Many people have commented on the Financial Crisis Inquiry Report released in January. After following the Commission’s progress and reading much of the press on it, I also offer my thoughts and I present two main for discussion:
the financial crisis was and is a failure of governance and
executive management took excessive risk for corporations while risking almost nothing for themselves.
Years of buybacks and leveraging left companies with low capital reserves and no safety nets. Deregulation and self-governance seems to have meant a lack of moderation and even a negligent management of capital. And in the end it meant that government and foreign investors had to step in to avert catastrophe. The ultimate failure of corporate governance results in a system in which the leading executives have no effective accountability to their board, to their shareholders or to anyone else and are able to reward themselves in such a way as to create vast personal wealth notwithstanding the failure of the enterprise itself. So, the financial crisis is at its core a failure of corporate governance.
Certainly, the Financial Crisis is many other things and I make no claim to priority. I can only be certain that unless the corporate governance failure is addressed, we can be confident that there will be an uninterrupted series of crises all based on the predictability that “power tends to corrupt and absolute power corrupts absolutely.”
“Our financial system is, in many respects, unchanged from what existed on the eve of the crisis. Indeed, in the wake of the crisis, the U.S. Financial sector is now more concentrated than ever in the hands of a few large, systemically significant institutions.” (FCIC Final Report, xxvii, page 28 of digital version)
This was the conclusion of the Financial Crisis Inquiry Commission. It underscores the futility of the public reforms and illuminates the confusing choreography of the government response – all of which happened before the duly appointed Commission had a chance to identify the problems that caused the crisis. The cart came before the horse.
No one doubted that there was sufficient raw material in this crisis (including the government’s responses) to provide legitimate basis for a wide range of conclusions. And no one doubted that we would see wide ranging opinion depending on the analyst’s predilections.§ What could we expect of a Commission in which the legislative majority had gratuitously (by virtue of having 60 Senate votes) bestowed veto rights on the minority? What could we expect of a report was due well after laws addressing the crisis had been written and just following a predictably poisonous election?
The report takes the form of a narrative of pre-tuned conclusions. There is, in fact, little analysis of the several components of this crisis. The majority membership of the Commission rants about “stunning instances of governance breakdowns” (FCIC Final Report, xix, page 19 of digital version) and the minority concludes: “These firms should have had much larger capital cushions and/or mechanism for contingent capital upon which to draw in a crisis.” Ben Heineman recently wrote on the Harvard Law School Corporate Governance Forum (HLS blog 1/31/11) pointing the finger at the major financial institutions,
“They, not the government, drove us to the edge of another Great Depression. The conclusion about massive private sector failure is summed up in a quote from JP Morgan’s Jamie Dimon, who, when reflecting on the causes of the crisis, told the Commission; ‘I blame the management teams 100% and no one else.”
There is a simple measure of damages – the difference between the amounts paid by the companies in buying back their stock and the cost to shareholders of the new government money. The overwhelming conclusion is that the only reason for the buy backs was to enhance compensation schemes based on returns on equity. CEOs have a unique conflict of interest and yet they play a major role in -- or even drive -- buy back decisions. Here is failed corporate governance.
A Failure of Governance
Allen Greenspan has famously acknowledged his “mistake” in couching policy in the belief that profit seeking institutions can be depended to act so as to preserve and enhance their own value. And yet this “mistake” appears significantly different from the sense of his public statement. Executives, indeed, can be counted on to advance their own interests, but – what Greenspan failed to take into account – they are willing to do so on a basis that is not in the best interest of the institution to which they have fiduciary duty.
“After considerable soul-searching and many congressional hearings, the current CEO-dominant paradigm, with all its faults, will likely continue to be viewed as the most viable form of corporate governance for today’s world. The only credible alternative is for large--primarily institutional--shareholders to exert far more control over corporate affairs than they appear to be willing to exercise. Fortunately, it seems clear that, if the CEO chooses to govern in the interests of shareholders, he or she can, by example and through oversight, induce corporate colleagues and outside auditors to behave in ways that produce de facto governance that matches the de jure shareholder-led model. Such CEO leadership is critical for achieving the optimum allocation of the nation’s corporate capital.” (Greenspan speaking at Stern Business School, 3/26/2002)
Wow! Nine years later it is clear that we did not get that kind of leadership from CEOs. It is equally clear that we never will. In a sense, self-regulation applied to executives not to corporations. Greenspan’s mistakes are continued blindness to the reality of corporate governance challenge – the absence of a system of effective accountability of management power. It will be the work of another Commission to devise satisfactory solutions. Beguilingly, Greenspan lurches towards a promising beginning – he identifies owners as the appropriate party to monitor corporate management, but he utterly fails to grasp the nature of the crucial fiduciary relationship that institutional shareholders have with respect to their beneficial owners. “Willing to exercise” is a standard of conduct anathema to the proper role of Trustees.
§ In the spirit of candor, it will be apparent that I am not immune from this disease.