Why Corporate Governance Matters — And How to Get it Right

Say the words "corporate governance" and most people yawn. So it's probably no shock that a recent Group of 30 report on the topic came and went without much mention.

That's unfortunate because getting governance right is essential to the safe, sound and successful operation of a financial institution. It's the framework the people in charge of a company use to ensure accountability and transparency; it's how they balance the varying demands of shareholders, customers, employees and regulators.

Without solid corporate governance, a bank is rudderless in a sea of competing interests, so efforts to improve it are central to reforming our financial system.

The Group of 30 is a force-field of economic and financial policymakers, past and present, domestic and international. It's all the men who have been influencing financial services policy for decades: Paul Volcker, Gerry Corrigan and Bill Dudley; Adair Turner, Jean-Claude Trichet and Mario Draghi; Larry Summers, Ken Rogoff and Martin Feldstein. The list goes on and it doesn't get any less impressive.

This group of heavyweights decided to take a close look at corporate governance and issued 80 pages of analysis and recommendations last month.

"Toward Effective Governance of Financial Institutions" pulls no punches. Consider this from the foreword: "In the wake of the crisis, financial institution governance was too often revealed as a set of arrangements that approved risky strategies (which often produced unprecedented short-term profits and remuneration), was blind to the looming dangers on the balance sheet and in the global economy, and therefore failed to safeguard the financial institution, its customers and shareholders, and society at large. Management teams, boards of directors, regulators and supervisors, and shareholders all failed, in their respective roles, to prudently govern and oversee."

The project was launched about a year ago under the meticulous eye of Roger Ferguson, the former Federal Reserve Board vice chairman who now leads TIAA-CREF. Ferguson worked closely with John Heimann, a former comptroller of the currency now with the Financial Stability Institute; Bill Rhodes, the legendary Citigroup executive; and David Walker, a former British regulator who is now a senior advisor at Morgan Stanley International.

The Group of 30 sent pros from Ernst & Young and Tapestry Networks to personally interview executives and directors at 36 of the world's largest financial services firms about their company's governance.

The report is chock full of ideas for executives, regulators and even shareholders, but it's prime target is directors. The board is the linchpin because it controls three factors critical to a company's success: business strategy, risk appetite and the selection of key officers, including the chief executive.

"Boards that permit their time and attention to be diverted disproportionately into compliance and advisory activities at the expense of strategy, risk, and talent issues are making a critical mistake," the report states.

Boards "must take a long-term view that encourages long-term value creation in the shareholders' interests, elevates prudence without diminishing the importance of innovation, reduces short-term self-interest as a motivator, brings into the foreground the firm's dependence on its pool of talent, and demands the firm play a palpably positive role in society."

That's quite a daunting list, and I doubt there is a bank board in this country that isn't drowning in compliance issues such as implementing the Dodd-Frank Act and addressing the myriad "matters requiring attention" flagged by examiners.

So I'd like to devote this column to a list of questions this report ought to spark in the minds of bank executives and directors.

For instance, is your board focused on the important issues, the ones that matter to the company's long-term vitality? Or do urgent but unimportant issues bog you down? Does your board understand the risks the company is taking? Is management's explanation of its strategy clear and convincing? Does the board play an active role in hiring senior executives? When it comes to the people accountable for risk — the chief risk officer, the CEO, the directors — who is authorized to slam on the brakes?

Of course, the key to any board's effectiveness is its chairman.

"Mature, open leadership" is a must, the report says. "Effective chairs capitalize on the wisdom and advice of board members and management leaders and on the board's interactions with supervisors and shareholders, individually and collectively. Good chairs respect each of these vital constituents, preside, encourage debate, and do not manage toward a predetermined outcome."

Ask yourself, does that describe your board's chairman?

What sort of culture exists among the people at the top? Do words like integrity, independence and respect come to mind when you think of your company? Is debate welcomed or discouraged? Is bad news confronted head-on or swept aside? Do checks and balances exist? Or is power concentrated in one person or one group?

"Values and culture drive people to do the right thing even when no one is looking," the report says. They are the "ultimate 'software' that determines the behaviors of people throughout the financial institution and the effectiveness of its governance arrangements."

Governance is an art, not a science, and there is no one right way to do it. That said, the Group of 30 report does draw some conclusions:

• Smaller boards work better. "Boards with 8 to 12 members are best positioned to encourage candor and facilitate constructive debate." 

• Diversity helps. "Recruit members who collectively bring a balance of expertise, skills, experience, and perspectives. … Members with experience in the CEO role, in finance, and in regulation are particularly valuable." 

• Boundaries must be set. "Respect the line between the board's responsibilities for direction setting, oversight, and control, and management's responsibilities to run the business. It is misguided and dangerous to conflate the responsibilities of management with those of the board."  

• Follow-up is not optional. "Ensure that rigorous and robust processes are in place to monitor organizational compliance with the agreed strategy and risk appetite and with all applicable laws and regulations. Proactively follow up on potential weaknesses or issues."

The report also suggests a bank's board regularly assess its effectiveness and to share its findings with regulators. "Boards should conduct periodic self-evaluations that include candid and constructive feedback on the performance of directors and committees. They should discuss the findings with their supervisors."

Does your board do that?

Speaking of supervisors, how well does yours know your institution? Does the examiner in charge understand how the company makes decisions about risk? How the board works? "Supervisors need a deep and nuanced understanding of each financial institution's strategy, governance approach, culture, leaders, and issues."

Finally, the Group of 30 reiterates a recommendation that governance experts have been touting for years: split the chairman and chief executive roles. "If the job of the board is to control management, then an irresolvable conflict of interest arises when the most powerful board member (the chair) is also the most powerful member of management (the CEO)," the report says.

Interestingly, among the megabanks, only the two most humbled by the crisis — Citigroup and Bank of America — have separate chairmen and chief executives.

The rest of the giants continue to flout what is a commonly accepted best practice in Europe and Japan. It makes you wonder just how strong their boards are.