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.