UK FSA Officlal Urges Investors to Help Ensure Effective Risk Management

While senior management and others bear a strong responsibility for the financial crisis, a UK FSA official said that investors have to engage more actively with senior corporate management and independent directors in the areas governance, risk management, and compensation. In remarks at a recent seminar, FSA Chief Executive Hector Sants noted that, since weak risk management and unsound governance will impact negatively on long term investment performance, investors must engage with the audit committee in ensuring adequate risk controls. Investors must also engage senior management and independent directors on the construct of their boards.

As a corollary to sound risk management, he continued, the firm’s compensation policies must be consistent with effective risk management. The FSA has set out a draft compensation code to ensure that firms have policies in place which are consistent with sound risk management and which do not expose them to excessive risk. The senior official pledged to rigorously pursue this agenda. But, to be truly effective, there must also be a partnership with the investors. While historically, investor influence has only been wielded at board level, noted the FSA official, it must now extend to the organization as a whole.

The FSA draft Compensation Code does not set levels of remuneration, which is a matter for the boards of companies and their shareholders. The principles in the Code will be used by the FSA to assess the quality of a firm’s' compensation policies and linkage, if any, between such policies and excessive risk-taking.

The FSA may also ask the compensation committee to provide evidence of how well its policies measure up against these principles, together with plans for improvement where there is a significant shortfall. Firms will also be asked to use the principles in assessing their exposure to risks arising from their remuneration policies as part of the process

More broadly, the official urged investors to challenge annual reports and company announcements. In parallel to regulators taking a macro-prudential approach, long term investors must assess all risks to a business and challenge the information offered by a company, and more importantly, interrogate that which is made freely available. Companies have become very good at framing the information presented to regulators, he said, by focusing on the information of their choosing. Likewise, some investment management models rely on company reported information.

Similarly, he observed that there was an over reliance on the views of credit rating agencies, which are often geared around quarterly reporting cycles and thus do not encourage investors to make a more long term assessment. This issue is exacerbated by the free-rider problem in that an investor who has engaged earlier than others bears a greater cost of their actions. Other investors tend then to be less inclined to engage or the herd mentality comes into play with little challenge of others views. The official urged investors to first understand the securities or derivatives before buying the financial product.