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Corporate Governance Viewpoints

Making It Count: Independent Nonexecutive Directors

by Brandon Davies


This article was first published in Quantum magazine.

The inability of independent nonexecutive directors (INEDs) to rein in banks’ excesses has been highlighted in the wake of the financial crisis. Brandon Davies, an INED himself at Gatehouse Bank, examines whether proposed reforms to strengthen their role go far enough.

Corporate Governance Reform

In the wake of the global financial crash, governments and regulators have set in motion a root-and-branch reform of how financial institutions should be run. But one area which still needs to be properly addressed is corporate governance. Many countries have paid too little attention to the quality of the directors whose failure to fulfill their responsibilities was critical to the scale of the crisis.

Board-level reform will have to be tackled whatever the impact of other, broader changes such as banks having to introduce higher capital “weights” for many asset classes, as well as complying with liquidity requirements and a balance sheet gearing ratio. Many jurisdictions are also limiting government-implicit guarantees to systemically important institutions, ensuring that banks can be wound up in an orderly manner. Other suggested reforms include restricting deposit guarantees to retail operations and limiting the scope of banking undertaken by retail firms; and ensuring that “agency problems” associated with remuneration structures do not encourage reckless behavior.

But none of this addresses the vital need to strengthen corporate governance. The point is reinforced when the recent record of British and American banks is contrasted with those in nations such as Australia and Canada, where there is a much greater emphasis on assessing the quality of board members and, consequently, the impact of the crisis was greatly mitigated.

The Regulatory Approach

The Financial Stability Board (FSB), an international body set up to help develop global international regulatory standards, has highlighted deficiencies in corporate governance, above all when it comes to risk. It points out: “Across the FSB member jurisdictions, supervisory expectations for risk governance have increased, particularly for so-called systemically important financial institutions, as this was an area that exhibited significant weaknesses during the global financial crisis… The inclusion of a firm-level survey in the peer review (to be published in the first half of 2013) reinforces the message that a firm’s board and senior management are responsible for managing its risk.”

The message that better governance is needed is, it seems, at last getting through. Regulators in the United Kingdom have recently taken a lead in establishing stricter standards for board members. But there is a strong case for arguing that the current thinking of the Financial Services Authority (FSA), the lead UK regulator, is not radical enough.

The FSA accepts that the crisis exposed significant shortcomings in the governance and risk management of firms and the culture and ethics which underpin them. It argues that this is not principally a structural issue but a failure in behavior, attitude, and, in some cases, competence that requires action from governments and regulators. This is at least an acknowledgement that the current principles of corporate governance are no longer adequate.

Challenging Executives

A board has a number of important responsibilities to shareholders, regulators, customers, and staff. One of the most important roles it plays (any failure in which can have disastrous consequences for all stakeholders) is that of challenging executive management’s proposed actions, restraining such actions where they may result in unacceptable risks, and holding them to account for their actions.

Governance failings that have time and again been highlighted in regulators’ reports on bank failures seem to focus on three specific problems: the failure of boards properly to challenge dominant and overambitious senior executives, most notably in their reckless acquisition of new business and businesses; the failure of boards to hold themselves and their executives to the “risk appetite” agreed with their regulators for the proper conduct of their banks’ business; and declining to penalize senior executives for failure.

The solution, says the FSA, is to get boards to set a “tone from the top,” based on a full knowledge of the institution’s strategy and how the business model will be affected by strategic decisions. There should also be a clear understanding of what might cause the banks to fail.

Board members should have sufficient expertise to execute their responsibilities, but be diverse enough to avoid “groupthink”—and the chairman should ensure this balance is struck. Boards should have the information and capacity to monitor the way in which their decisions are implemented, as well as having a system to assess their own effectiveness.

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