Monday, 31 January 2011

Our financial services regulation is bonkers

A business associate pointed out that much of banks' proprietary dealing has decamped to Singapore, which made me think about how inept so much financial services regulation has proved to be. It is regulation by huffing and puffing. Instead of thinking and taking measured steps that are designed to have particular effects  the politicians constantly play to the gallery and think about the next day's news headlines rather than careful policy-making. The outcome is virtually guaranteed to have unintended consequences.

So EU politicians rail at hedge funds although they were not actually the cause of recent financial instability; but ok, they could be connected with the next crisis. But financial institutions are flexible. They move abroad to avoid new regulations and new taxes. What good have the regulations and the taxes done? The hedge funds are still funded by EU banks but now they are outside the reach of EU regulators so, instead of having improved the risks we all face, the politicians have pushed them beyond our control.

Similarly with the proprietary trading. It may be carried out by non-bank institutions or outside EU jurisdiction but, if you follow the money trail, it is still, effectively, the same EU banks that are taking the risks and the profits(losses). So the effect has been the precise opposite of what was intended. Madness.

Thursday, 27 January 2011

Business Leaders see little profit in Corporate Social Responsibility (CSR)

A survey of 700 UK business leaders by the government funded Carbon Trust shows that 77% state that the main benefit of going green is to enhance their reputation. Which is not surprising because less than a third think it will improve their profits.

It is worth examining that result. A whopping 92% said that there were growth opportunities for their companies in the green economy, 40% think it will outstrip growth in the ‘conventional economy’ (so 60% think it won't) and 75% think it will account for more jobs. But…less than a third is investing in R&D despite these growth prospects and despite a belief that new technology will drive it. And why is that? Because less than a third think it will improve their profits. The obvious conclusion from the data is that they believe it is largely a public relations exercise and a response to legislation and not a serious profit opportunity.

Of course the Carbon Trust has not drawn these conclusions from their data but they wouldn’t would they?

Tuesday, 25 January 2011

Diversity and discrimination in and around the boardroom

The Corporate Governance Code addresses the importance of diversity in companies and research from Tomorrows Company indicates that diversity imroves corporate performance. But progress is painfully slow, with women and ethnic minorities poorly represented on quoted company boards.

Then, this weekend yet another newspaper article put this into perspective for me. It was a perspective the writer did not intend – these are often the articles that provide the deepest insights for the reader – those whose authors actually have the least insight themselves. It reported directors of consultancies complaining about having to turn down work because they could not recruit the right people into key positions. The specific detail was given that they wanted people ‘typically those with MBA’s and about 15 years’ experience’; and I thought how precise that is. The issues that arise, though, are as relevant to industry, finance and commerce as to consultancy.

The first insight this provides is how limited and narrow-minded the recruiters are. And the second insight is a realisation of who is excluded: women who have taken a career break to start a family are excluded, older people are excluded, those who have not followed a conventional career path or come from poor backgrounds are excluded. This last category is also important because it indirectly affects ethnic minorities. Since black people are under-represented at top universities it is harder, on average, for them to demonstrate their abilities as quickly as competitors in the jobs market. There is clear evidence that a better school improves the chance of attending a top university which, in turn, helps to get that first job which goes on to provide the experiences that enhance career prospects. So individuals from poorer areas find themselves first disadvantaged, then discriminated against for their education, then for their speed of progress and finally for their age.

The issues of discrimination are complex and inter-related but so many of the impediments are quite unnecessary. Why, for example, is it necessary for the professions to limit entry to graduates? This discriminates against late developers who seek qualifications through adult education and is likely to affect those who performed less well at school, who often come from poorer and from ethnic backgrounds. In the past, people from humble backgrounds could join professional firms at a junior level and work their way up, obtaining qualifications at night school or through correspondence courses. Nowadays adult education is becoming more expensive and harder to find – yet more discrimination against those who are badly served by the education system. Does a degree, say in history, mean you are a better surveyor, lawyer or accountant? An excellent degree may display qualities of thought and an ability to write well, but often it is simple discrimination based on a type of snobbery and it damages social mobility. If you can get a good grade in the professional exams there is every chance that you will be just as competent as someone who has a degree in a non-relevant subject.

Consider the number of jobs whose advertising is clearly aimed at the young. An older applicant will not be considered yet may be better suited and more competent. Does it matter that they may be less ambitious because they are closer to retirement? In fact most companies shed workers as they get more senior because there are far fewer senior vacancies than junior ones. Therefore it is quite unnecessary to seek only ‘ambitious, dynamic young accountants with ten years post qualification experience’ because someone with thirty years experience might well do that job better, will be around for ten years before retirement and will not need a redundancy package when they can progress no further up the career pyramid.

And where does this argument lead eventually? It leads to an explanation of why company boards under-represent women, older workers, ethnic minorities and those from poorer backgrounds. Of course exceptional individuals will claw their way to the top regardless of any disadvantages they may suffer – but the statistics show quite clearly that these are exceptions. And this is no argument for quotas or for positive discrimination. There is no satisfactory way to ensure perfect equality of outcomes as well as of opportunity. But the point is to ask ourselves whether those ‘people specifications’ need to be as tightly drawn as they are? If we were more adventurous and less discriminatory in recruitment at all levels we would end up with more diverse, more dynamic and more innovative boards and more successful companies.

Wednesday, 19 January 2011

Philip Hampton, RBS Bank chairman, declares many bankers are overpaid

Seen this really important post on Robert Peston’s BBC blog? It is not just another piece about overpaid bankers. He quotes Philip Hampton, RBS Bank chairman, who he interviewed for a BBC 2 documentary.
The star quality, as it were, seems to filter down to people who don't seem so star quality. There is, if I can use the expression, a sort of gangmaster cultural phenomenon in this, that you recruit top people who really do make a difference, who really do move markets and get business and are really high achievers.
 But they do tend to associate themselves with people who aren't such stars, but they want them around and they trust them, sometimes they move with them and there is a team associated with it. And the disparities between the top stars in the team and some of the journeymen players, if you like, is probably not as marked as it should be."

Inevitably some will see similarities with Premier League football teams, in which even quite mediocre players earn tens of thousands of pounds per week, because that's the going rate for the Premier League.

Hampton says that when the real stars leave, "they take their clients and their business with them, and we see this routinely". That's why RBS feels obliged to pay huge bonuses to these top performers. But it is "one of the major challenges" to reduce the pay of the more average bankers in the teams assembled by these stars.

Hampton also implies that investors have been irrational in allowing banks to pay huge bonuses. He says:

"This explosive growth in financial services meant that thousands of people, arguably tens of thousands of people, are extraordinarily highly paid. The most peculiar thing about it all, actually, if you look at the last ten years of massive increases in pay is that the performance for shareholders has been pretty disastrous really across most banks.

So the upshot is that top bankers recognise they are paying out far too much to their staff at the same time as the performance of most banks “has been pretty disastrous”. The problem is that either they like the resulting upward pressure on their own pay...or they really don’t know what to do about it. Maybe Vince Cable is right, after all, and they need a hand?

Thursday, 13 January 2011

Companies not complying with Companies Act reporting requirements

I blogged recently about the FRC’s recent report “Effective Company Stewardship: enhancing corporate reporting and audit”. The FRC also gives data showing admittedly lowish levels of outright non-compliance with Companies Act 2006 reporting requirements; although a hefty 32% of accounts examined failed over non-financial KPI’s (Key Performance Indicators). A raw average of 42% of company reports may have complied but were judged to ‘fall short’ on the list below. In view of my previous criticisms, it is noteworthy that whilst 100% of reports complied with requirements in relation to principal risks, a whopping 66% fell short of being adequate. So they supplied the legal boilerplate without giving shareholders adequate information upon which to make judgements.

% non-compliant
% falling short
Business description
Principal risks
Performance and position
Trends and factors
Corporate social responsibility
Contractual arrangements
Financial KPI’s
Non-financial KPI’s

Tuesday, 11 January 2011

FRC urges companies to cut the flannel in annual reports

Well the latest publication of the FRC, Effective Company Stewardship, doesn’t use those precise words but it does urge directors to reduce the length of annual reports whilst making them more useful. The FRC also specifically urges the reduction in legal boilerplate, particularly in relation to reporting principal risks and uncertainties.

I have blogged about this before, citing the example of GlaxoSmithKline that agreed in 2010 a $750m financial settlement of a US lawsuit that alleged appalling misconduct in relation to the supply of drugs there. Their annual report did refer to the lawsuit - boilerplate - but reported nothing about how it had occurred or actions taken to improve governance or to prevent a recurrence. That is a pretty remarkable lack of reporting (despite pages and pages devoted to risk committee structures and broad, uninformative statements of principal risks) when the total costs of the governance fiasco must have been around $1bn.

But although there is much sense in the FRC report there is also much to make you weep. Despite paying lip service to proportionality and avoiding excessive compliance costs they find it impossible, in practice, to restrain their urge to impose increasingly prescriptive (and costly) demands on business. They never seem to wonder whether any of it does any good – serves any purpose. Do they commission any academic studies, I suspect not?

Companies take risks in order to earn financial returns. That is what business does. Sometimes they fail and the result may be business failure. Expanded reporting of risks and uncertainties will not stop that. Wider responsibilities for audit committees and enhanced reporting will not stop that. There is also no undisputed, published evidence that shareholder value is enhanced by all this reporting detail.

But there is sense here too
  •  Not quite demanding an audit of the directors’ report but requiring auditors to disclose incompatibilities between the directors report and financial statements or information gathered during the audit.
  • Encouraging greater auditor scepticism
  • Enhancement of auditor reporting to audit committees
  •  Enhanced audit committee reports to shareholders
But then they go and spoil it by suggesting the auditors report on the ‘completeness and reasonableness of the audit committee report’ – that is two sets of cost and the auditors are effectively writing the committee’s report anyway; why not get the auditors to report in the first place?

And worse…they propose investor involvement in auditor appointment. On the one hand, many will not want to be involved and on the other hand, which investors? Do you involve an activist hedge fund or a foreign, sovereign wealth fund or a union? Who gets excluded and why exclude individual private investors? No, it is a silly idea and profoundly discriminatory.

But then back to some sense again
  • In return for requiring directors, executives and auditors to make ‘forward looking statements of belief or judgement’ the FRC proposes a ‘safe harbour defence’ as long as they were not made ‘recklessly, dishonestly or fraudulently’

Sunday, 9 January 2011

CEO Education

This is interesting because of its implications for diversity. If CEO appointments are highly influenced by educational attainment then this must affect the prospects of groups such as those from poorer or ethnic backgrounds who are less likely to be able to get to the top universities. That the authors of the study found no long-term correlation between education and performance suggests unfair discrimination. The short-term effect they found could result from the MBA's tuition in cost-cutting, which achieves short-term benefits but at a risk to long-term performance.

I conclude that to increase diversity in the boardroom demands that recruiters show greater flexibility in their approaches. If they stick to old-fashioned techniques then there will be no improvement. Recruitment of more women to senior levels demands a more open approach to flexible career patterns whilst recruitment of more minorities and those from poorer backgrounds means placing less emphasis on  those factors that are unlikely to be able to meet. The evidence of this study suggests that the old fashioned ways do not produce better results.

CEO Education (from
"A paper by Sanjai Bhagat, Brian Bolton, and Ajay Subramanian finds that CEO education has no statistically significant effect on CEO tenure or turnover:
We use six main measures of CEO education: whether or not the CEO attended a Top-20 undergraduate school, whether or not the CEO has an MBA, law or masters‟ degree, and whether or not the MBA or law degree is from a Top-20 program. Our study includes more than 14,500 CEO-years and more than 2,600 cases of CEO turnover from 1993-2007.
Our results show that CEO education does not play a significant role in the decision by a firm to replace its current CEO; poorly performing CEOs are replaced, regardless of their education. Education, however, does play a significant role in the selection of the replacement CEO. There is a significantly positive correlation between the education levels of new CEOs and those of the CEOs they replace. Further, hiring new CEOs with MBA degrees leads to short-term improvements in operating performance. However, we do not find a significant systematic relationship between CEO education and long-term firm performance. CEO education does not seem to be an appropriate proxy for CEO ability. Our results lead to the puzzling implication that, while CEO education appears to play an important role in the hiring of CEOs, it does not affect the long-term performance of firms.
To my mind, these findings make perfect sense. I suspect that the effect of one's education on one's job performance, if any, is short lived. I wasn't a lawyer for very long before I was relying on what I had learned on the job rather than in school, for example. What a CEO learned 30 years ago in b-school thus probably has zero impact on his job performance today.

At the same time, however, the correlation between education and hiring is equally unsurprising. There is an inherent problem in corporate governance of structural bias. Indeed, it's not just a problem of corporate governance; rather it is a pervasive failure among institutions of all types. Institutional decision makers tend to replicate themselves when they hire new people. They tend to lean towards people with the same background and socialization. If we plausibly assume most corporate directors have a top 20 education and a professional degree, we'd expect CEOs they hire to have the same.

Whether shareholders would be better served by more diverse boards that presumably would pick more diverse CEOs is a question for another day."


Monday, 3 January 2011

Bribery and Corporate Governance

Although I have written before about the new Bribery Act and corporate governance, I was struck by a newspaper headline, “US war on terror is tangled up in web of bribery, corruption and fraud”. The report stated that the US investigators are working on 110 cases of suspected fraud with at least a dozen US army procurement officers already convicted of taking kickbacks. A major, was jailed for 17 years for taking nearly $10m in bribes and the Special Investigator General for Iraq Reconstruction (SIGIR) has obtained over 40 other convictions..

The lessons that leap out are that corruption depends upon three things;

Controls and procedures

To prevent corruption there must be a network of controls so that deals and contracts are independently reviewed. Clearly the US was in a hurry to get things moving in Iraq and decided to sacrifice normal controls. I remember reports about huge sums of money being disbursed in the early days of the occupation without even proper records being kept. That also brings us on to the second point…

The cultural climate

Even with controls in place, if there is a culture that accepts and promotes bribery it is very hard for them to work effectively, not least because record keepers, investigators and judges can be bribed. So the potentially dishonest individual is assailed with numerous temptations whilst seeing a culture of impunity around them. Once again, the US compromised for political reasons – the agencies of a generally uncorrupt US chose to dispense money through local political bigwigs, fuelling an explosion in corruption.

Let us not use only US institutions to illustrate this. Consider Mrs Andreasen, chief accountant at the European Union Commission who, according to the Daily Telegraph was

“shocked to discover that the EU did not have double-entry book-keeping when she joined the Commission in January, fearing that funds could be diverted without leaving an electronic fingerprint. Her claims, which were originally dismissed by Mr Kinnock's office [Kinnock was a British commissioner whose role was meant to be to control fraud], were later substantiated by a secret internal report from the Court of Auditors.

She claims that her superiors ignored warnings, so she eventually contacted the Court of Auditors and then MEPs. Mr Kinnock first moved her to another job, then subjected her to disciplinary proceedings, and finally suspended her...

He denied that Mrs Andreasen had been mistreated, saying that she violated staff rules by defaming her superiors, bringing disrepute on the Commission, and violating hierarchy lines.” This is the classic response of the company whose misdeeds are shown up by a whistleblower. In response many countries, including the UK, have introduced legislation to protect whistleblowers. It is hard to think how she could have defamed Kinnock who has lost any reputation that might have been capable of defamation.

Individual integrity

Only last is individual integrity an issue and, as implied above, once corruption takes hold it is hard to root out because the honest know they will not be protected. Indeed they fear they will be attacked by the corrupt and hauled before corrupt justice if they speak out.

Parallels with the corporate situation are clear. Controls are necessary but not sufficient without a culture of integrity because behaviours matter as much as rules. The Enron case is often cited as an example; there were rules and procedures that should have prevented at least some of the misbehaviour there but individuals did not act appropriately to enforce them and the Board itself connived at a conflict of interest which had only one possible purpose – to mislead users of published accounts. This permitted an inappropriate cultural climate to overwhelm the controls.

And back to the individual. The corrupt individual will still occasionally find ways to bypass controls or a cultural climate that is unfriendly to malfeasance - whilst the incorruptible individual will occasionally defeat corruption.

Since most companies have controls in place and there exists a mix of honest and dishonest people everywhere, the lesson is that the cultural climate at the top that is most important and provides the action point. Whether the US reconstruction in Iraq, The European Commission Budget or Enron, we find that it is political decisions at the top that provide cover for corruption.