UK CORPORATE GOVERNANCE AND BANKING REGULATION

[Sapphire Capital]

CORPORATE GOVERNANCE AND BANKING REGULATION
WORKING PAPER 17
Kern Alexander
Cambridge Endowment for Research in Finance
University of Cambridge
Trumpington Street
Cambridge CB2 1AG
Tel: [phone]
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[e-mail]
June 2004
This Working Paper forms part of the CERF Research Programme in International Financial Regulation
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Abstract
The globalisation of banking markets has raised important issues regarding corporate governance regulation for banking institutions. This research paper addresses some of the major issues of corporate governance as it relates to banking regulation. The traditional principal-agent framework will be used to analyse some of the major issues involving corporate governance and banking institutions. It begins by analysing the emerging international regime of bank corporate governance. This has been set forth in Pillar II of the amended Basel Capital Accord. Pillar II provides a detailed framework for how bank supervisors and bank management should interact with respect to the management of banking institutions and the impact this may have on financial stability. The paper will then analyse corporate governance and banking regulation in the United Kingdom and United States. Although UK corporate governance regulation has traditionally not focused on the special role of banks and financial institutions, the Financial Services and Markets Act 2000 has sought to fill this gap by authorizing the FSA to devise rules and regulations to enhance corporate governance for financial firms. In the US, corporate governance for banking institutions is regulated by federal and state statute and regulation. Federal regulation provides a prescriptive framework for directors and senior management in exercising their management responsibilities. US banking regulation also addresses governance problems in bank and financial holding companies. For reasons of financial stability, the paper argues that national banking law and regulation should permit the bank regulator to play the primary role in establishing governance standards for banks, financial institutions and bank/financial holding companies. The regulator is best positioned to represent and to balance the various stakeholder interests. The UK regulatory regime succeeds in this area, while the US regulatory approach has been limited by US court decisions that restrict the role that the regulator can play in imposing prudential directives on banks and bank holding companies. FSA regulatory rules have enhanced accountability in the financial sector by creating objective standards of conduct for senior management and directors of financial companies. The paper suggests that efficient banking regulation requires regulators to be entrusted with discretion to represent broader stakeholder interests in order to ensure that banks operate under good governance standards, and that judicial intervention can lead to suboptimal regulatory results.
JEL Codes: K22; K23; L22; L51; G28
Keywords: Government Policy and Regulation; Corporation and Securities Law; Regulated Industries and Administrative Law; Economics of Regulation; Firm Organization and Market
Acknowledgements
The research and writing of this paper benefited from the financial support of the Cambridge Endowment for Research in Finance and the Ford Foundation. The author is most grateful to his colleagues at CERF and to Dr. Rahul Dhumale of the Federal Reserve bank of New York. An earlier version of the paper was presented at the Annual Meeting of the American Society for Comparative Law in November 2003, which was held at the Stetson University College of Law in Saint Petersburg, Florida.
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Corporate Governance and Banking Regulation:
The Regulator as Stakeholder
The role of financial regulation in influencing the development of corporate governance principles has become an important policy issue that has received little attention in the literature. To date, most research on corporate governance has addressed issues that affect companies and firms in the non-financial sector. Corporate governance regulation in the financial sector has traditionally been regarded as a specialist area that has fashioned its standards and rules to achieve the overriding objectives of financial regulation - safety and soundness of the financial system, and consumer and investor protection. In the case of banking regulation, the traditional principal-agent model used to analyse the relationship between shareholders and directors and managers has given way to broader policy concerns to maintain financial stability and ensure that banks are operated in a way that promotes broader economic growth as well as enhancing shareholder value.
Recent research suggests that corporate governance reforms in the non-financial sector may not be appropriate for banks and other financial sector firms.1 This is based on the view that no single corporate governance structure is appropriate for all industry sectors, and that the application of governance models to particular industry sectors should take account of the institutional dynamics of the specific industry. Corporate governance in the banking and financial sector differs from that in the non-financial sectors because of the broader risk that banks and financial firms pose to the economy.2 As a result, the regulator plays a more active role in establishing standards and rules to make management practices in banks more accountable and efficient. Unlike other firms in the non-financial sector, a mismanaged bank may lead to a bank run or collapse, which can cause the bank to fail on its various counterparty obligations to other financial institutions and in providing liquidity to other sectors of the economy.3 The role of the board of directors therefore becomes crucial in balancing the interests of shareholders and other stakeholders (eg., creditors and depositors). Consequently, bank regulators place additional responsibilities on bank boards that often result in detailed regulations regarding their decision-making practices and strategic aims. These additional regulatory responsibilities for management have led some experts to observe that banking regulation is a substitute for corporate governance.4 According to this view, the regulator represents the public interest, including stakeholders, and can act more efficiently than most stakeholder groups in ensuring that the bank adheres to its regulatory and legal responsibilities.
By contrast, other scholars argue that private remedies should be strengthened to enforce corporate governance standards at banks.5 Many propose improving banks’ accountability and efficiency of operations by increasing the legal duties that bank directors and senior management owe to depositors and other creditors. This would involve expanding the scope of fiduciary duties beyond shareholders to include depositors and creditors.6 Under this approach, depositors and other creditors could sue the board of directors for breach of fiduciary duties and the standard of care, in addition to whatever contractual claims they may have. This would increase banks managers’ and directors’ incentive of bank managers and directors to pay more regard
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to solvency risk and would thereby protect the broader economy from excessive risk-taking.
The traditional approach of corporate governance in the financial sector often involved the regulator or bank supervisor relying on statutory authority to devise governance standards promoting the interests of shareholders, depositors and other stakeholders. In the United Kingdom, banking regulation has traditionally involved government regulators adopting standards and rules that were applied externally to regulated financial institutions.7 Regulatory powers were derived, in part, from the informal customary practices of the Bank of England and other bodies that exercised discretionary authority in their oversight of the UK banking industry. In the United States, banking regulation has generally been shared between federal and state banking regulators. The primary objective of US regulators was to maintain the safety and soundness of the banking system. There were no specific criteria that defined what safety and soundness meant. Regulators exercised broad discretionary authority to manage banks and to intervene in their operations if the regulator believed that they posed a threat to banking stability or to the US deposit insurance fund. As US banking markets have become more integrated within the US as well as international in scope, US federal banking regulators increased their supervisory powers and developed more prescriptive and legalistic approaches of prudential regulation to ensure that US banks were well managed and governed. Today, under both the UK and US approaches, the major objectives of bank regulation involve, inter alia, capital requirements, authorisation restrictions, ownership limitations, and restrictions on connected lending.8 These regulatory standards and rules compose the core elements of corporate governance for banking and credit institutions.
As deregulation and liberalisation has led to the emergence of global financial markets, banks expanded their international operations and moved into multiple lines of financial business. They developed complex risk management strategies that have allowed them to price financial products and hedge their risk exposures in a manner that improves expected profits, but which may generate more risk and increase liquidity problems in certain circumstances.9 The limited liability structure of most banks and financial firms, combined with the premium placed on shareholder profits, provides incentives for bank officers to undertake increasingly risky behaviour to achieve higher profits without a corresponding concern for the downside losses of risk. Regulators and supervisors find it increasingly difficult to monitor the complicated internal operating systems of banks and financial firms. This has made the external model of regulation less effective as a supervisory technique in addressing the increasing problems that the excessive risk-taking of financial firms poses to the broader economy.
Increasingly, international standards of banking regulation are requiring domestic regulators to rely less on a strict application of external standards and more on internal monitoring strategies that involve the regulator working closely with banks and adjusting standards to suit the particular risk profile of individual banks. Indeed, Basel II emphasises that banks and financial firms should adopt, under the general supervision of the regulator, internal self-monitoring systems and processes that comply with statutory and regulatory standards. This paper analyses recent developments in international banking regulation regarding the corporate governance of banks and financial institutions. Specifically, it will review recent international
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efforts with specific focus on the standards adopted by the Basel Committee on Banking Supervision. Pillar II of Basel II provides for supervisory review that allows regulators to use their discretion in applying regulatory standards. This means that regulators have discretion to modify capital requirements depending on the risk profile of the bank in question. Also, the regulator may require different internal governance frameworks for banks and to set controls on ownership and asset classifications.
In the UK, the financial regulatory framework under the UK Financial Services and Markets Act 2000 (FSMA)10 requires banks and other authorised financial firms to establish internal systems of control, compliance, and reporting for senior management and other key personnel. Under FSMA, the Financial Services Authority (FSA) has the power to review and sanction banks and financial firms regarding the types of internal control and compliance systems they adopt.11 These systems must be based on recognised principles and standards of good governance in the financial sector. These regulatory standards place responsibility on the senior management of firms to establish and to maintain proper systems and controls, to oversee effectively the different aspects of the business, and to show that they have done so.12 The FSA will take disciplinary action if an approved person - director, senior manager or key personnel - deliberately violates regulatory standards or her behaviour falls below a standard that the FSA could reasonably expect to be observed.13
The broader objective of the FSA’s regulatory approach is to balance the competing interests of shareholder wealth maximization and the interests of other stakeholders.14 The FSA’s balancing exercise relies less on the strict application of statutory codes and regulatory standards, and more on the design of flexible, internal compliance programmes that fit the particular risk-level and nature of the bank’s business. To accomplish this, the FSA plays an active role with bank management in designing internal control systems and risk management practices that seek to achieve an optimal level of protection for shareholders, creditors, customers, and the broader economy.15 The regulator essentially steps into the shoes of these various stakeholder groups to assert stakeholder interests whilst ensuring that the bank’s governance practices do not undermine the broader goals of macroeconomic growth and financial stability. The proactive role of the regulator is considered necessary because of the special risk that banks and financial firms pose to the broader economy.
Part I of this paper considers “governance” within the context of the principal-agent framework and how this applies to the risk-taking activities of financial sector firms. Part II reviews some of the major international standards of corporate governance as they relate to banking and financial firms. This involves a general discussion of the international norms of corporate governance for banking and financial institutions as set forth by the Organisation for Economic Cooperation and Development and the Basel Committee on Banking Supervision.
Part III analyses the FSMA regulatory regime for banking regulation and suggests that its requirements for banks and financial firms to establish internal systems of control and compliance programmes represents a significant change in UK banking supervisory techniques that establishes a new corporate governance framework for UK banks and financial firms. This new regulatory framework departs from traditional UK company law by establishing an objective reasonable person
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standard to assess whether senior managers and directors have complied with regulatory requirements, with the threat of substantial civil and criminal sanctions for breach.16 Part IV argues that this new regulatory framework for the corporate governance of banks promotes some of the core values in the corporate governance debate over transparency in governance structure and information flow, and the supervisor’s external, monitoring function. Part V analyses the legal framework of US bank regulation and how it addresses corporate governance problems within banks and bank/financial holding companies. Part VI concludes with some general comments and how the internal self-regulatory approach of UK bank regulators is becoming the predominant model in sophisticated financial markets and represents the trend in international standard setting, but questions still remain regarding the regulation of multi-national bank holding companies and the legal risks that arise from uncertainty in the meaning of certain banking statutes that call into question the discretion of regulator’s discretion to balance stakeholder interests and to exercise effective prudential oversight.
I. Corporate Governance and Banking regulation
A. Why Banks Are Special?
The role of banks is integral to any economy. They provide financing for commercial enterprises, access to payment systems, and a variety of retail financial services for the economy at large. Some banks have a broader impact on the macro sector of the economy, facilitating the transmission of monetary policy by making credit and liquidity available in difficult market conditions.17 The integral role that banks play in the national economy is demonstrated by the almost universal practice of states in regulating the banking industry and providing, in many cases, a government safety net to compensate depositors when banks fail. Financial regulation is necessary because of the multiplier effect that banking activities have on the rest of the economy. The large number of stakeholders (such as employees, customers, suppliers etc), whose economic well-being depends on the health of the banking industry, depend on appropriate regulatory practices and supervision. Indeed, in a healthy banking system, the supervisors and regulators themselves are stakeholders acting on behalf of society at large. Their primary function is to develop substantive standards and other risk management procedures for financial institutions in which regulatory risk measures correspond to the overall economic and operational risk faced by a bank. Accordingly, it is imperative that financial regulators ensure that banking and other financial institutions have strong governance structures, especially in light of the pervasive changes in the nature and structure of both the banking industry and the regulation which governs its activities.
B. The Principal-Agent Problem
The main characteristics of any governance problem is that the opportunity exists for some managers to improve their economic payoffs by engaging in unobserved, socially costly behaviour or “abuse” and the inferior information set of the outside monitors relative to the firm.18 These characteristics are related since abuse would not be unobserved if the monitor had complete information. The basic idea – that managers have an information advantage and that this gives them the opportunity to take self-interested actions – is the standard principal-agent problem.19 The more 6
interesting issue is how this information asymmetry and the resulting inefficiencies affect governance within financial institutions. Does the manager have better information? Perhaps the best evidence that monitors possess inferior information relative to managers lies in the fact that monitors often employ incentive mechanisms rather than relying completely on explicit directives alone.20
Moreover, the principal-agent problem may also manifest itself within the context of the bank playing the role of external monitor over the activities of third parties to whom it grants loans. In fact, when making loans, banks are concerned about two issues: the interest rate they receive on the loan, and the risk level of the loan. The interest rate charged, however, has two effects. First it sorts between potential borrowers (adverse selection)21 and it affects the actions of borrowers (moral hazard).22 These effects derive from the informational asymmetries present in the loan markets and hence the interest rate may not be the market-clearing price.23
Adverse selection arises from different borrowers having different probabilities of repayment. Therefore, to maximise expected return, the bank would like to only lend to borrowers with a high probability of repayment. In order to determine who the good borrowers are, the bank can use the interest rate as a screening device. Unfortunately those who are willing to pay high interest rates may be bad borrowers because they perceive their probability of repayment to be low. Therefore, as interest rates rise, the average “riskiness” of borrowers increases, hence expected profits are lower. The behaviour of the borrower is often a function of the interest rate. At higher interest rates firms are induced to undertake projects with higher payoffs but, adversely for the bank, lower probabilities of success. Moreover, an excess supply of credit could also be a problem. If competitor banks try to tempt customers away from other banks with lower interest rates, they may succeed in only attracting bad borrowers – hence, they will not bother to do so.
To avoid credit rationing, banks use other methods to screen potential borrowers.24 For example, banks can use extensive and comprehensive covenants on loans to mitigate agency costs. As new information arrives, covenants can be renegotiated. Covenants may also require collateral or personal guarantees from firms about their future activities and business practises in order to maximise the probability of repayment. The banks lending history produces valuable information that evolves over time. Banks therefore are depositories of information, which in itself becomes a valuable asset that allows banks to ascertain good borrowers from bad, and to price risk more efficiently by attracting good borrowers with lower interest rates and reducing the number of riskier borrowers.
C. Regulatory Intervention
The foregoing illustrates the wide range of potential agency problems in financial institutions involving several major stakeholder groups including, but not limited to, shareholders, creditors/owners, depositors, management, and supervisory bodies. Agency problems arise because responsibility for decision-making is directly or indirectly delegated from one stakeholder group to another in situations where objectives between stakeholder groups differ and where complete information which would allow further control to be exerted over the decision maker is not readily available. One of the most studied agency problems in the case of financial institutions involves depositors and shareholders, or supervisors and shareholders.
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While that perspective underpins the major features of the design of regulatory structures - capital adequacy requirements, deposit insurance, etc. - incentive problems that arise because of the conflicts between management and owners have become a focus of recent attention.25
The resulting view, that financial markets can be subject to inherent instability, induces governments to intervene to provide depositor protection in some form or other. Explicit deposit insurance is one approach, while an explicit or implicit deposit guarantee is another. In either case, general prudential supervision also occurs to limit the risk incurred by insurers or guarantors. To control the incentives of bank owners who rely too heavily on government funded deposit insurance, governments typically enforce some control over bank owners. These can involve limits on the range of activities; linking deposit insurance premiums to risk; and aligning capital adequacy requirements to business risk.26
While such controls may overcome the agency problem between government and bank owners, it must be asked how significant this problem is in reality. A cursory review of recent banking crises would suggest that many causes for concern relate to management decisions which reflect agency problems involving management. Management may have different risk preferences from those of other stakeholders including the government, owners, creditors, etc., or limited competence in assessing the risks involved in its decisions, and yet have significant freedom of action because of the absence of adequate control systems able to resolve agency problems.
Adequate corporate governance structures for banking institutions require internal control systems within banks to address the inherent asymmetries of information and the potential market failure that may result. This form of market failure suggests a role for government intervention. If a central authority could know all agents’ private information and engage in lump-sum transfers between agents, then it could achieve a Pareto improvement. However, because a government cannot, in practice, observe agents’ private information, it can only achieve a constrained or second-best Pareto optimum. Reducing the costs associated with the principal-agent problem and thereby achieving a second-best solution depends to a large extent on the corporate governance structures of financial firms and institutions and the way information is disseminated in the capital markets.27
The principal-agent problem, outlined above, poses a systemic threat to financial systems when the incentives of management for banking or securities firms are not aligned with those of the owners of the firm. This may result in different risk preferences for management as compared to the firm’s owners, as well as other stakeholders, including creditors, employees, and the public. The financial regulator represents the public’s interest in seeing that banks and securities firms are regulated efficiently so as to reduce systemic risk. Many experts recognise the threat that market intermediaries and some investment firms pose to the systemic stability of financial systems. In its report, the International Organisation of Securities Commissions (IOSCO) adopts internal corporate governance standards for investment firms to conduct themselves in a manner that protects their clients and the integrity and stability of financial markets.28 IOSCO places primary responsibility for the management and operation of securities firms on senior management.
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II. International Standards of Corporate governance for banks and financial institutions
A. Organisation for Economic Co-operation and Development
The liberalization and deregulation of global financial markets led to efforts to devise international standards of financial regulation to govern the activities of international banks and financial institutions. An important part of this emerging international regulatory framework has been the development of international corporate-governance standards. The Organisation for Economic Co-operation and Development (OECD) has been at the forefront, establishing international norms of corporate governance that apply to both multinational firms and banking institutions. In 1999, the OECD issued a set of corporate governance standards and guidelines to assist governments in their efforts to evaluate and improve the legal, institutional, and regulatory framework for corporate governance in their countries.29 The OECD guidelines also provide standards and suggestions for “stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance.”30 Such corporate-governance standards and structures are especially important for banking institutions that operate on a global basis. To this extent, the OECD principles may serve as a model for the governance structure of multinational financial institutions.
In its most recent corporate governance report, the OECD emphasized the important role that banking and financial supervision plays in developing corporate-governance standards for financial institutions.31 Consequently, banking supervisors have a strong interest in ensuring effective corporate governance at every banking organization. Supervisory experience underscores the necessity of having appropriate levels of accountability and managerial competence within each bank. Essentially, the effective supervision of the international banking system requires sound governance structures within each bank, especially with respect to multi-functional banks that operate on a transnational basis. A sound governance system can contribute to a collaborative working relationship between bank supervisors and bank management.
The Basel Committee on Banking Supervision (Basel Committee) has also addressed the issue of corporate governance of banks and multinational financial conglomerates, and has issued several reports addressing specific topics on corporate governance and banking activities.32 These reports set forth the essential strategies and techniques for the sound corporate governance of financial institutions, which can be summarized as follows:
a. “[e]stablishing strategic objectives and a set of corporate values that are communicated throughout the banking organi[z]ation;”33
b. “etting and enforcing clear lines of responsibility and accountability throughout the organi[z]ation;”34
c. “[e]nsuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to undue influence from management or outside concerns;”35
d. “[e]nsuring that there is appropriate oversight by senior management;”36
e. “[e]ffectively utili[z]ing the work conducted by internal and external auditors, in recognition of the important control function they provide;”37 9
f. “[e]nsuring that compensation approaches are consistent with the bank’s ethical values, objectives, strategy and control environment;”38 and
g. “[c]onducting corporate governance in a transparent manner.”39
These standards recognize that senior management is an integral component of the corporate-governance process, while the board of directors provides checks and balances to senior managers, and that senior managers should assume the oversight role with respect to line managers in specific business areas and activities. The effectiveness of the audit process can be enhanced by recognizing the importance and independence of the auditors and requiring management’s timely correction of problems identified by auditors. The organizational structure of the board and management should be transparent, with clearly identifiable lines of communication and responsibility for decision-making and business areas. Moreover, there should be itemization of the nature and the extent of transactions with affiliates and related parties.40
B. Basel II
The Basel Committee adopted the Capital Accord in 1988 as a legally non-binding international agreement among the world’s leading central banks and bank regulators to uphold minimum levels of capital adequacy for internationally-active banks.41 The New Basel Capital Accord (Basel II)42 contains the first detailed framework of rules and standards that supervisors can apply to the practices of senior management and the board for banking groups. Bank supervisors will now have the discretion to approve a variety of corporate-governance and risk-management activities for internal processes and decision-making, as well as substantive requirements for estimating capital adequacy and a disclosure framework for investors. For example, under Pillar One, the board and senior management have responsibility for overseeing and approving the capital rating and estimation processes.43 Senior management is expected to have a thorough understanding of the design and operation of the bank’s capital rating system and its evaluation of credit, market, and operational risks.44 Members of senior management will be expected to oversee any testing processes that evaluate the bank’s compliance with capital adequacy requirements and its overall control environment. Senior management and executive members of the board should be in a position to justify any material differences between established procedures set by regulation and actual practice.45 Moreover, the reporting process to senior management should provide a detailed account of the bank’s internal ratings-based approach for determining capital adequacy.46
Pillar One has been criticized as allowing large, sophisticated banks to use their own internal ratings methodologies for assessing credit and market risk to calculate their capital requirements.47 This approach relies primarily on historical data that may be subject to sophisticated applications that might not accurately reflect the bank’s true risk exposure, and it may also fail to take account of events that could not be foreseen by past data. Moreover, by allowing banks to use their own calculations to obtain regulatory capital levels, the capital can be criticized as being potentially incentive-incompatible.
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Pillar Two seeks to address this problem by providing for both internal and external monitoring of the bank’s corporate governance and risk-management practices.48 Banks are required to monitor their assessments of financial risks and to apply capital charges in a way that most closely approximates the bank’s business-risk exposure.49 Significantly, the supervisor is now expected to play a proactive role in this process by reviewing and assessing the bank’s ability to monitor and comply with regulatory capital requirements. Supervisors and bank management are expected to engage in an ongoing dialogue regarding the most appropriate internal control processes and risk-assessment systems, which may vary between banks depending on their organizational structure, business practices, and domestic regulatory framework.
Pillar Three also addresses corporate governance concerns by focusing on transparency and market-discipline mechanisms to improve the flow of information between bank management and investors.50 The goal is to align regulatory objectives with the bank’s incentives to make profits for its shareholders. Pillar Three seeks to do this by improving reporting requirements for bank capital adequacy. This covers both quantitative and qualitative disclosure requirements for both overall capital adequacy and capital allocation based on credit risk, market risk, operational risk, and interest rate risks.51
Pillar Three sets forth important proposals to improve transparency by linking regulatory capital levels with the quality of disclosure.52 This means that banks will have incentives to improve their internal controls, systems operations, and overall risk-management practices if they improve the quality of the information regarding the bank’s risk exposure and management practices. Under this approach, shareholders would possess more and better information with which to make decisions about well-managed and poorly-managed banks. The downside of this approach is that, in countries with undeveloped accounting and corporate-governance frameworks, the disclosure of such information might lead to volatilities that might undermine financial stability by causing a bank run or failure that might not have otherwise occurred had the information been disclosed in a more sensitive manner. Pillar Three has not yet provided a useful framework for regulators and bank management to coordinate their efforts in the release of information that might create a volatile response in the market.
Although the Basel Committee has recognized that “primary responsibility for good corporate governance rests with boards of directors and senior management of banks,”53 its 1999 report on corporate governance suggested other ways to promote corporate governance, including laws and regulations; disclosure and listing requirements by securities regulators and stock exchanges; sound accounting and auditing standards as a basis for communicating to the board and senior management; and voluntary adoption of industry principles by banking associations that agree on the publication of sound practices.54
In this respect, the role of legal issues is crucial for determining ways to improve corporate governance for financial institutions. There are several ways to help promote strong businesses and legal environments that support corporate governance and related supervisory activities. These include enforcing contracts, including those with service providers; clarifying supervisors’ and senior management’s governance roles; ensuring that corporations operate in an environment free from corruption and
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bribery; and aligning laws, regulations, and other measures with the interests of managers, employees, and shareholders.
These principles of corporate governance for financial institutions, as set forth by the OECD and the Basel Committee, have been influential in determining the shape and evolution of corporate-governance standards in many advanced economies and developing countries and, in particular, have been influential in establishing internal control systems and risk-management frameworks for banks and financial institutions. These standards of corporate governance are likely to become international in scope and to be implemented into the regulatory practices of the leading industrial states.
The globalization of financial markets necessitates minimum international standards of corporate governance for financial institutions that can be transmitted into financial systems in a way that will reduce systemic risk and enhance the integrity of financial markets. It should be noted, however, that international standards of corporate governance may result in different types and levels of systemic risk for different jurisdictions due to differences in business customs and practices and the differences in institutional and legal structures of national markets. Therefore, the adoption of international standards and principles of corporate governance should be accompanied by domestic regulations that prescribe specific rules and procedures for the governance of financial institutions, which address the national differences in political, economic, and legal systems.
Although international standards of corporate governance should respect diverse economic and legal systems, the overriding objective for all financial regulators is to encourage banks to devise regulatory controls and compliance programs that require senior bank management and directors to adopt good regulatory practices approximating the economic risk exposure of the financial institution. Because different national markets must protect against different types of economic risk, there are no universally correct answers accounting for differences in financial markets, and laws need not be uniform from country to country. Recognizing this, sound governance practices for banking organizations can take place according to different forms that suit the economic and legal structure of a particular jurisdiction.
Nevertheless, the organizational structure of any bank or securities firm should include four forms of oversight: (1) oversight by the board of directors or supervisory board; (2) oversight by nonexecutive individuals who are not involved in the day-to-day management of the business; (3) oversight by direct line supervision of different business areas; and (4) oversight by independent risk management and audit functions. Regulators should also utilize approximate criteria to ensure that key personnel meet fit and proper standards. These principles should also apply to government-owned banks, but with the recognition that government ownership may often mean different strategies and objectives for the bank.
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III. UK FINANCIAL REGULATION AND CORPORATE GOVERNANCE: THE STATUTORY AND REGULATORY REGIME
A. Corporate Governance and Company Law – Recent Developments
The Combined Code of Corporate Governance
This section reviews recent developments in UK corporate governance and discusses the relevant aspects of UK company law. The boards of directors of UK companies traditionally have had two functions - to lead and to control the company. Shareholders, directors and auditors have had a role to play in ensuring good corporate governance. In the 1990s, reform of corporate governance at UK companies became a major issue of concern for shareholders as well as policymakers. This was precipitated by a number of serious financial scandals involving major UK banks and financial institutions.55
In May 1991, a committee chaired by Sir Adrian Cadbury was established to make recommendations to improve corporate control mechanisms not only for banks but also for all UK companies.56 The Cadbury Committee’s main focus was on financial control mechanisms and the responsibilities of the Board of Directors, the auditor, and shareholders.57 The Committee published a final report in 1992, which concluded that the cause of these problems were not the need for improved auditing and accounting standards, but widespread defects in the internal control systems of large UK companies.58 In the report, the Committee defined corporate governance ‘as the system by which companies are directed and controlled’.59 Moreover, the Committee recommended that the boards of all listed companies registered in the UK should comply with the Code immediately or explain why they have not complied.60
In recent years, UK corporate governance has been greatly influenced by the corporate and financial scandals in the United States, and by the broader framework of reforms being undertaken in the European Community.61 As a result, a revised Combined Code came into effect on 1 November 2003, based on proposals of the Financial Reporting Council.62 The revision incorporated proposals of the Higgs Review63 regarding the role and effectiveness of non-executive directors and the proposals of Sir Robert Smith’s report64 on audit committees.65 The Code was amended to reflect proposals in the Higgs review that a change in board structure should be based on two principles: (1) enhancing the role of non-executive directors, and (2) splitting the role of the CEO and board chairman.66 The chairman should be an independent, non-executive director who can take a detached view of the company’s affairs. Another important proposal of the Higgs Review was that independent, non-executive directors should be used more to transmit the views of shareholders to the Board.67 In this way, non-executives would have more responsibility to monitor the performance of the company’s executive directors.
The FSA now considers compliance with the Code to be an important issue for investor consideration.68 Although the Combined Code is technically voluntary in a legal sense, public companies listed on the London Stock Exchange and other regulated exchanges are required to state in their annual reports whether they comply with the Code and must provide an explanation if they do not comply.69 This is
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known as the ‘Comply or explain principle’.70 The requirement to comply or explain does not apply to non-listed companies.71
In 2003-2004, the FSA undertook a review of corporate governance and the regulation of the capital markets that seeks to examine the following issues: the interaction of the Combined Code with the listing rules; the conflicts of interests that can arise when directors serve on several different boards; and the value of applying the FSA’s Model Code on financial regulation to the corporate governance practices of publicly listed companies. Moreover, regarding financial institutions, the FSA recognises that corporate governance standards and practices must be devised with broader systemic issues in mind, which requires the regulator to take a more proactive role balancing shareholder and other stakeholder interests.
As mentioned above, the combined code is not a legal requirement under UK financial regulation. For example, it is not part of the FSA’s banking regulation regime or the Listing Rules for the capital markets. It has therefore not been subject to FSA investigations and enforcement.72 It should be recalled that the Cadbury Report recommended that the combined code be applicable to all companies – listed and unlisted.73 The UK Government has taken this a step further by proposing in its White Paper, entitled Modernising Company Law, that the combined code should be legally obligatory and enforced by a new Standards Board.74
B. English Company Law and Directors’ Duties
Unlike United States corporation law, company law in the UK has traditionally provided that directors owe a duty to the company, not to the shareholders.75 This legal principle provides a point of departure for analysing the regulator’s role in devising corporate governance standards that seek to balance the various interests of shareholders, creditors and stakeholders. The UK Companies Act 198576 provides the legal mechanism to ensure that UK companies are managed and operated in the interests of shareholders. The board of directors has sole responsibility for setting and controlling the company’s internal governance system, whilst the main external governance system is the market for corporate control.77 As discussed above, most of the provisions of the Combined Code are not legally binding and form a type soft law in the regulation of companies. Nevertheless, the Companies Act and the Combined Code together form a comprehensive framework for ensuring that private and public UK companies are managed for the benefit of shareholders.
Although the traditional model of UK corporate governance focuses on shareholder wealth maximisation, it should be noted that English company law has traditionally stated that directors owe a duty to the company, not to individual shareholders.78 This position has been interpreted as meaning that directors owe duties of care and fiduciary duties directly to the shareholders collectively in the form of the company, and not to the shareholders individually.79
The starting point of analysis for this area of the law is the case of Percival v Wright,80 in which the court held that directors of a company are not trustees for individual shareholders and may purchase their shares without disclosing pending negotiations for the sale of the company.81 In essence, a director owes duties to the company and not to individual shareholders.82 However, a director who does disclose
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certain information to shareholders has a duty not to mislead the shareholders with respect to that information.83 The rule in Percival v Wright has been subject to substantial criticism by various UK government committees, including the Cohen Committee84 and the Jenkins Committee.85 The law has now evolved to a point where the courts recognise that a fiduciary duty may be owed by directors to individual shareholders in special circumstances, such as where the company is a family-run business.86
Therefore, under English law, barring special circumstances or regulatory intervention, company directors owe their duty to the legal person - the ‘company’- rather than to shareholders or to potential shareholders.87 Although the UK company law model is based on the notion of the shareholder ‘city state’,88 the directors owe their fiduciary duties directly to the company, and only indirectly to the shareholders.89 It is difficult, however, to separate the interests of the company from those of the shareholders. Indeed, the interests of the company are in an economic and legal sense the interests of the shareholders, which can be divided further into the interests of the present and future shareholders including a balance between the interests of the various shareholder classes. Therefore, discretionary exercise of the directors’ duties must be directed toward the maximisation of those shareholder interests - that is, to maximise profits. The technical legal duty, however, is to the company, not the shareholders.
The principle that the director’s duty is owed to the company raises important issues regarding how the interests of the company should be defined. Is the company merely an aggregate of the interests of the shareholders? Or does the company itself encompass a broader measure of interests that includes not only the shareholders’ interests, but also the interests of other so-called ‘stakeholders’? The general view of the English courts in interpreting the Companies Act 1985 is that a director’s legal duties are owed to the company and that the company’s interest are defined primarily in terms of what benefits the shareholders. UK corporate governance standards, as set forth in the Combined Code, reinforce this position by holding that shareholder wealth maximisation is the main criteria for determining the successful stewardship of a company.90
In the case of bank directors, English courts have addressed senior management’s and directors’ duties and responsibilities over the affairs of a bank. The classic statement of directors’ duties regarding a bank was in the Marquis of Bute’s Case,91 which involved the Marquis of Bute, who had inherited the office of president of the Cardiff Savings Bank when he was six months old.92 Over the next thirty eight years, he attended only one board meeting of the bank before he was sued for negligence in failing to keep himself informed about the bank’s reckless lending activities. The judge rejected the liability claim on the grounds that, as a director, the Marquis knew nothing about the affairs of the bank and furthermore had no duty to keep himself informed of the bank’s affairs.93 In reaching its decision, the court did not apply a reasonable person standard to determine whether the Marquis should have kept himself informed about the bank’s activities.
This case appeared to stand for the proposition that a ‘reasonable person’ test would not be applied to acts or omissions of a director or senior manager who had failed to keep himself informed of the bank or company’s activities. In subsequent
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cases, the courts were reluctant to apply such a lenient liability standard. In Dovey v. Corvey94 a third party brought an action in negligence against a company director for malpractice and the court applied a reasonable person standard in finding the director not liable.95 The court found that the director had not acted negligently in receiving suspicious information from other company officers and in failing to investigate further any irregularities in company practice.96 The significance of the case, however, was that the court recognised that a reasonable person test should be applied to determine whether a director had breached its duty of care and skill. But the reasonable person test would not be that of a ‘reasonable professional director’ – rather, it would be that of a reasonable man who had possessed the particular ability and skills of the actual defendant in the case.97 In Marquis of Bute’s case, it would not be difficult to show that the defendant did not possess the requisite skills at hand to make an informed judgment.98 On the other hand, it would be easier to do so regarding an experienced and skilled senior manager who had failed to act on information that was of direct relevance to the company’s operations.
The courts have developed this reasonable person standard in several cases, 99 the most recent of which is Dorchester Finance Co., Ltd. v. Stebbing,100 where the court found that the reasonable person test should apply equally to both executive and non-executive directors. More generally, modern English company law would set forth three important standards regarding the duty of care and skill for directors. First, a director is not required to demonstrate a degree of skill that would exceed what would normally be expected of a person with the director’s actual level of skill and knowledge.101 Second, a director is not required to concern herself on a continuous basis with the affairs of the company, as his or her involvement will be periodic and will be focused mainly at board meetings and at other meetings at which he or she is in attendance, and he or she is not required to attend all meetings, nor to be liable for decisions that are made in his or her absence.102 Third, a director may properly rely on company officers to perform any day-to-day affairs of the business while not being liable for any wrongdoing of those officers in the absence of grounds for suspicion.103 Notwithstanding the courts’ efforts to define further the reasonable person standard for company directors, it can be criticised on the grounds that it may create a disincentive, in the absence of regulatory standards, for skilled persons to serve as directors, especially for financial companies that often require more technical supervisory skills in the boardroom.
Regarding fiduciary duties, English company directors have the paramount duty of acting bona fide in the interest of the company. Specifically, this means the director individually owes a duty of good faith to the company, which means the director is a fiduciary of the company’s interest. Although the director’s fiduciary duties resemble the duties of a trustee, they are not the same.104 The fiduciary duties of directors have been set forth in the Companies Act and fall into the following categories: the directors may act only within the course and scope of duties conferred upon them by the company memorandum or articles,105 and they must act in good faith in respect to the best interest of the company, while not allowing their discretion to be limited in the decisions they make for the company.106 Moreover, a director who finds himself or herself in the position of having a conflict of interest will be required to take corrective measures.107 16
C. The Financial Services and Markets Act: The Statutory Framework
The Financial Services and Markets Act 2000 (FSMA)108 and its accompanying regulations create a regime founded on a risk-based approach to the regulation of all financial business. FSMA’s stated statutory objectives are to maintain confidence in the financial system, to promote public awareness, to provide “appropriate” consumer protection, and to reduce financial crime.109 FSMA incorporates and simplifies the various regulatory approaches utilized under the Financial Services Act of 1986, in which self-regulatory organizations were delegated authority to regulate and to supervise the financial services industry.110 FSMA created the Financial Services Authority (FSA) as a single regulator of the financial services industry with responsibility, inter alia, for banking supervision and regulation of the investment services and insurance industries. 111
To achieve these objectives, the FSA has been delegated legislative authority to adopt rules and standards to ensure that the statutory objectives are implemented and enforced.112 In so doing, the FSA must have regard to seven principles, which include “the desirability of facilitating innovation in connection with regulated activities;” “the need to minimi[z]e the adverse effects on competition that may arise from anything done in the discharge of those functions;” and “the desirability of facilitating competition between those who are subject to any form of regulation by the Authority.”113
The FSA has established a regulatory regime that emphasizes ex ante preventative strategies, including front-end intervention when market participants are suspected of not complying with their obligations. Under the FSMA framework, regulatory resources are redirected away from reactive, post-event intervention towards a more proactive stance emphasizing the use of regulatory investigations and enforcement actions, which have the overall objective of achieving market confidence and investor and consumer protection. In devising regulations, the FSA is required to conduct a cost-benefit analysis of the regulations’ impact on financial markets.114 Although many leading economists have criticized the use of cost-benefit analysis,115 the FSA has adopted a comprehensive framework for such assessments. It has published its internal guidance, which allows market participants and the investing public to gain a better understanding of the basis on which regulations are adopted. In addition, FSMA provides for a single authorization process and a new market abuse offense116 that imposes civil liability, fines, and penalties for the misuse of inside information and market manipulation.117
The FSMA sets out a framework to protect the integrity of nine of the UK’s recognized investment exchanges, including the London Stock Exchange, the London Metal Exchange, and the London International Financial Futures Exchange.118 The FSA has the power to scrutinize the rules and practices of firms and exchanges for anti-competitive effects. Moreover, the FSA has exercised its statutory authority to create an ombudsman and compensation scheme for consumers and investors who have complaints against financial services providers for misconduct in the sale of financial products.119
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The FSA’s main functions will be forming policy and setting regulation standards and rules (including the authorization of firms); approval and registration of senior management and key personnel; investigation, enforcement and discipline; consumer relations; and banking and financial supervision. The FSMA requires the FSA to adopt a flexible and differentiated risk-based approach to setting standards and supervising banks and financial firms. The FSA has authority to enter into negotiations with foreign regulators and governments regarding a host of issues, including agreements for the exchange of information, coordinating implementation of EU and international standards, and cross-border enforcement and surveillance of transnational financial institutions.
In pursuit of these aims, the FSA has signed a number of memoranda of understanding (MOUs) and mutual assistance treaties with foreign authorities that provide for co-operation and information-sharing.120 The FSA, the UK Treasury, and the Bank of England signed a domestic MOU providing a general division of responsibilities in which the Treasury maintains overall responsibility for policy and the adoption of statutory instruments, while the FSA has primary responsibility for the supervision and regulation of all financial business, and the Bank of England conducts monetary policy and surveillance of international financial markets.121
D. The FSA’s Corporate Governance Regime
A major consequence of FSMA is its direct impact on corporate-governance standards for UK financial firms through its requirement of high standards of conduct for senior managers and key personnel of regulated financial institutions. The main idea is based on the belief that transparency of information is integrally related to accountability in that it can provide government supervisors, bank owners, creditors, and other market participants sufficient information and incentive to assess a bank’s management. To this end, the FSA has adopted comprehensive regulations that create civil liability for senior managers and directors for breaches by their firms, even if they had no direct knowledge or involvement in the breach or violation itself. For example, if the regulator finds that a firm has breached rules because of the actions of a rogue employee who has conducted unauthorized trades or stolen client money, the regulator may take action against senior management for failing to have adequate procedures in place to prevent this from happening.
1. High-Level Principles
The FSA has incorporated the eleven high-level principles of business that were part of previous UK financial services legislation.122 They applied to all persons and firms in the UK financial services industry. These principles also apply to senior management and directors of UK financial firms. The most widely invoked of these principles are integrity; skill, care, and diligence; management and control; financial prudence; market conduct; conflicts of interests; and relations with regulators. FSA regulations often cite these principles as a policy basis justifying new regulatory rules and standards for the financial sector. These principles are also used as a basis to evaluate the suitability of applicants to become approved persons to carry on financial business in the UK.
Principle Two states that “ firm must conduct its business with due skill, care and diligence.”123 The FSA interprets this principle as setting forth an objective, reasonable person standard for all persons involved in the management and direction
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the rest is at:
www-cfap.jbs.cam.ac.uk/publications/files/WP17%20-%20Alexander1.pdf