Banking Crisis: reforming corporate governance and pay in the City - Treasury Contents


Summary



In this Report, the third in our series on the banking crisis, we focus our attention on remuneration in the City of London, as well as on the nexus of private actors—including non-executive directors, institutional shareholders, credit rating agencies, auditors, the media—who are supposed to act as a check on, and balance to, senior managers and the executive boards of banks.

Remuneration in the City of London

On remuneration we conclude that the banking crisis has exposed serious flaws and shortcomings in remuneration practices in the banking sector and, in particular, within investment banking. We found that bonus-driven remuneration structures encouraged reckless and excessive risk-taking and that the design of bonus schemes was not aligned with the interests of shareholders and the long-term sustainability of the banks. We express concern that the Turner Review downplays the role that remuneration played in causing the banking crisis and question whether the Financial Services Authority has attached sufficient priority to tackling remuneration in the City. The Report outlines clear failings in the remuneration committees in the banking sector, with non-executive directors all too willing to sanction the ratcheting up of remuneration levels for senior managers whilst setting relatively undemanding performance targets. We propose a number of reforms to remuneration in the banking sector. These include enhanced disclosure requirements on firms about their remuneration structures and about remuneration below board-level, reforms to remuneration committees to make them more open and transparent, and a Code of Ethics for remuneration consultants.

Remuneration in Lloyds and RBS

Next we turn our attention to remuneration practices in the specific cases of the part-nationalised banks. We argue that, whilst there is a strong case for curbing or stopping bonus payments for senior staff in Lloyds Banking Group and Royal Bank of Scotland, we accept the argument that the position of the banks would be worsened if they could not make bonus payments. If bonuses were prohibited at these banks, they would struggle to recruit and retain talented staff to the detriment of the taxpayer as a major shareholder in both institutions. That said, we highlight the lack of transparency regarding the exact cost of bonus payments, including deferred bonus payments, and call on the Government and UKFI to rectify this problem.

Sir Fred Goodwin's pension

We conclude that Lord Myners' assertion that his precept to the RBS Board—that there should be no reward for failure—did not represent an adequate oversight of the remuneration of outgoing senior bank staff. Instead, it would have been far better if Lord Myners had given a stronger, clearer direction of Government requirements for a bank in receipt of public funds and had assured himself by demanding to be kept informed of the detailed negotiations that were taking place. Secondly, we are not convinced that Lord Myners was right to take on trust RBS's suggestion that there was no option but to treat Sir Fred as leaving at the employer's request. It would, we believe, have been open to Lord Myners to insist that Sir Fred should have been dismissed. Finally, we are not convinced that the Treasury was right to rely on the current RBS Board to handle these negotiations without direct Treasury involvement. The RBS Board had shown itself to be incompetent in the management of the bank, steering it towards catastrophe, and was also possibly dominated by Sir Fred; there were no grounds for trusting them with this operation. We suspect that Lord Myners' City background, and naiveté as to the public perception of these matters, may have led him to place too much trust in an RBS Board that he himself described to us as "distinguished".

Non-executive directors

The current financial crisis has exposed serious flaws and shortcomings in the system of non-executive oversight of bank executives in the banking sector. Too often, eminent and highly-regarded individuals failed to act as an effective check on, and challenge to, executive managers, instead operating as members of a 'cosy club'. We pinpoint three problems: the lack of time many non-executives commit to their role, with many combining a senior full-time position with multiple non-executive directorships; in many instances a lack of expertise; and a lack of diversity. Our Report calls for a broadening of the talent pool from which the banks draw upon, possible restrictions on the number of directorships an individual can hold, dedicated support or a secretariat to help non-executives carry out their responsibilities effectively, reforms to ensure greater banking expertise amongst non-executives directors as well as stronger links between non-executive directors and institutional shareholders.

Shareholders

We also examine the failure of institutional investors effectively to scrutinise and monitor the decision of boards and executive management in the banking sector, concluding that this may reflect the low priority some institutional investors have accorded to governance issues, and that in some cases they encouraged the risk-taking that has proved the downfall of some great banks. We are particularly concerned that fragmented and dispersed ownership combined with the costs of detailed engagement with firms by shareholders has resulted in the phenomenon of 'ownerless corporations' described to us by Lord Myners. We argue that the Walker Review of corporate governance in the banking sector must address the issue of shareholder engagement in financial services firms and come forward with proposals that can help reduce the barriers to effective shareholder activism. However, we are not convinced that Sir David's background and close links with the City of London make him the ideal person to take on the task of reviewing corporate governance arrangements in the banking sector.

Credit rating agencies

We also examined the role played by the credit rating agencies in the banking crisis, an issue we first looked at over twelve months ago. We remain deeply concerned by the conflict of interests faced by credit rating agencies, and have seen little evidence of the industry tackling this problem with any sense of urgency.

Auditors

We also assess the role of auditors in the banking crisis. We note that the audit process failed to highlight developing problems in the banking sector, leading us to question how useful audit currently is. We also remain concerned about the issue of auditor independence and argue that investor confidence and trust in audit would be enhanced by a prohibition on audit firms conducting non-audit work for the same company. We recommend that the FSA consult on ways in which financial reporting can be improved to provide information on bank activities in a more accessible way.

Fair value accounting

We regret the power of the European Commission to pick and choose which international accounting standards should be implemented in the EU and call on the Treasury to consider the impact of the Commission's powers on the objective of establishing a single global set of accounting standards.

Media

Finally, we also looked at the role of the media in the banking crisis. We conclude that the evidence did not support the case for any further regulation of the media in response to the banking crisis. We argue that the press has generally acted responsibly when asked to show restraint in particular areas and that, too often, those responsible for creating the current crisis have sought refuge in blaming the media for their own conduct.


 
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Prepared 15 May 2009