Paradise questioned Featured

7:00pm EDT February 23, 2009

The financial crisis left many economies, including our own, in a “disastrous twilight.” Among the casualties of the crisis are debunked ideas and practices, failed institutions and tattered reputations.

Smart Business talked to Timur Gök, an instructor in the Department of Finance at Northern Illinois University, about corporate governance mechanisms, risk management practices and what the future may hold.

What is corporate governance?

Corporate governance is the set of rules that shape and constrain how effectively corporate managers deliver on their promises to investors in general and shareholders in particular. The rules may be explicit or implicit; they may be defined by laws, regulations and social norms. For instance, in the U.S. the fundamental promise is to enhance the value of the firm. The financial crisis is partly the outcome of failed governance mechanisms that led to the violation of that fundamental promise.

How do we ensure that promises made are promises kept?

The basic problem is that shareholders to whom promises are made have limited involvement in corporate decision-making, are less informed about corporate actions, and rely mostly on boards of directors to manage and monitor corporate management. Rules and sanctions support this system, but they alone cannot solve our problem. As any effective parent, teacher or supervisor can tell us, the linchpin of the system is incentives, and in the corporate world, a big part of that is compensation.

Poorly structured compensation schemes have led CEOs of several large financial firms to take on ever greater risks to boost their short-term compensation at the expense of the long-term viability of their firms and indeed of the entire system. Corporate boards of directors approved and oversaw the compensation schemes. We must revisit how compensation schemes are designed and how performance is monitored and rewarded.

What are some of the issues beyond performance and rewards that led us to where we are today?

Closely tied to the failure of performance and reward mechanisms is the failure of corporate risk management. At the quantitative level, no one can any longer ignore the fundamental shortcoming of models that were built on the assumption that volatilities and market declines that we experienced over a matter of days were supposed to happen once every million years! So, a top priority is to develop and deploy better quantitative tools. We also have to be much more diligent about systemic risks.

However, better models and a heightened awareness of systemic risks are unlikely to keep us out of trouble. Even with our limited tool-set, there were warnings about troublesome trends, such as the real estate bubble. Why were these warnings not heeded? This brings us to structural failures. Faulty corporate governance systems allowed some financial institutions to take on ever more risk while senior managers sidestepped or dismissed risk managers and boards of directors remained on the sidelines. Others were culpable as well: policymakers, regulators, rating agencies, wishful investors. Global imbalances exacerbated the problems.

How should we address failures at so many levels?

We must address many issues simultaneously. We need more effective regulators, and we also need to revisit what role, if any, rating agencies should play in the future.

As a first step, the balkanized U.S. regulatory system should be streamlined. Subsequently, we should begin to see greater regulatory scrutiny. The focus should be on better regulation and not necessarily more regulation. At a moment like this, it is altogether too easy to overlook the vital role financial markets and innovations have played in creating vast material wealth in Western nations. We must understand fully why the system malfunctioned.

What about firms?

Firms must take an integrated view of corporate governance and risk management. This puts the onus on corporate boards to provide better oversight. Board audit committees or a subset must directly oversee corporate governance as well as corporate risk management practices. Under the direction of the board, corporations must take an integrated view of risk — financial, operating, hazard and strategic risks. We refer to such an integrated approach as enterprise risk management. We also need better risk management training and skills, tighter controls and accountability, and better reporting.

What are some broader implications?

Incentives and trust are two pillars of the free market system — incentives to deliver on promises and trust that promises will be kept and, ultimately, enforced. This is an opportunity for us to mend the system by replacing what is broken and to restore confidence in the system by dispelling the aura of private gains and social losses.

TIMUR G√K is an instructor in the Department of Finance at Northern Illinois University. Since 2006, he has been the regional director in Chicago of the Professional Risk Managers’ International Association (PRMIA.org). Reach him at (815) 753-6395 or tgok@niu.edu.