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Governance in times of crisis

Jane Diplock AO

Chairman, Securities Commission New Zealand
& Executive Committee, IOSCO

Women Corporate Directors
Hong Kong, 20^th May 2009

Introduction

As the Financial Times announced in its edition of 9^th May - "The end of the world has been cancelled for now, if we are to believe recent market movements. Confidence is slowly returning to investors, who have discovered they are still alive after last autumn's near death experience".

Nevertheless there is still a lot of work to be done to restore confidence.

Now firstly, let me say how very pleased I am to be here with you in Hong Kong, a city I have had cause to visit on a number of occasions and one that I admire for its entrepreneurial spirit, openness and vibrancy. Indeed Hong Kong is recognised by the Canadian based independent research organisation, the Fraser's Institute, as having the freest economy in the world. In second place comes Singapore followed closely by New Zealand.

Tribute to Susan

I am not only particularly honoured and delighted to be invited to meet and speak with you wonderful women today at the inaugural Women Corporate Directors function in Hong Kong, but I especially welcome the opportunity to just say how much I, and New Zealand, appreciate Susan Stautberg. Susan has provided ongoing and tireless support to developing many valuable connections between our two countries. Susan is well known through political, diplomatic and business circles in New Zealand for the marvellous networks and strategic guidance she has brought to New Zealand Government offices in the US. I thank Susan for her outstanding contribution over a number of years.

Recently, Susan has also received a significant honour in the US. I salute her as a truly global woman.

I would also like to thank and acknowledge Alice Au, as WCD China Chair. Alice, I have a strong feeling this chapter will very quickly become an important part of the WCD global network.

We do meet in unprecedented times. For many of us, never before have we confronted such profound and resounding challenges in the financial markets and the world's economies more generally. The turmoil in turn is impacting economies around the world, with many in recession or heading that way. The challenges of the current crisis are front of mind for all of us - from politicians to regulators, to regulatory institutions and organisations, to businesses, company directors and consumers. We are all touched in one way or the other.

There are two main thoughts I want to leave with you today. The first is that this is a truly global crisis and therefore needs truly global solutions. The solutions will not be found just in Europe or just in the US - to succeed they must be truly global. The second thought is that this is fundamentally a crisis of ethics.

Quote from John Bogle

Allow me to quote from someone I admire greatly, a co-member of the Financial Crisis Advisory Group, John Bogle, founder and former CEO of Vanguard Group of Mutual Funds in the US. He wrote an article last month in the Wall Street Journal. It was headed "A crisis of ethic proportions", not quite a pun. I quote from the article as follows:

"The driving force of any profession includes not only the special knowledge, skills and standards that it demands, but the duty to serve responsibly, selflessly and wisely, and to establish an inherently ethical relationship between professionals and society."

We have all witnessed a broad deterioration of traditional ethical standards in business going to the heart of good governance.

Corporate governance

Corporate governance is the codification of good ethical standards. It provides a set of guidance tools that ensures, to quote John Bogle again, that "self interest does not get out of hand".

You will all be aware of the essential principles of good governance which, to remind, include - the need to observe and foster high ethical standards; ensure a board has a balance of experienced, independent, skilled and knowledgeable directors; remuneration policies need to be transparent, fair and reasonable; risks need to be identified and managed through good process; directors must ensure the quality and independence of the external audit process. And so on.

Financial crisis

I would now like to share with you some of my observations and comments on the current financial crisis. It is true that macro economic fiscal imbalances between the United States and China probably contributed to the behavioural outcomes in the US. Domestic US policies were also contributing features. Bankers looking for margin at times of low interest rates and generally permissive market conditions also contributed to the financial turmoil. The causes are multifarious and for those of you who have not read Lord Turner, of the UK FSA, elegant report on the crisis I recommend it to you.

It is clear that leading up to the crisis unregulated market forces overwhelmed traditional ethical standards of professional conduct developed over centuries.

The idea which was at large before the crisis that markets would correct themselves has been largely discounted. This idea led to a climate of opposition by some regulators and policy makers to regulatory changes which might have assisted to correct excessive behaviours within markets. It is now clear that the governance of our institutions has been wanting. The inbuilt disciplines that were thought to be self correcting failed and corporate behaviours demonstrated self interested excesses. The challenge for the future is to encourage directors' behaviours along ethical lines whilst also preserving the capacity for markets to innovate.

Corporate governance is enshrined in different guises in different legal systems. It can be covered in company law, it can reside in principles or in guidance but I believe we will increasingly see it in a more formalised style, as the potential for excesses are attempted to be curbed.

Financial innovation which had provided decades of prosperity, began to exhibit the appearance of alchemy through an explosion of complex securitizations. This, together with the credit enhancement of increasingly complex structures that were not readily comprehensible and the apparently externalised risk remaining on the balance sheet of banks created many grey under-regulated areas of the market.

With the benefit of hindsight we can see a vicious chain of events, masked by the sophistication of financial engineering, of products and behaviours, which were fatally flawed. Eventually we saw destabilization of the whole system creating an unprecedented loss of confidence.

By my observation elements in this chain included - undisciplined credit; a reliance on the continuous growth of asset prices; opaque markets that developed toxic products which were over valued, not reflecting the true level of risk; lack of transparency; inadequate infrastructure; investor greed driven by seeking yield without reference to proper due diligence; and markets reflecting perceived rather than true value. Eventually when things went bad the value of sound assets was also destroyed as the real economy bore the brunt of the failure of the credit channels to function effectively.

Banks in particular suffered from having to repatriate risk onto their balance sheets for legal and reputation reasons which in many jurisdictions meant surviving only by turning to the lender of last resort - their government -thus transferring the liability onto the public ledger.

Finally when this bubble of structured products burst, the credibility of the most active market participants evaporated - as did eventually many financial institutions.

The governance gap

I was reading this weeks Economist and noted a special report on International banking entitled "Rebuilding the banks". I thought the report made a number of interesting observations. These include the need for regulators to apply greater scrutiny over the quality and composition of bank boards, and greater care by directors responsible for the appointment of key executives. Directors will need to dedicate more time to reviewing the business and so will need to limit the number of directorships they hold. The role of Chairman and CEO will increasingly separate, with greater scrutiny over the decision making process of both, to avoid "key person" risk. The audit and risk committees should also be separate. Indeed the very ownership model of banks in many cases needs a profound rethink. The Economist comes to a conclusion, with which I agree, that a fundamental improvement in the quality of bank management is the best defence against failure or high-risk activity. We have seen "a rush of empire building madness".

Shareholder interests ahead of agents

Another of my observations would be to recognise what John Bogle calls "the sea-change in capitalism" that occurred when giant companies were governed not by owners but agents. Recently some managers of public corporations came to place their own interests ahead of the interests of the company's owners. Whether it was the profligate lending by mortgage brokers in the US expecting that the risks would be sold on, or the conflicts of interest that lay at the heart of advising on and then rating complex securitized products - the drivers of behaviour were unethical and contrary to good corporate governance.

Remuneration

Another matter that the crisis has highlighted is the issue of excessive remuneration drivers leading to unethical outcomes and short term behaviours in some financial institutions. Managers acting contrary to the interests of their company by remunerating themselves for transactions which, while appearing to benefit the company in the short term, led to the collapse of the entity resulting in major losses. Remuneration structures in financial institutions and the incentive programmes in place are now being examined under the microscope of the global financial credit crisis. As EC Commissioner McCreevy put it "compensation incentives should not only focus on short term gains but overall shareholder interest and long-term, firm-wide, profitability".

In March this year the Institute of International Finance released a report on "Compensation in Financial Services" which concluded with the following remarks: "The challenge for the industry over the coming year will be to mobilise resources in order to design and implement compensation schemes with stronger linkages to shareholder value and risk once and for all ... Banks must retain the lessons learned, maintaining sound compensation practices throughout the cycle, and continuing momentum on changes to compensation even when good times return". This also links into the questions of effectiveness of audit committees and the oversight of auditors more generally.

Just today it is reported that institutional investors in Shell turned on the multi national group and voted down its remuneration report.

Global approaches to the crisis - IOSCO

What has become more evident than ever is that coordinated approaches are vital in today's globalised capital markets. As I said earlier this crisis requires global solutions.

Let me tell you a little about the organisation which has a significant role to play and which I have the privilege to Chair - the International Organisation of Securities Commissions (IOSCO). It is an important part of the global financial architecture. I have the honour to Chair the Executive Committee, the governing body of the organisation. IOSCO has 109 members and is the recognized international standards setter for securities regulation. IOSCO aspires to seeing globally operating markets that are fair, efficient and transparent, markets where investors are protected, and where systemic risk is reduced. As you can imagine, the global financial crisis has caused IOSCO to look carefully at what can be achieved in the area of reduction of systemic risk. It does this not only through promotion of full implementation of IOSCO's 30 Principles of securities regulation in all member states and IOSCO's Multilateral Memorandum of Understanding (MMOU) that facilitates cross-border exchanges of information and cooperation but also through specific projects. We consider that good corporate governance is critically important to the integrity and stability of capital markets. By setting high global standards of securities regulation, IOSCO contributes towards promoting greater corporate integrity and excellence in corporate governance.

IOSCO's work

IOSCO is undertaking considerable work aimed at specifically addressing the current crisis. I am pleased that the G20 Leaders have also recently recognized the significance of IOSCO's role and have endorsed its recent initiatives. Let me share with you several specific examples. Recent work includes a consultation report on short selling which proposes principles designed to help develop a more consistent international regulatory approach.

This work is being carried out by a taskforce chaired by Martin Wheatley, Chief Executive of the Securities and Futures Commission of Hong Kong.

Another recent consultation report deals with hedge funds oversight and recommends regulatory approaches to mitigate risks associated with the trading and traditional lack of transparency of hedge funds. Among other things, it examines whether hedge funds can pose systemic risk.

A taskforce on unregulated financial markets and products is examining ways to introduce greater transparency and oversight to unregulated market segments, such as over the counter markets for derivatives and other structured financial products. This taskforce has just published an interim consultation report recommending regulatory action designed to improve confidence in the securitization process and the market for credit default swaps (CDS)

In March IOSCO published the results of its review of implementation by credit rating agencies of IOSCO's Code of Conduct Fundamentals for Credit Rating Agencies. We also published a Note regarding the use of the IOSCO's Code as the basis for international oversight of credit rating agencies. We have seen conflicts of interest arising in the valuation of securities. What is most controversial and unacceptable is the fact that they helped design these financial instruments and then rated them. This Note was sent to the G20 and proposes mechanisms by which regulators can help assure adequate cross-border supervision of globally active credit rating agencies.

Finally, IOSCO also published a report which contains recommendations to improve the supervision of commodity futures markets and global regulatory cooperation.

All these IOSCO initiatives require the underpinning of good governance. Indeed the failures and weaknesses of corporate governance practices within some companies clearly helped to deepen the crisis. This eventually saw the demise or nationalization of significant global corporations. While I do not suggest that governance failings were the only cause of either the crisis or corporate failure, they were certainly significant factors.

So while much of the visible rescue focus earlier this year has been from a political level and with a prudential perspective in propping up the banking systems around the world, the conduct regulators are also playing a critical part in addressing the weaknesses in the regulatory frameworks to avoid such problems arising in future.

Conclusion

The regulatory solutions for the 21st Century are going to be significantly different from those of last century.

While there has been talk of a global financial regulator, the IMF perhaps, in my view this is a quixotic quest. While there will be greater coordination and cross sectoral work at the global level, it will remain the obligation of national regulators and policy makers to bring about change on the ground. It is my belief that a series of closely networked solutions will be developed and these solutions will require the cooperation of all major players in the global financial architecture as well as commitment at national jurisdictional level. To be effective these solutions will require high sets of robust global standards constantly updated to reflect market changes, effective enforcement capacity across borders and watchful eyes and actions across the world on stability issues. IOSCO is very much part of these 21st Century solutions.

My thesis also extends to the absolute need for ethical corporate governance in each jurisdiction. Good corporate governance is critically important to the integrity and stability of capital markets. Indeed the global model that I have described rests solidly on the foundations of good corporate governance - especially in times of crisis.

To conclude, I would like to leave you with a quote from a speech made earlier this month by the Chief Executive of the UK Financial services Authority, Hector Sants: "The structure of governance in financial companies does not need radical overhaul. The attitudes and competence of the individuals who conduct that governance does. In particular we need to create governance arrangements that foster challenge without creating conflict. The effectiveness of governance is the key issue and addressing this challenge is the responsibility of all of us, not just regulators and boards."

Thank you.

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