Introduction
The Medici Bank (Banco Medici) formed and run by the Medici family of Italy in the 15thcentury until its liquidation in 1494 was highly reputed in Europe. The collapse of this financial institution made it a foremost corporate insolvency case in history. Its failure was largely ascribed to the family’s excessive spending and extravagant lifestyle. There have been more major corporate collapses in the centuries to follow of which Overend, Gurney & Co, Danatbank, Texaco, Bank of Credit and Commerce International, and Barings Bank can be referenced.
Corporate failures in the 21stcentury have not been different from the occurrences in the historical archives irrespective of increased corporate regulation and sophistication. The first decade of the millennium has been characterized by two waves of corporate failures. The first of the two is the dot-com bubble (1999-2001) followed by the financial crisis of 2007-2009. Corporate failures in both crises have partly been attributed to poor risk oversight with respect to corporate governance and has led to growing concerns by regulatory bodies across the globe. More so, the scandals at Enron (America), Pamalat (Italy), Satyam (India) and Olympus (Japan) indicate that the seemingly failure of corporate governance is not a function of geography. Considering the number of corporate scandals and or failures over the years amid the increased regulations, is there any shred of residual potency in corporate governance to address the age old agency cost?
The Agency Cost
Corporations take risk in their value creation processes. Risks essential for the firm to remain in business are inherent, inseparable in their operations and earn the firm rewards in the form of revenues. Thus, firms primarily face business and financial risks in their daily operations. The former is the risk of financial losses due to poor managerial decision making and corporate strategy whilst the latter is risk arising from market movements as well as changing interest rate regimes.
Considering that firms take on varying amounts of risks in their operations in order to realize returns, these risks can be skewed upwards in an attempt to maximize returns (risk and return commensurate each other). This trade-off between risk and return has always been an incentive for business managers to underscore inherent risks in pursuit of higher returns. Exploitation of this trade off by executive management at the blindside of those charged to oversee corporations have more often than not led to undesired consequences. This has proven to be the case, especially when managerial incentives are not aligned with business performance. Therefore, since managers of businesses cannot be trusted to do right all the time as noted by Adam Smith (1776) “The directors of companies, being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own”, there is always the need to oversee what managers do with the assets entrusted to their stewardship through corporate governance.
Corporate Governance
Investor pessimism of self-serving managers necessitate adherence to good corporate governance in firms to safeguard their interest. Merchant & Van der Stede define this governance system as the set of mechanisms and processes that help ensure that firms are managed and directed to create value for their owners whilst concurrently fulfilling responsibilities to other stakeholders. In eliminating skepticism on the part of shareholders and other stakeholders (such as debt holders) the elements of good corporate governance are institutionalized in firms to assure all parties. These elements that help monitor the soundness of the firm at each material time are either internal or external in nature. Both the internal and external monitoring mechanisms strive to keep management in check of their responsibilities towards all stakeholders.
The external elements are mechanisms instituted by regulatory bodies such as the Securities and Exchange Commission (SEC) and respective counterparts in various jurisdictions and other government agencies that exist to regulate public institutions. Auditors, bankers, suppliers and the media also serve as external forces to keep management in check thereby limiting agency cost.
The board of directors and its related committees such as the audit committee, risk committee etc. make up the internal monitoring element of corporate governance. These two elements augment each other to ensure good corporate practices are followed closely in the operations of the firm.
Risk Governance
The oversight responsibility of a firm is the topmost priority of its board of directors. The well-being of the firm is their primary fiduciary duty. The board members therefore formulate policies that serve to protect the long term interest of the firm and by proxy those of the stakeholders. They ensure appropriate risks are assumed for strategic growth whilst ensuring survivability in the longer term. With such a mandate the constituent members of a board are expected to be highly skilled and experts in their areas of competence to be able to contribute meaningfully as well as question intelligently and also understand thoroughly answers presented by executive management. It is documented that nonexecutive directors were bamboozled by management in some corporate governance scandals because these directors lacked the necessary skills in probing. A highly skilled board is a solution to this weakness. In their performance monitoring role, shareholders and all other stakeholders count on the board of directors to ensure that good corporate practices are not compromised in the pursuit of firm objectives. One important tool that aids the boards of directors in its firm wide oversight responsibility is a risk management framework.
A risk management program ensures that the risk taking activities of the executive management of the firm is compliant with the risk policy of the firm and mitigates the risks the board deem unsustainable. The appropriate risk appetite of the firm in pursuit of its strategic objectives is decided upon by the board of directors at the apex of the governance hierarchy. This policy is communicated in the best possible way that eases understanding and compliance in the firm.Effective procedures for identifying, assessing and managing risks are equally implemented by the chief risk officer of the firm. The risk management framework communicates to the board and management the assumed risks of the firm with respect to its risk appetite and the mitigating measures taken. It is worth mentioning that poor communication is cited as one of the failures of risk management in the build up to the financial crisis because most of those charged with oversight responsibility had less and or misleading information.
Conclusion
There have been some unfortunate corporate governance scandals and scepticism is mounting. However, good corporate governance still remains a potent tool in managing business and financial risks for corporate sustainability and success when both internal and external monitors are better equipped in dealing with the ever evolving sophistication of corporations. Newer cases of corporate scandals continue to expose the weaknesses inherent in existing governance structures that need tweaking. As observed in the aftermath of the financial crisis, communication is a vital tool in risk management. Therefore, information channeled to the board and management by risk management ought to be accurate, complete and timely for decision making.Internal auditors (serving as the first line of internal oversight) should be extra diligent in authenticating information and business processes. The auditfunction of the board audit committee is also pivotal in this regard. The committee has to ensure the accuracy of financial numbers, regulatory compliance, best in business practices and risk management activities. The independence of this committee in its review work coupled with newer requirements that constituent members be financially literate augments good corporate governance. More so, there is the evolving role of the risk advisory director to the board of directors of a firm. The importance of understanding risk management information (risk and risk processes) independently by board members has placed a premium on risk specialists who are appointed to support the board in risk matters. This practice is also improving the effectiveness of the board of directors in their risk oversight. Last but not least the drive to align executive compensation fuelled by shareholder activism with longer term firm performance also ensures the longevity of corporations via good corporate governance.
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