Regulation

The Gathered Storm


By Marcus Killick, Chief Executive Officer, Gibraltar Financial Services Commission (01/01/2012)

Once in a while everyone gets lost. It could be on an unfamiliar road, it could be in IKEA.  Sometimes we get lost in what we are doing; suddenly finding ourselves stuck without a clue and without a plan. Some get lost more than others but it happens to us all at least sometimes.

 

The curious thing about being lost is that whilst we do not know the right direction we often know the wrong one. We sense that one route, one option is incorrect. When we get lost in a city at night we may not know where the hotel is but we do know the nearby dark alley is not the way to get there.

 

2011 has been the year of governments, central bankers and regulators being lost. Some admit it publicly, most admit in private. The economy is being driven by events beyond precedence and beyond control. Every glimpse of blue sky that appears as an austerity measure is agreed or more money injected is rapidly blotted out by the enveloping storm around us.    

 

Like my colleagues (and if there are those who have a fool proof plan, my apologies but you have been a bit quiet about bringing it forward), I have watched events unfold with horror. The regulatory system has not borne the brunt of the blame for this crisis as government failure sits clearly as the culprit. Nevertheless being innocent of the cause does not absolve one from having to try and be part of the solution.

 

So we are lost. This does not make our situation hopeless but it does require us to regain our bearings. Let us start by determining the directions we shouldn’t be heading in.

 

Firstly we must be careful of relying on the adequacy of the banking stress tests. To date they have failed to act as a warning sign for problem banks. Within months of each test a seemingly ‘safe’ bank has collapsed. Stress tests are extremely valuable but not when they only partially test what is needed.  The exclusion of sovereign debt exposure from a stress test is akin to testing the safety of a car by doing everything except seeing how it would perform in a head-on crash.

 

Next, beware of cosmetic or rushed solutions. The focus on executive pay, whilst morally justified, is a distraction.  Of course rewarding short-termism had an impact on the market and pushed institutions (or rather individuals within them) to make high risk decisions that padded their bonuses. However, the bonus culture is merely a symptom of a greater malaise and it is that which must be tackled.

 

Similarly root and branch reform of a country’s regulatory structure, however laudable, is not really appropriate in the midst of a crisis. Such changes should wait for the more benign weather we will eventually reach.

 

Furthermore, stop pretending that quantitative easing is free of side effects, some of which could be material. Just because the economic environment currently is keeping inflation in check doesn’t mean this will always be the case.    

 

Finally we will not regulate our way out of this crisis.  The plethora of EU directives, regulations and initiatives is overwhelming. Where is the prioritisation? Can’t some of it wait?  If a directive etc is not designed to immediately deal with the existing crisis or is highly material in preventing another imminent systemic problem, shelve it for later. There is a real risk that not only will excessive regulation choke off recovery but may make matters worse by creating systemic weaknesses of its own.

 

If the above are directions down which we should not venture, where should we be heading?

 

I have said, I have no panacea, I know no one who has one indeed I do not believe one exists. Survival will not come with magic bullets but incremental steps. One of these, and one I believe is achievable at low cost with significant impact, is to sort out the issue of effective corporate governance.  I admit that, as a solution, it lacks the thrill of “an attack on fat cat bonuses” but it works.

 

Virtually every failure in the crises (plural, as we have had more than one) has stemmed ultimately from poor corporate governance, particularly weak boards. Sir Fred Goodwin was regarded as an outstanding CEO, yet the very things that made him appear so outstanding were those that bought RBS to its knees.

 

There is nothing wrong with a strong CEO, indeed to be a successful CEO one has to have strength of purpose and belief. However that cannot be allowed by the board to become dominance. Gone are the days when a board was simply a rubber stamp to the executive, yet still the practice permeates through all sizes of financial institutions.

 

Progress has been made, the 2009 ‘Review of corporate governance in UK banks and other financial industry entities, commonly known as the Walker Review, made a number of sensible and effective recommendations, but maybe it is time to go further.

 

To provide for effective board challenge, particularly in complex financial institutions we now need professional non executive directors.  It is this failure, not the lack of cultural diversity that cripples some boards.  We need board members who have the time (and are remunerated accordingly) to understand the risks and impacts of Solvency II, CRD IV, MiFID II, AIFM, the proposal on Packaged Retail Investment Products (PRIPs), in so far as they affect the firm on which they are on the board. We need board members who can question a firm’s exposure to credit default swaps. Such boards will add true value to the companies on which they serve. Their knowledge will restore confidence of that firm in the industry and beyond. They will be truly able to undertake their role of making policy, taking strategic decisions and oversight. Their knowledge will prevent ‘group think’ far more than their age, sex or ethnic origin.

 

I said earlier that I regarded the remuneration issue as being a symptom of a bigger malaise. It is a board that should set remuneration policy and be accountable for it. Trying to regulate it inevitably will result in the individual nature of firms being lost in a ‘one size fits all’ straitjacket. Some firms will find imaginative ways around the issue (by relocation or otherwise) and may, in turn, create new threats.

 

Professional non executives will also be pivotal in ensuring the board and therefore the firm has the correct cultural approach. Here I am not referring to the modern concept of ‘stewardship’ (although it is important) but rather the basic behaviour of the firm. Professional non execs will be far more versed in board behaviour and more able to enforce appropriate behaviour. As the Institute of Chartered Secretaries and Administrators (ICSA) themselves have stated: “Appropriate behaviours are an essential component of best practice corporate governance; and that the absence of guidance on appropriate boardroom behaviours represents a structural weakness in the current system.”  You cannot enforce appropriate behaviour by regulation but a good board can.

 

Good corporate governance will not pay off Italy’s debts. It will not save the population of much of Europe from years of austerity. It will not eliminate the risk of new nationalist movements springing up. It is, however, a vital element in the restoration of core values and principles, which will eventually steer us back to growth.

 

We do not live in soft, benign times. Countries as well as firms teeter on the brink of the abyss.  We may be lost but surely it is better to be lost in a car with someone who can read a map and will shout if they think the driver is about to drive over a cliff.