TRUST MELTDOWN II Highlights the Trends and Offers Solutions on How to When Nocontrolmechanismsareinplace

Home , Keep it Up, Meltdown (Image Comics)

Trust-Cover-2011.indd 1 9.80 SFR-U$- isbn 978-3-906501-19-2 Trust MeltdownII cense tooperateisatrisk. transparency,Without standards. li accounting industry‘s improve the to working and media the from hiding longer no with starting trust, regain TRUST MELTDOWN II highlights the trends and offers solutions on how to when nocontrolmechanismsareinplace. blamed here is the nature of mankind; it is human nature to do less good be to nature only The catastrophe. natural a been had subprime that ed was no solution. Neither was trying to play the blame game that pretend hope in this regard turned out to be counterproductive. And hiding away Obviously, improved. figures economic pure Street‘s the Wall while even Did 2010 help it to improve? No, the media reputation actually worsened the than worse ranked tobacco industry.was it that so, much so south, gone had financial sector the of reputation media the 2009: in line bottom The media. opinion-leading the for story convincing a longer no was money of out crisis that raised questions regarding its license to operate. Making money had not caught a mere cold, so much as it had been hit by a fundamental The first TRUST MELTDOWN report made it clear that the banking industry in 2009and2010tomakesureanotherMeltdownwillnothappen? ques same the tions: What asking have you learned keep from the crisis? And Street what was implemented Main and Street Wall on media the as happened has recovery no standpoint reputational a From same. the remained headlines the yet, But expected. than better much were 2010 in presented results financial the Yes, clear: is picture the 2011 in Now, sector wasnolongerloosingmoney. media would calm down in 2010 as better results the proved that the finance expected they But frank. were collapse Lehman the following lines head the rough; be to 2009 expected sector financial the in Everybody

E Beirut BerlinBostonLondonNewYorkOstrava PretoriaSt.PetersburgTianjinWindhoekZurich - - - -

Trust Meltdown II Roland Schatzand Frank Brettschneider Matthias Vollbracht Anikar M.Haseloff Maciej Piechocki Christian Dreyer Cornelis Reiman Cornelis Michael P. Krzus Robert Zoellick Oliver C.Oehri Olivier Servais Liv Watson Henry Schäfer 21.01.2011 16:25:14 Uhr Edited by Kurt Ramin Jake Leon

Trust Meltdown II

Edited by Roland Schatz & Liv A. Watson

INNOVATIO Publishing Ltd. Beirut Boston Pretoria Tianjin Zurich

| 1 Cover Artwork: Malte Lück

Special thanks to and Dr. Christian Kolmer and Racheline Maltese for editing this volume

2 | Content:

Introduction by Roland Schatz 5 1. Reputation: The Trust Meltdown Continues 1.1. The Financial Industry Continues to Ignore the Need for Reliable Answers by Roland Schatz 12 1.2. Two Years After Lehmann: Reputation Remains a First-Rate Risk for Banks by Matthias Vollbracht 24 1.3. Only he Who is Understood Can Convince. The Comprehensibility of Bank Communications by Prof. Dr. Frank Brettschneider and Dr. Anikar M. Haseloff 51

2. Accounting: Transparency is Key to Regain Trust 2.1. The Role of IFRSs and XBRL in Enhancing Transparency in Financial Reporting by Olivier Servais, Maciej Piechocki 62 2.2. Natural Capital: The Finance Sector & Financial Reporting – Catalysing Action? by Kurt Ramin and Cornelis Reiman 67 2.3. Integrated Reporting – A Means for Corporations to Become Socially Responsible and Accountable 77 by Liv Apneseth Watson 2.4.The Case for Integrated Reporting by Michael P. Krzus 82

3. Governance: The Rules for Regaining Trust 3.1. Trust, where Trust is Due by Christian Dreyer CFA 893.2. Microﬁnance Investment Funds – Analysis of Portfolio Impact before and after the Financial Crisis by Henry Schäfer and Oliver C. Oehri 97 3.3. Responding to Current Challenges: The Economics of Shared Societies by The Club de Madrid 112 3.4.Synopsis of Report on Deterring Financial Reporting Fraud – A Platform for Action by the Center for Audit Quality 120 3.5.The G20 Must Look Beyond Bretton Woods II by Robert Zoellick 144 Contributors 147

| 3 4 | Introduction by Roland Schatz

Everybody in the financial sector Did 2010 help it to improve? No, the expected 2009 to be rough; the head- media reputation actually worsened lines following the Lehman collapse even while the pure economic figures were frank. But, at the same time, improved. Obviously, Wall Street‘s the chief executives of the finance hope in this regard turned out to be sector speculated the media would counterproductive. And hiding away calm down in 2010 as better results was no solution. Neither was trying proved that Wall Street was no lon- to play the blame game that pre- ger losing money. tended that ‘sub-prime’ had been a natural catastrophe. The only nature Now, in 2011, the picture is clear: yes, to be blamed here is the nature of the financial results presented in 2010 mankind; it is human nature to do were much better than expected. Yet less good when no control mecha- the headlines remained the same. nisms are in place. From a reputational standpoint there has been no recovery as the media No company can exist for two con- on Wall Street and Main Street keep secutive years reporting that its own asking the same questions: what business, products, and, above all, have you learned from the crisis? And its management are time and again what was implemented in 2009 and associated with massive accusations 2010 to make sure another meltdown from the judiciary, politics and soci- will not happen? ety: correspondingly, the ratings recorded by Interbrand for selected fi- The first TRUST MELTDOWN report made nancial institutions all point towards it clear that the banking industry had the negative. This development was not caught a mere cold, as much as it particularly shocking for Citibank had been hit by a fundamental crisis or UBS which, after the halving of that raised questions regarding its li- their brand value in 2009, now also cense to operate. Making money out had to suffer a further loss of 13% in of money was no longer a convincing 2010. Others such as HSBC or Morgan story for the opinion-leading media. Stanley had, in particular, learnt their The bottom line in 2009: the media lessons from their communication reputation of the finance sector mistakes in 2008 and 2009, and in has gone south, so much so, that it 2010 were rewarded with a balanced was ranked worse than the tobacco media image. This also paid off in industry. the brand value index: although the

| 5 Introduction

Chart 1: Global Brand Value 2009 - 2010

Brand value 20%

+10% +8% +7% -20%

-40% 2009/2010 change: -13% -13%

-60% HSBC Morgan Stanley AMEX Citi UBS 2008-2009 change Source: Interbrand, Best Global Brands, http://www.interbrand.com/de/best-global- brands/Best-Global-Brands-2010.asp; http://www.interbrand.com/de/best-global-brands/ best-global-brands-2008/best-global-brands-2009.aspx losses from the prior year could not try. Far more fatal for the entire yet be compensated for, the trend industry was the lack of clear com- was at least upwards. munication by the individual banks regarding the repeatedly posed Similarly to the tobacco industry, the questions: banks, with their communication 1. Why did you portray the products behaviour prior to and in particular as being secure when you must after the ﬁnancial crisis in autumn have and could have known in 2008, manoeuvred themselves into a advance that they did not comply position which made individual dif- with the usual requirements? ferentiation difﬁcult. The fundamen- 2. What have you done to prevent tal loss of reputation became less due this in the future? to the images from the respective hearings in Washington, London or The answers which were given in Berlin in which the banks’ directors 2009 were already then rejected as were optically perceived similarly to unconvincing by the opinion-lead- those accused in the tobacco indus- ing media. The tactic employed by

6 | those responsible of not learning the the criticism doubles: every second lessons from this in the following 12 statement is negative, even though months, and instead convincing the the actual business data were again sceptics through repetition, may have positive in 2010 – from Citi through worked in the 20th century. However, to UBS. The fundamental rejection in the wake of Enron etc., as well as of the financial institutions and their the experiences from the unforget- representatives can clearly no longer table value-destroying machine, be justified by saying that the people the internet bubble, in which the were dissatisfied with their finan- banks also played their part in the cial performance. Goldman Sachs or first instance, it no longer works to Deutsche Bank are earning money replace sound argument with good again but the wording of the head- clothes and expensive appearances. line by the FINANCIAL TIMES on GS “The The chart below spells out the un- bank we love to hate most“ was not changed destructive result: concrete dictated by the mood of just one day. banks and concrete bank directors are, on average, negatively presented This is not just due to the conduct of in the opinion-leading media – but if bank representatives since the bank- the same media mention “banker“ ing crisis. The information on their

Chart 2: Individual Banks and the Banking Industry in Comparison, Tone of Coverage 2003-2010

10%

-10%

-20%

-30%

-40% Individual banks -50% Individual bankers Banks in general -60% 2003/1 2005/1 2007/1 2009/1 2004/1 2006/1 2008/1 2010/1 Basis: 50,081 reports (at least 5 lines/seconds) in 21/29 German TV and print media

| 7 Introduction

actual business also did not improve the banks. 33,000 French nationals and the products remain untrusted. publicly supported this campaign Even though the banks may them- within 4 weeks. On the day itself, selves be under the impression that of course, little happened because their customers are “satisfied” , they the initiators had neglected to offer derive this “satisfaction” solely from an alternative. This example, how- the fact that their customers have ever, illustrates the explosive mood not closed their accounts. This, how- amongst the banks’ customers. ever, appears to be more for a lack of alternatives than consensus amongst Reporting on the products of banks banks’ customers, taking into account – and partly also of insurance com- the fact that they are getting an in- panies - has in any case not stopped terest rate of maybe 3% or 4% from since the Lehman collapse. In princi- their bank for keeping their money ple, not one week passes by without at their bank - in some regions it warnings against the “life insurance” remains unchanged at less than 2% product. Although these voices had - while the banks’ top management already come to be more vociferous are themselves again talking about in the 90s, the intensity with which profits of over the 20% mark in the one of the cornerstones of people’s media. contact with the financial world was being questioned took on a new In an interview on the 8th of Octo- quality in 2010. All the more so as ber 2010, the former soccer player this product, contrary to the pur- Eric Cantona in passing remarked chase of a car or a computer, is solely “3 million protesters on the streets based on a customer’s trust in the means nothing, but if these 3 million credibility of the offerer: year after people would withdraw their money year customers keep on giving their from the banks – that type of action money to a partner without getting would have some consequences“. something in return in order to hope- The interview was published in the fully receive more in total after some context of the riots in France. The decades. Telling customers month af- Belgian screenwriter, Géraldine Feuil- ter month in large letters (except by lien, and a 24 year old actor, Yann insurance companies and the banks Sarfati, then launched the campaign who sell their products) that this, in “Bankrun 2010“ (www.bankrun.com) principle, is not a good product, does as well as the Facebook page “Stop not promote trust. In particular not Banque“ through which, on the 7th in a context where people are now of December 2010, they called for the also being confronted with the term public to withdraw their money from “toxic” in relation to products from

8 | the banking sector, a term which the brand value of the various insti- they only know from their experienc- tutions, so the impact of a disastrous es with environmental disasters. The media reputation on their products chart below illustrates the connection was tangible: the flight to other as- in which the word “toxic“ appears sets such as gold or silver drove their together with bank products in the prices to new record highs in 2010. FINANCIAL TIMES, WALL STREET JOURNAL and Regional institutions experienced BARRONS. Even though the intensity growth rates never seen before. diminished during 2010, it remains Banks such as the GSL Bank doubled striking that, even in 2010 still, the the money entrusted to them in a elite of the financial media used the short time solely because they gave term more frequently in connec- their customers the assurance that tion with products in the financial they would not act like Deutsche industry than with products in the Bank or the representatives of Wall chemical, food or pharmaceutical Street. industries. At the same time, complaints against Just as the media reporting on banks individual bank representatives in- in general reflected, for instance, on creased in both America and Europe:

Chart 3: Connotation of the Word “Toxic” 2009/2010

Number of stories in connection with "Toxic" 4,000 Assets Environment 3,000

2,000

1,000

0 2009 2010 Source: FT, WSJ (print & online), BARRON’S, text search

| 9 Introduction

Chart 4: Evaluation of Banks and Accountants in US Media, 2002-2010

20%

-20% Lehman -40% Enron Banks Accountants -60% 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: 41,153 reports (at least 5 lines/seconds) in 5 US TV and print media people were no longer prepared to For this reason, TRUST MELTDOWN II, simply return to business as usual and after continuing the trend data on write off their losses while reading reputation, turns its focus to answer- on a daily basis that bank representa- ing the question as to what extent tives were again paying themselves the ﬁnancial world used the year bonuses. 2010 in order to implement the improvements required since the And, together with the banks, anoth- 70s in respect of accounting as well er industry was coming under close as transparency. But even here the scrutiny – the auditors. Their hopes potential of all the participants re- for better conduct towards the public mains virtually untapped: Chapter 2 did not pay off – what had already shows that although the one-report- been indicated in TRUST MELTDOWN I ing initiative was able to make clear became ever clearer in 2010: whether progress (behind this is an attempt PWC or Ernst & Young, their media to numerically record more than reputation dropped dramatically in just material values on the balance the past 12 months. sheet), the requirements for annual and quarterly reports are still far

10 | removed from reﬂecting at least 50% of the value of a company.

As long as nothing changes in respect of this fundamental wrong, banks will continue to make their decisions based on only slightly relevant data and auditors will (not) audit their proﬁtability, even though relevant criteria such as the duration and quality of customer contracts, the relevance of new products and the quality of employees, etc are absent. And yet, these are the value drivers – not the number of company cars, the 30% paid off computer or the interest expense for loans of the 75th subsidiary. This is approximately equivalent to a patient whom a doctor diagnoses as being healthy or as having cancer based solely on measuring his blood pressure and listening to his chest. Everyone would change his doctor – but which bank and which auditor can companies turn to to have the full value of their activities audited if they themselves do not have the know-how or the willingness to record the overall values?

TRUST MELTDOWN II highlights the trends and offers solutions on how to regain trust, starting with no longer hiding from the media and working to improve accounting standards. Without transparency, the industry‘s license to operate is at risk.

| 11 12 | 1. Reputation: The Trust Meltdown Continues

1.1. The Financial Industry Continues to Ignore the Need for Reliable Answers by Roland Schatz

All the Devils Are Here is the title of The trust meltdown regards the one of many books which have made financial world reached a new level. headlines since the collapse of Bear However, just a few bankers noticed Stearns, the insolvency of Leh-man this: even in 2010, most of the CEOs Brothers and the ensuing assistance in hearings put forward the thesis by taxpayers to countless financial that the subprime crisis had been an institutions in America, Europe and “accident“ which nobody could have the rest of the world. Monkey Busi- foreseen and which, in principle, ness was a second one, Liar’s Poker a similar to a tsunami, “had simply en- third and Casino Capitalism a fourth gulfed the financial world“ like the in an unending chain of attempts to destructive waves which destroyed make the actions of bankers compre- the Asian coastline in 2005. Nobody hensible. The authors are not tabloid could have foreseen this. Even more journalists, but employees or experts fatal were the headlines after the from science and financial journalism. hearings in which those responsible for the financial disaster were quoted

Chart 1: Rating of Tobacco and Banking Companies in international TV News 2009/2010

Share of +/- ratings (%) in international TV news 100% 14 12 28 22 80%

48 49 60% 42 53 40%

20% 36 38 39 19 0% 2009 2010 2009 2010 Tobacco Banking

negative no clear rating positive Basis: 107,160 reports in 40 international TV news programs

| 13 Reputation

as saying that, in principle, no one likely to prevent a repeat of these did anything wrong. mistakes.

In TRUST MELTDOWN I, it was clearly If in the first TRUST MELTDOWN BOOK, argued that this view of things was the casino metaphor was viewed only advocated by certain bankers as a journalistic exaggeration to be and that the reports in the media taken seriously, then, when it comes worldwide evaluated and judged the to this similarly-titled sequel, that events differently: the reputation lenient view is no longer tenable for of the financial industry, already in one of the most respected economic the first year after the bank col- researchers, Prof. Hans-Werner Sinn. lapses, plummeted to the level of The comparison of an entire indus- the tobacco industry, an industry on try to an irresponsible gambler who which any newspaper is allowed to would not even take responsibility write that its products are harmful for the sequences of his actions is to the health of consumers. Nothing now firmly imprinted in people‘s changed in 2010 in this regard. Quite minds. to the contrary: not least due to the lack of self-assessment and the obvi- Media impact research tells us that ous inability for self-criticism, banks such impressions – in particular if are now rated even lower compared they continue unchallenged over than the tobacco industry. a period of more than one year – are difficult to correct. The CEO of ticularly fatal as banks themselves Deutsche Bank, Josef Ackermann, could have clearly presented better (always selected as one of the best figures in 2010. This development amongst its own ranks) might assess was, of course, also reported on in this best. Long before the banking the opinion-leading media.Despite crisis, he had to answer to the court this, nothing changed in the evalua- in Dusseldorf for a decision custom- tion of the industry. Reports in 2010 ary in the financial world. It is not dealing with management mistakes just the photo of the Swiss-born CEO as well as banks‘ lack of willingness sporting the victory sign, which was to address issues increase further. meant in fun, that will haunt the Criticism of top management became banker until his retirement. All of more vociferous quarter after quarter the participants in those proceedings because they continued to refuse to did not want to read the writing on actually investigate the real reasons the wall that, in a functioning de- for the loss of money entrusted to mocracy, no group is exempted from them, something which hardly seems the norms of society.

14 | It changes nothing in people’s per- vency in 2008 had citizens not come ceptions that Ackermann was able to to their rescue, got caught out yet “buy” his way out of the judgement again in 2009 and 2010 as they had with an amount in the millions; the profit maximization on the agenda at CEO of Deutsche Bank will no longer the cost of a part in the community be able to reach the acceptance level of states. That this was partly done of one of his predecessors, Dr. Alfred using the monies of those who had Herrhausen, despite his multifaceted just a few months previously saved commitment. One photo is already in their workplaces, was appropriately place for when the media acknowl- picked up by the media. The run on edge his departure after a 50-year individual banks was introduced in professional TRUST MELTDOWN career: I – and in 2010 became reality. In the second year after the Lehman A small ancil- bankruptcy and lary aspect was the largest bank revealing: an bailout in finan- acronym defined cial history, the by the banking financial world, world in 2009 for including stock various states in exchanges, did lit- Europe which had tle to contribute potential or real to changing these headlines. Even payment difficulties – PIIGS. This was though most were no longer show- possibly intended to be a derivation ing losses for 2009 in 2010, and some from the readily formulated BRIC ne- had also repaid the tex monies with ologism coined by a Goldman Sachs interest, the same accusations in con- expert for the four emerging eco- nection with the subsequent prob- nomic powers of Brazil, Russia, India lems (now on the part of countries and China. But, after the taxpayers with low and extremely irresponsibly in Portugal, Ireland, Italy, Greece and managed resources that have dried Spain had paid their contribution in up due to the bailout) dominated 2008 ensuring that the supposedly the media. Instead of finally seeing creative neologists could carry on themselves as part of society and con- with their business, the neologism ducting themselves in an appropriate proved to be telling in more ways manner, these same financial institu- than one. To officially describe an tions that would have filed for insol- entire nation as “pigs“ reveals the

| 15 Reputation

character of the neologist as well as fundamental changes. Only once that of the user. GISIP or SIGIP would this text is read and its view shared also have been conceivable as a let- by several media, is hope born. ter combination if the creatives had And, in the context of Wall Street’s been solely concerned with an abbre- meltdown, the reports were in sync viation for the now risky European throughout the world. It was then states. However, it was no accident indeed surprising that, despite this, that PIIGS was chosen. in most of the same banks almost the same conduct was continued by the It makes it clear from the outset that same people. Particularly as, in the the bankers, now bankrupt thanks interim, countless specialist books to meaningless speculations, again were complementing the headlines saw themselves as something bet- and, in 200, 300, 400 or 450 pages, ter directly after their rescue by the as in Im Freien Fall – Vom Versa- taxpayers. In the very second that the gen der Märkte zur Neuordnung acronym PIIGS tripped off the tongue der Weltwirtschaft by Nobel prize of a Barclays Bank employee, who laureate Joseph Stiglitz, in principle was, cynically, believed to have previ- revoked licences to operate due to ously earned his money at Lehman the statements made by Wall Street Brothers, it was clear to journalists offenders to the tribunals in Wash- that absolutely nothing had been ington: understood by the banks. Likewise, 1. “Yes, they knew what they were it could also be assumed that almost doing,“ none of the promised new safety 2. “Yes, they were warned by experts mechanisms to prevent the next bank several times,” insolvency would work, because, 3. “Yes, it was clear to them that the apparently, it wasn‘t just the top products which they bought could executives of Wall Street who had not work.” tried to explain their actions that had no sense of responsibility, but Everywhere, in the aftermath of such their staffs as well. Without this, no a ﬁnding, at least the top manage- turnaround in people‘s behavior can ment of the respective organizations be expected. Middle management is changed. The current developments responsible for product development, in Tunisia show that even in the rarely top management. aftermath of the expulsion of a dicta- tor who ran the affairs of his country This is alarming for one reason in into ruin, people expect not only the particular: no journalist seriously as- tyrant and his family to stop down, sumes that his text can actually effect but also, during the subsequent

16 | period, painstakingly ensure that They were fined by stock exchange his employees do not reappear in regulators in ZUrich on January 14, government under another title; they 2011, because they had violated the must also step down. In the after- publicity regulations of the stock math of the worldwide banking col- exchange previously in 2007. Why lapse, this was not evident. Here and did it take so long before the stock there a CEO had to step down, the exchange finally had the courage to first are now in prison, but a change call the proverbial spade a spade? in the responsible staff did not, in The shareholders of UBS refused to principle, take place anywhere. approve the actions of the board for their 2007 annual report – and, And that happened despite hardly a despite this, the old and the new day passing in which people did not management of UBS believed that read in their media that the con- they could save themselves over time trolling bodies did not believe the with excuses. Even the new chair- protestations of Wall Street Manag- man of the board, Kaspar Villiger, as ers and imposed significant penalties: a former entrepreneur and former the British financial regulator, FSA, member of the Swiss government, decreed that Barclays pay a fine of was not only highly knowledgeable GBP 7.7 million as well as damages of in the matter but fundamentally GBP 59 million to the victims of their also independent in the audit of incorrect advice. Barclays sold prod- the company documents, on join- ucts to the insurer, AVIVA, without ing UBS, ultimately had to bear the giving buyers the correct informa- headlines that he was not delivering tion regarding the risks of these two the transparency he had promised. funds. His predecessor, Peter Kurer, in an interview with NZZ AM SONNTAG even UBS, whose old and new top man- went as far as to say that, in the agement made headlines in 2010 context of the information demands with statements that they, in princi- made of him by experts, the then ple, had no knowledge of what they CEO Marcel Rohner and the rest had done. (What CEO of a pharma- of the management, it amounted ceutical company would be left in to “lynch justice in a subtle form.“ office by his administrative board or With the current judgement by the the government if one of his prod- Swiss stock exchange, according to a ucts caused massive damage and he statement by the commercial lawyer, declared publicly that he could not Daniel Fischer, the way is now clear have known that its composition and for an independent body to institute production might prove harmful?) misfeasance proceedings – in par-

| 17 Reputation

ticular as the formal approval of the lieved rather in announcing a record board for 2007 is still pending. At the result for the second quarter – with- head of UBS then was Marcel Rohner, out mentioning the known risks. That who took over from Peter Wuffli in UBS at that time disclosed the loss of July in a cloak-and-dagger operation. CHF 229 million from its DRCM hedge This event led to massive headlines fund indicated that their knowledge then. UBS’s corporate customers of the rule of the duty of disclosure experienced in 2007 that 9 out of 10 remained unchanged. Why they nev- transfers were not carried out by UBS ertheless kept the significantly higher although the amounts were actually risk of their subprime involvement shown in their accounts. The chair- secret, only announcing a general man of the board was Marcel Ospel, profit warning for the 3rd quarter on who, similarly to Peter Kurer later, October 1, 2007, will have to be ex- expressed his lack of understanding plained to the independent bodies in in response to questions by share- Switzerland and the US by all those holders, customers and the company responsible during the course of 2011. and, until 2011, acted as if he and his team had done everything right. As UBS and the conduct of its top But, contrary to their protestations management are not isolated cases, of not having known anything – and it is in the nature of the observer contrary to the newspaper reports – even if not directly affected by the in WSJ, FT, etc., in which warnings of banks’ conduct – that no new trust the massive risks of the subprime can be born in year two after the business had been sounding since disaster. After all, all people are ulti- 2001 - the Swiss stock exchange, after mately the victims several times over: auditing the documents, came to the as taxpayers they (without being obvious conclusion that the decisive asked) had to make their contribu- bodies already knew of the massive tion to ensure that an industry was valuation losses caused by the effects rescued from bankruptcy without of the mortgage crisis in the US at being held accountable. An industry the end of July/beginning of August which basically owns no product in 2007. This, as a consequence must, the actual sense of the word and of course, have had a significant consequently, since its establishment, effect on the overall result of the remains liable to prove a service bank. Its own shareholders, and of comparable to that of the automo- course the market, would have had bile, pharmaceutical, or IT industry. to be informed immediately. Instead, These tax monies are now no longer the team around Marcel Ospel and available for the education of their Marcel Rohner on 14 August 2007 be- children, necessary investments in

18 | infrastructure, etc. The fact that lying in the accounts of their banks. in Germany the term “no alterna- This does not remain without its tive,” used by Angela Merkel when consequences: the doubt of people in speaking about the various so-called their elites is growing. “emergency parachutes,” was chosen as the misnomer of 2010, gives an There is almost no sector of soci- idea as to how citizens would have ety from which people on average voted if a referendum had taken receive trust-building information place in 2008 to vote for or against regarding the conduct of its leaders. the no-consequences rescue of the 2010 revealed not only the continu- banks, and then again in 2010 regard- ous violation of the Maastricht Treaty ing the support activities for highly by almost all European governments, indebted countries. But people pay and thereby the non-existent control the price not only for the conduct of by the supervisory bodies in Brus- bankers through the support actions sels, but the schools and churches of their governments, to which they also made headlines for their mis- did not give their agreement, but, as conduct towards innocent children. a matter of course, also receive less Doubt dominates in such a climate. interest for the money that they have And for the banks, more impor-

Chart 2: Long-term Trends: Politicians, Managers and Religion Tone of TV coverage, 2000-2010

TV Tone (surplus of +/- statements) 10% 0% -10% -20% -30% -40% -50% -60% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Politicians Managers Religions/Religious Leaders Basis: 110,705 stories on politicians, 25,416 reports about managers, 10,095 stories about religions/rel. leaders in German, UK and US TV news

| 19 Reputation

tantly, the willingness to forgive is Depression were justified or not. We not promoted as there is no longer know that our children are no longer any other leadership group which receiving the same standard of edu- can credibly stand as an advocate cation in the schools that they did at for Wall Street. Governments have the time when our tax monies went again lost the short term credit they to the banks. Still, we read that these had acquired in 2008 by not claim- bankers, who would be unemployed ing the consequences at the latest in if it weren’t for our money, are again 2010. Religious leaders are concerned paying themselves bonuses, such as with themselves, and researchers, the Credit Suisse boss Brady who has two years after the collapse of the no ethical problems in having CHF financial system, are unable to come 70.9 million paid out to him, and are up with ideas which would exclude now under suspicion of weakening a repeat of that which is not predict- our currency.” No politician will be able. able to constructively argue against such a perception - and lose his posi- For the banks, the problem is exacer- tion. The increase in extreme parties bated by the fact that 2010 continued was announced in TRUST MELTDOWN I to keep finances at the center of – in 2010 this became a reality not reporting due to the serious crises in only in the European elections. Greece and Ireland. People had to read and see that the banks were ac- Increasingly, the system question is cused of trying to make money from being asked and the answers, which the weakening of the euro. For peo- would have had to be given at least ple on the other side of Wall Street in the opinion-leading media, also do and the other financial centres it is not advocate for an improved climate not a question of products or market in favor of banks. Using the example conduct. For them, contributions in of Germany, the chart shows how, in the newspapers or interviews, such connection with the crises, the escala- as with Stéphane Garelli, professor at tion becomes ever greater in the the IMD in Lausanne and long-time opinion-leading media. WEF manager, on the “currency war“ read very simply: “We have given the banks the shirts off our backs so that the financial system will supposedly not collapse. Two years after the horror stories, we are still seeing no indications as to whether the threats of falling back into a Great

20 | Initially, the intensity of the reporting in the ﬁnancial system increases:

Chart 3: Salience of the “Social Market Economy” in the Values Coverage, German ARD and ZDF News Shows, 2001-2010 30% 25% 20% 15% 10% 5% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Share of all reports Basis: 6,480 reports about the situation in Germany with regard to political values

Then, the actual value of the system is questioned ever more extremely due to shocking individual cases:

Chart 4: Evaluation of the “Social Market Economy” in the Values Coverage, German ARD and ZDF News Shows, 2001-2010

100% 80% 60% 40% 20% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 negative no clear rating positive Basis: 533 reports about the situation in Germany with regard to political values

| 21 Reputation

So that, in the end, in the light of this workplaces were created, as it should news selection, people come to an as- happen only once in the history of sessment of the strength of their own Germany. For the first time, more democratic financial system – which than 40 million officially registered in no way corresponds to reality: workplaces were reported in 2010

Chart 5: Opinion Poll “Equity”, 1995-2010

70% 63% 60% 58% 57% 56% 56% 56% 60% 52% 47% 47% 50% 43% 40% 39% 35% 30% 31% 29% 30% 27% 28% 23% 21% 21% 20% 15% 10% 0% 1995 1998 1999 2000 2001 2002 2004 2005 2006 2007 2010 Unjust Just

Basis: Poll among Germans aged 16 and older; Question: “What do you think: Are the economic conditions in Germany – I am speaking about what the people have and what they earn – by and large just or not?” („Wie sehen Sie das: Sind die wirtschaftlichen Verhältnisse bei uns in der Bundesrepublik – ich meine, was die Menschen besitzen und was sie verdienen – im Großen und Ganzen gerecht oder nicht gerecht?” Source: IfD Allensbach

Because the extent to which the – at an overall population of 80 mil- people in Germany turned away from lion. Experts have long talked about the social market economy in surveys, full employment, but discussed far is the same extent to which their more frequently is the fundamental personal prosperity increased on problem that not enough qualiﬁed average year on year, unemployment employees are available for the mar- ﬁgures decreased and, to a degree, ket opportunities on offer.

22 | In principle, at least in the largest national economy in Europe, an excellent environment has been created to sustainably discuss and solve the fundamental problems in the financial world. However, the communication by the financial institutions does not give people the impression that a) they are interested in working on the problems which led to the financial crisis, and b) due to this lack of interest, they are not able to offer any proposals for solutions.

To date, such sets of circumstances have historically always led to actions in particular on the part of those who felt as if they had been fundamentally harmed. Such a “keep it up” attitude towards ﬁnancial institutions harbors massive risks which they, but even less the responsible politicians, can neither evaluate nor shape.

| 23 Reputation

1.2. Two Years After Lehmann: Reputation Remains a First-Rate Risk for Banks by Matthias Vollbracht

We believe that banking crises will happen again Hans Wright, S&P, FT, 06.01.2011

Banks still struggle to regain trust Switzerland and a few other Europe- – reputation risks are said to hinder an economies as well as parts of Afri- business ca, with a double-dip development in The financial industry faced two ma- the US and UK and a slump in some jor reputational challenges in less debt-prone countries like Greece, Ire- than a decade: first Enron and the land and Spain. Many news reports bursting of the New Economy bubble have placed the blame for the crisis in the early 2000s, and then the inter- more on the global banking industry, national financial crisis followed by and less on excessive monetary policy a recession in major global econo- and supervision failures or greedy mies in 2007-2009. 2010 was a year of investors. continued growth in major emerging markets such as China, Brazil and Banker bashing has become rather India, a year of recovery in Germany, popular; during the height of the cri-

Chart 1: Rating of Banks – FINANCIAL TIMES 2002-2010 (Without Reports on Analysts’ Research) Share of +/- ratings (%) of banks 40%

30%

20%

10%

negative positive 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010

Basis: 140,548 reports on banks in the FT Europe

24 | Chart 2: Top 10 Banks by Negative Reports – FINANCIAL TIMES 2010 (Without Reports on Analysts’ Research)

Lehman Brothers Goldman Sachs Citi BofA Merrill Lynch UBS JP Morgan Chase RBS Societe Generale

Deutsche Bank negative HSBC positive 0 50 100 150 200 250 300 350 Number of +/- ratings

Basis: 11,551 reports on banks in the FT Europe sis, the banking industry garnered up lasting criticisms of the financial in- to 50 percent of all the business cov- dustry and especially of banks. erage by major international TV news broadcasts. So, has the global trust In a nutshell, the slight recovery in meltdown in the financial industry the overall rating of the banking continued in 2010 or are there signs industry since 2008 cannot make up of recovery? Is the media reporting for the fact that the vast majority of about change in key image criteria stories are still rather negative, put- such as products and customer relating the banking industry at the same tions, or are allegations of breach of level as tobacco, energy (remember trust and misselling still dominant? BP’s oil spill) and airlines (the volca- MEDIA TENOR continued its comprehen- no eruption didn’t help to improve sive analysis of national and cross-na- the image). Even worse, the recovery tional TV shows, as well as interna- is nearly entirely connected to pri- tional leading business papers such as vate banks again reporting increas- the FINANCIAL TIMES and THE WALL STREET ing profits and being less dependent JOURNAL, on general topics and specific on public loans and bailout guaran- issues such as analysts’ quotes to find tees. In contrast, the tone of cover- evidence for improving the images or age when it comes to products and

| 25 Reputation

customer services has dropped to fortunately, the image tsunami isn’t an even lower level. Investigations over yet, and there is little evidence into what went wrong and who is that business as usual is going to to blame have started with the ex- bring any changes in the near future, pected time delay and led to nega- as sovereign nations struggle to foot tive coverage in 2010 as indicated in the huge bill of stimulus packages last year’s Trust Meltdown Report and bailout programs. No. 1. News coverage of investigations and lawsuits have shed light on The analysts’ view: what value is in business practices which are broadly the banking industry? not believed to have changed as yet. This section discusses analysts’ views So, the media and a large part of the of banks. For these purposes, ana- public seem to still be waiting for the lysts are regarded as experts from righteous fruits of repentance as a banks, rating agencies and similar precondition for rebuilding trust. As institutions. The analysis is based on the Scriptures put it: Let your change an examination of experts’ quotes in of heart be seen in your works (Mat- international financial media such as thew 3:8). The hype over Goldman BARRON’S, THE WALL STREET JOURNAL and Sachs prior to BP’s oil spill might be the FINANCIAL TIMES, as well as LES ECHOS, taken as example. Negativity was MINT and EXPANSION. so strong that Goldman Sachs filed harmful media reporting as a reputa- Previous analyses of analysts’ quotes tion risk which might affect busi- by MEDIA TENOR have already shown ness (THE WALL STREET JOURNAL, March 2, that the quoted experts, on average, 2010). gave companies more positive ratings than other sources cited in the media This chapter explains more in depth or even journalists themselves. Par- the development of banks’ images ticularly striking was that at the time in analysts’ quotes in international of the New Economy, but also after, opinion-leading media (e.g. THE WALL little in fact changed. STREET JOURNAL, BARRON’S, LES ECHOS, FINANCIAL TIMES, and MINT). This is fol- A look at the automobile industry lowed by an analysis of coverage in shows that analysts had apparently international or pan-national news regained their trust. The upbeat sen- networks (CNN, BBC WORLD NEWS, AL timent and improved figures was in ARABIAH, and AL JAZEERA) and finally recent months positively reflected in a glance at 40 international news rising share prices, the GM IPO not shows from Europe, the Middle East, being the only indicator there of. the US, South Africa and China. Un- The analysts’ quotes on companies in

26 | Chart 3: Rating of Banks / Insurance / Car Industry Analysts’ Quotes, 7/2009 – 12/2010 Analysts' quotes: banks/car industry/insurance 30%

20%

10%

-10%

-20% III/09 IV/09 I/10 II/10 III/10 IV/10 Banks Car industry Insurance

Basis: 3,433, 12,807, 1,335 statements in 8 (9) international financial news media opinion-leading media have several the reporting. Thirdly, analysts them- functions: Firstly, they give journal- selves indicate that the reporting, ists a third opinion (leaving open the including quotes by other analysts, principles according to which ana- also contributes to characterise the lysts’ quotes were selected). There is, further mood and sentiment. in any case, little empirical evidence to suggest that analysts with the How do the cited experts, who large- most precise predictions were cited ly hail from the banking sector itself, disproportionally compared to the now rate the situation in the finance others. Secondly, analysts‘ quotes industry? The trend analysis shows render complex and condensed com- that there is no standard rating. This pany information in concise, concrete applies to both banks and insurance figures and trends, such as buy/sell companies. With the exception of recommendations or profit estimates. AIG, scores of insurance companies The current level of analysts’ assess- conceded that they had acted more ments serves to assist both journalists conservatively than banks and that and financial markets in the evalu- the sentiment towards them was thus ation of new figures which has a friendlier than that towards banks. significant influence on the tone of This is mirrored in the positive ratings

| 27 Reputation

of the first quarter of 2010, when the in the form of Basel III would have on annual results of 2009 were reported the business development of banks. on. For insurance companies, the scepticism related to the consequences of The successful handling of the so- the low-interest environment in parts called stress tests, in which the banks’ of Europe and the US as well as the balance sheets were tested for their possible effects of Solvency II. robustness against shocks in respect to minimum equity requirements, The picture is very heterogeneous was a positive factor in analysts’ com- with regards to cited sources. Af- mentaries in Q3 2010. The climate ter the rating agencies stood mas- of opinion for banks and insurance sively under fire during the financial companies thereafter, however, de- crisis due to their clearly over-posi- teriorated again. Contributors to this tive statements on toxic assets, they turn of events were concerns regard- switched to “at risk” in their ratings ing the possible failures of highly of banks. The most negative ratings, indebted countries such as Ireland, on average, were cited from Fitch, but also a certain worries of what in- but also Moody’s and S&P negative fluences a tightening of regulations ratings trumped positive ratings by

Chart 4: Rating of Banks by Different Analyst Sources, 7/2009 – 12/2010

Moody's S&P Fitch

Deutsche Bank Goldman Sachs Nomura Citibank Morgan Stanley UBS Credit Suisse Barclay's Capital BNP JP Morgan negative RBS positive Macquairie -40 -30 -20 -10 0 10 20 Share of +/- and neutral rating Basis: 3,433 statements in 8 (9) international ﬁnancial news media

28 | more than 20 percentage points. In in certain types of broadcasts, e.g., the current environment, the re- for certain target groups (regional / gained scepticism is, of course, only according to subject matter) is an im- credible to a limited extent, but it is portant one. As a rule, news broad- another nail in the coffin where it casts are destined for a regional comes to banks‘ regaining trust. news audience for reasons relating to language. It is possible that there If one leaves the rating agency sec- is a relevant number of the world tor and compares the ratings by population who are in the position of bank analysts, then the comments by following and understanding English Deutsche Bank and Goldman Sachs broadcasts if they could be received were the most advantageous on the locally via satellite or cable. The well- whole, whereas Macquarie, RBS and known research studies on market JP Morgan were on average, quot- share nevertheless state that these ed regarding negative ratings. The broadcasts are rather less attractive quotes by JP Morgan had a special to the masses compared to popu- role to play. JP Morgan not only lar local news offerings. This would, passed the stress test with flying co- however, not necessarily limit their lours, but fed the debate around the significance for image creation tak- capital requirements of major inter- ing into account the extent to which national banks with its own calcula- opinion leaders such as analysts par- tions. ticipate in the creation of images, and the extent to which such offer- On the whole, analysts‘ and experts‘ ings are consumed. quotes still did not give the banks the all-clear as core capital is assumed In addition to the local/internation- in the additional regulatory require- al news broadcasts, pan-national or ments. Analysts, however, exclude international formats such as BBC the question as to whether the busi- WORLD, CNN, AL JAZEERA and AL ARA- ness models will receive their license BIYA were analysed. BBC WORLD and to operate, not only in the legal CNN, in particular, claim to be the sense, but also in the social sense. global elite media and AL JAZEERA and AL ARABIYA are, in any case, beyond Does watching CNN make a national boundaries both important difference? news platforms in the Arabic-speak- From the viewpoint of reputation ing world. management, the issue of whether the image is negative in all or most An analysis of individual broadcasts broadcasts, or particularly negative proves that the reporting on banks

| 29 Reputation

Chart 5: Tone of Coverage on Banks in Individual News Shows, TV News 1 – 11/2010 Al-Arabiyah Nile News LBC Al-Manar TRT Al-Jazeera Dubai TV CCTV SABC 3 News @ One SABC 3 News @ 10 SABC 2 Afrikaans News SABC 3 English News SABC 3: Africa News Update E-TV News SABC Zulu/Xhosa News SABC SiSwati/Ndebele News SABC V enda/Tsonga News SABC Sotho New Summit TV CBS Evening News Fox News 0% 20% 40% 60% 80% 100% ARD Tagesthemen negative no clear rating positive ZDF heute journal RTL Aktuell ARD Tagesschau ZDF heute TF 1 BBC 1 10 o'clock news ITV News at Ten BBC World BBC 2 Newsnight RAI Uno SF DRS Tagesschau SF Rundschau SF Eco SF Börse TV E 1 CNN NBC Nightly News ABC World News Tonight CBS Evening News Fox News 0% 20% 40% 60% 80% 100% negative no clear rating positive Basis: 7,227 stories on banks on 40 international news shows is predominantly critical in the rat- BBC and on ITV. The situation is some- ing of most broadcasts. The image what different for CNN. CNN recorded of banks portrayed by BBC WORLD was a rather less critical view of banks thus as critical as that on the national compared to NBC, ABC, CBS and FOX.

30 | Despite this, the percentage of nega- in the international and pan-regional tive ratings was over the 40 percent formats. mark and, in this regard, no other image was, in principle, transmitted via More striking is that the focus on CNN that was not transmitted by the managers, another major negative other American formats. factor in reporting, was less than on the national shows. For example: If one compares the pan-regional and On CNN, 6.8% of the contributions internationally oriented broadcasts between January and November with national broadcasters, then the focused primarily on management, differences in the structure of the whereas on ABC and CBS the propor- subject matter, at ﬁrst glance, do not tion was 16% and 17% respectively. necessarily explain the differences For BBC WORLD, the proportion was that exist in the ratings. It is rather 6%, and at BBC 1 10 o‘clock it was to be expected that broadcasts with twice as high. a high proportion of research quotes by banks portray a rather neutral pic- In respect to rating, BBC WORLD and ture. The research component, how- CNN thus do not necessarily make ever, is not immediately noticeable things easier for the banking indus-

Chart 6: Tone of Coverage of Banks in Individual News Shows, TV News 1 – 11/2010 (Only Individual Banks) Share of +/- and neutral rating 100%

80%

60%

40%

20% positive no clear rating negative 0% BBC World CNN Al-Arabiyah Al-Jazeera Basis: 217/131/420/21 reports on banks on the news shows listed above

| 31 Reputation

try. The analysis provides further in- with the exception of its declaration sights on which companies were ad- as a commercial or investment bank dressed in the individual broadcasts. to the US authorities, was subjected to less obvious ﬂuctuations. Internationally, Goldman Sachs has become synonymous with (invest- In 2010 Lehman Brothers was still ment) banks. With respect to the sur- present in the media as a historical vivors of the ﬁnancial market crisis, in reference – and even named rela- many of the numerous media reports tively often. However, more than 5% Goldman Sachs stood for those busi- (BBC WORLD NEWS) and more than 15% ness practices that were denounced. (CNN) of contributions about banks This is actually somewhat surprising concerned Goldman Sachs between in view of the changes in the bank- January and November. While most ing landscape in the last two years, as of the contributions appeared be- it was Goldman Sachs‘s competitors tween January and July, the focus which were primarily involved in the was on April. Whereas in 2009 Gold- takeovers of the no longer competi- man Sachs, was still blamed for the tive competition, while the organi- relative persistence of the crisis, at sational structure of Goldman Sachs, least in some media, the image was,

Chart 7: Relative Visibility of the Top 5 Banks on Individual News Shows, TV News 1 – 11/2010 Goldman Sachs Lehman Brothers UBS Barclays Citi HSBC Goldman Sachs JP Morgan Bank of America Citi BofA Merrill Lynch Samba Al Rajhi Bank National Bank of Kuwait Saudi Fransi HSBC Citi Dexia HSBC Lloyds TSB Royal Bank of Scotland UBS Share of coverage % Gulf International Bank 0% 5% 10% 15% 20% Basis: 217/131/420/21 reports on banks on the news shows listed above

32 | Chart 8: Rating of Goldman Sachs on Individual News Shows, TV News 1 – 11/2010 Share of +/- and neutral rating 100%

80%

60%

40%

20% positive no clear rating negative 0% BBC World CNN Al-Arabiyah Al-Jazeera Basis: 37/38/12/0 reports on GS on the news shows listed above

Chart 9: Rating Timeline of Goldman Sachs on International TV News Shows, 2006 – 11/2010 Share of +/- ratings (%) 70% negative positive 60%

50%

40%

30%

20%

10%

0% 2006 2007 2008 2009 2010 Basis: 628 reports on Goldman Sachs and senior management in international TV news shows

| 33 Reputation

on the whole, negative in 2010. Until nature of TV – strong polarization the oil platform crisis, the fraud in- given the lack of space and time to vestigations against Goldman Sachs explore issues in depth and a tenden- were the top subject matter for cy to polarize ratings. However, TV weeks – and not only on the US news. news characteristics are not enough to explain the level of negativity as Reporting in the second half-year other industries have, at the same was more balanced, not least after time, done much better. Overall rat- the SEC hearing, but Goldman Sachs’s ings (expressed as the sum of positive image clearly did not remain untar- minus negative ratings) have ranged nished, even in the elite media, BBC between +10 and -60 in the period WORLD NEWS and CNN. 2002 to 2010 with the UK news, on average, presenting the harshest im- Against this background, the ques- age. According to MEDIA TENOR’S long- tion that must be asked is this: is term research, a reputational crisis the absence of bad news the start manifests if a rating hits the -10 mark of reputational recovery? The latest for more than two months in a row. headlines regarding the appointment Looking at these criteria, the bank- worth billions at Facebook has al- ing industry achieved a somewhat ready led to warnings that this could sustainable rating in 2005 and 2006 mark the next bubble. The analysis only. makes evident that proﬁts alone can no longer ensure a good image for After the collapse of Lehman and management, products and social re- a banking crisis which saw central sponsibility. banks and politicians fearing meltdown, ratings were rather low in After digressing regarding selected 2008 and 2009, registering at be- international media, we will go on low the -40 mark in Germany, and to take a further look at the image the UK and US media. Apart from of banks, this time from the point of Leh-man, the names differed from view of the competing news broad- country to country (e.g., Hypo Real casts. Estate in Germany, Northern Rock in the UK, Washington Mutual and Some kind of stabilization but no Merrill Lynch in the US), but the mes- clear recovery sage was more or less the same: Toxic Banks have barely seen balanced or subprime papers mainly related to even positive news coverage in the an inﬂated US real estate market recent past in international TV news. were packaged and sold all over the That is to some extent due to the world, leading not to risk diversity,

34 | Chart 10: Rating of the Banking Industry, Germany, UK, US (TV) 2002-2010

Balance of ratings of banks 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% -70% -80% 2002 2003 2004 2005 2006 2007 2008 2009 2010 Germany UK US

Basis: 10,886 / 3,192 / 3,934 stories of banks and their senior management in German, UK and US TV news shows but rather to an international pan- to be poisoned with toxic assets. And demic infection of banks. If this had self-regulation or a soft approach happened in the food industry, su- such as public warnings might not be pervisory bodies would have imme- sufficient when it comes to regula- diately shut down (toxic) production. tors, central banks and rating agen- In the banking industry, the so-called cies – or when it comes to rebuilding sub-prime crisis no longer held wa- their reputations. ter, but central banks and financial authorities rushed to give support What is the current trend now? Over- to troubled banks trying to prevent all ratings have deteriorated further another major systemic shock the size in Germany and the US, given further of Lehman. Even in 2010, the word insights (e.g., by courts and feder- “toxic” has more often been con- al investigations shedding light on nected with financial issues than en- business practices which have been vironmental issues, as research in FT, labeled criminal acts). In Germany, WSJ and BARRON’S for 2009 and 2010 this has especially hit publicly held shows. As no one in their right mind Landesbanken which have seemed to would want to be poisoned with be strong buyers of structured loans toxic food, investors wouldn’t want giving a higher average return and

| 35 Reputation

Chart 11: Connotation of the Word “Toxic” 2009/2010

Number of stories in connection with "Toxic" 4,000 Assets Environment 3,000

2,000

1,000

0 2009 2010 Source: FT, WSJ (print & online), BARRON’S, text search lacking an otherwise sound and sus- archives/1514) during the first quarter tainable business model. Based on of 2010. Future actions might have an the general ratings and stereotypes even larger impact. analysis, the image turnaround has yet to come as current rating levels Bank managers: bashing continues are not sufficient for rebuilding pub- Given the strong trend towards per- lic trust. Rising profits on the back sonalization in news reporting, and of an economic recovery will not be taking into account the fact that enough to restore credibility. The business is always about people ground for revelations such as those – even if they are developers and announced by Wikileaks is rather programmers of automatic trading fertile. The “Move your Money” cam- programmes – the rating of senior paign launched by HUFFINGTON POST’S management in the banking industry Arianna Huffington before Christmas is another key indicator for measur- 2009 has, according to the website, ing whether public acceptance is on encouraged around 9 per cent of US the rise again or not. adults to turn away at least some of their money from the big banks Recent polls (e.g., in Germany) have (http://moveyourmoneyproject.org/ shown slight improvements for

36 | Chart 12: Rating of Bankers, Germany, UK, US (TV) 2006-2010

Balance of ratings of banks 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% -70% -80% 2002 2003 2004 2005 2006 2007 2008 2009 2010 Germany UK US

Basis: 1,468 / 431 / 559 stories on banks’ senior management in German, UK and US TV news shows Deutsche Bank’s Josef Ackermann, Hayward, but, in light of the massive but the diagram above makes the volume in 2008/2009, a moderate vol- point that this is not a general trend. ume with consistently negative tone Instead, in 2010 negativity in Ger- is enough to keep the fire burning. many again moved to even lower rankings than in 2008 and 2009. At A breakdown by companies shows the same time, the ratings in the UK the most negativity for Goldman and US TV news improved slightly, Sachs in 2010, in Germany for Bayern- but still showed a -45 – 40-point gap LB, Hypo Real Estate and in the U.K. to any substantially balanced cov- for HBOS and RBS. erage which might award bankers with more trust again. The GfK 2010 Besides the fact that investigations trust index shows that bankers lost 15 and court cases continue to fuel the points compared to 2008 in Germany, fire, the lack of prominent senior scoring at 57 per cent in 2010. managers from the global financial industry heading a campaign to un- The volume of negative reports de- veil what went wrong and lobby for creased in 2010 compared to 2009 substantial change might be a reason as the cameras shifted to BP’s Tony behind the slow image recovery in se-

| 37 Reputation

nior management. So far, it has been whether this would cause a change up to movie makers, politicians, sci- in reporting on banks’ management. entists and journalists to head up the Experience in other industries (e.g., education on the reasons for and the IT) indicates that it is more about lessons learned from the crisis. How integrity and readiness to take on re- do you rebuild trust? Much of the sponsibility than on gender alone. global media is currently promoting the idea of increased diversity, espe- Banking visibility: volcano eruption cially that of having more women in and BP’s oil spill eclipsed banking prominent management and con- industry news in 2010 trolling positions, allowing them to MEDIA TENOR’S fundamental research manage change and communication. has unveiled that trust basically starts The investment banking culture, in to recover around nine months after particular, has been frequently la- negative coverage ends and an issue belled as male dominated and driven is no longer grabbing top headlines by testosterone rather than reason in the media. The previous section of (e.g. Handelsblatt 16.09.2010). There this chapter has shown that the tone are too few cases of prominent fe- towards the banking sector hasn’t male bank CEOs to do a forecast on changed fundamentally so far – so

Chart 13: Volume of Coverage of Banks, Germany, UK, US (TV) 2006-2010

Volume of coverage of banks 1,200 Germany UK US 1,000

800

600

400

200

0 I 2006 I 2007 I 2008 I 2009 I 2010 II 2006 II 2007 II 2008 II 2009 II 2010

Basis: 4,827 / 1,916 / 2,797 stories on banks (brands) in German, UK and US TV news shows

38 | what about the volume aspect? As that this hope has not been fulfilled. with the bankers, the volume of cov- Instead, there is evidence that the erage on individual banks declined level of negativity was sufficient to substantially in 2009. However, other make people move their money. MEDIA TENOR rankings show that vol- There has been no successful cam- ume in 2010 was still large enough to paign in Germany similar to that in claim a top spot in the industry rank- the US, but the business figures of ings. Another important fact is that the small German GLS Bank, which the volume of coverage still exceeds claims to be doing sustainable busi- pre-crisis levels. In Germany, volume ness only, show that people outside in 2010 was around double that of the US moved their money as well. 2006, and on the UK and US TV news GLS reported a rise in client num- it was even more. bers from 55,000 in 2007 to 80,000 in summer 2010. Some senior industry figures have been for the storm to pass over be- Banking and financials – a silver fore emerging from their caves to lining continue doing business as normal. If there is one image criteria which The tone and visibility analysis shows has really shown some progress in

Chart 14: Volume of Coverage of Goldman Sachs versus BP, UK, US and German media April, 5 – May 31, 2010 Volume of coverage of GS versus BP 600

500

400

300

200

100 Goldman Sachs BP 0 4/5-11 4/19-25 5/3-9 5/17-23 4/12-18 4/26-5/2 5/10-16 5/24-31 Basis: 4,827 / 1,916 / 2,797 stories on banks (brands) in German, UK and US TV news shows

| 39 Reputation

Chart 15: Tone of Coverage of Banks: Financial Solidity / Stocks, UK, US and German TV News 1/2006 – 11/2010 Balance of ratings of banks 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% -70% -80% 2002 2003 2004 2005 2006 2007 2008 2009 2010 Germany UK US

Basis: 2,083 / 1,120 / 830 stories on banks on German, UK and US TV news shows tone then it is the news coverage on to be self-fulfilling prophecies. banks’ financials and stock sentiment. Theoretically, increased profitability The bailout programs, a dive for might be good news for banks’ im- cover in fixed income business and ages. Unfortunately, the trust melt- low interest rates boosted earnings in down and fundamental criticism of 2009/2010 compared to the previous the business model doesn’t allow years. In principle, financial solidity is for a 1:1 transfer of higher profits to a core image criterion as it is in gen- improved image. Even the ratings of eral considered to be an equivalent organizations such as Deutsche Bank to overall success and thus makes a and Goldman Sachs display a high company attractive to investors and level of ambivalence when it comes employees (with clients it’s not that to the rating of financials/stock. simple). Reports about financial con- Deutsche’s 41.5 per cent share of posi- straints have accelerated the decline tive rating on financials in 2009/2010, of banks such as Northern Rock and, for instance, contrasts with a 20.3 per especially in the banking industry, cent share of negative reports. any rumors about solvency problems might be as bad as a factual shortage Why is this? One reason might be of liquidity because such rumors tend that the discussions on passing so-

40 | called stress tests and tighter govern- to serve (potential) customers bet- ing rules concerning equity capital ter than competitors. As a result, the have made journalists point to con- welfare of the provider of goods, as cerns that even increased profitabil- well as of the customer, will increase. ity will not be enough to meet future So much for the theory. When it challenges. Some of these concerns comes to banks and customers, the are shared and disseminated by the media have shown little evidence rating agencies as well. However, an- over the course of the last three years other, probably more challenging, ar- that the bank-customer relation, on gument when it comes to trust is that average, leads to happier clients. Crit- the media and sources quoted by the icism hasn’t softened since then de- media questioned the legitimacy of spite a great deal of negativity imme- recent profits, especially those gener- diately after the collapse of Lehman, ated by investment banks. A recent FT when many private banking clients story (13.12.2010) in which the words realized that they had lent money to “investment bank” and “casino” are Lehman without actually knowing used as synonyms is typical. that they had done so. In 2010, the balance of negative and positive rat- Unfortunately, the positive profit ings hit the -60 to -100 mark. news can, to some extent, even be counter-productive when it comes to Basically, if banks have been in the rebuilding trust. Besides the argu- news due to their products and client ments listed above, rising profits go relations, the story has been nega- hand in hand with increasing bonus- tive. The trust polls display that this es and the 2010 coverage on bankers’ type of coverage hasn’t enhanced bonuses garnered little public sym- reputations. Basic trust in the indus- pathy with bankers cheering higher try is challenged as court trials shed earnings. light on the mechanics of creating and distributing products, which only Banks and customers: troubled a few people understand, and how relations not just on toxic products banks didn’t counsel customers ac- At the end of the day, the mere rea- cording to industry and legal guide- son for the existence of businesses lines. This finding is not a contradic- is to offer products and services and tion to polls such the GfK industry make money that way. According to poll which says that around 50 per Adam Smith, competition – the in- cent of people have some kind of, visible hand – will turn egoists into or full, trust in their personal service cooperative individuals because of person. their personal advantage if they start

| 41 Reputation

Chart 16: Tone of Coverage of Banks: Products / Customer Relations, UK, US and German TV News 1/2006 – 11/2010 Balance of rating of banks' products/customer relations 100% Germany UK US

50%

-50%

-100% I 2006 I 2007 I 2008 I 2009 I 2010 II 2006 II 2007 II 2008 II 2009 II 2010 Basis: 437 / 255 / 73 stories on banks on German, UK and US TV news shows

Criticism has circled around various cated in managing large financial issues as different types of clients and risks; selling complex investment relations were linked to the financial products to private clients who do and economic crisis: not meet their risk profiles; com- a) Inter-bank relations: e.g., selling municating in professional lan- toxic assets to other institutions guage and terms of business which making them bailout cases costing are normally not understood by taxpayers money; there have been private clients; excessive fees for allegations of fraud and insider “minor” violations of client con- trading as well, drying up funding tracts, e.g., delayed credit card for other banks debt payments; inappropriate han- b) Banks – corporates: funds drying up dling of customer data (e.g., data during the economic crisis worsen- were stolen or published) ing companies’ problems in dealing with declining orders and investing The connector between these very in new technology different types of problems is a per- c) Banks – private clients: selling real ceived lack of integrity and common estate loans to people who cannot sense regarding what sustainable afford them and who are not edu- business relations are all about. What

42 | might be the trigger to find a way lapse of Lehman has gone far beyond out of the trust crisis surrounding the question of how much of prof- products/services and customer rela- its have been invested in art collec- tions? Obviously, launching Facebook tions. In the light of the systemic pages and spamming clients with crisis, even countries with a strong information in social media will add economy and low public debts have to the frustration and aggregation realized that banks can become too rather than rebuild trusting relations. big for a national fix if things go very Some companies have been able to wrong. Until 2007, the term systemic achieve fair and balanced coverage risk was insider vocabulary among by putting customer advisory boards regulators and central banks and, in in place which meet on a regular ba- the business news, bigger was said sis and have the right to recommend to be better while mergers were basic changes in the design of prod- mostly cheered. Three years of this ucts or customer communications. has taught journalists that the rescue Another way of building customer re- of a single bank can be more expen- lations can be the communication of sive than all the money spent on solutions, e.g., the successful financ- social benefits for an entire country ing of technological innovations and in one year. Economic stimulus pack- company growth. However, in the ages and bailout packages for the age of online media, these stories can financial industry have led to spiral- no longer be communicated by press ling public debt in scores of coun- releases alone, but need to be told in tries between 2008 and 2010. So it is compelling stories showing company little wonder that the tone of cover- staff and customers at work. age has been mostly negative since 2007 when it comes to the media Banks and the state: taming the reporting on banks and their rela- beast tions with state and society. In this Corporate citizenship has become a context, mistakes by regulators and popular concept in business over the public supervisory bodies have played last decade, and banks have invested a certain role. However, most of the heavily in cultural projects, founda- time, media reporting was not so tions and environmental issues. It much centred on institutional failure seems obvious that such positive re- but on factual or claimed unlawful porting on good corporate citizen- behaviour. ship is likely to build trust between the company and the regional or The slightly upbeat reporting on the national community. However, the UK TV news contrasts with a declin- discussion about banks since the col- ing rating in Germany and a still

| 43 Reputation

Chart 17: Tone of Coverage of Banks: State / Society / Regulation, UK, US and German TV News 1/2006 – 11/2010 Balance of rating of banks' relations to society/the state 100% Germany UK US

50%

-50%

-100% I 2006 I 2007 I 2008 I 2009 I 2010 II 2006 II 2007 II 2008 II 2009 II 2010 Basis: 1,089 / 332 / 720 stories on banks on German, UK and US TV news shows strongly negative tone of coverage are communicated as measures to in the US Banker bashing and calls improve stability and global wel- for tougher regulation, additional fare and are met with constructive taxes on banks’ profits and higher cooperation by the banks, it could equity requirements have provided happen. However, the coverage has fertile ground for politicians to put shown how difficult it is for interna- the blame on the banks. But, as ex- tional politicians such as the G20 to plained in last year’s Trust Meltdown find and apply common rules. And study, it has been seen by at least the banking industry has stressed the some politicians as a chance to come negative consequences of greater back to the playing field after global- regulation more than it has displayed ization was said to have diminished any kind of repentance and concern the power of national governments. over the next crisis. Instead, there are some signs of a return of project-fo- Are last year’s and current efforts, cused CSR management. It is doubt- such as Basel III, additional taxes and ful whether this will be helpful for considerations, overdone and is there rebuilding trust. enough systemic relevance to rebuild trust in the banking industry? If they

44 | Balanced image proﬁle in emerging US, and that the ratings in the Ara- markets bic-speaking news and in China and In recent years there has been much South Africa were on the whole bal- talk of a global ﬁnancial and eco- anced or positive for the sector. nomic crisis and, in general, scores of commentaries also stated that Against this background, can the the- bankers had an image problem the ory that the banks’ image crisis is an world over. This could, of course, be international or global phenomenon the case, but in light of the analy- which requires relevant basic mea- sis of news broadcasts in 11 different sures hold water, or are the ratings in countries/regions, the information China, the Arab countries and South emanating from the media need not Africa proof instead that reactions necessarily be responsible for this. in countries such as the UK or the US An analysis of a total of 40 news and Germany were more excessive broadcasts in these 11 countries over and that this will normalise in the 11 months in 2010 shows that the near future? ratings of banks in Switzerland and Spain were clearly less negative than The answer to these questions must in other European countries and the focus on various aspects. The ques-

Chart 18: Tone of Coverage of Banks in Different Countries, TV News 1 – 11/2010

Germany France UK Italy CH Spain USA Arabic TV Turkey China South Africa

0% 20% 40% 60% 80% 100% negative no clear rating positive Basis: 7,227 stories on banks on 40 international news shows

| 45 Reputation

tion on the one hand concerns the The reports on Chinese TV, in con- extent to which the banks from the trast, reflected a somewhat different home countries or home regions type of news selection and prepara- were affected by the distortions of tion than in other countries. The pic- the financial crisis, and the extent ture for the banks is the same for the to which the media reported on the other sectors, although there were, distortions and their consequences. It for instance, major distortions in the must be noted here, that the extent Chinese economy due to unemploy- of the effects fluctuated from market ment and wage pressures. to market, and amongst others, de- pended on the degree to which the The picture in the Arabic region can banks were enmeshed in the interna- be summarised as follows: For the tional capital market and bought the domestic institutions, the picture toxic assets and held them in their was, on average, better than for the portfolios. foreign institutions (e.g., US institutions). In view of the financial servic- It is hardly surprising that, at the es offered in the Arabic region, there starting point of the crisis in the US are surely in-principle differences the picture was the most negative. It (Takaful products conforming to the was here that the most bank insol- Islamic religion which exclude certain vencies occurred as a result of the products/product types) on the one distortions, and it was here that the hand, and, also a certain (self-)cen- subprime property market and the soring in the reporting on local/re- high liquidity of markets were consid- gional authorities in order to avoid ered by many experts to be the main problems with official censorship. causes for the international crisis. In 2010, the German media engaged The banking image seen in context itself critically with the mistakes in There are various indictors for the the field of the public banks, above drop in crisis reporting. One indicator all by WestLB and LBBW, but also of is an improvement in the rating. We BayernLB and others. The problems have seen in the above that banks at of private banks were reported on to this point continue to lack a break- a greater degree in 2008/2009. In this through which would lead to the regard, it must be noted that the im- regaining of trust on a broad scale. age problem of the banks, which led Another indicator is absolute pres- to a reputation problem, was a fun- ence and presence compared to com- damental problem at least in Europe peting news broadcasts. With respect including the UK and in the US. to absolute presence, it was shown above that although the reporting

46 | Chart 19: Volume of Coverage of Different Industries, TV News Shows 1 – 11/2010

Volume of coverage (Top 10) Banking Transport/Airlines Oil/Gas Automobile Media IT/Electronics Mining Utilities Retail Insurance Number of stories 0 2,000 4,000 6,000 8,000 Basis: 58,212 stories on companies and managers on 40 international TV news shows on banks in 2010 was lower than that panies – all of them providers of of 2008/2009, visibility was therefore shocking headlines and pictures in less as a result. However, looking at the past year. relative presence and rating as an aid, i.e., comparing the attention In addition to strikes and spectacu- paid to the banking industry with lar accidents, the volcanic eruption in the visibility of other industries, then Iceland ensured a high degree of at- there are no indications of normality tention on transport companies and yet, even from this side. airlines. The accident involving the BP platform in the Gulf of Mexico put Despite crisis events, which partly the oil companies in the centre of at- kept the world media on edge for tention of the worldwide media, and weeks, the banking industry re- the automobile industry has always mained the top industry in respect enjoyed a high degree of popularity to attention in the period January from journalists, even on TV news. to November 2010. It also competed Unusual and more tragic was the with industries such as the energy presence of the mining companies. sector, airlines and the mining com- The accident in Chile, with its weeks-

| 47 Reputation

long rescue work until the happy ers, even the “Detroit Big Three,“ as ending, dominated the news in late clearly re-consolidated in the mean- summer. However, the relatively high time. The image winners in industry degree of attention for insurance reporting by international TV news companies was unusual. A signifi- shows were, however, the retail and cant proportion of the attention fell IT industries. In any case, these were on the US giant, AIG, which had hit among the most frequently named the skids during the financial crisis industries. In regard to the IT indus- and was stabilised with record sums. try, Steve Jobs scored above all with The investigations on the crisis and Apple and the media again saw in the possible sale of Asian branches to the iPad, a pioneering role for an en- repay debt were important topics, es- tire industry. pecially on the US news. Less in the spotlight were other parts An analysis of the ratings of industry of the financial sector, such as private reporting shows banks ranked third equity and venture capital compa- – only superseded by airlines and nies as well as funds. Here the image the energy industry. In contrast, the was relatively balanced on the whole, media see automobile manufactur- while clearly friendlier than for banks

Chart 20: Rating of Different Industries, TV news shows 1 – 11/2010

Banking

Transport/Airlines

Oil/Gas

Automobile

Media

IT/Electronics

Mining

Utilities

Retail

Insurance

0% 20% 40% 60% 80% 100% negative no clear rating positive Basis: 58,212 stories on companies and managers on 40 international TV news shows

48 | Chart 21 Rating of Banks / Car Industry, TV News Shows 7/2008 – 11/2010 Balance of rating of banks/car industry 100% Banks Car industry

50%

-50%

-100% II 2008 I 2009 II 2009 I 2010 II 2010

Basis: 22,667 stories on companies and managers on 40 international TV news shows and insurance companies. Above all, the medium term, then the clearly venture capital financiers were able more beneficial evaluation trend to score. In this area there should for automobile manufacturers im- also be a point of reference for immediately becomes apparent. If, in age recovery for the banks in com- 2008/2009, it was about the survival munications and strategy to address of companies such as GM and the their role as enablers of growth, European subsidiaries of Opel and workplaces and the well-being of the Chrysler, and if German companies company. battled a drop in demand and short- time work, then the positive evalu- Insurance companies, on the whole, ation trend in 2009/2010 not only fared better than banks, but even contributed to the economic recov- here critical evaluations were the ery, but to recognition by the media order of the day. These, however, that important headway was being affected more the field of products/ made on the way to more sustainable prices/customer relationships, particu- mobility with electric and hybrid cars larly in the health insurance sector. which use up less resources and emit fewer hazardous pollutants. In addi- If one compares the reporting on tion, the media triggered an innova- banks and automobile companies in tion competition, including the issue

| 49 Reputation

of how suppliers from high-wage This was usually based on three ele- countries could also produce low-cost ments: (1) Admitting to past problems cars for future drivers in India and and keeping up a continuous flow other emerging countries. There is no of news on their successful handling talk of such fundamental changes in (e.g., reducing toxic papers, improv- the business model in the reporting ing risk management). (2) More in- on the banking industry, rightly or tensive media communication, in par- not. Here, the media do not (yet) see ticular at top management level (3) an in-principle change in course on a Clear communication for the custom- broader basis. er’s benefit, improvement measures and growth areas (e.g., innovation fi- Closing remarks nancing). But journalists still see such Irrespective from which perspective companies as the exception rather the international banking sector is than the rule. examined, whether regarding the subject matter of financial solidity, customer relations or the handling of mistakes in the past, the basis for a return to trust on a wider front is not yet apparent from the various media channels investigated. There are certainly markets, such as in South Africa and China, which have appeared to be unaffected by the crisis news reports, but, in the most important financial centres, scepticism dominates in the wake of the collapse of Lehman Brothers and the bursting of the subprime bubble. The simple improvements to image which arose from the field of finance have not been sufficient to raise the average. In addition, there remains un- ease regarding higher bank profits, in particular in politics and NGOs. A few individual companies have suc- ceeded in keeping their image on an even keel or in bringing it back on a constructive course in its early stages.

50 | 1.3. Only he Who is Understood Can Convince. The Comprehensibility of Bank Communications by Prof. Dr. Frank Brettschneider and Dr. Anikar M. Haseloff

1. Comprehensibility and acceptance situation where banks place more The effects of the worldwide finan- value on comprehensibility? cial and economic crisis were also felt by numerous small investors in many In particular, when it comes to banks, countries. In many cases the finan- customers want to be comprehensibly cial losses have been the result of informed of the features of the prod- speculative forms of investment, the ucts and the risks. The internet also risks of which had been inadequately plays a decisive role in this process. explained to bank customers. As a It is easier than before for customers result, communication by the banks today to compare the documentation – with the public in general and with on products or Terms and Conditions. their customers specifically – has When deciding to purchase a product shifted further into the limelight. or not, one of the main issues is com- Legal regulations, such as providing prehensibility. One can only compare an easy to understand product fact or consider products and Terms and sheet, are being discussed in some Conditions that are understandable. countries. In Germany, for instance, And for journalists, comprehensible the obligation to record consultations press releases have a greater chance with potential customers is included of being selected from the flood of in these new laws. Communication by reports that arrive in editorial offices the banks with their customers is also on a daily basis. Therefore, compre- being subjected to several quality hensibility is not only meaningful in tests conducted by different custom- direct communications with customer care organisations. ers, but also in indirect communications transmitted via the mass media. Numerous problems due to inappropriate advice and the continued Banks thus have a great opportu- negative results achieved by banks in nity to regain and develop the trust tests which examine customer con- of their customers and the public in sulting lead to some questions: How general by using easy to understand easy is it to understand financial com- and transparent communication. munications? Are bank documents Comprehensibility can also be a com- comprehensible to end customers petitive advantage over the compe- without special prior knowledge? Has tition. The growing importance of the financial and trust crisis led to a comprehensibility as a competitive

| 51 Reputation

advantage can also be seen in the to improve these compromises? fact that several companies from the financial sector recently use compre- 2. The research design hensibility in their marketing cam- The comprehensibility of communica- paigns. For example, the ERGO insur- tion by a total of 39 banks primarily ance company has developed a broad active in retail banking was investi- campaign in Germany based almost gated. The banks included Commerz- solely on comprehensibility as main bank, Cortal Consors, Deutsche Bank, advantage. Other financial institutes HypoVereinsbank (UniCredit Group), have reacted already and, at the mo- ING-DiBa, Postbank, Sal. Oppenheim, ment, there are several campaigns Targo Bank (formerly Citibank), and based on comprehensibility (al- Sparkasse (German savings bank) as though, not much has changed in the well as Volksbank and Raiffeisenbank communication itself until now). (both are types of cooperative banks in Germany). The following types of Taking this background into consid- documents were analysed for their eration, a study was conducted to formal comprehensibility: Account measure the comprehensibility of dif- opening documentation, General ferent bank documents. In this study, Terms and Conditions, data protec- the following research questions tion declarations, press releases and were empirically investigated: newsletters. A total of 295 docu- • How comprehensible is the comments were analysed in the period munication by banks with their cus- from 01.04.2010 to 01.88.2010. The tomers and the public in general? documents were only investigated • Are there any differences in com- for their formal comprehensibility. prehensibility between banks? Accuracy of content was not tested. • What are the typical barriers to Likewise, the advisory services did not comprehensibility? form part of the analysis. The goal of • Are there certain documents (e.g., the study was to analyse the formal account opening forms, General comprehensibility of the documents Terms and Conditions, press texts) and to draw conclusions regarding which are particularly comprehen- their comprehensibility for custom- sible or incomprehensible? ers with a normal level of education • Are there any differences in the but without a business management comprehensibility of the various or financial background. Investiga- documents between banks? tions show that the participants un- • Has comprehensibility been com- derstand (are able to remember and promised and, if so, can certain interpret correctly) formally compre- patterns or approaches be derived hensible texts by up to 30 percent

52 | better than formally incomprehensi- certain length make comprehension ble texts with the same content. for the reader more difﬁcult. The optimal sentence length depends on The comprehensibility of communica- the medium used. For example, the tion was determined in a two-stage length of sentences in letters or on process consisting of a quantitative the internet should be markedly low- and a qualitative section. The com- er than, for instance, in press releas- prehensibility software, TextLab, was es. And the greater the average word used for the quantitative analysis. length, the more it can be assumed This software programme calculates that there are conglomerations of various validated readability formu- complex, compound or foreign words lae (Amstad formula, Wiener Sach- in the text. Therefore, the frequen- text formula WSFT, the SMOG index cy of longer words is also an impor- and the LIX readability index). Read- tant indicator of incomprehensibility. ability formulae give a very good ﬁrst Sentences containing more than 20 impression of the comprehensibil- words also compromise comprehensi- ity of a text. Thus, various US au- bility. Nested sentences or sentences thorities, for instance, use the Flesch written in passive language can also Reading Ease formula to check docu- be barriers to an easy understanding ments for citizens before they are of a document. published. Documents must reach a certain threshold to be regarded as One of the main formulas used in the comprehensible and be allowed to be study is the Hohenheimer Compre- published. hensibility Index. This index compris- es the readability formulae and the TextLab also calculates numerous individual values. This key perfor- individual text factors which are im- mance indicator expresses the com- portant for comprehensibility (aver- prehensibility of communication on age sentence length, average word a scale of 0 (not at all comprehen- length, percentage of words with sible) to 20 (very comprehensible). To more than six characters, percent- compare: texts by the German Bild age of nested sentences, percentage newspaper achieved an average score of sentences containing more than of 16.8 points on the scale, whereas 20 words, percentage of sentences dissertations only achieved 4.2 points written in passive and the percent- on the scale. age of foreign words and abstract nouns). The higher the average sen- In the second stage, the documents tence length, for instance, the more were investigated by language ex- complex the content. Sentences of a perts using a guideline at the word

| 53 Reputation

and sentence level. The goal of the it is no coincidence that they enjoy qualitative analysis was to identify greater trust from the public in times typical compromises and possibly of crisis. Figure 1 gives an overview of repetitive language patterns. The ex- the overall comprehensibility of sev- perts followed a set guide line. This eral selected institutions. guideline took into account the following assessment criteria: language However, there are not only signifi- style, specialist terminology/wording, cant differences between the com- sentence structure, sentence con- prehensibility of different financial structions, placement of information, institutions, but the comprehensibil- as well as clarity and transparency of ity of individual text types also var- expression. ies greatly. The document with the highest comprehensibility rating was 3. Results of the study the newsletter of a Volksbank: 18.08 Banks do not appear to have ad- points. However, a newsletter by equately learnt their lessons from Postbank also scored highly at 17.30 the banking crisis and the associated and landed in the Top 10. Newslet- breakdown in trust from their cus- ters and press releases are thus by far tomers and the public. Overall, the the most comprehensible documents. comprehensibility of the analyzed These sometimes handle complex documents showed much room for financial subject matters, but the improvement. The average compre- banks manage to present these sub- hensibility of bank communications ject matters often simply and com- across all institutions and text types is prehensibly. The reason for this is 9.98 points on the Hohenheim Com- largely due to the fact that they are prehensibility Index. The best ranked written by experienced journalists or institution, a Sparkasse (German PR experts in communications depart- savings bank), achieved a score of ments. 12.86. Thus, even the better ranked banks still have room for improve- In contrast, the most incomprehensi- ment. The lowest ranked institution ble document was the General Terms merely achieved a comprehensibility and Conditions of a local bank: 3.25 score of 7.79 points. On the whole, it points. General Terms and Conditions is clear that the smaller institutions and data protection declarations are with a local presence, Volksbank and also generally the most difficult to Sparkasse, on average communicate understand text types. The reason for more comprehensibly than the large this is not least that these types of institutions. They appear to be lin- texts must have legal certainty and guistically closer to the customer and thus often come directly from the le-

54 | Figure 1: The comprehensibility of selected banks; Hohenheim Comprehensibility Index of 0 (incomprehensible) to 20 (very comprehensible) Stadtsparkasse Munich 12.86 Commerzbank 10.67 Sal. Oppenheim 10.25 Deutsche Bank 10 Dresdner Bank 9.18 ING-DiBa 9.11 HypoVereinsbank 8.33 Targo Bank 7.87 Cortal Consors 7.83 Postbank 7.79 0 2 4 6 8 10 12 14 16 Hohenheim Comprehensibility Index gal department. Nonetheless, several 4.7 points: HypoVereinsbank (4.67), comprehensible General Terms and Deutsche Bank (4.58), Commerzbank Conditions proved that even legal (4.58) and SEB (3.42). This indicates a texts don’t necessarily need to be great potential for banks to further incomprehensible. Banks should be- improve the communication with come more aware that even General journalists and the general public. Terms and Conditions, data protection declarations or account open- Two types of texts are considered in ing forms can be written for a wide further detail in the following: data customer group with heterogenous protection declarations and press re- educational backgrounds. leases.

Amongst the ten most incompre- Data protection declarations hensible texts were, however, not Data protection declarations direct- only data protection declarations ly address the customers of a bank. and General Terms and Conditions, These are therefore documents which but also, surprisingly, many press re- should be as comprehensible as possi- leases. The most incomprehensible ble so that even readers with a lower press releases scored between 3.4 and level of education can understand

| 55 Reputation

the relevant information contained worded very complexly and incom- therein. Consumers are highly sen- prehensibly. This is partly due to the sitised to this subject matter, in par- required legal certainty. However, ticular given the current media hype there are signiﬁcant differences be- around data security and data mis- tween the banks (see ﬁgure 2). The use. It can thus be assumed that more excellent results achieved by the top consumers today actually actively en- performers prove that data protec- gage themselves with the data pro- tion declarations can certainly be tection provisions. And, as consumer worded comprehensibly. The lowest protection agencies time and again scoring data protection declarations, point out how carefully the handling in contrast, are closer to the linguistic of personal data must be checked, it level of a doctoral thesis. A marked can be expected that a growing num- improvement by the banks is need- ber of customers will take an interest ed here, if they are not to lose more in these documents. trust.

The average score for all data protection declarations was 7.96 points. Most data protection declarations are Press releases

Figure 2: The comprehensibility of data protection declarations of selected banks; Hohenheim Comprehensibility Index of 0 (incomprehensible) to 20 (very comprehensible)

Stadtsparkasse Munich 14 Sal. Oppenheim 12.75 HypoVereinsbank 12 ING-DiBa 7.83 Dresdner Bank 7.33 Commerzbank 7 Deutsche Bank 6 Postbank 5.9 Targo Bank 5.67 Cortal Consors 5.5 0 2 4 6 8 10 12 14 16 Hohenheim Comprehensibility Index

56 | Press releases are the only document results can be classified as very com- type investigated by us which are not prehensible. Here it can be seen, that directly addressed to the end cus- even complex financial subject mat- tomer. Nevertheless, press releases ters can certainly be communicated are an important instrument for the comprehensibly. Nine banks achieved banks for informing the public of the scores of more than 12 points for banks’s activities. In addition, press their press releases, which can be re- releases are often published on the garded as comprehensible. However, website of a bank and can also be the press releases of a total of three seen by customers there. Further, banks had to be classified as incom- editorial offices are today suffering prehensible (see Figure 3). more from the consequences of the financial crisis. Editorial personnel The greatest barriers to comprehen- are being cut back and the pressure sibility are long sentences, nested in the editorial offices is on the in- sentences and foreign words. The crease. For this reason, press releases longest sentence, believe it or not, must be written clearly and compre- consisted of 81 words. At the end of hensibly as ever decreasing numbers this sentence readers can‘t even re- of journalists must make their selec- member how it started. A sentence tions from an ever increasing num- length of 20 words and up makes it ber of press releases. Comprehensible difficult to retain the overall con- wording therefore increases the pros- text of the sentence. Nested sen- pects of success of a press release. tences also interrupt the reading flow and are often more difficult to As the comprehensibility of press re- understand than simple main clauses leases can vary greatly depending on without subordinate clauses. Foreign the subject matter, five press releases words are part of any language, but from each bank were analysed. The people are often totally unaware of average score for all press releases how to use them. Nevertheless, for- was 10.60 points on the Hohenheim eign words can be a great barrier to Comprehensibility Index scale of 0 the comprehensibility of a text if they (incomprehensible) to 20 (very com- are used thoughtlessly and appear prehensible). Thus, press releases are, in too great a number. The average on the whole, the most comprehen- percentage of foreign words to all sible type of document. The compre- words in the documents investigated hensibility of the press releases, how- by us was 5.6 percent (min: 0 per- ever, fluctuated sharply – between cent, max: 15.5 percent). The use of 5.67 and 15.86 points. The press foreign words is thus certainly within releases of the banks with the best the usual range. The percentage of

| 57 Reputation

Figure 3: The comprehensibility of press releases of selected banks; Hohenheim Comprehensibility Index of 0 (incomprehensible) to 20 (very comprehensible) Volksbank Stuttgart 15.86 Postbank 11.16 ING-DiBa 9.82 Dresdner Bank 9.47 Deutsche Bank 9.23 Commerzbank 8.78 Sal. Oppenheim 8.75 HypoVereinsbank 8.08 Naspa 8 Targo Bank 7.6 Cortal Consors 5.67 0 2 4 6 8 10 12 14 16 18 Hohenheim Comprehensibility Index foreign words in newspaper articles Figure 4). is also in the region of 5 to 9 percent depending on the medium. The Therefore, individual documents with banks can therefore, in principle, be the lowest scores prove that there is given a positive report here. certainly potential for improvement at individual banks. Scores of 15 per- Foreign words are also not a com- cent and more of foreign words indi- promise of comprehensibility per se. cate a very high degree of complexity Some foreign words can be more and an over-use of specialist lan- easily understood terms such as guage. In some of the foreign words “Kaution” [security deposit] or they identiﬁed there is a glaring compro- can be more difﬁcult terms such as mise of the comprehensibility rules. “Bonität“ [credit rating]. However, Foreign words such as “Bonität“ the frequency of foreign words says [credit rating] or “Votum” [vote] a lot about the comprehensibility of were used, in particular in the Gen- a text. Are these explained? Or does eral Terms and Conditions and in the the bank use foreign word after for- data protection declarations, with- eign word without explaining them out the relevant expert knowledge to the layman? Again, there are large being explained to the reader. Banks differences between the banks (see should control the use of foreign

58 | Figure 4: Percentage of foreign words in texts of selected banks

Cortal Consors 8.12% ING-DiBa 7.41% HypoVereinsbank 7.37% Naspa 7.1% Dresdner Bank 7% Deutsche Bank 6.61% Targo Bank 6.45% Commerzbank 6.27% Sal Oppenheim 6.25% Mercedes Benz Bank 4.08% 0% 2% 4% 6% 8% 10% Percentage of foreign words words if they want to improve com- in the study. Many banks here give munication with their customers. And away considerable potential for ac- if specialist language has to be used tive, transparent and comprehensible because of legal reasons, banks have communication with their customers. to opportunity to explain the most difficult words to their readers. Some of the banks included in the investigation set a good example. 4. Conclusions and recommendations Many banks have documents which One lesson from the financial crisis are comprehensibly worded. Press is that customers should understand releases and newsletters are thus what banks do with their money, the most comprehensible document what the concrete provisions are that types of banks. They are usually writ- the contracts are based on and how ten by journalists or PR experts and the banks handle their data. Banks scored an average of 10.60 points on can regain the trust of their custom- the comprehensibility scale. The ten ers through easy to understand and lowest scoring banks nevertheless still transparent communication. Howev- show a clear improvement potential er, in reality, banks often cause con- even in their press releases. fusion amongst their customers with Data protection declarations, Gen- cumbersome wording. Convoluted eral Terms and Conditions or account sentences and unintelligible wording opening declarations, in contrast, are are the biggest problems identified worded very complexly and incom-

| 59 Reputation

prehensibly. The comprehensibility of as very positive examples here. these document types often suffers • Many banks give away a great po- due to the necessary legal certainty tential for active, transparent and wording. Banks often put legal cer- comprehensible communication. tainty before comprehensibility here. Sentence length, specialist lan- These documents are released by guage, foreign words and complex legal departments, not by communi- sentence constructions were identi- cations departments. Customers with- fied as typical barriers. These com- out a high level of education could promises of the comprehensibility only understand the General Terms rules can be very easily controlled and Conditions of several institu- and do not need to occur in this tions with difficulty according to the form and frequency. Short sentenc- comprehensibility assessment (index es and avoiding nested sentences score: 3.25). should be the rule. Foreign words and specialist terms should, where And, almost every tenth sentence was possible, be avoided or at least ex- written in the passive by the banks plained. investigated. Passive sentences can, in • Banks should, in all relevant com- certain contexts, represent a barrier munication departments and for for comprehensibility as they obscure all communication instruments, who is acting. They are impersonal develop an awareness that there a and create distance between the number of objectively measurable bank and its customers. The percent- language standards for compre- age of passive sentences in the press hensible writing, and that their release of a local financial institution application benefits the reputation was astronomically high at more than and can represent a competitive 55 percent. In such cases, banks al- advantage. most carelessly give away the oppor- • Standards and rules should be de- tunity to actively and transparently fined for a company’s own cor- approach their customers. porate language. These should be assimilated in the corporate Comprehensible communication language. The most important would not even be so difficult. requirements for comprehensible • Documents which are meant for writing should also be integrated the end customer in particular must in the company‘s language guide- be optimised for comprehensibil- lines. Equally important is a strate- ity. Through this, a bank can clearly gy to make the practical implemen- signal transparency. Some of the tation possible. banks in the test could be regarded

60 | In general, only what is understood can also convince. And convincing is necessary. A growing number of customers feel that they are no longer bound to a bank in the long term. These people have become more demanding. They want to be wooed and convinced. The same applies to the general public; the ﬁnancial crisis has left deep scars of distrust in individual banks as well as in the industry as a whole. Banks should make every effort to regain this lost trust. Now, comprehensibility is surely not the most important means to rebuild the lost trust, reputation and the good name; actions and transparent products are necessary for this. But, comprehensibility can nevertheless play an important role. Banks which communicate comprehensibly signal to their customers, „We are taking you seriously. And we are interested in dialogue.“ That would indeed be a start. As it is, some banks are setting an example.

| 61 2. Accounting: Transparency is Key to Regain Trust

2.1. The . Role of IFRSs and XBRL in Enhancing Transparency in Financial Reporting by Olivier Servais, Maciej Piechocki1

Introduction ums continues to feed the growing In the current economic climate information exchange demands of an where the after-shocks of the last expanding, global audience, online great meltdown continue to rever- technologies such as XBRL (eXten- berate, few people would argue sible Business Reporting Language) against the need for transparency have a role to play in enhancing the in financial reporting. But what is transparency of financial information meant by financial reporting trans- communicated to users. parency? In the IFRS Conceptual Framework it is characterised by “the Fulfilling disclosure requirements attributes that make the informa- and communicating with the IFRS tion provided in financial statements Taxonomy useful to users … understandability, XBRL was developed specifically to relevance, reliability and comparabil- communicate information between ity” (IFRS Conceptual Framework 24). businesses and users of financial information by providing a common, Through its objective to develop a electronic format for business report- single set of high quality, under- ing. Applying universally accepted standable, enforceable and globally mark-up tags that are defined in a accepted financial reporting stan- central taxonomy to items of busi- dards based upon clearly articulated ness information ensures that the principles, the IFRS Foundation and understandability, reliability and its standard-setting body – the IASB comparability of the information (International Accounting Standards (i.e., its content) is maintained when Board) – aims to support this trans- the information is transmitted. The parency by providing the world’s fact that XBRL tags are extensible integrating capital markets with and can be applied to a range of in- a common language for financial formation – even if it is not necessar- reporting. However, the degree to ily IFRS-related – permits additional which business information is under- information which is not necessarily standable, relevant, reliable and com- contained in the taxonomy to be parable is dependent not only on the reported, thereby ensuring that all content and data within, but also the relevant information can disclosed. external mechanism used to transmit By maintaining the integrity and the information. As the shift to- comparability of business informa- wards online communication medi- tion, XBRL – likes IFRSs – helps to

62 | Chart 1: Taxonomy Composition

standardise business information, standable, relevant, reliable and therefore IFRSs and XBRL form a comparable, three broad categories perfect partnership for enhancing of disclosures can be reported using transparency in financial reporting. the taxonomy – IFRS disclosures, com- The IFRS Foundation recognised the mon-practice disclosures and entity- potential impact that XBRL could specific disclosures. have on financial reporting. The Foundation also realised that if XBRL In terms of IFRS disclosures, the IFRS were applied in conjunction with Taxonomy is the XBRL representation IFRSs, it could improve access for of the IFRSs, including IASs (Interna- users to financial information and tional Accounting Standards) and the could also support IFRS adoption and IFRS for SMEs (Small and Medium- implementation. The Foundation sized Entities), issued by the IASB. therefore launched the IFRS XBRL ini- The taxonomy is developed following tiative in 2001 to create and publish a standard approach, whereby the an XBRL taxonomy containing tags content of the taxonomy is devel- for all IFRS disclosures, known as the oped based upon each IFRS in turn, IFRS Taxonomy. In order to ensure on a standard-by-standard basis (e.g., that the information transmitted IAS 1, IAS 2, IAS 3 … IFRS 1, IFRS 2, using the IFRS Taxonomy is under- etc). By following this approach, the

| 63 Accounting

taxonomy remains consistent with users of financial information to see, IFRSs and accurately reflects IFRS understand and react to changes in disclosures in terms of granularity of information, thereby allowing them detail and disclosure characteristics. to identify comparability in financial models. IFRS reporting is largely disclosure-driven, and shifts in reporting In order for information that is truly practice gradually become manifest relevant and understandable to be via changes in an IFRS. While these reported, the IFRS Taxonomy enables changes are necessary in order for entities to report additional, IFRS or financial information to remain rel- non-IFRS-related information that is evant and understandable, they can necessary to understand their finan- cause problems in terms of compa- cial statements. This information can rability. However, XBRL taxonomies largely be classified as arising from are able to support this comparabil- either common-practice or from oth- ity by enabling entities to react to er entity-specific requirements, also changes in disclosures whilst also as disclosing information required by supporting continuity in the face of a local regulator. For this reason, the such changes through automated IFRS Taxonomy has been developed change management (i.e. version- as an open, core taxonomy which an ing) information. This also enables entity can tailor to its specific needs Chart 2: Disclosure of Inventories

64 | by adding its own tags. By allowing time for that entity and in a consis- entities to report a range of informa- tent way for different entities“ (IFRS tion – whether related to IFRSs disclo- Conceptual Framework 39). sure requirements, common-practice or entity-specific – the IFRS Taxonomy However the IFRS Conceptual ensures that entities are able to meet Framework also states that “the compliance requirements whilst also need for comparability should not be disclosing information that is rel- confused with mere uniformity and evant and which provides a “true and should not be allowed to become fair” view. an impediment to the introduction of improved accounting standards“ Comparability and Transparency (IFRS Conceptual Framework 41). with the IFRS Taxonomy This leads to full understanding of Information comparability has al- the notion of extensibility which is a ready been briefly discussed, but in characteristics of the XBRL in general the specific context of continuity in and IFRS Taxonomy in particular. an entity’s reporting, i.e. how to en- While the IFRS Taxonomy represents sure that company A’s 2010 financial central repository of tags, it allows statements are comparable with its for additional tags which represents 2011 statements. However another entity disclosures. This should not be aspect of comparability that should confused with reporting according to be considered is inter-company a form. In other words the IFRS Tax- comparability. The IFRS Conceptual onomy allows for comparability on Framework states the necessity of the level of disclosure requirements both aspects of comparability: “Users in the IFRS. In the same time being must be able to compare the finan- highly extensible does not enforce cial statements of an entity through uniformity. It is also important to time in order to identify trends in mention that the comparability in its financial position and perfor- reporting according to the IFRS Tax- mance. Users must also be able to onomy goes beyond simple labelling compare the financial statements of of line items in financial statements. different entities in order to evalu- It will often happen that different ate their relative financial position, entities will label the same line item performance and changes in financial differently (i.e., net income, profit position. Hence, the measurement (loss)). If numbers reported for such and display of the financial effect of line item are tagged with the IFRS like transactions and other events Taxonomy tag of “ProfitLoss“ they must be carried out in a consistent remain comparable while allowing way throughout an entity and over for entity specific naming. It cre-

| 65 Accounting

ated also possibilities of comparing parability (and thus transparency) financial statements from different between financial reports (in XBRL) jurisdictions. If entities in Poland will available in distributed data pools. report “Wynik całkowity“, entities in For example XBRL IFRS Taxonomy fil- Germany “Geschäftsergebnis“ and in ing in EDGAR can be easily compared Japan 純利益（純損失） but all will use with XBRL IFRS Taxonomy filing in the IFRS Taxonomy tag of “Profit- Chilean or South African repository. Loss“ the comparability will remain This is opportunity for global capi- maintained. tal markets to truly have access to globally comparable and consistent High quality, accepted and imple- financial information. mented IFRS Taxonomy is a critical requirement for comparability and Conclusions transparency (overcoming the issue XBRL as a reporting mechanism in of distributed data pools). XBRL role its own right has great potential should not be overstated - this is to improve business reporting and merely a transport standard to get to deliver better, faster, cheaper financial information from A to B business information. However the (between computer systems). What mechanism can only be as effective as is however often underestimated the information that it is being used is the role of XBRL taxonomies and to report, and in the case of finan- the IFRS Taxonomy in particular. The cial reporting specifically it is when IFRS Taxonomy represents baseline XBRL is combined with IFRSs, as it is for comparability of financial infor- in the IFRS Taxonomy, that the true mation reported in compliance with potential for financial information IFRSs. It organises concepts repre- transparency (understandability, rel- senting all disclosure requirements, evancy, reliability and comparability) thus becoming a knowledge base. can be truly realized. Even when financial information is transferred to analytical systems and 1 The IFRS Foundation is an independent, leaves XBRL format, there will always not-for-profit private sector organisation be a need for using the taxonomy to working in the public interest. Its main mission, through its standard-setting body understand what such financial in- – the IASB – is to develop a single set of formation expresses. The interesting high quality, understandable, enforce- aspect of the IFRS Taxonomy is that able and globally accepted international as a central “knowledge base it does financial reporting standards (IFRSs). The not enforces existence of a central opinions expressed in this document are financial reports repository (global those of the authors and do not necessar- EDGAR). Indeed it allows for com- ily reflect the views of the IASB or the IFRS Foundation.

66 | 2.2. Natural Capital: The Finance Sector & Financial Reporting – Catalysing Action? by Kurt Ramin and Cornelis Reiman

Sustainability and the Finance Sector reach in tracking and valuing finan- Given the widespread impact of the cial products if the financial sector is recent global financial crisis, increas- to play a critical role as a catalyst and ingly, the finance sector is now in line integrator in moving other global fi- to be affected by factors of sustain- nancial reporting initiatives forward. ability, as well as intensifying social and environmental risks and impacts. A changing agenda for financial As a direct consequence, more atten- institutions tion must be paid by financial institu- We now understand the intellectual tions to sustainability programs that argument that natural capital (land, are shaped and driven by factors such air, water, and living organisms in as corporate strategies, policies, goals particular) provides significant value and initiatives. In turn, these are to society and the economy. But, it is based on drivers of economic, social not recognised or accounted for ac- and environmental risk, as well as, cordingly. What does this mean for in addition to reputation, financial the finance sector? Let‘s explore the return and natural resources. Sustain- type of risks that financial institutions ability programs ensure that, amid should begin to think about when it environmental, social and economic comes to natural capital; these are: uncertainty, an organization is able to adapt and, thereby, remain viable Credit risks: The default of invest- for the long-term interest of its own- ments can be caused by risks as- ers. sociated with natural capital, and this can also prompt inaccurate Financial reporting systems will play information affecting counterparts. a major part in watching the sector‘s Collateral risk is central to this, as progress towards sustainable policy banks don’t have the means of adoption. This will include IT sys- recognising the loss of natural capi- tem integrations, making financial tal and what this means in relation flows more transparent and increas- to their investments. ing pressure for implementing a less speculative global currency model. Operational risks: These are most Appropriate accounting and report- serious when it comes to an ac- ing systems are needed urgently. Ad- celeration of natural disasters or ditionally, these must have a global the effects of ecological degrada-

| 67 Accounting

tion on business outputs, such as and the valuation mechanisms that agriculture. Losses are a probable are already implemented. outcome. Key innovation trends in the sector Reputation risks: being associated Investors can play a forward-thinking with financing an entity that is in- role in treating natural capital issues volved in major ecological liabilities as drivers of shareholder value. bears increased risk. Once a finan- There are several areas where some cial institution loses its reputation innovation is taking place and where in this manner, it is very difficult to effort is needed by the industry to ac- build that back up. celerate necessary change.

These risks, and others, are recog- Benchmarking nised inherently by the 2010 UN- The Natural Value Initiative (see sponsored study on “The Economics www.naturalvalueinitiative.org) is a of Ecosystems and Biodiversity” (also leading example of benchmarking referred to as the TEEB initiative - and has found that only one out of 31 see www.teebweb.org), Even so, the companies analyzed in the food, bev- finance sector must pioneer funda- erage and tobacco sectors were par- mental changes in how it estimates ticularly mature in their approach to and analyzes risks. It is more than natural capital. Benchmarking com- likely that some within the finance panies in the responsible investment sector will be hit harder than others. research industry are developing fast. The insurance sector represents a par- But, these entities are trying to cover ticular case in point where exposure a large amount of companies by way to natural capital risk is more proof predominantly public information nounced, especially due to accelerat- that is available. It is noteworthy that ing climate and environmental risks. a study released by the UN-backed Principles for Responsible Investment It must be said that the lack of agree- (PRI) and the UN Environment Pro- ment on valuation mechanisms and gramme Finance Initiative (UNEP FI) metrics are a barrier. Yet, banks to- estimated that global environmental day use a wide range of instruments. damage was caused by human activ- These must be brought together in a ity in 2008 represented a monetary systematic way, such as in a financial value of $6.6 trillion, with this be- sector tool kit that addresses natu- ing equivalent to 11% of global GDP. ral capital. This would also identify Major financial companies, such as good examples of the financial in- Bloomberg, Thomson Reuters Asset4, struments, the institutional processes, Risk Analytics, are now getting into

68 | this space. Even so, attention also perspective, as well as hard business needs to be given to what is being case numbers to the story, and to benchmarked as different companies any associated campaigning. It stands are good at varying elements. Many to reason that an individual event, smaller entities, such as AccountAbil- such as the BP oil spill in the Gulf of ity (see www.accountability.org) and Mexico, can have a significant impact Gaia-Metrics (see www.gaia-metrics. upon single investments and related com) are helping clients to bench- industries. mark information or provide standards and tools. In turn, this leads to Knowledge barriers better reports. There is a need to accelerate transla- tion of the biodiversity and natural Valuation and Risk capital issue into business language Banks, the investment sector and in- and associated cultures. A key consid- surance companies have developed eration here is that the older gen- excellent risk and valuation models. eration of financiers today does not The various environmental risk fac- fully understand, or relate to, the tors must be embedded into the gen- language of ecologists, climatologists eral risk policies, with this needing to and earth scientists. In some areas of be beyond what, so far, is kept with- the finance sector, the type of scien- in the boundaries of project finance tific data that is developed by assort- (for example, Equator Principles). ed earth scientists can cause financial Frankly, there is still too much focus analysts to feel discomfort, confusion on externalities. Consequently, valu- and apathy. In relation to this issue, ations must be more object, entity North American Electric Reliability and business model-centered. Corporation (see www.nerc.com) is looking at collaboration between the Awareness academic sector and finance sector Reputation is still the leading driver on biodiversity information. There of change in the finance sector. Ex- is also an urgent need to bridge the amples of ecosystem failures as driv- worlds of science-based policy on ers of change are rare. Civil society ecological infrastructures (for in- and NGOs are playing an important stance, what is the optimum level of role in highlighting the issue. But ecological balance?) and financial in- their strategies could also be more vestment (for instance, how does this effective at targeting the right stories ecological equilibrium translate onto related to risk and opportunity for economic and financial values?). the finance sector. It is vital, therefore, to bring an operational risk

| 69 Accounting

Accounting & Reporting and fragmented income tax laws in Financial reporting is reliant on un- most countries. One other standard derpinning standards and there is that could benefit considerably from also a need for standardization in the modernization of standards is the how natural capital accounts are UN System of National Accounts (UN- measured and integrated into finan- SNA or SNA) that, currently, focuses cial statements. NGOs and investors too much on boundary definitions have different ways of doing this, instead of object tracking and valu- thereby making it difficult to know if ations. we are comparing like with like. As a positive sign of possible prog- Several models, such as that of the ress, the need to have more global Global Reporting Initiative (GRI), are overarching standards is already now proposing solutions to the dis- identified with the emergence of the closure and reporting of natural capi- International Integrated Reporting tal accounts (see www.gri.org), with Committee initiative (see www.inte- this based on sustainability. However, gratedreporting.org). these efforts need to engage more thoroughly with accounting bodies Financial institutions, in particular and financial regulators in order to global banks, with their worldwide experiment with enhancing the regu- operations and huge capital as- lations and standards. One huge issue set base, could serve as a driver and here is that the public sector (which catalyst to utilize emerging reporting has most nature assets under man- systems such as the GRI. By so doing, agement) doesn’t report consistent- the banks would serve as a leading ly. Also, while International Public example in terms of better integrat- Sector Accounting Standards (IPSAS) ed reporting and a new way forward are starting to appear in public sec- in relation to financial reporting. tor reporting (see www.ifac.org), it In effect, financial institutions are is a very slow process of adoption. trailblazers in utilizing the fair value Note that IPSAS are based on glob- model and, with it, these entities can ally accepted International Financial lead worldwide accounting conver- Reporting Standards (IFRS) and there gence. Certainly, the debate around is no real reason why the necessary fair value accounting has highlighted implementation of appropriate stan- the need for global harmonisation of dards cannot be accelerated. Fur- asset and liability valuations. How- thermore, adoption of IPSAS would ever, banks are weak in object track- have an enormous and positive effect ing, as is evidenced by recent mort- on modernizing totally outdated, gage failures where it was difficult

70 | Table 1: Largest Banks by Asset Size, 2009

Rank Bank Country Total Assets ($B) Date 1 BNP Paribus France 2,964 12/31/09 2 Royal Bank of Scotland UK 2,747 12/31/09 3 HSBC Holdings UK 2,364 12/31/09 4 Credit Agricole France 2,243 12/31/09 5 Barclays UK 2,233 12/31/09 6 Bank of America United States 2,233 12/31/09 7 Mitsubishi UFJ Financial Japan 2,196 3/31/10 8 Deutsche Bank Germany 2,162 12/31/09 9 JP Morgan Chase United States 2,032 12/31/09 10 Citigroup United States 1,857 12/31/09 Source: Global Finance Magazine 2010 for banks to trace obligations back IT Infrastructure to the original owners through the Financial institutions are proven lead- intervening multiple layers of securi- ers in developing global risk models, tization. but demonstrate less success in using global IT platforms similar to what In this regard, consider Table 1 in ERP system packages have done for which the massive asset holdings of the industrial sector. global banks are shown. Of particular interest is the asset level of While this is cause for concern, and Deutsche Bank, which has fallen for necessary change, there is increas- by nearly a trillion US Dollars from ing pressure for worldwide system $3.1 trillion in 2008, to $2.2 trillion improvements (for example, see the in 2009. Remarkably, there is no daily news on system changes and reasonable explanation provided improvements on www.finextra.com in the annual report or other pro- and the just-published Senior Super- nouncements for such a significant visors Group Issues Report on Risk reduction. This is indicative of weak Appetite Frameworks and IT Infra- accounting regulations in that a size- structure, (see www.sec.gov/news/di- able bank can avoid any justification gest/2010/dig122310.htm). Global IT for a more than obvious drop in its structures will lead to essential con- assets. solidation in the finance sector and

| 71 Accounting

new business models will emerge as • Better GRI and sustainability, as a direct consequence. Hopefully, this well as product and infrastructure will result in less speculation (particu- reporting, by BDF (Object tracking); larly in relation to currencies) and • More sophisticated reporting on enhance trust in reported numbers financial instruments and currency generated by the sector. reporting by DB (Value reporting); • Weak metrics on people and intan- In addition, financial institutions can gible reporting by both companies learn from industrial applications of (Object reporting). object tracking and support the development and improvements in valuation standards. For instance, there Separating Unit and Value Flow in are ones promoted by the Interna- the Supply Chain tional Valuation Standards Council The mixed attribute model, which (see www.ivsc.org). The separation of pulls together historical and fair objects and valuation could, in effect, values in the same financial state- be a new way forward in financial ment, (see the United States Securi- reporting. ties Exchange Commission report to Congress, www.sec.gov/news/stud- Financial Reporting ies/2008/marktomarket123008.pdf, Regarding the separation of object on page A-7), is one of the culprits in tracking and valuation, it is worth- making financial reporting difficult while to compare the financial state- to understand. Separating unit flow ments of an industrial/consumer and value flow would be one way goods company, such as BDF Nivea forward in order to bridge business (BDF), and a financial institution, reporting and reporting on nature. such as Deutsche Bank (DB) in respect On a micro-level, there is much more to their reporting on people, prod- unit data available regarding ecosys- ucts, infrastructure, financial assets tems and biodiversity than there is and intangibles. It is noteworthy that value data. In business, particularly both are IFRS-reporting companies. in the finance world, it is the other way around as there is greater focus Besides the relative size and volume on value flow in order to capture risk of their presentations (2009 Annu- and uncertainty. In this regard, con- al Report: DB: 434 pages; BDF: 134 sider huge general reserves and rein- pages) a comparison indicates that surance of insurance companies. the major differences in their reporting are:

72 | ‘Einstein‘s Formula’ for Financial With modern technology, such as Reporting geo-tagging and photo-mechani- It is worth contemplating, at this cal object recognition we are now point of the discussion, that elec- able to track and find any number of tronic transfer and tracking systems objects in the business supply chain. (especially XBRL in combination with Thereby, relativity becomes appar- RFID, GPS and other useful applica- ent when any objects are identified tions) create a global, intelligent, and monitored. Particularly, all iden- chart of accounts that can help to tifiable objects can be aligned, and make information, whether business- valued, in order to support improved related or otherwise, more useful for decision making. Whether objects are stakeholder purposes (see Figure 1). apples, customers, capital items, stock holdings or deliveries, all of these

Figure 1: Modern Technology Enables Improved Decision Making

“Einstein’s Formula" of Financial Reporting for objects, entities - in various business models

OBJECTS X VALUE @ Location @ Time fixed (unmovable) – variable

GPS – Dimension Point in time or geo- and picture tagging Duration Quantity X Level: historic fair value cash Financial Reporting Goes Global IFRS

| 73 Accounting

can be monitored and managed with particular point in time and when re- considerable ease. quired, the objects can be multiplied with the appropriate value files so as Even so, there is a need for business to avoid mixing apples and orang- entities to obey a couple of rules to es, as occurs in the mixed attribute set the boundaries. For instance, ev- model. ery entity must make an individual decision on how to define objects The above-mentioned segregation within their entity. Thus, objects en- lends itself well to the alignment tering and leaving the entity could of biodiversity and ecosystem data have different object definitions. with financial and business informa- Some industries already have defined tion. Dependencies and any impact object definitions for their entire sup- on business, such as from the use of ply chain (for example, RosettaNet). subsoil assets, as well as the pollu- Outsourcing and cloud-computing tion of water, air and earth, could be are other ways to coordinate object better explained. Instead of the cur- definitions within industries. Unmov- rent silo approach, business report- able (fixed) objects can employ dif- ing and reporting on biodiversity ferent tracking devices than movable and ecosystems could be integrated. (variable) objects. Sustainability reporting, currently, is still something of a stepchild to other In addition, objects can be broken reporting needs as it lacks timeliness, down into the following business/fi- seriousness and enforcement. nancial reporting areas: • People (number of people x rates, Aligning Financial / Business benefits, etc.) Reporting and Sustainability • Tangible assets and infrastructure Reporting through Disclosure (number of cash-generating units x Most often materials, resources and fair value, value in use) other valuable information is spread • Products and Services (Stock-keep- widely within an organisation, as ing units x price) well as externally. Once all of this • Financial assets and liabilities (con- is organized into meaningful seg- tracts, currency units x fair value) ments (such as the aforesaid objects • Intangibles and Communication and sub-objects) the associated unit (identifiable units x fair value) and value flow can be analysed. Pieces of information (now referred These objects can be aligned to valu- to as objects) that might be diffi- ation files (such as fair values, histori- cult to explain could, at a minimum, cal costs and cash flow points). At a be aligned to a particular sector (for

74 | example, social networks and their As the heading in this figure sug- influence in the people section of any gests, this application involves a hu- so-called financial report). Then, an man interface in ranking and flag- indicative value can be given as an ging the results of any search. The attribute in the form of a reporting left side of the screen shows a tree- disclosure. view of the hierarchy for basic navigation. Modern content analysis tools, such as Gaia Metrics SDR Data Prep, can In the main part of the screen, the help us to find, sort, and adjust infor- top table shows a list of hits of any mation in internal company docu- search, such as documents that con- ments as well external publications, tain the concept in the search pa- and align them (in terms of who, rameters related to the selected tree where, and when) in accordance with to the left. The second (and middle) a meaningful taxonomy or reporting table shows the details of where, and system. An example of this systematic how many times the given concept and effective approach is provided in occurs in the hit document. This is figure 2. also known as a span. Finally, the

Figure 2: ContentContent Analysis with�Analysis Human Filtering�with Human�Filtering

| 75 Accounting

lower area shows details about the 2. The TEEB for Local and Regional selected span as is summarized in the Policy Makers was released on Sep- middle table. This is where a human tember 9 2010; filter can score the span, and also add 3. The TEEB for Business Report was a description for why they scored it released on July 13 2010; the way they did. That adds to the 4. The TEEB for Policy Makers Re- effectiveness of subsequent search- port was released on November 13, es, increasingly so over time and 2009. through additional interrogations of Senior Supervisors Group Issues Re- all objects and related information. port on Risk Appetite Frameworks and IT Infrastructure, December Call for Action – the way forward 23, 2010, www.sec.gov/news/di- Financial institutions are going gest/2010/dig122310.htm through major changes in relation to determining the current usefulness Websites and future form of their business www.iasplus.com models. In the process, these signifi- www.ifrs.org cant and influential entities must pay www.xbrl.org more attention to sustainability re- www.iucn.org porting. Consider that nature, with www.ivsc.org its plentiful amounts of metrics, and www.finextra.com financial institutions, with their ex- www.accountability.org tensive knowledge as to risks assess- www.integratedreporting.org ment and valuations, can become a www.nerc.com powerful combination, as well as a www.naturalvalueinitiative.org catalysing factor in improving finan- www.gaia-metrics.com cial reporting. www.sec.gov/news/studies/2008/ marktomarket123008.pdf References The Economics of Ecosystems and Biodiversity study (TEEB) study, (see www.teebweb.org): 1. The TEEB Synthesis Report Main- streaming the Economics of Nature: A synthesis of the approach, conclusions and recommendations of TEEB was released on October 20, 2010;

76 | 2.3. Integrated Reporting – A Means for Corporations to Become Socially Responsible and Accountable by Liv Apneseth Watson

The BP oil spill that leaked more than tegrated representation of a compa- 19 million barrels of oil into the Gulf ny’s performance in terms of both fi- of Mexico made it readily apparent nancial and non-financial results, and that our existing system for corpo- many smart companies are providing rate reporting has failed sharehold- integrated reports as a means to seek ers and stakeholders alike in evaluat- new business opportunities, safe- ing a company’s risk. The traditional guard reputation, maximize competi- reporting of companies consisted tive advantage and mitigate opera- primarily of balance sheets, income tions risk. statements and the accompanying directors‘ report that together outlines whether a company‘s performance is not measuring up. Some go as far as “To make our economy sustain- to say that the over-consumption of able we have to relearn everything finite natural resources, coupled with we have learnt from the past. That the very real risk of catastrophic cor- means making more from less and porate accidents and climate change, ensuring that governance, strategy is the greatest challenge facing our and sustainability are inseparable. world. Integrated Reporting builds on the practice of Financial Report- Since BP crisis companies find them- ing, and Environmental, Social and selves in the midst of a rapid global Governance (ESG)- or Corporate transformation with increased de- Social Responsible (CRS)- Report- mand to perform, not only finan- ing, and equips companies to stra- cially, but also as a good corporate tegically manage their operations, citizen that reports its results to brand and reputation to stake- stakeholders. The notion of com- holders and be better prepared to panies looking beyond profits to manage any risk that may compro- their role in society and reporting it mise the long-term sustainability to stakeholders is generally termed of the business.“ Corporate Social Responsibility (CSR) reporting. Weaving these reports Professor Mervyn King, Chairman together into one report is referred of the Global Reporting Initiative, to as integrated reporting. That is, (GRI) integrated reporting refers to the in-

| 77 Accounting

According to Klaus Schwab, the Ex- Some of these organizations are: ecutive Chair of the World Economic • Principles for Responsible Invest- Forum Global, corporate global citi- ment (PRI) represents signatories zenship means that companies must to the United Nations’ Principles not only be engaged with stakehold- for Responsible Investment (PRI). ers but be stakeholders themselves Launched in 2005, the PRI today alongside governments and civil accounts for more than 560 global society. His reasoning is that compa- investment institutions with more nies depend on global development, than $18 trillion in assets un- which in turn relies on stability and der management. PRI signatories increased prosperity so it should be in pledge to integrate consideration their direct interest to help improve of CSR issues into investment deci- the state of the world. This think- sions and ownership practices. They ing among global leaders today is recognize that social and environ- increasingly driving companies to mental issues can be material to produce, mostly on an annual volun- the financial outlook of a company tary basis, corporate social responsi- and, therefore, to shareholder val- bility reports. Over the last few years ue. a selected number of companies have started integrating CSR reporting • Ceres, and advocacy non-govern- into their annual reports. Integrated mental organization (NGOs) is on reporting is part of the shift in busi- the green bandwagon and works ness responsibility towards becoming with investors worldwide to im- corporate global citizens. Integrated prove corporate and public policies reporting therefore provides greater on climate change and other en- context for performance data, clari- vironmental, social, and corporate fies how sustainability fits into the governance issues. As part of this company’s DNA, and helps embed mission, Ceres launched and coor- sustainability into company decision dinates the Investor Network on making. Climate Risk (INCR), an alliance of more than 90 institutional investors There is increasing demand from and financial firms that collectively international investors, accounting manage nearly $10 trillion in assets bodies, governments and other stake- to influence companies to report holders for integrated reporting. The CSR reports. best illustration of this trend is the growing number of organizations • AccountAbility is an organization and public and private initiatives that that has developed the AA1000 make CSR reporting their business. series of standards that are prin-

78 | ciples based to help organizations • Corporate Responsibility Index become more accountable, respon- (CRI): These are being developed in sible and sustainable. They address many parts of the world by stock issues affecting governance, busi- exchanges, NGOs, and the pub- ness models and organizational lic and private sector; all with the strategy, as well as providing op- vision of improving corporate re- erational guidance on sustainability sponsibility by providing a system- assurance and stakeholder engage- atic process that assists companies ment. The AA1000 standards are in identifying their non-financial designed for the amalgamated risks. The Dow Jones Sustainabil- thinking required by the low car- ity INdex and the FTSE4 Good are bon and green economy, and they used largely as socially responsible support integrated reporting and investment indices. assurance. • The WICI, The World’s Business • The Global Reporting Initiative Reporting Network (www.wici- (GRI) provides a framework for global.com) is a private/public sec- companies and organizations on tor partnership for improving the sustainability disclosure. Its vision is reporting of intellectual assets and that disclosure on economic, envi- key performance indicators that ronmental and social performance are of interest to shareholders and become as commonplace and com- other stakeholders. On October 16, parable as financial reporting and 2008 WICI released its first version as important to organizational suc- of a comprehensive information cess. The GRI Consortium is a net- framework and XBRL taxonomy to work-based organization that has help companies better communi- pioneered the development of the cate with their investors and other world’s most widely used sustain- stakeholders about business strat- ability reporting framework and egy and performance. is committed to its continuous improvement and application. More • The Prince’s Accounting for Sus- than 1,000 organizations glob- tainability Project (A4S): His Royal ally declare that they use the GRI Highness the Prince of Wales him- Guidelines for their sustainability self leads this important project. reporting, including 3M, Cisco Sys- Accounting for Sustainability is a tems, Citigroup, Dell, Eli Lilly, Intel, project that brings organizations General Electric, Procter & Gamble, and other key stakeholders togeth- Walmart and United Technologies. er for the purpose of developing practical tools that enable environ-

| 79 Accounting

mental and social performance to around the organization’s strate- be better connected with strategy gic objectives, its governance and and financial performance and, business model and that integrates thereby, embedded into day-to-day both material financial and non-fi- operations and decision making. nancial information.

The objectives for an integrated re- “The case for globally consistent porting framework are to: financial reporting standards is • support the information needs well understood and accepted. It of long-term investors by show- is appropriate to apply the same ing the broader and longer-term global approach to other aspects consequences of decision mak- of corporate reporting. This initia- ing; tive represents an important step • reflect the interconnections be- on that journey.“ tween environmental, social, governance and financial factors Sir David Tweedie, Chairman of in decisions that affect long-term the International Accounting Stan- performance and conditions, dards Board making clear the link between sustainability and economic value; • International Integrated Report- • provide the necessary framework ing Committee (IIRC): On August 2, for environmental and social fac- 2010, The Prince’s Accounting for tors to be taken into account sys- Sustainability Project and the Glob- tematically in reporting and deci- al Reporting Initiative announced sion making; the formation of the International • rebalance performance metrics Integrated Reporting Committee. away from an undue emphasis The committee‘s bold vision is to on short-term financial perfor- bring forward a global comparable mance; and framework for CSR reporting. They • bring reporting closer to the in- plan to present this global initiative formation used by management to the G-20 Meeting in Paris in 2011. to run the business on a day-today basis. (Source: International The IIRC has been created to re- Integrated Reporting Committee spond to the need for a concise, (IIRC)). clear, comprehensive and comparable integrated global report- All these organizations collectively ing framework that is structured have a huge influence on corporate

80 | ing so. Market evidence already exists “I believe we will look back on the that indicates the value investors, creation of this Committee as a analysts and other stakeholders place turning point in the development on important non-ﬁnancial informa- of corporate reporting.” tion (e.g., Environmental, Social and Governance or ESG data) that gives Jane Diplock, Chairman of the a more comprehensive view of an New Zealand Securities Commis- organization’s performance. Recent- sion and Executive Committee of ly, over 250 of the world’s largest the International Organization of institutional investors, representing Securities Commissions (IOSCO) over $15 trillion in combined assets under management, demonstrated their commitment through the UNPRI behavior and policy makers. From to invest in companies that follow Southwest Airlines to United Tech- good sustainability and ESG practic- nologies to Walmart companies of all es. As we can see, there are poten- types and sizes are voluntarily com- tially several reasons for companies municating integrated information to go green and produce integrated to stakeholders about their business‘s reports with the ultimate goal of impact on the environment. Stock becoming socially responsible and ac- exchanges are starting to incorporate countable to all stakeholders. mandatory CSR disclosure standards the same way that ﬁnancial reporting is a requirement for all companies. The 2010 UN Sustainable Stock Exchanges event in China focused on how stock exchanges and key stakeholders can improve CSR disclosure and performance of listed companies, either through voluntary exchange- led initiatives or regulation. The conclusion of the meeting was that there is a strong business case for stock exchanges to strengthen CSR disclosure requirements. Starting on June 1, 2010, all 450 companies listed on the Johannesburg Stock Exchange will be required to publish an integrated report or explain why they are not do-

| 81 Accounting

2.4. The Case for Integrated Reporting by Michael P. Krzus

Background risks is often boilerplate. There is not Reporting matters. When done right, enough robust disclosure of financial reporting gives stakeholders a win- and nonfinancial key performance dow through which to view the heart indicators and contextual narrative and soul of a company. Reporting around environmental, social and provides insight into how a company governance issues. views itself and its role in society. It communicates a company’s perfor- The encouraging news is that a na- mance, both good and bad. It cre- scent trend, but a trend nonetheless, ates commitments to improve in the towards better reporting is coming future, both through specific targets to light. Companies in diverse sectors and in response to the feedback a and based in different parts of the company gets from all of its stake- world are starting to adopt integrat- holders based on the information it ed reporting. Novo Nordisk In Den- makes available to them. mark, Altron in South Africa, Natura in Brazil, American Electric Power in The business reporting model, as we the US, Takeda Pharmaceutical in Ja- know it today, is fraught with short- pan, and Philips in The Netherlands, comings. The model is rooted in the to name only a few companies, have Great Depression, a time when hard published integrated financial and assets such as factories, equipment sustainability reports. These compa- and land created value. Today, value nies know integrated reporting is and risk arise from, among other the best way to communicate with things, innovation, people, custom- stakeholders on how well they are er loyalty, leadership, technological executing strategies that integrate change, supply chains and business sustainability into the company’s core partners, and finite natural resourc- operations and processes. es. There are too many companies that view reporting as a compliance The case for integrated reporting exercise, rather than a stakeholder Why are companies voluntarily communications and engagement preparing integrated reports even tool. Companies frequently fail to though the process requires substan- provide enough of the information tial work and collaboration amongst used for decision-making. Discussion groups that often operate in silos? of strategy, plans, opportunities, and Perhaps it is enlightened self-interest

82 | or even the foresight to anticipate the long term as society’s values market forces or regulatory actions. change.

In One Report: Integrated Reporting In addition, Robert Eccles and Kyle for a Sustainable Strategy,1 Robert Armbrester make a persuasive case G. Eccles and I asserted, “Practic- for what drives companies to adopt ing integrated reporting brings four integrated reporting in a forthcom- major benefits to the company. First, ing paper, Integrated Reporting in it provides greater clarity about rela- the Cloud.2 Eccles and Armbrester tionships and commitments. Second, not only cite three primary benefits it leads to better decisions. Third, it of integrated reporting, internal ben- deepens engagement with all stake- efits, external market benefits, and holders. Fourth, it lowers reputation- managing regulatory risk, but also al risk.” Each of these benefits can be provide a detailed drill-down into summarized as follows: each of these points. This soon to be released paper also looks beyond • There will be greater clarity about glossy paper reports and talks about the trade-offs that must be made how cloud computing can enable the as an entity seeks to balance the adoption of integrated reporting. need for long-term viability―of both the business itself and the The emerging integrated reporting world it relies on to create value― movement with the demands for short-term A growing number of progressive competitiveness and profitability. companies have seized the initiative • Deeper understanding of the re- to adopt integrated reporting, and lationships between financial and they are to be commended for their nonfinancial performance will drive efforts. However, absent a broader better informed decisions and lead and organized movement, the adop- to more efficient and effective use tion of integrated reporting will be of capital and other resources. slow. • Deeper engagement by an entity with a wider range of stakeholders In August 2010, The Prince’s Account- will promote a better understanding for Sustainability Project (www. ing within a company and across accountingforsustainability.org) stakeholder groups about how and the Global Reporting Initiative their interests are related. (www.globalreporting.org) jointly • Improved risk management pro- announced the formation of the cesses will increase the likelihood International Integrated Reporting that the company is viable over Committee, or IIRC (www.integrat-

| 83 Accounting

An idea whose time has come International Companies Subscribing to Integrated Reporting

CHILE

© 2010, Robert G. Eccles and Michael P. Krzus 1 edreporting.org). The role of the IIRC between standard-setters and con- is to: vergence in the standards needed to underpin integrated reporting. 1. Raise awareness of this issue and 5. Promote the adoption of integrat- develop a consensus among gov- ed reporting by relevant regulators ernments, listing authorities, busi- and report preparers. nesses, investors, accounting bodies, and standard setters for the The IIRC is preparing a discussion best way to address it. paper for release in June 2011. The 2. Develop an overarching integrated results of the consultation will be reporting framework setting out used to develop integrated report- the scope of integrated reporting ing proposals for presentation at the and its key components. November 2011 meeting of the G20 3. Identify priority areas where addi- in Paris. tional work is needed and provide a plan for development. On a parallel track and coordinated 4. Consider whether standards in this with the work of the IIRC, the Global area should be voluntary or man- Reporting Initiative (GRI) (www.glo- datory and facilitate collaboration balreporting.org) Board of Directors

84 | in October 2010 approved a project bodies, companies, analysts, inves- for the fourth generation of the GRI tors, and accountants as is being Guidelines (G4) for delivery by the done by the IRC in South Africa. The end of 2012. One key objective for G4 stock exchange can also play the is to provide a foundation for compa- role of aggregator of these reports nies preparing an integrated report and organize working groups to based on the framework being devel- study themes in order to generate oped by the IIRC. insights for the IIRC that will be useful in developing a single global in- Another potentially powerful initia- tegrated reporting framework.” tive is being driven by the UN Prin- ciples for Responsible Investment (UN At the Sustainable Stock Exchang- PRI) (www.unpri.org). One contrib- es (SSE) Global Dialogue in Xiamen uting catalyst for this initiative may in September 2010, Aviva Investors be the June 2010 paper, Integrated announced that the top 30 stock reports voluntary filing, (http://www. exchanges will be receiving a letter world-exchanges.org/news-views/ from investors that are signatories views/integrated-reports-voluntary- to the UN PRI applauding them for filing) by Robert Eccles and Mervyn their sustainability efforts and invit- King.3 Eccles and King believe: ing them to consider other ways of encouraging listed companies to re- “The role that stock exchanges port on ESG (environmental, social, can play will vary according to the and corporate governance) issues, laws of the country in which they including corporate integration of are based, but in all cases they can material sustainability information make an enormous contribution in within financial reports, in other accelerating the rapid and broad words, integrated reporting. The adoption of integrated reporting UN PRI and others are meeting with by all entities to ensure a sustain- stock exchanges around the world to able society. In some cases, the stock discuss how exchanges could encour- exchange will have the authority age listed companies to adopt inte- itself to design and implement such grated reporting and the ways the a program. In other cases, the ex- business community can help stock change can encourage the appropri- exchanges do this. In addition, the ate regulatory body in its country, UN PRI recently met with investors such as the securities regulator, to in London to discuss how investors do so. In all cases, a voluntary filing could encourage companies to adopt program will require the collabora- integrated reporting. tion of stock exchanges, regulatory

| 85 Accounting

The future of integrated reporting Integrated reporting is a collective History was made on October 14-15, action problem, which simply means 2010 when a diverse group represent- everyone with an interest in the qual- ing analysts and investors; compa- ity of corporate reporting has a re- nies; technology and data vendors; sponsibility to act. My thoughts on a accounting bodies; regulators and single action that analysts and inves- standard setters; NGOs; and civil soci- tors; companies; regulators and stan- ety from around the world gathered dard setters; technology and data at the Harvard Business School’s 2010 vendors; and stakeholders can take Workshop on Integrated Reporting. to bring us closer to making those vi- sions for the future a reality follow. The workshop participants discussed the concept of integrated reporting, These ideas were originally published the role of reporting as a contribut- in The Landscape of Integrated Re- ing factor to the creation of a more porting: Reﬂections and Next Steps sustainable society, and the actions and are reprinted with the permis- necessary to ensure the rapid and sion of The President and Fellows of widespread adoption of integrated Harvard College, Cambridge, Massa- reporting. chusetts.

The thinking of the participants • Analysts and investors who believe has been captured in a free ebook, that integrated financial and non- The Landscape of Integrated Re- financial information – whether porting: Reflections and Next Steps about strategy, plans, opportuni- (http://www.smashwords.com/books/ ties, and risks or environmental, view/30930). This collection of articles social and corporate governance submitted by 64 workshop partici- issues – is critical to their decision- pants includes the thought-provok- making should tell regulators that ing opening remarks of Harvard Busi- integrated reporting is good for ness School dean, Nitin Nohria. This investors and markets. Analysts and ebook is to help broaden the aware- investors must directly engage in ness of integrated reporting, to help a conversation with regulators. It give it greater definition and clarity, is not enough to sign a letter or a and to help spread its rapid adoption petition proclaiming that the signa- around the world. Topics include the tories represent X trillion dollars or vision for integrated reporting; the Euros under management; institu- role technology could play; and the tional investors and pension funds, myriad challenges to the broad adop- not just their membership organi- tion of integrated reporting. zations, need to look regulators in

86 | the eye and explain why integrated assurance standards means that reporting matters. it is premature to call for regula- • The CEOs of the 40 or 50 compa- tion today. Integrated reporting nies voluntarily issuing integrated “laboratories” similar to the U.S. reports should be much more vo- Securities and Exchange Commis- cal about why their companies sion XBRL Voluntary Filing Program have chosen to issue “one report.” should be established by, for exam- There is no stronger, more force- ple, members of the International ful advocate for integrated report- Organization of Securities Commis- ing than the CEO of a company sions. In a voluntary filing program, actually doing it. CEOs should tell companies could furnish integrat- their employees, shareholders, cused reports and provide what they tomers, suppliers, regulators, and consider to be critical measures of others about how the process of financial and nonfinancial perfor- implementing integrated reporting mance and explain how they are has led to: (1) greater clarity about related. Investors, NGOs, and oth- the relationship between financial ers could comment on these vol- and nonfinancial performance and untary filings, thereby helping the the trade-offs that must be made reporting companies to improve when balancing financial and soci- their communications. This Wikipe- etal demands; (2) better informed dia-like approach could also result decisions, which have improved the in a more enlightened and partici- allocation of resources; (3) deeper patory approach to regulation and engagement with all stakehold- standards setting. ers resulting in a business strat- • XBRL, which was highly touted in egy more attuned to society’s ever the vision statement created by changing needs; and, (4) two-way this group at the HBS workshop, conversations that have helped to will not become a widely adopted lower reputational risk, thereby reality unless technology and data increasing the likelihood of long- vendors are willing to commit their term corporate viability. financial and human resources to • Regulators should create an envi- building taxonomies for the public ronment that encourages innova- good. Today’s financial reporting tive companies to experiment with when coupled with the potential integrated reporting. Even though volume of relevant nonfinancial in- I firmly believe in the eventual formation threatens to overwhelm need for mandates around inte- the most sophisticated of analysts grated reporting, the inchoate and investors. The promulgation of state of reporting frameworks and standards from the U.S. FASB, IASB,

| 87 Accounting

IOSCO members, European Com- 1 Eccles, Robert G., and Michael P. Krzus. mission, Global Reporting Initiative, One Report: Integrated Reporting for or the International Integrated Re- a Sustainable Strategy. New York: John porting Committee must be accom- Wiley & Sons, Inc., 2010. panied by a robust XBRL taxonomy. 2 Eccles, Robert G. and Kyle Armbrester, I don’t see this happening without “Integrated Reporting in the Cloud,” private commitments to build pub- (working title). Forthcoming in IESE In- lic taxonomies. sight Review, First Quarter 2011, Issue 8. • Stakeholders, as it was said at the Barcelona: IESE Business School. http:// HBS workshop, must continue to www.ieseinsight.com/review/. ask tough questions. However, 3 Eccles, Robert G. and Mervyn King, “In- stakeholders need to understand tegrated reports voluntary filing.” Focus that hard questions rarely result in (World Federation of Exchanges), June simple black-and-white answers. 2010. Management will be making difficult choices that will result in one stakeholder group or another being disappointed, angry, or both. All stakeholders need to understand that an obvious and over- whelming “victory” by any single constituency is in fact a Pyrrhic victory. The value of “tough questions” is not necessarily reflected in the ultimate answer, but rather in the resulting understanding of how to balance the demands of the capital markets and the demands of the society on which business entities rely to create value.

Integrated reporting is a necessary step towards the long-term viability of―a business, the economy, our society, and the planet Earth. The stakes are high, so we have got to do this right!

88 | 3. Governance: The Rules for Regaining Trust

3.1. Trust, where Trust is Due by Christian Dreyer CFA When my love swears that she is made of truth, I do believe her though I know she lies, That she might think me some untutored youth, Unlearned in the world‘s false subtleties. Thus vainly thinking that she thinks me young, Although she knows my days are past the best, Simply I credit her false-speaking tongue: On both sides thus is simple truth suppressed: But wherefore says she not she is unjust? And wherefore say not I that I am old? O! love‘s best habit is in seeming trust, And age in love, loves not to have years told: Therefore I lie with her, and she with me, And in our faults by lies we ﬂattered be.

Shakespeare, Sonnet 138

The crisis mantra has been – and con- What can I know? tinues to be – of restoring trust, of The ﬁrst question at the core of Ger- rekindling those animal spirits that man philosopher Immanuel Kant’s are at the heart of the aggregate of Critique of Pure Reason helps us to human behaviour that is the econ- understand why trust is deemed im- omy. But perhaps the boom that we portant for economic cycles, but it are now yearning to return back to also leads us to question the validity by brute policy force already car- of trust as a driver for action. ried the seed of self-destruction? A long-term investor, we are acutely Ever since Roosevelt’s ominous 1933 aware of the wild gyrations of mood nothing to fear but fear itself, the swings, yet we advocate the policy loss of trust is considered to be at the makers keep their cool and stay away heart of economic crises. Yet, like from trying, and inevitably failing, to pregnancy, trust is a binary variable micro-manage actors, whereas eco- only in individuals. In the market- nomic actors should regain modesty place, it lies at one end of a measur- in the face of uncertainty. Capitalism able continuum of outcomes of the is resilient, States are not. cognitive process. What is, then, the opposite of trust?

| 89 Governance

Analysis Confidence Knowledge Faith Perception Skepticism Trust Questions Answers

In the real world of limited resources, ers were able to draw cash from their limited knowledge and fundamental real estate by increasing the mort- uncertainty about the future, making gage to the higher value of their decisions based on trust is inevitable. homes, hence the notion of the ATM In economic terms, relying on trust at home. They trusted that rising reduces transaction cost in an econo- prices would invariably help them my and thus encourages activity. But build their home equity, given a year what activity? or two.

Indeed, the buildup to the finan- Next in line for leverage were banks. cial crisis may be read as a story of Thanks to confidence in the Great overabundance of trust, of overcon- Moderation with its promise of per- fidence. When trust began to revert manently low interest rates and low to its mean – as it always does, the volatility, they had no qualms to op- house of cards collapsed. What fol- erate their balance sheets with very lows is a brief summary of that nar- low equity ratios. Their confidence rative. was boosted by a regulatory framework (Basel II) that relied on risk- Ground zero of the crisis was the US weighting: Irish banks, for instance, real estate market. Everybody was were obliged to hold zero capital for confident that the only way this mar- Irish government debt. These low ket could go was up. With that as- capital ratios generated outsize prof- sumption firmly in place, everybody itability. Profitability was enhanced wanted a piece of the action, even if even further by the securitisation of they could not afford it, and banks loan portfolios which were packaged were happy to oblige, assuming that and sold off under the originate to the rising tide would lift all boats. distribute model to other investors. The subprime market was born. Instrumental in that sale were top grade ratings equivalent to risk-free The wealth effect was an important investments from rating agencies. driver of consumption growth: Own-

90 | Rating agencies trusted their mod- built on the notion of trust: banks go els, which promised very low prob- down if their liabilities are all called abilities of default even for portfo- at the same time in a bank run. This is lios of subprime loans, as long as the where Bagehot’s1 lender of last resort portfolio was diversified enough. This (the central bank) steps in. However, would be the objective presumption, Bagehot would have groaned at the without taking into account the con- extent and indiscriminate nature of flict of interest built into the Rating bank rescues performed recently: His agencies’ business model by the fact precept only covers rescuing illiquid that the issuer pays for its own rat- banks; insolvent ones should be left ing. to default. But, obviously, default was not an option politically – hence Investors of course put faith in both the second part is often conveniently Rating agencies and analysts, expect- forgotten in the case of large institu- ing that they could save on onerous tions. due diligence for their investment activity by delegating the task to oth- In the meantime, we have arrived at ers. It is a known fact, though, that the stage where most of the excess analysts tend to herd around the financial sector leverage has been consensus opinion because the single transferred to nations’ balance sheets biggest career risk for an analyst is to (private sector excess leverage has be wrong and alone. If the analyst is come down only marginally so far). right and alone, then that’s consid- Consequently, sovereign debt once ered a lucky outlier, but if he’s wrong deemed risk-free is now under scruti- in a crowd, then everybody else was ny for default risk, and the first domi- equally wrong as well. That explains noes are already falling. The issuer the reluctance of analysts to stray of the world’s reserve currency gets too far from the consensus mark and away with high debt levels at very leads to group think. low rates for now because investors still trust in the USD’s status for lack When the edifice of trust started of a better alternative. And default is crumbling and threatened to take still not an option politically. the banking systems of several countries down with it, nations took up The boom therefore rested on clay the gauntlet and saved banks, even feet of abundant trust and overcon- though many countries’ balance fidence. Trying to rebuild it might sheets were already stretched with be possible, but judging from the debt. This was deemed necessary as experience of increasingly severe past the fractional banking system itself is crises, the next one would be even

| 91 Governance

worse. Should we really strive to go that all possible outcomes are known, back there? Can we sustainably go but not their statistical distribution. back there? That can be estimated by empirical means, though. However, there Economic decisions are made in the needs to be a single, homogeneous realm of uncertainty. It is useful to model that causes the phenomena gauge its extent by reference to a which we can observe in the world of taxonomy of uncertainty.2 fully reducible uncertainty. Complete certainty is only available Under partially reducible uncertainty, Taxonomy of Uncertainty we are in a casino that may or may not be honest, and the rules tend to change from time to time without notice. This is where the monsters of reality live. Observed phenomena may well be generated and explained by multiple models. Sometimes, markets are liquid and efﬁcient; sometimes they freeze up without warning. Analysis is valuable and has explanatory power, but only to the extent that it can reduce uncertainty.

The top two levels of uncertainty (irreducible uncertainty and “Zen in the domain of classical physics and uncertainty”) are characterized by may therefore be disregarded in our model ignorance beyond the reach context. of any meaningful quantification. Therefore, they do not suit the re- Most models of financial markets quirements of practical life. work with the definition of risk that is used at the second level of risk The taxonomy of uncertainty thus re- without uncertainty: all statistical veals two crucial facts: properties of risk are fully known. • Risk and uncertainty are two al- This is the risk level appropriate to together different animals, even describe an honest casino. though the terms are often used Only now are we beginning to ap- synonymously: Risk can be cap- proach economic reality. Under fully tured, described and forecast fully reducible uncertainty, we assume by statistical means, whereas un-

92 | certainty cannot. In an uncertain Leadership in a liquidity crisis is much reality, there always remains an unless demanding than in a solvency knowable likelihood of the unex- crisis, because liquidity crises tend to pected. be of shorter duration and often do • Many, if not most, economic deci- not require painful measures. Usu- sions are made under conditions ally they can be resolved by taking a of uncertainty rather than merely swaggering stance on the part of the risk. Weighted by impact, uncer- lender of last resort, deploying shock tainty decisions are almost certainly and awe and waiting until the crisis more important than risk decisions. blows over. In a solvency crisis, how- The crisis has demonstrated beyond ever, painful & therefore unpopular doubt the inability of risk-based cuts are inevitable. Deferred cuts are models to cope with uncertainty usually even more painful. It is in this issues. Effective practical conse- context that Mervyn King, the Gover- quences are yet to be drawn. nor of the Bank of England, is quoted as having said that whoever wins the What ought I to do? 2010 UK elections will be unelectable That brings us to the second question for a generation. Definitely not an from Kant’s Critique. Given that trust encouraging outlook for the incom- is not an unadulterated, stable good, ing team. and that economic decisions have to be made under uncertainty, what is a Many of the shock and awe measures responsible course of action for polit- taken during the crisis and in its wake ical, regulatory and corporate leaders proved to be of a hitherto unknown and investors? quality: Treasuries and central banks became directly involved in negotia- Today’s leaders know trust – they live tions with threatened actors in order and breathe it. That’s why they re- to find ways to stabilise them, rather sponded forcefully to a perceived loss than taking the traditional path of of trust in the system as the symptom authoritative action. Negotiations by of a liquidity crisis. But that response definition take place among equals, may well have been the wrong therefore, by choosing a negotiated course from a systemic perspective. approach, the authorities accepted It assumed that the crisis was just a to being placed at the same level as transient crisis of confidence (as in their counterparts. Bagehot’s bank runs), whereas, in fact, it has become increasingly evi- Subsequently, governments took dent that we are dealing with a sys- over or guaranteed liabilities from temic solvency crisis. the financial sector without losses

| 93 Governance

to holders of such liabilities, thereby taking the place of a regular actor in the ﬁnancial markets with its own particular agenda, rather than the traditional role of the watchdog on one hand and the boringly conserva- tive and predictable seller of government debt on the other (let’s forget the tax authority for now). With rescue operations and – even more so – with unprecedented monetary and ﬁscal policy action, authorities en- tered the business of issuing promises they could not be sure they would be able to honour.

By doing so, authorities introduced systemic uncertainty at a level that was not built to handle it: the state. Citizens expect the state to be for- ever, whereas actors in the capital- ist system may succeed or fail – they come and go. Failure is a necessary, indispensable part of the system. With permission of williambanzai7. Capitalism has built in redundancy to blogspot.com cope with uncertainty whereas States do not. Their failure to honour a much of the crisis rescue action had promise is a major event. to be based on emergency law.

The modern state has evolved to re- Authorities ought never to have left duce uncertainty for its citizens. In their relative comfort zone of fully the terminology of uncertainty, its reducible uncertainty. By entering mechanism – the rule of law – is al- the twilight zone of partially irreduc- most entirely located within the third ible uncertainty, by making promises layer of fully reducible uncertainty. they could not be certain they can The only gateway to uncertainty honour, they gave up their claim to (apart from foreign policy) is the permanence. Demanding trust is very state of emergency and emergency well if you can be sure that it will be law. It is hardly surprising, then, that deserved by honouring the promises

94 | you make, but if it is obvious from Add to that mix an unstable curren- the onset that you are wagering cy union, managed currencies and on an outcome that is beyond your potential regional armed conflicts. control (“Yes, we can”), then the de- The resulting picture is complex mand is foolhardy at best or disin- and not very pretty. Hence, the an- genuous at worst. Electorates around swer to Kant’s third question What the world intuitively comprehend may I hope? is “Not much.” that and are deeply dissatisfied. In the scenario that is currently cen- What may I hope? tral, we will have kicked the can But such is the state of play. The au- down another couple of years. Global thorities’ choice of action has turned growth resumes shakily, driven by out to be relatively beneficial for the growth engines India and China, now, and we must hope it remains standing in for the deleveraging US. that way in the interest of every- However, that scenario indeed car- body. Nevertheless, the crisis is far ries the seed of self-destruction in an from over. Indeed, the fundamental even bigger crisis because leaders will odds of an unfavourable outcome conclude that now, they really know are mounting steadily: how to manage the system. Over- • Government debt is unsustainably confidence and trust will know no high and rising, even at low inter- bounds – for a while. est rates; • deleveraging is a long-term process The second scenario is less pretty in that will take years to bring pri- the near term, but more favorable vate leverage down to its historic longer term: Authorities take reso- means, thereby reducing demand lute steps to restructure their respec- and potential growth; tive consolidated balance sheets as • relatively feeble cyclical growth well as the financial services industry, in mature markets is a result of putting a credible end to Too Big to unprecedented and unsustainable Fail. This will likely cause some short- monetary and fiscal policy action; term market disruption, but it will • demographic dynamics of ageing put the nexus between the political populations are not helping; domain and the financial industry at • inflationary signals in the BRIC a healthy arm’s length again. growth engines may put a break on their fast expansion; The long-term investor always need • the political debate around auster- to be prepared for all imaginable ity or fiscal stimulus is heating up scenarios – and some unforeseeable everywhere. ones, too. That means that our pref-

| 95 Governance

erence lies with a course of action Some think that the crisis has dealt which would (re)create a predict- capitalism a fatal blow from which able and robust, or, in Nassim Taleb’s it will never recover. I beg to differ: word: anti-fragile environment as Capitalism as a mode of resource al- quickly as possible. To address the location is extremely resilient and will agency issues and conﬂicts of interest survive the collapse of a host society that are everywhere, this framework that has become too complex. Let us needs to encompass a high degree of hope against hope, therefore, that transparency so that economic reality rather than make them more com- is faithfully represented in business plex, we will be able to reduce the reporting. One of the worst disser- complexity of our governance struc- vices to the cause of building trust in tures in order to make them more ro- a trustworthy framework was per- bust. That way, we might be able to petrated when accounting standard trust in Trust again. setters were forced to defuse some of their more powerful transparency provisions for the alleged beneﬁt of stability. But there can be no stability built on opacity. References: Until such time, prudent investors ev- 1 Walter Bagehot: Lombard Street, A erywhere move to preserving wealth description of the Money Market, rather than growing it. That may well London 1873 run counter to the interest and inten- 2 Andrew Low, Mark Mueller: tions of ill-advised authorities and WARNING: Physics envy may be leaders. But it is plausible in the face hazardous to your wealth; 2010 of some literature on crises and col- http://arxiv.org/abs/1003.2688v3 lapse such as Tainter3 and Reinhart / 3 Joseph Tainter: The Collapse of Rogoff.4 Complex Societies, Cambridge 1990 4 Carmen Reinhart, Kenneth Rogoff: Let me quote the Global Guerrillas This Time is Different – Eight Cen- Blogger John Robb: turies of Financial Folly; Princeton “The need for evolutionary ad- 2009 vances at the local level will always 5 http://globalguerrillas.typepad. outstrip the pace of evolutionary com/globalguerrillas/2010/04/ change at the center. When the avoiding-collapse.html?utm_ mismatch grows too large, the en- source=feedburner&utm_ tire system collapses.”5 medium=feed&utm_campaign=Feed:+typepad/ rzYD+%28Global+Guerrillas%29

96 | 3.2. Microﬁnance Investment Funds – Analysis of Portfolio Impact before and after the Financial Crisis by Henry Schäfer and Oliver C. Oehri

Introduction loan ranging from USD 50 to 5,000, a Microfinance has become a globally so-called microloan (a.k.a. microlend- heeded theme since the UN declared ing), is the most common form made 2005 the International Year of Mi- available by this type of financial ser- crocredit, and in 2006 Muhammad vice (Felder-Kuzu, 2005). The exten- Yunus was awarded the Nobel Peace sion of microloans to microentrepre- Prize. The origins of microfinance neurs in developing and emerging lie in, among other things, a philan- market countries is conducted by mi- thropic movement whose aim was to crofinance institutions (MFIs), which provide credit aid to economically ac- specialise in this type of credit exten- tive people in poverty. Microfinance sion and are locally based (Oehri et can be an effective instrument for al, 2010). fighting poverty. Over the years, the start volume has grown very rapidly In practice, the aforementioned basic and produced a new market seg- idea has solid references in the area ment which has allowed micro-en- of developmental help and assis- terprises official access to financial tance. Approximately 2.7 billion peo- services. In accordance with this rapid ple are affected by poverty and live growth and the transformation of on less than USD 2 per day (World the microfinance sector, the market, Bank, 2007). Of these, many people and especially the participants, have can be considered as economically become subject to significant struc- active as they try to increase their tural changes. At a very basic level, income and improve their living situ- microfinance can be understood as ation. Hence, they also have a need the availability of financial services for small business loans and other (loans, saving models, capital trans- financial services in order to become fers and insurance) to micro-entre- economically independent. Accord- preneurs and households with low ing to current estimates, however, a incomes that would otherwise have great majority of these microentre- no possibility of using the services of preneurs are still dependent on bor- local credit institutions. Microfinance rowing from informal moneylenders thus provides affected population at horrendous interest rates. Based segments primarily in developing and on the assumption that 500 million emerging market countries with ac- small businesses each year require cess to financial products. A business an average loan of approximately

| 97 Governance

USD 500, the annual demand for portfolio are not sufficiently known microloans stands at USD 250bn (Di- (Oehri and Fausch, 2008). eckmann, 2008). According to expert opinions, only a portion of today’s This study analyses the risk-return credit needs are presently being met. profiles of selected MFIFs and the im- The national credit markets of de- pact of MFIFs on standard-structured veloping countries cannot at pres- portfolios. The research is set out as ent meet the required credit volume follows: In Part 2, we give a short alone, therefore sustainable access to overview of the applied methodol- international capital markets and for- ogy. Relevant criteria for our fund eign (investment) capital is a crucial selection are described in Part 3. In component (Oehri et al, 2010). Part 4, we analyse the risk-return pro- file of the selected MFIFs and their The topic of microfinance as a fi- benefits and risks in standard-struc- nancial investment has particularly tured portfolio. Part 5 contains the experienced a boom in recent years. impact of the financial crisis and Part They are finding increasing interest 6 is the conclusion of the paper. from institutional investors as well as private investors. At the end of 2008, Methodology over 100 so-called Microfinance In- In order to quantify the portfolio vestment Vehicles (MIVs) were identi- theoretical influence of the selected fied worldwide with an investment MFIFs the following framework has volume of a good USD 6.6 billion. been chosen: The Microfinance Investment Funds 1. First we build a sample portfolio (MFIFs) represented just a small part consisting of stocks, bonds, hedge of the MIVs. In general, MIVs are funds and a money market. The directly invested in MFIFs. These in- sample portfolio consists of a global vestments can be made in the form stock index (MSCI World), a global of equity or debt capital. Studies of bond index (JPM GBI – Government the investment capital structure of Bonds Index), a hedge funds index MIVs have revealed, that debt capital (Hedge Funds Research Index HFRI), (fixed income investments) is still pre- and a money market fund (UBS Mon- ferred and 75% of the microfinance ey Market Fund). The risk-free invest- investment volume is being effected ment opportunity is represented by from this form (Reille et al, 2009). the 6-month LIBOR. 2. Furthermore, we define three in- Due to the novelty of MFIFs, the an- vestment strategies dependent on nual return and risk characteristics as the investors various risk attitudes, as well as the benefits in a diversified shown in Table 1.

98 | Table 1: Sample Portfolios – Three Investment Strategies Asset Classes Investment MFIF Stocks Bonds Hedge Money strategy Funds Market Growth 0% 60% 10% 25% 5% Balanced 0% 40% 30% 20% 10% Defensive 0% 20% 50% 20% 10%

3. Finally we modify the portfolios – Research sample – five restrictions “defensive.” “balanced” and have been introduced to select MFIFs: “growth” with MFIFs. 1. Microfinance investment quote: at least 70% In this context, we analyze the effects 2. Capital structure: Debt >50% (mi- of 5% and 10% MFIFs substitution crofinance fixed income mutual for these three investment strategies funds) (defensive, balanced and growth) as 3. Time series: at least 5 years well as the impact of the recent fi- 4. Money market adequate return nancial crisis. A total of 24 portfolios (LIBOR plus) were created, whereas 5% and 10% 5. Price setting / Net Asset Value of the given asset classes are substi- (NAV) evaluation: monthly tuted by MFIFs.

The expected portfolio return (µp) and the portfolio risk (σp) are determined on the basis of the following formula (Markowitz, 1952).

n n n 2 2 µ = x µ (1) σp = x x ov (2) σ p = σp (3) p Σ i i Σ Σ i j ij i =1 i=1 j=1

The Sharpe Ratio is given as the quo- tient of the realised excess return and the portfolio risk.

rp− r SR f (4) p= σ p

| 99 Governance

Based on the MFIF opportunity set, the following two MFIFs and the SMX as an industry benchmark were chosen:

Table 2: Overview of Selected MFIFs Dexia Micro- responsAbility SMX USD – Credit Fund Global Micro- Symbiotics Mic- (Dexia) ﬁnance Fund roﬁnance Index (responsAbility) (SMX) Fund currency US Dollar US Dollar US Dollar Inception September 1998 November 2003 December 2003 Observation period 11 years 6 years 6 years

Empirical results The following distribution parameters are given for the observation period:

Table 3: Overview of Distribution Parameters, Monthly End-date, Risk-free Rate: LIBOR 6 Months USD, Own Calculations, Data Sources: Datastream, responsAbility, Symbiotics

Period Re- Risk Min. Max. LIBOR Sharpe turn Ratio Dexia 01.99-12.09 4.71% 1.01% -0.72% 1.22% 3.53% 1.1651 responsAbility 01.04-12.09 4.19% 1.23% -0.33% 2.54% 3.35 % 0.6853 SMX 02.04-12.09 4.51% 0.53% 0.06% 0.99% 3.38% 2.1399

The observation period reaches from 31.12.1998 to 31.12.2009 and includes different market phases: the bear market from 1999 to 2002, the bull market from 2003 to 2006 as well as the ﬁnancial market crisis starting in July 2007.

100 | Table 4: Overview of Distribution Parameters, Monthly End-date, Risk-free Rate: LIBOR 6 Months USD, Own Calculations, Data Sources: Datastream, responsAbility, Symbiotics

Period Return Risk Min. Max. LIBOR Sharpe Ratio MSCI World 01.99-12.09 1.57 15.59 -17.84 9.92 3.53 NA 01.04-12.09 3.66 15.16 -17.84 9.92 3.35 0.0206 JPM GBI 01.99- 12.09 5.43 7.31 -5.12 6.82 3.53 0.2596 01.04 – 12.09 5.35 7.40 -5.12 6.82 3.35 0.2712 HFRI 01.99-12.09 5.88 6.06 -6.54 6.85 3.53 0.3887 01.04-12.09 3.60 6.30 -6.54 3.32 3.35 0.0399 UBS MM 01.99-12.09 2.86 0.55 0.01 0.57 3.53 NA 01.04-12.09 2.49 0.48 0.01 0.44 3.35 NA

Diagram 1: Overview of the Observation Periods (Market Phases)

| 101 Governance

Table 5: Dexia Micro-Credit Fund Correlation Matrix (January 1999 - December 2009)

Dexia MSCI JPM GBI HFRI Money Market Dexia 1.00 MSCI -0.09 1.00 JPM GBI 0.04 -0.08 1.00 HFRI -0.15 0.65 0.00 1.00 Money Market 0.31 -0.02 -0.11 0.11 1.00

Dexia If the Dexia MFIF is taken as a sub- As can be seen in Table 5, the Dexia stitute for the given asset classes, in MFIF shows a low correlation to all two of four substitutions the risk-ad- considered asset classes. The Dexia justed excess return (Sharpe Ratio) MFIF correlates to the bond index improves. If the Dexia MFIF is chosen slightly positive (+0.04), and has a to substitute stock investments the negative correlation to the stock and best risk-adjusted return of the port- hedge funds index (-0.09 and -0.15 folios can be achieved. Compared respectively). to stock investments the Dexia MFIF

Table 6: Sharpe Ratios (01.1999 - 12.2009, Own Calculations)

Sample new portfolios portfolio (Dexia substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth NA NA NA NA NA NA NA NA * Balanced 0.03 0.05 0.09 0.02 0.02 0.02 0.01 0.04 0.05 Defensive 0.18 0.24 0.30 0.18 0.19 0.18 0.17 0.20 0.22 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution

* indicates that the growth portfolio only consists of 5% money market, and therefore, no 10% substitution is possible for the money market.

102 | Table 7: Standard Deviations in % (01.1999 - 12.2009, Own Calculations)

Sample new portfolios portfolio (Dexia substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 10.38 9.60 8.82 10.38 10.39 10.15 9.93 10.37 * Balanced 7.27 6.53 5.81 7.19 7.12 7.05 6.83 7.26 7.26 Defensive 5.26 4.75 4.32 5.02 4.80 5.07 4.89 5.26 5.25 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution generates constant positive returns ly during unfavourable market devel- during all market phases. Therefore opments. Compared with the sample the risk-adjusted excess return for portfolio, a decline in the Sharpe Ra- portfolios can be smoothed, especial- tio is proven if Dexia MFIF is taken as

Diagram 2: Overview of the Observation Periods Including Returns from Dexia

| 103 Governance

Table 8: Returns in % (01.1999 - 12.2009, Own Calculations)

Sample new portfolios portfolio (Dexia substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 3.10 3.26 3.41 3.06 3.03 3.04 2.98 3.19 * Balanced 3.72 3.88 4.03 3.68 3.65 3.66 3.60 3.81 3.90 Defensive 4.49 4.65 4.80 4.45 4.42 4.43 4.37 4.58 4.67 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution a substitute for the hedge fund and the MFIF. Therefore the bond invest- the bond index. We argue that the ment generates smoother returns in Dexia MFIF, the hedge funds and the a portfolio compared to its substi- bond index have low correlation to tute, the Dexia MFIF, especially dur- most asset classes as well as to each ing unfavourable market phases. other. Therefore beneficial portfolio In general, the standard deviation characteristics (low correlation, high is reduced through a 5% substitu- Sharpe Ratio) of both asset classes tion with Dexia MFIF on average by are only replaced by each other. This about 0.25%, and through a 10% results in a loss of diversification as substitution even by about 0.49%. well as performance within the port- The results show that the MFIF offers folio and subsequently to a lower an important risk reduction benefit Sharpe Ratio. within the portfolios analysed, due to reduced risk and lower correlation to When looking at the portfolio risk traditional asset classes. (see Table 7), it can be seen that the Dexia MFIF leads to a reduction of The Dexia MFIF increases expected portfolio risk, with exception of the portfolio returns for all portfolio 10% bond substitution with Dexia strategies when it is used as a sub- MFIF for the growth portfolio (10.39). stitute for stock and money market In this case it leads to an increase in investments. Regarding bond- and standard deviation. We argue that hedge funds investments the op- the bond index has a lower correla- posite is demonstrated, since the tion to the stock index compared to expected returns are lower for all

104 | Table 9: responsAbility Correlation Matrix (January 2004 - December 2009)

respons- MSCI JPM GBI HFRI Money Ability Market responsAbility 1.00 MSCI -0.29 1.00 JPM GBI 0.05 0.04 1.00 HFRI -0.17 0.75 0.00 1.00 Money Market 0.42 -0.02 0.03 0.09 1.00 portfolio strategies. This result is not responsAbility so surprising because the expected The same procedure used to analyse returns of the stock index and the Dexia is now carried out on the sec- money market fund are lower during ond MFIF (responsAbility). The obser- the observation period than those of vation period was six years from 2004 the Dexia MFIF. On the other hand, to 2009. the expected returns of the bond and hedge funds index are higher than The beneﬁts of responsAbility MFIF those of the Dexia MFIF. This means in a portfolio depends on the asset that in this context the Dexia MFIF class to be substituted as well as the substitution into bond or hedge fund chosen investment strategy. A substi- investments has an adverse effect on tution leads to improvements in the portfolio returns. Sharpe Ratio for all asset classes and

Table 10: Sharpe Ratios (01.2004 - 12.2009, Own Calculations)

Sample new portfolios portfolio (responsAbility substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 0.04 0.05 0.05 0.03 0.03 0.04 0.05 0.05 * Balanced 0.09 0.11 0.12 0.09 0.08 0.10 0.11 0.10 0.12 Defensive 0.18 0.21 0.24 0.18 0.18 0.20 0.21 0.20 0.22 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution

| 105 Governance

Diagram 3: Overview of the Observation Periods Including Returns from responsAbility

investment strategies expected for asset classes. Except in the case of a the bond index. money market substitution the investment strategy Defensive leads to A responsAbility MFIF substitution higher risk. demonstrates a risk reduction in all

Table 11: Standard Deviations in % (01.2004 - 12.2009, Own Calculations)

Sample new portfolios portfolio (responsAbility substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 10.38 9.61 8.83 10.33 10.29 10.11 9.83 10.36 * Balanced 7.47 6.73 6.01 7.33 7.22 7.21 6.95 7.45 7.43 Defensive 5.58 5.03 4.54 5.31 5.06 5.36 5.16 5.65 5.54 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution

106 | Table 12: Returns in % (01.2004 - 12.2009, Own Calculations)

Sample new portfolios portfolio (responsAbility substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 3.76 3.78 3.81 3.70 3.64 3.78 3.81 3.84 * Balanced 4.04 4.07 4.09 3.98 3.92 4.07 4.10 4.12 4.21 Defensive 4.38 4.40 4.43 4.32 4.26 4.41 4.44 4.46 4.55 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution

In terms of portfolio returns the re- SMX sponsAbility MFIF substitution has The same procedure used to anal- a positive impact on the return for yse Dexia and responsAbility is now all investment strategies, except it is carried out on the SMX as an indus- used as substitution for bond invest- try benchmark. Not surprisingly, the ments. The analysis shows that MFIF results for the SMX are similar to the substitution is favourable in terms of substitutions analysed above. a risk/return relationship in all investment categories with exception of The conducted analysis shows that the bond index. the beneﬁts of a MFIF substitution

Table 13: Sharpe Ratios (01.2004 - 12.2009, Own Calculations)

Sample new portfolios portfolio (SMX substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 0.02 0.02 0.03 0.01 0.01 0.02 0.02 0.03 * Balanced 0.07 0.01 0.11 0.07 0.06 0.08 0.06 0.08 0.03 Defensive 0.16 0.19 0.22 0.16 0.16 0.18 0.15 0.18 0.04 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution

| 107 Governance

Table 14: Standard Deviations in % (01.2004 - 12.2009, Own Calculations)

Sample new portfolios portfolio (SMX substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 10.44 9.68 8.91 10.40 10.37 10.18 9.92 10.43 * Balanced 7.52 6.79 6.07 7.39 7.28 7.02 7.51 7.45 7.50 Defensive 5.62 5.07 4.59 5.36 5.11 5.41 5.22 5.61 5.60 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution depends mainly on the market situa- turmoil, we must compare the sam- tion. The impact of the financial cri- ple portfolios before and after the ses on portfolios with MFIF substitu- financial market crisis. For that pur- tion is analysed in the next part. pose Dexia is used as representative of the MFIFs due to the longest avail- Impact of the financial crisis able data sample of all mutual funds. Demonstrating the impact of mi- Therefore we analyszd and compared crofinance substitution in challeng- Panel A (before the crisis: 31.12.1998 – ing market times provides suitable 30.06.2007) and Panel B (after the cri- examples. In order to analyze the sis: 01.07.2007 – 31.12.2009). We took consequences of the recent market Dexia as representative of the MFIFs.

Table 15: Returns in % (01.2004 - 12.2009, Own Calculations)

Sample new portfolios portfolio (SMX substitution with given asset class) Investment Stocks Bonds Hedge Money strategy Funds Market Growth 3.56 3.62 3.67 3.52 3.48 3.62 3.68 3.66 * Balanced 3.91 3.96 4.02 3.87 3.82 3.97 4.02 4.01 4.11 Defensive 4.30 4.35 4.41 4.26 4.21 4.36 4.41 4.40 4.50 % MFIF 0% 5% 10% 5% 10% 5% 10% 5% 10% substitution

108 | Findings for the different MFIFs are such as the financial crisis. close to each other, but Dexia has the longest duration (11 years). The opposite can be observed for the bond substitution which results in a The analysis across all asset classes negative Sharpe Ratio. This is due to and investment strategies shows an a change in correlation between MFIF increase in the average Sharpe Ra- and the bond index from 0.00 to 0.18 tio. As expected, lower returns and (relating to the similar characteristics higher risk can be observed during of both asset classes). The higher cor- the crisis. relation implies a shift in investor behaviour from risky portfolios to less The financial crisis had its strongest risky portfolios in those times. impact on stocks and hedge funds. Before the crisis, stocks and hedge For the chosen observation period, funds offered higher returns than the the overall analysis shows that the Dexia MFIF. However, this relation- MFIFs provide a stable risk/return ship changed in July 2007. The cor- relationship regardless the market relation between Dexia and the stock cycle. Therefore, portfolio substitu- market, as well as Dexia and the tion with MFIFs can be a meaningful hedge funds index, decreased sub- tool of portfolio diversification. stantially to -0.35 respectively -0.34. Consequently, a MFIF substitution of Conclusions stock and hedge funds has a posi- Summing up, it can be stated that all tive impact on the Sharpe Ratio and the analysed MFIFs show low volatil- therefore also on portfolio perfor- ity, low correlation to the analyzed mance, especially in uncertain times asset classes as well as stable returns

Table 16: Dexia Micro-Credit Fund Correlation Matrix (July 2007 - December 2009)

Dexia MSCI JPM GBI HFRI Money Market Dexia 1.00 MSCI -0.35 1.00 JPM GBI 0.18 -0.08 1.00 HFRI -0.34 0.65 0.00 1.00 Money Market 0.58 -0.02 -0.11 0.11 1.00

| 109 Governance

for the chosen observation period. mechanisms, technologies and busi- The study results suggest that MFIFs ness models. An opportunity could can be a meaningful tool for portfo- be the combination of microfinance lio diversification. The findings are and climate protection. One way of dependent on the observation pe- combining consists of the assump- riod, since the correlations between tion that granting microcredit loans the individual investment catego- covers part of the financing for de- ries vary with time and cannot be centralised and renewable energy regarded as fixed. However, it has to technology (microenergy credits), in be stated that the most important order to enable the use of more ef- factor of substitution with MFIFs is ficient cooking facilities, solar cook- the quality of the underlying microfi- ers or small biogas systems. There is nance portfolio. So if the portfolio at a challenge as well as a danger that risk of the MFIFs changes, the above these micro(energy) loans do not mentioned benefits of the substitu- lead directly to the generation of tion may change adversely. Further- income. In this respect, it could help more, it is important to note that if emission credits were generated there is no secondary market for mi- from projects of the Clean Develop- crofinance and therefore no continu- ment Mechanism (CDM). Companies ous pricing according to supply and from industrial countries could invest demand. in projects that bring about reductions in emissions, and issue credits Over the last years, the start volume for these. The companies could then grew very rapidly and produced a use these credits to cover their own new market segment which allowed emissions, as required, for instance, micro-enterprises official access to in European emissions trading. How- financial services. In accordance with ever, the procedure is complex and this rapid growth and the transfor- involves a cost-intensive approval mation of the microfinance sector, procedure. At present, there is not the market, and especially the par- yet a clear answer to the question of ticipants, have become subject to whether it is feasible to link micro- significant structural changes. Today, credit loans and emission credits. the microfinance sector is confronted with new challenges as well as new This paper is primarily research on opportunities. An important step in the portfolio impact of microfinance improving this situation lies in de- investment funds. The results of this veloping new or additional finan- study cannot be considered as termi- cial sources with affordable condi- nal and deliver a first insight into the tions through innovative financing portfolio theoretical consequences of

110 | MFIFs. We have therefore to address Benchmark Survey, CGAP BRIEF, further research to verify the results http://www.cgap.org/gm/docu- as well as to consider other aspects. ment-1.9.38570/BR_MIV_Perfor- mance_Prospects.pdf References World Bank (2007): Understanding Dieckmann, Raimar (2007): Microfi- Poverty, www.worldbank.org nance: An emerging investment opportunity, Deutsche Bank Re- search, http://www.dbresearch. com/PROD/DBR_INTERNET_EN- PROD/PROD0000000000219174.pdf Felder-Kuzu, Naoko (2004): Making Sense - Microfinance and Micro In- vestments, p. 1-102 Markowitz, Harry (1952): Portfolio Se- lection, in: Journal of Finance, Vol. 7, p. 77 -91. Oehri, Oliver; Fausch, Jürg (2008): Microfinance Investment Funds – Analysis of Portfolio Impact, World Microfinance Forum Geneva, http:// www.microfinanceforum.org/cm_ data/Oliver_Oehri_-_Paper_6.pdf Oehri Oliver; Dreher, Christoph; Schäfer, Henry (2010): Microfi- nance: A New Type of Investment for Socially Oriented Clients – Mar- ket, Participants and Risk Aspects, p. 1 – 148, electronic book version under http://www.cssp-ag.com/hp/ en/navigation-left/info-center/stud- iespublications/details/article/49/ Buch-Microfinance-A-new-type-of- investment-for-socially-oriented-clients.html Reille, Xavier; Gilsovic-Mezieres, Jas- mina; Berthouzoz, Yannis (2009): MIV Performance and Prospects: Highlights from CGAP 2009 MIV

| 111 Governance

3.3. Responding . to Current Challenges: The Economics of Shared Societies by The Club de Madrid1

We, the Members of the Club de Ma- The Club de Madrid (www.clubmadrid , are concerned with issues such drid.org), made up of over 70 former as climate change, social divisions and heads of state and heads of govern- intergroup hostility, and of course ment takes a keen interest in the the problems resulting from the fi- challenges which the global commu- nancial crisis. We are now able to go nity faces. Being now out of office, behind the immediate problems and its members are not faced with deal- examine the underlying dynamics ing with the day to day demands that which have made these problems so come to current leaders and are able intractable. From our time in office to take a longer term view of the cur- and our political experience before rent situation. Their status as former and after, we are aware of the inter- leaders mean that they are then dependent world and the importance well placed to bring those issues to of reaching common approaches to the attention of current leaders and problems which we all share but we work with them to develop ways of are also aware that it is inordinately responding. They aim to bring new difficult to achieve such common perspectives to these problems. positions. There is a tendency to consider the short term interest of But there is another sense in which one´s country, or more correctly, we are very aware of the interde- one´s government. And leaders have pendency of the world, in that the to respond to the pressures from issues we face are interdependent. political and economic interests that As we work on responding to climate look for special privileges and special change, building sustainability and protection. promoting what we call shared societies to combat social divisions, It is also an interdependent world as we realize that they are intimately capital is now not rooted in specific bound up with the financial crisis states but is free to move where it that we are struggling with. will be to its advantage. So global business has outstripped the capacity This interdependence works in both of individual states to regulate and directions. Resolving the financial cri- international organizations have not sis is necessary to respond effectively developed to take on that responsi- to the other challenges we face. But bility. equally appropriate responses to

112 | the other issues opens up ways to Shared societies enjoy better pros- respond to the financial challenge. pects for economic well-being, which we understand to be sustained eco- In particular, the Shared Societies nomic growth with equity, and gains Project of the Club de Madrid has for all. You cannot have sustained been examining how economic well- and equitable economic well-being being is linked to progress on achiev- where you do not have inclusion. ing a shared society. Our members Shared societies generate economic have adopted the following state- dividends for governments, busi- ment which succinctly explains and nesses, communities, families, and advocates our develops the economic individuals. Through a virtuous cycle, rationale for shared societies. these economic dividends of shared society further enhance a society’s The Club de Madrid Statement on capacity to be shared, which in turn the Economics of Shared Societies generates more economic dividends. We, the Members of the Club de Madrid, are committed to the devel- To explore these links further, the opment of Shared Societies, where Club de Madrid established an Expert people hold an equal capacity to par- Working Group which reported to ticipate in and benefit from econom- the Members and has confirmed and ic, political and social opportunities elaborated on our analysis of this regardless of race, ethnicity, religion, virtuous cycle connecting economic language, gender or other attributes wellbeing and shared societies. and where, as a consequence, relations between groups are peaceful. How does the virtuous cycle work? 1. Governments that engage and We are convinced that this is not only invest in all members of its society inherently desirable but also eco- –- through such means as equitable nomically beneficial. We bring this distribution of resources, educa- message to current national leaders tion, health care, and infrastructure and their countries but also to global -- foster a productive and dynamic financial and political institutions environment to maximize the eco- which too often overlook this fact nomic contributions of all individuals, and focus on fiscal rectitude, which regardless of their race, ethnicity, is important, to the detriment of religion, language, gender or other the social and human dimensions of attributes. social development and economic growth, which are equally important. 2. Such governments are responsive to all the people’s needs, and remain

| 113 Governance

in contact with their populations’ 5. When the broader economy flour- priorities. This responsiveness leads ishes so too do individual households. to societies composed of populations Households, that are included within that identify with and support the broader society and benefit from the common good. When government economic dividend of a more stable engages and invests in its people, society, tend to be stronger and more they are more likely to have a sense resilient in the face of misfortune. of belonging and to be more will- The economic contribution of all indi- ing to support the state, enhancing viduals becomes a critical factor in a stability. country’s ability to overcome external shocks to its economy. 3. Therefore business enterprises in shared societies can draw on a stable, This virtuous cycle is also enhanced more educated, diverse and produc- by the reductions in costs that result tive population and access the skills from a shared society and the release and creativity offered by all individu- of resources previously set aside to als. Entrepreneurship, creativity and maintain the status quo, including innovation flourish in a peaceful, policing and security measures to tolerant and stable environment manage intercommunity tensions. and it becomes attractive to inward investment. The overall economic Shared societies make economic and wellbeing of a country or community social sense. is enhanced. What can we do? 4. An added benefit of this social We urge all leaders and global fi- contract between government, the nancial institutions to recognise that business community and all sections Shared Societies benefit everyone of the public is increased transpar- and to take all steps to bring them ency of the political institutions and about. Any other policy is short sight- an increased understanding of public ed. We also call on them to adopt the spending. This contributes to reduced Call to Action of the Club de Madrid. corruption and less wasteful public We commend to them the existing spending. Taken together, a shared Ten Commitments for Shared Societ- society enhances the fiscal dividend ies of the Club de Madrid which to the state, enhancing its economic indicate how a shared society can be wellbeing and provides the resources achieved. to farther promote a shared society. We invite the wider community to support leaders working to build

114 | shared societies, realizing that they current leaders for serious consider- too will ultimately beneﬁt, and en- ation and implementation. courage them to bring the economic argument for building shared societ- The Guiding Principles and recom- ies to leaders who are not at present mendations mentioned in the state- responding to it. ment are:

The Expert Working Group that Recommendations on Policy, Practice the Club established has identified and Structural Initiatives Ten Guiding Principles that should The following recommendations of guide national and international the Club de Madrid, mainly related policymakers in their discussions and to economic policy, are partly based formulations of all policies related to on the report of the Working Group fiscal, social, and economic develop- but are also the result of the Club ment policy. The Members of the de Madrid’s own deliberations. Most Club of Madrid endorse and adopt of them are practical applications of these Guiding Principles in its work the Guiding Principles and that link both in peer to peer consultation in is made explicit in the way they are specific countries, in its involvement laid out. with International Bodies such as the United Nations, World Bank and re- Guiding Principle 1 gional intergovernmental bodies and Shared societies, in which diverse in its participation in public debate groups and individuals are eco- and discussion generally. nomically integrated and utilise their talents and skills, tend to be more We call on current leaders and inter- stable societies which enjoy higher national institutions to adopt these economic growth than divided societ- Guiding Principles as a framework for ies their own policies and programmes. Guiding Principle 2 We seek a fairer and more inclusive If groups and individuals are eco- international order to provide the nomically marginalized they have no global environment in which individ- reason to feel a sense of belonging ual countries are encouraged to build to the state and are less likely to sup- their own Shared Society. port the state or society and contribute to the economic wellbeing of all. We and the Expert Working Group have made a series of specific recommendations which we commend to

| 115 Governance

Therefore: systems that correct gross income • In setting national goals and policy inequalities and benefit more dis- frameworks, governments and advantaged groups in order to gain international institutions need to public support for such systems. consider fairness and equality as • Governments need to involve the important factors alongside finan- public more in decisions on pub- cial rectitude and support for the lic expenditure decisions in order business sector to achieve their support for those policies and to ensure the poli- • A key priority for public spending cies meet the needs of the wider should be those sectors which up- population. This requires greater lift marginal groups and facilitate transparency about economic is- their participation in the economy sues, greater participation and in as productive members of society – general greater public influence on sectors including education, public public expenditure. health, infrastructure development in marginal areas and support for Guiding Principle 5 entrepreneurial activities within National and local economic policies marginalised communities and programmes play a major role in creating an inclusive dynamic for all Guiding Principle 3 groups. The cost of investing in a shared society and ensuring that marginalised Guiding Principle 6 groups feel they have a full place in National and local economic policies society is more than compensated and programmes too often mainly for by the contributions those people benefit those who are already suc- can then make. cessful and influential, and as a result reinforce social divisions. Guiding Principle 4 Leaving groups and individuals on Therefore: the margins of society is not cost • Taxation policies should be as- free, as it creates social, political and sessed in terms of their impact on security problems which are avoid- the achievement of a shared soci- able, unnecessary and costly. ety and their reduction of inequal- ity between groups. Therefore: • More creative mechanisms are • Governments and international in- needed for the delivery of so- stitutions need to raise awareness cial spending, with, particularly in of the benefits of progressive tax countries facing the challenge of a

116 | growing youth population, empha- more disadvantaged countries and sis on education and training. more disadvantaged communities. • Governments need to promote • A key requirement for a more ef- greater awareness among the in- fective and fairer international formal and underground econo- governance is greater complemen- mies of the benefits of joining and tarity and coordination between supporting the formal economy as the various IGOs which deal with a means to broaden the tax base. economic and financial issues. • A second key requirement is that • Those countries that have insuffi- inter-governmental institutions be- cient or deficient systems of social come more democratic by allowing protection need to reform them to smaller and poorer states to have establish basic universal coverage more influence and decision mak- as they support the development ing power alongside wealthy and of a shared society and external as- economically powerful states. This sistance should be provided for low should lead to more effective poli- income countries that do not have cies because they take into account sufficient resources. the needs of all nations. At present international financial institutions Guiding Principle 7 are heavily weighted in favour of The international economic frame- richer and more powerful states works and institutions that support them need to be reformed to ensure Guiding Principle 8 a fair, equitable and sustainable Existing international economic international economic order and frameworks need to ensure that business practices, and encourage wealthier countries and vested inter- appropriate national policies lead- ests do not benefit at the expense ing to shared societies and greater of poorer states and marginalised economic wellbeing throughout. groups within all states.

Therefore: Therefore: • Because national governments are • International agreement is required often powerless in the face of glob- on tax avoidance and tax haven al economic forces including global which allow the more mobile, who business corporations and economi- are often the more wealthy mem- cally powerful states, urgent action bers of society and business organi- is required to reform the global sations, to avoid playing their full ﬁnancial institutions to ensure part in supporting government ﬁ- they are responsive to the needs of nances.

| 117 Governance

• International consensus on the Guiding Principle 9 taxation of global business organi- Well intentioned economic policies sations is necessary to ensure that often fail to benefit marginalised sec- they pay taxes in the countries tions and integrate them into society where profits are made. because of unintended consequences. • In order to increase economic op- They can be subverted by influential portunities for the population of sectional interests. low income countries, high income countries should create fair trading Therefore: conditions, including the opening • Governments should establish sys- of markets and the phasing out of tems of monitoring and auditing subsidies to agriculture, which dis- public policies to ensure that they tort trade and impose heavy costs do not disadvantage already mar- on the developing world. High ginalised groups and, instead, that income countries have to create they help to involve them in the greater awareness with their popu- wider society. lation of the unfair nature of sub- • International institutions should sidies and protectionism, including take steps to assist states to moni- those who benefit from them. tor how far their actual or pro- • It would be desirable to create a posed policies will increase of de- global fund to support countries crease marginalisation of sections building a shared society, creating of the population. For example, the opportunities for those previously Article IV Consultation process of excluded and providing them with the IMF could broaden the content social protection. The UN Social of policy discussions with its mem- Protection Floor Initiative could bers to include aspects of social co- provide the framework for such a hesion and shared societies. fund. • However, such actions are only ap- • Governments and international propriate if these bodies are more fiscal bodies should explore in- accountable to the wider member- novative ways to raise funds (e.g., ship. international tax on financial transactions, carbon taxes) to address Guiding Principle 10 the divisive social and economic Economic policies are more likely to implications of climate change, benefit those who are marginalised which are expected to be especially and integrate them into a shared harsh on the developing world and society if marginalized groups are disadvantaged groups, and ensure involved in the planning and imple- progress towards shared societies. mentation of policies and pro-

118 | grammes and if there is a mechanism ers mean that they are then well placed to screen policies and programmes to bring those issues to the attention of for their differential impact on each current leaders and work with them to section of society. develop ways of responding. They aim to bring new perspectives to these problems. Therefore • Mechanisms should be put in place that ensure marginalised sections of society are consulted and involved in economic and other policies which affect their interests. This may include a statutory right to consultation • Self-help initiatives should be introduced and supported, as they ensure that people can participate and inﬂuence their own affairs

Academic research The academic community should be encouraged and supported in carrying out studies to conﬁrm and explain the link between shared societies and economic wellbeing and in particular it is suggested that a Shared Societies Index offers a potentially powerful tool. 1 The Club de Madrid (www.clubmadrid. org) is a non-partisan organization made up of over 75 former heads of state and heads of government from over 55 countries. Its membership takes a keen interest in the challenges which the global community faces. Being now out of ofﬁce, Club de Madrid Members are not faced with dealing with the day to day demands that come to current leaders and are able to take a longer term view of the current situation. Their status as former lead-

| 119 Governance

3.4. Synopsis of Report on Deterring Financial Reporting Fraud – A Platform for Action by the Center for Audit Quality1

Prologue: Financial Reporting Fraud auditors, external auditors, investors, – What it is and why the Center for regulators, academics and others. Audit Quality Cares On a number of occasions over the In October 2010, the CAQ released past few decades, major public com- Deterring and Detecting Financial panies experienced financial report- Reporting Fraud – A Platform for Ac- ing fraud, resulting in turmoil in the tion, a report that draws from those US capital markets, a loss of share- discussions and interviews, consid- holder value, and, in some cases, the ered in light of related research and bankruptcy of the company itself. guidance on the topic. The report The Sarbanes-Oxley Act of 2002 has contains ideas for lessening the risk done much to improve corporate of financial reporting fraud, relat- governance and deter fraud; how- ed points to ponder and an exten- ever, financial reporting fraud – an sive bibliography of fraud-related intentional, material misrepresenta- research. It represents a first step in tion of a company’s financial state- longer-term initiatives and collabora- ments – remains a serious concern for tions for the deterrence and detec- investors and other capital market tion of financial reporting fraud, to stakeholders. benefit investors and other participants in the capital markets. In 2009, the Center for Audit Qual- ity (CAQ), which is committed to enhancing investor confidence and public trust in the capital markets, convened five roundtable discussions (four in the United States, one in London) with more than 100 participants, which were followed by more than 20 in-depth interviews, to capture views on fraud deterrence and detection measures that have worked and ideas for new approaches. The participants included corporate executives, members of boards of directors and audit committees, internal

120 | Below is a synopsis of the CAQ’s re- though even the best controls can- port, Deterring and Detecting Fraud, not completely eliminate the risk of including ideas for increasing the fraud. Finally, individuals who com- ability of those involved in the finan- mit financial reporting fraud must be cial reporting process to deter and able to justify or explain away their detect financial reporting fraud. The fraudulent actions. full report is available for free download at http://www.thecaq.org/Anti- Typically, financial misstatement or FraudInitiative/CAQAnti-FraudReport. manipulation starts small, intend- pdf. ed as “just a little adjustment” to improve results. But as the need to Chapter 1: Understanding the Land- maintain the deception continues scape and one misstatement leads to another until the perpetrator is locked Why Commit Fraud – The Seductive in, loses objectivity, and heads down Triangle the slippery slope to commit major Theoretically, anyone has the poten- fraud. tial to engage in financial reporting fraud, including some individu- Historically, most major investiga- als who had previous reputations for tions of financial statement frauds high integrity. Three factors, referred have involved senior management, to as the fraud triangle, often com- who are in a unique position to per- bine to lead individuals to commit petrate fraud by overriding controls fraud: pressure or an incentive to and acting in collusion with other engage in fraud; a perceived oppor- employees. When fraud occurs at tunity; and the ability to rationalize lower levels in an organization, indi- fraudulent behavior. viduals may not initially realize that they are committing fraud; they may The CAQ’s anti-fraud report discuss- see themselves as simply doing what es the top three pressures that can is expected to “make their numbers.” lead an individual to commit fraud: personal gain (including maximiz- Participants in the Financial Report- ing performance bonuses and stock- ing Supply Chain and Their Roles in based compensation); the need to Mitigating the Risk of Financial meet short-term financial expecta- Reporting Fraud tions; and a desire to hide bad news. Management, boards of directors, Opportunities for fraud usually are audit committees, internal auditors, greatest when the tone at the top and external auditors make up the is lax or controls are ineffective, al- public company financial report-

| 121 Governance

The Sarbanes-Oxley Act – Legislation for Strong Governance and Accountability

The Sarbanes-Oxley Act of 2002 was enacted in response to the corporate scandals of the late 1990s and early 2000s. The act mandated significant reforms to public companies’ governance structures and the oversight of public company accounting firms. Many of its requirements were intended to raise the standard of corporate governance and lessen the risk of fraudulent financial reporting. In particular, the act:

• Reinforces the responsibility of corporate officers for the accuracy and completeness of corporate financial reports, and adds a requirement for the public certification of each periodic report filed with the SEC that includes financial statements. The chief executive officer and chief financial officer must certify that each such periodic report complies with the requirements of the Securities Exchange Act of 1934 and that the financial statements are fairly presented. • Establishes criminal penalties for a willful and knowing untrue certification. • Provides for the return of the bonuses and profits of executives involved in fraudulent financial reporting. • Requires evaluations and additional information regarding a company’s internal control over financial reporting by management, and a related report by the external auditor for certain companies. • Requires other additional information, including whether the company has a code of ethics for senior financial officers. • Increases the role of the audit committee, including requirements for financial expertise and responsibility for oversight of the company’s external auditor. • Requires companies to establish whistleblower programs, and makes retali- ation against whistleblowers unlawful. ing process or supply chain and have Management has primary responsibil- complementary and interconnected ity for the financial reporting process roles in delivering high-quality finan- and for implementing controls to cial reporting to the investing public, deter and detect financial reporting including the deterrence and detec- fraud. Boards of directors and audit tion of fraud. committees are responsible for over-

122 | Shared Responsibility to the Investing Public for Mitigating the Risk of Financial Reporting Fraud

sight of the business and the control – an opinion on the effectiveness of environment. The audit committee the company’s internal control over oversees the financial reporting pro- financial reporting. cess, the internal audit function, and the company’s external auditors. Themes Related to Fraud Deterrence Internal auditors play a key role in a and Detection company’s internal control structure How can those in the financial re- and have a professional responsibility porting supply chain individually and to evaluate the potential for the oc- together mitigate the risk of financial currence of fraud and how the orga- reporting fraud? While there is no sil- nization manages fraud risk. External ver bullet, the report identifies three auditors must be independent of the key themes: company they audit and provide a • A strong, highly ethical tone at the public report on the company’s an- top that spreads throughout the nual financial statements, including― corporate culture is the primary for US public companies with $75 mil- line of defense and is one of the lion or more in market capitalization most effective weapons to deter

| 123 Governance

fraud. An effective fraud risk man- Point to Ponder agement program is a key compo- If internal audit is expected to as- nent of the tone at the top. sess and challenge the tone at the • Skepticism, a questioning mind- top of a company, is the function set that strengthens professional structured properly to maintain objectivity on the part of all par- its objectivity? For example, if the ticipants in the financial reporting career path of most internal audit supply chain, is an essential tool in staff (including in some cases the evaluating fraud risk and in deter- chief audit executive) is to rotate ring and detecting potential finan- back into the mainstream organi- cial reporting fraud. zation, is there a conflict of inter- • Strong communication among sup- est that potentially compromises ply chain participants, which is es- objectivity? sential to a thorough understanding of fraud risk and to an effective Management plays the most critical anti-fraud program. role in building a strong ethical culture. To do so, senior management must clearly communicate ethical Chapter 2: Tone at the Top – The expectations and visibly live by them. Power of Corporate Culture Importantly, employees need to hear the same messages from their direct A strong ethical culture starts at the supervisors, because they have the top with a company’s most senior most powerful and direct influence leaders and flows through the entire on the ethical judgments of their em- organization, influencing all three ployees. sides of the fraud triangle. A strong ethical culture creates an expectation Tone at the top is reinforced through to do the right thing and counteracts the establishment of a comprehen- pressure and incentives to commit sive fraud risk management program fraud. It also supports well-designed, with a readily available confidential effective controls that reduce oppor- whistleblower program. In fact, stud- tunities for fraud and increase the ies show that fraud most often is de- likelihood that fraud will be found tected through tips. In multinational quickly. In addition, a culture of hon- organizations, it is critical that ethics esty and integrity severely limits an and fraud deterrence programs also individual’s ability to justify fraudu- account for cultural differences. lent actions. Boards and audit committees support and reinforce the tone at the top, in

124 | part by choosing the right manage- Because external auditors work with ment team. Audit committees over- a wide variety of people across many see the financial reporting process, parts of a company’s operations, they including monitoring fraud risk and often have the opportunity to gain the risk of management override of insights at various levels about the controls. Boards, through the com- company’s culture, as well as on the pensation and audit committees, can effectiveness of internal controls. review compensation plans, especial- They also can leverage their expe- ly those for senior management, for rience from working with multiple unintentional incentives to commit clients. External auditors can serve financial reporting fraud. as a useful resource for boards, audit committees, and members of man- The internal audit function tests and agement who may not have a similar monitors the design and effective- breadth of experience or training. ness of fraud programs and internal control over financial reporting. Summary of Considerations Related According to The Institute of Inter- to Tone at the Top nal Auditors (The IIA), internal audit should operate with organizational For Management independence, which commonly in- 1. Clearly state the organization’s eth- cludes direct reporting to the audit ical standards in a set of core values committee and unrestricted access and a formal code of conduct, and to the board and audit committee hold all personnel strictly account- should matters of concern arise. able for compliance with the code. Enforce discipline for violations External auditors have the responsi- consistently across all levels of the bility to plan and perform an audit organization. to obtain reasonable assurance that 2. Set the right tone at the top. Em- the financial statements are free of bed the code of conduct into the material (substantive) misstatement, company’s culture by “walking the whether caused by error or fraud. talk” (e.g., leading by example), increasing communications and Point to Ponder training, and reinforcing the stan- How can the board and audit com- dards at all levels of the company mittee identify when a previously through appropriate management strong tone at the top starts to systems and processes. shift and morph into something 3. Build a mood in the middle that more receptive to inappropriate mirrors the tone at the top. Empha- risk-taking or behavior? size the critical role of supervisors

| 125 Governance

in setting the tone for their direct 2. Adopt a strong tone of compliance, reports and their teams by both communicate it to the entire orga- word and deed. nization, and hold management 4. Establish a comprehensive fraud accountable. Take decisive action risk management program, includ- against any member of senior man- ing a whistleblower program and agement who does not follow the fraud awareness training for all company’s ethical standards and employees. Consider cultural dif- code of conduct. ferences in other jurisdictions. As- 3. Regularly review key strategies sign responsibility for the fraud risk and business plans and assess the management program to an appro- achievability of goals in light of priate member of senior manage- current circumstances. Goals should ment, and assess the effectiveness be structured to avoid a rigid short- of the program at least annually. term focus that might push man- 5. Internally communicate actions tak- agement or employees to commit en related to information received fraud. from the whistleblower program. 4. Establish a regular process for as- 6. Design incentive compensation sessing management integrity, and programs so that their structure do not let this activity become per- does not unintentionally provide functory. a potential motivation for miscon- 5. Approve the internal audit charter duct or fraud. and the annual work plan to make 7. Set and enforce high standards for sure it is aligned with and address- compliance with internal controls es the committee’s needs and its over ﬁnancial reporting, including expectations for internal audit. careful monitoring and providing 6. Review and understand the results adequate resources to comply with of reports to the whistleblower established procedures. program, focusing on complaints that involve senior management or For Boards and Audit Committees reﬂect on the ethical culture of the 1. Personally “walk the talk” of the company. Make good use of the in- company’s core values and code ternal audit function. of conduct. In other words, lead 7. Evaluate ways to strengthen re- by example. Be visible outside the lationships between the audit boardroom, and interact personally committee and the compensation with employees at various levels to committee – either through over- obtain their perceptions of the cor- lapping membership, joint meet- porate culture and reinforce high ings, or audit committee chair ethical standards. attendance at relevant meetings

126 | of the compensation committee sults and correct applicable find- – with the objective of design- ings. Analyze year-over-year changing compensation packages that es in key metrics. promote ethical behavior, as well 5. Evaluate soft controls and the cor- as providing incentives to meet fi- porate culture, including assess- nancial goals and build long-term ment of the company’s fraud risk shareholder value. management program, and involve 8. Consider the role of the audit com- appropriate other departments in mittee in evaluating performance addressing the results. and compensation of the chief 6. Establish or otherwise ensure there audit executive, as well as the ben- is a formal process to educate the efits of adopting a policy that the board and audit committee on audit committee agrees with em- the risks and red flags of financial ployment or termination decisions reporting fraud, with a particular for both the chief financial officer focus on the risks of management and the chief audit executive. override of controls.

For Internal Audit0rs For External Auditors 1. Work proactively with the au- 1. Inquire of management and the dit committee to develop a clear, audit committee how they inte- shared vision of the internal audit grate tone at the top through function in order to reinforce the the entire organization and into integrity and importance of the the culture at all levels. Focus the function throughout the company. discussion on the details of the 2. Require basic fraud detection train- company’s communications and ing, including the detection of training programs, including the financial reporting fraud, for all in- tools that help each level of man- ternal auditors. agement reinforce the desired mes- 3. If appropriate, consider allocat- sages with its direct reports. ing one internal audit position for 2. Discuss with management and au- a fraud specialist, ideally someone dit committee how they monitor with appropriate experience and the company’s culture to confirm certifications. that it doesreflect the tone at the 4. Take an active and visible role in top. Ask what tools and method- supporting the ethical culture, in- ologies are used, such as employee cluding evaluating hotline results, surveys and reports summarizing conducting ethics surveys of em- whistleblower program results, and ployees, and collaborating with what is done with the results. other departments to address re- 3. Proactively engage the audit com-

| 127 Governance

mittee in discussing observations and controls, and remaining aware of related to the tone at the top ob- the potential for fraud, particularly tained as part of the audit, as well if the organization is under financial as on insights into ways to iden- pressure. tify possible red flags and warning signs. The foundation for effective gover- 4. Provide management, the board, nance and oversight by the board and the audit committee with ex- and its committees is skepticism in amples of leading practices related the form of vigorous and probing to ethics communications, hotlines, questions of management, the inter- and whistleblower programs to nal auditors, and the external audi- mitigate the risk of financial re- tors to find sources of bias. To do so, porting fraud. the audit committee first needs to acknowledge the possibility that bias may exist and that something may Chapter 3: Skepticism – An Enemy of go awry, potentially even resulting in Fraud fraud. Good board and audit committee members know what techniques Skepticism involves the validation to use to evaluate management, how of information through probing to ask the right questions, when to questions, the critical assessment of ask follow-up questions, and how to evidence, and attention to inconsis- identify and assess possible “uncom- tencies. Skepticism is not an end in fortable” behavior. Asking the same itself and is not meant to encourage questions of various people is anoth- a hostile atmosphere or micro-man- er way that board and audit commit- agement; it is an essential element of tee members can assess the consis- the professional objectivity required tency of answers and obtain multiple of all participants in the financial perspectives. reporting supply chain. Skepticism throughout the supply chain increas- To exercise skepticism effectively, es not only the likelihood that fraud members of the board and the audit will be detected, but also the per- committee must have a thorough ception that fraud will be detected, knowledge of the company’s busi- which reduces the risk that fraud will ness, including its industry, its com- be attempted. petitive environment, and the key risks that may affect management’s Management exercises skepticism ability to accomplish objectives. In by periodically testing assumptions particular, board and audit commit- about financial reporting processes tee members need to understand

128 | how their organization makes mon- Point to Ponder ey. Because revenue manipulation Whistleblower tips can serve as an and the acceleration of future results important source of information into the current period are the most about fraud and other misconduct. common forms of financial reporting How can external auditors better fraud, understanding what accounts use the data regarding the nature for the company’s revenue is critical and frequency of whistleblower to deterring and detecting financial tips to enhance their fraud risk reporting fraud. Audit committee assessment? members should be comfortable in asking probing questions and should material misstatement due to fraud, use internal auditors, external audi- how assets of the company could be tors, ethics and compliance person- misappropriated, the possibility of nel, or others as sources of informa- management override of controls, tion to supplement what they learn and how management could com- directly. mit and conceal fraudulent financial reporting. Skepticism also is central For both internal and external audi- to the execution of the audit plan, as tors, skepticism is an integral part of auditors must be alert to indications the conduct of their professional du- of fraud risks as audit evidence is ties. Because of their constant pres- evaluated and modify the audit plan ence in the company and their inti- accordingly. mate knowledge of the company’s culture, personnel, and operations, Summary of Considerations Related internal auditors are particularly well to Skepticism situated to identify early signs of potential fraud, including signs that the For Management external auditor normally might not 1. Acknowledge that fraud can occur be in a position to identify. and consider such risks as part of the company’s risk assessment pro- Professional standards require mem- cess. bers of the external audit engage- 2. Build skepticism into the culture. ment team to discuss the potential Establish a clear expectation that for material misstatement due to all levels of management will ques- fraud, which should inform the audit tion and challenge all results for plan and the nature and extent of which they are responsible, with audit testing. The team should con- the specific intent of confirming sider where the company’s financial that corporate standards of accura- statements could be susceptible to cy, excellence, and ethics were met.

| 129 Governance

3. Aggressively pursue the root cause porting fraud. of any deficiencies in controls, and 5. Question management in detail take remedial steps promptly. about its program for managing 4. Monitor your company and bench- fraud risk, focusing on areas where mark it with others in the industry management has identified the for the purpose of identifying indi- greatest vulnerabilities, including cators of fraud. the risk of management override of controls. Ask management to ex- For Boards and Audit Committees plain how those vulnerabilities are 1. Confirm that all board and audit being addressed and consider using committee members have a strong internal audit to evaluate the ef- understanding of the company’s fectiveness of management’s activi- business and its industry. Use out- ties. side training and consultants as 6. Use the internal and external audi- necessary, with the objective of tors as key resources. Have regu- teaching all members of the board lar, confidential meetings between and audit committee to ask prob- the audit committee and the chief ing questions about strategy and audit executive, and perhaps sepa- operations. Audit committee mem- rately with other senior members bers should also have a working of the internal audit department, understanding of financial report- as well as executive sessions with ing, even if they are not financial the external auditor. experts. 2. Ask questions of management, in- For Internal Auditors ternal auditors, and external audi- 1. Suggest to the board and audit tors to extract potential concerns committee specific ways in which related to opportunities or incen- internal audit can provide support, tives for financial reporting fraud. with a particular focus on the risk 3. Use face-to-face meetings whenev- of financial reporting fraud. er possible to obtain information, 2. Take the lead role in assessing the encourage open discussion, and company’s program to mitigate the assess non-verbal communications risk of financial reporting fraud, such as body language. and report annually to the audit 4. Actively oversee those aspects of committee on that assessment. the company’s strategy and risk management program that affect For External Auditors financial reporting, with a specific 1. Based on the fraud risk assessment focus on risks that could potentially developed in planning the audit, create incentives for financial re- suggest questions in advance that

130 | the board and audit committee Chapter 4: Communications – may want to ask management. Knowledge Sharing to Deter and 2. Regularly evaluate internal com- Detect Fraud munications and training programs to confirm that they adequately Each of the participants in the fi- address the exercise of professional nancial reporting supply chain has a skepticism and the assessment of separate but interconnected role in fraud risk. the shared responsibility to deter and 3. Reinforce the importance of inter- detect fraud. Fulfilling this respon- viewing and inquiry skills in the au- sibility successfully requires using dit process, including consideration each participant’s complementary of non-verbal communications. activities by sharing information and concerns and identifying any gaps in 4. Emphasize the value of checking the collective efforts to mitigate the with others as a means of obtain- risk of financial reporting fraud. Fre- ing sufficient audit evidence, and quent, high quality communications provide guidance on mechanisms enhance the knowledge and under- and methodologies such as compa- standing of all parties, resulting in ny communications to verify infor- better questions and a constantly im- mation. proving communications process. 5. Consider including in the brain- The audit committee is a hub for storming sessions individuals out- coordinating many financial report- side of the engagement team with ing communications because it has industry expertise and those who primary reporting lines from man- have experience with situations in- agement, the internal auditor and volving financial reporting fraud. the external auditor. It is the respon- 6. Consider face-to-face meetings to sibility of the audit committee to obtain information, in order to en- see that these communications work courage open discussion and assess well. Adequate time on the board non-verbal communications. and audit committee agendas for all 7. Encourage the academic commu- priority matters promotes open, two- nity to strengthen the auditing way discussion and critical challenge curriculum’s focus on professional rather than a superficial or minimalist skepticism and techniques for fraud approach. detection. In particular, executive sessions of the board and audit committee with the chief financial officer and key employees, the internal auditors and

| 131 Governance

the external auditors are invaluable External auditors are required to in providing all parties with a broad report annually to the audit com- perspective on the company’s finan- mittee on a variety of matters and cial reporting environment and the audit committees are one source of reporting culture, including whether input into an auditor’s assessment controls are respected and complied of the risk of material misstatement with faithfully. in a company’s financial statements and the related audit response. Executive sessions provide the op- These communications should not be portunity for the audit committee viewed as a routine compliance exer- to go beyond the review of finan- cise, but rather as the starting point cial reports and have open dialogue for an in-depth discussion of any on “soft” topics such as corporate matters that concern either the audit values, management style and the committee or the external auditors. potential for financial reporting fraud. For example, when the audit Of course, not all communications committee is discussing the finan- run through the audit committee; cial statements with management or communications also regularly oc- the results of internal audit engage- cur between management and the ments with the chief audit execu- internal auditor, management and tive, committee members may want the external auditor and the internal to consider specifically asking about auditor and the external auditor. In and probing the controls over finan- most organizations, the internal au- cial reporting, including controls over dit function reports administratively management override. Conversations to a member of senior management with operating personnel and with and the internal auditor’s activities financial management below the top serve a key role in helping manage- level can provide valuable insights ment assess the effectiveness of the into the company’s culture and the control environment and the risk of risks it is facing. Audit committees financial reporting fraud. Internal au- should consider asking questions such ditors should consider management’s as “Were you pressured to do any- risk assessment and other input in thing?” and “What are you uncom- developing its audit plan, although fortable with?” If the person knows management should not limit the that his or her response will be held scope of internal audit’s work. The in confidence, they will be more in- Internal audit’s findings and recom- clined to share concerns. mendations can provide management with important insights in assessing whether the intended tone

132 | at the top and ethical messages have Point to Ponder permeated throughout the organiza- There is almost never enough time tion’s culture. on board and audit committee agendas, and yet time constraints The objectives and professional should not limit critical discussions. standards of internal and external What are the best techniques to auditors with respect to the risk of ensure that all issues of concern financial reporting fraud are similar to the board and audit commit- and complementary. Internal audit’s tee are adequately discussed? One evaluation of management’s fraud approach is to minimize opening risk assessment, as well as the results remarks and formal presentations. of internal audit’s testing of internal What else works well? controls, are important to the external auditor’s assessment of fraud risk ployees at all levels in the organiza- and its planning of the external au- tion. dit. Similarly, the results of the exter- 2. Work proactively to make sure that nal audit may also inform the ongo- boards, audit committees, inter- ing internal audit plan. nal auditors, and external auditors Participants in the financial report- are well informed on a timely basis ing supply chain should work dili- about the company’s operations, gently to establish and maintain an strategies, and risks, including the environment of open and ongoing latest developments. communication. The goal is to share knowledge, insights and concerns to For Boards and Audit Committees enhance the collective efforts of all 1. Routinely ask questions of manage- supply chain participants and make ment, internal auditors, and exter- the whole greater than the sum of its nal auditors to elicit indications of parts. Communications also encour- potential concerns related to incen- age collaboration among all stake- tives or opportunities for financial holders and stimulate continuous reporting fraud. improvement in efforts to deter and 2. Work to connect with the orga- detect financial reporting fraud. nization outside the boardroom. Seek opportunities to interact with Summary of Considerations Related managers, employees, and possi- to Communications bly also vendors and customers to enhance knowledge of the com- For Management pany and possible risks of financial 1. Encourage two-way communica- reporting fraud. tion between managers and em-

| 133 Governance

Financial Reporting – Lines of Communication

134 | For Internal Auditors Chapter 5: The Case for Collaboration Establish a regular schedule of face- – Increasing Effectiveness across the to-face meetings with senior man- Financial Reporting Supply Chain agement, the audit committee, and the external auditor to exchange While supply chain participants work insights and perspectives. Explore to deter and detect financial report- opportunities for the external audi- ing fraud one company at a time, tor to best use the work of internal the collective sharing of ideas and audit. resources would greatly advance efforts to mitigate financial reporting For External Auditors fraud. 1. Proactively promote opportunities The CAQ believes that such collabo- for robust conversations between ration would indeed enhance the the external auditors and the audit ability of participants in the financial committee on relevant matters, reporting supply chain to deter and including the factors considered in detect financial reporting fraud and the auditor’s assessment of fraud thereby sustain and enhance confi- risk and the company’s approach dence in the capital markets over the to developing significant account- long term. In addition to the discus- ing estimates. Seek an executive sion participants, the CAQ sought session with the audit committee at input on this report from Financial all meetings to encourage candid Executives International (FEI), the conversation, even when there are National Association of Corporate no special concerns or significant is- Directors (NACD), and The IIA, orga- sues to discuss. nizations that already are actively 2. Work with boards and audit com- engaged in efforts to mitigate the mittees to vary the nature and risk of financial reporting fraud. focus of their questions to man- Each of these organizations provided agement, internal auditors, and significant support and insights, and others such as key employees in expressed interest in further collabo- order to extend the breadth and ration. depth of the discussion and obtain an enhanced understanding of the The effort has thus far received a business and the potential risks of positive reception. In light of the financial reporting fraud. importance of this issue to investor confidence, the CAQ will continue to encourage continued collaboration among these key stakeholders (and other professional organizations

| 135 Governance

where appropriate) to better use and potential red flags, while at the existing resources, share ideas, and same time further strengthening in- prioritize future activities to advance ternal control systems. An important the deterrence and detection of and related area for consideration is financial reporting fraud. We antici- a greater understanding of the hu- pate that the results of these efforts man conditioning that can prevent will be transparent and inclusive, and people from finding a fraud even will be communicated broadly to the when they sense that something key stakeholder groups. Such com- may not be right. It will be impor- munication could be through white tant to identify and comprehend the papers or other written materials, as environmental and behavioral factors well as the delivery of webcasts and that may discourage an individual conferences. In addition, we intend from asking the next question that these efforts to complement the might uncover the fraud. activities of the PCAOB’s Financial Re- porting Fraud Resource Center, and 2. Promoting additional efforts to look forward to opportunities for col- increase skepticism laboration with the new Center. All stakeholders could benefit from efforts to enhance the ability to We are focusing our initial efforts in think critically and skeptically about four areas: the information presented to them. For example, a key method used by 1. Advancing the understanding of stakeholders to identify potential conditions that contribute to fraud indicators of concern is the review The fraud triangle does not explain and analysis of a company’s financial one critical phenomenon: why one results and related complex informa- person takes actions to distort finan- tion. Developing tools or techniques cial results, while another in a similar to enhance the ability of manage- situation does not. Working togeth- ment, internal auditors, external au- er, the major stakeholder groups can ditors and audit committee members use their current guidance, analyze to evaluate a company’s financial past frauds, pursue further areas of results (by comparison, for instance, research, and develop new materi- with management budgets, ana- als to enhance understanding about lyst expectations, and the results of the pre-conditions and indicators of industry peers) could facilitate more financial reporting fraud. Building robust discussions and help identify awareness in these areas could assist potential indicators of concern. In ad- all financial reporting supply chain dition, frameworks to assist in assess- participants in identifying fraud risks ing other potential fraud risk factors,

136 | such as compensation arrangements, 4. Exploring the role of information could further enhance the review technology in facilitating the process. This could be complemented deterrence and detection of by enhancing stakeholders’ com- fraudulent financial reporting munication and interview skills, and Given its central role in systems of by examining behavioral traits or internal control, information technol- other environmental factors that may ogy can be helpful in deterring and impede the application of effective detecting fraud. Technology also skepticism. can be misused to facilitate fraud if not adequately controlled. Ongo- ing discussion of the benefits and 3. Moderating the risks of focusing challenges related to information only on short-term results technology could help all stakeholder An emphasis on short-term results groups identify and address technol- can create pressures on multiple ogy-related risks for fraud. In addi- levels of an organization, which tion, it would be beneficial to con- can increase the risk of financial sider whether additional or improved reporting fraud. It is important that use of technology would enhance management, boards and audit com- internal control structures and assist mittees, and internal and external in identifying potential fraudulent auditors remain sensitive to the pres- activity. For example, increased use ence of and potential risks associated of technology could facilitate the op- with short-term goals and take steps eration and monitoring of controls, to lessen them. Stakeholders can lessen the risk of human interven- share perspectives on short-termism, tion, and provide information about its role in the accomplishment of an the effectiveness of controls. Explor- organization’s objectives (including ing ways to enhance stakeholders’ those of investors), and its impact on ability to use electronic information a company’s operating environment to identify possible signs of fraud and system of internal controls. This could enhance their ability to detect awareness and sharing of experiences fraudulent behavior. Focused col- could allow all stakeholders to better laboration could produce new ideas understand and evaluate potential and tools, such as data queries and risks and mitigating factors, which analyses that could be applied to would enhance their understanding general ledgers, sub-ledgers, e-mails, of their respective responsibilities. vendor master files, and other electronic repositories to assist in identifying potential fraud. Stakeholders in the financial reporting supply chain

| 137 Governance

also may want to consider exploring ing with these and other stakehold- whether a standardized data format ers in these endeavors. for key elements of a company’s general ledger would significantly 1 The Center for Audit Quality (CAQ) is an facilitate the development of tools to autonomous public policy organization assist in monitoring, analyzing, and representing a membership of approxi- evaluating financial information. mately 700 public company auditing firms that is dedicated to enhancing investor Conclusion confidence and public trust in the capital markets. Headquartered in Washington, While there is no silver bullet solution DC, the CAQ fosters high quality per- to deterring and detecting fraud, formance by public company auditors, every group in the financial reporting convenes and collaborates with other supply chain plays a key role in fraud stakeholders to advance the discussion of deterrence and detection – from critical issues, and advocates policies and senior management to boards, audit standards that promote public company committees, internal auditors, and auditors’ objectivity, effectiveness and external auditors. While the Sar- responsiveness to dynamic market condi- banes-Oxley Act has led to significant tions. The CAQ is entirely funded by mem- improvements in financial reporting bership dues. Membership in the CAQ is processes and controls and overall open to US accounting firms registered corporate governance, all supply with the Public Company Accounting chain participants must maintain a Oversight Board (PCAOB) and others. For vigilant watch for the presence of the more information, go to www.thecaq.org elements of the fraud triangle. Literature The observations in this report represent the beginning of a focused and Askelson, Ken CIA, CPA, CITP, et al. coordinated long-term effort to ad- Global Technology Audit Guide 13: vance the deterrence and detection Fraud Prevention and Detection in of financial reporting fraud, with the an Automated World. The Institute ultimate goal of benefiting investors, of Internal Auditors Research Foun- other users of financial reports, and dation, 2009. participants in the capital markets. Association of Certified Fraud Exam- The CAQ is especially pleased that iners. 2010 Report to the Nations the FEI, the NACD, and The IIA have on Occupational Fraud and Abuse. agreed to join with us to collaborate 2010. http://butest.acfe.com/rttn/ and advance this complex and vital is- rttn-2010.pdf sue. The CAQ looks forward to work-

138 | Association of Certified Fraud Exam- tionDetectionResponse/Download- iners. 2008 Report to the Nation ableDocuments/managing_busi- on Occupational Fraud and Abuse. ness_risk_fraud.pdf 2008. http://www.acfe.com/docu- AuditNet. Internal Auditing and ments/2008-rttn.pdf Fraud: The Auditor’s Role. 2009. Association of Certified Fraud Exam- http://www.auditnet.org/articles/ iners. Occupational Fraud: A Study FraudSurvey2010.htm of the Impact of an Economic Re- BDO Consulting. The Value and Ef- cession. 2009. http://www.acfe.com/ fectiveness of Corporate Anti-Fraud documents/occupational-fraud.pdf Programs: A Comprehensive Study Association of Certified Fraud Exam- of Sophisticated Investors. 2009. iners. Tone at the Top: How Man- http://www.bdoconsulting.com/ agement Can Prevent Fraud in the resources/thought-leaders/Effec- Workplace. 2006. http://www.acfe. tiveAF-ResultsFinal.pdf com/documents/tone-at-the-top-re- BDO Consulting and Financial Execu- search.pdf tives Research Foundation. Segre- American Institute of Certified Public gation of Duties Checklist. 2009. Accountants Audit Committee Ef- http://www.bdocca.com/resources/ fectiveness Center. The Audit Com- thought-leaders/SegDutiesCheck- mittee Toolkit: Public Companies, list-19.pdf 2nd Edition. 2008. Childs, Ralph and Tony Malone. American Institute of Certified Pub- Best Practices in Ethics Hotlines: A lic Accountants. Management Framework for Creating an Effec- Override of Controls: The Achil- tive Anonymous Reporting Pro- les Heel of Fraud Prevention. gram. The Network, 2009. http:// 2005. http://www.aicpa.org/For- staging.tnwinc.com/Libraries ThePublic/AuditCommitteeEffec- White_Papers/Best_Practices_in_ tiveness/AuditCommitteeBrief/ Ethics_Hotlines.sflb.ashx DownloadableDocuments/manage Committee of Sponsoring Organiza- ment%20override%20achilles_heel. tions of the Treadway Commission. pdf Fraudulent Financial Reporting: American Institute of Certified Public 1998-2007: An Analysis of US Pub- Accountants, Association of Certi- lic Companies. 2010. http://www. fied Fraud Examiners, and Institute coso.org/documents/COSOFRAUD- of Internal Auditors. Managing the STUDY2010.pdf Business Risk of Fraud: A Practical Guide. 2008. http://www.aicpa. org/InterestAreas/ForensicAnd Valuation/Resources/FraudPreven-

| 139 Governance

Committee of Sponsoring Organiza- Ernst & Young. Driving Ethical tions of the Treadway Commission. Growth –New Markets, New Chal- Fraudulent Financial Reporting: lenges: 11th Global Fraud Survey. 1987-1997: An Analysis of US Public 2010. http://www.ey.com/Publica- Companies. 1999. tion/vwLUAssets/EY_11th_GLOB- Committee of Sponsoring Organi- AL_FRAUD_Survey/$FILE/EY_11th_ zations of the Treadway Commis- GLOBAL_FRAUD_Survey.pdf sion. Internal Control – Integrated Ernst & Young. European Fraud Sur- Framework. 1992. vey 2009: Is Integrity a Casualty of Compliance Week and Integrity In- the Downturn? 2009. http://www. teractive Corporation. 2009 Global ey.com/Publication/vwLUAssets/ Integrity Survey. 2009. http://www. European_fraud_survey_2009_- complianceweek.com/s/2009GlobalI _Is_integrity_a_casualty_of_the_ ntegritySurvey.pdf downturn/$FILE/Ernst%20&%20Yo Cressey, Donald. Other Peoples’ Mon- ung%20European%20fraud%20sur ey: A Study in the Social Psychology vey%202009.pdf of Embezzlement. 1953. Ethics Resource Center. 2009 National Deloitte. Ten Things about Financial Business Ethics Survey. 2009. http:// Statement Fraud – Third Edition: A www.ethics.org/nbes/files/nbes-fi- Review of SEC Enforcement Releas- nal.pdf es, 2000-2008. 2008. http://www. Ethics Resource Center, et al. Leading deloitte.com/assets/Dcom-United- Corporate Integrity: Defining the States/Local%20Assets/Documents/ Role of the Chief Ethics & Compli- FAS_ForensicCenter_us_fas-us_dfc/ ance Officer. 2007. http://www. us_dfc_ten_things_about_financial_ corporatecompliance.org/Content/ statement_fraud_241109.pdf NavigationMenu/Resources/Surveys/ Durtschi, Cindy and Rosemary Ful- CECO_Definition_8-13-072.pdf lerton. The Effect of Professional Ethics Resource Center and Working Skepticism on the Fraud Detection Values. Critical Elements of an Or- Skills of Internal Auditors. 2004. ganizational Ethical Culture. 2006. http://papers.ssrn.com/sol3/Delivery. http://www.workingvalues.com/ cfm/SSRN_ID617062_code329911. Dec06WorkingValuesWhtPpr.pdf pdf?abstractid=617062&mirid=1 Erickson, Merle, Michelle Hanlon, and Edward Maydew. Is There a Link Between Executive Compensation and Accounting Fraud? University of Chicago, 2004.

140 | Financial Executives Internation- cfainstitute.org/learning/prod- al. 2007 Survey on Sarbanes- ucts/publications/dig/Pages/dig. Oxley 404 Implementation. v39.n3.39.aspx?WPID=Topic_List_ 2008. http://www.financialex- Tabbed&PageName=All ecutives.org/eweb/DynamicPage. KPMG. Fraud Survey 2009. 2009. aspx?site=_fei&webcode=ferf_pub_ www.kpmginfo.com/NDPPS/ detail&prd_key=54ec0b8e-b0cb- FlippingBook/21001nss_fraud_sur- 4955-af8c-7c9e42c68d00 vey_flip/index.html Financial Executives Research Foun- KPMG. Fraud Risk Management – De- dation and Gary Rubin. Fraud veloping a Strategy for Prevention, Risk Checklist: A Guide for As- Detection, and Response. 2006. sessing the Risk of Internal Fraud. http://www.us.kpmg.com/Rutus_ 2007. http://www.financialex- Prod/Documents/12/FRM-White-Pa- ecutives.org/eweb/DynamicPage. per.pdf aspx?site=_fei&webcode=ferf_pub_ KPMG. Integrity Survey 2008-2009. detail&prd_key=64a0e785-0955- 2009. http://us.kpmg.com/Ru- 4e11-810f-d45db31b6546 tUS_prod/Documents/8/Integrity- Financial Executives Research Foun- Suvey08_09.pdf dation. Earnings Guidance: The KPMG Audit Committee Institute, et Current State of Play. Robert Kuep- al. Highlights from the 6th Annual pers, Nicole Sandford, and Thomas Audit Committee Issues Confer- Thompson, Jr., 2009 ence: Setting the 2010 Agenda. http://www.financialexecu- 2009. http://www.kpmginstitutes. tives.org/eweb/DynamicPage. com/aci/insights/2010/pdf/2010-au- aspx?site=_fei&webcode=ferf_pub_ dit-committee-issues-conference- detail&prd_key=64a0e785-0955- highlights.pdf 4e11-810f-d45db31b6546 KPMG Audit Committee Institute and Hurtt, Kathy. Development of a Scale National Association of Corpo- to Measure Professional Skepticism. rate Directors. The Audit Commit- Auditing: A Journal of Practice and tee Journey: Recalibrating for the Theory – Volume 29, No. 1. Ameri- “New Normal” – 2009 Public Com- can Accounting Association, May pany Audit Committee Member 2010. Survey. 2009. http://www.kpmg. Johnson, Shane, Harley Ryan, and com/Global/en/IssuesAndInsights/ Yisong Tian. Managerial Incen- ArticlesPublications/Documents/Au- tives and Corporate Fraud: The dit-committee-journey-2009-mem- Sources of Incentives Matter. ber-survey.pdf CFA Digest – Volume 39, No. 3. KPMG Audit Committee Institute. The CFA Institute, 2009. https://www. Audit Committee Journey: Charting

| 141 Governance

Gains, Gaps and Oversight Priorities National Association of Corporate – 2007-2008 Public Company Audit Directors and the Center for Board Committee Member Survey. 2008. Leadership and Its Alliance Part- http://www.surveys.kpmg.com/aci/ ners. Report of the NACD Blue Rib- docs/surveys/ACI_NACD_Journey07_ bon Commission on Risk Gover- 08_POSTFINAL.pdf nance: Balancing Risk and Reward. Lowenstein, George and Scott Rick. 2009. Hypermotivation. Journal of Mar- National Association of Corporate keting Research, 2008. Directors and the Center for Board http://qbox.wharton.upenn.edu/ Leadership. Report of the NACD documents/opim/research/Hyper- Blue Ribbon Commission on Board motivation.pdf Evaluation: Improving Director Ef- LRN. Ethics and Compliance Risk Man- fectiveness – 2005 Edition. 2005. agement: Improving Business Per- Nelson, Mark. A Model and Literature formance and Fostering a Strong Review of Professional Skepticism Ethical Culture through a Sustain- in Auditing. Auditing: A Journal of able Process. 2007. http://www.lrn. Practice and Theory – Volume 28, com/docs/lrn_risk_management.pdf No. 2. American Accounting Asso- LRN. The Impact of Codes of Conduct ciation. November 2009. on Corporate Culture: Measuring Oversight Systems Inc. 2005 Over- the Immeasurable. 2006. http:// sight Systems Report on Corporate www.lrn.com/docs/lrn_code_of_ Fraud. 2005. http://www.oversight- conduct_whitepaper.pdf systems.com/whitepapers/Over- National Association of Corporate sight_Systems_Survey_on_Fraud. Directors and Its Alliance Partners. pdf Guidance for Governance Challeng- Public Company Accounting Over- es – 2010 and Beyond. 2010. sight Board. AU Section 316.01, National Association of Corporate Consideration of Fraud in a Fi- Directors and the Center for Board nancial Statement Audit. PCAOB Leadership and Its Alliance Part- Interim Auditing Standard. ners. Report of the NACD Blue Rib- http://pcaobus.org/Standards/Audit- bon Commission – Audit Commit- ing/Pages/AU316.aspx tees: A Practical Guide. 2004. Public Oversight Board. The Pan- National Association of Corporate el on Audit Effectiveness Report Directors and the Center for Board and Recommendations. 2000. Leadership and Its Alliance Part- http://www.pobauditpanel.org/ ners. Report of the NACD Blue Rib- download.html bon Commission on Audit Commit- PricewaterhouseCoopers. 2009 Glob- tees. 2010. al Economic Crime Survey. 2009.

142 | http://www.pwc.com/us/en/foren- Framework Practice Guide: Defi- sic-services/publications/2009-glob- nition of Internal Auditing. 2010. al-economic-crime-survey.jhtml http://www.theiia.org/guidance/ PricewaterhouseCoopers. Economic standards-and-guidance/ippf/defi- Crime in a Downturn: The 5th Glob- nition-of-internal-auditing/ al Economic Crime Survey – United The Institute of Internal Auditors. States Supplement. 2009. http:// International Professional Practices www.pwc.com/us/en/forensic-ser- Framework Practice Guide: Internal vices/publications/assets/2009-glob- Auditing and Fraud. 2009. al-economic-survey-us-supplement. Tonello, Matteo and The Conference pdf Board, Inc. Revisiting Stock Market Roth, James, PhD, CIA, CCSA. Best Short-Termism. 2006. http://ssrn. Practices: Evaluating the Corporate com/abstract=938466 Culture. The Institute of Internal Young, Michael R. Accounting Ir- Auditors, 2010. regularities and Financial Fraud: A Soltani, Bahram. A Closer Look at Corporate Governance Guide. CCH. Financial Reporting: Understand- 2006. ing the Fraud Risks Associated with Corporate Reporting Is Vital to Maintaining Organizational Well- Being. 2009. http://www.thefreeli- brary.com/A+closer+look+at+financ ial+reporting%3A+understanding+ the+fraud+risks+...-a0210607342 The Aspen Institute. Overcoming Short-Termism: A Call for a More Responsible Approach to Invest- ment and Business Management. 2009. http://www.aspeninstitute. org/sites/default/files/content/images/Overcoming%20Short-termism% 20AspenCVSG%2015dec09.pdf The Institute of Internal Auditors and Audit Executive Center. Knowledge Alert: Emerging Trends in Fraud Risks. 2010. www.theiia.org/download.cfm?file=35943 The Institute of Internal Auditors. International Professional Practices

| 143 Governance

3.5. The G20 Must Look Beyond Bretton Woods II by Robert Zoellick

With talk of currency wars and dis- rates. Mr. Baker worked with his G7 agreements over the US Federal Re- colleagues and central bankers to or- serve’s policy of quantitative easing, chestrate international cooperation the summit of the Group of 20 lead- to build private-sector confidence. ing economies in Seoul on November 11–12, 2010, is shaping up as the latest History moved on after the huge test of international cooperation. So changes of 1989 and the experience we should ask: cooperation to what of the 1980s is still being debated, end? but this package approach was significant for its combination of pro- When the G7 experimented with growth reforms, open trade and ex- economic coordination in the 1980s, change rate coordination. the Plaza and Louvre Accords focused attention on exchange rates. Yet the What might such an approach look policy underpinnings ran deeper. like today? First, to focus on funda- The Reagan administration, guided mentals, a key group of G20 coun- by James Baker, the then Treasury tries should agree on parallel agen- secretary, wanted to resist a protec- das of structural reforms, not just tionist upsurge from Congress, like to rebalance demand but to spur the one we see today. It therefore growth. For example, China’s next combined currency coordination with five-year plan is supposed to trans- the launch of the Uruguay Round fer attention from export industries that created the World Trade Or- to new domestic businesses, and the ganisation and a push for free trade service sector, provide more social that led to agreements with Canada services and shift financing from oli- and Mexico. International leader- gopolistic state-owned enterprises to ship worked with domestic policies to ventures that will boost productivity boost competitiveness. and domestic demand.

As part of this “package approach” With a new Congress, the US will G7 countries were supposed to ad- need to address structural spending dress the fundamentals of growth and ballooning debt that will tax fu- – today’s structural reform agenda. ture growth. President Barack Obama For example, the 1986 Tax Reform has also spoken of plans to boost Act broadened the revenue base competitiveness and revive free-trade while slashing marginal income tax agreements.

144 | The US and China could agree on es. The World Bank Group and the specific, mutually reinforcing steps regional development banks could be to boost growth. Based on this, the the instruments of building multiple two might also agree on a course for poles of future growth based on pri- renminbi appreciation, or a move to vate sector development. wide bands for exchange rates. The US, in turn, could commit to resisting Fifth, the G20 should complement tit-for-tat trade actions, or, better, to this growth recovery program with a advance agreements to open mar- plan to build a co-operative mon- kets. etary system that reflects emerging economic conditions. This new system Second, other major economies, is likely to need to involve the dollar, starting with the G7, should agree to the euro, the yen, the pound and a forego currency intervention, except renminbi that moves towards inter- in rare circumstances agreed to by nationalization and then an open the others. Other G7 countries may capital account. wish to boost confidence by committing to structural growth plans as The system should also consider em- well. ploying gold as an international reference point of market expectations Third, these steps would assist emerg- about inflation, deflation and future ing economies to adjust to asymme- currency values. Although textbooks tries in recoveries by relying on flex- may view gold as the old money, ible exchange rates and independent markets are using gold as an alterna- monetary policies. Some may need tive monetary asset today. tools to cope with short-term hot money flows. The G20 could develop The development of a monetary norms to guide these measures. system to succeed Bretton Woods II, launched in 1971, will take time. But Fourth, the G20 should support we need to begin. The scope of the growth by focusing on supply-side changes since 1971 certainly matches bottlenecks in developing countries. those between 1945 and 1971 that These economies are already contrib- prompted the shift from Bretton uting to half of global growth, and Woods I to II. Serious work should their import demand is rising twice as include possible changes in Interna- fast as that of advanced economies. tional Monetary Fund rules to review The G20 should give special support capital as well as current account pol- to infrastructure, agriculture and de- icies, and connect IMF monetary as- veloping healthy, skilled labour forc- sessments with WTO obligations not

| 145 Governance

to use currency policies to remove trade concessions.

This package approach to economic cooperation reaches beyond the recent G20 dialogue, but the ideas are practical and feasible, not radical. And it has clear advantages. It sup- plies a growth and monetary agenda that parallels the G20 ﬁnancial sector reforms. It could be built upon prompt incremental actions, combined with credible steps to be pur- sued over time, allowing for political dialogue at home. And it could help rebuild public and market conﬁ- dence, which will remain under stress in 2011. Perhaps most importantly, this package could get governments ahead of problems instead of react- ing to economic, political and social storms.

Drive or drift? How the G20 decides could determine whether multilat- eral cooperation can achieve a strong economic recovery.

First published in the FINANCIAL TIMES, November 7 2010.

146 | Contributors

| 147 Contributors

Frank Brettschneider is Professor for Christian Dreyer CFA is owner of Communication Studies and Commu- Tertium datur AG, a Swiss consulting nication Theory at the University of ﬁrm specializing in smart institutional Hohenheim. His research focuses on asset management and pan- Euro- campaign communication, public opi- pean pension funds. nion, media effects, and communica- His earlier professional responsibili- tion performance management. He ties were: is member of the advisory board of CFO at an IT security outsourcer, the international institute for media Head of investment research at Basler analysis “Media Tenor” and director Kantonalbank, of the Centre for Communication Portfolio Manager and Assistant to Performance Management. www. the CEO of Baloise Bank SoBa. As a uni-hohenheim.de/komm/ volunteer, he served on the board of the Swiss CFA Society in several capacities, including President, from 2000 until 2010. He currently chairs the International Accounting Stan- dards Board‘s Analyst Representatives Group.He has been elected for a second term to the Strategic Advisory Council for the IASB‘s XBRL activities. Chris holds a Master‘s Degree in political economy from the University of St. Gallen HSG in Switzerland and a Master of Laws degree from Edin- burgh University (UK). He is Swiss citizen and lives near Basle, Switzer- land. His twitter handle is @x3er.

148 | Anikar Haseloff is founder and ma- Mike Krzus is a partner with, Grant naging director of the H&H Commu- Thornton LLP. He is currently serving nication Lab GmbH. He also teaches as the president of the Enhanced at the University of Hohenheim. His Business Reporting Consortium and research and teachings focuses on he is one of the EBRC’s delegates Readability and Usability, especially to the World Intellectual Capital web-usability. In his company, he Initiative. He is a member of the develops computer-based tools to AICPA Assurance Services Executive measure readability and is a consul- Committee and past Chairman of the tant to different companies regar- AICPA XBRL Assurance Task Force. ding readability. In his academic Prior to joining Grant Thornton, Mike position he focuses mainly on eye- worked in the Assurance Professional tracking and user behavior. Standards Group of Arthur Andersen. He focused primarily on U.S. and international standards for new types of attestation and assurance services. Mike’s background includes diverse management experience in industry and public accounting. He has held positions including Year 2000 project director, director of internal audit and director of financial reporting for publicly held companies. In addition, Mike was in the national SEC practice of an international public accounting firm and was a director in the accounting and auditing quality control group of large Chicago-based public accounting firm.

| 149 Contributors

Oliver Oehri, lic.oec.HSG, is a CSSP Maciej Piechocki is Senior Project founding partner, Mr Oehri has Manager at the IFRS Foundation, taught internationally for several the oversight body of the IASB. He years on the subject of “Microfinance is responsible for the technological Investments”. In his previous capa- development of the IFRS Taxonomy city, he developed and successfully and the coordination of other global implemented the first microfinance IFRS and XBRL initiatives such as the investment fund in Liechtenstein. Interoperable Taxonomy Architecture Prior to this, he directed research project. Maciej is also involved in the in microfinance at the University of IFRS Foundation’s global outreach Liechtenstein. Mr Oehri is a board of activities to promote understanding directors’ member of a Liechtenstein and adoption of IFRSs and XBRL. fund management company and as Maciej is a member of the XBRL Inter- a committee chairman is responsible national Standards Board and the Ta- for fund management review/invest- xonomy Architecture Working Group. ment controlling. As an Associate He was an initiator of the Polish XBRL Partner of the Fund-Academy in jurisdiction and the founding mem- Zurich and as a financial consultant ber of the XBRL Poland Association. at a St. Gallen consultancy, he was Maciej holds a PhD in Economics (dr. able to amass profound theoretical rer. pol.) with a major in Manage- and practical experience in the area ment Information Systems, an MSc of investment products. Mr Oehri has in Management and Marketing from a graduate degree (Lizentiat) from the University of Economics in Poz- the University of St. Gallen with an nan, Poland, and an MSc in Business emphasis on financial and capital Administration from the Freiberg market theory. He teaches at the University of Technology, Germany. University of Zurich as well as at the University of Liechtenstein.

150 | Kurt Ramin is a Director at AccountA- Cornelis Reiman applies international bility and Head of Standards. start-up, turnaround and business Kurt is a pioneer in global reporting development skills as a Board-level languages and standards, having pre- advisor. Previously, he was President viously been a director and advisor of an economic development entity to the International Financial Repor- promoting International Financial ting Standards Foundation at the Reporting Standards in developing IASB in London for over 10 years. His countries. Before that, he was Dean work on behalf of the IASB involved and Vice President of universities in introducing XBRL and IFRS to more Thailand and Singapore. than 70 countries. During his tenure Formerly, he taught postgraduate with the IASB he served as the Global international business, management Chairman of XBRL and was a mem- and economics at Monash University. ber of the EU Commission High Level Prior to academia, he consulted in Expert Group and the Brookings Insti- the private and public sectors on is- tute Task Force on Intangibles. sues such as corporate management, Prior to joining the IFRS Foundation strategic planning, regional economic and its predecessor, the IASC, Kurt development and business incubati- was a partner at PricewaterhouseCo- on. IBM and Arthur Andersen & Co. opers in New York. He holds MBA, employed him earlier. CPA, and CEBS degrees and is a board He has a Ph.D. in Economics, FCPA member of several international (Australia and Singapore), FCIS and organizations and a member of the CA, as well as computing, marketing AICPA, Financial Executives Interna- and management qualiﬁcations. tional and other professional asso- ciations. Kurt Ramin currently serves as Treasurer on the Council of the International Union for Conservation of Nature (IUCN),

| 151 Contributors

Dr. Henry Schäfer is chairholder of Roland Schatz, born 1965 in Bielefeld, Department III (Chair of Finance) at Journalist in the 5th generation, stu- the Institute of Business Administrati- died philosophy, economics, history on. Previous to his current occupation and political science. at the University he belonged to the His journalistic background: Braun- top management in an international schweiger Zeitung, epd and Freibur- consulting firm specializing in Mer- ger Nachrichten. gers as Senior Financial Consultant Foundation of INNOVATIO Publishing and in a major German bank Ltd. in 1985 to support the old idea Prof. Schäfer’s main focus in research of a Greek Agora with authors as is on the valuation of assets, in Karl Popper, Helmut Maucher, Samu- particular regarding real options and el Brittan: Journals, books, congresses non-financial parameters, economic with a focus on media monitoring, analysis of networks, financing of East-West Dialogue, culture manage- start-ups and companies from the ment, and applied business ethics German “Mittelstand”, and micro- 1993 Foundation of Media Tenor. economics. Particular relevance is given to research regarding „Sustai- 2008 he was announced Global nability & Finance“. Media Export of the UN Alliance of Civilization, 2009 he founded the To date Prof. Schäfer has undertaken C1 World Dialogue Foundation with research and consulted several major Prince Ghazi of Jordan. well-known global firms. Among these are DaimlerChrysler, Bosch, Porsche, PricewaterhouseCoopers, Ernst & Young, KPMG, Deutsche Bank and LBBW.

152 | Olivier Servais is Director of XBRL Matthias Vollbracht is Director of Activities at the IFRS Foundation and Economic and Business Research at also Chair of the XBRL International Media Tenor International in Zu- Nominations Committee. He has rich/Switzerland. In his research and served as European Director of XBRL consulting work, Matthias Vollbracht International, and is a member of focuses on the impact of media co- a number of global XBRL working verage on public opinion, individual groups and committees. stakeholder groups and the reputation of institutions and individuals. Furthermore, he works on studies to explore the impact of media on asset prices and economic behaviour such as investors’ and consumers’ conﬁ- dence as well as inﬂation expectations. Matthias Vollbracht received his degree in economics from the University of Mainz, Germany and has worked as a business journalist before joining Media Tenor.

| 153 Contributors

Liv Apneseth Watson Robert B. Zoellick Board of Director – IRIS Business Ser- 11th Chief Executive of World Bank vices (India) Private Limited Mr. Zoellick was formerly Vice Chair- XBRL International Steering Commit- man, International of the Goldman tee Member Sachs Group, and a Managing Direc- Chair – XBRL International Jurisdic- tor and Chairman of Goldman Sachs‘ tion Development Working Group Board of International Advisors. Liv A. Watson is one of the founders In 2005-2006, Mr. Zoellick served as of XBRL and recently joined the Deputy Secretary of the U.S. State De- Board of Director of IRIS Business Ser- partment. From 2001 to January 2005, vices Private Limited. IRIS is a leading Mr. Zoellick served in the President‘s information and technology player, cabinet as U.S. Trade Representative. which has been in existence for close From 1993 to 1997, Mr. Zoellick served to 15 years. IRIS’ core strengths lie in as an Executive Vice President of working with unstructured informati- Fannie Mae. on received from various sources, and Following Fannie Mae, Zoellick standardizing and streamlining such served for a year as the Olin Visiting information sets. IRIS has been very Professor at the U.S. Naval Academy. closely involved with the XBRL space, From 1985 to 1993, Mr. Zoellick served in the areas of taxonomy creation, with Secretary James A. Baker, III at software solutions and conversion of the Treasury Department (from De- data into XBRL format. puty Assistant Secretary for Financial She is serving on the board of direc- Institutions Policy to Counselor to the tors of Media Tenor International. Secretary); State Department (Under- secretary of State for Economic and Agricultural Affairs as well as Coun- selor of the Department).

154 |