Corporate Governance: How to Say No and Still Get Lunch

As regulators we have learned that the maintenance of adequate levels of quality capital is critical to the safety of depositors and policyholders. It is important, only in part, because it provides a cushion to absorb losses and represents a substantial financial commitment by owners. Most important, it imposes discipline on the management of the enterprise.

As many of you know, regulatory minimum capital standards are in place for banks, trust and loan companies and P and C insurers. The trust company standards are being revised. There are rules in final draft form now out for life insurers. As regulators, we pay a lot of attention to capital and regard any failure to meet these standards as indicative of serious trouble leading to regulatory intervention.

We look to directors of regulated institutions, therefore, to accept responsibility for maintaining a stock of good quality capital in excess of minimum standards, and for ensuring that the shareholders are able and willing to inject more capital if needed or a widely-held institution maintains a position in the market enabling it to raise more capital if needed.

Directors should ensure that there is a sound capital management plan in place on a consolidated and non-consolidated basis that is frequently reviewed and adjusted as needed. Growth strategies should be consistent with the size of the required capital base and access to new capital.

Directors must be satisfied that dividends are not declared when doing so increases risk to depositors or policyholders. They need to be particularly careful if parent companies have funded their capital investments by short- and medium-term borrowings or commercial paper.

They also need to be extremely cautious if the institution is heavily dependent on depositor or policyholder funds that can be withdrawn quickly. This means that they must, from time to time, be prepared to act independently of--or even contrary to--what shareholders are asking for. Not easy--and it may be unfriendly.

And, of course, both directors and auditors must ensure that the accounting measurement of equity capital is very conservative. As I said in 1988, accounting errors of only five per cent of total assets can wipe out the capital base.

Directors should understand that poor asset quality is the key and constant element in institutional failure. It is very important that they and the auditors keep a constant eye on the asset-risk management controls employed by management, including a strong focus on how assets are put on the books in the first place. Directors should be satisfied that their own attitudes to risk are reflected in the quality and nature of assets acquired and the integrity of the borrowers.

Both directors and auditors need to be assured that bad news isn't hidden and problem assets are identified early and accounted for properly. Management should have the experience and skills to manage problem situations effectively to minimize losses. In a number of cases there has been a reluctance to do this.

I could go on and on about directors' responsibilities for asset quality. I will focus on a few specifics:

• Good lending and investment policies, including the kinds of borrowers and loans to avoid;

• Ensuring a wide spread or diversity of assets--lack of concentration;

• Potential losses in the off-balance sheet book;

• Unrealistic optimism as to the value of all assets--loans, investments, joint ventures, real estate, goodwill, deferred taxes; and

• Assets in which any related party or director had, or has, an interest must be legal and of the highest quality.

Directors have a clear statutory responsibility for ensuring quality management the governing acts, after all, state: "The directors shall manage the business and affairs of the company."

A great deal has been written about the relationship between the board and management, and I am not sure I have much wisdom to add. But the issue of the relationship between the CEO and board is important--who is boss? Does the CEO manage the board or does the board manage the CEO--and does it have to be one or the other?

However this works, the board has the overriding duty to see that management is not only good, but excellent, and that the management practices, including risk management, are first class--and constantly improving.

Some key factors that directors should ensure:

• Management focus on the interests of the institution itself as distinct from (I am not saying contrary to) the interests of the shareholders; and management compensation and other incentives should reflect this;

• Management acceptance of its responsibilities to depositors and policyholders--they are, after all, key to the survival of the institution;

• Individual accountabilities for poor performance, write-offs and losses;

• A management control culture that is tough, disciplined and pervasive through all levels up to the top;

• Excellent and efficient computer personnel and systems--this is very important;

• All the businesses conducted by the institution are encompassed by intelligence networks and information systems within management's experience and capacity;

• Management relations with the external lawyers, auditors and actuaries are open and professional, and that such professionals are not punished if they act in an independent and appropriate manner; at the same time directors should be satisfied with the quality of professional services being provided; and

• Management relations with the regulators are open and responsive. Directors should, through reading reports and direct contact, be assured that they understand the regulatory concerns and that they are being dealt with properly.

Satisfactory and sustainable profitability is the core ingredient in assuring safety and soundness. One of the problems in the system is that current profitability levels are unsatisfactory.

There are three components:

• A focused business where management knows the customers, understands their needs and provides services and products that meet these needs in the eyes of the customers;

• Low operating and funding costs. This involves good people working efficiently and state of the art systems; and

• Low levels of bad debts and other asset losses.

The directors' job is to ensure that they understand the business ingredients of sustainable profitability and keep management focused on the basics. The business strategies should be coherent and workable over a long term--immediate gains that cause medium- and long-term problems should be avoided.

The board also needs to caution management about the risks and rewards trade-offs--particularly nowadays when some companies seem to have a desperate need to generate profits quickly. This is particularly difficult when companies need to earn high returns to cover high costs of money.

Directors and auditors need to be sure that the accounting practices used by management are rigorous and conservative. In particular, optimistic asset valuations and revenue recognition policies cause trouble sooner or later. Of current concern to us is the accounting for derivatives and securitization transactions.

My office has put in place a number of procedures designed to assist both directors and auditors in ensuring sound accounting--and I think they are working well. We will continue to use our power to influence and, if necessary, to control accounting practices to ensure that earnings are soundly measured. We are against gimmicks.

This, in terms of measurement, is a more elusive matter. Liquidity consists of maintaining a stock of liquid assets and cash flows so that asset commitments are met, obligations are settled on due dates and operations continue so that no one has any doubts about the institution as a going concern.

Good liquidity practices are an essential component of maintaining confidence. They are clearly essential if, for whatever reason, there are marketplace concerns about safety. A solvent institution should be able to avoid liquidity funding crises--but only if it has good asset: liability or liquidity management practices, including, where necessary, contingency plans.

Directors need to pay some attention to the specifics of liquidity management and understand good practices. In particular, they should be satisfied as to the reasonableness of the forecasts involved and liquidity management always involves using forecasts.

I have said earlier that our supervising programs are built on trying to ensure the kind of self-governance duties and practices I have described. This work brings us into repeated contact with management, directors, auditors and actuaries in aiding them to focus on safety issues and to be aggressive in developing and maintaining strong control cultures.

We monitor these processes. One of our key early warning signs of trouble is evidence that they are not working. In recent years, we have become much more unpleasant where we see breakdowns. Let me describe some of the problems .we have encountered.

• We observe a general unwillingness by directors to accept our criticisms of management actions. If there is a perceived difference between the regulator and management, they seem to prefer to take management's side rather than look hard at the issue. They often do not insist on getting the kinds of information that management may be loathe to provide. I think this pressure is a function of the boardroom culture of Canada under which criticism of the issue is read as criticism of the person. One should not normally see close questioning of the CEO on his decisions as a vote of non-confidence in him personally, although this cannot be avoided if the situation is bad enough.

I used to believe that a word to the wise was sufficient. I now know that not much happens unless people are hit on the head with bluntness. Any ambiguity of message from us will likely be manipulated in favour of not doing anything if it is disagreeable.

Owners and directors have great difficulty believing bad news. It is akin to the medical-denial syndrome--"I have some symptoms but I'm not sick and don't need to see the doctor." Directors want good news and cheerful stories. In fact, I often have the impression that people smile at us, tell us what they think we want to hear and go on as before.

Where the institution is closely held, we see little evidence that its outside directors, acting in the interests of the company itself, its depositors or policyholders, are able to stand up to the owners. In fact, the normal pattern is that the directors, even the outsiders, who are on the board of the institution are also on the board of the holding company. This is dangerous.

More positively, in most situations we are familiar with, the institution itself has not become exposed through inappropriate related-party transactions. Boards have, with some exceptions, kept good control over these. We have, however, seen high-risk assets taken on in response to owners' pressure for more profits.

The one common characteristic of every institutional failure in the last five years is a financially weak shareholder who could not add strength or value to the institution. These shareholders generally received steady--even unquestioned--support from both the banks and others who were financing them, from their legal advisers and their boards. There was also aggressive accounting--mainly related to goodwill--at holding company levels. These holding companies are generally not regulated.

• Auditors have been slow to accept really rigorous accounting. This is getting better--but only when we write new rules. While I believe audit performance has generally improved in recent years, I have to tell you there is, in the regulatory and government circles in which I work, a high degree of scepticism about the capacity and independence of auditors. The new Chief Accountant of the SEC in Washington, a former auditor himself, is so sceptical of bank accounting and related audit work, that he is pushing hard to have all banks mark their balance sheets to market and to do this frequently.

• We have been disappointed in auditors' lack of understanding about credit risk management. They often do not address the vital issue of how loans are made in the first place.

• We have forged structural relationships with auditors and with the profession in order to enhance the capacity of auditors to be independent and to do better audits. We are also including consultations with them in developing accounting rules--which are getting steadily tougher. In the end, we probably cannot avoid pushing closer to mark to market accounting.

Let me try to put all this together. One can regard any failure of an institution as a function of market failure with bad assets, self-governance failure and regulatory failure.

My own view is that the combination of market failure and poor, or even only moderately competent, corporate governance gives me, the regulator, very little capacity to act so as to prevent the failure, even it we act quickly, although we can mitigate the damage. We do not--and cannot--manage the institution. We cannot take control of viable companies that meet their capital tests or even force changes of top management.

These are important issues. If one concludes that sound, even excellent, self-governance is not adequate to maintain the safety and soundness of institutions under pressure, and working with the regulatory procedures we now have, then the system is due for a lot more rules and regulations.

If the current view is that any failure is, first and foremost, a regulatory failure, it will mean that society does not believe corporate governance processes work. Such a view will lead to the increases in regulatory interventions that we are seeing in the U.S. The pressure for early intervention could lead to a system under which the regulators are required to seize the shares of companies that are still solvent but are in trouble. These interventions will become very intrusive and extremely costly.

There is a government and political view that more regulations, using very precise and arbitrary procedures, including seizure, will deal with the problem. I do not think that this is so--and U.S. evidence does not support it.

But unless we have corporate governance procedures that are excellent and credible, this is what could happen. We will do all we can to support the governance process. But if it is not recognized, as I said at the beginning, that the required levels of competence and attention have really increased in recent years, it won't work.

The appreciation of the meeting was expressed by Harry Seymour, President and CEO, Pathfinder Learning Systems Corp., and a Past President, The Empire Club of Canada.