GOVERNANCE, TRUST AND BUSINESS
Sir Michael Snyder
When I agreed to deliver today's lecture, I guessed that the topic might be relevant and current, but like all of us I suspect, I did not anticipate just how current and how relevant it would be. The concepts of governance and trust - how businesses are managed and how they interact with their stakeholders - are right at the centre of the current financial crisis, and the spotlight will be on them as never before as we go into the recovery period.
However, before I address the main topic of today, I would like to briefly discuss a few of the different possibilities as to what has caused the current financial crisis.
One of the most prevalent explanations is that banks had believed that the credit markets were possibly being over-cautious with regards to the scale of defaults on US sub-prime mortgages. The banks predicted that confidence would be restored in the following few months, and that the high risk attitude would once again be able to continue. However, this attitude did not return as, according to the Bank of England's Financial Stability Review, there was a global re-appraisal of risk. The report concluded that the recent global credit boom had led to the creation of assets whose liquidity and credit quality were of uncertain value in any climate other than one of unbridled optimism.
Some may also say that it was a change in the stability of the British banking system. Between 1717 and 1931, British banking was stabilised through the Gold Standard, and was associated with the highest level of trust. In these times, it was classified as something of a relationship banking scenario, where your local bank manager was seen as a family friend: the banks would only lend money to people that they know would repay them. However, the banking system was under some stress due to the enormous debt arising from World War I and the reluctance of the British banking system to revalue the Pound against its current Gold Standard. Coupled with the US banking system entering into some fairly foolish investments in the 1920s, the global debt escalated and was, I think, the major factor in the Great Depression, and it was a huge contributor in the Thirties to the onset of World War II.
After the Great Depression and World War II, this style of banking went into full decline. The former picture of the lifelong friendly bank manager, there to advise and keep clients out of financial trouble, soon disappeared, particularly as large investment banks became more interested in investing in one-off transactions and, increasingly, investing in derivative products. Ultimately, the global banking system began to follow the US banking style, which focuses on taking higher risks in order to gain higher returns. With the promises of course of high bonuses for employees, they became very much more willing to take high risks with the banks' money. This helped to create a loss of trust and confidence in the British banking system.
In an environment where a mutual trust between customer and bank was once the foundation of our financial system, this new 'American attitude,' as it were, towards high profits and high risks had severely damaged people's confidence and trust in the system. It has been suggested that a possible solution to the crisis is for our banks to go back to their original roots and focus much more on protecting the clients' interests as well as the banks', rather than just focusing on big rewards, but this whole attitude shift has been fuelled by the vicious circle of media linking expectations of high returns with envy, greed, and a failure to understand that big rewards means high risk.
Another theory as to the cause of the crisis is the breakdown of the floating currency system. A fixed currency system had been initiated at the Breton Woods Agreement in 1944, where the US Dollar was set at $35 per ounce of gold, and all other currencies were then set as a fixed rate to the Dollar. The second, and equally important, aspect of the Breton Woods Agreement was the creation of the World Bank and the IMF to regulate trade through monetary support. When the United States resorted to funding the Vietnam War through inflation, the price of gold rocketed as investors turned to commodities to hedge against this inflation. Confidence in the Dollar started to slide, and other countries began to seek, as the Gold Standard allowed them to, the conversion of their Dollars into gold. This combination resulted in a gold drain, and forced President Nixon to end Breton Woods in 1971, which reduced the capability of the International Monetary Fund to regulate global transactions.
Now we have had 37 years of trade deficit not being self-regulating because of the floating currency. The other nations involved of course were happy to let the United States run these deficits, since this provided liquidity in the international monetary system. This created something of a glut of false money, which dramatically increased investment opportunities, raising property prices and so on, as larger than normal amounts of money were available to chase fewer opportunities - the supply and demand principle. This caused the inevitable bubble and the current bust. Because so much investment, mainly in the United States, was being defaulted on, the ultimate loser was not only national financial institutions but trade surplus nations as well, causing the global negative effect we are facing today.
However, regardless of what you may think the cause is, although it almost certainly emanated from the world's largest economy, the financial crisis has had a number of different effects on the economy. For the first time in sixteen years, our own economy is contracting, and at a faster rate than was anticipated. In addition, the value of the stock market has reduced, unemployment is rising, house prices are beginning to fall, and many companies are beginning to have cash flow problems.
So, what effect has the crisis had specifically on trust and confidence in business and governance?
I believe that what has happened, and what is happening, is tied very closely to the idea of trust and confidence. Inevitably, the media, and indeed some political commentators who should know better, are painting a picture of failure of the business model, which I believe is a vital part of free society. It is far too easy, isn't it, to depict business, especially financial services business, as a conspiracy against the public good rather than as a generator of wealth, of tax revenue and of economic growth. So let me first accept that there have been failures of governance, failures of trust, and failures in the system of law and regulation which underpins, but should not replace, that trust and governance. Things have gone wrong, and I believe that a loss of trust and confidence in our financial system is at the core of this crisis.
For example, banks lend money or grant credit because they believe that there is a good chance of getting it back together with some interest. Now they see the risk/reward balance being tilted away from them, to the extent that, for a while, their credit with each other also ran dry. They no longer believed, post-Lehman and post-Bear Stearns, in each other's ability to repay loans and pay interest, which therefore creates a massive decline in the liquidity in the market. Restoring that trust has taken massive interventions by Governments and Central Banks, flooding the system with liquidity so that it is accessible for all banks. But that is only the start of the process which restores credit to families and to businesses, and working through that process will be long and painful. In fact, the Governments of the world are now underpinning confidence in the financial system, and one Government, Iceland, has already really lost that battle. However, I do believe that, with the Governments of all of the world's major economies, importantly including China, as a surplus country, have taken that concerted action, and having taken it, will succeed. In parallel to restoring liquidity, credit and the financial system, it is also imperative to restore confidence in the way that financial services and banking companies run and govern themselves. Trust is really central to the debate.
As the senior partner of a top twenty accountancy firm, I belong to a profession for which a major task is restoring, or inspiring even, business confidence, and confidence springs from trust. So those involved in a business - the shareholders, the investors, suppliers and customers - all need to have access to information, such as audited accounts, and informed professional opinions, and I believe accountants are, boring as some of us may be, central to that process. The worrying issue is that trust in professionals generally is now questioned very frequently. There is no longer the former assumed respect and trust that there used to be, and successive Governments are partly responsible for dumbing down the independence and integrity of these professions by considerable external regulation as opposed to public oversight of self-regulation. We now tend, don't we, to be wary of professionals and question their credibility, their intentions and all of this without any evidence whatsoever of wrongdoing.
Indeed, Government itself fuels this process as well. Of course, I am not here to take pot-shots at Her Majesty's Revenue & Customs. Taxes are necessary contributions of civil society, and public services must be maintained and improved, but there has been a worrying move, trend as it were, in recent years away from the Revenue assuming that legitimate businesses would set out to pay the tax which was lawfully due from them and that their accountants would advise them in such a way, so that the process worked efficiently and with the minimum of confrontation. The tendency of some parts of the Revenue is now to treat all businesses, and their advisors, in an adversarial way as potential tax evaders and criminals, without, I have got to say, any evidence, has I think helped damage that trust. Here I do believe that successive Governments must accept some of the blame.
And then there is corporate governance, and you will all be familiar with the streams of work that have been done on this topic since the Eighties, the achievements especially of, say, Sir Adrian Cadbury, and the establishments of codes which depend on the excellent principle of comply or explain - in other words, if a company is going to run its governance in a way that differs from the accepted norms, then it should say so. In this way, the wider stakeholder community can make an informed decision on whether or not to enter into a relationship with it. It is the perception that governance has failed that is a major part of the criticism directed at financial services firms, especially the large investment banks.
A global investment bank is an incredibly complex organisation, dealing across borders and time zones, in dozens of markets and in hundreds of products, and it makes such a bank a challenge to manage, let alone to govern. Of course, to say this is not to make excuses for failures of management, regulation or of supervision, but it is to suggest that there is always a danger of this when businesses become too complex. When those who are responsible for governing, as well as for managing a business, cannot actually understand the complexities of it and are not empowered to ask the right questions, something is wrong. Indeed, it was clearly wrong in a number of cases, where senior management either did not understand the totalling, the summation or accumulation, of the risks that the companies were running, or believed, wrongly, that the risk/reward ratio was still tilted very much in their favour.
Good governance should be about focusing on the things that really matter: integrity, independence of thought and long-term returns for shareholders and not just for very senior management. In addition, for good governance to work, it is important not to spend too much time on process or on box-ticking. Good governance and good legislation are the allies, not the opponents, of innovation and of competitiveness.
One of the biggest dangers, I think, as we recover from the current crisis is that Government regulators and institutional shareholders will insist on prescriptive structures. This will, in turn, suppress innovation, corporate growth and development, where not just the mature, careful assessment of risk, but an attitude of safety first, becomes embedded. This will be a particular danger in those banks where Government has taken significant stakes, quite rightly in my opinion, and nominated its own directors. I believe that we need to resist the continuing drive towards a risk-free society in all its manifestations. We need to avoid the danger of creating a boring, dumbed down, blame-wary society. This has never been possible, and I doubt it ever will be. We all need to stretch assets, take balanced risks, develop and improve. It will be a challenge for regulators to avoid moving away from regimes which encourage innovation and competitiveness towards the heavy-handed approach that if something is not explicitly allowed, it is forbidden. But I suggest that as global economic activity subsides and trade slows, there will be even more, not less, need for new ideas and for balanced and mature risk-taking.
British law and practice still enshrine the position of the shareholder as the owner of the business, as the stakeholder with a completely different status from other stakeholders. Directors are still employed by the shareholders, and non-executive directors have a special responsibility towards them, as independent representatives of their interests.
There are others surrounding the supply of qualified and experienced non-executives, and about their interaction with employed directors but, in most cases, the system works. The caricature of the amiable friend of the chairman attending a short monthly board meeting, followed by a good lunch and a good glass of wine, has been become just that - a caricature.
Let us instead ensure that the board exercises its role properly, back perhaps to the chief executive and his insistence on comprehensive verbal explanations of a product, not only for an individual product, but for the effect on the whole business and on its counterparties. Let us also applaud work by institutional representative shareholders, investment and pension funds, and insurance companies, to insist on proper standards of governance. This is good as long as they remember that the individual shareholder is by no means dead yet, and as long as they do not go too far in damaging good management on personal feelings or whims, or indeed, get carried away sometimes with their own importance.
You may remember earlier that I said that statute law and imposed regulation support trust and good governance - they do not replace it. This is, I think, the central message for the difficult months ahead. Legal frameworks are needed. They need to be effective, responsive, transparent, and applied to everyone. The structure of English common law, with its roots in commonsense and precedent, provides just such a framework, but its aim must be for trust and good self-governance to flourish, not to remove or try to eliminate the need for them.
So what can be done about the current crisis? What is the current situation in the City? Is it all doom and gloom, or is there some hope for the future?
Yes, it is obviously true that confidence in financial institutions has been damaged. There is a definite lack of trust, but in order to pull out of this current, or impending, economic slump, which some say will last for over eighteen months, we need to work out how to put that trust and confidence back into the system.
In one of his recent articles, the Prime Minister has been advocating the revival of the Breton Woods Agreement in order to build a global society. He has urged President-Elect Barack Obama to reject the ideas of protectionism and putting up trade barriers to protect American jobs. Gordon Brown's main theory is that strong banks, unfrozen markets, greater transparency and international supervision are the four keys to recovery. He stresses that in order to re-create confidence in financial systems, it is crucial for all banks in Britain to meet certain capital requirements; secondly, it is vital to open the money markets that have been closed for medium-term funding from the private sector, as its current closure reflects a loss of confidence between banks. He is quoted saying, 'The role of banks is to circulate the savings from deposits, our pensions, and from companies to those who need to spend or invest them. The cost at which banks can borrow this money directly affects, or nearly directly affects, the cost of mortgages for homeowners and of lending for businesses. This paralysis of lending from loss of confidence jeopardises the flow of money to every family and every business in the country.' Thirdly, he recommends stronger international rules for transparency, including disclosure and a higher standard of conduct, claiming that successful market economies need trust, which can only be built through shared values. Fourthly, he mentions that national systems of supervision are simply inadequate to cope with the huge cross-continental flows of capital that we are dealing with today, that the Financial Stability Forum and a reformed IMF should play their part, not just in the crisis resolution, but also in crisis prevention.
However, others have said that the re-strengthening or reformation of the IMF and World Bank could actually make things worse in the long run. In Gordon Brown's proposal, he assumes that financial regulators were inadequate and need to be strengthened in order to prevent future crises. Of course, this may well be true. However, according to a report by the Heritage Foundation, the Federal Reserve and the US Treasury did actually warn financial companies, such as Fannie Mae and Freddie Mac, about the continuing risks, but they chose not to take the advice. The Bush Administration even proposed in Congress to restrict these high risk practices, but the proposal was rejected. So this leads to the question of, if national financial systems and Governments were pre-warned about these potential risks, how would the restructuring of global financial regulators assist in any way? Who would know better than the national Government about its own current financial situation?
Personally, I believe the answer is somewhere in the middle. Instead of a single world regulator, I think that having an international forum for regulators, perhaps based on the G20, to coordinate the supervision of global institutions could be a possible solution. To get national regulators working together would be desirable and a positive contributor to understanding and to stability. I would not favour, as one or two voices in Europe are, a single European regulator, as, frankly, it simply would not work. This crisis is a global one, and one region could never operate in isolation, but it could add costs in that region, making it uncompetitive.
I also welcome the Mayor of London, Boris Johnson's, forward-looking, positive approach to helping with the economy, with plans like refocusing the London Development Agency's £400 million budget towards promoting jobs, skills, and economic growth, investing £600 million in training to give Londoners the skills that they need, introducing a range of energy-efficient measures, and lobbying Government to have a competitive tax regime to ensure that London remains a global centre. These ideas are of course very similar to those of the City of London Corporation, some of which stem back to work that I did in my former role as Chairman of Policy and Resources. We helped promote the City by influencing the framework in which we operate, including regulation and competitive taxation; by influencing infrastructure, pushing ahead with over fifty major infrastructure projects, such as upgrades to the Tube, and indeed by Crossrail, which we also helped to fund; by ensuring security and safety - and I do not mean just physical security and safety, but economic security, and indeed, a focused police force; and by creating and influencing the environment in which we live and work - schools, culture, medicine, shops - in fact and in short, to make London a nice place to live.
We have also promoted the City looking outwards, by opening offices in Brussels to engage in the influencing of the vast amounts of regulation emanating from the European Union, and in China and India, to ensure we remain a global magnet for business and talent - indeed, also to form relationships that will last as those vast economies become eminent.
Whatever the right idea is, financial systems are the oil of the economic engine, essential for each one of us, so it is imperative that we work together in these difficult times to solve the current issues. Financial services and banks need to be large enough to cope with the vast global trading corporations. Even if this makes management or governance of these institutions more difficult, we need to rise to those challenges.
Throughout time, it has been capital that has expanded the human condition, with its ability to encourage not only trade but advance technology, and it is in this vein that the financial system must be, once again, allowed to flourish as a free market without Government ownership, right though that was at the time, and not die under the constraints of total regulation. Communism in the former Soviet Union died because of its lack of capital and the lack of opportunity for reward from capital. There are those, thankfully few, in the United States and Europe, and indeed one or two in the United Kingdom, who believe that regulation should restrict or restrain, but in a global, competitive world, this merely means that global businesses will operate and centre themselves elsewhere, much to the economic detriment of London and the UK.
I suggest that the answer instead lies in proportionate regulation and the re-establishment of effective internal governance where it has been damaged. This would help direct companies and their shareholders towards a generation of strategic or long-term returns, rather than short-term ones. This is significant, as it may be that one of the effects of this crisis will be to re-assert the value of long-term corporate performance over the pursuit of short-term returns. This is a time when we need to be promoting London and other UK cities to foreign business investors. With the dramatic decrease of the Pound and the continuous decline in property prices, particularly commercial ones at the moment, London is becoming more and more affordable and desirable for foreign travel and investment. Times are, of course, very serious and difficult, and no one knows exactly how events will unfold over the next months. We could, of course, all continue to concentrate on the downside, both of the financial and economic markets, but at some stage, and who knows when, a few people are going to realise that halved share values, halved property prices and decimated bank values are good buying opportunities, and then there will, I think, be a rapid rise in those same prices. Whatever happens and when, I really believe that this country, this trading nation, with its relatively small domestic markets, needs to nurture and promote its financial and professional services industries.
As you can probably tell, I am an optimist, and I think that this is with good cause. I have run my own firm through a previous recession, and will do so through this current crisis. We need, all of us, to actively look for the opportunities that this crisis gives to create an even more competitive and innovative environment for our financial and professional services for the future. As with all business cycles experienced over the last 300 years, the economy always recovers and continues to grow, and this will be no exception, and with the positive and swift movements experienced across the globe, we are already moving towards the turning of the tide.
So, in conclusion, even in these troubled times, there is hope. We forget this sometimes. Take a look around you the next time you are walking around the City - it is still a very much a fast-paced environment and a City on the go. Things have and will go on, even in these turbulent times. However, in order to progress and climb out of the current crisis, we must ensure that we fully restore trust, confidence and good governance back into our financial systems. The journey will, indeed, be rocky, and I am sure that we will all be affected in one way or another, but London is a city that can, and will, survive through these tough times.
©Sir Michael Snyder, Gresham College, 11 November 2008