Thursday, March 12, 2009

Financial Meltdown and Governability

I was watching a BBC discussion moderated by Nik Gowing at Davos. The eminent panel included a vice-chairman of AIG, a Berkeley Professor (also a board member in a major investment bank), the Guyanese head of state and the Swedish Finance Minister. The moderator and the audience were after the major banks, which had caused the meltdown, while the representatives from AIG and the investment bank were defending their position. The AIG vice-chairman (who is actually not on the board of AIG) said that the $85 billion bail-out of AIG was actually a bail-out of the financial system rather than the bank, much to the amazement of the moderator and the audience! The professor denied that the board members of the bank were to blame, and attributed the crisis to a systemic failure.

While it was amusing to watch the show, it set me thinking on some deeper issues around the meltdown that didn’t seem to have received the attention they deserved – the entire idea of ‘Governability’. The hundreds of billions in bail-out have gone largely into salvaging troubled mega corporations, with their toxic assets, and not to the smaller banks and other financial institutions. In fact, the smaller banks seem to be wooing away business from the big banks because of their stability and proximity to customers.

The question is: has the growing diversity of business under a single umbrella since the repeal of the Glass-Steagall Act in 1999 made governance difficult? Has the complexity of the various financial and derivative products made it impossible for executives and the board to manage the inherent risks in the business? Is there a size beyond which no company can be governed or managed effectively?

Expectations from the board and management

It is expected (and justifiably so) that the CEO and the executive leadership team are in complete control of all aspects of the operating and financial performance of a company. It is also expected that the board has the ability to oversee and govern the company at a sufficient level of depth to assure itself that it is well managed, that the business and financial risks are attended to and that the organization is legally and ethically above board. I would look at this as the basic fiduciary responsibilities of the executive team and the independent board members.
However, as a company becomes large and more complex, there is bound to be a point where the board and management are unable to provide the requisite executive attention and governance oversight to all critical aspects of the business. It is at that point that the company becomes too big to be governable.

How big is too big?
As always, there is no universal definition of appropriate size. It is for the board and the management to determine the point at which they feel they’ve lost control of all critical aspects of the business.
Just imagine the plight of independent board members at any large bank with hundreds of different lines of business, countries of operations, products, exposures and risks. Are they really capable of understanding and overseeing the various aspects of the business they have undertaken a fiduciary responsibility to govern?

Clearly, a Bear Sterns and Lehman, which could not predict their own fall a few weeks ahead of the actual occurrence, were too big. The management and the board were clearly not in control of the business. It is likely that a Bank of America, which looked solid but had to seek a government fund injection soon after its Merrill acquisition, may also be too large to be governed.

There are many factors that have contributed to the meltdown. The pursuit of growth and market dominance at any cost have led companies to bite off more than they can chew.; This has led not just to indigestion, but death or near death. To maintain the integrity and health of our financial systems, it is critical for the regulators to apply themselves to the aspect of governability.

Bringing governability into sharp focus
To bring governability and manageability into focus, we must clearly define the accountabilities of the CEO, his leadership team and the independent board members. We need to clearly distinguish between the corporation, as a distinct legal entity, from its management and board.
When someone is appointed as a CEO or as a senior executive in a corporation, there is an implicit understanding that he would perform his function with diligence. Similarly, it is expected that every independent board member will discharge his or her role with the same level of diligence and professionalism.

It is the responsibility of the management and the board to ensure that the company does not become unmanageable and ungovernable in any way – either in terms of size and / or complexity. This can be enforced by making the executives and board members personally accountable for negligence and misconduct in the discharge of their responsibilities. This is similar to the professional liability carried by any other professional, like a doctor, lawyer or accountant.

While Sarbanes-Oxley brought a level of individual accountability at the executive and board level to the accuracy of financial reporting, it could not prevent the failure of these mega corporations. The need, therefore, is for regulations to go beyond reporting accuracy to adequacy of management supervision and board oversight to the critical aspects of a corporation’s functioning.

The meltdown has brought out the shocking realization that the current form of capitalism is far from perfect and that free market mechanisms can create global havoc. While the economic repercussions have been quite severe for employees and investors, one of the few positive outcomes could have been to take a fundamental relook at the current financial system and subject it to a major overhaul. We have lost a significant part of this opportunity because of government interventions and bail-outs. It is now imperative for regulators and corporations to do what it takes to avoid a repeat of this fiasco. Ensuring manageability and governability is one necessary step in this direction.

Sudhakar Ram
CMD Mastek Ltd

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