Corporate governance issues: estimative solutions for the world financial crisis.

Serban, Claudia ; Tiron-Tudor, Adriana ; Man, Mariana 等

1. INTRODUCTION

The sub-prime phenomenon of today's financial crisis represents a shift in the way that mortgages have been traditionally funded. In the past, banks funded mortgage loans from the deposits they received from their clients.

When coupled with a system of regulations, loan viability evaluations, checks and balances, this minimized risks of defaulting loans, bank-run inducing panic, etc. However, sub-prime financing began with a desire to cater to high-risk borrowers with weak credit histories and weak documentation of income hence the label, sub-prime'. Banks processed the mortgage payments as mortgage-backed securities, mortgage bonds or collateralized debt obligations (CDOs') and subsequently sold them to financial institutions worldwide (Faulkender & Wang, 2006). With the fall of house prices, mortgage lenders began calling in their loans. This affected borrowers many of whom, being high-risk and of low(re)payable status in the first place, defaulted.

The dispersion of credit risk and the widespread effect on financial institutions in turn caused lenders to reduce lending activity or to make loans at higher interest rates, which in turn reduced the availability of and access of fund by individuals and corporations not originally involved in mortgage-backed securities, thereby creating a credit crunch, a economy-wide and multi-sector disappearance of credit as a spiraling result of falling confidence in one sector (in this case, the sub-prime market).

2. THE EAST-ASIAN FINANCIAL CRISIS

The East Asian financial crisis of 1997-2000 developed along similar lines. As with the sub-prime fiasco, it began with a frontier of new opportunities for profit i.e. the new emerging Asian-Pacific markets. Massive expansion of credit occurred to fill the demand for a wave of new investments which took the form of both actual constructions and speculative activity. The latter kind of investments eventually grew as unbridled optimism and promises of even greater gains fueled more and more lending, then over-lending, far stretching the bounds of a healthy risk market (Aboody & Levine, 2005). With access to funds on low interests, owners of these financial companies began lending out (on high interests) to speculators who wanted to make a killing by betting on, say, the real-estate market.

The liberalization of capital accounts to allow firms (including banks) to take on short-term foreign debt and the virtual non-existence of foreign exchange hedging created even more vulnerability.

The combination of higher interest rates with falling investor confidence and dodgy balance sheets contributed to many East Asian economies entering a state of meltdown (apparently, only Hong Kong escaped devaluation).

3. WORLD FINANCIAL CRISIS AND THE EAST ASIAN CRISIS. ARE THEY SIMILAR?

A common backdrop to both crises was abundant liquidity and excessive, imprudent credit expansion. Prior to the Asian crisis, capital flows into the region surged, leading to a sharp rise in bank lending and corporate borrowings. Foreign investors bought high-yielding Asian securities or U.S. dollar-denominated debt instruments assuming that Asian economies would continue to grow rapidly and currency pegs would hold indefinitely. Similarly, the current crisis was preceded by massive flows of capital into the United States to finance its current account deficits. That abundant liquidity was intermediated by financial institutions into consumer credit and mortgages, which were converted into mortgage-backed securities (MBSs) and CDOs.

In the Asian financial crisis, credit imprudence came in the form of connected lending to large corporate entities or to mega projects and property developments that were of dubious commercial viability. In the big crisis, that search led to the proliferation of mortgage loans in the supreme category, the so-called ninja (no income, no job, and no assets) loans. Another sign of trouble prior to both crises was the rapid increases in property asset prices. Such asset bubbles have been linked in past crises to the availability of easy credit. The growth of speculative and instable borrowers leads first to an asset bubble and then to the widespread realization that the increased lending is unsustainable. The result is a sudden pullback in financing and a crash. Such financial instability is apparent in both crises. Huge mortgage growth, representing speculative and instable borrowings, could have trapped the United States in a superficially virtuous but insidiously vicious housing price cycle (Antle et al., 2006). While house prices were rising, creditors felt safe lending on appreciating collateral, which in turn fed housing demand and prices.

Similarly, lending to corporate entities in Asia was spurred by booming economies and easy credit, with many loans, ending up in unprofitable projects, sustained only by further debt infusions. Both of these unsustainable cycles were destined to unravel.

4. DID BANKS PLAY THE LEVERAGE "GAME"?

One of the major catalysts for the current financial crisis was the spate of defaults and foreclosures in 2007 and 2008, which also generated considerable dead weight costs in their own right. Two big reasons for the defaults and foreclosures were the downturn in house prices and a dramatic decline in the quality of mortgage loans. Several factors in the mortgage market contributed to this latter reason: Loan quality declined in large part because of one particular unintended consequence of securitization, namely, that mortgage lenders did not bear the costs of these declines in loan quality, and so did not care about them. Another likely reason for the decline in loan quality was the failure of lenders to understand exactly the terms of the loans they were being offered, which rendered them unable to internalize the costs of default and foreclosure fully.

5. CONCLUSIONS: FUTURE CORPORATE GOVERNANCE DIFFERENT, BUT MORE EFFECTIVE?

First of all, why is corporate governance so important? Corporate governance is a key element in enhancing investor confidence, promoting competitiveness, and ultimately improving economic growth. It is at the top of the international development agenda.

The current crisis came about as a result of a limited number of excesses or failures in corporate governance. These should not be taken as a sign of system meltdown. Can boards and regulators ensure that internal governance in the form of judicious design of incentives and compensation is set up correctly to achieve this objective? The unprecedented government bailout of financial markets and firms in the current crisis has forced executive compensation in banking and finance into the open. The bright new financial system--for all its rich rewards and unimaginable wealth for some-has failed the test of the marketplace by repeatedly risking a cascading breakdown of the system as a whole. Taxpayers wonder how highly paid "talent" could have been instrumental in creating a financial disaster of epic proportions. And having been forced to take equity stakes in most of the largest US and foreign financial firms and guarantee their debt, taxpayers naturally feel that they should have a say in how such people get rewarded. In the compensation discussion, two issues appear to stand out compensation of top management and compensation of key cohorts of "high performance" employees. To the extent that the pay packages of senior management deviate materially from the long-term financial interests of shareholders, any overcompensation problem is a failure of corporate governance. When the system fails, it often seems to involve massive exit packages (rewards for failure) or executives liquidating shares that turn out, after the fact, to have been overvalued at the time of sale. So the real issue may not require the wholesale redesign of top management compensation, but rather how to address the difficulties investors have in perceiving risks and accurately valuing the equity of financial firms. It would be surprising if financial firms do not start to think through compensation approaches more closely aligned to risk exposure and shareholder interest.

There are the following policy recommendations to advance and implement such thinking: greater disclosure and transparency of compensation practices, not necessarily major retargeting of top management compensation, is necessary in order to apply greater market discipline to top management pay practices & for high-performance "risk-taking" employees, an interesting idea is the bonus approach. In good times, with a rising tide lifting all boats, the combination of the rising tide and leverage makes it impossible to tell good performers from bad ones, since most people generate decent to spectacular returns. It is in bad times that the wheat is separated from the chaff. So compensation should have a multi-year structure, with bad performances subtracting from the bonus pool in the same way that good performances add to it. The public and political uproar was very much part of the overall corporate governance system; the system reacted swiftly and it would seem, effectively.

The biggest challenge for Europe was not the break up of old structures but rather the build up of new ones. It will take a lot more than corporate governance reforms to complete this second phase of the restructuring process. Speculation on the future of corporate governance suggests both a conclusion and a question: It will be different, but will it be more effective?

Corporate governance in the future will reflect an increasing emphasis on customer satisfaction as a way of measuring the adaptability of the organization over time. By focusing too strongly on financial records (and audit committee work), we lose sight of the fact that departments like operations and human resources are very important components (in forecasting future success).

The world of corporate governance will benefit from the establishment of a new type of corporate information and control architecture. In fact, our main conclusion is we should go beyond this to propose that a network of more specialized board groups and advisory stakeholder councils comprising employees, lead customers, suppliers, and others offers a useful solution to the governance vacuum that exists in many large corporations today. While agreeing that customer and employee satisfaction and loyalty are indeed good predictors for (the) future success of a company, these measures have to be viewed with a long-term lens, one that accommodates the fact in the short-run, managements may take actions to reduce costs and the size of the labor force to achieve long-term success--actions that could adversely affect non-financial indicators used as inputs for corporate governance. It's also important to notice that future corporate governance will mitigate the problems identified until now, by establishing a new type of corporate information and control architecture. A network of boards and advisory stakeholder councils will govern sustainable competitive corporations.

Network governance provides the only way to mitigate the information overload introduced by a unitary board through decomposing decision-making labor. Network information and control systems can also provide requisite variety of information feedback and control from strategic stakeholders to provide competitive advantages. This will require employees, lead customers, suppliers, and members of the host community to be organized into self-appointed advisory councils in order to bond and integrate their interests with the corporation's. Network boards are important because they remove and use the conflicts of interests between stakeholders. Network boards introduce "distributed intelligence" and specialize in decision-making labor in a way similar to M-Form firms. Watchdog boards take over the compliance roles of auditing and governance boards take over the role of nominating and remunerating directors.

This greatly simplifies the duties of the executive board to increase shareholder value. In addition, non-executive directors become politically independent of management and can obtain information independent of management from the stakeholder boards to evaluate management and the strengths, weaknesses, opportunities, and threats of the business.

6. REFERENCES

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Almeida, H.; Campello, M. & Weisbach, M. (2007). The cash flow sensitivity of Cash. Journal of Finance, pp. 163-170

Faulkender, M. & Wang, R. (2006). Corporate Financial policy and the value of cash. Working Paper. Washington University

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