The banking crisis revealed a core corporate governance problem in UK banks. In this article I will first explain briefly the reasons of the financial crises and after that I will discuss on whether proposed stewardship and shareholder empowerment, as a reform, response this governance failure.
Between 2003 and 2007, shareholders validated the strategies of the firms that pursued high-leverage, high return, and high-risk strategies and penalized those that did not. Some banks made riskier loans, became more involved in buying and selling securitized assets, and operated with more leverage. Such a change in business strategy meant a move to greater expected returns and greater risk. Any banks whose managers failed to implement the new math of high return got stuck with a low stock price. As long as the economy was expanding, the riskier business strategies worked well, but when the economy slowed, the higher risk became observable and the realization caused stock prices to fall. It appears that the market underestimated the risk being taken and thus failed to provide an objective, critical reference point for monitoring purposes. To the contrary, stock prices confirmed the strategies until well past the point of no return.
Regarding to remuneration, there is certainly a connection between receiving high remuneration and the culture of high risk taking. Therefore, we have clear evidence that the remuneration issue actually has played a significant role in the financial crisis, when these risks became reality. Remuneration before the crisis had become, in fact, very focused on short-term targets and bonuses. Shareholders in the banks were either actively encouraging this short-term risk or then they remained passive. This general climate of bold risk taking caused the banks to pursue high-risk strategies with high returns in the short run and the focus was not at all on the long term control or mitigation of the risks. In addition, If we have a look at the Kay review, to avoid short termism, he identified disclosure as a problem. Quarterly disclosure is creating an incentive in short termism, putting so much pressure on the company. So he recommended removing it. Moreover, non-executives did not understand the corporate governance problem of the banks, now they have a team to advice them to deal with high financial risk.
Some people believed that increased shareholder power would have imported more effective risk management in advance of the crises. Managers of financial companies appeared as quick-buck artists who had used their compensation schemes to siphon millions of dollars from companies on the brink of collapse. Their shareholders, as the primary bearers of losses incurred, emerged as victims along with the taxpayers. Blame for managers meant sudden political traction for a law-reform agenda put forward by proponents of shareholder empowerment. Shareholders' passivity, rather than activity, has characterized the reform perception of the shareholder role in corporate governance. This characterization led to the conclusion that if only they were more active they would be more responsible "stewards" of the Corporation.
However, the U.K. regulatory response to the financial crises in the form of "stewardship" and shareholder engagement was an error built on misunderstanding of the key active role shareholder played in the enormous corporate governance failure represented by banking crisis. In the bank failures, activism, not passivity was a significant problem, and the result has been devastating for the private and public sector. In short, we have learned the wrong lesson about shareholders from the banking crisis. Passive overseas shareholders and vulnerable boards allowed activist shareholders to focus on the short term. Regulatory responses such as stewardship and shareholder empowerment are inappropriate because they risk accelerating this short-term trend. Encouraging stewardship is problematic in the U.K. context because of the deep imbalance in the power structure of U.K. companies, which has focused on current shareholders to detriment of board independence. This imbalance makes corporation particularly vulnerable to shareholder activism, which may be focused on short-term gains to the detriment of the longer-term interest of the company.
In conclusion, remuneration, shareholders and organization was problematic but non-executives and the shareholders are the most problematic ones so the core of corporate governance code failed in the banking crisis. Finally, we know a lot about what went wrong but have done little about it.
14.02.2018
Atty Gonenc Yay, LL.M