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Interim Market Report 2011 - Corporate Governance Environment

As we reported earlier this year the reforming zeal that was evident in the aftermath of the financial crisis has dissipated. Reforming the governance and regulation of the banks and wider financial services industry is no longer a coordinated crusade and does not enjoy the political focus it did. It has increasingly settled into regional and national initiatives. The crisis in this respect may ultimately have been a terrible waste. However, in both the UK and EU, regulators are acting against a backdrop of a simmering sovereign debt crisis and a banking system that remains fragile. The financial services industry is a significant part of the UK economy and as in most other countries, in spite of the need to reduce the threat posed by their banks, there is little appetite to undermine their competitiveness.

Within the UK, in spite of shrinking their balance sheets by £1.5trillion, the deleveraging of the banks is nowhere near complete. When assessing what can realistically be achieved by regulatory reforms, ensuring this process is allowed to continue without disorderly defaults and a crisis remains the unpublished policy objective.

The global response to the financial crisis and the coordination of the regulatory response took place under the auspices of the G20. Whilst the objectives remain consistent, regional and national initiatives are being promoted at the expense of international co-ordination. This is perhaps only to be expected in a world of different levels of development and growth. It is recognition that a ‘one size fits all’ approach is not practical in a diverse global economy. As co-ordinated financial reforms are in danger of ultimately yielding little, it is perhaps crucial to get the capital requirements of the banking sector right. Basel III guidelines require banks to boost their core tier one ration of equity to risk-weighted assets from 2% to 7% . Whilst regulators around the world signed up to Basel III, it is clear that having agreed the need for more capital, implementing common rules and standards is a far greater challenge. However the issues are complex. The EU’s capital requirements directive designed to incorporate Basel III into the regions banking rules appears to have loopholes that are set to undermine the requirements. Critics would argue that policy makers are under pressure from the banks to relax the requirements to avoid slowing economic growth. However, we have recently experienced what a system that is not sufficiently capitalised to be able to absorb losses does for growth. An undercapitalised banking system is a disaster waiting to happen. Given the lack of clarity in the rules it is not surprising that many risk managers in Europe do not believe Basel III is assisting them.

At a national level the Independent Commission on Banking led by Sir John Vickers delivered its interim report in April. It baulked at the formal separation of retail and investment banking. This was in spite of recognising that a state guarantee for retail banking provides cheap funding for the universal bank’s investment or ‘casino’ banking activities which were previously described by Lord Turner as lacking any social utility. In essence the rather moderate proposals plan is to impose a 10% tier one capital ratio on systematically important lenders and to ring fence retail banking away from investment banking. The government has seemingly accepted these interim proposals and the attempt to gain greater financial stability without fully separating retail and investment banking. Given the banks are in the process of rebuilding their capital bases this should not be too draconian or undermine London as a global financial centre. However as with Basel III and so much regulation, the devil is in the detail. There are so many grey areas including what might be regarded as capital and what is a retail or investment banking activity.

Whilst a universal regulatory environment is out of reach, the pressure on effective governance remains. The new regulatory structure for the UK has begun to emerge. In April the FSA announced an internal reorganisation to help it evolve into its new structure. The Supervision and Risk business units have been replaced with a Prudential Business Unit that as the Prudential Regulatory Authority (PRA) will become a subsidiary of the Bank of England. A Conduct of Business Unit will become the FSA’s renamed Financial Conduct Authority which will focus on consumer protection and market regulation. The Financial Policy Committee has also recently had its first meeting. As part of the Bank of England it will sit alongside the Monetary Policy Committee and is tasked with identifying where banks and other financial institutions are collectively taking excessive risks. It is planned to have the power to control the supply of credit and to stop asset bubbles developing.

However banks have already been warned that they will be scrutinised more intensely following the introduction of the PRA. This is a move away from simply regulating structures, activities and compliance with procedures. Its incoming head, Hector Sants, has stated that their judgements would no longer be taken on trust and the PRA is far more likely to challenge their decisions. The regulator will take their own view formed from their own analysis of the issues which affect the safety and soundness of a bank. The regulator will have the power to modify business plans. The FSA is already searching for excessive risk taking with the introduction of Business Model Assessments (BMAs).

The financial services industry in the UK is under intense regulatory scrutiny with much new regulation coming into effect in 2012. It is not surprising that 2011 is likely to be the year when the heaviest investment in risk management and compliance personnel and systems is made. The cost is considerable and just how much is boiler plate might remain to be seen. However, it is clear that boards are becoming more actively involved in risk management and it has become an integral part of management. There are any number of initiatives that financial services groups are embarking on to strengthen and improve risk management strategies, processes and systems.

Measured by the number of people employed in corporate governance and the costs involved, the financial services industry dominates corporate governance. It is perhaps easy to forget that the financial services industry represents rather less than 10% of GDP and that corporate governance does have implications for the rest of the economy. However, in recent years regulatory developments in industry and commerce have been limited. This may be indicative of the success of the present regime. Whilst major companies still fail, and it is central to capitalism that they are allowed to do so, it is rarely as a consequence of poor governance per se. More recently many corporate collapses have involved the activities of private equity houses. Having replaced equity with debt they have left companies thinly capitalised and unable to navigate what may be modest downturns in business. It could be argued that where the collapse of a company has wider social implications such as those operating in the utility, medical and care home sectors, there should be greater regulatory scrutiny.

Whilst the EU has launched a Green Paper on corporate governance reform it has potentially little relevance to the employment of corporate governance practitioners in the way that Sarbanes Oxley did after the accounting scandals ten years ago.

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