Sir John Stuttard has spent his career with accountants, PricewaterhouseCoopers, of which he is now a vice-chairman. He has focused on auditing, acquisitions, stock exchange listings, and privatizations for UK, US, and Scandinavian companies. He was made a Knight, and then a Commander, of the Order of the Lion of Finland, and has been Chairman of the Finnish–British Chamber of Commerce. He served in the Cabinet Office for two years and spent five years in China as PwC executive chairman. He has also been a director of the China Britain Business Council. He is currently a trustee of Charities Aid Foundation and of Morden College, a governor of King Edward’s School, Witley, and on the board of other charities. He served as Sheriff of London in 2005–2006 and Lord Mayor in 2006–2007.
The Blame Game
When something goes wrong, regrettably, I’m afraid it’s human nature to point the finger at someone else. All too rarely does one admit responsibility and a share of the blame.
Back in the late summer of 2007, when it was clear that many financial institutions were facing difficulties, the first group to be attacked was the credit rating agencies. In September that year, European Union Commissioner Charlie McCreevy criticized credit rating agencies such as Moody’s and Standard & Poor’s for their conflicts of interest and poor methodologies. European Central Bank president Jean-Claude Trichet joined in.
Then the focus switched to the regulators, particularly after Northern Rock in the United Kingdom had to be bailed out by the government. It was unusual and refreshing, therefore, to witness the United Kingdom’s Financial Services Authority publish two separate internal reports criticizing itself for shortcomings caused by frequent changes in senior staff, inadequate review and discussion of findings, and failure to engage properly with Northern Rock.
Towards the end of 2008 and during the first two months of 2009, the criticism has been directed at bank executives, with their large bonuses, and to the nonexecutive directors who, it is alleged, should have exercised better corporate governance.
So who actually is to blame for what happened and what needs to be done to limit the possibility of it happening again? To begin with, we should all have seen it coming. Large trade surpluses in China and the Gulf countries generated huge foreign exchange reserves, which were typically invested in US Treasury bonds and Eurobonds, leading to inflated credit in the global financial system and the lowering of real interest rates.
This cheap, available money led to an extension of credit around the world. At the same time, investors were searching for higher yield and financial institutions became even more imaginative at creating new financial instruments. Financial activity exploded with, for example, the value of outstanding credit default swaps increasing from almost nothing in 2000 to over US$60 trillion in 2007. Gearing by financial companies increased tenfold in the period 1987 to 2007 and household debt doubled.
Was it surprising, therefore, that the bubble eventually burst? When there is too much credit in the system and when the price of borrowing does not reflect the intrinsic risk, there is bound to be a day of reckoning. And the fallout has been simply devastating for many.
Our global institutions, our governments, and many economists seemed content to allow agreeably high levels of economic growth to continue without spotting the thunder clouds gathering. And the media, usually so quick to criticize, didn’t blow the whistle either. We were all riding on a cloud of hubris.
The Role of the Regulators
And what of the regulators? A major problem is that our financial companies have become global, whereas financial regulators are, for understandable national reasons, predominantly national. And they each have their own structures and methodologies when it comes to regulation, just like different religions.
For example, in the United States there are many regulators for different parts of the financial sector and there is an insurance regulator in each state. In Britain, there is just one, the FSA, and in many other countries, such as China, there are three.
But the philosophies and methodologies are also very diverse. The French, the Germans, and the Chinese are very prescriptive. Their form of regulation is rules-based. Yet, America was very liberal and flexible in its approach. In his book The Age of Turbulence, completed in June 2007 when the crisis was brewing but not yet fully upon us or recognized, Alan Greenspan, formerly Chairman of the Federal Reserve, wrote: “Public sector surveillance is no longer up to the task,” and “We have no sensible choice other than to let markets work.”
I was concerned to read this. While the capabilities of financial regulators to provide oversight have indeed diminished in recent years because of the complexity of financial markets, regulators are appointed by governments to protect people and to protect economies from systemic failure, as well as fraud.
But then much of the blame must be laid at the door of those banks that took the greatest risk or did not test their strategies and their business models, or made acquisitions at high prices. Lehmans is no longer with us and others such as the Royal Bank of Scotland are, effectively, in state ownership. Bankers have apologized. The finger has also been pointed at nonexecutive directors for allowing such risks to be taken on their watch.
The Responsibilities of Governments
At the end of the day, governments must take responsibility for the effective management of the economy. They are expected to ensure economic growth, reasonable levels of employment, limited inflation and the health of the various sectors (not least the financial sector to provide a payments system), credit for investors, as well as opportunities for savers to invest for retirement. After all, if things go wrong, governments have to step in, as we have witnessed throughout the world in recent months.
At present, the conflicting needs of deleveraging banks yet encouraging bank lending represent a real dilemma for any government seeking to recover after the credit bubble has burst.
The priority must be to prevent hardship. Yet this should not be at the expense of long-term remedies or driven by short-term political expedience. The world’s political leaders have an opportunity to put forward simple propositions.
To try anything too complicated would not work. After all, there are as many views globally about the form and manner of regulation as there are faiths, and it is inconceivable that there will ever be one world religion.
The goals should be very clear. The politicians should encourage a world body —possibly the IMF—to monitor global trends and influence national governments. They should establish a global College of Regulators to share best practice, establish clear responsibilities, and ensure better communication between regulators.
Principles for Best Practice
They need to develop a set of principles (not rules) for best regulatory practice, based around improvement in risk assessment, risk management, closer relations between regulators and those regulated, and recruitment of higher caliber staff in the regulatory bodies. That means rejecting the laissez-faire approach as represented by the phrase: “We have no sensible choice other than to let markets work.”
Regulators should be encouraged to be more interventionist with financial institutions when identifying risky strategies or high-risk product areas and request directors to cease these activities. Regulators also need to control the shadow banking system and to focus more on risk. But we don’t want more box-ticking. Instead, we should adopt the maxim of “one in, one out” when it comes to new regulations. We need better regulation, not more regulation.
Finally there should be a review of accounting rules on off-balance sheet credit and securitized intermediation, to ensure that arrangements to remove potential risks from balance sheets are correctly communicated to shareholders and others. That however does not mean giving in to suggestions that we should turn the clock back on “mark-to-market”, since to do so would hide the truth and delude those who rely on corporate reports.
In most countries, with the exception of China, there is a need to reduce debt and to encourage savings. We cannot keep living beyond our means. That is unfair on future generations as well leading, inevitably, to financial and economic hardship.
Action is also required by companies and their directors. During the last decade, banks have merged with investment banks and have become hugely innovative. There have been suggestions that the financial sector has become too innovative, driven by high remuneration and encouraging bonuses. New instruments have become so complex, prompting Warren Buffett to say in 2002 that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially dangerous”.
There is anecdotal evidence that many senior executives did not fully understand what their bright young things had cooked up. There is further evidence that nonexecutive directors did not fully understand the complexities of the business and did not fully appreciate the risks.
Equally important is strengthening corporate governance yet further, by supporting nonexecutive directors more, so that they perform their job better. They need comprehensive information about the business, about new business areas, about potential risks, about plans to innovate, and manage risks. They need more, independent assessments of business trends, of management performance, and of prices to be paid for major acquisitions.
We know from experience that things go wrong when a dominant, enthusiastic chief executive is not subject to challenge from a strong chairman and a talented, informed board. The wrong strategies are chosen, inflated prices are paid for acquisitions, and frauds often result.
In the United States, there is a need to separate the roles of chief executive and an independent chairman. In the United Kingdom we believe that we have the right corporate governance framework in place, but it doesn’t always work in practice as well as it might.
It has been suggested that chief financial officers should be more independent from their chief executives by, for example, arranging for them to report jointly to the independent chairmen—and that chairmen should also be involved in selecting and assessing the performance of chief financial officers.
Another proposal is for nonexecutive directors to have a dedicated corporate executive to advise them on particular issues and to commission independent valuations of proposed major acquisitions.
It is also important that nonexecutive directors do not take on too many directorships. That means they will be able to devote more time to the companies on whose boards they sit—and, to facilitate this, ensure that they are properly paid, given their knowledge, expertise, and expected time commitment.
The recent recommendations (published in November 2009) following the review in the UK by Sir David Walker into the corporate governance of banks and other financial sector entities represent a real step forward. There is now a crying need to develop a set of principles which can be agreed and applied globally, since many of our financial institutions are now global rather than national in character. It has taken the accountants over 35 years to develop international accounting standards which are now, almost, universally agreed. We need to move faster in the area of corporate goverance. But who will take the lead?
Credit rating agencies also need to review their practice to ensure that conflicts of interest are managed and that they are seen to be independent. Attacks on these agencies are reminiscent of the attacks on auditors about a decade ago—and remedies have been found in my profession, with which governments, investors, and commentators have confirmed that they are now satisfied.
Rebuilding Trust and Confidence
But a further and final thought is the need to rebuild trust and confidence in the financial system. We, here in London, have long prided ourselves in our integrity where the phrase “my word is my bond” was in common parlance. A high standard of ethics is the bedrock of professionalism in banking, share dealing, and trading, as it is in medicine. Perhaps one outcome of the financial crisis is a greater awareness of rebuilding such fine values in the global financial system.
We need to rediscover Adam Smith’s concept of socially responsible capitalism. This is a debate in which we should all be engaged—to minimize the chances that the current financial crisis will recur.