Effective corporate governance is composed
of three key components, said UK FSA Chief Executive Hector Sants, setting the
right tone from the top, a board with the skills to enable it to function effectively,
and ensuring effective information flows from management. More broadly, in
remarks at a recent seminar, he noted that a firm’s culture is central to good
governance. Financial regulators should ensure that the right enablers are
present to incentivize a corporate culture that delivers the right outcomes.
While regulators
have a role to play in ensuring that firms have the right governance and
culture, the FSA official emphasized that is not for the regulator to determine
the culture. Ultimately, even a successful regulatory regime will not be
sufficient to ensure good outcomes. Firms need to have an appropriate culture focused
on delivering the right long-term obligations to society. The right cultures
are rooted in strong ethical frameworks and the importance of individuals
making decisions in relation to principles, he said, rather than just
short-term commercial considerations. In particular, this means that, when a
regulator expresses a clear instruction, firms should not continue to resist
for reasons of expediency and short-term gain. Further, history teaches that regulators
cannot rely solely on the motivation of individuals alone, said the CEO, thus credible
enforcement is needed to require individuals to be driven by principles rather
than just commercial expediency.
Central to a regulator’s role in
promoting effective boards is the utilization of the authorizations process to
encourage firms to make the right appointments. The FSA Chief Executive
said that history demonstrates the importance of a regulator having a proactive
approach to judging the suitability of directors, in particular their
competence. This proactive approach must be focused only on those key roles and
has to be a judgment not just about the effectiveness of individuals, but about
the board as a whole.
According to the FSA official, the
role of a regulator is to create boundaries within which firms take
responsibility for their own decisions. In the past the capital and liquidity
boundaries for banks were nearly non-existent and thus corporate managements were
not sufficiently constrained in their judgments. For example, the new capital
and liquidity standards will address these shortcomings but will not remove the
necessity for management to make good judgments and the need for regulators and
shareholders to hold those firms to account.
With regard to tone at the top, it is
crucial that the board understand the circumstances under which the firm would
fail and constantly asks the ‘what if’ questions. To do this well, said
the official, a board needs to understand its business model, understand and
focus on the material risks, and challenge the executives on the execution of a
strategic plan. If this is done well, he continued, this should result in a
firm that not only delivers shareholder returns but one which is prudentially
robust and delivers a fair deal to its customers.
With regard to technical skills, the FSA is
assessing whether the board collectively understands and can address the
breadth of the business. The FSA does not expect all non-executive
directors to be technical experts in financial services and does not expect
every member of the board to have the same degree of technical knowledge. A
diverse board encourages creativity and is less likely to demonstrate group
think and herd mentality. However, having just one non-executive with specific
industry knowledge on a large insurance company board is clearly not adequate,
said the senior official, adding that it is a question of balance.