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Home > Corporate Governance Best Practice > Why the “Credit Crunch” May Be Good for Corporate Governance

Corporate Governance Best Practice

Why the “Credit Crunch” May Be Good for Corporate Governance

by Terry Carroll

Executive Summary

  • In the United Kingdom the corporate governance industry probably originated in 1992 following the Cadbury Report. The collapse of Barings Bank in 1995 and then the subprime crisis in America contributed to the worldwide financial crisis.

  • In 2001 Enron failed, and this scandal also brought down the largest accounting firm in the world, Arthur Andersen. In September 2008, Lehman Brothers filed for bankruptcy, becoming one of the largest banking failures in global history.

  • The credit crunch has been more of a liquidity crunch because the banks stopped lending to each other. In the United Kingdom Northern Rock failed because it was unable to find sufficient funds to service its mortgage lending commitments.

  • By the time the process of unraveling the global financial mess began, many reputable institutions had failed, with investors losing their money. Banks constantly complain about burgeoning regulation, but self-regulation hasn’t worked.

  • Corporate governance has become a global industry. The fallout from the credit crunch and the stricter Basel II capital adequacy requirements will affect both the cost and availability of funding.

  • There are still incompetence, inadequacy, and the mediocre in the boardrooms of some British companies. Boards of directors need to take more responsibility for their actions and must think about how their operations are funded.

The Origins of Corporate Governance

In her article “A board culture of corporate governance,” Gabrielle O’Donovan defines corporate governance as “an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity and integrity.”

In the United Kingdom the corporate governance industry was probably born in 1992 with the Cadbury Report. This followed the debacles surrounding Robert Maxwell in 1990 and the collapse of Polly Peck. Together with other developments, especially the Hampel Report, the Combined Code on Corporate Governance was produced in 1998 and has since undergone further revisions.

Banking failures have always produced a regulatory response. The Barings collapse in 1995 also contributed to the demands for better governance, but some of the ways in which the Barings board failed should already have been covered by sound business and banking practice. In particular, there was inadequate supervision of Nick Leeson, but, in addition, the principle of “separation of function” was breached.

And this is the fundamental problem with corporate governance. Best business and financial practice should be sufficient to guide most boards. If certain directors had been better at self-regulation, much of the panoply of governance might not have been needed.

As with many other debacles in corporate America, the root cause of the subprime crisis may have been excessive pursuit of growth and individual reward. However, it was exacerbated by complex additional layers of derivative transactions, increasingly off balance sheet and often offshore.

The premise in this article is that the principles of good governance, if they had been applied, would have led to better oversight and challenge. It is also that the lessons to be learned are applicable to most companies in their general business.

Problems in Corporate America and Banking

In 2001 Enron failed, following allegedly fraudulent accounting practices. This scandal also brought down the largest accounting firm in the world, Arthur Andersen. That firm was also implicated in the ultimate failure of WorldCom in 2002, which involved a $3.8 billion fraud.

While in the United Kingdom history of governance regulation has been measured and considered, the scandals in the United States led directly to the Sarbanes–Oxley Act, which was hurriedly put together and has had far-reaching consequences beyond the shores of America.

On September 13, 2008, Lehman Brothers filed for bankruptcy, becoming one of the largest banking failures in global history. While, unlike Barings, it was not brought down by fraud, some would say the company was in part the architect of its own demise, as it was as vigorous as many in promoting the development of what has now been called “subprime” lending.

Although the bill was picked up by the shareholders of the financial institutions that failed and by taxpayers, there was growing anger that the executives had reaped handsome rewards—even where losses were incurred. This has left another legacy for better governance to resolve.

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Further reading

Reports:

Article:

  • O’Donovan, Gabrielle. “A board culture of corporate governance.” Corporate Governance International Journal 6:3 (2003). Online at: tinyurl.com/ybuzoat

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