The Financial Instruments
It is two years since the first casualties of the US sub-prime mortgage market flagged up more deep-rooted flaws in the global banking sector and the financial instruments it was selling, but there is still no sign (perhaps unsurprisingly) of any institution or individual taking the bold step to say that they are responsible for wiping trillions of dollars worth of wealth off the face of the Earth...Instead, bankers, boards, regulators and so on in Europe and the US are more disposed to admitting some degree of fault as part of a collective effort, while still largely pointing their fingers at others. For example, regulators blame banks and their boards for not following their regulations, rather than blame themselves for not providing adequate enforcement of the rules. Credit agencies blame investors for not questioning the flawed research they were putting out, and investors blame bank boards for pursuing such high risk business strategies, even though large institutional investors, such as pension funds, effectively sanctioned these pursuits by either voting in favour of them at the annual general meeting, or not voting at all. Below are the main culprits behind the recent economic turmoil – no one is still quite sure yet if some markets are heading for recession or even a depression – and what part they played in the enveloping crisis. Readers can judge for themselves what degree of culpability should be accorded to each group.BoardsAs those in charge of their organisations’ business strategy and appetite for risk, the first finger of blame is definitely pointing towards board members. However, not many have accepted any personal fault. Of the four disgraced UK bankers hauled before the Treasury Select Committee on February 10 – Andy Hornby and Lord Stevenson, former HBOS CEO and chairman respectively, and Sirs Fred Goodwin and Tom McKillop, former CEO and chairman of Royal Bank of Scotland respectively – only Sir Tom admitted that he did not understand some of the details of the financial instruments he had to approve. Management’s failure to appreciate the risks inherent in parts of their business strategy has long been a bone of contention with some investors (institutional and private) for some time, especially with regards to the suitability of non-executives to be on the board. Supposed to challenge management’s thinking, critics have argued that they cannot fulfil that role if they are unable to grasp what is actually going on, especially since they do not need to be from the same industry sector – the idea being that these “independent” executives can bring their different experiences into the boardroom and raise a fresh perspective on management thinking.However, there are obvious pitfalls – namely, that they have none or little relevant industry experience, or understanding. For example, only by May 2007 did HBOS boast a senior experienced banker as a non-executive (John Mack), and by then it was too late. But even where experienced bankers acted as non-executives, it seems that they made little impact. Colin Buchan, a former investment banker, served as a non-executive at RBS between 2002 and 2007, while Sir Derek Wanless, a former NatWest banker, was a non-executive at Northern Rock.Robin Ashby, spokesman for the Northern Rock Small Shareholders’ Group, has long been concerned about the performance of the non-executive directors of Northern Rock in their role of holding the executive to account on behalf of the shareholders. “What did they do to earn the fat fees they received? Did they do much except warm chairs? They were supposed to be industry experts,” he said.Steve Tatton, Editor of Income Data Services’ latest executive compensation review, which showed that non-exec salaries had risen once again last year, told the Financial Times this February: “Shareholders have a right to wonder where all this investment of time and money into corporate governance has got them and what steps now need to be taken to get the corporate governance framework to function properly.”Audit committees’, in particular, have been blamed for rubber-stamping boardroom strategies that they did not fully understand. Peter Montagnon, Director of Investment Affairs of the Association of British Insurers (ABI), said that people were not sufficiently aware that some of the off-balance sheet structures that were blowing multi-billion pound holes in company balance sheets actually existed. “Investors tell me frequently that they audit committees don’t know enough about what is going on. This relates to the committees’ knowledge and also to the accounting standards and what has to
be reported. We need to make it clear to committees that they need to be on top of what is going on and on top of how this is being reported.”RegulatorsThe UK’s “light touch” system of principles-based regulation has come a cropper during the credit crisis, but so too has the US’ rules-based system. So what’s the answer? Increased regulation and rules are not usually at the forefront of any request a financial services firm might make to the FSA, but there does seem to be a consensus among investors and the UK watchdog itself that more effective enforcement – rather than drafting in new rules – and a “harmonisation” of existing regulations and principles would help achieve greater compliance, disclosure and understanding. However, at the heart of any effective regulation lies the integrity of the regulator, and “the UK’s FSA just doesn’t have it,” says one City insider. “No one has any faith in the FSA – consumers or the industry. It’s useless,” said another source. Such views may be borne out by the fact that the people in charge of “improving” the UK’s financial regulatory system have also come a cropper. Sir Derek Higgs, the architect of the last revamp of corporate governance following the Enron and WorldCom scandals, which designed to make non-executive oversight more effective, became chairman of Alliance & Leicester. Though he left in 2007, the bank needed to be rescued last year by Spanish banking group Santander because of excessively risky lending. Meanwhile, Sir Steve Robson, a non-executive director at RBS which is now 70 percent owned by the public purse, is also a non-executive director of the Financial Reporting Council – the UK’s corporate reporting and corporate governance watchdog.The recent resignation of FSA Deputy Chairman Sir James Crosby over allegations of his involvement in sacking HBOS’ head of group regulatory risk because he dared to warn the board of the bank’s high risk exposure (said to be without merit by HBOS, the FSA and Sir James) have not helped the watchdog’s profile. Furthermore, the FSA tried to extricate itself from the furore by saying that it had been aware of HBOS’ high-risk strategy since 2002 – while not doing anything about it. In June 2006 the FSA continued to pose “concerns” about the strategy of HBOS but, despite flagging up these issues, the bank did not act, and the regulator did not flex any muscles. There are also claims that even the regulator does not understand some of the financial instruments it is meant to be keeping an eye on, and that some products are largely free of regulatory oversight. Speaking at the FSA’s Asset Management Conference, Robert Jenkins, Chairman of the Investment Management Association, the trade body for the UK’s £3.4trn asset management industry, said: “Investment banks are creating and distributing structured investment products aimed at the retail investor. Deceptively simple in sales pitch but complex in construction, they carry issuer risk, liquidity risk, and a level of costs which the retail buyer may not fully understand. Yet this is an area largely free from regulatory oversight and competes directly with a highly regulated traditional investment industry where agency status is central, transparency of fees and holdings de rigueur and government pressure to raise levels of treating customers fairly foremost. Is someone asleep at the watch?”Granted, the FSA has made serious errors. On March 26 2008 it admitted a catalogue of mistakes in the run-up to the collapse of Northern Rock in 2007, the first UK casualty of the current crisis to be nationalised – the most alarming of which included the fact that no senior FSA member had a meeting with the bank between January 2005 and August 2007, and that until February 2007 the team responsible for regulating Northern Rock were experts in insurance, not banks. The FSA’s internal probe also revealed that despite the Rock’s highly aggressive business plan, just eight meetings were held between the bank and FSA staff during the period, including two by telephone and five on one day. A typical rival bank would have had nearly 30 FSA meetings over the same period. However, the British Bankers’ Association insists the real blame lay with the bank’s management, not the regulator. It says: “No amount of regulation can ensure that wrong decisions are never made.”Credit rating agenciesThe role of a credit rating agency – such as Fitch, AM Best, Standard & Poor’s and Moody’s – is to gauge the creditworthiness of organisations issuing debt instruments, such as corporate and government bonds, so that investors, banks, regulators and other market operators can use them to measure relative credit risk. Billions of dollars-worth of debt is issued and borrowed based on their analysis. If a company is “downgraded”, investors either feel compelled to dump shares, or force the company to dump executives and change tack – quickly. But as well as rating traditional bonds, credit rating agencies also offer advice on structured financial products, such as collateralised debt obligations (CDOs), complex portfolios of fixed-income assets that are divided into “tranches”, with each tranche containing assets holding a different level of credit risk. It is here that credit rating agencies became unstuck. While CDOs became a favourite for investors, many included sub-prime mortgage bonds. The rest is history. Attacks on rating agencies focus on two charges. Firstly, agencies receive fees from organisations issuing debt and constructing debt instruments such as CDOs, so they are being paid by the issuers whose securities they rate. This, critics argue, makes them unable to provide objective information about the risks associated with investing in these debt instruments. Secondly, credit rating agencies’ methods of rating and categorising CDOs do not make it easy enough for investors to see the true levels of risks they carry. The triple-A ratings assigned by credit rating agencies would have led some investors to believe that these complex debt structures were bomb-proof. But not all AAA securities are created equal. As demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols. This is a fact that has not escaped US and European regulators. In May 2008 Ingrid Bonde, the chair of the task force on credit rating agencies for the Committee of European Securities Regulators (CESR), which groups the EU’s national supervisors, said that “the events of last year surely merit a thorough re-evaluation of the current self-regulatory regime. Although credit rating agencies ratings are legally no more than opinions, there is a clear public interest aspect to the information they provide.”As a result, market regulators are taking another look at the industry’s practices. At the beginning of July last year the SEC, the US financial regulator, concluded that credit rating agencies failed to manage conflicts of interest in assigning top ratings to bonds backed by sub-prime mortgages and other assets. The conclusions were far from complimentary. “The public will see that there have been significant problems,” said Christopher Cox, SEC chairman. “There have been instances in which there were people both pitching the business, debating the fees and were involved in the analytical side”, adding that credit raters were “deluged with requests” for ratings and “the volume of work taxed the staffs in ways that caused them to cut corners” and “to deviate from their models”.But actual rules-based reform of the industry does not seem to be on the agenda. Instead, principles rather than rules seem to be the way forward, with self-regulation to be kept intact. The irony has not been lost on some highly-placed critics. In December European Commissioner for Internal Markets Charlie McCreevy said that the trust placed in many credit ratings to determine capital requirements had now been shown “to be wholly misplaced”. He added that he was “flabbergasted at the naivety of anyone who thinks these same credit rating agencies should be trusted to abide by a non-legally enforceable voluntary code of conduct drawn up under palm trees – a code that has proven itself to be toothless, useless and worthless time and time again. Fool me once, shame on you. Fool me twice, shame on me.”InvestorsInstitutional investors have been keen to pour scorn on directors and audit committees, but they have been reticent about their own voting records and engagement activities with boards. Armed with three mighty weapons – the vote at the annual general meeting, the option to disinvest, and the ability to issue governance warnings, like the ABI and its “red-top reports” – critics say that they are rarely used, and that pension funds are largely “toothless tigers” or “sleepy”. The Trades Union Congress’ Fund Manager Voting Survey 2008 found that a significant number of fund managers support the large majority of remuneration reports, even when there are contentious issues at stake. It also found that half of the fund managers responding to the survey supported 80 percent or more of the remuneration resolutions on which they voted, despite widespread public and professional condemnation of the levels of executive pay.Furthermore, investors’ have also been slow to challenge “positive” financial data. Their over-reliance on the reports and ratings of credit ratings agencies such as Moody’s and Standard & Poor’s led to a burgeoning trade in high-risk investments, such as collateralised debt obligations. Arthur Levitt, a former chairman of the Securities and Exchange Commission, the US financial services watchdog, said in September 2007 as the scale of the crisis was dawning, that “we need investors to accept more responsibility for evaluating structured financial products.” He added: “Credit ratings agencies play a critical role in the capital markets, but their judgments are guides, not stamps of approval. Too often, institutional investors have been investing in sophisticated credit products on the basis solely of the credit rating and without fully understanding the inherent risks they are undertaking.”AuditorsThe government is under pressure to investigate the role of external auditors in the British banking collapse following revelations that the Big Four firms have generated as much revenue from providing non-audit services as they have from their audit work since 2000. Following the collapse of Enron and the revelation that its external auditor Arthur Andersen was also providing internal audit services, the types of extra consultancy services that auditors provide to their clients has come in for criticism – though not much scrutiny or
censure, argue some. John McFall, the Labour chairman of the Treasury select committee, has laid the problem out to parliament: “What is the role of auditors? Is it to examine the books and provide a company’s board, and the public, an accurate view of the health of that company? Or is it to provide other services that are more profitable than the auditing undertaken for that company?” Moves are afoot to try to resolve some of these issues. Just before Christmas the Financial Reporting Council (FRC), the UK’s corporate governance watchdog, revealed its draft plan for its Audit Inspection Unit in 2009 and 2010. Among the big issues it plans to examine is whether auditors can maintain the quality of their work in a transformed economic environment and that, as more risks will be more prevalent, whether auditors can step up to the mark and audit them appropriately. Its inspection work is expected to mirror that of the Financial Reporting Review Panel, which checks that financial information complies with accounting standards, and which has already revealed it will look at banking. But auditors believe that the FRC needs to place more focus on directors and their financial reporting. Phil Crooks, head of assurance at Grant Thornton, says that while the focus on audit and the pressure on auditors is fair, “there needs to be a lot more focus on companies’ understanding of disclosures”. Others also believe that auditors are unfairly being blamed for not giving opinions on issues outside of their remit. Appearing before the Treasury Select Committee investigation into the banking crisis on January 28 this year Professor Michael Power of the London School of Economics defended the performance of the audit industry, saying that expectations on auditors are too high and the profession should not be expected to avert management failure or challenge flawed business models. “Auditors are not there to challenge business models with finance directors. That is not their job. For that to happen, things would have to change substantially. Auditors ultimately rely on a variety of external sources including market prices and management,” he said. Risk management/corporate governanceThe success or failure of any entity is dependent on the nature of the risks inherent within the business, and how they are identified, controlled, mitigated, and leveraged. Ultimate responsibility for risk management and corporate strategy rests with the board, but boardroom thinking is meant to be challenged by assurance functions such as internal audit and risk management. However, these functions say that they are only meant to raise concerns – not ensure that they are addressed. This view is hardly a ringing endorsement for sound corporate governance.For example, several risk managers and heads of internal audit have told this magazine that they and their colleagues in other financial institutions had told their boards and senior management “for years” that they were at risk due to their dependence on certain product lines, particularly in the housing market, but their concerns were ignored. One head of internal audit at a major European financial services provider told World Finance that “our team had identified a number of risk areas with regards to some of the products we were selling. We flagged it up to the board as high-risk, but they responded that they wanted to pursue a high-risk strategy because they were looking for high returns. That strategy worked for a while, and then it didn’t, and we ended up in deep shit. The point is simple: we can tell the board about their exposure to risks, but it is not our role or responsibility to make it change the business strategy.”This view appears to be shared by management, if the allegations made by one former risk manager are to be believed. Paul Moore, formerly head of group regulatory risk at beleaguered bank HBOS has told MPs that former HBOS CEO Sir James Crosby sacked him in 2005 after he warned the bank’s board about its potentially dangerous “sales culture”. Mr Moore said that he saw evidence of “negligence” and even “recklessness” during his time at the bank, adding that: “I realised the bank was moving too fast and I raised those challenges very strongly at board level. I also raised issues of cultural indisposition to challenge and inappropriate behaviours, and ultimately I was sacked… I told the board they ought to slow down but was prevented from having this properly minuted by the chief financial officer.” The bank, however, says that Mr Moore was made redundant and that his allegations have “no substance and no merit”. Mr Moore claims he was “summarily dismissed” by Sir James, who said that Moore “had lost the confidence of key executives and non-executives but refused to explain why”. Moore said that, after suing for unfair dismissal, he received “substantial damages” but was subjected to a “gagging order” preventing him from speaking out. He had decided to talk publicly about the issue now because, he said, “the public interest demands it”. Mr Moore’s account of his warnings and his alleged treatment by Sir James was disclosed in an evidence session of the Treasury committee, at which figures including former HBOS Chief Executive Andy Hornby and former chairman Lord Stevenson apologised for bringing their banks to the verge of collapse. However, Lord Stevenson said Mr Moore’s claims had been rejected after a nine-month inquiry by the FSA. Mr Hornby also rejected Mr Moore’s claim that he was met with “threatening behaviour” from some HBOS executives when he tried to raise concerns. In his written evidence to the committee, Mr Moore said the HBOS story was like the “Emperor’s new clothes” with no one prepared to “step out of line” and say what was going wrong. 
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