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Governance Failure in Banks is Key to Credit Crunch

Small Business News

16th October 2008

Climbing out of the Credit CrunchThe principal source of the credit crunch is a failure in corporate governance at banks, which encouraged excessive short-term thinking and a blindness to risk, says ACCA (the Association of Chartered Certified Accountants) last week in a report about the year-long financial crisis.

ACCA's policy paper Climbing Out of the Credit Crunch, examines five key areas: corporate governance, remuneration and incentives, risk identification and management, accounting and financial reporting and regulation - and recommends that accepted practices in all these areas need to change to avoid future failures.

Richard Aitken-Davies, President of ACCA, said:

"The fundamental responsibilities of a corporate board - to provide strategic oversight and direction, to ensure a strong control environment and to challenge the executive - appear to have been inadequately discharged. Remuneration and incentive packages have encouraged short term thinking. We need to ask what inhibited banks' boards from asking the right questions and understanding the risks that were being run by their managements.

"If banks' existing incentive and career structures meant enormous rewards for failure, then this needs to change. Firstly, we have to question whether the relative share of banks' income paid as remuneration compared with dividends has been in the best interest of long-term shareholders. Secondly, risk management and remuneration/incentive systems must be linked. Executive bonus payments should be deferred until there is incontrovertible evidence that profits have been realised, cash received and accounting transactions cannot be reversed.

"Increased transparency of regulation is also important. Most large banks now combine both retail and investment banking activities, and the regulatory goal should be for separation of retail from investment banking to protect retail customers from wholesale risk, or at least to alert them to the risks if they opt to deposit funds in banks combining the two."

But ACCA also accepts that the accountancy profession must come under scrutiny.

Richard Aitken-Davies added:

"Accounts preparers, standard-setters and auditors must all learn from the last year. It is clearly unacceptable that poor quality loans can be sliced, diced and parcelled up with an AAA sticker and overvalued on banks' balance sheets as a consequence. ACCA still believes that fair value accounting has an important part to play in modern global financial reporting but we must make sure the model is as robust as we can make it."

Key recommendations from the report are:

  • Risk management failures need to be addressed. Weaknesses in these areas meant risk management departments in banks did not have sufficient influence, status or power.
  • Clearer rather than heavier regulation is needed. In the UK, there is confusion about what the FSA is trying to achieve and the extent to which it is committed to protecting the interests of customers. It is vital that the public know what they are putting their money into.
  • Lack of training to enable management to understand complex products and the underlying business models has to be addressed

Richard Aitken-Davies concluded:

"The financial industry and all involved in it need to learn the hard lessons from the past year and be bold enough to make the changes needed to climb out of the credit crunch - and make sure the mistakes made are not repeated."