Introduction by: Professor Erik Berglöf, Chief Economist, European Bank for Reconstruction and Development

Welcome to the EBRD to this joint event with the CEPR and ECGI, European Corporate Governance Institute. We thought this was an appropriate venue for a discussion of corporate governance; this is our boardroom. And this room takes 150, we have a bit of a lop-sided audience today but you balance it now, thanks.

Of course, most corporate governance experts will say that’s, you know, too many people in the boardroom. And even our 23 plus directors sitting around this table is probably not the model for corporate governance of any institution, but that’s the way multilateral institutions work.

But, anyhow, very welcome to this room, and we are very happy to do this initiative together, these issues of bank governance are very much on our agenda, and have been since we were set up. It’s about a third of our investments in some places in Europe and the former Soviet Union are in the financial institution sector and we are, last time I counted, more than 100 at least banks in the region. So very much the theme of this event, bank governance, before, during and after the crisis, all those aspects are very important to us. And right now of course what we are struggling with is to, you know, what to do during the crisis and how we can relate to, as a private sector institution, a private sector development institution, to the increased state influence in the banking sector. We understand and very much support that this has to be part of the crisis management but of course the long-term concern is for us is how long is this going to last and what would be sort of the outcome in the end.

I’m Swedish myself and we went through something similar in the early 1990s and we still have the government owning a major share in one of the largest banks in the region. So these things can stay with us for quite some time. And of course state ownership in some places in Europe, in the former Soviet Union, it’s not the same thing as state ownership as in western economies.

So I don’t want to be lengthy here, I want to give the floor to Richard Portes, the founder and President of CEPR, and very much someone who has thought about these issues over the years. I want to give you floor and also give you a chance to introduce the speakers; we’re very happy to have a mixture of academic and practitioners on this panel. But Richard, the floor is yours.

Professor Richard Portes, Founder and President, Centre for Economic Policy Research (CEPR)       
Thank you very much Erik, it’s a great pleasure to be collaborating again with the EBRD. CEPR has with EBRD on events in the past and we are very pleased with that collaboration. CEPR was also very much present at the creation of ECGI so that is a long-running affair as well, and we’re very pleased to be collaborating together on this event.

It’s quite right that I’ve been worried about this problem for a long time and I can remember writing papers at the beginning of the 1990s about dealing with bad debts in Central and Eastern Europe and the structure of the banking system and so forth. I don’t know that they’re classic papers but it was relevant at the time. And the issues, I think at least some of the issues, are the same today. The corporate governance is the question that we’re dealing with in this seminar but you might say that’s really a long run issue; what about sorting out the crisis.

Bank corporate governance is different to the governance of other corporations for all sorts of reasons. It’s particularly hard to understand because of course one of the main reasons banks exist is that their assets are opaque and very hard to evaluate. As a consequence, trying to understand whether banks are doing what they do effectively is very difficult to accomplish. They’re also different because bank losses to some extent are socialised. Bank depositors have access to a safety net, which makes them much less concerned about the quality of the bank’s investment decisions than if they had not. And we know from recent events, and we knew before them anyway, that many banks are too important to be allowed to fail. And that raises questions about what we should think about when we address the governance of banks in the first place. Typically, when one talks about the governance of standard corporations, one says it’s got something to do with the enforcement of shareholder property rights, and with creating effective contracts, whether formal or tacit. But it’s not necessarily obvious that that’s the case in the context of banking. If a board simply maximises shareholder wealth one might ask whether, given the presence of the safety net and the too big to fail problem, it does so at the expense of other interested social parties.

So governance is difficult to understand.  Moreover, there are also legal issues in this area. The Banking Act, which has just passed into the statute books in the United Kingdom, incorporates procedures for dealing with insolvent banking institutions, which we’ve never had in the United Kingdom before. And those procedures ran into difficulties to some extent during the legislative process, because procedures for redistributing banking assets were criticised, by the BBA amongst others, for infringing the European Convention on Human Rights, because they undermined the property rights of bondholders. So there are institutional issues with stressing non-traditional stakeholders in the context of banks, as well as theoretical economic concerns.

But it is certainly the case that bad governance in banks is one of the things that has been focused on, whether fairly or unfairly, as a possible cause of the crisis. An issue that has been much in the news, in the United Kingdom at least, is banker remuneration. We know that bankers were highly remunerated generally in cash,  on the basis of the preceding year’s performance, and not generally but often in cash, on the basis of the preceding year’s performance in banks. We know that very often, or at least that it seems very often, that those rewards were for profits that were marked to market;  they were profits in illiquid instruments that were essentially actually being valued according to a model. Some of those profits may have been hard to realise; others were genuine, but perhaps arose because the bank managed to reduce its capital adequacy requirements. For example, this is one of the criticisms that’s been levelled at Northern Rock. Profits that reflect clever management of capital adequacy requirements are perhaps genuine, but they may come at a social cost. Similarly, if the bank becomes too systemic to fail, its share price will increase:  bonuses will be paid, but there is no obvious reason why we should view this as a desirable policy outcome.

Non-executive directors have also been criticised for not asking enough awkward questions prior to the crisis. This is a salient theme in policy discussion in the United Kingdom at the moment. On the other hand, given what I’ve said about the conflicting objectives of banks, we still have to convince ourselves that any of this was really bad for shareholders two years ago.

Another aspect of the banking sector that’s been talked about a lot in this context is the complexity of banks. Banks have become increasingly complex over the last five to ten years. We’ve started to hear the phrase “too complex to manage,” as opposed to “too big to fail,” or maybe even “too big to save,” in the last year or so. It’s not entirely clear that anyone truly understood exactly what Citigroup was doing two years ago. If a bank is truly too complex to manage, is a non-executive’s job really a part-time affair? And what hope do the very dispersed investors that banks, in this country at least, tend to have,  of making sense of a bank’s business? If these are serious concerns, we should ask ourselves how much genuine economic benefit scale and scope expansion generate. So one of the questions that’s closely related to questions of governance in banking is whether stricter competition policy might be a good thing: would it reduce complexity, improve governance, and diminish systemic fragility at a stroke? I don’t know the answer, but I think it’s something that we should be thinking about.

I also think it’s a little harsh to suggest that non-executive directors are in general incompetent. One can look at the UK banking sector and find a bank that two years ago had, amongst its non-executive directors, a former Chief Executive of NatWest; the Chief Executive of a major fund management company; a former member of the  Court of the Bank of England; a Director of 3i, the venture capital firm; and a former PWC partner. That bank was Northern Rock. So I think it’s hard to suggest that Northern Rock’s problems arose because its non-executive directors were stupid, inexperienced or incompetent. But maybe they didn’t fully appreciate the complexity of the business, and maybe they didn’t have the right incentives to reduce the complexity of the business.

So things that one might think about as policy responses that I’ve seen suggested are, for example, giving non-executive directors in large, complex financial intermediaries permanent support staffs of the sort that the monetary policy committee has. The danger of course is that doing so would damage the unitary board, so it’s not obvious that this is necessarily the optimal response. Or the non-executive directors could be given formal reporting roles. So maybe, for example, they should be forced to sign off on pro-forma regulatory requirements. Maybe their jobs should be more like half-time rather than very part-time jobs, with obligations to gather data and to write formal reports to the bank that can be scrutinised and discussed. On the other hand maybe these things are too onerous and maybe they’d make it very hard to find satisfactory non-executive directors. Perhaps that’s something we could discuss.

It has been suggested by policy makers that there should be formal competence and educational requirements for senior bankers. Apparently Terry Wogan  has more banking qualifications than most of the directors of UK banks. So perhaps formal educational requirements are not the point. Nevertheless, there may be a rationale for requiring banking non-executive directors at least to attend some external educational event, so they understand things like securitisation, and the role of the shadow banking sector.

Another thing that’s important in this context is length of tenure. At a time when banking directors don’t tend to stay in their jobs very long, there may be an argument for making non-executive directors stay longer rather than shorter, so at least they’ve seen a large chunk of an economic cycle. On the other hand as I’ve heard other commentators suggest, maybe the key issue here is just personal responsibility and strength of character, which is something we can’t really legislate for.

I have already touched up compensation. The Financial Stability Forum is going to report to the G20 on this before they meet in London. The sorts of questions they will address are whether incentives are sufficiently long-term enough, whether competnation should be spread over the cycle, whether executives lose enough when things go wrong, and, interestingly, why was this never a source of major concern 30 years ago? One reason for that is probably that many of the institutions that paid huge salaries 30 years ago were partnerships, and that’s certainly no longer the case. Perhaps partnerships had better long-term incentives.

On the other hand, partnerships couldn’t be very big. I’ve done work on partnerships myself; one of the reasons partnerships disappeared in the investment banking world was the need for large scale and for high levels of capital. So, once again,  there’s a trade off between scale and governance, and perhaps this needs to be thought about more carefully. One might also ask exactly what the appropriate structure of compensation committees is in the city. When most institutions feel they need to be in the top quartile of compensation, the role of these institutions seems to be to benchmark salaries, and to allocate top quartile incomes.  The long-term impact of this is of course to move the quartiles up.

On the other hand the evidence here is rather limited. We know for example that Dick Fould lost over $650 million when Lehman failed. So it’s not as if he didn’t have any skin in the game. Moreover, Lehman employees collectively lost over $10 billion. Forcing people to hold stocks in corporations may not make them internalise the risks they’re taking any more effectively.

Another issue that’s probably worth discussing today is risk management, which has been discussed a lot. Risk managers and senior risk managers haven’t always had a very high status within banks. They haven’t generally sat on the board, although most boards have a risk committee composed largely of non-executive directors. There are questions to be asked here about the extent to which the risk committees are properly trained, and to which they have a voice in arguing with powerful chief executives. So reporting lines matter, and the design of bonus pools matters too. Should a risk manager be paid from the same pot as the risk taker? I don’t know exactly what the statistics are on this, and I’m not sure that anyone does. But it seems clear that many risk managers were not paid from a different pool.

There are also questions here about the impact of regulators upon risk management. When regulators base capital requirements on internally generated measures of risk, one has to wonder what the consequences of better risk assessment would be for capital requirements. And if the consequence will be an increase in capital requirements, to the extent that capital requirements are expensive, perhaps the incentives to do better risk assessment are somewhat attenuated.

I'm running out of time, but I'll just note some related questions concerning the role of ratings agencies. Does the recognition of ratings agencies by regulators undermine risk assessment incentives, and cause banks essentially to step aside from some of their responsibilities. A related question,  which I won’t address now, is whether audit committees have enough power, and whether audit committees particularly are sufficiently involved in the risk management activities of the firm.

A final point, which I’ll stop on, is the importance of whistle-blowing in this industry.  This has been much in the news. Paul Moore was head of Group Regulatory Risk at HBOS between 2002 and 2005. According to recent evidence that he presented to the House of Commons Select Treasury Committee, he was fired for blowing the whistle on excessive risk-taking in the firm. Harry Marcopoulos blew the whistle on Madoff to the SEC, where he says that officials were too slow, too young and too under-educated. Whistle-blowing has been in the news again over the weekend, in the context of Barclays, who, I have to stress, have done nothing illegal.

In this area, we could perhaps learn from other regulated sectors. The regulation of industrial cartels in the United States has arguably been improved by rewarding whistle-blowing. The first member of a cartel to come forward and acknowledge its existence can in some circumstances avoid penalties. Perhaps there’s scope for doing something like that in the context of banking, where whistle-blowers appear, notwithstanding rhetoric to the contrary, to have been squashed in recent years.

Those are all the points I was going to make to start us off.

Professor Richard Portes
We now turn to Marco Becht, who is professor of economics at the Free University of Brussels, Universitè Libre de Bruxelles, and a stalwart of ECARES there, the research centre, but also the Executive Director of European Corporate Governance Institute; Marco.

Professor Marco Becht, Professor of Finance and Economics, Solvay Brussels School of Economics and Management
Thank you Richard, well I shall be very brief since we do not have that much time. The theme of the forum is the corporate governance before, during and after the crisis. So I shall give you my 30-second views on the before, during and after.

Now first of all on the before, I completely agree with what Alan said. We do know that corporate governance was a contributing factor to the problems that banks have experienced. However, I think we do not yet know what exactly the common theme to those problems were. Alan has already mentioned the remuneration issue; let me just add another perplexity to this, which is the ownership structure.

I think a simple analysis, corporate governance analysis, would suggest that the trouble at the US banks was due to dispersed ownership and a lack of shareholder rights at those banks.

I think that this view really fit the facts, because in the UK there is certainly no lack of shareholder rights, however, widely held banks did get into trouble here. If you move to the Continent, we have examples of banks with block holders that are in trouble. And in Germany, and this is a particularly disturbing fact, the banks that got into serious trouble there were the banks owned and controlled by the state. In fact banks supposed to lend to the Mittelstand suddenly got into student loans and securitised mortgage lending in the United States; we do not exactly know why. Well we know why but clearly that is a different problem we have in the widely held banks. So I think whatever the answer is there are probably multiple problems here and there is no one single answer to what the problem was before.

Now turning to the during, I think we are now at a very delicate moment of this crisis. Because if you see the stock market, the memo circulated by the CEO of Citigroup seems to have convinced everybody that the crisis is over. We might learn over the next two months, maybe this afternoon, that this is not true. Government has taken ownership positions in banks, but so far has refrained from taking full control. I personally side with those commentators who say that this is not enough to stop this crisis. Government has to go further and unfortunately take full control of the banks. I personally think that this is the only way in which we can solve the lending problem. It is also the way we can solve the toxic asset-pricing problem. I think it is also the way we can solve the problem that banks do not want the government money because they do not want the restrictions that come with it. And I think what we see at Barclays, trying to sell iShares, is just a warning of what CEOs are willing to do: selling off the family jewels and the silver, in order not to take government money.

Now turning then to the after, well the after, of course, who knows; it depends what happens in the next two months. I think one important question from a governance point of view is if are we going to return to the situation before, namely the governance of banks is left to shareholders and government comes in through prudential regulation. Or does government have to get involved more closely in the governance of banks through equity stakes or by actually appointing people to the boards of banks. This concludes my initial comments.

Professor Richard Portes
These are the questions. We have not got easy answers to them. I have on my left two well-known experts in these issues and I don’t know whether they want to come in now or respond to discussion from the floor. But we have Leo Goldschmidt, who is a Director of ECGI and the former Chair of the Belgian Banking Institute. And Antonio Borges, who is the Chairman of the European Corporate Governance Institute and has been for several years, but is also now the Chair of the Hedge Fund Standards Board. And so concerned very directly with corporate governance issues there as well.

Antonio Borges, ECGI Chairman
I’ll be brief but I’ll at least contribute to the discussion by presenting slightly different perspectives on the issues that were raised. Clearly the questions that were put on the table, in particular by Alan Morrison, are the right ones in many ways and the ones that concern us all today. Unfortunately most of those questions do not have an answer just yet, and we still need to do a lot of work to understand things a lot better.

Indeed banks are different; and therefore corporate governance of banks cannot be looked at in the same way as in other organisations. A very important part of this is indeed the complexity of the business. Banking and finance in general, have evolved extremely rapidly, creating very complex products through very significant innovations. I think myself that these new products are good and that we need them. We just have to know how to manage them and how to govern this process of innovation. I would be extremely unhappy if, as a consequence of the current crisis, we decide to go back ten, twenty or even thirty years to a simpler form of finance which would respond a lot less to the needs of the world and in particular to the ability to deal with risk, which is so central in our modern societies.

Let me just clarify one point about this issue of complexity. Keep in mind that complexity does not exist only in sophisticated investment banks, hedge funds and other places. Think of the insurance industry, for example, or the re-insurance industry, which are absolutely crucial to our modern world. These have some of the most complex systems to deal with risk that one can think of. In fact one needs to be a real specialist to understand most of what’s done in the insurance and re-insurances industries. If we were to say we will only deal with what we understand, we would eliminate most of modern insurance and re-insurance.  This would be a major disaster. So the whole idea of complexity of finance is an issue that is a challenge indeed, but one that we have to deal with quite carefully.

Complexity does present a very serious dilemma for corporate governance. It is quite right to say that most board members, especially non-executive board members, and, I would argue, even some of executives, even some of the CEOs of these financial institutions, do not understand a large part of the business that they are involved in. How can they govern the corporations if they don’t understand what’s going on? On the other hand, how could anybody possibly understand every dimension of the risk-taking that these institutions undertake when they are so specialised and indeed so complex?  This is one of the most significant corporate governance challenges that we have to deal with.

Even people with great financial experience may not be fully aware of all the risks that are being taken. In fact I’m prepared to say they can never be fully aware of all the risks that are being taken.  The diversity of risks, of products and of innovations that take place in a modern, advanced financial institution is just beyond the comprehension of a single person. So how do we deal with this?

The other challenge is that the whole idea that compensation alignment will solve the problem. I won’t spend too much time with this.  The data that was just presented is sufficient in itself. The institutions that failed caused absolutely gigantic losses to the individuals that were running them. There can be no argument about alignment. So what we have to conclude is that alignment of compensation with shareholders’ interest is just not enough; it’s not sufficient to solve the problem. There must be some other issues in place.

I’d like to just add two more points. One is that most of the problems that we have gone through are of a collective nature, of a systemic nature if you want. And that raises the bar to a much higher level. Many people within their individual organisations thought they were doing the right thing; they thought they were managing risk appropriately; they thought they were prudent managers or directors acting in the interests of shareholders. They just didn’t see the tsunami coming because it was of a systemic nature, much larger than matters relating to their own organisation and their own strategies and risk policies.This is where the issue becomes far more complex. If policy makers, central bankers and top supervisors of all these advanced countries did not see it coming, how could we expect a non-executive director in a banking institution to be more prescient, more knowledgeable and better informed.

The other point that I’d like to make is that there are some very serious differences across the universe of finance. Some institutions emerged much better than others from the crisis. Some in fact that had almost no involvement or were not affected at all by the crisis. How come certain banks, commercial banks, investment banks, came out of the crisis almost unscathed with virtually no impact while others went really overboard and ended up bankrupt? Where is the difference?  Where is the difference in corporate governance? Can we look at the composition of the boards of these institutions and find any particular differences? In my view, no.  In my view the main difference is that if we look at the reasons why some of those that came out better, it’s because they had in place risk management systems and procedures that were far superior to the others or because they had an attitude with respect to risk in general that was a posteriori revealed to be superior and far more appropriate to the circumstances.

Who is responsible for that? Who put in place these risk systems? I’m not sure that it was the board. It was mentioned here today that in some institutions, the people in charge of risk management had virtually no power. I can tell you that in others they had all the power and that makes all the difference.

So the point I’m trying to make is that what the people in charge of corporate governance should focus on is not so much micro management of the organisation; it’s not so much to try to make sure they understand every product that’s being sold or proposed. It is to make sure that there is a proper balance between those very active, commercially-driven bankers who want to generate revenue and those who have the responsibility to look at the risk. There needs to be a proper attitude with respect to risk in place and proper distribution of power. If I was a non-executive director of a banking institution I would focus a lot more on that than on anything else.

And I have also witnessed changes in people younger than myself when they succeeded me. I left my Bank 20 years ago. And I have observed these younger people having a completely different attitude towards risk and towards commercial drive. We were considered old fogies, antiquated and outdated. In addition the younger generation had incentives that were not only oriented towards the company, the Bank, but increasingly towards their own personal interest. And this is all the more important when they have no direct connection with risks that they take or certainly no sanctions that they can see. That can lead to an attitude of hit and run.

So at slight variance with Antonio, alignment of interests may to a certain degree be part of the solution - and perhaps not only at the very top. Where I very much agree with Antonio is that on boards you will not find people who are competent in every facet of what the bank has to manage and to market. But they have to see to it that the structures are in place and certainly the most important thing is their own attitude towards risk and their sense of responsibility.

Professor Richard Portes
So here we are; we’re just at the stage that in order to give us a little bit of disagreement, I would say I’m a little sceptical about the incentives story here and the alignment of interests, in particular in partnerships. The point about partnerships it seems to me is that they can’t be too big. And that we have got to the point where a number of these institutions are not only too big to fail or too big to rescue, but also too big to manage. And that it may be necessary to break them up in order to make it possible to have effective corporate governance.

And if you take the example that Antonio raised about insurance companies and their risk management systems… wonderful risk management, absolutely right. But if you put next to an insurance company, under the same hat, a hedge fund or whatever, that’s writing a lot of CDS contracts, like AIG did, they might have been in the same building but they weren’t in the same ball park. And they certainly were not subject to the kinds of risk control that was being applied in the insurance side of the business.

And the answer is to date they can be too complex to run effectively. This I think is a fundamental issue, whether governments do take control or not, is that they will have to face whether in the process of divestment, whether to break these institutions up. Or simply in the regulatory capacity, on competition policy grounds or on broader regulatory grounds, whether they think that these institutions are too big to handle in the modern, complex risk environment that they face.

We’re open to interventions, whether they be interventions or straight questions and please just state your name and whom you’re representing if that’s appropriate.

Mrs Patricia Jackson, Partner, Ernst & Young
A lot of the focus on incentives is on individual bonuses, but of courses there’s another whole aspect to the incentives that probably ought to be debated. That is the very high return on equity targets that the banks had set and were being demanded by the shareholders. Now in order to achieve those a lot of divisions within the banks, including the treasury operations, were given such high profit targets that they had to meet that actually they had no choice. They had to go into structured projects. So I just throw that into the mix.

Paul Arlman, Chair, Dutch Chapter, Transparency International
I’d like to underline Alan’s last point about whistle-blowers. When you analyse the actual protection, whether legal or outside legal, of whistle-blowers anywhere in the world, they’re deeply insufficient. And I’m quite sure that Alan has read the articles about King Lear and the whistle-blowers in the Financial Times in the last two weeks. So I would argue that in banks like in other enterprises, better protection inside and outside of whistle-blowers would be a great step forward.

I have a second point, which I make with a certain pleasure seeing that among the speakers there are six different nationalities. My point is a very simple one: it is to require any company including banks to have at least one non-executive director who doesn’t come from that country and who brings a foreign element. And lest there be any misunderstanding, Chairman, I do not suggest that that foreigner would be the whistle-blower. Thank you.

Professor Richard Portes
Well, Marco is very familiar with the actual data on foreign representation in corporates more broadly, not just banks, in Europe. But I don’t think he wants to recite all that now. But it’s quite interesting actually if you look across institutions, the relatively low degree of foreign participation in directorship in boards, with the exception of a few, typically small countries where foreigners are brought in.

Professor Marco Becht
Unfortunately academics play the role here of saying sorry it is more complex than you thought, which is not really very attractive when you try to resolve a crisis. But I think it is an important part of our role to gather and point out empirical facts. Fortis had a very international board; it was the most international board of all Belgian companies. It was also a fact that when the crisis hit none of the foreigners participated; it was essentially the Belgian directors who signed the appropriate documents and dealt with the politicians. So I think it is one thing to have foreigners when times are good and they give advice; it is  another thing when the crisis hits. There were non-Belgian directors on board. Maybe when people have the occasion to meet them privately, just ask how much they got involved in or how much they were consulted during this crisis period.

Chris Olson, Senior Evaluation Manager, EBRD
I want to thank you first of all for a very interesting panel discussion, brilliant contributions to many problems that people at EBRD are going to be thinking about and working on. I’d like to comment on the observation that this was a systemic problem that wasn’t detected and where could that have come from. One of the characteristics I think of so much of the financial innovation over the last decade was related to ways to externalise risk from financial institutions, and transfer risk out of, through financial institutions, out of financial institutions. And there was a greater and greater reliance on a public good which is called liquidity, which is a very delicate and scarce good in fact. But so many of the structures, particularly the ones that were structured and rated, relied increasingly on repayment in stress scenarios through liquidation of assets, be they bonds or collateral of various kinds.

I wonder if some of the institutions that did better in this crisis were less reliant on trying to externalise risk in different ways, perhaps kept their businesses closer allied to underlying cash flows and didn’t count on externalising their problems. And so of course when everyone wound up having to dump their assets, the liquidity that was assumed to be there was of course not there.

Antonio Borges
I’d like to comment on this and also link it to previous points from the audience. It is very appropriate to focus on liquidity.  I would argue that the root of this crisis was excessive liquidity for way too long time.  This led to a search for profitability under conditions that were extremely favourable from the financial point of view and to a massive underestimation of risk. Under these circumstances, it is not surprising that the vast majority of financial institutions fell into the temptation of underestimating risk and then got into very serious trouble. Management of liquidity overall and therefore of monetary policy, has to be centre-stage if we want to have a more stable financial system for the future.

My second very important point is that there was a demand for very high returns on equity. But this does not explain the differentiation across institutions. Some of the institutions that survived better, that did better, that were more immune to the crisis, (and I would single out Goldman Sachs and the Spanish banks as examples) had probably exceptionally high return on equity and yet none of the exposure to risky assets and to some of these more damaging consequences of this financial crisis. So the difference must be elsewhere.

The difference is which of these institutions understood risk well and which did not. Did some institutions externalise those risks or did they internalise them? You can take all the risks in the world and you can set up all the systems in the world to deal with risk. You can then transfer the risk to the investors. But if you’re a financial institution and keep them on your balance sheet, you’re taking risks with money that’s not yours and that’s a totally different story.

So to go back to Richard’s point, if hedge funds want to take risks and fail, it’s their investors that bear the consequences. They should know what they’re doing; there is no systemic risk. When Argentina went bankrupt, lots of people throughout the world lost a great deal of money. It was a massive bankruptcy of $60 billion or something of that nature: no systemic risk whatsoever. All that risk was in the hands of individual investors throughout the world.

If a bank like Goldman Sachs sets up risky products and sells them to their clients, fine. If a bank like Lehman Brothers takes those risks on their balance sheet, and then they cannot deal with them, then there is systemic risk; it’s a totally different perception of things. And this is precisely the point about AIG operating as a hedge fund, not understanding the credit-default swaps market sufficiently and taking risks with money that’s not theirs in a way that if things go wrong it creates a massive systemic problem.

There is an issue here. It’s not so much whether we want to keep on taking risks or not, which I think we do, and we have to. It’s not so much whether by taking risks we will have institutions that fail, and they should fail. It’s only if we take risks that lead to failures that create systemic risk, then we will have a massive problem. This is the discussion now: how can we, for certain crucial institutions from the point of view of systemic risk, restrain them from taking risks that they shouldn’t. That’s the point that’s on the table very much right now.

Paul Lee, Director, Hermes Equity Ownership Service
I’m nervous about the suggestion that the large paper losses made by Lehman executives sort of undermines the argument that alignment between shareholders and executives is a powerful tool. I think it’s important to think about the structuring of pay and also the psychology of pay.

Lehman, in common with most of the investment banks, had a system whereby roughly half of annual bonuses were deferred into shares. Lehman actually deferred them into shares for longer than most of its peers. There are two problems with that. Firstly there is a huge lack of alignment between the executives and client interests and shareholder interests by it being driven solely by annual bonuses. Because clearly what we have seen beyond doubt is that only looking at performance in a single year does not actually tell you anything about genuine performance, either for clients or for shareholders.

But secondly the use of deferral into shares, if you think about the psychology from the perspective of the executives, actually reduces the importance and the value of those shares to them. This is because they feel intangible to the individuals. I think therefore actually we need to be clear that the structures that we did have were not aligning interests in any way. And the fact that people lost money on paper doesn’t undermine the argument that we need to move towards greater alignment of interests.

Professor Marco Becht
I agree with Paul’s intervention. I think it goes to show that the whole issue of designing these incentive contracts is in fact complex. And I think empirically we do not know yet what went wrong in the ones that were there. And of course the challenge is to design new ones that also take into account what Antonio mentioned, which is the systemic risk. Because that of course, even in your scheme, is not figured in at all. What is the contribution of an institution to systemic risk which, even if you take a long run incentive for a particular institutions, you do not factor in at all. So I think we have to come up with schemes that address this problem.

I also want to use the opportunity to rebalance what we said before. Listening to ourselves just now we sounded a little bit like Chuck Prince. The music was playing and we could not resist; we all heard it; we were all innocent. I think this is not what we have been saying. There have been people who were running scams. There were individuals who pushed loans onto poor minorities they knew should have never borrowed; they then repackaged these loans and sold them with misleadingly high credit ratings to managers of other peoples’ money . In fact, many people and institutions were involved in this transformation process. And I think we also have evidence that many of these people knew perfectly well what they were doing. So I think we should not sound as if everything was collective myopia.

I do not think everybody in the financial industry was involved but many people were. So I think some of the public anger is justified and once we get our tax bills to make us pay for the bailouts, I think the anger will become even more widespread. So I think we just should be very cautious and not say this was all a tsunami and everybody is innocent. It is a half-truth and would lead us to the wrong conclusions.

Professor Richard Portes
Yes, well certainly the ratings agencies carry a substantial burden of responsibility, no doubt about that. Whether we’re pursuing the right path in dealing with that problem is another matter, which takes us away from this panel.
 
Nadeem Mujtaba, Managing Director, Gulf Ventures Corporation
I’ll try and bring a perspective from an emerging market compared to the developed market perspective that I’ve been hearing. The extent to which a number of financial institutions that have been affected by this tsunami, in a number of emerging markets, is somewhat different than the developing market. And the hypothesis that I would like to raise as a result of that observation is something similar to what Antonio was saying. That is the attitude towards assuming risk and attitude towards managing risk.  Many of the emerging market institutions did not have or did not think that they had the capability to understand those risks. This could be one explanation for that.

I will give you examples of “Islamic” banking where, for different reasons, certain risks were not assumed. But it comes down to attitude towards assuming certain risks, which then led a number of emerging market institutions to remain more towards less risky types of businesses, doing things that they understood rather than doing various other things that they did not understand that well.

I guess the challenge in a developing market context is you can’t put the genie back in the bottle. Complexity is here to stay; the risk management tools are here to stay. Which organisations should be allowed or not allowed to take some of those risks, and how do you govern them? So I’m trying to segment it a little bit and to say where from an emerging market perspective, do we see the issues are. Thank you.

Dr Filippo Vergara Caffarelli, Economist, Banca d'Italia
I have a question actually originating from a comment made by Marco Becht on the relevance of the ownership structure for a bank's exposure or vulnerability towards the crisis. I've been recalling some of the banks which haven't been hit that badly and I was realising that some of them, or actually those I could name, had quite a concentrated ownership structure. I'm thinking of some banks in continental Europe and I was wondering how much that is actually a common feature of this type of ownership structure. Thank you.

Professor Marco Becht
I do not know yet. Give us a year and there will be at least five studies on this. And then we decide which one is the one that is accurate. I think we have too much anecdotal evidence; we need to go back to the lab and work on it.

John Cooke, International Financial Services, London and a former insurance regulator at the Department of Trade and Industry
I’d really like to follow up on the question that’s just been asked. Because I’d be interested to know what the panel thinks about the role of regulatory institutions in approving or barring directors according to whether they are fit and proper (in the classic terms of “probity, competence and financial standing”). My impression is that the whole question of fit and proper has rather gone away. In the UK the risk of judicial review has I think led regulators to fear that unless a proposed director actually had a criminal record it might be very difficult to enforce a ruling that they were not fit and proper. And yet it is an absolutely basic tool of governance and regulation. So I’d be interested in views on whether this could or should be strengthened.

Professor Richard Portes
Well the FSA long maintained that the right way to deal with hedge funds in particular was fit and proper. That was the only regulatory assessment if you like, or intervention, in hedge funds. And maybe that was the right policy. I think they applied it fairly seriously. But Antonio may have some comment on that.

Antonio Borges
With respect to hedge funds, I have no particular comment. It’s important to note that hedge funds are regulated in the UK.  The FSA has the right to authorise or not authorise them. The ‘fit and proper’ quality of their leaders is a very important dimension of this. Furthermore, the FSA also has the authority if they want and whenever they want, to supervise or actually to oversee what hedge funds are doing or not doing and whether hedge funds are or not following the FSA principles.  These principles are not detailed in very concrete terms for hedge funds but are always applicable. This is an important point to keep in mind because this is very different from the regulatory environment for hedge funds elsewhere in the world. This makes it a lot more difficult to have something like Madoff happen in the UK in the same way that it happened in the US.

Now this said, I think that a very important element or fallout of the current crisis is indeed the individual responsibilities of directors and whether or not we’re going to go back to a more serious assessment of whether someone is ‘fit and proper’ to run a large financial corporation. There have been quite a few cases when people have failed their duties as directors and this should not be swept away.

Dr David Ladipo, Advisor, Nestor Advisors Ltd
I’d like to pick up on a point that Antonio made about the focus on return on equity. One of the things that I’m doing at the moment at Nestor Advisors is a study of 25 European banks. And I’ve been looking at the banks that had rather spectacular increases in their return on equity in the three or four years in the run-up to this current crisis.

And what’s interesting for me is to de-compose the return on equity into an increase in return on assets and an increase in leverage. Banks like BBBA and Santander, which had, as you said, rather impressive ROE figures, did not have a spectacular increase in leverage. Whereas other banks, it’s probably safe to pick on UBS so I’ll pick on them, did have a rather spectacular increase. And it was so spectacular that if you had stripped out the leverage component you would have actually had a decrease in return on equity.

There are other banks as well that fall into that same category.  If you think about the non-executives’ role in those banks, you would say they should not have been dazzled by the return on equity figures. They should have realised that it was driven by leverage, and they should have realised that in effect, there was a decrease in economic profit or economic value added, as a consequence of that increase in leverage. Unfortunately if you look across the banks you see that their cost of capital, which goes into their EP figures, remained invariant to the leverage mix.

So when I look at that I think to myself I can understand why the non-executive directors would see an increase in economic profit; they would say these are very sophisticated models by which we arrive at these numbers. We must be doing something good. And I think to myself well what we need at the moment is some mechanism to enable non-executive directors to step back and not be dazzled by these models. And do what the Canadians did, for example, which is put a floor on leverage. I’ve yet to hear of a Canadian bank that’s sort of blown up in a way that we’ve seen in Europe or in the United States. I just wondered if any of the panellists had any comment on that.

Professor Richard Portes
Just that the Canadians are very, very proud of that. I was in Toronto a couple of weeks ago and I can tell you. They think that one of the things they’re bringing to the table at the G20 is that they’re better than the others in this respect and indeed, they and the Spanish too, have had relatively successful bank regulatory systems.

Chris Pierce, Global Governance Services
My perspective is that it is the boards that have failed us. The boards are responsible for setting the corporate governance regime and there are other gatekeepers, there are other stakeholders, that influence corporate governance. But essentially, it is the board that focuses upon directing and controlling the company. And I don’t see it necessarily as being the risk management system that has created the problems. I think that’s further downstream of the problem; I go slightly upstream on it. And I ask two very simple questions of  directors.

There are two areas that directors should know about: one is in terms of the products, and the other is in terms of the markets that they operate within. And I think many directors within financial institutions are totally unable to articulate what products they are dealing with, and this is essentially due to securitisation. And so we get examples of parliamentary select committees asking what is a CDO squared and individual directors of banks not being able to give  explanations as to the products that are currently offered by the bank and the related complexities of some of the securitisation. And directors should be able to answer that. If they can’t answer it, who can within the organisation?

And secondly, they are unable to articulate the markets. They are able to say we operate perhaps in certain geographic areas but they are not able to use more sophisticated segmentation models in terms of the markets within which they are operating. And therefore if they can’t articulate products and they can’t articulate the markets, they are therefore totally unable to articulate any form of risk associated with those two key areas of operations and activities. Thank you.

Gian Piero Cigna, Corporate Governance Specialist, EBRD
Well, first of all thank you very much for this very interesting panel discussion. I guess there are two main issues that came out from the discussion.

First of all that corporate governance for banks is different; banks are particular corporate animals different from other kinds of companies. But if we look at the corporate governance benchmarks, let’s say, the UK combined code, we don’t see any difference in the approach to banks.

And the second issue is that there’s been a lot of discussion on risk. Going back to the UK combined code and all the guidance, we see very little reference to risk management committees. I was recently reading a report on assessment of 25 major banks in Europe: risk management committees are present only in the minority of banks, something like 40%.

So, going back to the team of the conference, my first question to the panel is: “are we going to see a sort of formalisation”? If really risk management is so important, which I think it is, because it’s part of the banks’ business: are we going to see the formalisation of the risk management committee, as a body that best practices will recommend be present in all banks?

And then my second question is on independent directors. What is strange enough is that all banks that actually suffered from the crisis had independent directors: all of them, without any exclusion. So maybe we focus on the wrong issue?

According to my understanding, non-executive independent directors must have a clear understanding of the risk, especially when they sit on the board in the risk management committee. But when we see today’s banks’ business, maybe the business became too complicated. So, should we think about two concepts of corporate governance: one for commercial banking and one for investment banking?

Professor Richard Portes
Thank you very much. I think we’ve had quite a wide range of questions and comments and I just wonder if anyone on the panel would like 30 seconds each or a minute each to respond in the end.

Professor Marco Becht
I personally think we haven’t seen the end of this. And I wonder what will happen next week.

Professor Alan Morrison
I too have no idea what will happen next week. The things I take away from this discussion are that complexity is terribly important and non-executive directors ought to understand their businesses. And that perhaps we need to think a little harder about the formal constitution of board committees.

Antonio Borges
I fully agree that leverage is indeed a very serious issue here. There have been radical moves in leverage which should have been contained, and indeed boards might have had a role to play here. Many people have pointed out that hedge funds are a serious risk to the financial system because they’re highly leveraged. Hedge funds were leveraged, 2:1, 1.8:1, a year ago and two years ago. Now they are leveraged 1.4:1, meaning 40% versus 100% of equity. Banks, in particular some of the banks that are in the newspapers everyday, were leveraged at 50:1 or 40:1.  This is indeed is a totally different ballgame.

Going back to my earlier remarks, if you have massive liquidity in the system and if the monetary authorities flood the system with liquidity, it is extremely difficult to resist. You can blame the boards for everything but there is a point when you just cannot.  When everybody’s doing it, you just cannot refrain from it. It takes a lot of courage and understanding not to go with the flow.

Another point - the degree of understanding of risk is extremely important to bear in mind. Emerging markets are one example: “we don’t understand these things very well, let’s stay away from them”. Contrast this with AIG: “we don’t understand these things very well, but we go into it anyway”. Whether you understand or don’t understand risk, this is one area where the board might have something to say.

I’m all in favour; indeed the ECGI mission is to give boards more authority and more power. But if you require board members to understand all the products they’re selling and all the risks that the company’s taking, you’re demanding too much. Very few executives in the automobile industry understand how an automobile works.  Do the boards in pharmaceutical industries fully understand the science behind the products that they’re selling? If there was a demand to have that kind of qualification for board members and non-executive board members in particular, you wouldn’t get anybody onto boards.

Leo Goldschmidt
Yes, I think that we’ve seen most of this before except for two things. One is complexity, which was abundantly underlined; and the other is the international trend, the global character.

On complexity, various things have been proposed. You yourself Richard spoke about breaking up banks. That is a possibility; we’ve had separation of activities before – but we’ve dismantled it. The Glass Steagall act in the 1930s was about that, and we’ve done away with it. So there should be a deep reflection on whether something of the sort should be reinstated.

Regarding the global aspect, we have seen that supervision has abundantly failed. It’s a very difficult the problem because on top of the individual interests of banks, there are national interests that come into play. And so one of the big regulatory issues today is to figure out whether we want inter-national cooperation or whether we want supra-national supervision. These are things that will be addressed. The de Larosière report is essentially about that but hasn't yet gone to the bottom of it.

Professor Erik Berglöf 
I just want to thank everybody for coming. I think the, you know, I’m, as you know, worked for many years on corporate governance before coming here. And it’s quite humbling to try to translate this sort of role of an academic commentator to actual design of corporate governance arrangements that we have to think of in basically every single investment that we are making. And I think one feature that really stands out, and it stand out particularly now in this crisis, is this contextual nature of corporate governance. And of course it’s nowhere clearer than in corporate governance in banks, where you have, Marco gave the example of Fortis. But there are, you know, we see it now in every bank crisis in or crisis individual bank in the countries where we operate. That you have this international component; you have the local, national component, you have the relationship with, this is one of the most regulated industries, you know. The regulators, supervisors, you know, it’s an incredibly complex business.

And I think what comes out, to me at least, is and several of you have focused on it. It is that in corporate governance we were not focusing enough on risk before. And, you know, how to build in procedures for risk. And I think this is something, I think, works, whatever context you are dealing with, I think, that’s an element we need to think a lot more about. And also how we defend risk interest inside and some comments have been referring to that, inside organisations.

Leo was saying, you know, we should have known, I mean, you were trained by people who experienced the Depression but, you know, I come from a country that went through this kind of crisis, you know, less than 20 years ago. And at the early stage of the crisis, the Swedish banks were all saying, you know, we had this experience and we are well protected, we are well prepared for this. But actually in the end it was a slightly different kind of risk, and we know that every crisis has its own features.

So both in terms of the contextual nature of governance and bank governance but also the historical context, and what we learn from previous experience, I think we have a lot more to do.

Thank you very much for coming and please enjoy the rest of the day.