Good governance is a vital part of any corporation, both within and beyond the financial sector. The culture of an organisation, its appetite and its approach to managing risk ultimately flow from the policies and practices set at the very top. The rules and requirements set by regulators and internally within the institution will only go so far; an organisation’s culture and risk appetite determine how an institution responds to the spirit of the requirements and circumstances that are not addressed by the rules.
Equally, weak corporate governance can have severe repercussions. This is particularly true within the financial sector, where failures in governance and risk management can have an effect on the entire financial system and broader economy. Overseas, financial institution boards’ lack of understanding about the risks faced by their institutions, and an absence of robust governance frameworks through which they could monitor the risk-taking actions of management, were major contributors to the GFC.59 The significant effect of the GFC on economic growth, employment and the financial system in many countries underscores the importance of strong governance frameworks.
To contribute to the effectiveness of the financial system, sound corporate governance requires clarity of the responsibilities and authority of boards and management. There are differences in the duties and requirements of governing bodies for different types of financial institutions and, within institutions, substantial regulator focus on boards has confused the delineation between the role of the board and that of management.
Importance in the financial industry
Reflecting the importance of corporate governance to all industries, standards and requirements are placed on company boards and management from several sources. The Corporations Act 2001 places a common set of requirements on all corporates to provide a baseline for corporate governance, including that the primary duty of the board is to the company. Listed entities are also subject to ASX’s corporate governance standards, which aim to promote accountability to shareholders and maintain the integrity of the market. The latter incorporate disclosure standards, including risk management practices that assist shareholders and creditors assessing the risk appetite and practices of the company.
In the financial industry, the relevant prudential Acts provide that insurer directors and superannuation fund trustees place the interests of policyholders and members ahead of those of shareholders. There are no equivalent provisions for ADIs under the Banking Act 1959. Duties of governing bodies therefore differ across types of financial institutions. The Inquiry invites further information from stakeholders on whether the diversity of duties of governing bodies in different parts of the financial industry is appropriate.
Corporate governance prudential standards, set by APRA, are common for ADIs and insurers. These place requirements on the structure of boards and the independence of directors. The respective standards for superannuation do not have structure or independence requirements but do cover conflicts of interest. In 2013, the Government released a consultation paper on how best to ensure an appropriate provision for independent directors on superannuation trustee boards.60 This included how independence could be defined and the optimal board structure.
There is a sound public policy rationale for requirements and oversight in the financial sector of corporate governance generally, and risk management specifically.61 A function of the financial sector is to transform and manage financial risk. This can involve higher use of leverage, increasing the risk of stakeholders exposed to poor risk management. Appropriate frameworks, which enable institutions to understand and manage often complex risks, are crucial. Adequate reporting of these frameworks is important in promoting market discipline and allowing investors to make informed choices about the risks they take on.
Understanding and managing risk are particularly important, as excessive risk taking has the potential to disrupt the entire financial system and economy. This was evidenced during the GFC, demonstrating that, in the absence of good corporate governance, the benefits of appropriate Government interventions can be high.
Internationally, where the impact of the GFC was greatest, regulators have taken a strong approach to corporate governance in financial institutions. In a number of cases, other jurisdictions have placed significantly more onerous requirements on management and boards than in Australia. For example, in the United States, financial institutions are prevented from making capital distributions if stress-tests reveal weaknesses; in New Zealand the regulator can bring criminal cases against directors in specific circumstances, including misleading disclosures in offer documents; and in Europe, there are significant remuneration controls.
The role of boards and management
Ultimately, the board is accountable for the actions of the institution. Good corporate governance across all industries involves clear and distinct duties performed by the board and senior management. A board’s obligations are: overseeing, directing and monitoring the performance of the company; approving and overseeing strategic policies and frameworks, including for risk management; and satisfying itself that such policies and frameworks are effective. Management is responsible for operational day-to-day activities and implementing strategic policies and frameworks. Generally, boards oversee what management implements. In the Inquiry’s view, although there is a public policy case for specific corporate governance requirements on financial institutions, there is no case for regulation to alter the delineation of responsibilities between boards and management.
A number of submissions raise concerns that APRA’s requirements have become too prescriptive and do not respect the appropriate division between the responsibilities of the board and those of management. This includes where supervisory matters are referred by APRA directly to the board, which is often taken to imply the board itself must take responsive action. Many industry participants believe the requirements imply an excessive level of managerial ownership by the board and, in some cases, overstate the board’s influence. Submissions argue that this diminishes boards’ ability to focus on governance and strategic direction, hampering their capacity to perform their core functions.
This is not unique to Australia. Speaking in a United States context, Federal Reserve Governor Tarullo noted:
“But it has perhaps become a little too reflexive on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration”.62
Submissions and consultation also revealed discontent with the increased management time and attention on governance and regulatory matters that require a number of levels of review — including independent reviews requiring the appointment of external consultants — adding to the cost of compliance.
Given the breadth of concern, the Inquiry invites further information from stakeholders on where they specifically believe corporate governance requirements unduly place managerial responsibilities on boards. Consultation to date suggests that at least part of the issue appears to be uncertainty about APRA’s expectations of how boards need to meet governance requirements.
Remuneration structures and policies are a specific aspect of corporate governance that can materially affect the risks taken by the institution. In the lead-up to the GFC, compensation practices around the world contributed to a culture of excessive risk taking within firms, as short-term gains were rewarded with little regard for the longer-term risks.63 On the cause of the crisis, Adair Turner concluded that “inappropriate incentive structures played a role in encouraging behaviour which contributed to the financial crisis” although he also noted that they likely made a smaller contribution than other factors.64
The FSB has produced principles to address risk created by remuneration structures. Broadly, these involve linking compensation to the long-term performance of investments to discourage excessive short-term risk taking. Overseas regulators have taken a variety of approaches, ranging from high-level principles on how remuneration should be set — including the ability to ‘claw back’ past bonuses — through to regulator approval for bonuses paid.
APRA considers remuneration in its supervision of financial institutions. To date, Australia has taken a principles-based approach to remuneration, requiring financial institutions to align incentives with long-term performance. This appears appropriate in the Australian context, where there have been fewer financial failures and where remuneration packages are more contained than in some other countries.
The more prescriptive approach to remuneration policy taken in some jurisdictions, such as the regulator approving senior management bonuses, is unlikely to be appropriate for Australia. It presupposes that the regulator is better placed to assess the performance of individuals than the institution itself, or that the regulator has specific capacity in this regard. It also has challenges, such as the possibility the regulator will be overly risk averse due to public scrutiny and popular political pressure to lower bonuses. This could lower risk taking below an efficient level.
Policy options for consultation
Requirements on boards
Submissions are critical that the current regulatory and supervisory system does not delineate appropriately between the role of boards and management.
Consultations suggest that part of this may reflect a lack of understanding about APRA’s expectations of boards. Reflecting a desire to not be in breach of the requirements, this has resulted in disproportionate compliance measures by a number of institutions. According to APRA, its standards do not require boards to micro-manage the organisation. Instead, they aim to ensure boards implement appropriate policies and frameworks, particularly relating to risk, and are satisfied that these policies are effective. In addition, correspondence is often addressed to boards with the intention of ensuring that they are aware of APRA’s concerns and ensure that management addresses them, not for the board’s direct action. If this is the case, APRA should clarify its expectation of boards to dispel misconceptions. The Inquiry notes that actions are already underway in this regard.65 This should assist with concerns in this area.
A further step would be for regulators to review their frameworks for corporate governance requirements, potentially with input from independent advice.66 A review would aim to determine whether requirements imposed upon boards are consistent with the fundamental obligations of a company director. This could be used to identify areas where management could more appropriately undertake such obligations.
The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:
- No change to current arrangements.
- Review prudential requirements on boards to ensure they do not draw boards into operational matters.
- Regulators continue to clarify their expectations on the role of boards.
The Inquiry seeks further information on the following area:
Is it appropriate for directors in different parts of the financial system to have different duties? For example, differences between the duties of directors of banks and insurers and trustees of superannuation funds. Who should directors’ primary duty be to?
59 G30 2012, Towards Effective Governance of Financial Institutions, G30 Special Report, G30 Working Group, Washington DC.
60 Commonwealth of Australian 2013, Better regulation and governance, enhanced transparency and improved competition in superannuation, Discussion paper, Canberra.
61 Tarullo, D 2014, Corporate Governance and Prudential Regulation, remarks at the Association of American Law Schools 2014 Midyear Meeting, 9 June, Washington DC.
62 Tarullo, D 2014, Corporate Governance and Prudential Regulation, Remarks to Association of American Law Schools Midyear Meeting, 9 June, Washington DC.
63 See for example Blinder, A 2009, ‘Crazy Compensation and the Crisis’, The Wall Street Journal, 28 Mayand Rajan, R 2008, ‘Bankers’ pay is deeply flawed’, Financial Times, 9 January.
64 Turner, A 2009, The Turner Review: A regulatory response to the global banking crisis, Financial Services Authority, London.
65 See Littrell, C 2014, Letter to all CEOs of ADIs, general insurers and life companies, 8 May.
66 CBA 2014, First round submission to the Financial System Inquiry, page 93.