governance

Global governance expert Philip Armstrong believes the traditional board model is ill-equipped for change in the banking sector – a view that adds a different dimension to problems in the Australian financial services sector and the regulatory response.

Released in early February 2019, the final report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry considered board issues such as organisation culture, governance and remuneration in its recommendations.

Commissioner Kenneth Hayne called on boards to be more proactive in dealing with non-financial risks, ensure they receive the right information from management and regularly assess their entity’s culture and governance. Understandably, the report did not specifically consider whether the governance model of banks is still appropriate for such large, complex organisations.

Armstrong, Director of Governance at the Gavi Alliance in Switzerland, believes the conventional model of independent non-executive directors governing banks is partly the reason for recurring problems in the sector. “As they look at systemically important banks, regulators worldwide need to be concerned if they are addressing the symptom or the cause. Adding endless regulation to address the most recent lapse without looking at the whether the conventional governance structures remain appropriate and fit for purpose will not necessarily address the challenges the banking sector increasingly encounters in a complex national and global financial markets system.”

Armstrong adds: “Regulators need to consider if a board of part-time directors that meets once a month can meaningfully get its head around the sheer size, complexity and regulatory requirements of large banks in this modern era.”

A former head of the Global Corporate Governance Forum, Armstrong stresses his comments on governance models relate only to banks. “In organisations less complex, the model of part-time, independent non-executive directors can be highly effective. But with banks, the traditional governance model makes it hard for boards to provide the required oversight given the sheer weight and plethora of regulations now imposed on the banking sector.”

Part-time bank directors, some of whom come from outside the industry, can struggle to understand the business sufficiently to challenge management, shape strategy and govern risk management, says Armstrong. “We’re expecting non-executive directors who might only spend a limited portion of their time on their bank board role to ask the right questions of management who live and breathe the organisation and its industry daily.”

The regulatory response, here and overseas, to problems in the banking sector has been more regulation and higher governance expectations. The Australian Prudential Regulation Authority’s (APRA) report last year on the Commonwealth Bank, considered a governance landmark, implied that boards need to dig deeper in their organisation.

Some governance observers believe regulators want bank boards to have a quasi-management role, although that is not obvious from APRA’s report and certainly not from Hayne’s. But pressure on boards to spend more time in their organisation, digest extra information, consider a wider range of non-financial risks and spend time with stakeholders grows by the year.

“The traditional governance model of bank directors having their ‘nose in, and fingers out’ of the organisation doesn’t seem to align with these increasing expectations,” says Armstrong. “I’m not saying bank boards should get involved in management, but having mostly part-timers governing banks is proving challenging against this background.”

Armstrong’s comments are directed at global rather than Australian banks. Still, our banks face similar issues to their peers in developed markets and broadly similar governance challenges. If anything, the governance challenges of Australian banks are amplified by their size and concentration in this market, and intense public and market scrutiny.

“There hasn’t been enough debate on whether bank governance can be improved through a redesign of bank board models to meet the regulatory expectations imposed on them,” says Armstrong. “It’s a bit like the little Dutch boy with his finger in the dike: we keep adding ‘patches’ to bank governance, hoping it holds together. But pressure on bank governance is building to the point where it will struggle to keep up and is potentially perilous for bank directors.”

Anecdotally, board packs of some Australian banks are more than 1,000 pages each month and likely to get longer after the Royal Commission. In the case of the Commonwealth Bank, 10 directors, nine of whom are non-executives, govern an organisation valued at $128 billion and is made up of several multi-billion-dollar businesses in their own right.

Armstrong says bank boards should challenge traditional governance orthodoxies. He says there is merit in having more executive directors and fewer non-executives; possibly a one-third, two-third split that would reduce bank board independence levels. “If you had the Chief Financial Officer and Chief Risk Officer, in addition to the CEO, on the bank board, you’d have three directors with a lot more knowledge of the business and its industry, and a higher level of accountability for the executive team.”

Armstrong favours a return to bank boards having more industry specialists as directors. “Frankly, the push for diversity has taken boards too far away from industry experts. Diversity is important and valuable, but banks need more directors who have decades of experience in their industry and instinctively understand the organisation and its risks and opportunities and accompanying familiarity with complex financial instruments used by banks.”

He believes bank boards should be more accommodative of former CEOs moving straight to a directorship – an unpopular notion in modern governance. In Australia, CEOs are discouraged from joining their organisation’s board upon leaving the top job, at least for a few years.

“I understand the new CEO might not want the former CEO on the board and that the board needs to ensure sufficient separation between itself and management. But a former CEO who knows the organisation back to front arguably can add more value to the board than a director who has never worked in the industry, provided he or she can make the transition to governance from his or her previous management role.”

Armstrong says there is a case for larger bank boards and better resourcing of the Chairman’s office. “The current governance trend is for smaller boards but in the case of bank boards, having eight to 10 directors monitoring such large organisations across numerous committees, which are often technically sophisticated, might not be enough. There could be a need for larger boards allowing for board committees to be appropriately resourced – and greater investment in bank governance.”

Armstrong’s suggestions are fundamentally about improving industry knowledge on bank boards by having more former and current executives on them. That approach is not without complication but the benefit is having directors who know the business.

Appointing boards comprising mostly directors from outside banking who spend their first term on the board getting their head around the business opens up potential governance gaps in oversight and monitoring, says Armstrong. “Bank directors have to hit the ground running from day one and that only happens if you have industry knowledge or at least a board that comprises a strong component with the appropriate background, knowledge and expertise.”

Private-equity governance models

David Beatty, Conway Director of the Clarkson Centre for Business Ethics and Board Effectiveness at the University of Toronto, believes traditional governance models in developed markets are losing their effectiveness because of the speed and complexity of business.

“You have non-executive directors who, on average, spend 250 hours a year on a role attempting to challenge and guide executives who spend more than 3,000 hours annually on their job. The gap between a director’s understanding of the business and management’s is like the Grand Canyon.” Beatty adds: “The truth is, you have a bunch of part-timers on boards who invest a limited amount of time on each directorship, and might only meet every month or two, trying to keep up with highly complex businesses. Many directors are experienced and skilled, but they don’t spend anywhere near enough time in the large businesses to deeply understand them.”

Beatty, a leading thinker on shareholder activism and governance, has served on more than 40 boards and is a senior adviser to McKinsey & Co. He says the traditional governance model still works from a compliance perspective, but is less effective in strategy and risk management.

“Boards, generally, have done a reasonable job on the monitoring aspect of their job. Where they’re struggling is understanding the nuances and complexities of modern business because everything is moving so fast. Even executive teams are struggling with this and they work full-time in the business and have usually spent their working life in the industry.”

Beatty says the benefits of companies being publicly listed, and subject to greater regulatory requirements, are starting to outweigh the costs. “A CEO of a large company typically spends 15-20 per cent of time dealing with the board and other governance issues. Yet some surveys show executive teams believe boards do not add significant value. So, organisations are making a huge time and cost investment in their board and not getting enough in return.”

Beatty believes a response to the limitations of modern governance is underway: private equity funds investing trillions of dollars as more companies choose to remain private. And tech and other high-growth companies issuing dual-class shares to ensure founders keep control and are not hostage to market demands or shareholder activism.

Boards of private equity-backed unlisted companies tend to be smaller, have industry specialists and directors who have greater “skin in the game” through equity incentives.

“Worldwide, we continue to see a decline in the number of listed companies,” says Beatty. “I suspect we are at a point where high-growth organisations believe the cost and complexity of being a listed entity, and all the governance and market interaction that entails, is no longer worth it. Private equity capital is plentiful and executives who run privately owned companies can get on with their job rather than spend so much time on board, governance and investor-relations issues.”

Tailored corporate governance codes

Dr Roger Barker, director of corporate governance at the Institute of Directors (UK), says the traditional governance model suits mature organisations in “steady-state scenarios” but is becoming less effective with high-growth businesses and others experiencing disruption.

“The big governance trend has been to push executive directors out of boards and replace them with non-executive, independent directors. Having directors who have distance from the company is a prized governance asset, but this model is becoming challenged in a volatile business climate.”

Part of the problem, says Barker, is a tendency to apply blanket governance rules and expectations to listed companies, regardless of size or strategy. “Developed markets have one corporate governance code for all their listed companies. The ‘comply or explain’ nature of these codes provides flexbility, but companies often find it easier to comply with everything.”

Barker says 75 per cent of companies in the Footsie 350 index fully comply with the UK Corporate Governance Code and the remaining quarter mostly comply. “Increasingly, investors expect companies to comply with all governance requirements and have reporting handed to them on a plate. Companies don’t want to risk not complying, standing out and having to explain why they chose not to follow a governance recommendation. Even smaller listed companies end up complying with a raft of governance recommendations that are unnecessary for them.”

Barker says debate is needed on having different governance codes for different types of listed companies. “I doubt it will happen, but organisations need greater scope to tailor governance to their needs. Currently, we have smaller, high-growth businesses subject to similar governance expectations that mature organisations face.

We may need to move away from this one-size-fits-all governance model and take a more nuanced approach.”

Barker believes more companies will choose to remain private and expects greater focus on private-sector governance. “The benefit of private ownership is being better able to deal with volatility and uncertainty because the organisation is shielded from the ups and downs of financial markets, investor sentiment and market and media scrutiny.”

The UK has taken steps to strengthen private-sector governance. The Wates Corporate Governance Principles for Large Private Companies, part of reforms to the UK Corporate Governance regime, was released in the UK this year. The new reporting requirement applies to companies in the UK that have either 2,000 employees or a turnover of more than £200 million and a balance sheet of more than £2 billion. Private companies that meet this criterion must publish a corporate governance statement in their annual report and website.