27 October 2008:
The principal cause of the credit crunch was not sub-prime mortgage defaults but a failure of corporate governance at banks, according to international accountancy body the Association of Chartered Certified Accountants. The ACCA has published a policy paper, “Climbing Out of the Credit Crunch,” available for download here.
In this paper, the ACCA asserts the following:
“Underlying much of the credit crunch has been a fundamental failure in corporate governance. While the financial institutions involved may have been in compliance with local requirements and codes, they have ignored the key point – good corporate governance is about boards directing and controlling the organizations so they operate in their shareholders’ interests. Boards should be answerable to company owners, to account properly for their stewardship and to ensure both sound internal control and the ethical health of the organizations. The use of overly-complex financial products, which thwarted effective supervisory control, and the unethical advancement, at the point of sale, of loans to people with little realistic hope of repaying them shows a lack of basic corporate governance.”
“In early 2007, few senior managers thought they were betting on the viability of their banks. It appears they did not understand the risks and were using risk assessment with tools which were inappropriate. Boards may not have expended the necessary time and energy, and/or lacked the expertise to ask the right questions.”
I support these conclusions. I find it difficult to believe that a Board would willingly accept the risks associated with sub-prime mortgages if they truly understood the risks. In other areas of a bank, particularly derivatives trading, the use of stress testing to evaluate market risk and historical data to evaluate credit risk, there are good tools to evaluate risk. In the sub-prime mortgage area the tools used were ineffective. Under the COSO Enterprise Risk Management Framework, the Board and management establish a risk appetite for trading activities. If a Board were fully informed, I would expect that sub-prime trading would have been considered high risk, and appropriate checks and balances implemented. Rather, under the existing regulations mortgages were considered low risk and required lower reserves than other types of assets.
I think that there are at least two lessons to be learned:
- Effective corporate governance needs to be implemented
- Corporate governance is no longer a quarterly exercise; it is something that needs to operate on an ongoing basis
On a final note, it is likely that something similar to what happened to policy management under the Federal Sentencing Guidelines could occur, i.e. issuing policies is no longer enough, you must demonstrate that people have read and understood the policies and that there is a mechanism to keep the policies up-to-date.
In the future it may not be sufficient to pay lip service to corporate governance; instead you may need to prove that you have a functioning GRC system in place. This will most likely apply to all industries, not just the financial services industry.
Source: Christopher Fox, CA GRC Group