invited to offer advice to board members when matters of such sensitivity are being discussed. While the possibility of improving board performance through involvement of laws and regulations may prove difficult, companies have an option of improving them through their own creative ways. The aim of improving board practices is to ensure competence and independence and thereby eliminate inherent conflicts within the organizations set-up. In order to enhance this, nomination of board members by shareholders should be considered as good practice. Further, the role of the Chairman of the directors’ board should be separated from that of the Chief Executive Officer in order to enhance the independence of the board (OECD 17). Defining the professional qualities and skill composition of the board is also an important consideration when making an effective board to run the company’s activities. The need for internal control and accountability The need for proper accounting standards and internal control systems is necessary in order to mitigate the occurrence of future financial crises. Accountability should be made part of the corporate culture which everyone in the organization should follow closely. The need for increased accountability also calls for the use of international standards of accounting. These standards create a uniform way of doing things such that the law can easily catch up with companies involving themselves in poor accounting practices (OECD 14). Europa (6) notes the importance of disclosure of information in maintaining accountability in a company. It is a powerful regulatory tool that enhances transparency and minimizes breach of regulations quite effectively. Full disclosure of company accounts are therefore of great importance in order to minimize fraud. Accountability should also be extended to other departments within a company so as to ensure that employees are doing what is expected of them. This way, the interests of the shareholders are well guarded and the continuity of the business is assured. Exercising shareholder rights The exercise of shareholder rights must be enhanced in order to protect shareholder interests. According to ICGN (3), shareholders should be more involved in assessing the directors’ accountability so as to ensure that their profits are being utilized optimally. They should be in a position to influence major decisions and approve activities that board members undertake on behalf of the business. OECD (11-12) notes that they should also take advantage of their voting powers to regulate remuneration in such a way that their interests are well aligned with those of the directors. Shareholders rights should also be elevated so that they are able to appoint and fire boards. This way, they are able to influence how the company is run to a certain extent. Setting ethical boundaries Tactics aimed at extorting returns from customer’s amount to poor corporate governance and should therefore be avoided. The authorities should device rules to counter any attempts by companies to oppress customers through charging high prices and introducing products that are not beneficial to them despite the financial outlays involved. Each organization should be held responsible for losses and damages that their customers undergo while using their products or services. This would certainly discourage profit-hungry companies which take advantage of customers’ naivety to siphon money from them. Learning from mistakes The effective correction of a mistake can only be realized once the people involved recognize that they erred in the first place. As such, this should be the first step towards avoiding a financial crisis in the future. Company managers and directors should use the recent global financial crisis as a lesson and source of reference in their future endeavors. Accordingly, managers must re-evaluate their strategies in order to avoid mistakes which were made by companies that suffered the effects of the crisis. It is important for the underlying causes of the problems to be identified and the desired actions taken in order to address them. It is highly possible that those involved are likely to be in denial. Such denial could facilitate more failures in the future and should therefore be mitigated. Conclusion This paper concludes that corporate governance shortcomings contributed significantly to the Global Financial Crisis. The financial crisis can be equated to a test; which the corporate governance arrangements did not manage to pass. The failures in corporate governance failed to guard the affected companies against unwarranted risks and eventually subjected them to serious losses. In particular, the inability of boards to understand and mitigate risks is to blame for the irreversible effects suffered by major companies around the world. Notably, there was inconsistency in controls and performance-based remuneration which encouraged risk taking behavior among managers in the financial sector. High risk lending, emanating from financial institutions’ attempt to capture the market and to make enormous profits, cost the sector highly and led to a collapse of various institutions. The need for independent boards is apparent in order to enhance accountability. Further, the idea of using part-time boards is seen as a destructive way of managing a company due to poor communication lines that are likely to exist between them and the executives thus making it hard to monitor their activities. In order to ensure that efficient boards are formed, a number of issues emerge. More importantly however, the need to identify qualifications that directors should posses and the importance of involving shareholders in the selection of board members is highly emphasized. In conclusion, companies need to use the experiences gained during the recent Global Financial Crisis as a learning tool. It should not only be a lesson to companies but is should also serve as a reference point in handling future crises. Companies must seek to correct each of the shortcomings identified in corporate governance to make effective strategies aimed at voiding losses in future. The formation of risk management plans is particularly important since it will be effective in avoiding risk and dealing with the effects of risk in case another crisis occurs in future. Word Count: 5039 Works Cited Europa. 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