cg course research paper (rachid zair)

Al Akhawayn University (AUI)Executive MBA Program 2010-2012Course MGT 6313

FINANCIAL SYSTEM CRISIS: A CORPORATE GOVERNANCE DEFICIENCY?

Research Paper

Group 2 - Rachid ZAIR & Kamal HANDIZI

“The global crisis was caused by the over-50’s not knowing what the under-30’s were doing” – Johann Rupert, Remgro Chairman.

SUMMARY

I. INTRODUCTION ……………………………………………………………………………………….. 2

II. THE GLOBAL FINANCIAL CRISIS (GFC) ………………………………………………….…….... 2

II.1. Overview of the GFC ………………………………………………………………………………………………………… 2

II.2. Causes & Economic Consequences of the GFC ……………………………………………………….…………… 3

III. CORPORATE GOVERNANCE ASPECTS IN THE GFC ………..……………………….…………. 3

III.1. Corporate Governance (CG) Role in the GFC ……………………………………………………………………

III.2. International CG Responses & Reforms ……………………………………………………………………………

IV. CONCLUSION …………………………………………………………………………………………….

REFERENCES ….………………………………………………………………………………………………

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I. INTRODUCTION

As predicted by Karl Marx in his Das Kapital, the evolution of capitalism, as

an economic system, stumbles necessarily on recurring periods of

economic crises with varying degrees of severity. The last such event was

the Global Financial Crisis (GFC) that has heavily shaken the world

financial system over the period 2007-2010.

Based on a review of the Internet literature dealing with the GFC, the

objective of the present research paper is: (1i) to make a synthesis of the

different views on the role of CG practices of certain international financial

firms in the triggering of the crisis, and, (2i) to summarize the main CG-

related response actions taken during and in the wake of the crisis.

The paper’s main body is organized into four sections. Section II outlines

the GFC, lists its main causes and illustrates its consequences; section III

exposes the different experts’ views with regard to the role of CG practices

in “guilty” international financial firms in the onset of the GFC; and, finally,

section IV dresses a listing of the major response actions and reforms

implemented during and in the aftermath of the crisis.

II. THE GLOBAL FINANCIAL CRISIS (GFC)

II.1. Overview of the GFC

At the origin of the GFC lies the crisis known as the US subprime mortgage

crisis (SMC) of August 2007. The SMC was essentially a real estate and

financial crisis initiated by the bursting of a housing bubble in the United

States in late 2006. At its onset, the SMC had manifestations and effects

localized mostly to the USA. The SMC was in fact marked by a sharp

increase in the residential mortgage delinquencies and foreclosures rate,

dramatic decline of the market value of the subprime mortgage baked-

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securities (MBS), and a large drop in the capital and liquidity of many

banks and financial institutions, as well as tightening credit.

Later, the US credit crunch cascaded quickly, by domino effect, into a

series of other crises which affected other economic sectors and countries.

The resulting sectorial crises had large scale effects such as the collapse

of US and European housing markets, collapse of the global stock markets

and financial systems and the bankruptcy or bailout of many large

international banks and financial institutions (See Annex I: Examples of

failures of major financial institutions).

II.2. Causes & Economic Consequences of the GFC

III.2.1. Causes of the GFC

As it could be expected, a complex set of causes were at the origin of the

GFC. During their Washington Summit (15 September 2008), the G20

leaders made a declaration on the GFC where they identified its root

causes in the following:

Market participants aggressively seeking higher yields without an

adequate appreciation of the risks and failing to exercise proper due

diligence;

Weak underwriting standards, unsound risk management practices,

increasingly complex and opaque financial products (namely, MBS1),

and consequent excessive leverage combining to create vulnerabilities

in the financial system; and,

Policy makers, regulators and supervisors, in some advanced countries,

not adequately appreciating and addressing the risks building up in

financial markets, not keeping pace with financial innovation and not

considering the systemic ramifications of domestic regulatory actions.

The central theme in this broad identification of the causes underlying the

GFC is remarkably linked to financial risks2 and, indeed, many authors

1 MBS: Mortgage Backed Securities.2 Risks tied up with innovative financial products through securitization processes (product risk), vulnerable financial systems (system risk), uncertain and unstable financial markets (market risk), and inadequate policy-making and regulation that might create risks or failed to address risks (policy risk).

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tend to interpret that crisis as the natural consequence of a number of

risky economic conditions which met and exacerbated over the period

leading up to the GFC.

III.2.2. Economic Consequences of the GFC

The costs and negative consequences of the GFC were immense. In

August 2009, the International Monetary Fund (IMF) calculated that the

total cost of the GFC to the international economy reached 11.9 trillion

US$3, which represented the fifth (or 20%) of the entire world’s annual

economic output.

According to a report issued by the Pew Charitable Trusts4, the United

States, the focal country of the GFC, suffered massive losses of income,

jobs, wages and wealth. For the period 2008-2009, these losses included:

650 billion US$ of GDP income, 5.5 million jobs, 360 billion US$ in wages,

3.4 trillion US$ of real estate wealth, 7.4 trillion US$ stock wealth and 230

billion fiscal rescue cost. This total crisis cost is equivalent to an average

loss of 188,250 $ for each US household.

III. CORPORATE GOVERNANCE ASPECTS IN THE GFC

III.1. Corporate Governance Role in the GFC

Since the start of the GFC, observers’ attention focused on the major

financial firms which were either the creators or takers of the innovative,

yet risky, financial products and derivatives that triggered the crisis. As

many of these firms either spectacularly collapsed or were bailed-out,

investigations were directed particularly to their CG practices with the goal

of determining the exact contribution of these practices in the promotion

3 Including cash injections into banks, and the cost of purchasing “toxic assets”, guarantee over debt and liquidity support from central banks.

4 The Pew Charitable Trusts is an independent non-profit, non-governmental organization (NGO), founded in

1948. With over US$5 billion in assets, its current mission is to serve the public interest by "improving public policy, informing the public, and stimulating civic life.". Official website: http://www.pewtrusts.org/

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http://www.pewtrusts.org/


of short-termism and aggressive risk taking which characterised these

firms in the period leading up to the crisis.

There have been basically three views regarding the role of the CG

practices of the “guilty” financial firms in the generation of the GFC. These

views are exposed below:

1st View – The GFC was unrelated or little related to CG

This first view is based on the fact that CG has improved significantly since

the 1970s in the countries most affected by the GFC (USA, EU countries,

etc.). In fact, following publication of several CG codes and principles in

the 1990s and early 2000s by such organizations as the OECD, IMF and

the World Bank, many business organizations in these countries

implemented “satisfactory” CG systems consisting of boards of directors

with the “right” dose of independent directors and separated chairman

and CEO functions and corporate audit, risk and compensation

committees. These CG systems provided also for increased and incentive-

driven executive pay to deliver value to shareholders as well as for an

increased protection of small shareholders’ rights; at the same time, large

shareholders (institutional shareholders and hedge funds) gained more

monitoring power over corporations. Supporters of this first view further

argue that the existing CG frameworks were significantly strengthened by

the Sarbanes Oxley Act of 2002 which made mandatory many best CG

practices such as board independence and audit procedures, with severe

penalties for any breach of the legislation.

In view of this giant leap made by CG since the 1970s in the countries of

interest, advocates of this first view conclude that practically all major

firms, in particular the big banks and financial institutions, were

satisfactorily governed in the period preceding the GFC.

2nd View – The GFC was closely associated with the insufficient implementation of CG principles and codes

The second view holds that the GFC correlated positively with deficiencies

in the implementation of CG principles and codes. This position is

championed by such organizations as the OECD and the Financial

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Reporting Council (UK). Reports by these organizations incriminate four

weak areas in the CG practices of the pre-crisis era, including (i) executive

remuneration, (ii) risk management, (iii) board practices, and the, (iv)

exercise of shareholders rights. For example, the 2009 report of the OECD

Steering Group on CG states that the already existing CG standards

adequately addressed those four key areas and that the ineffective

implementation of these standards was one of the key factors behind the

GFC.

3rd View – The GFC was at least in part caused by a systemic failure of corporate governance

This intermediate view blames the GFC partly on a systemic failure that

affected simultaneously the three fundamental dimensions of the US CG

framework which are:

Regulatory Governance

Regulatory governance means the control by the State over corporations

through such tools as government statutes, regulations and policies.

Advocates5 of the 3rd view argue that there was a failure along the

regulatory dimension of CG in the period prior to the GFC, manifested, for

example, in the substantial deregulation of the finance industry.

The typical example of deregulation most often cited is the repeal of the

Glass-Steagall Act (1933). Passed in the aftermath of the Great Depression

Crisis of 1929, the Glass-Steagall Act effectively separated commercial

banks from investment banks and allowed only the formers to take

whatever degree of risk with their depositor’s money. The repeal of this

Act by the Gramm-Leach-Bliley Act (1999) marked the culmination point of

deregulation beyond which greed won out over prudence in the US finance

industry.

5 One such advocate is the former Managing Director of the IMF, Dominique Strauss-Kahn, who has blamed the GFC on regulatory failure to guard against excessive risk-taking in the financial system, especially in the US.

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Another example of regulatory failure frequently mentioned is the

issuance of the Basel II Accord in June 2004 by the BCBS6, permitting

investment banks to substantially increase their debt level and leverage.

Market Governance (MG)

Market regulation refers to the control of corporate behavior through the

use of various market mechanisms such as supply & demand, price signal,

free competition, etc.

Advocates of the 3rd view argue that the sine qua non condition for an

effective regulation by the market of the financial industry was not

actually in place during the time period leading up to the GFC. This

condition is what is known as the Efficient Market Hypothesis (EMH). The

EMH postulates that when the flow of information is “even” between the

Interior of firms (“management”) and their Exterior (“Investors”),

regulation through the action of the market forces is most effective. In

reality, this flow of information is never perfectly “even”; this problem is

known as “information asymmetry”. In the pre-GFC era and a part from

that information asymmetry problem, there was an additional problem of

“information failure”. Indeed, despite that the risk-related information was

properly disclosed by financial firms as required by the applicable

provisions of the CG standards, most of the disclosed information related

to extremely complex financial products and derivatives and, hence, was

not of much use to external market players.

Stakeholder Governance (SG)

Stakeholder governance is the control and influence over corporate

decision-making by key stakeholder groups (including shareholders) who

have direct or indirect interests in the corporation. The German and

Japanese CG models are classical examples of CG frameworks that allow

for the participation of a wide range of stakeholder groups in the day-to-

day operation of corporations.

6 Basel Committee on Banking Supervision.

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With regard to this dimension, advocates of the 3rd view argued that the

due to the absence of formal participative arrangements in the US CG

model, corporate stakeholder groups failed in fully playing their regulative

role in the pre-GFC period. In particular, institutional investors of major

financial banks and institutions were blamed for their passive behavior and

lack of involvement which reduced the accountability of boards and in

particular of independent directors who were not very watchful of the

“management myopia” that proliferated in the pre-crisis years.

III.2. International CG Responses & Reforms

In the wake of the crisis, both countries have engaged in wide-ranging regulatory efforts to contain the damage

and prevent such a catastrophe from occurring again, and these efforts have included corporate governance

reform proposals intended to curb risk-taking. on both sides of the Atlantic these proposals have sought to

empower shareholders--not only in financial firms, but in all public companies--evidently in the belief that this

would permit the shareholders to constrain reckless managers of banks and other types of entities in the future.

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Appendix IExamples of failures of major financial institutions

Continental Europe

• DEXIA – Bailed out by Belgium, France and Luxemburg to the tune of $9bn in September 2008

• FORTIS – Partially nationalized in September 2008, with Belgian, Dutch and Luxembourg governments investing $16bn in the bank.

• HYPO REAL ESTATE – German Government has provided capital injections to prop up HRE over a period of time since September 2008, and now owns a 90% stake.

• UBS – Bailed out by Swiss Government in October 2008.

United Kingdom

• NORTHERN ROCK – Nationalized by United Kingdom Government in February 2008.

• BRADFORD & BINGLEY – Nationalized by United Kingdom Government in September 2008.

• HBOS – Taken over by Lloyds Banking Group in January 2009.

• RBS – United Kingdom Government took majority stake in RBS in October 2008.

United States

• LEHMAN BROTHERS – Filed for bankruptcy protection on 15 September 2008.

• CITIGROUP – Massive United States Government bailout in November 2008.

• BEAR STEARNS – Distress sale to JP Morgan Chase in March 2008.

• MERRILL LYNCH – Distress sale to Bank of America in December 2008 – now Bank of America Merrill Lynch

• WACHOVIA – Bought by Wells Fargo in November 2008 after government had attempted to force a sale to Citigroup.

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• AIG – Bailed out (or ‘nationalized’) by United States Government 16 September 2008 with issuance of credit liquidity facility accompanied by warrant for 79.9% of AIG shares. The credit facility was subsequently increased to over $100bn.

• WASHINGTON MUTUAL – Taken over by the Government and distress sale to J.P. Morgan on 28 September 2008.

• FREDDIE MAC – (Government Sponsored Enterprise) Taken over (placed on ‘conservatorship’ by United States Federal Housing Finance Agency) by United States Government on 7 September 2008.

• FANNIE MAE – (Government Sponsored Enterprise) Taken over (placed on

‘conservatorship’ by United States Federal Housing Finance Agency) by United

States Government on 7 September 2008.

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A myriad of reports and recommendations have identified these failings and proposed solutions to

ensure that these same mistakes are not repeated

Afloat in excess liquidity derived largely from huge Asian savings, United States

banks and home-loan institutions had, for some time, stepped up their practice of

providing mortgage loans to borrowers at high risk of being unable to repay them

(socalled “sub-prime” mortgages). By mid-2007, it was realised that this growing

practice was running into difficulty, with declining house prices and home

foreclosures up by 93% on the previous year.

The banks and home-loan institutions involved had often sold on these risky

debts to other financial institutions, which bundled or packaged (“securitised”)

them into “mortgage-backed securities” and other more complex financial

instruments for sale to investors, often through the intermediary of other

financial institutions. These sometimes did not look too closely at what they were

buying and selling, lured by the temptation of higher yields in a low interest-rate

environment, the prospect of mammoth bonuses and falsely reassuring ratings

from the credit agencies. The power of United States regulatory agencies to

intervene had, in the meantime, been curtailed by a free-market philosophy

resulting in deregulation.

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The extent to which this “toxic debt” had penetrated the financial world became

apparent as the crisis unfolded throughout the rest of 2007 and 2008. Major

banks, home-loan institutions and insurance companies ran into trouble. Several

filed for bankruptcy, were taken over or nationalised, mainly in the United States

and Europe. Trust was undermined between financial institutions, which lost faith

in the system, and banks virtually stopped lending – the so-called credit crunch –

with predictable effects on consumption and investment. Stock markets

plummeted as the crisis deepened in September-October 2008. Global financial

markets were affected. The entire financial system was threatened with collapse,

and governments and central banks soon stepped up their efforts to prevent it.

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The financial reform bill put forth by the Obama Administration is, first, about preventing another collapse of the Wall Street firms and re-regulating the financial industry to some degree.

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The GFC was the result of ‘a perfect storm of economic conditions’ which

included the subprime mortgage crisis, the property collapse, the liquidity crisis,

market volatility and an accommodating accounting and regulatory environment.

Most commentators also agree that corporate governance failings played a

contributory role. In particular, there has been widespread criticism of the chronic

and reckless risk-taking by management, which was fuelled by the banks’

remuneration policies.

The credit crunch

The global financial crisis (GFC) or global economic crisis is commonly believed to have begun in July 2007 with the credit crunch, when a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis. This, in turn, resulted in the US Federal Bank injecting a large amount of capital into financial markets. By September 2008, the crisis had worsened as stock markets around the globe crashed and became highly volatile. Consumer confidence hit rock bottom as everyone tightened their belts in fear of what could lie ahead.

The sub-prime crisis and housing bubble

The housing market in the United States suffered greatly as many home owners who had taken out sub-prime loans found they were unable to meet their mortgage repayments. As the value of homes plummeted, the borrowers found themselves with negative equity. With a large number of borrowers defaulting on loans, banks were faced with a situation where the repossessed house and land was worth less on today's market than the bank had loaned out originally. The banks had a liquidity crisis on their hands, and giving and obtaining loans became increasingly difficult as the fallout from the sub-prime lending bubble burst. This is commonly referred to as the credit crunch.

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Although the housing collapse in the United States is commonly referred to as the trigger for the global financial crisis, some experts who have examined the events over the past few years, and indeed even politicians in the United States, may believe that the financial system was needed better regulation to discourage unscrupulous lending.

The global financial crisis enters a new phase

The collapse of Lehman Brothers on September 14, 2008 marked the beginning of a new phase in the global financial crisis. Governments around the world struggled to rescue giant financial institutions as the fallout from the housing and stock market collapse worsened. Many financial institutions continued to face serious liquidity issues. The Australian government announced the first of it's stimulus packages aimed to jump-start the slowing economy.

The U.S. government proposed a $700 billion rescue plan, which subsequently failed to pass because some members of US Congress objected to the use of such a massive amount of taxpayer money being spent to bail out Wall Street investment bankers who some people may have believed could be one of the causes of the global financial crisis.

By September and October of 2008, people began investing heavily in gold, bonds and US dollar or Euro currency as it was seen as a safer alternative to the ailing housing or stock market.

In January of 2009 US President Obama proposed federal spending of around $1 trillion in an attempt to improve the state of the financial crisis. The Australian government also proposed another stimulus package, pledging to give cash handouts to tax payers, and spend more money on longer-term infrastructure projects.

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REFERENCES (No comprehensive list)

Internet Papers:

[01] Vidya Sagar Thalluri, Prashanth: “Satyam Computers Corporate Governance Fiasco (B): The Role of Independent Directors”. IBSCDC, 2009.

[02] “The Largest Corporate Fraud in India: Satyam Computer Services Limited”.

[03] Loganathan Krishnan: “Legal Issues on the Scandals Involving Auditors”. Second ICBER, 2011.

[04] Anup Agrawal & Sahiba Chadha: “Corporate Governance and Accounting Scandals”. University of Alabama, 2003.

[05] A.C. Fernando: “Satyam – Anything but Satyam”. LIBA, 2010.

[06] Srinivas Shirur: “Tunneling vs Agency Effect: A Case Study of Enron and Satyam”. September, 2011.

[07] Deepti Khedekar: “Corporate Crime - A comparison of Culture at Enron and Satyam”. University of Nebraska, 2009.

[08] Pranav Mittal: “The Role of Independent Directors in Corporate Governance”. National University of Juridical Sciences, Kolkata (India), 2011.

[09] K. Ramachandran: “Indian Familly Businesses: Their Survival beyond Three Generations”. Indian School of Business.

[10] The Pakistan Accountant Magazine: “Would Satyam Happen in Pakistan”. January – Marsh, 2009.

[11] Nandini Rajagopalan & Yan Zhang: “Recurring failures in corporate governance: A global disease?”. Business Horizons, 2009.

[12] Michael Barton & Parag Bhutta: “Satyam Computer Services Ltd.: Accounting Fraud in India”. University of Notre Damme, 2009.

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Internet Articles:

[13] Asia Times: “Raju brings down Satyam, shakes India”

[14] EconoMonitor: “The Satyam Scandal: Causes, Consequences and Cures”

[15] Rediff India Abroad: “Satyam Fiasco: IT Firms to Feel Ripple Effect”

[16] India Corporate Law Blog: “Beyond Satyam: Analyzing Corporate Governance in India”

[17] Livmint.com: “The 3 Phases of the Satyam Scam”.

[18] Legal Era: “Performing the Audit Process: Have We Learnt from Satyam”.

[19] Business Standard: “Satyam: How guilty are the independent directors?”.

[20] The Big Picture Blog: “Satyam's ex-independent directors”.

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