1. © International Centre for Financial Regulation 2010. All rights reserved. 1 Improving corporate governance in the financial sector Barbara Ridpath 17 June 2010

2. © International Centre for Financial Regulation 2010. All rights reserved. 2 Contents 1.Perceived failings of corporate governance 2.Key questions 3.Framework; work since the crisis 4.Outstanding issues 5.Will these changes make a difference?

3. © International Centre for Financial Regulation 2010. All rights reserved. 3 Perceived failings of corporate governance Inadequate understanding of underlying business Inadequate understanding of nature and scale of risk Inadequate control of risk and risk appetite Perceived conflicts of interest Difficulties of challenging executive directors Remuneration culture de-linked from risk culture Perception that remuneration structure drove short-termism (though both Bear Stearns and Lehman had very long vesting and holding periods for employee stock payments) Shareholders did not properly exercise their role as owners

4. © International Centre for Financial Regulation 2010. All rights reserved. 4 Key question: can regulation make up for management failures? Board responsibilities vs. management responsibilities Regulatory responsibility vs. corporate responsibility The changing role of the shareholder

5. © International Centre for Financial Regulation 2010. All rights reserved. 5 Framework: Existing UK corporate governance framework The existing UK corporate governance framework is currently characterised by a mix of binding legislation, formal rules and “soft law”.

6. © International Centre for Financial Regulation 2010. All rights reserved. 6 Framework OECD: Principles of good governance 1999, revised 2004 Basel Committee on Bank Supervision 1999, 2006 UK from Cadbury Principles to the Combined Code

7. © International Centre for Financial Regulation 2010. All rights reserved. 7 Work since the crisis UK Walker Review 2009 FSA 2009 Financial Reporting Council 2010 Basel Committee on Bank Supervision Principles for Enhancing Corporate Governance, Consultative Document, March 2010 European Commission corporate governance Consultation launched June 2, 2010 Commission staff working document OECD Corporate Governance and the Financial Crisis, June 2009

8. © International Centre for Financial Regulation 2010. All rights reserved. 8 Walker review’s five core themes Role of institutional shareholders Governance of risk Functioning and evaluation of the board Remuneration Board size, composition and qualification

9. © International Centre for Financial Regulation 2010. All rights reserved. 9 Walker Review: Final recommendations Board size, composition and qualification NED understanding, induction, ongoing training and support Increased time devoted to board responsibilities FSA should interview board members and look at board performance Functioning and evaluation of the board Role, qualifications and time of chairman; annual election Role of senior independent director Role of institutional shareholders Institutional shareholders Stewardship Code should be ratified by the FRC Seek opportunities for constructive engagement and disclose voting record Governance of risk Board Risk Committee and independent Chief Risk Officer Risk committee due diligence appraisal on acquisitions and disposals Separate risk report in annual accounts

10. © International Centre for Financial Regulation 2010. All rights reserved. 10 Walker Review: Final recommendations (cont’d.) Remuneration Disclosure of compensation ‘bands’ for high-end employees Risk adjustment of performance incentives

11. © International Centre for Financial Regulation 2010. All rights reserved. 11 Financial Services Authority Remuneration Approved persons Significant influence functions

12. © International Centre for Financial Regulation 2010. All rights reserved. 12 Basel Committee on Banking Supervision (comments due 15 June) Determine bank’s risk tolerance/appetite Oversight of senior management Risk policy, management and internal controls Independence of the Chief Risk Officer; CRO direct access to board Code of conduct Protection of depositors as stakeholders Approval process and due diligence for new products and structures Customer due diligence Effective relationship with supervisor Self-criticism—evaluation of board workings Role of controlling shareholders: board members have responsibility to the bank regardless of who appoints them Treatment of banking subsidiaries vs. group and parent company boards Promote transparency of reporting and disclosure

13. © International Centre for Financial Regulation 2010. All rights reserved. 13 Financial Reporting Council No distinction between financial institutions and other corporate entities Principles Leadership Effectiveness Accountability Remuneration Relations with shareholders

14. © International Centre for Financial Regulation 2010. All rights reserved. 14 Changes New principles on board composition and selection Responsibilities and time commitment of directors Director development and board evaluation reviews Annual re-election of directors for FTSE 350 Annual explanation of business model and determination of risk appetite Alignment of performance related pay with long term interests of the company and its risk policies and systems.

15. © International Centre for Financial Regulation 2010. All rights reserved. 15 EU DG Markets Green Paper on corporate governance in financial institutions Premise: ‘Current system of checks and balances must be significantly strengthened, duly applied and enforced so that all involved will have a greater awareness of their accountability and liability...’ Issues: –Expertise and time commitment –Board composition and diversity –Evaluation of board performance –Risk Oversight –Remuneration –Dialogue with Supervisors Questions: –All listed, or just financial institutions (bank and life insurers)? –Shareholders'’ responsibilities

16. © International Centre for Financial Regulation 2010. All rights reserved. 16 Outstanding issues From existing work: Should all corporates be treated the same? –Large or small –Financial institutions or all listed companies Should boards have any responsibility for systemic stability? Will changes make a difference? Yet to be addressed: Compliance in multiple jurisdictions for companies operating globally –Competitive aspects –Conflicts The role of shareholders Incentives resulting from remuneration from unrealized gains Impact of living wills on complexity, governance and multiple boards

17. © International Centre for Financial Regulation 2010. All rights reserved. 17 The role of shareholders: investor activism Gap between ultimate beneficial owner and board as agent Reduced component of long-only holders such as life insurers and pension funds ‘Free rider problem’ Cost of activism given preponderance of low cost index-linked and ETF investments Increasingly international component of ownership with different views on appropriate governance Business models geared to short-term equity performance Investor time horizon shortened—focus on quarterly earnings Other stakeholders: Debt holders? Employees? Pensioners?

18. © International Centre for Financial Regulation 2010. All rights reserved. 18 Conclusions: will proposed changes make a difference? Need to keep testing to see if changes result in more consistent performance Impact of board expertise and diversity? Alignment of staff on risk appetite and management; alignment of incentives and cultures Does ‘poacher-gamekeeper’ work? Adversarial approach ‘4 eyes’ approach ‘Back to the future’ Alignment of interests: stakeholders and clients Management needs to ‘walk the walk’ not just ‘talk the talk’ (cf Enron) Interaction between Board and supervisors?

19. © International Centre for Financial Regulation 2010. All rights reserved. 19 www.icffr.org