Comments on European Commission Green paper on Corporate governance in financial institutions and remuneration policies (COM(2010) 284.

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1 Comments on European Commission Green paper on Corporate governance in financial institutions and remuneration policies (COM(2010) 284. From Jim Stewart, Senior Lecturer in Finance, School of Business, Trinity College, Dublin, 2. Ireland tel General Comments The Green paper does not deal with the issue of necessary structural change in the financial sector. Changes in structure, for example separation of utility banking from casino banking will in turn affect governance. This is particularly important as it is recognised in the Green Paper (p. 4) taxpayers are inevitably stakeholders, but in the event of structural change this is likely to only apply to utility banks. The Green Paper (and the Commission Staff Working Document) ignores the cyclical nature of financial crises, driven by financial innovation, and in particular the key insight of Minsky that given financial innovation, financial crises are inevitable (see reference 1). There is one brief reference to the diffusion of complex financial regulation in the Working Document (p. 3). Appropriate corporate governance and regulation needs to be determined in the context of ensuring desirable structural change and recognising the pervasive influence of financial innovation and its effects in causing information asymmetries within an organisation and between an organisation and outside stakeholders and regulators. Far too much emphasis is given in EU policy to the roll of competition and markets. In some cases. for example money transfer, the most efficient market structure may be a monopoly or oligopoly, which must then be tightly regulated.

2 General Question 1 The Role of Board of Directors There is an over emphasis in the Green Paper on the role of directors. There is a voluminous literature on the separation of ownership from management. Senior management control large organisations. Some of these senior managers may be members of the board, but the vast majority of senior management are not members of the board. A key issue is their remuneration especially via options and their short run perspective. There is a brief reference to remuneration schemes at other levels in the financial institution (Working Document, p. 20), and a reference to Commission Recommendation 2009/384/EC which does not deal with the issue of excess pay and remuneration (relative to other sectors) and the role of options in pay, which can lead to excess risk taking. The Green Paper is however, correct in identifying as an important issue the narrow social and gender backgrounds of boards of directors (Par 3.3). This is a particular issue for the governance of Irish financial and other institutions (See reference 4, TASC Mapping the Golden Circle) Corporate governance codes are not a legal requirement and assume that the directors as a board are in charge. This is true of a minority of cases. Senior management some of whom sit on the boards of companies, are in reality in control. In this context the comment in the Green Paper (p. 12) that increased cooperation between the board of directors and the supervisory authorities would also seem desirable is puzzling. Does this mean that this cooperation does not take place at present? The requirement that the board alert supervisory authorities as to any systemic risks is again puzzling. Should the regulator not be more aware of these risk than an individual institution? General Question 2 Risk Management Function Some financial innovation depends on increased uncertainty in order to be profitable, for example in the case of credit default swaps. Hence it is the interests of some financial firms to increase uncertainty. The

3 proposal for improved Value at risk analysis (Commission Staff Working Document, p. 21) is not appropriate. This issue is lucidly discussed in the Turner Review ( which is not referred to either in the Green Paper or the Working Document. Sometimes risk avoidance simply involves implementing existing rules not devising new rules. A key aspect of the breakdown of risk management in three documented cases of rogue traders (Barings Bank, Allied Irish Banks and Society General) was the failure of key personnel to take holidays and hence were in a position to cover their fraud. General Question 3 The Role of external auditors The Green Paper ignores the complete failure of auditors in cases of bank failure. It was not a question of auditors informing competent authorities of things that were amiss. In many cases they considered that there were no issues. The Working Paper states in relation to auditors that there seems to have been a tacit consensus that the problems at stake and their systemic nature were beyond to control of financial institutions auditors (p. 33). There is no source for this stated belief. Presumably it is derived from the responses of the 10 major listed banks interviewed for the purposes of the Green Paper. Why auditors failed completely deserves analysis, and may derive from the inherent conflict of interest between the public duty role of auditors and their remuneration by auditees (see reference 2). General Question (4) The Role of Supervisory Authorities and Technical and Professional skills More financial education is not a solution. Boards of existing banks in Ireland and the UK often had several members who were qualified accountants, several of these being outside directors. For Ireland there is an almost inverse relationship between the quality of corporate governance and the proportion of the board that were qualified accountants. One of the main failures in Ireland was a building society (Irish Nationwide Building Society whose chairman was for several years a former professor of banking and finance. Depfa Bank (responsible for most of the losses of Hypo Real Estate)

4 operating in the IFSC in Dublin, had two former Governors of Central Banks on the Board and other highly qualified individuals. General Question (5) Shareholder Control The Report assumes that the dominant form or ownership is and perhaps should be the joint stock company. Many large institutions are mutually owned, for example Rabo Bank. The main problems affecting this bank stem from the purchase of a formerly State owned bank in Ireland Agricultural Credit Company. One solution to corporate governance type issues arising from remuneration via stock options would be to encourage the development of mutually owned type institutions. In some countries (Spain, UK, Ireland) some of these institutions have experienced difficulties, but State support has in general been far less than that in the case of banks whose shares are quoted on the stock market. Some of these points are developed further in reference (3). There is some limited discussion in the Green paper (p. 8) of new categories of shareholders. These new categories of shareholders may have very different governance expectations and roles than other classes. This is in particular true of hedge funds. Hedge funds as shareholders are more likely to be influential in the case of a large free float (proportion of a firms shares that may be bought or sold as distinct from shares that are held for the long term because of group structure, etc.) Consideration should be given to limiting the ability of hedge funds to take short term positions in financial institutions most or all of whose liabilities are guaranteed by the State. Concluding Comment In conclusion the analysis of the working Paper and proposals in the Green paper seem very dependent on the responses from a limited sample. In the interests of transparency it would be very useful to know who these firms were and hence identify what their particular vested interest (if any) may be in any outcomes. Some financial systems that were less dominated by large listed banks performed better than those systems with large listed banks, for example Italy. Mutuals and similar organisations have a key role to play in the future architecture of the financial system. They occur in all EU states. They

5 are subject to less conflicts of interest than stock market quoted financial firms and because of the absence of stock options may have superior governance. References (1) J. Stewart (2010) Financial Innovation and the Financial Crisis paper given at ISS Schumpeter Conference 2010, Aalborg University, Denmark, June 2010 (2) J. Stewart (2006), Auditing as a Public Good and the Regulation of auditing, Journal of Corporate Law Studies, October 2006, pp (3) J. Stewart (2010), Mutuals and Alternative Banking, available at (4) TASC (2010), Mapping the Golden Circle, available at