Prem Sikka argues that the present global credit crisis demonstrates the necessity of democratising major financial institutions
THE financial clouds are getting darker and Western economies are hurtling towards a deeper economic crisis. In order to prop up public confidence, some banks are being bailed out by taxpayers – and the queue is likely to become longer. The crisis highlights deep flaws in the governance of banks and financial institutions and a wide-ranging debate on this is urgently needed.
Global banking losses from the credit crisis may reach $1.3 trillion (£650 billion). With more than $900 million of losses, IndyMac Bancorp has become the biggest retail bank to fail in the United States. This has been followed by the government rescue of Fannie Mae and Freddie Mac, which account for about half of the $12 trillion mortgage market in the US. These two entities alone have some $3.3 trillion (£1.65 trillion) of exposure off balance sheet – in other words, not adequately reported in their accounts. Citigroup alone may have $1.1 trillion (£550 billion) of assets and liabilities off its books. Other banks may be re-examining possible consequences of their own financial engineering and one can only speculate about how regulators and governments made any sense of the risks of the banking sector.
In Britain, Northern Rock has been bailed out by taxpayers. Bradford and Bingley is teetering. The Royal Bank of Scotland is now worth little more than half of the £49 billion price tag it had barely a year ago. A large number of banks are relying on help from governments or, more correctly, taxpayers. Analysts expect more banking failures whose effects will be felt in other sectors, as well stoking fears of loss of jobs, homes, savings, pensions and investments.
Governments have used public finances to bail out banks, but have been slow to introduce reforms. Even then, much talk is focused on the external regulation of the financial industry. However, the crisis has been manufactured in corporate boardrooms through the reckless pursuit of short-term profits, executive remuneration, market shares and global supremacy.
For years, together with the rest of the corporate sector, banks have resisted the democratisation of businesses and now we are all paying the price. Attention should also focus on the governance of banks and financial institutions, particularly the role of executive directors, non-executive directors and auditors.
Company directors treat businesses as their private fiefdoms. At almost all banks, executive remuneration has been linked to profits and that inevitably provides incentives to massage accounts and cook the books. In pursuit of short-term profits, banks have developed novel accounting practices, highly leveraged financial structures and risky business strategies. They have marketed products without checking their capacity to cause mass financial destruction. All this helps to report higher profits and maximise executive remuneration, but many directors are simply not around to face the music when their business models fail.
Savers, borrowers, employees and local communities suffer from banking failures, but none have any representation on company boards and are not in a position to check the selfish impulses of directors.
For far too long, big business has resisted the presence of diverse stakeholders on company boards. It has instead opted for non-executive directors. During the committee stages of the Companies Act 1989, Labour argued that non-executive directors should be directly elected by stakeholders, including employees and customers. This would have created frameworks of accountability and helped to call directors to account. However, after coming to power in 1997, Labour did nothing.
The current financial crisis has again shown the ineffectiveness of non-executive directors. Almost all banks have non-executive directors and hardly any are known to have objected to their business practices. Most are directors’ friends and in no position to make any independent assessment of their policies. They hold multiple appointments and are seasoned passengers on the corporate gravy train. They spend 10-20 days a year at each company for some £60,000 in fees. Their time and commitment is utterly inadequate when it comes to understanding the complexities of any business or for restraining the excesses of company directors.
The non-executive directors at Enron were criticised in a report published by the US Senate Committee on Governmental Affairs. Former British Conservative Cabinet minister John Wakeham, a non-executive director at Enron, was also criticised. When faced with questions about events at iSoft, the troubled software company working in the National Health Service, Sir (later Lord) Digby Jones, the former director-general of the Confederation of British Industry and iSoft non-executive director said: “There is a limit to what a non-executive can know. They have to rely on what advisors tell them and what the executive team tells them.” In other words, non-executive directors are ornamental poodles. None of this persuaded the Government to take a fresh look at the way businesses are governed.
The deepening financial crisis further confirms that audit reports are not worth the paper they are written on. Despite the legal fiction that auditors are appointed and remunerated by shareholders, the reality is that auditors are hired and paid by company directors. The profit-maximising auditing firms cannot bite the hand that feeds them. Auditors do not owe a duty of care to any depositor, borrower or regulator.
The subprime crisis has been making headlines for over a year. The shrinking liquidity has been central to the deepening credit crunch. Billions of pounds worth of bank assets have been parked off balance sheet. Northern Rock, IndyMac and Freddie Mac received clean bills of health from their auditors. Despite a history of accounting problems, Fannie Mae, received a clean bill of financial health. The Carlyle Capital Corporation, Bear Stearns and Thornburgh Mortgage hit the financial buffers within days of receiving soothing audit reports. Audits which cannot spot trillions of dollars going off the balance sheet are not worth anything. How big does a problem have to be before auditors notice anything?
The current financial crisis shows that the biggest risks are borne by taxpayers, depositors, savers and employees. None have any direct say in how banks are governed. As taxpayers are effectively underwriting the financial system, they should be the prime beneficiaries of banking profits. Governments should demand ownership as a necessary condition of financial help. The governance structures should be changed. Directors of banks should be directly elected by stakeholders, including employees, borrowers and savers. They should owe a duty of care to all stakeholders. The corrosive link between profits and director remuneration should be broken. Instead, remuneration should be linked to a variety of performance indicators, including risk management, quality of service to customers, service to local communities and the capacity to cause financial destruction. Banks should not be allowed to inflict hardship on the elderly, rural communities or the less well-off by closing branches. They should be required to demonstrate that, as a result of closure, the local community will not be worse off. If non-executive directors are to be retained, they should be directly elected by bank employees, depositors and savers and be forbidden from holding multiple appointments so they can function as meaningful invigilating executive directors.
The current system of ex-post financial audits, conducted by captive accounting firms, is woefully inadequate. These tasks should be performed on a real-time basis by auditors directly employed by financial regulators. Unlike the present auditors, they should also be concerned with the efficiency and effectiveness of banks in achieving financial and social objectives. Their performance should be evaluated by the National Audit Office and subject to regular hearings by the Treasury Select Committee.
None of this likely to please the neo-liberals keen to privatise banking profits and socialise losses. But there is no private lender who would not impose conditions for providing financial support. The same should apply to the finance provided by taxpayers. The democratisation of banks and big business should be a necessary price of providing public finance to them. The pursuit of private profits, at almost any cost, has brought us to the edge of economic disaster and ultimately only democratisation offers any hope of checking the corrosive effects of finance.
Prem Sikka is professor of accounting at the University of Essex
