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Newsroom & speeches
12 March 2009
1. Good afternoon.
2. Thank you Joanne for that introduction and for the kind invitation to join you at this NAPF Investment Conference.
3. I’m particularly pleased to be able to speak to you on the subject of governance. This issue is now a hot topic: the penny has dropped in that sound governance is not a “nice to have” - it’s a necessity.
4. I believe that, more than ever before, we are reaching a consensus on what good corporate governance looks like, and on how important it is. Now, we must act on that consensus. Because higher standards of governance won’t happen automatically. We have to work to achieve them.
5. And it is investors who must take the lead, devoting more time and money to improving their ability to constructively challenge managers in investee companies and secure business improvement as a consequence.
6. The most glaring examples we have of failures of governance we have recently seen have been in the banking sector.
7. We have clear evidence that corporate governance failed to understand, price and manage risk taking in our banks. We now know the result of these failures.
8. The key questions for this audience have to be:
9. In the past year and a half, shortcomings in a number of areas have become clear:
10. The OECD has stated - and I agree with them - that while corporate governance deficiencies were not the sole or direct cause of the financial crisis, they undoubtedly facilitated, or did not prevent, practices that resulted in misjudgement, poor performance and failure to anticipate systemic risk.
11. These failures contributed to systemic instability and we have now had the need for substantial policy interventions on a level that no one could have anticipated a year ago.
12. While it’s obvious there have been some major failings, the UK’s corporate governance regime is held in high regard in other countries. Others look to us for examples to follow.
13. But even with all this work, the stark truth is that some old problems are still manifest. Our best efforts have not been enough - more must be done. The need for better governance and supervision, well-functioning boards and proper shareholder oversight, engagement that is informed, well resourced and consistent applied, cannot be ignored.
14. We are now seeing some in the industry putting up their hands and admitting they didn’t get it right, saying they could have been more effective and recognising that they have to up their game. I wholeheartedly commend that honesty.
15. I was particularly interested in the evidence given by the Chief Executive of Legal and General Investment Management, Peter Chambers, at his appearance before the Treasury Select Committee on 27 January as part of the committee’s ongoing banking enquiry.
16. He explained how they had engaged repeatedly - and at the highest levels - with financial institutions whose practices caused them concern, but with no discernible effect. It seems they hit a brick wall beyond which they could not make progress.
17. What does this say about the tools that investors have at their disposal to make sure their voices are heard and their views gain traction within a company’s boardroom?
18. This is not a new problem – a number of you have probably heard me making similar points before I was in Government. I know Joanne has.
19. Indeed, in preparing this speech I returned to the report on institutional investment that I compiled for government in 2001; I found two extracts which I feel are particularly pertinent to this issue. The first reads:
20. The second reads:
21. I said these things in 2001 and I believe they remain pertinent today.
22. I don’t believe that the recent major corporate failures we have seen are representative of a problem with our principles of corporate governance - which are respected internationally. Rather, they are a result, frankly, of failures to do what is required by the principles in a professional way that acknowledges the responsibility of investors to their clients and their beneficiaries.
23. I think we all share the same goal: we want our companies run by well functioning, informed, committed boards and management, operating with effective scrutiny and challenge from non-executives and accountable to fully engaged shareholders.
24. For shareholders there is an obvious self-interest in good corporate governance: it contributes to better company performance by helping a board discharge its duties in the best interests of shareholders, thus delivering shareholder value over the longer term.
25. And for companies, effective corporate governance means better management of risk and franchise sustainable long-term growth in value.
26. We must all learn from the lessons of the last 18 months. But I have a strong belief that the financial and economic challenges we are now confronting and have had to confront over recent months have created a new and widespread determination to do better in the future. We now have the opportunity to make real improvements and deliver lasting change. We must not let that chance slip.
27. I mentioned before that we are seeing a much greater degree of consensus than before around what constitutes good governance.
28. Bodies such as the International Corporate Governance Network, the OECD, and other organisations are echoing each other’s sentiments on what is required.
29. Just about everyone is stating that improved corporate governance needs to be part of the solution and I am sure this will be part of the discussions at forthcoming G20 meetings too.
30. And across the spectrum the debate is moving on from what needs to be done to how best to implement change. There is now a much greater willingness to act, principally because the costs of inaction have been exposed so dramatically.
31. I’d therefore like to turn to three key steps to bring about the real improvements we need.
32. The first step is regulatory.
33. I know that Hector Sants spoke to you yesterday, so I will only touch briefly on the work of that the FSA is doing to improve the bank regulatory framework. The work falls into three areas: risk management, remuneration and the vetting of senior appointments.
34. The FSA is working closely with its international counterparts and the Financial Stability Forum to design a system of supervision to counter pro-cyclicality. Such international cooperation is a vital part of our response.
35. And it will focus to a much greater extent on the risk management practices of our banks.
36. Remuneration is an area that has received a lot of attention recently – and it is one that needs to be addressed.
37. You will no doubt have seen that the FSA has recently published its code of practice on remuneration policies which is currently being consulted upon.
38. The FSA will assess bank remuneration policies against the detailed criteria in the Code to ensure that the policies are consistent with sound risk management and do not expose banks to excessive risk. Where firms’ policies are deemed inappropriate, the FSA will be able to require firms to put in place improvement plans and apply sanctions, including requiring additional capital.
39. The Code is consistent with the Government’s key objective in this area which is to ensure that banks, both in the UK and globally, develop sustainable long-term policies to reduce the risk of excessive risk-taking
40. And progress in this area is being reinforced by market pressure: an increasing number of banks have recognised their own interest in sustainable long-term remuneration policies and are reviewing their policies to this end.
41. Activities previously regarded as highly profitable are being re-examined in the cold light of experience. The value of certain skills and the appetite of banks to engage in the activities where these skills were believed to exist has plunged.
42. The final area of FSA work that I will touch upon is the Approved Person Regime, by which the regulator can scrutinise director competence and tackle shortcomings in competence.
43. The FSA has proposed changes to the regime to allow them to assess the fitness and propriety of non-executive directors and directors of parent holding companies that control major UK banks. This will further enhance their ability to assure proper governance of UK financial institutions.
44. The FSA’s ability to hold individuals accountable for carrying out their responsibilities provides additional incentives for honest, prudent and sensible management and is one of the key ways to bring about continued emphasis on senior management responsibility within the industry.
45. While I’m speaking on regulatory issues, I’d like to touch on the issue of the treatment of dated subordinated debt in Bradford & Bingley.
46. Some of you may be aware that on 19 February we laid a statutory instrument before Parliament to clarify the circumstances in which principal and interest on the dated subordinated notes issued by Bradford & Bingley will become payable.
47. We have made clear that such amounts of principal and interest will not become due until the debt owed to the Financial Services Compensation Scheme by Bradford & Bingley has been repaid.
48. The Order also gives Bradford & Bingley the option to continue to make payments of principal and interest on the dated notes.
49. Whether to make the payments, or to defer them until after the debt to the Financial Services Compensation Scheme has been repaid, is a matter for the Bradford & Bingley Board, who will consider payments on a case-by-case basis.
50. In each case principal and interest would become due and payable only to the extent that Bradford & Bingley could make payment and continue to be solvent thereafter.
51. This Order also deals with the ranking of dated subordinated debt in the case of a winding up or administration of Bradford & Bingley.
52. There appears to have been confusion among some investors on this point, so I want to make absolutely clear that if such a situation were to occur, the normal creditor hierarchy would be retained. That is to say the dated subordinated notes would rank ahead of all undated notes, which in turn rank ahead of equity.
53. So, regulatory reform represents the first of three steps to implement the changes we need. The second step is a comprehensive review of existing practice. The Chancellor has appointed Sir David Walker to undertake a review of corporate governance in the banking sector.
54. Sir David’s review will complement the FSA’s work, by ensuring that boards can deliver sustainable long-term performance in parallel with the FSA’s requirements.
55. Sir David’s review will dovetail with the work of Adair Turner on the future of regulation and supervision of the UK banking system by examining how boards function and interact with other parties.
56. And he will need to examine how boards should operate both in terms of their committee set-up and ensuring that management is subject to effective and rigorous scrutiny.
57. This review will raise very fundamental questions about the operation and effectiveness of the boards of our major banks. Some of the areas which I hope Sir David will consider exploring include:
58. Remuneration is an area I feel strongly about. For too long we have seen remuneration consultants being used by companies to ensure that their executive pay is above the median or in the upper quartile in the sector. All this does is drive pay upwards without any attendant link to performance. Remuneration consultants should work solely and independently for NEDs, and be clear about potential risks and pitfalls and unintended consequences of the schemes they propose.
59. The inexorable rise in executive remuneration has to stop. There is a clear need for a sheet anchor in relation to executive pay. Perceived fairness is key.
60. The Government is now a shareholder and you will no doubt have noticed that through UK Financial Investments we have taken a firm line on the remuneration policies in our engagement with those banks in which the public have a stake.
61. This is not because we want to dictate pay levels or micromanage companies; we are simply acting as any responsible and engaged shareholder should. Benefits consultants should write explicitly and solely for independent directors and should be required when developing proposals to be clear about potential risks and scope for unintended consequences.
62. To support shareholder action we need remuneration committees that are more open to a wider range of views. Should they, for instance, consider formally seeking views from investors, employees and their representatives? Indeed you may be aware that from this April companies will have to report on how they have taken company-wide pay and employment conditions into account when setting directors’ pay.
63. I note that the NAPF has recently put out its updated corporate governance and voting guidelines in which they urge investors to take a “stronger stance” in respect of executive pay. I echo this sentiment wholeheartedly.
64. It is of course fair to assume that the recommendations in Sir David’s review on bank governance will have wider resonance in the field of general corporate governance. This is particularly the case in respect of the work he will be doing on the role of institutional shareholders.
65. Sir Christopher Hogg and the Financial Reporting Council, the guardians of the Combined Code, will therefore be paying close attention to what Sir David recommends in respect of banks and consider the application of these lessons more widely to institutional investors.
66. This brings me to the third area I want to discuss which is ensuring that institutional shareholders and their agents are fully committed to effective governance.
67. While pension fund trustees rightly can and do delegate investment decisions and rely on investment advice, trustees are nonetheless the ultimate decision-makers for occupational pension funds. Pension trustees and other ultimate investors must show that they are taking governance more seriously.
68. We need to address some familiar gaps that have been exposed.
69. Our model of dispersed equity ownership means that too often shareholders are disunited. Boards complain that they hear conflicting views from shareholders and individual shareholders can become isolated.
70. Coalitions of small shareholders often have more influence than single organisations acting alone. Investors therefore need to think about what barriers there are to effective cooperation and what needs to de done to remove those barriers.
71. I hear talk of concert parties and that there is fear and anxiety. If this is the case, then there is a clear need to speed up discussions so that this does not pose an impediment to proper engagement.
72. How can you ensure that your actions are properly coordinated and your views adequately heard? Clearly organisations like the NAPF and ABI will have a role to play here.
73. Evidence suggests that shareholders are often too passive, just accepting the decisions management make. But passivity is no longer an option. For those invested in index tracking funds, this is already clear – for you there is no relative luxury of being able to sell shares and walk away; engagement is crucial.
74. Trustees owe it to their pension holders to challenge effectively where necessary. And you should not underestimate the long-term financial value of insisting on sound governance.
75. There are very real risks if no one feels bothered to think or act like an owner – dismissing it as unnecessary because of portfolio diversification or the free-rider effect. Disengaged investors lead to ownerless corporations and the risk of unaccountable executives and boards running amok. It carries with it substantial economic risk.
76. If you agree with this view, you will need to dedicate proper resources to this task – as I stated at the outset, improvements will not happen automatically, they will only come about through concerted action.
77. The right relationships will be vital, and due regard must be had to any potential conflicts of interest.
78. Trustees and institutional investors should re-examine your relationships with fund managers. Have you made it clear that you want corporate governance taken seriously? Is it explicitly in the investment mandate, with clear articulation of expectations and consequences or just expected to be thrown in as part of the package? How can and do you hold fund managers to account? Do your fund managers have the right incentives? If not, what are you going to do to ensure their incentives are aligned with your time horizons of steady, long-term growth? Can you agents be relied upon to be sufficiently independent from companies to challenge decisions? Are your fund managers too close to those they are expected to monitor? How do you deal with potential conflicts of interest?
79. Is there anything that needs to be done to ensure that fund managers who are part of a larger, integrated financial services organisation are able to air their views without feeling constrained by competitive pressures from other areas of their firms? How are your interests protected when your fund manager has other clients with competing objectives in the same situation – debt for equity swaps being an example. While some have suggested the existence of hazard last year when some fund managers were invested in both Lloyds and HBOS – though not necessarily for the same client.
80. It is clear that investors need to be actively debating these issues with directors. I want to see open and constructive debate on what gaps have been exposed and what needs to be done to close them. Shareholders and non-executive directors should be addressing these practical challenges in a way that promotes a greater understanding of the realities that each side faces.
81. I am encouraged by what I hear at events like this. Therefore, building on this I want to see the leaders from the investor and director communities sitting around the table, and I will be working with industry to arrange a gathering for later this year to address these issues and have an open and frank discussion
82. Because this is in all our interests. The more searching the analysis, the stronger the consensus achieved. And I can assure you, the stronger will be the influence on our thinking.
83. The financial crisis has exposed corporate governance failings that must be addressed. I have set out the steps that the authorities are taking, but the industry must act too. Doing nothing is not an option.
84. The financial and economic difficulties have exposed complacency in the practices of the past - and have forged a renewed consensus that corporate governance must not be ignored.
85. We need to see pressure from regulatory authorities on the one hand complemented by pressure from institutional investors on the other.
86. You have a well-respected framework of governance principles to guide you.
87. The spirit to bring about real change is here - your challenge is to use that spirit to deliver results for your ultimate beneficiaries.
88. Thank you.
[ENDS]
