The script for City grandee Lord Myners’ furious walkout from the Co-operative Group last month could have been written a year ago by the Financial Stability Board (FSB), in a damning report on risk governance in finance – which still has resonance for many firms.
Risk governance at financial institutions rests in three key functions: the board, the firm-wide risk management structure and the independent assessment of risk governance. The FSB report exposed extensive weaknesses that resulted in firms’ failure to understand the risks they were taking. The crisis, it said, had highlighted the fact that many boards had directors with little financial industry experience and limited understanding of the rapidly increasing complexity of the institutions they were leading. Too often, it reported, directors were unable to devote sufficient time to understanding the firm’s business model and were “too deferential to senior management.”
Conditions round the boardroom table are now – rightly – tightening. From this reporting season onwards, directors of ‘premium’ (formerly ‘primary’) listed companies in Britain are required to confirm that “the annual report and accounts, taken as a whole, is fair, balanced and understandable.”
Reports and accounts have assumed massive proportions, particularly in financial institutions. Barclays’ 1990 accounts ran to 64 pages. By 2013, that had grown seven-fold, to 430 pages. Comparing balance sheets across time is notoriously difficult as the definitions change so much. However, historically, directors could understand the risk in financial statements because they were relatively short, risks were apparent and, in any case, there were higher liquidity and equity cushions if things went wrong. The introduction of the Basel Capital Accords coincided with a dramatic reduction in equity ratios from around 5% to 2% by 2007 and a parallel fall in liquidity, in many big banks’ cases from nearly 20% to less than 1%, as banks sought greater leverage on scarce equity. Equity ratios are now recovering to previous levels, but liquidity cushions are not.
Boards are under more pressure to make the all-important front half of reports and accounts, the foothills before the mountains of figures, more accessible – to make sure they tell the business’ story in a consistent, clear and uncluttered manner. The risk-taking that makes the real money for most institutions poses the toughest reporting challenge.
A recent symposium focusing on the ‘confidence accounting’, or accounting for uncertainty, programme hatched by Long Finance and backed by amongst others the CISI and the ACCA, highlighted the need for a move away from the boilerplate approach and towards reporting on risks more usefully. The ground here has shifted to the integrity of the numbers, rather than their sheer volume. Four-fifths of the participants clearly expressed the view that the current trend towards voluminous reporting, especially at banks, is obscuring the key risks. In parallel, 67% agreed or strongly agreed that commercial sensitivities are used as a smokescreen for resisting the request for enhanced risk disclosure.
Bank boards are being cajoled to broaden their representation by gender and social composition, to understand and represent more clearly the societies in which they operate. A more daunting and immediate challenge lies in understanding the risk information presented to the board by the risk managers and also by their finance, treasury, planning and business divisions. The latest ‘Banana skins’ survey of bank risk points to ongoing concerns about the macro-economic environment, including the impact of rising interest rates, potential asset bubbles and softness in some emerging markets, and whether banks may be tempted to misprice risk and inadvertently missell products. And concerns about technology and crime risks are rocketing.
Boards at major firms now face two further challenges when trying to understand and get to grips with risk. Firstly, regulators, as a result of continuing pressures on the system post-September 2008, are expecting big players to set their capital requirements on the basis of system-wide stress which is only scantily understood.
Secondly, ‘incentive risk’: one of the most telling aspects of the banking crisis was the way in which many staff, from the top, including boards, to near the bottom, were found not to behave the way they might have been expected. “You get the behaviour you incentivise” is trite and frequently wrong. Not only is it very difficult to get incentives right, but even the the best laid schemes o' mice an' men can go awry, with a potent medley of unintended consequences. Risk guru Brandon Davies, formerly of Barclays, believes there might even be value in replacing board remuneration committees with board incentives committees, to focus minds more clearly on the connections between incentives and behaviours.
Risk in finance will not get easier to identify, to measure and to manage – complexity, of regulation, of structures, of instruments, will only increase, and risk in modern finance stems in large part from that complexity. There is an overarching risk, as Susan Rice of Lloyds has warned, that “banks forget too quickly the cautionary lessons from the recent financial crises and therefore fail to be robust in challenging ‘clever’ new ways to make profit.”
So it is high time that individual directors of financial institutions, whatever their gender, colour or sexual orientation, got to grips with current risk issues and enabled themselves to make those “robust challenges” that Lady Rice believes necessary. The ‘banana skins’ report, not to mention the CISI’s risk examination, would be a wake-up call for many. Directors must be prepared to demonstrate that they have readied themselves for those challenges – if, or when, the next crisis hits, the public and politicians will ask out loud what the responsible individuals did to prepare for it.