International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

CORPORATE КОРПОРАТИВНАЯ OWNERSHIP & CONTROL СОБСТВЕННОСТЬ И КОНТРОЛЬ

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383 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 EDITORIAL

Dear readers!

An economic crisis has shown lack of attention to crucial issues in governance business entities. Recommendations for corporate governance enforcement have been proposed by business community, society and regulators. However, risks, performance, reporting and corporate control issues are still under the discussion. With respect to this role of legal environment in establishing appropriate solutions for corporate governance effectiveness is relevant. It is clear that corporate governance enforcement and other legal issues is an increasingly important area of focus and substantial discussion should be arranged. Understanding that real business conditions can differ from theoretical models proposed by science, that’s why it’s important to form a platform for practitioners and theorists to outline main challenges and prospective solutions for improving corporate governance world.

This issue pays attention to the problems of corporate governance rating model, account auditing in the corporate system, pension fund governance, european banking system.

Yutaka Harada investigates corporate governance in the wake of a financial crisis, explains why the banking crises occurred and how we can avoid them in the future. Mauro Romano and Christian Favino verify whether the international crisis has significantly changed the structure of the interlocking directorate network that links large firms in the regulated Italian market; investigate the changes that have occurred in the interpersonal network of directors of the same firms previously observed. Roberto Moro Visconti and Maria Cristina Quirici investigate frontier faces key trendy issues, which are likely to deeply reengineer the relationship among different stakeholders, as it has already happened, on a different and more sophisticated scale, with traditional banking. Hugh Grove and Maclyn Clouse conclude that the five Chinese companies analyzed in this paper had poor auditing, boards that did not get involved, and boards and management that violated the NYSE’s key corporate governance principles. Ronald H Mynhardt recommends that a world supervisory body on corporate governance be established and proposes that a summit be called to discuss and create such an authority. Michael Maingot, Tony Quon and Daniel Zéghal conclude that the small increases in the number of risk disclosures by S&P 500 and TSX companies after the financial crisis did not make the readers of the annual reports more aware of the increased risks that companies faced in the wake of the 2008 financial crisis. Sanjana Brijball Parumasur and Patsy Govender summarize that a new management paradigm is needed to effectively overcome current chronic organizational problems. This means that the leadership cannot be engulfed in a quagmire of protocols and operating procedures, bureacracy, and chains of command that imprison themselves and cause paradigm blindness. Aleksandra Szunke concludes that the modern response system creates a new paradigm of central banking, in which the institutional and instrumental framework of monetary authorities go beyond the traditional understanding of the functions of central banks, strongly associated with prevention activities, as well as regulatory and supervisory initiatives. Roberto Moro Visconti analyses how clan governance rotates around informal relationships, which concern also untitled land, intrinsically unfit for collateral lending. W J Pienaar proposes two techniques that may be used as additional decision-making instruments when evaluated projects show similar degrees of long-term financial viability.

We hope that you will enjoy reading the journal and in future we will receive new papers, outlining the most important issues and best practices of corporate governance!

384 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 CORPORATE OWNERSHIP & CONTROL Volume 11, SPRING 2014 SPECIAL CONFERENCE ISSUE, CONTINUED 2

CONTENTS

Editorial 384

JAPAN’S FINANCIAL CRISIS IN 1992 AND UNBALANCED INCENTIVES 388

Yutaka Harada

This paper investigates corporate governance in the wake of a financial crisis. In Section 1, the author will explain why the banking crises occurred and how we can avoid them in the future. And in Section 2, there will be discussion on Japan’s financial crises in 1990s, focusing on why Japan’s financial authorities delayed efforts to resolve the NPL issue and why they did not try to expand the monetary base. The bank supervision authority (Ministry of Finance at that time) and financial institutions had incentives to delay the disposal of bad loans. They wanted to cloud their responsibilities by delaying the disposal. Their strategy had the desired effect, as many escaped their responsibilities because of the delay.

BROKEN TIES AND CORPORATE GOVERNANCE CHANGES UNDER UNCERTAINTY CONDITIONS. A LONGITUDINAL STUDY OF ITALIAN BOARDROOM NETWORK EVOLUTION 399

Mauro Romano, Christian Favino

The paper aims to verify whether the international crisis has significantly changed the structure of the interlocking directorate network that links large firms in the regulated Italian market. Furthermore the paper, which is a development of a preceding research study, also investigates the changes that have occurred in the interpersonal network of directors of the same firms previously observed. To this end, the authors present a preliminary analysis of the evolution of corporate governance in the main European regulated markets through a dynamic comparison of some synthetic statistical data observed at the end of the years 2006, 2008 and 2010. In the second part, after framing the interlocking directorate concept, the authors examine the evolution of the interlocking directorate network during the aforementioned observation period (2006-2010) with respect to larger Italian listed companies (FTSE MIB) and their directors.

THE IMPACT OF INNOVATION AND TECHNOLOGY ON MICROFINANCE SUSTAINABLE GOVERNANCE 420

Roberto Moro Visconti, Maria Cristina Quirici

The authors provide the analysis, which is addressing, in a multidisciplinary and innovative comprehensive way, apparently weakly related topics such as MF governance, and IT issues, within recessionary cycles. This hardly investigated frontier faces key trendy issues, which are likely to deeply reengineer the relationship among different stakeholders, as it has already happened, on a different and more sophisticated scale, with traditional banking.

385 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

To the extent that technology (with access to Internet, social networks, cashless electronic payments, etc.) reshapes the equilibriums among different stakeholders, it is likely to have important – albeit under-investigated - corporate governance consequences, softening the conflicts of interest among stakeholders and reinforcing the business model, making it more resilient during recessions, with positive externalities on both sustainability and outreach.

CORPORATE GOVERNANCE STANDARDS IN CROSS-BORDER INVESTING: LESSONS LEARNED FROM CHINESE COMPANIES LISTED IN THE UNITED STATES 429

Hugh Grove, Maclyn Clouse

In this work authors examine five Chinese company stocks that have been listed on United States exchanges with either initial public offerings (IPOs) or reverse mergers, often called reverse take-overs (RTOs). Their shares were initially well received in the market, especially as China’s economy continued to grow at rates much higher than the rest of the world’s countries, with increasing stock prices creating significant gains for their investors. However, in spite of these firms’ apparent compliance to the U. S. regulations, there is now evidence of fraud, poor auditing, and a lack of corporate governance and control. The resultant stock price declines have led to billions of dollars of losses for investors, and some of these Chinese firms have subsequently been delisted by U. S. stock exchanges. In this paper, we will show that had auditors, boards of directors, and financial analysts been more diligent and responsible, these problems could have been identified earlier than they were. Perhaps some of the investors’ losses could have been prevented.

UNIVERSAL CORPORATE GOVERNANCE STANDARDS: RECOMMENDATIONS FOLLOWING THE GLOBAL FINANCIAL CRISIS 438

Ronald H Mynhardt

The study found that it appeared that corporate governance has failed and action needs to be taken. The study recommends that a world supervisory body on corporate governance be established. It also proposes that a summit be called to discuss and create such an authority. In addition, the formulation of a set of universal corporate governance standards for implementation by the members was suggested.

THE EFFECT OF THE FINANCIAL CRISIS ON RISK DISCLOSURES: A COMPARATIVE STUDY OF U.S. AND CANADIAN CORPORATIONS 447

Michael Maingot, Tony Quon, Daniel Zéghal

The paper critically analyses risk disclosures by non-financial U.S. companies and determines the impact of the 2008 financial crisis on these disclosures; examines risk disclosures by non-financial Canadian companies and to determine the impact of the 2008 financial crisis on these disclosures; compares the number of risk disclosures by these U.S. companies with Canadian companies in the same sectors.

LET MANAGEMENT DRIVE THE DESIRED ORGANIZATIONAL CULTURE AND CULTURE SHIFT 459

Sanjana Brijball Parumasur, Patsy Govender

In this work attention is predominantly paid to the need for an evolution of management thought and a shift in the management paradigm. It aims to show how managers can drive the desired organizational culture and culture shift in an environment dictated by complexity, risk, attitudes and behaviours, amongst others. It uses the Competing Values Framework (CVF) to determine the dominant leadership model, focus, direction and organizational culture.

386 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

CHANGES IN MONETARY POLICY AFTER THE CRISIS - TOWARDS PREVENTING BANKING SECTOR INSTABILITY 470

Aleksandra Szunke

This study advances research on identification the general framework of the response system of central banks on the phenomenon of banking sector instability, in the context of preventing it in a long term. Current - the traditional system proved to be ineffective, because it did not prevent the spread of the factors that led to the destabilization of the banking market.

CLAN GOVERNANCE AND LANDLESS SOCIAL CAPITAL: AN ANTHROPOLOGICAL STAKEHOLDERSHIP MODEL 477

Roberto Moro Visconti

The paper analyses clan governance rotates around informal relationships, which concern also untitled land, intrinsically unfit for collateral lending. Comparison between the West and the Rest does not suggest automatic dominance of formal governance patterns, but rather painfully converging standards, under the centripetal influence of disordered globalization, which may flatten cultural differences, up to the point of spoiling valuable “biodiversities”.

THE APPLICATION OF SYSTEMS ANALYSIS TO ENHANCE THE PERFORMANCE OF LOGISTIC SYSTEMS IN SUPPORTING ECONOMIC GROWTH AND DEVELOPMENT 485

W J Pienaar

The paper provides guidelines on how decision-makers can choose capital projects on the basis of economic and financial criteria by applying a systems-analysis approach. Project appraisal, selection and prioritisation criteria are listed, followed by a description of the way in which the result of each appraisal technique should be interpreted. Criteria that should be adhered to in the selection of mutually exclusive projects and the prioritisation of functionally independent projects in order to maximise net output in the long run are supplied. Applications of the proposed investment decision rules are illustrated by examples. Two techniques are proposed that may be used as additional decision-making instruments when evaluated projects show similar degrees of long-term financial viability. Five performance areas that collectively best represent successful organisational logistics performance are detailed.

SUBSCRIPTION DETAILS 496

387 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

JAPAN’S FINANCIAL CRISIS IN 1992 AND UNBALANCED INCENTIVES

Yutaka Harada*

Abstract

In this paper the author analyzes corporate governance in the wake of a financial crisis. In Section 1, the author will explain why the banking crises occurred and how we can avoid them in the future. And in Section 2, there will be discussion on Japan’s financial crises in 1990s, focusing on why Japan’s financial authorities delayed efforts to resolve the NPL issue and why they did not try to expand the monetary base. The bank supervision authority (Ministry of Finance at that time) and financial institutions had incentives to delay the disposal of bad loans. They wanted to cloud their responsibilities by delaying the disposal. Their strategy had the desired effect, as many escaped their responsibilities because of the delay.

Keywords: Financial Crisis, Corporate Governance, Unbalanced Incentives, Japan.

* Waseda University, Japan Email: [email protected]

This paper has been prepared for the International Conference on “Corporate Governance: A Search for Advanced Standards in the Wake of Crisis,” organized by Politecnico di Milano; Virtus Interpress; and International Center for Banking & Corporate Governance, Ukrainian Academy of Banking of the National Bank of Ukraine, on May 8, 2014, in Milan Italy. I thank Mr. Takashi Yoshimatsu, and participants of the conference for their insightful and helpful comments. Remaining errors are my own.

Introduction whatever) are always captured by special interest groups that they regulate, and regulations are After experiencing “Two Lost Decades” of deflation conducted for the regulated. Without this information, and recession, which some have called the “Great we cannot create an effective corporate governance Recession,” Japan has been trying to revive the system. economy through a bold, expansionary monetary By 1992, Japanese banks and security companies policy in the present Prim-minister Abe’s had amassed NPLs and bad debts much higher than administration (December 2012-). The results of this they could manage given their scale. They failed to policy, though, are not yet clear. reveal the full extent of their losses and experienced a One factor behind the protracted economic long recession before a banking crisis finally occurred stagnation was Japan’s banking crisis, although there in 1997 and 1998. This was quite different from the is no consensus on the magnitude of its impact. In experience of other countries. In the wake of the general, policy authorities try to expand the monetary global financial crisis of 2008, the United States base and promptly solve the problem of resolved its NPL issue in a year and expanded the nonperforming loans (NPLs) after a banking crisis monetary base. I believe Japan’s unique experience (See Mishkin 2013, p. 241, Chapter 9, “Government provides many interesting lessons. Intervention and the Recovery,” for example), but The structure of this paper is as follows. In Japanese authorities did neither. Why didn’t they? Section 1, I will very briefly explain why the banking What were the motives for their behavior? crises occurred and how we can avoid them in the The purpose of this issue is to analyze corporate future. And in Section 2, I will discuss Japan’s governance in the wake of a financial crisis, but we financial crises in 1990s, focusing on why Japan’s firstly need to know the respective concerns and financial authorities delayed efforts to resolve the motives of financial institutions, financial supervision NPL issue and why they did not try to expand the authorities, and central banks. Stigler (1971) warns monetary base. Then, my concluding remarks follow. that regulators (congress, government agencies, or

388 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

1. Inevitability of Financial Crises Bad loans

What is a financial crisis? Regarding the second problem of bad loans, one solution would be a deposit insurance system, under Reinhart and Rogoff (2009) use the term “financial which depositors can be repaid their money. The crisis” in a very broad sense. They include sovereign impact on the total economy would not be serious if defaults, banking crises, exchange rate crises, and the amount of money the insurance system must pay even inflation. It might be reasonable to include is small. But it would be serious if the amount is inflation, since under inflation debtors do not actually substantial. repay the true value of their debts. In this paper, In the insurance system, other banks that do not though, I will use the term in a narrower sense, have huge bad loans or the government will have to focusing on banking crises. A banking crisis occurs bear the burden; banks will thus need to increase their when a significant part of the banking sector becomes margins, and the governments will have to borrow insolvent due to heavy investment losses, a banking money by issuing bonds or raising taxes, causing panic, or both, according to Reinhart and Rogoff interest rates to rise and public expenditures to (2009) (p. xxvi). decline. This will affect the total economy for a long time if the magnitude is substantial. Banks do not keep the deposit The value lost by bad loans in the case of Japan and Scandinavian countries are estimated to be 20% Financial crises are inevitable, in a sense, because of GDP for Japan (See Source of Figure 4), 4.4% for banks accept deposits, which originally meant putting Finland, 2.8% for Norway, and 3.8% for Sweden something (money, in this case) in some place (a (Sandal (2004) p.84, Table 1) bank). Banks do not keep the money, however, but Under what circumstances would banks and loan it out leaving a small fraction of it to the bank as securities companies have such huge losses? a reserve. Therefore, there are two risks. One is not being able to repay the deposit when people make a Is sufficient capital requirement a run on a bank, since it does not have the money on solution? hand. The second is that money loaned can become uncollectable. The first is an insufficient capital requirement. If Lehman Brothers and other financial institutions had Liquidity problem enough capital, could the crisis have been avoided? The magnitude of the crisis would probably have been The first problem occurs because of a fractional lessened (Admati and Hellwig (2013)), but how much reserve banking system; there is thus a proposal to capital is enough? How can we measure the capital, divide the banking system into two parts, one for and how can the government regulate? If capital is not settlements, and the other for investments. The cash, measurement and pro-cyclical problems would settlement banks would have a very high reserve ratio, arise. perhaps only purchasing short-term government If the capital is invested in assets, the value of bonds (Litan 1987 and Kay 2009, for example). those assets would increase under good business Still, if the investment banks amass huge bad conditions and decrease in bad conditions. The capital debts, this could cause major problems. Lehman requirement would induce optimistic behavior among Brothers, after all, was not a bank but a securities financial institutions during prosperous periods and company, and its bankruptcy triggered the global pessimistic behavior in periods of stagnation, causing financial crisis. The fractional reserve banking system wider economic swings. may be a reason for financial crises, but even if we Of course, some propose a capital requirement to instate a 100% reserve banking system in place of a avoid the pro-cyclical problem. Actually, the fractional reserve system, we will not be able to avoid international bank regulation authority, the Bank for financial crises. Thus, I will not dwell on the International Settlements, proposed non pro-cyclical shortcomings of the fractional reserve system in this regulations on capital requirement (BIS (2011), BIS paper but focus instead on bad assets as triggers for (2013)), but still there are problems with the proposal. financial crises. Regulations to require increasing the ratio of cash and Banks can mutually borrow and lend cash, and cash equivalents to total capital might help to avoid central banks can extend loans to the banks if they measurement and pro-cyclical problems, but still it have good loans and assets as collaterals. There is also would not be a solution because we do not know how a risk that a 100% reserve banking system will sap to discount the value in prosperous periods or to capitalism of its dynamism if banks can find good precisely increase the value in a recession. opportunities for economic development just by creating loans. Excessive monetary expansion

The second is excessive monetary expansion.

389 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Monetary expansion can create optimism, cause can make them very deliberate if they are betting their bubbles, and result in bursts, leading to massive bad own money. assets and financial crises. Some economists recommend pursuing a monetary policy that does not 2. Japan’s Financial Crisis in the 1990s create bubbles so nothing could burst (BIS view, See White 2006), but how can we differentiate bubbles Japan’s peculiarity from asset price increases that reflect new technological opportunities, discovery of new Financial crises have been repeated even though most resources, and market participations of new countries. people understand the disastrous aftermath, but not all If policy authorities misinterpret the opportunities as crises have had a huge impact on the whole economy. bubbles, then the economy would lose a chance for Based on extensive data collection, Reinhart and growth. Other economists argue that central banks Rogoff (2009, p.216, Table 13.1) identified the “Big should only respond to general prices and Five” financial crises and 13 milder financial crises employment, not to asset prices (FRB view, See among industrialized countries since World War II Mishkin (2007)). (the five are Spain in 1977, Norway in 1987, Finland Schumpeter (1912) interprets the credit creation in 1991, Sweden in 1991, and Japan in 1992, and the process as an entrepreneurial activity. I cannot see that milder cases are the UK in 1974, 1991, and 1995, central bankers would have greater insights into the Germany in 1977, Canada in 1983, the US in 1984, economy than Schumpeter. Iceland in 1985, Denmark in 1987, New Zealand in 1987, Australia in 1989, Italy in 1990, Greece in Unbalanced risk sharing 1991, and France in 1994), but not all the crises caused significant damage to the economy. Third, I would stress the unbalanced risk sharing of Figure 1 shows the growth rates of real GDP economic agents. In a fractional banking system, before and after the respective crises of the average of banks have no penalty even if they do not have cash the 13 milder crisis-hit countries and the Big Five to repay depositors. Banks can very easily borrow the countries. The Big Five are divided into the average cash from the central bank at cheap cost. Managing of the three Scandinavian countries, Spain, and Japan. directors of banks are only fired when they amass In the case of Japan, the five-year average growth huge bad assets. Bank capital is the equity owners’ rates are shown as the rates after the crisis greatly money, not the general managers’. Of course, bank fluctuated. capital can offset the losses caused by bad assets to In the Big Five cases, the economies suffered some extent, but it cannot change the behavior of long stagnation, but in the milder cases, real economic bank managers. In this sense, the capital requirement growth rates did not decline. Among the Big Five is not enough. Bank managers are simply fired if they countries, the three Scandinavian countries returned to make huge NPLs. their pre-crisis rates in three years. It took nine years Some argue that the greed of financial for Spain, and then the growth rate became higher. institutions created financial crises, but their greed Japan’s prolonged stagnation is an exception.

Figure 1. Real GDP Growth Rates Before and After the Crisis

(%) 7 6 5 4 3 2 1 0 -1 -3 -2 -1 0 +1 +2 +3 +4 +5 +6 +7 +8 +9 +10 -2 -3 years before or after the crisis Three Scandinavian countries Milder crisis countries Spain Japan, 5-year average after the Crisis

Source: IMF, International Financial Statistics, SNA (Cabinet Office) for Japan Note: Selection of countries and periods is based on Reinhart and Rogoff (2009), p.216, Table 13.1 Growth rates for Japan after crisis are 5-year averagse, because annual growth rates are very volatile

390 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Japan’s annual real economic growth rate was not have increased the rate. It recognized its own error 4.7% in the 1980s, but it declined to 1.1% in the and lowered the rate, but then it was too late.” 1990s, to 0.8% in 2000s, and 0.8% from 2010 to 2013. Pro-cyclical capital requirement problem The two Lost Decades began when the bubbles that formed in the end of the 1980s burst in the early The abrupt monetary expansion and contraction 1990s. This paper will only focus on why the bubble caused a typical pro-cyclical capital requirement occurred and burst. How can the factors outlined in problem. The monetary policy made asset price Section 1 - excessive monetary expansion, capital fluctuate. Under Japanese regulations, capital includes requirement, and unbalanced risk sharing - explain a portion of the difference between the current price Japan’s bubble, its collapse, and the long stagnation? of stocks and their book value. The stock price of a company reflects the value of real estate the company Monetary expansion and contraction owns. Share prices increased due to an expansionary monetary policy, causing an increase in capital value Monetary expansion and contraction at the end of the and an expansion of bank loans, but then decreased 1980s and early 1990s obviously caused the bubble when a tightening monetary policy caused the and its collapse and the economic fluctuations of that opposite phenomenon. period. Monetary expansion lowered interest rates, Figure 2 shows the monetary base, bank loans, encouraged expansion of loans by banks, increased and index of industry production. The monetary base, the price of collateral such as real estate and stocks, bank loans, and IIP are shown to have fluctuated in and again encouraged the expansion of loans. the same way around 1990. The increase in land prices was criticized by Figure 3 shows the stock price index (Nikkei journalists, who pointed out that the average salaried stock price average) and land price index (for 6 major worker was now unable to afford a home even if they cities and other cities, index of urban land price, worked all their lives (Hasegawa (1989)). 1 Takenaka commercial use). The Nikkei average kept tripled (2005) showed that the public was very critical to the between 1985 and the end of 1989. The land price politics about sharp increase of housing price. Bank of index (6 Major Cities, Commercial Use) likewise Japan Governor Yasushi Mieno aggressively shrunk increased by 3 times between 1986 and 1991. The the money supply in 1989 and 1990. He raised the fluctuation occurred with the monetary expansion and official discount rate (the symbolic Japanese policy the contraction as shown in Figure 3. rate at that time) from 2.5% in May 1989 to 6% in The monetary base is an indicator of monetary August 1990, and as a result, land prices sharply policy, so we can conclude that the BOJ caused the declined while wages didn’t decrease. But because of economic fluctuations in the late 1980s and early monetary contraction and a decline in annual 1990s. There are many academic studies on this topic, household income, the ratio of land prices to wages and most Japanese economists (Kosai et al. 2000, also increased. 2 Miyao 2002) agree that monetary policy caused the Governor Mieno was portrayed as a hero in the fluctuations at the period. Japanese media because he was able to lower land However, there is no consensus that monetary prices.3 He realized, though, that NPLs were policy and NPLs caused the two Lost Decades. Some becoming a serious problem in the early 1990s. economists focus on bad assets, but others stress that During the bubble era, Japanese banks extended loans deflationary monetary policy caused it.4 The taking land as collateral. The loans turned bad as land government should have taken a policy to resolve the prices declined. NPLs if the first was correct. And the Bank of Japan He thus lowered the call rate from 8% in should have expanded the monetary base if the second 1991 to 3% in 1992. Takemori ((2010) pp. 230-31) reason was correct. The two reasons, however, are not questions, “Why did the BOJ abruptly have to mutually exclusive, because bad assets would increase decrease short-term interest rates by half while if an expansionary monetary policy is not taken. But doubling it just the previous year? The BOJ should neither policy was taken. I will briefly explain why monetary policy and bad loans reduced the real economic growth rate after the latter half of the 1990s, 1 Rupo: Shutoken Zetsubo Jutaku Jijou (Report: Desperate Condition of Housing in Tokyo Area,” Aera Weekly, August 1, and I will explain how the Japanese government 1989, wrote, ”There was a time that common people could actually treated bad loans and made monetary policy. have owned a house near Tokyo.” 2 The ratio of condominium price to average annual household income in metropolitan area increased 4.2 in 1985 to 8.0 in 1990, and declined to 4.9in 2002, but increased to 6.2 in 2011because income also declined. Data is in Ministry of Land, Transport, and Infrustructure, Juutaku Keiai Data Shuu (Data on Housing and Economy), Juutaku Sangyou Shinbunsha, 2011. 4 Most Japanese economists argue that structural problems 3 Mainich Newspaper’s Colum, “Yurakucho: Onihei,” praised caused the Lost Two Decades, but none of them can point Governor Mieno as he decreased land price (Mainichi out what structural problems caused them. See Harada Newspaper, March 19, 1992). (2012).

391 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Figure 2. Monetary base and IIP

Change rate to the same month of the previous year 40%

30%

20%

10%

0%

-10%

-20%

01 May011982 May011986 May011990 May011994 May011998 May012002 May012006 May012010

01January 1981 01January 1993 01January 1985 01January 1989 01January 1997 01January 2001 01January 2005 01January 2009 01January 2013

-30%

01 September01 1983 September01 1987 September01 1991 September01 1995 September01 1999 September01 2003 September01 2007 September01 2011

-40% Industrial Production Index Monetary Base Bank Loans

Sources: Bank of Japan, Ministry of Economy, Trade and Industry Note: industrial prodction and monetary base are sesonally adjusted

Figure 3. Indexes of Urban Land Price, Stock Price, and Consume Price

600 150

140 500 130 400 120

300 110

100 200 90 100 80

0 70 1980 1985 1990 1995 2000 2005 2010

6 Major Cities, Commercial Other Cities, Commercial Nikkei Stock Price, 1983=100 CPI, 2010=100, Right Axis

Sources: Bureau of Statistics, Institute of Real estate Economy of Japan, Nihon Keizai Shinbunsha (Newspaper Company) Note: 2000=100 if it is not stated.

392 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Why did monetary policy reduce the hypothesis.’ The other reason is that banks growth rate after the latter half of the continuously extended loans to the very companies 1990s? that created the NPLs in the hope that the problem would eventually somehow go away. Extending loans Textbooks on economics explain that monetary policy to inefficient firms made the whole economy does not affect the real economic growth rate in the inefficient, and may have caused the Lost Decades. I long run, but unemployment increased from 2.5% in call this hypothesis the ‘expanded loans to low-return- 1990 to 5% in 2000. During this period, the labor company hypothesis.’ market could not have become inefficient or rigid With respect to the credit crunch, Miyao (2004) because nominal wage rigidity was partly destroyed at concludes, after surveying several studies, that in the the end of the 1990s, and firms could begin to flexibly first half of the 1990s the effect was limited with a hire labor through temporary employment agencies or credit crunch being seen in some sectors of the from contract agencies. Thus, the two Lost Decades economy, and that only in 1997-98 was there a credit can be explained by a decline in the utilization of crunch which affected the economy overall. And even labor and production facilities. Monetary policy can in 1997-98, the results are mixed. stimulate an economy in such a situation. I have Japan has various public financial institutions written on this topic at length in another paper supporting small companies, such as the Japan (Harada 2012). Here I just wish to state that Japan’s Finance Corporation for Small and Medium real GDP could have been substantially higher by, say Enterprise and the National Life Finance Corporation 7.5%, if Japan’s Okun’s Law coefficient is 3 (both merged to form Japan Finance Corporation in (according to Kurosaka 2011, the coefficient is 3 from 2008), and also system infrastructure, such as credit 2001 to 2007), and the unemployment rate decreases guarantee corporations, in all prefectures, which from 5% to 2.5% because deflation can be overcome especially extend loans to small companies in a only with an expansionary monetary policy. recession when a credit crunch might occur. While Ahearne et al. (2002) show that the BOJ was these entities might make the economy inefficient in responsible for deflation and the delay in recovery by the long run, in the short run they support it and not expanding the money stock. mitigate the adverse effects of recession. Harada (2013) flatly explained that wrong On the other hand, Sakuragawa (2002) shows monetary policy could have an effect for two decades that banks expanded loans to companies with low if those policies were repeated. In fact, the BOJ did returns, resulting in a high ratio of NPLs to total not expand the money supply in response to the assets, and a high debt to assets ratio in the 1990s. negative demand shocks that repeatedly occurred; it Caballero, Hoshi and Kashyap (2008) argue that excessively expanded the money supply in the late Japanese banks kept credit flowing to otherwise 1980s and sharply contracted the money supply in the insolvent borrowers (which they call zombies). The early 1990s. In the middle of the 1990s, the BOJ did congestion created by the zombies reduces the profits not pursue an expansionary policy in response to the for healthy firms, which discourages their entry and excessive appreciation of the yen. During the financial investment. crisis of 1997-98, the BOJ did not expand the These arguments are reasonable, but how can we effective monetary base (Matsuoka 2000). Just before gauge the impact of extending loans to non-profitable the collapse of IT bubble in 2000, the BOJ increased firms on the total economy? First we would need to interest rates. And the BOJ ended its quantitative know the amount of loans extended to non-profitable easing monetary policy while the inflation rate was firms, but no study provides this data, although the not continuously positive in 2006. In response to the Financial Services Agency has said that aggregate Lehman shock, other central banks aggressively NPLs written off from 1992 to 2013 were 100 trillion expanded the monetary base, but the BOJ did not, yen (See source of Figure 4), which were mainly which resulted in an excessively strong yen. These created in the bubble period through the extension of misguided monetary policies continued to reduce loans to firms which later become unprofitable. If Japan’s growth rate. loans to non-profitable firms totaled 100 trillion yen and assuming that loans to non-profitable firms Did a decline in financial intermediary conducted in the 1990s were, say, the 100 trillion yen functions significantly reduce the growth (I think most NPLs were created in the bubble rate? period), then this means that the Japanese economy lost 100 trillion yen in normal investment in the Rapid monetary expansion and contraction caused 1990s. great swings in the Japanese economy, and at the Japan had total capital stock of 1,346 trillion yen same time, it created huge bad assets, leading to in 2000.5 Even if the 100 trillion yen in loans had protracted stagnation. There are two reasons. One is that NPLs eroded bank capital, and banks could not expand loans, which reduced the growth rate of the 5 Private capital stock and fixed asset of general government, economy. I call this hypothesis the ‘credit crunch System of National Accounts, Cabinet office, Government of Japan, Private capital stock at 2000 price, fixed assets of

393 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 been utilized for completely useless purposes, the trillion yen as of the end of September 1992 (MOF capital stock would only have been reduced by 7.4% (1992)). These amounts were severely (=100/1346). This means that real GDP would have underestimated, nobody believed the figure, and were been lowered by only 2.2%6, translating to the 1.1% bound to grow. In June 1995, MOF expanded the GDP growth rate of the 1990s being lifted to 1.3% if definition of bad loans and reported that the total inefficient loans had not been made. This might be an amount was 40 trillion yen. important factor explaining the two Lost Decades, but And in 1997 and 1998, big financial companies the numbers are guesses at the most. went bankrupt. Sanyo Securities, Hokkaido Additionally, the value of NPLs depends on the Takushoku Bank, and Yamaichi Securities went monetary policy adopted. NPLs depend on the prices bankrupt in November 1997, the Long-Term Credit of collateral, which depend on land and other asset Bank of Japan in October 1998, and the Nippon prices. Collateral prices would not have much Credit Bank in December 1998. declined if monetary policy had defended the fall of The MOF could not hide the truth any more. The land prices. But the Bank of Japan did not expand the Financial Reconstruction Law was enacted in October monetary base. This is a problem that I will discuss 1998, and the MOF and the Japanese government later in this paper. changed their policy to write off bad loans and to proceed with their disposal. Two measures to be taken after bubble At the beginning of the 2000s, the accumulated burst loss caused by the bad loans was found to be nearly 100 trillion yen, as shown in Figure 4. After a bubble bursts, two policies should be taken. One is to expand the money base to avoid a decrease Hit and run by the U.S. CEOs in land and stock prices.7 The other is to write off NPLs. Both policies are effective, but the government In case of the U. S., managers did not have incentives and the BOJ took neither. It might be reasonable that to delay the settlements of the NPLs, as long it did not the second was not taken because managing directors cause legal problems. Richard S. Fuld, Jr., chairman of banks have responsibility for the NPLs; if the NPLs and CEO of Lehman Brothers, had been receiving 350 are huge compare to the assets or profits of the banks, million dollars since 2000, and Stanley Onyle, CEO the managing directors will have to quit. And in some of Merrill Lynch, resigned because of the massive loss cases, banks may go bankrupt, causing not only in October 2007 and got 160million dollars as managing directors but also employees to lose their retirement allowance.8 Their pays were completely jobs. legal, and they did not have to return their income The supervising authority for the Japanese even after the profits of these companies were found banking industry was the Ministry of Finance at that to have been an illusion. time. It had close ties with banks and securities Japanese CEOs recently have come to be paid companies, and many MOF officials retired into better than in the past (around 1 million dollars or lucrative jobs at the banks. more a year), but they were only paid several hundred What the MOF initially did was to deny the thousand dollars a year then, with a low taxed existence of NPLs, or at least to underestimate their retirement allowance and a very low taxed private value. In April 1992, the MOF for the first time retirement pension. They therefore had an incentive to published a report indicating that the bad loans (with hide the NPLs, since their long-term payments would an arrearage of more than 6 months) of 21 major be lost when the NPLs were discovered. banks were 7 to 8 trillion yen, as of the end of March In the case of U.S. CEOs, hit and run was the 1992. In November 1992, it published another report strategy, but for Japanese CEOs hiding the problems showing that the bad loans had increased to 12.3 and delaying their resolution was their central concern. general government at nominal figure, but this rough Additionally, the Japanese government had not calculation does not produce any significant difference. experienced a major bank bankruptcy, so financial 6 Assuming an ordinary Cobb-Douglas function, officials wanted to think that NPLs would not be 0.7 0.3 GDP=AL K , we can get lnGDP=lnA+0.7lnL+0.3lnK. Then, serious and that land prices would recover; this would decrease of capital stock by 7.4% causes decline of GDP by lower the value of the NPLs, making them more 2.2% (0.3×7.4%). 9 7 Some argue that monetary expansion increases price and manageable . As Figure 2 shows, however, land prices nominal interest rate at the same time, then does not did not recover, and the value of NPLs continued to increase asset price. Assuming that nominal profit and increase. nominal interest rate increase at the same rate of inflation rate, then value of asset price becomes P/(1+ri+p-p) from the formula of infinite geometric progression where P : profit, ri: 8 “Sekai Hendo Kiki no Naka de (9): Bei Goyoku Shugi no real discount rate, p: inflation rate. Increase rate of profit is Magarikado (World Change in Crisis (9): Corner of Greedy- offset by that of additional factor of p to real discount rate. ism in the U.S.),” Asahi Newspaper, January 9, 2009. This model is not held true in the real world. It is repeatedly 9 Noboru Yanai, Former Managing Director of Long Term confirmed that monetary expansion in recession increases Credit Bank of Japan, said , “CEOs (of banks) were eager to stock price. Recent monetary expansion of the U.S. and survive by hiding bad assets as expecting divine winds might Japan increased stock price sharply. brow sometime.” (Matsushima and Takenaka (2011) P.493).

394 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Figure 4. NPLｓ and its Loss

120

100

80

60

40

20

0

Loss by Settlements of NPL Accumulation of the Loss Bad Loans

Source: Financial Service Aagency, "The status of Loans held by all banks based on the Financial Reconstruction Act." Note: End of March period of each year

Many former MOF officials testified that before Delaying disposal is effective in clouding the end of the 1990s, Japan did not have a system that responsibilities resolves the NPLs of banks. Before the middle of the 1990s, MOF tried to solve the problem by letting the To delay the writing off of NPLs is effective in big banks merge small banks that had bad loans. Of clouding the responsibilities of policy failures. The course, this means, however, cannot be applicable CEOs of Japanese banks who had created the NPLs when big banks had huge NPLs. had retired with handsome allowances were not MOF did not try to enact a new law to solve the prosecuted, and their successors were prosecuted for problem, because they were afraid of giving up the trying to hide the NPLs. Hiding NPLs is, of course, privileges to supervise financial institutions that gave unlawful in Japan, as Japanese law clearly stipulates them lucrative jobs. MOF was given the rights from that accounting records must be true. the ruling Democratic Party of Japan, and LDP was Former CEOs of Long-Term Credit Bank of not interested in it until the NPL problems appears in Japan and the Nippon Credit Bank (both went early 1990s.10 MOF could not supervise the financial bankrupt in 1998) were prosecuted on charges of institutions well, and it needed a new law, but in order accounting fraud in 1999 and 1998 respectively. In the to make a law, they explained to LDP why they failed, first and second trials, they were handed guilty and they might to lose the privilege. It is reasonable verdicts but were acquitted by the Supreme Court in for LDP to take the privilege from MOF because they 2008 12 and 2011 13 on the grounds that the MOF had have to make a new law that give tax money to banks allowed, at that time, window-dressing of accounts with NPLs, which was not popular to the public. The and not including information on the subsidiary new law, Financial Reconstruction Law was enacted companies that had purchased the bad assets of parent in 1998, the supervision role was taken away from banks at high prices. MOF, and Financial Supervisory Agency (Financial The initial prosecutions were as if the courts did Services Agency after 2000) was created in the same not punish the thieves but those who bought the stolen year.11 goods. Japanese prosecutors probably recognized that this is not fair, but when the public became outraged over the fact that NPLs were being written off with

12 “Moto Chogin Todori ra Gyakuten Muzai, Kessan ’ Iho de nai’ (Turn Table to Not-Guilty for the Former CEO of Long- 10 Former Secretary General of Liberal Democratic Party, Term Credit Bank of Japan, Account Settlement was not Koichi Kato said, “Banking and finance is sanctuary where Illegal,” Asahi Newspaper, July 19, 2008. politicians cannot enter” (Matsushima and Takenaka (2011) 13 “Nissaigin Funshoku Jiken, Kyukeieijin ni Gyakuten Muzai p. 430). (Fraud of Account Settlement for Nippon Credit Bank, Turn 11 Actually MOF succeeded in making the agency like a Table to Not-Guilty for the Former CEO),” NihonKeizai bureau of MOF. Newspaper, August 30, 2011.

395 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 tax money, they were affected by public opinion. Governors since Mieno have tried to skirt their Prosecutors were thus inclined to make cases in responsibility, asserting that the BOJ cannot control accordance with public opinion and the will of the money supply, exchange rate, asset prices and politicians (Sato 2005).14 price levels, and arguing that monetary policy is not NPLs were disposed of by 2002, as shown in effective if bank loans do not expand. This is a kind of Figure 4, after the responsibilities became vague an old real bills doctrine that BOJ official had gotten enough. used to. Actually, Governor Mieno answered the BOJ Why didn’t BOJ expand money? cannot control monetary base to the question at the Diet by Kozo Yamamoto, Member of the House of Then, the simple question arises as to why BOJ didn’t Representatives, who had been criticized the BOJ’s ease monetary policy? 15 In case of settling NPLs, it reluctance on monetary expansion since the 1990s. needs time to vague responsibilities, but time is not Naturally Yamamoto got angered to the answer needed to expand money. Why was the BOJ reluctant (Yamamoto (2010) p.129), but this is the center of the to expand the money supply? BOJ’s traditional doctrine. At that time, the BOJ is under MOF, then, the The real bills doctrine asserts that money stock question should be also asked to MOF. The relation can be neither undersupplied nor oversupplied if the between the BOJ and MOF is complicated. Actually central bank accepts and discounts commercial bills MOF was responsible for bank supervision, but was assured by the demand of decent business activities not responsible for monetary policy. MOF (real bills) because decent commercial bills create commissioned the BOJ to make monetary policy, but both supply and demand at the same time. This MOF could take out the mandate from the BOJ, but doctrine suggests that the central bank only responds they did not. They allowed the BOJ took deflationary to correct demand and is not responsible for policy while Japanese banks had huge bad loans. addressing economic fluctuations, inflation, and Yoshimasa Nishmura who was Director General, deflation. The BOJ, however, forgot that demand Banking Bureau, MOF in 1995 and 1996 answered to depends on the discount rate decided by the central interviewers, “There wasn’t such an idea (to expand bank. The central bank can actually control demand money and to support the general price and asset with interest rates and by changing the ease with prices) at that time, “ and also said, “The problem which bills are accepted. would not have occurred if there was no deflation, The BOJ is ignorant to the mechanism of and price increased by 3 to 4%. Land price would not monetary policy. And MOF officials that they never have declined (NPLs would have been much thought that monetary policy can increase asset price, smaller).” (Matsushima and Takenaka (2011) p.342- that is collateral price, and can decrease the value of 343.) bad loans as I mentioned. MOF might be only ignorant to the monetary Journalists and academics have tended to agree policy, and they did not think that monetary policy with the BOJ’s assertions, even though they are very can control nominal variables such as price, exchange different from that the roles and functions of monetary rate, nominal GDP, and asset prices.16 policy that are taught in textbooks, in which the For the BOJ, the reasons were as follows: money supply, price levels, and exchange rates (and Governor Mieno shrank the money supply and real economic growth rates in short-run) are seen as lowered land price, and he was praised by the media being controlled by monetary policy (See Mankiw as a hero 17 as I mentioned, however, realized that he (2002) Chapter 29 and 30, for example). 18 had made a mistake as Takemori already pointed out. Because of his monetary policy, Japanese banks Worrying about banks’ balance sheets accumulated huge bad assets, but he could not change the situation. Japanese price levels started to gradually Because of long sustained deflation, the economy has decline, which made the bad asset problem more continuously been shrinking, and interest rates have serious. declined to an almost abnormal level. Ten-year government bond yields are less than 1%. Under such low interest rates, the Japanese government has been 14 Sato called this investigation Kokusaku Sousa (national investigation). Sato explained this kind of investigation in a issuing a huge amount of government bonds to different case. See Sato (2005). finance public construction projects to stimulate the 15 This partincludes a summary of Section5 of Harada (2013). economy. Japanese banks and insurance companies, 16 Japanese high lank bureaucrats including the BOJ are unable to identify good investment opportunities, lobbyist rather than experts on the matters that they are responsible. They have a lot of knowledge about interests and human relations of politicians and businessmen, but lack 18 Some economists oppose the real bills doctrine. Kikuo of the knowledge as experts. Mr. Hiroaki Taya, former MOF Iwata, who was a professor of economics at Gakushuin elite bureaucrat, answered to an interviewer, “It was the University before being appointed deputy governor of the power how much we drunk with influential politicians and BOJ in March 2013, pointed out in the early 1990s that the bureaucrats at that time,” (Kishi (1996)p.48). BOJ can control the money supply and that it should increase 17 For example, ”Kinyuu Seisaku Kui wa Nai (No regret for my the monetary base and money stock (Iwata (1992), but many monetary policy),” Mainichi Newspaper, December 17, 1994. economists chose to side with the BOJ.

396 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 have been buying and holding huge stocks of It now admits that the reason it has not pursued government bonds. What would happen, then, should monetary expansion is to restrain an increase of the BOJ take an aggressive expansionary monetary interest rates. Hayakawa‘s statement is one example. policy? BOJ officials have been arguing that reflation is The economy may recover, but prices and dangerous because it increases interest rates and interest rate will increase. If interest rate increases, the decreases bond prices. Such a possibility cannot be market price of bonds would decrease. The banks and denied, but the problem is not so serious now. The insurance companies holding these bonds could be hit balance sheets of some small banks may be damaged badly by such a decline. by a decline in bond prices. Capital injections of The losses in the financial sector as a whole will hundreds of billion yen might be needed to protect not be substantial. Government bonds do not make up deposits. But the benefits of ridding deflation would a large portion of the assets held by Japan’s so-called be an increase of 100 trillion yen to GDP, and this megabanks and major regional banks, which also hold means tens of trillion yen of additional tax revenue. equities, real estates and foreign assets, enabling them The cost of capital injection can be easily financed by to cancel out any bond losses with the increased value a small part of the increase in revenues. of equities and profits from foreign assets caused by Additionally, there would have been no need to the yen’s depreciation. But some smaller financial save such banks if the BOJ had aggressively institutions have invested too much in government expanded the money stock in the early 1990s. At that bonds and do not hold equities and foreign assets. As time, Japanese banks did not hold as many bonds as the Bank of Japan is the guardian of the banking they do today. sector, it is natural to think that it wants to avoid losses for private banks. Therefore, the BOJ has Conclusions continued to pursue a deflation policy that does not raise interest rates. There are many arguments why Japan experienced the This is a fact that BOJ bureaucrats have two Lost Decades, but many economists agree that the admitted. A former high-ranking BOJ official has bubble and its collapse in the late 1980s and early said, “At present, banks have a lot of government 1990s are related to the subsequent stagnation of the bonds. In terms of total volume, the big banks are economy. And there is consensus that policy predominant, but most of their holdings mature in two authorities should promptly resolve the issue of bad years or a little more. The maturity of bonds held by loans and expand the money base after financial regional banks, on the other hand, is little longer, crises. The U.S. did both after the global financial around four years. Regional banks do not have as crisis in 2008, but Japan did neither, which at least many investment opportunities, and they need longer– partially explains the Lost Decades. term bonds offering higher interest rates. Should bond This paper explained why they did neither. The prices decline, the losers will be the regional banks, bank supervision authority (Ministry of Finance at rather than the megabanks (Hayakawa (2012).” that time) and financial institutions had incentives to delay the disposal of bad loans. They wanted to cloud The BOJ is a co-op for banks their responsibilities by delaying the disposal. Their strategy had the desired effect, as many escaped their This is the reason the BOJ has been reluctant to take responsibilities because of the delay. an expansionary monetary policy. The BOJ is not the In the U.S., managing directors could take a hit- guardian of the currency but of banks. As the chief of and-run strategy, and they did not have incentives to the banking sector, the BOJ cannot ignore the banks’ delay the disposal, and the FRB was free from fears. It is easier to understand the behavior of the ignorance. The FRB had clear ideas that monetary BOJ if it is compared to the Central Union of policy can control nominal variables such as price Agricultural Co-operatives, whose role is to guide all levels, asset prices, and nominal GDP, to some extent. the agricultural co-operatives in Japan and protect The lessons for corporate governance of Japan’s their interests. The BOJ has to protect banks and experiences in the Lost Decades are clear. Firstly, cannot take risks that might hurt some of them. governance systems should be also applied to policy There are many small interest groups such as authorities. They need to be governed not to delay the small banks, farmers, construction companies, disposal of bad loans and to not cause deflation and medical doctors, nurses, transportation industries, day an asset price crash. A severe requirement for the nursery and preschools in Japan that politicians have accuracy of accounting data is a good policy, and it been unable to consolidate effectively. The paralysis has been adopted in Japan since the early 2000s. in Japan’s monetary policy has been caused by Inflation targeting or nominal GDP targeting for Japan’s political system. Japanese politicians are central banks is a good policy, and an inflation target usually afraid of breaking up small interest groups, was in effect adopted in Japan in 2013. and Japan’s inactive monetary policy has been the Secondly, financial institutions have to seriously result. abide by the requirement for accurate accounting. Recently, the BOJ has begun to confess the truth. Values of assets are known only after they are cashed.

397 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Values derived through calculation by mathematical (Okun’s Law and Employment Adjustment),” Nihon models are only imaginary, not real. Bonuses of Rodo Kenkyu Zasshi (Journal of Japanese Labor employees of financial institutions should be linked to Studies,, No. 610, May 2011. revenues after assets are cashed. 19 16. Litan R. What Should Banks Do? Washington, DC: Brookings Inst. 207 pp. 1987. Thirdly, unbalanced risk sharing is an important 17. Mankiw, Gregory, Principles of Economics, Sixth cause of financial crises. CEOs’ money should be Edition, South Western, 2008. incorporated into the capital of financial institutions. 18. Matsuoka, Mikihiro, “Daremo Shiteki shinai Ito sezaru A bonus system linked to cash profits is helpful in Kinyu Hikishime (Unintended monetary contraction lessening the degree of the unbalance. that nobody points out),” The Daiyamondo, 8 July 2000. 19. Matsushima, Shigeru and Harukata Takenaka, Nihon References Keizai no Kiroku – Jidai Shogen Shu (Documents of Japanese Economy – Testimonies of the Periods), Saeki 1. Admati, Anat and Martin Hellwig, The Bankers' New Shuppan, 2011. Clothes: What's Wrong with Banking and What to Do 20. Mishkin, Fredericc S., “Estimating Potential Output,” about It, Princeton University Press, 2013. Remarks at the Conference on Price Measurement for 2. Afanasyeva, Olga, “Executive Bonuses Clawback: The Monetary Policy, Federal Reserve Bank of Dallas, World’s Largest Banks Cases,” Dallas, 2007. 3. The Corporate Ownership and Control, volume 11, 21. The Economics of Money, Banking, and Financial 2014. Markets, Global Edition, Tenth Edition, Pearson, 2013. 4. Ahearne, Alan G., J. E. Haltmaier, and S.B. Kamin, 22. Ministry of Finance, “Kinyu Gyosei no Tomen no Un- “Preventing Deflation: Lessons from Japan’s you Hoshin no Jisshi Jokyo ni tsuite (On the Present Experience in the 1990s,” Federal Reserve. International Situation of Conducts of Financial Supervision Finance Discussion Paper Series, 2002-729., 2002. Policies),” Ministry of Finance, October 30, 1992. 5. Caballero, Ricardo J., Takeo Hoshi, and Anil K 23. Miyao, Ryuzou, “The Effects of Monetary Policy in Kashyap, “Zombie Lending and Depressed Japan,” Journal of Money, Credit and Banking, Vol. 34, Restructuring in Japan,” American Economic Review No. 2, May 2002. 2008, 98:5, 1943–1977, 24. “Ginko Kino no Teika to 90 Nendai Iko no Defure 6. BIS (Bank for International Settlements), Basel III: A Teitai (Declining function of banks and deflationary global regulatory framework for more resilient banks stagnation since 1990s)” in Hamada and Horiuchi and banking systems - revised version June 2011. (2004). 7. BIS (Bank for International Settlements), Basel III: The 25. Reinhart, Carmen, and Kenneth Rogoff, This time is Liquidity Coverage Ratio and liquidity risk monitoring different, Princeton University Press, 2009 tools, January 2013 26. Sakuragawa, Masaya, Kinyu Kiki no Keizai Bunseki 8. Harada, Yutaka, “Policy Issues Regarding the Japanese (Economic Analysis on Financial Crisis), The Economy - the Great Recession, Inequality, Budget University of Tokyo Press, 2002. Deficit and the Aging Population,” Japanese Journal of 27. Sato, Masaru, Kokka no Wana (Trap of the State), Political Science, Vol.13, No.2, p. 223-253, June 2012. Shinchosha, 2005. 9. “Why Political Opposition to an Expansionary 28. Schumpeter, Joseph A., Theory of Economic Monetary Policy Remains Strong in Japan,” presented at Development: An Inquiry into Profits, Capital, Credit, “Japan-Korea conference: Japan and Korea in vortex Interest and the Business Cycle (Social Science Classics compared,” on June 27, 2013 at Sanjo Conference Hall, Series), Transaction Publisher, Reprint Edition, 1983. University of Tokyo (Hongo Campus) sponsored by the Firstly printed, Theorie der wirtschaftlichen Japan-Korea Cultural Foundation and University of Entwicklung, 1911. Niigata Prefecture. 29. Stigler, Geroge, “The theory of economic regulation,” 10. Hayakawa, Hideo, “Wagakuni Kinyuugyou no Kadai Bell Journal of Economics and Management Science 2 (Issus of Japanese financial industry),” Shin Kokusaku, (spring): 3-21, 1971. September 2012. 30. Sandal, Knut, ”Chapter 3 The Nordic banking crises in 11. Iwata, Kikuo, “Nichigin Riron o Hoki seyo (Discard the the early 1990s - resolution methods and fiscal costs,” Bank of Japan theory)” Shukan Toyo Keizai, September p.84, Table 1, in More, Thorvald G., Jon A. Solheim and 12th 1992), Mane Kyokyu Zo wa Kano (Increase of Bent Vale eds. The Norwegian Banking Crises, Norges money supply is possible, Nihon Keizai Newspaper, Bank skriftserie / Occasional Papers, No.33, Oslo 2004. December 24th 1992. 31. Takemori, Shumpei, Chuou Ginkou wa Tatakau 12. Kay J. 2009. Narrow Banking: The Reform of Banking (Struggles of Central Banks), p.230-31, Nihon Keizai Regulation. London: CSFI. 95 pp. Shinbun Shuppansha, 2010. 13. Kishi, Nobuhito, Kensho Okurasho Hokai (Analysis: 32. Takenak Harukata, “Chapter 3 Chika Baburu eno Taio Collapse of Ministry of Finance), Toyokeizai wa Naze okuretaka (Why did the response to Land Price Shinposha, 1996. Bubble delay?),” in Matsumura, Michio, Heisei Baburu: 14. Kosai, Yutaka, Osamu Ito, and Ritsuko Arioka, Sakiokuri no Kenkyu (Bubble in Heisei Period: Studies “Baburuki no Kinyu Seisaku to sono Hansei (Monetary on Postpone), Toyokeizai Shinposha, 2005. Policy in the Bubble Age and its Reflection,” Kinyu 33. Yamamoto, Kozo, Nichigin ni Tsubusareta Nihon Keizai Kenkyu (Studies of Monetary Policy), vol. 19 No. 4, (Japanese Economy crashed by Bank of Japan), Fast December 2000. Puresu, 2010. 15. Kurosaka, Yosio, “Okun Hosoku to Koyo Chosei 34. White, William, “Is Price Stability Enough?” BIS working Paper Series 206, 2006.

19 Afanasyeva (2014) recommends clawback policy of CEOs’ Newspaper and News Magazine articles are not included. remuneration.

398 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

BROKEN TIES AND CORPORATE GOVERNANCE CHANGES UNDER UNCERTAINTY CONDITIONS. A LONGITUDINAL STUDY OF ITALIAN BOARDROOM NETWORK EVOLUTION

Mauro Romano*, Christian Favino**

Abstract

The recent systemic crisis that has affected the financial markets and real economies of major industrialized countries has had significant effects on the corporate governance and key organizational choices of large firms. In this context, the present study aims to verify whether the international crisis has significantly changed the structure of the interlocking directorate network that links large firms in the regulated Italian market. Furthermore the paper, which is a development of a preceding research study, also investigates the changes that have occurred in the interpersonal network of directors of the same firms previously observed. To this end, we present a preliminary analysis of the evolution of corporate governance in the main European regulated markets through a dynamic comparison of some synthetic statistical data observed at the end of the years 2006, 2008 and 2010. In the second part, after framing the interlocking directorate concept, we examine the evolution of the interlocking directorate network during the aforementioned observation period (2006-2010) with respect to larger Italian listed companies (FTSE MIB) and their directors.

Keywords: Corporate Governance, Board of Directors, Italy

* Department of Economics, University of Foggia, Italy ** Department of Economics, University of Foggia, Via Caggese n. 1, 71121 Foggia, Italy Phone: (+39) 0881.781728 Fax: (+39) 0881.573116 Email: [email protected]

1. Introduction

In the recent past, international literature has often especially in the Italian market, where large firms focused on the nature and scope of the systemic crisis often belong to corporate groups structured in that has affected the financial markets and real pyramid form. To be noted is that major Italian economies of major industrialized countries since the companies, including those listed on the regulated second half of 2008. The changed economic market, are often owned by a small number of family environment, which is still characterized by a high firm groups. Consequently, unlike companies in other degree of instability and uncertainty, has had a geographical contexts, these are characterized by significant impact on corporate results and, in many cross-shareholding relationships and common cases, has also had relevant repercussions on the directors. Authoritative literature considers this a evolution of corporate governance, on the relevant factor that distinguishes Italian firms, which composition of governing bodies and, more generally, warrants further examination and discussion since this on the main organizational choices of firms. affects firm governance structure, the related The aspects most analysed in this context, decision-making capacity and, more generally, especially in international literature, include the business performance. potential effects of the crisis on both the evolution and Despite the significant number of interlocked the intensity of personal relations that directly and companies in the Italian context, national literature indirectly exist between large firms. has paid scarce attention to this issue. Although more Ties of a personal nature established between recent studies have shown growing interest in companies that share one or more board directors is a analysing the causes of the formation of personal ties phenomenon - also known as interlocking directorate between companies, and the consequences of this - that is present in all areas of international business, phenomenon on business results, at the domestic level but is particularly widespread in Europe and no studies have focused on the repercussions of the

399 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 crisis on the structure of the network and the higher showing a high degree of density and duplication of (or lower) intensity of the phenomenon in question. interlocks) compared to those observed in the United The present work intends to contribute to the Kingdom and the United States (more extensive but theoretical debate by examining the effects of the less dense) (Comet and Pizarro, 2011; Windolf and crisis on the structure of interlocking directorates that Beyer, 1996; Windolf, 2002; Santella et al., 2008). link major companies listed on the Italian regulated The analyses are also intended to provide market. information on the evolution of the governance of The first part of the research examines the most European firms in the period 2006-2010 to verify, significant changes in the composition of governing albeit indicatively, whether the effects of the 2008 bodies of listed companies operating in the main international crisis - still ongoing - have led to European regulated markets and purposes a significant changes in the composition of the comparative analysis of some synthetic statistical data governing bodies of the companies surveyed. observed at the end of the years 2006, 2008 and 2010. Moving onto the data analysis20, to be first noted The second part, specifically dedicated to the is that while the number of directors that constitute theme of personal ties between companies, first the boards of companies operating in the main frames the concept of interlocking directorate in a European markets ranges from 12.80 (year 2006) to theoretic perspective by systematically examining the 12.10 (year 2010), considerable differences emerge in main authoritative contributions in literature. some national contexts. Subsequently, we examine the effects of the Particularly significant is the case of German financial crisis on changes in the interlocking companies where the average number of directors directorate network in relation to larger Italian listed (over 17 units), although lower than in 2006 (-10 %), companies and their directors. Applying the Social remains the highest when compared with other Network Analysis technique, we compare the main European countries such as the Netherlands where the synthetic indicators suggested by literature (density, average number of directors stood below the threshold betweenness, closeness, etc.) that enable examining of 9 units. the evolution of the network in the aforementioned The comparison of the data for the period 2006- observation period (2006, 2008 and 2010). 2010 also captures differences in evolutionary terms The concluding section offers some brief between the different national contexts: countries with observations that also include insights on the possible more numerous governing bodies showed a future developments of this research. downward trend in the number of components (particularly Germany and Italy) while the UK and 2. The Composition of the Governing Switzerland showed an increase in board size, Bodies of Companies Listed on EU particularly in the Anglo-Saxon context, where the Regulated Markets in 2006-2010 average number of directors in 2006, equal to 8.30, increased in 2010 to 12.4 (approximately + 49.4%). Prior to the description and analysis of the network of In dynamic terms, both these trends could be interpersonal ties between companies operating in viewed as a consequence of the 2008 crisis, taking Italy, it seems appropriate to provide some data on the into account, in this sense, that board size depends on composition and evolution over time of the governing many variables that lead to alternately favouring more bodies of companies listed on the main regulated or less extensive governing bodies (Coles et al., markets. 2008). This premise is crucial to frame the interlocking On the one hand, the need to accelerate the phenomenon as part of the broader issue concerning decision-making process and simultaneously contain the evolution of corporate governance mechanisms in administration costs may have led the first group of the European context following the systemic crisis companies (those with a larger board) to reduce the that occurred in the second half of 2008. number of board directors. On this point, literature The analyses described in this section first aim has repeatedly shown that numerically restricted to highlight the differences in the corporate boards are more effective than those that are governance structure of companies operating in the excessively large (Lipton and Lorsch, 1992; Yermack, main European regulated markets: these differences, 1996; Eisenberg et al., 1998). referring to board composition and the specific characteristics of directors (in terms of nationality, gender, independence, etc.), suggest that the 20 The data examined in this section are the result of a re- interlocking phenomenon has specific characteristics elaboration of the information in the European Corporate Governance Report published every two years by Heidrick & depending on the territorial context in which it is Struggles International (www.heidrick.com). These reports observed. In this perspective, numerous studies have provide detailed information on companies listed on the main previously identified, for example, the significant European regulated markets: Austria (ATX), Belgium (BEL differences between the interlocking directorate 20), Denmark (C20), Finland (OMX Helsinki), France (CAC40), Germany (DAX30) Italy (S & P MIB), Netherlands networks in Italy, France and Germany (AEX), Norway (OBX), Poland (WSE), Portugal (PSI20), (notwithstanding their particular characteristics Spain (IBEX35), Sweden (OMX Stockholm), Switzerland (SMI) and the United Kingdom (top 50 of the FTSE).

400 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 1. Average number of directors per board

Country 2006 2008 2010 ∆ 2008-2010 ∆ 2006-2010

Netherlands 8.6 8.9 8.7 -2.2% 1.2% Switzerland 9.8 10.5 10.4 -1.0% 6.1% Sweden 10.8 10.8 10.7 -0.9% -0.9% United Kingdom 8.3 8.5 12.4 45.9% 49.4% Belgium 12.9 12.7 13.8 8.7% 7.0% Italy 15.5 13.4 13.9 3.7% -10.3% France 14.3 14.6 14.2 -2.7% -0.7% Spain 14.7 14.3 14.3 0.0% -2.7% Portugal 14.1 13. 15.2 16.9% 7.8% Germany 19.1 17.7 17.1 -3.4% -10.5%

European average 12.8 11.8 12.10 2.5% -5.5%

Conversely, in companies with smaller boards, risk of business failure (Platt and Platt, 2012). The the crisis may have determined the need to increase slight decrease (-1.2%) in the average European age the number of directors in order to acquire knowledge in the period 2006-2010, although in contrast with (Dalton et al., 1999) and new interpersonal skills expectations based on the theories formulated in (Booth and Deli, 1996), which could prove essential literature, may be justified on the grounds of a in effectively addressing the crisis according to what possible regeneration of the board of directors with some authors postulate in the resource dependence the entry of younger directors in the aftermath of the theory perspective (Pfeffer, 1972; Pfeffer and crisis. The choice of a partial generational renewal of Salancik, 1978). the board is supported in studies according to which Table 2 instead summarizes the age of directors: the presence of younger directors ensures the greater the European average in 2010, although showing a efficiency and effectiveness of the decision-making slight decrease compared to 2006, is around the 58- process, the greater propensity towards changes in the year threshold. The moderately high level of the business model in response to changes in the context average age of board members corroborates the of reference, and the improved ability to plan future largely unanimous studies that consider director strategies (Houle, 1990; Taylor, 1975; Waelchli and seniority (and related experience) as a positive factor Zeller, 2013). to improve corporate performance and to avoid the

Table 2. Average age of board directors

Country 2006 2008 2010 ∆ 2008- ∆ 2006-2010 2010 Sweden 57.1 57.1 55.5 -2.8% -2.8% Portugal 55.8 55.9 57.3 2.5% 2.7% Belgium 58.9 57.6 57.8 0.3% -1.9% Germany 58.7 60.1 57.8 -3.8% -1.5% United Kingdom 58.8 59.7 58.0 -2.8% -1.4% Italy 58.2 59.6 59.8 0.3% 2.7% Spain 56.6 58.9 59.8 1.5% 5.7% Switzerland 59.3 59.5 60.2 1.2% 1.5% France 60.8 61.6 60.4 -1.9% -0.7% Netherlands 62.9 62.4 62.4 0.0% -0.8%

European average 59.1 59.00 58.40 -1% -1.2%

Also in this case, significant differences emerge age that systematically exceeds the threshold of 62 between countries with respect to more restricted years. levels of seniority (in Sweden, for example, the In continuing the analysis, it is also useful to average value is 55.5 years) and those with an average examine the composition of boards of directors in terms of the different nationalities of their members

401 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 with respect to the country in which the registered terms of the different nationalities of their members office of each company examined is located. We find with respect to the country in which the registered a significant difference among the countries observed: office of each company examined is located. We find in some cases (the UK, the Netherlands and a significant difference among the countries observed: Switzerland), the percentage of foreign directors is in some cases (the UK, the Netherlands and over 40% and significantly above the European Switzerland), the percentage of foreign directors is average. This circumstance, according to literature over 40% and significantly above the European (van Veen and Elbertsen, 2008; MacLean et al., average. This circumstance, according to literature 2006), is influenced by the characteristics (ownership (van Veen and Elbertsen, 2008; MacLean et al., structure, corporate governance systems adopted, etc.) 2006), is influenced by the characteristics (ownership that distinguish the firms operating in each country structure, corporate governance systems adopted, etc.) examined. that distinguish the firms operating in each country In a dynamic perspective, a general increase of examined. foreign members on European boards (except In a dynamic perspective, a general increase of exclusively Portugal) was recorded in the period foreign members on European boards (except 2006-2010 with an increase of the European average exclusively Portugal) was recorded in the period from 18% (year 2006) to 24% (year 2010). This trend 2006-2010 with an increase of the European average can first be explained by the ongoing globalization of from 18% (year 2006) to 24% (year 2010). This trend business activities and financial markets. can first be explained by the ongoing globalization of Consequently, in view of the ongoing international business activities and financial markets. crisis, companies need to establish new relationships Consequently, in view of the ongoing international in territorial contexts that go beyond the local to take crisis, companies need to establish new relationships advantage of the possibility of extending their markets in territorial contexts that go beyond the local to take of reference (Luo, 2005; Andersen, 1993; Sanders and advantage of the possibility of extending their markets Carpenter, 1998). of reference (Luo, 2005; Andersen, 1993; Sanders and Not to be underestimated is that the growing Carpenter, 1998). number of foreign directors may also be linked, in Not to be underestimated is that the growing some cases, to the need to create greater governance number of foreign directors may also be linked, in control over the management of foreign subsidiaries, some cases, to the need to create greater governance requiring the appointment of trusted directors, in control over the management of foreign subsidiaries, accordance with the authoritative opinion of Mizruchi requiring the appointment of trusted directors, in (1996) who interprets interlocking directorate as a accordance with the authoritative opinion of Mizruchi management control and coordination tool. (1996) who interprets interlocking directorate as a In continuing the analysis, it is also useful to management control and coordination tool. examine the composition of boards of directors in

Table 3. Percentage of non-national directors on the board

Country 2006 2008 2010 ∆ 2008-2010 ∆ 2006-2010

Spain 7.6% 10% 10% 0.0% 31.6% Germany 7.3% 8% 11% 37.5% 50.7% Italy 7.9% 11% 12% 9.1% 51.9% Portugal 22% 21% 17% -19% -22.7% France 20% 26% 27% 3.8% 35% Sweden 15.8% 21% 31% 47.6% 96.2% Belgium 25% 36% 34% -5.6% 36% United Kingdom 31% 41% 40% -2.4% 29% Netherlands 36% 54% 47% -13% 30.6% Switzerland 45% 45% 53% 17.8% 17.8%

European average 18% 23% 24% 4.3% 33.3%

Another useful factor to examine is gender European context. The percentage of women on equality on the boards of large firms: in this case, boards of directors in some countries exceeds 10% albeit within the generalized condition of a lack of (with the remarkable example of Sweden, which female directors on the boards of major listed stands at around 30%) as opposed to other countries companies, significant differences emerge in the

402 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 where the female constituent does not exceed the the increasing focus of companies (and the world share of 5% (Italy and Portugal). economy in general) on gender equality, in adherence As regards the temporal profile, we observe a to recent empirical evidence emphasizing the positive gradual increase in the number of women in effects of a greater number of women in terms of governing bodies, with an average European value decision-making efficiency and management control that went from 8.4% in 2006 to 12% in 2010 (+ ability (Huse et al., 2009; Nielsen and Huse, 2010a, 42.9%). This increase can be reasonably attributed to 2010b).

Table 4. Proportion of women on the board

Country 2006 2008 2010 ∆ 2008-2010 ∆ 2006-2010

Italy 2.3% 3% 3% 0.0% 30.4% Portugal 0.7% 3% 4% 33.3% 471.4% Belgium 5.3% 8% 8% 0.0% 50.9% Spain 3.1% 6% 9% 50% 190.3% France 7.5% 8% 11% 37.5% 46.7% Switzerland 7.2% 9% 11% 22.2% 52.8% United Kingdom 15.2% 15% 12% -20% -21.1% Germany 12.4% 11% 13% 18.2% 4.8% Netherlands 9.0% 13% 15% 15.4% 66.7% Sweden 21.3% 22% 29% 31.8% 36.2%

European average 8.4% 10% 12% 20.0% 42.9%

Finally, two additional data should be tested in a market (the U.S.) that significantly differs mentioned: the presence of independent directors on from that in which European companies operate. the board and the frequency of meetings of the Alternatively, the reduction of independent governing bodies. directors could be seen as the consequence of an The first data shows that the presence of increasing degree of uncertainty inherent in independent directors on the boards of European companies in crisis that induces independent directors companies was 43% in 2010, a significant decrease to abandon their appointment, also to safeguard their when compared to the 54% in 2006. This trend seems reputation and reduce the risk of any liability related to be anomalous considering that in the context of an to the potential failure of the company (Arthaud-Day international market crisis one would expect an et al., 2006; Fahlenbrach et al., 2010; Finklestein et increase in the number of independent directors to al., 2009; Withers et al., 2012). strengthen governance control over the actions of Also to be noted is that the percentage of executive directors. Also to be considered, as independent directors varies considerably in the indicated by some contributions in literature (Erkens different national contexts examined: it assumes high et al., 2012), albeit limited to financial firms, is that values in the Netherlands (75%), Switzerland (62%) the presence of independent directors determines a and the United Kingdom (61%), and is significantly greater ability to acquire venture capital, which is more limited in Germany (21%), Portugal (30%), essential in ensuring the adequacy of capital and to Belgium (32%) and Spain (36%) (data for 2010). reduce the risk of insolvency during times of crisis. The often-recalled increasing level of The data in question could be interpreted by uncertainty due to the crisis also allows explaining the recalling those studies according to which in times of general increase in the number of directors’ meetings crisis, and therefore following a period of poor in the period examined. At the European level, an performance, the number of insider directors increase of 8% of meetings is shown in the 2006-2010 temporarily increases in preparation for the period; this increase is even more evident when replacement/succession of the CEO (Hermalin and comparing the 2006 figures with those of 2008, when Weisbach, 1988). The trend reverses once a new CEO the crisis manifested with greater intensity, imposing has been appointed, entailing other executive directors the frequent convening of governing bodies to take exiting and replacing these with new and often decisions to effectively deal with the changing independent directors. However, it is somewhat international economic and financial situation. The evident that the study in question, although providing evidence provided confirms Jensen’s (1993) a possible explanation as evidenced by the data postulation, namely, an increase in the number of examined, reflects the peculiarity of having been meetings of the board of directors is a reaction to negative results. In the same vein, also to be

403 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 considered is the effect of an increase in the number the years following the increase in the frequency of of meetings that, according to some authors, exerts meetings (Vafeas, 1999). positive effects in terms of improved performance in

Table 5. Percentage of independent directors on the board

Country 2006 2008 2010 ∆ 2008-2010 ∆ 2006-2010

Germany 28% 30% 21% -30% -25% Portugal 35% 22% 30% 36.4% -14.3% Belgium 41% 40% 32% -20% -22% Spain 40% 30% 33% 10% -17.5% Austria 23% 28% 36% 28.6% 56.5% France 51% 42% 40% -4.8% -21.6% Sweden 42% 45% 40% -11.1% -4.8% Italy 52% 45% 48% 6.7% -7.7% United Kingdom 91% 86% 61% -29.1% -33% Switzerland 75% 63% 62% -1.6% -17.3% Netherlands 85% 79% 75% -5.1% -11.8%

European average 54% 45% 43% -4.4% -20.4%

Except for the German context, where the the data is essentially in line with the European number of meetings was nonetheless extremely low in average (9.40), ranging from the minimum value the three years under observation (always below the recorded in Belgium (8.0) to the highest value found threshold of 6 meetings per year), in other countries in Italy (11.30) (data for 2010).

Table 6. Frequency of board meetings (average number of meetings per year)

Country 2006 2008 2010 ∆ 2008-2010 ∆ 2006-2010 Germany 4.4 5.8 5.9 1.7% 34.1% Belgium 8.9 8.6 8.0 -7.0% -10.1% Netherlands 8.1 9.3 8.3 -10.8% 2.5% Switzerland 7.3 8.2 8.4 2.4% 15.1% Portugal 8.7 10.6 8.9 -16.0% 2.3% France 7.4 8.1 9.0 11.1% 21.6% United Kingdom 8.7 9.6 9.4 -2.1% 8.0% Sweden 9.4 10.9 10.3 -5.5% 9.6% Spain 10.9 11.4 10.9 -4.4% 0.0% Italy 12 12.1 11.3 -6.6% -5.8%

European average 8.7 9.60 9.40 -2.1% 8.0%

3. Literature Review The systematic analysis of the literature, conducted as part of this research, suggests that the Interlocking directorate is a widespread and extremely authoritative contributions in literature can be usefully varied phenomenon in the international economic classified according to the following analysis reality: its complexity is the subject of constant objectives: interest in literature examining the different A. Examine the motivations and environmental sociological, organizational, managerial and legal factors that foster the creation of interpersonal profiles. networks, together with the analysis – also in This implies that any attempt at classifying the evolutionary and comparative terms – of the structure numerous scientific papers is considerably difficult of networks in different international contexts. when taking into account the different objectives and B. Analyse the consequences on corporate the specific aspects under study. behaviour of sharing one or more directors, the

404 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 functioning of the governance system and corporate c) the legitimacy model, which considers the performance. sharing of directors as a result of firms seeking to C. Assess the personal impact of interlocking on legitimize their value to investors through the creation directors with multiple appointments (increase of of a series of personal ties with other entities remuneration, acquisition of new skills, growing (DiMaggio and Powell, 1983) reputation, etc.). d) the career advancement model, whereby the D. Investigate possible causal links between creation of the interlocking directorate derives not so intense personal ties between companies in a given much from companies seeking to create ties with sector and the possible limitation (or alteration) of other entities, but from directors seeking an increasing competition in the markets. number of more important appointments, and firms In the first line of research (point A), some seeking directors with more experience, irrespective studies focus on the critical analysis of the reasons of the entities they are linked to (Stokman et al., (so-called models) that justify the creation and 1988; Zajac, 1988; Useem, 1979; Mace, 1971) dissemination of interlocks between large firms e) the social cohesion model, according to which (Fennema and Schijf, 1979; Koening et al., 1979; interlocks are the result of ties between members of Zajac, 1988; Mizruchi, 1996). the richer and more influential social classes that tend In this context, particularly significant are some to perpetuate their power through the mutual works that systematically examine the models and exchange of appointments (Mills, 1956; Mace, 1971; theories advanced by literature to explain the Domhoff, 1967; Zeitlin, 1974). development and evolution of the personal nature of The aforementioned research stream (point A) relationships between legally distinct firms. also includes many studies that examine the structure In particular, Koening et al.’s (1979) of interlocking networks by measuring the density of contribution argues that the spread of networks based ties, the number and the centrality of the different on common directors alternatively expresses one of parties involved, their evolution over time and the the following circumstances: different network characteristics according to the a) management control power (management geographic context under observation. control model) that is able to guide the votes of The contributions in this area focus in some shareholders at the time of the appointment or cases on a single country (or industry sector) and refer replacement of members of the board of directors to a specific date (Everard and Henry, 2002; Comet (Dahl et al., 1959; Cheit, 1964; Dively, 1972; Holden and Pizarro, 2011; Gambini et al., 2012), while et al., 1941) others, although focused within a limited geographical b) the need to build mutual cooperation relations context, examine the evolution over time of firm between firms (reciprocity model) by sharing networks (Heemskerk, 2007). Finally, additional directors (Dooley, 1969; Allen, 1974) studies propose analyses comparing the interlocking c) the volition of financial institutions to exercise directorate networks in different countries (Windolf control over debtor firms (finance control model) and Beyer, 1996; Santella et al., 2008; van Veen and (Aaronovitch, 1961; Perlo, 1957) Kratzer, 2011) or examine the evolution of the d) the presence of an elite group of influential network of personal ties between companies operating people (class hegemony model) who share common in distinct nations (international network) (Carroll et objectives and through their simultaneous presence in al., 2010; Heemskerk, 2013). large firms can ensure the maximization of personal The second stream (point B) includes studies, profit and more stable control power (Domhoff, 1967; referring to the aforementioned theoretical models Mills, 1956; Zeitlin, 1974). (particularly that of cooptation and monitoring), that In a later work, Mizruchi (1996) describes five aim to measure the effects of interlocking on separate models that justify the formation of personal decision-making, on the effectiveness of governance ties: mechanisms and on value creation. In relation to the a) the collusion model, according to which the latter point, the extreme variety of empirical results is diffusion of interlocks has origin in the desire of firms noteworthy and based thereon the literature has to create useful ties to exchange information, affirmed that interlocking positively (Phan et al., coordinate decisions within an industry and limit 2003; Elouaer Mrizak, 2009; Silva et al., 2006; Di competition (Pennings, 1980; Burt, 1983) Pietra et al., 2008; Li et al., 2013) or negatively (Non b) the cooptation and monitoring model, and Franses, 2007; Croci and Grassi, 2010; Drago et according to which interlocking directorate is an al., 2011) affects firm performance and business instrument adopted by firms to secure the resources value. Remaining on the theme of performance, the needed to reduce environmental uncertainty or study of Khanna and Thomas (2009) demonstrates a monitor the behaviour of companies entrusted with possible synchrony of results between companies their resources (consider the bank-firm relationship) linked by interlocking directorate. (Dooley, 1969; Pfeffer, 1972; Allen, 1974; Pfeffer Another part of literature instead focuses on and Salancik, 1978; Schoorman et al., 1981) particular circumstances that indirectly affect firm performance and business value.

405 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

First, we recall the studies that indicate a the primary source of interest on the interlocking weakening of control mechanisms due to the theme historically originates in the legislative excessive number of multiple appointments measures taken in the United States (first and undertaken by interlocked directors who, with limited foremost the Clayton Act) to limit the phenomenon of time and resources, often fail to effectively fulfil their common directors among competitor firms and to duties of control over the actions of executive discourage the adoption of collusive behaviours. This directors (Beasley, 1996; Fich and Shivdasani, 2006). line of research, although of primary importance, has Falling into this category are also studies that recorded limited results in terms of empirical demonstrate that interlocks are negatively related to evidence due to the extreme difficulty of proving (in persistence and balance sheet value relevance (Arena, statistical terms) the causal link between interlocking 2012). and market concentration. In addition, according to some authors, The studies of Pennings (1980) and Burt (1983), interlocking directorate also has repercussions on the while empirically demonstrating a relationship management of extraordinary (or non-recurring) between the degree of market concentration and the operations. According to Stuart and Yim (2010), for presence of interlocking directors, were unable to example, listed companies with interlocked directors verify the existence of a causal link between the two are more likely to be acquired by private equity firms. observed phenomena. In subsequent years, literature However, other authors have pointed out that the proposed some insights (Santella et al., 2008; Windolf attitudes of firms facing a takeover attempt are and Beyer, 1996) that through the analysis of network varyingly affected by the intensity and type of ties characteristics (density, multiple ties between that exist between the acquiring firm and the target companies, etc.) outlined two main interlocking entity (D'Aveni and Kesner, 1993). directorate models. On one side, those of a Beyond the firm perspective, the interlocking cooperative nature (present, for example, in Germany, directorate phenomenon is also shown to have Italy and France), which due to their structure induce significant effects in the personal sphere of shared hypothesizing agreements and collusion between directors (studies included in point C). firms; on the other hand, those of a competitive nature According to Fich and White (2005), for (observable in the British context) where the limited example, the reciprocal sharing of CEOs among presence of interlocks between firms and the different enterprises is an instrument that primarily characteristics of the associated entities appear to promotes the pursuit of the private interests of those respond better to the paradigm, based on resource involved, rather than as a governance mechanism for dependence theory, which qualifies personal ties as a the benefit of the firms. With this in mind, the means of acquiring and sharing resources essential to empirical evidence reported by Hallock (1997) is the survival and development of the enterprises unsurprising, according to which the sharing of involved. directors determines a significant increase in the remuneration of interlocked directors. 4. Theoretical Framework and It is quite evident that the benefits enjoyed by Explanation of the Research Aims directors who participate in interpersonal networks between companies are not exclusively limited to the According to the literature review proposed in the economic aspect. Some authors have thus focused on previous section, the present research is ideally the relative stability of the interlocking directorate positioning within the framework of studies that aim network, attempting to investigate the factors that to examine the interlocking network structure from an enable some directors to permanently occupy several evolutionary perspective in a given geographical different positions on the boards of large firms. In this context. sphere, we recall the aforementioned studies Compared to the studies carried out in recent according to which, on one hand, this implies a years, our study has some noteworthy distinctions. gradual reduction of the density of the interlocking We previously mentioned that some authors network in individual European contexts with a have in the recent past proposed a comparative simultaneous dissolution of the director elite shared at analysis of the structure of networks in Italy, national level (Heemskerk, 2007); on the other hand, Germany and the UK, although capturing their implying the rapid spread of interpersonal ties essential characteristics in only a single period that between companies operating in different European coincides with the beginning of 2008 (Santella et al., countries, which enables identifying a new elite of 2008). Other studies, while offering more complex more influential and internationally active directors and in-depth analyses of the evolution of the national network in the period 1998-2006, do not allow (Carroll et al., 2010; van Veen and Elbertsen, 2008; verifying whether the recent international crisis of Heemskerk, 2013). 2008 has somehow changed the structure of the Finally, the proposed classification model interlocking directorate network in the context of includes studies that have sought to examine the Italian listed companies. The results of the analysis theme of sharing directors in terms of the proper conducted by Santella et al. (2008) describe a functioning of markets (point D perspective). Indeed, relatively dense interlocking network among Italian

406 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 listed companies (especially in the blue chip the consolidation of the conditions of instability and segment), dominated in large part by an elite of uncertainty in 2010). directors relating, in many cases, to a small number of The study of interpersonal ties among firms in family controlled groups (industrial or financial). the sample was conducted by examining the With this in mind, our study intends to verify, composition of their governing bodies – the board of from an evolutionary perspective, whether the 2006- directors when adopting a traditional or monistic 2010 period saw significant changes in the density of governance model and the management board when ties within the overall network structure and to adopting a two-tier model - as resulting on 31 measure the centrality of the most influential December of each year (2006, 2008 and 2010) in the companies in the sample examined. Hence, building summary documents published periodically by on co-optation and control theory (Mizruchi, 1996), Consob (Italian Securities and Exchange we intend to specifically examine whether the need to Commission). address the 2008 international crisis and the The in-depth analyses foreseen in this research consequent desire to reduce environmental were implemented through identifying changes in key uncertainty in subsequent years (Schoorman et al., indicators used in literature in the Social Network 1981) contributed to a significant increase in the Analysis framework (Wellman and Berkowitz, 1988; density of ties and a possible change in the degree of Wasserman and Faust, 1994; Freeman, 2004; centrality of some enterprises, with respect to those Carrington et al., 2005; Scott, 2013). We thus generally observed, to create new alliances and examined, also in evolutionary terms, the level of consequently share distinctive competencies and cohesion of the network (density, geodesic distance), resources (Dooley, 1969; Pfeffer, 1972; Allen, 1974; the degree of centrality of the network as a whole and Pfeffer and Salancik, 1978). from the perspective of nodes (companies or Inspired by some recent research (Heemskerk, directors) that are more involved in personal network 2007; Carroll et al., 2010; Elbertsen and van Veen, relations (Freeman’s degree, closeness, and 2008; Heemskerk, 2013), the present work proposes a betweenness). In addition to the calculation of the key further study of the evolution of the network of synthetic network indicators, we also graphically influential directors (the so-called corporate elite) represent the network of companies in order to who, due to their presence on a number of boards of highlight, in a more immediate and direct way, the directors, liaise (and coordinate) between major main changes that occurred in the period under companies and consequently assume a prominent investigation22. position in the national economy. From the operational point of view, the network of ties between companies was analyzed by first 5. The Evolution of the Network Based on creating the so-called affiliation matrix composed of n Sharing Directors Between Large Italian columns (events) representing the firms in the sample Listed Companies in 2006-2010 (38 firms) and m rows (actors) corresponding to the respective directors in office at the end of each year 5.1. The data and the methodology observed23. adopted The matrix (m x n) resulting from the intersection of these two perspectives (affiliation To construct the database used in this research, matrix) was subsequently re-elaborated to generate reference was made to listed companies in the FTSE two symmetric matrices that respectively summarize MIB segment of the Italian Stock Exchange in the the presence of common directors among the years 2006, 2008 and 2010. From the original sample observed firms (adjacency matrix n × n) and, in the - composed of forty companies for each year of opposite perspective, the network of directors who sit observation – we excluded two entities under foreign on the board of directors of one or more companies law: STMicroelectrics and Tenaris21. (adjacency matrix m x m). All the indicators subject to The choice of the overall time period examined comment in the next section refer to the (2006-2010) is closely linked to the purpose of our aforementioned adjacency matrices that constitute our study, namely, to investigate whether the sudden research sample24. spread of the systemic crisis that has recently affected the world's leading economies (including Italy) has had a significant impact on the structure of personal ties between major Italian listed companies. 22 The Ucinet software was used to calculate the key The further methodological choice to perform synthetic network indicators (Borgatti et al., 2002); the the analysis on a biennial (2006, 2008 and 2010) graphic representation of the network was implemented with the correlated Netdraw visualization software. rather than annual basis, is aimed at facilitating the 23 next phase of discussing and interpreting the results The combination of m columns and n rows originated three separate affiliation matrices (2006, 2008 and 2010) for a total obtained, enabling focusing on three distinct periods of 49,932 items. each characterized by different economic and market 24 The adjacency matrix initially obtained from the re- conditions (i.e., the apparent stability of the economy elaboration of the affiliation matrix was dichotomized as in 2006, the emergence of the financial crisis in 2008, suggested by literature for the calculation of specific indicators (Prell, 2012). Thus, in some cases, regardless of the number of shared positions the correlated value in the 21 The list of companies that constitute the survey sample of matrix examined was given an equal unitary value (presence this research is given in Appendix A. or absence of the tie).

407 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

5.2. Results and discussion reduction in the degree of hierarchy in the network: both the Freeman's degree of the whole sample 5.2.1 The network of listed companies observed and the average closeness indicator in sharing common directors relation to the first component decreased by more than 10% in the period 2008-201026. These changes, Table 7 illustrates the key data describing the network although significant, indicate that in the years of personal ties between large Italian listed companies following the crisis, the network had a less centralized (FTSE MIB) and presents an immediate view of the structure. evolutionary trends of the interlocking directorate at Turning to the measures of centrality of the national level between 2006 and 2010. individual companies in the sample27, we note that the First to be noted is that the first component of most relevant nodes (represented by Pirelli, the network (i.e., the larger subgroup) increased in Mediobanca and Autostrade/Atlantia) maintained size from 30 units in 2006 to 34 units of 2010; their top position in the network during the entire conversely, in the same period, the number of ties period observed. Nevertheless, in accordance with significantly reduced from 73 to 61 (- 16.4%). that previously mentioned in reference to the network The reduction of the number of ties between as a whole, the number of direct ties between the companies is reflected in the network density, which more centralized firms (expressed by Freeman's particularly decreased in the period 2008-2010, degree) significantly decreased especially in the shifting from the value of 0.1038 to 0.0868 (- about period 2008-2010. Interesting to note in this context, 20%). The increase of companies in the first by way of example, is that that while in 2008 the component and the reduced number of interlocks in number of companies linked with at least ten other relation to 2010 renders the network structure less companies is equal to four (Pirelli, Mediobanca, dense than in 2006, resulting in an increase of the Atlantia and Telecom Italy), in 2010, this is only geodesic distance between enterprises: compared to found in two cases (Pirelli and Mediobanca). More an average distance of 2.4 nodes in 2006 and 2008, generally, the number of nodes (companies) that have the corresponding value in 2010 is 2.8 nodes25. The companies examined are in many cases linked by sharing several directors, with the result that 26 The centrality indicators of the entire network (in some the number of common directors among the entities cases, referring to the first component) summarize the varies from one to five. The years 2006 and 2010 average degree of centrality assumed by each actor with show, for example, cases of companies linked by five respect to the remaining companies in the network and thus provide information on the network hierarchy. With this in common directors: in 2006, this is observable in the mind, these indicators range between 0 and 1 (where not context of ties between Alleanza Assicurazioni and expressed as a percentage) and take values close to zero Banca Intesa, while in 2010, the greatest sharing of when a consistent degree of centrality exist among directors is between Exor and FIAT. Finally, in 2008, companies; to the contrary, when one or several companies focus the majority of their ties to a greater extent when the most intense ties, with four directors in common, compared to other companies, the observed indicator tends are observable in the relationship between Mediaset to converge towards the unitary value (Wasserman and and Mondadori (Table 8). Faust, 1994). 27 With reference to the key centrality indicators measured in We hereafter focus on the measures of network this research and referring to individual companies in the centrality (Freeman, 1979), both as a whole and with sample, the following should be clarified. reference to individual companies, to describe the The Freeman's degree is the simplest and most immediate evolution of the network and the different roles measure of centrality: it corresponds to the number of nodes played by firms in the period examined. (companies) with which another node is directly linked. The higher the number of direct ties, the more advantageous the Table 9 shows a moderately high degree of company’s position can be considered, while its role within hierarchy in the network (based on the value of the network can be considered the most central and active. Freeman’s degree) throughout the period of Other centrality indicators (based, however, on indirect ties observation, which means that, within the network, between companies) are closeness and betweenness. Closeness is the summary indicator of the proximity of a some companies have a more active role due to the node with respect to all the others and in numerical terms higher number of direct ties with other firms. corresponds to the inverse of the sum of the entire geodetic Examining the development of the centrality distance between a node and all the others (Sabidussi, 1966). Betweenness instead measures the number of paths indicators from a dynamic perspective, we observe a that pass through a given node: in this perspective, a company assumes a central role as an intermediary between other nodes to the extent that it contributes to fostering 25 In terms of reticular cohesion indicators, the density indirect ties between non-adjacent firms. In this way, the firm corresponds to the ratio between the number of ties actually acts as an intermediary between other businesses, able to existing in the network and the number of all ties potentially control the exchange of information within the network achievable. The geodesic distance instead represents the (Freeman, 1977). shortest distance (in terms of paths) between a pair of nodes: In general terms, it can reasonably be argued that centrality in this research, we examine the average geodesic distances summarizes the ability of firms to take an active role in the between all nodes of the first component, taking into account network, resulting from power of control over the flow of that an increase in this indicator (greater distance between information and resources that are exchanged between firms) corresponds to a decrease in the density of the directly related or mediated companies. reticular structure.

408 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 at least five direct ties decreased between 2006 and 2010 from 14 to 11 cases.

Table 7. Descriptive statistics of the network of Italian listed companies

2006 2008 2010 Number of companies observed 38 38 38 First Component 30 32 34 Components (minimum 2 linked nodes) 3 1 1 Isolated 4 6 4 Number of ties 73 76 61 Density 0.1038 0.1081 0.0868 Geodesic Distance (average distance) 2.4 2.4 2.8

Table 8. Distribution of interlocks (based on number of directors in common)

N. of directors in common 2006 % 2008 % 2010 % 1 51 69.9% 58 76.3% 49 80.3% 2 11 15.1% 12 15.8% 5 8.2% 3 9 12.3% 5 6.6% 5 8.2% 4 1 1.4% 1 1.3% 1 1.6% 5 1 1.4% - - 1 1.6%

Table 9. Centrality measures of the network of Italian listed companies

2006 2008 2010 Degree of centralization (Freeman’s degree) 28.98% 28.53% 25.08% Network centralization (based on closeness in the main component) 41.60% 39.51% 35.40%

The reduction in the total number of direct ties although similar, differs with respect to certain within the network has a positive effect on the companies. This in essence implies that some intermediating role played by some companies that on companies, despite having a lower number of direct closer inspection acquire, in the observed period, a ties than others (Freeman's degree), take on greater more important position within the network as strategic importance within the network since as a measured in terms of betweenness. In essence, with gatekeepers they link - albeit indirectly - other fewer direct ties within the network, increasing companies that are not adjacent. importance is assumed by those companies that also In a dynamic perspective, beyond the previously play the role of intermediaries (so-called gatekeepers) mentioned reduction in the number of direct ties between other businesses that are not directly linked, (degree) and the correlated increase in the degree of channelling the exchange of information and importance of intermediation of some firms resources. (betweenness), a general reduction was also observed In this context, comparing for each year the list (between 2006 and 2010) in the proximity (closeness) of companies with higher centrality indicators between companies. This reflects on the form and (expressed in terms of Freeman's degree and structure of the network, which, as already mentioned, betweenness), we observe that their composition, is less dense and more extensive in 2010 than in 2006.

Table 10. Centrality measures (Freeman’s degree) of Italian listed companies (companies with a Freeman’s degree above 5)

Company 2006 Company 2008 Company 2010 Pirelli 14 Pirelli 14 Pirelli 12 Mediobanca 13 Mediobanca 12 Mediobanca 11 Autostrade 9 Atlantia 11 Atlantia 8 Autogrill 8 Telecom Italia 10 Luxottica 8 Telecom Italia 8 Generali 9 Italcementi 8 Capitalia 6 Italcementi 8 Generali 7 Italcementi 6 Mediaset 7 Autogrill 6 Mediaset 6 Luxottica 7 Mediaset 6 Generali 5 Alleanza 7 Parmalat 6 Banc. Pop. Un. 5 Autogrill 7 Fiat 5 Alleanza 5 Parmalat 6 Eni 5 Fiat 5 Fiat 5 Parmalat 5 Eni 5 Luxottica 5 Intesa 5 Unicredit 5

409 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 11. Centrality measures (normalized betweenness) of Italian listed companies (top ten centralized companies)

Company 2006 Company 2008 Company 2010 Pirelli 17.596 Pirelli 16.109 Pirelli 21.078 Mediobanca 13.438 Atlantia 14.079 Mediobanca 16.532 Autogrill 10.849 Generali 12.504 Generali 15.234 Autostrade 8.159 Mediobanca 11.579 Luxottica 15.018 Telecom 5.089 Luxottica 7.256 Parmalat 12.947 Fiat 4.871 Italcementi 6.009 Fiat 11.299 Fondiaria-Sai 4.334 Telecom 5.094 Atlantia 11.162 Unicredito 4.327 Autogrill 4.773 Telecom 8.213 L’Espresso 4.204 Unicredit 4.580 Italcementi 7.596 Parmalat 3.442 M.P.S. 4.505 Tod’s 6.269

Table 12. Centrality measures (normalized closeness) of Italian listed companies (top ten centralized companies)

Company 2006 Company 2008 Company 2010 Pirelli 63.043 Pirelli 62.000 Pirelli 54.098 Mediobanca 61.702 Mediobanca 59.615 Mediobanca 52.381 Autostrada 54.717 Telecom 56.364 Generali 47.826 Telecom 53.704 Atlantia 55.357 Parmalat 47.143 Autogrill 52.727 Generali 52.542 Italcementi 46.479 Italcementi 49.153 Italcementi 50.820 Atlantia 46.479 Parmalat 49.153 Autogrill 50.000 Luxottica 44.595 Mediaset 47.541 Luxottica 48.438 Autogrill 44.000 Capitalia 45.313 Alleanza 48.438 Mediaset 42.857 Fondiaria-Sai 44.615 Parmalat 48.438 Eni 42.308

In further investigating the role and positioning 10 to 5), those with five units were present only in of the companies examined, we observe that the 2006 (2 cases) and in 2008 (3 cases). Of all majority of these have direct ties with other companies with direct ties with other companies of companies that play a strategic role within the higher centrality, the hegemonic role of Pirelli is network. This further amplifies the network cohesion noteworthy, which is present in all larger cliques in effects and the centralization of coordination power in each year (those with five for 2006 and 2008, those relation to a small group of firms and leads to the with four for 2010). formation of numerous cliques28 of significant size The graphic representation of the network, (more than four units). obtained using the Netdraw software, allows visually Again we note, in a dynamic perspective, that perceiving the evolution of the network structure that, the crisis of 2008 appears to have reduced the number as already mentioned, is progressively less dense and of cliques in the timeframe examined: those equal to more extensive in its meshes. four units were halved between 2008 and 2010 (from Beyond the positioning of individual companies, amongst which the central role of Pirelli is also graphically evident, it is interesting to note the 28 The term clique refers to the subset of highly cohesive increasing number of cut-off points (represented with nodes within which each node has direct ties with the other members of the clique; it follows that within cliques the triangles) that increased by less than 5 units (6 to 11) geodetic distances between all nodes are always equal to 1. from 2006 to 2010. This refers to those particular Herewith follows the composition of larger cliques identified in nodes whose eventual removal would result in the the years of observation: exclusion of one or more firms from the first - year 2006 (2 cliques of five units): 1) Autogrill, Autostrade, Mediobanca, Pirelli, Telecom Italia; 2) Alleanza component and, for this reason, are particularly Assicurazione, Banca Intesa, Generali Assicurazioni, significant in the network. The increase in cut-off Mediobanca, Pirelli points could be explained by the reduction in the total - year 2008 (3 cliques of five units): 1) Atlantia, Autogrill, number of ties between the firms observed (recalling Mediobanca, Pirelli, Telecom Italia; 2) Alleanza Assicurazioni, Generali Assicurazioni, Mediobanca, Pirelli, Telecom Italia; 3) that direct ties decreased from 73 in 2006 to 61 in Alleanza Assicurazioni, Generali Assicurazioni, Intesa San 2010). In this context, each tie takes on increasing Paolo, Pirelli, Telecom Italia importance and its absence is likely to interrupt the - year 2010 (5 cliques of four units): 1) Italcementi, chain of indirect ties in the network. Mediaset, Mediobanca, Pirelli; 2) Atlantia, Italcementi, Mediobanca, Pirelli; 3) Italcementi, Mediobanca, Pirelli, Unicredit; 4) Atlantia, Autogrill, Mediobanca, Pirelli; 5) Italcementi, Mediaset, Parmalat, Pirelli.

410 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 13. Cliques in the Italian listed company network

Minimum set size 2006 2008 2010 4 7 10 5 5 2 3 0

In graphic terms, the reduction of direct ties is 2010); a significant number of these directors held also reflected in the structure of the network, which as multiple positions in the companies observed, up to a mentioned, in the comparison between 2006 and maximum of five positions in 2006 (1 case), four 2010, is more extensive and less dense towards the positions in 2008 (4 cases) and in 2010 (2 cases). centre (Figure 1, 2, 3). This table also shows that the number of positions in the companies observed reduced 5.2.2. The Director’s Network and the significantly from 544 in 2006 to 491 in 2010 (- Evolution of the Corporate Elite in the 9.74%). This is again related to the aforementioned Wake of the Crisis data where it was observed that a profound change in the corporate governance structure took place in the From a different perspective, we examine the aftermath of the crisis, with a significant reduction of interpersonal component of the network focusing average number of directors on boards (also see Table specifically on the evolution of the corporate elite in 1) resulting in a rupture of many personal ties the wake of the crisis. between companies and a partial change of some Table 14 shows that the number of directors in dominant positions within the network. the 38 companies examined in the previous section decreased from 463 (FY 2006) to 420 units (FY

Table 14. Distribution of multiple directorships in the Italian listed company network

N. of directorships held by 1 person 2006 % 2008 % 2010 % 1 402 86.83% 371 86.28% 359 85.48% 2 48 10.37% 44 10.23% 53 12.62% 3 7 1.51% 11 2.56% 6 1.43% 4 5 1.08% 4 0.93% 2 0.48% 5 1 0.22% - - - - N. of directors 463 430 420 N. of directorships 544 508 491

The reduction in the total number of Also in this case, the lower density of ties has directorships in the observed companies has resulted led to an increase in the geodesic distance in the same in - similarly to that previously observed for the period (+ 10.90%) and a correlated decrease in the network of companies in the sample - a reduction in degree of hierarchisation of the network. the density of ties, especially in the first component, with a decrease of over 14% between 2006 and 2010 (from 0.049 to 0.042). Table 15. Descriptive statistics of the board of directors’ network

2006 2008 2010 Number of directors observed 463 430 420 First Component 373 359 379 Components (minimum 2 linked nodes) 7 7 5 Density 0.038 0.038 0.037 Density (in the main component) 0.049 0.048 0.042 Geodesic Distance (average distance) 3.152 3.216 3.538

Table 16. Centrality measures of the board directors’ network

2006 2008 2010 Degree of centralization (Freeman’s degree) 17.57% 16.27% 15.31% Network centralization (based on closeness in the main component) 36.74% 31.20% 28,78%

411 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Figure 1. Interlocking directorship network among Italian listed companies in the FTSE MIB (year 2006)

412 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Figure 2. Interlocking directorship network among Italian listed companies in the FTSE MIB (year 2008)

413 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Figure 3. Interlocking directorship network among Italian listed companies in the FTSE MIB (year 2010)

414 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

With regard to individual directors, to be first economic crisis that affected the two years following noted is the significant reduction of direct ties as 2008. Against this background, the predominant role measured by Freeman's degree, which on one hand of some particularly influential directors - members of weakens - albeit only partially and in relative terms - the so-called corporate elite - does not seem to have the central role of some directors (see for example, suffered significant streamlining, unlike that observed Benetton and Pesenti) that still retain their dominant by other authors with reference to other foreign position within the network and, on the other, countries (Heemskerk, 2013). One possible increases the role of other directors, who - although explanation for the greater stability of network relying on a smaller number of direct ties - occupy directors in the Italian context could be reasonably key positions that serve as hubs in the exchange of explained by the presence of numerous family information between the individual network nodes. controlled firms (or with concentrated ownership) In conclusion, a first preliminary examination of among the major listed companies. Indeed, in these the existing network of directors - which still requires companies, the tendency to change directors is lower further study - gives evidence of a significant and, more importantly, is less sensitive to firm evolution of interpersonal ties that is likely to be due performance (Chen et al., 2013). to the uncertainty resulting from the financial and

Table 17. Centrality measures (Freeman’s degree) of directors (top ten directors with highest Freeman’s degree)

Director 2006 Director 2008 Director 2010 Benetton G. 81 Benetton G. 64 Benetton G. 63 Pesenti C. 80 Pesenti C. 62 Pesenti C. 60 Perissinotto G. 66 Secchi C. 60 Secchi C. 60 Berheim A. 66 Perissinotto G. 58 Pagliaro R. 51 Mion G. 56 Libonati B. 55 Bombassei A. 50 Galateri G. 54 Pagliaro R. 55 Rampl D. 42 Cannatelli P. 53 Berheim A. 51 Palenzona F. 42 Bombassei A. 51 Mion G. 50 Clò A. 40 Secchi C. 42 Bombassei A. 50 Cucchiani E.T. 40 Rampl D. 41 Berlusconi M. 45 Nagel A. 39

Table 18. Centrality measures (normalized betweenness) of directors (top ten centralized directors)

Director 2006 Director 2008 Director 2010 Benetton G. 14.517 Caltagirone F. 11.682 Benetton G. 12.244 Gros Pietro G.M. 6.777 Perissinotto G. 9.257 Secchi C. 12.165 Pesenti C. 6.439 Benetton G. 9.234 Della Valle D. 8.273 Comoli M. 6.298 Stefanini P. 8.731 Pagliaro R. 7.086 Perissinotto G. 5.784 Secchi C. 7.333 Mincato V. 7.043 Erede S. 5.727 Gros Pietro G.M. 6.493 Ponzellini M. 7.008 Secchi C. 5.510 Mion G. 6.452 Mangiagalli M. 6.614 Ligresti G.M. 5.405 Bernheim A. 5.302 Pesenti C. 6.110 Marrone V. 5.349 Ligresti J. 3.959 Berger R. 5.176 Giarda D.P. 5.029 Ligresti G.M. 3.820 Del Vecchio L. 4.867

Conclusions hypothesis that the sharing of directors between large companies could find wider dissemination The analyses reported in the previous sections lead us concurrently with the periods of general crisis on a to develop some brief concluding remarks. national and international level. Therefore, the results First, there is no doubt that during the obtained contradict, from a certain perspective, some observation period of this study, significant changes previous studies that consider interlocking directorate took place in the personal ties amongst large as the effect of strategies adopted by companies to companies listed on the regulated Italian market. reduce environmental uncertainty (Schoorman et al., Indeed, all summary indicators examined show 1981). According to this perspective, one would have considerable changes, especially in the period 2008- expected that in a period of crisis the response of 2010. firms would be to intensify their relations with other A first analysis of the results obtained, which entities. deserve to be further explored and validated through It should be added, however, that several recent expanding the data collected, would seem to refute the studies, while confirming the gradual reduction of the

415 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 phenomenon of sharing directors in national contexts, reduction in national contexts) is the result of a choice report a significant increase in interlocking directorate adopted by companies or whether, to the contrary, the at the international level (Heemskerk, 2013). It would changes of the network of personal ties between thus be interesting to ascertain as a further future companies remains largely the result of a complex development of this research whether the reduction of process of co-optation between a few directors who personal ties, in the context of companies under represent an elite within the business system. The Italian law, has been partially offset by the creation of relatively high degree of network density and the new ties with foreign firms. This would be presence of redundant ties between associated unsurprising, especially in light of the aforementioned companies, although reducing as a result of the crisis, studies that consider international networks as an suggest that the significant drive towards the creation instrument adopted by firms to acquire new distinct of a personal network between companies is competencies and resources that are needed to initiate attributable to the volition of these directors to the revitalization and the recovery of economic enhance their status and their ability to indirectly activities. govern national and international economic levers. Contrary to what one might have expected, in this research we observe that in the period 2008-2010 References - i.e., in the period immediately following the spread of the crisis in the context of the real economy and in 1. Aaronovitch, S. 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56. Nielsen, S., and Huse, M. (2010a), "The Contribution of 73. Stuart, T. E., and Yim, S. (2010). Board interlocks and Women on Boards of Directors: Going beyond the the propensity to be targeted in private equity Surface", Corporate Governance-an International transactions. Journal of Financial Economics, 97(1), Review, 18 (2), 136-148. 174-189. 57. Nielsen, S., and Huse, M. (2010b). "Women directors' 74. Taylor, R. N. (1975), "Age and experience as contribution to board decision-making and strategic determinants of managerial information processing and involvement: The role of equality perception", decision making performance", Academy of European Management Review, 7 (1), 16-29. Management Journal, 18 (1), 74-81. 58. Non, M., and Franses, P. (2007), "Interlocking boards 75. Useem, M. 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418 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

APPENDIX A

Sample composition (FTSE MIB – Borsa Italiana)

Year 2006 Aem S.p.A., Alitalia S.p.A., Alleanza Assicurazioni S.p.A., Autogrill S.p.A., Autostrade (31/12/2006) S.p.A., Banca Intesa S.p.A., Banca Monte dei Paschi di Siena S.p.A., Banca Popolare di Milano S.c.r.l., Banca Popolare Italiana S.C., Banche Popolari Unite S.c.p.a., Banco Popolare di Verona e Novarla S.c.a.r.l., Bulgari S.p.A., Capitalia S.p.A., Enel S.p.A., Eni S.p.A., Fastweb S.p.A., Fiat S.p.A., Finmeccanica S.p.A., Fondiaria-Sai S.p.A., Generali Assicurazioni S.p.a., Italcementi S.p.A., L'Espresso S.p.A., Lottomatica S.p.A., Luxottica S.p.A., Mediaset S.p.A., Mediobanca S.p.A., Mediolanum S.p.A., Mondadori S.p.a., Parmalat S.p.A., Pirelli S.p.A., Saipem S.p.A., Sanpaolo Imi S.p.A., Seat Pagine Gialle S.p.A., Snam S.p.A., Telecom Italia S.p.A., Terna S.p.A., Unicredito Italiano S.p.A., Unipol S.p.A. Year 2008 A2A S.p.A., Alleanza Assicurazioni S.p.A., Atlantia S.p.A., Autogrill S.p.A., Banco (31/12/2008) Popolare S. C., Bulgari S.p.A., Buzzi Unicem S.p.A., Enel S.p.A., Eni S.p.A., Fastweb S.p.A., Fiat S.p.A., Finmeccanica S.p.A., Fondiaria-Sai S.p.A., Generali Assicurazioni S.p.A., Geox S.p.A., Impregilo S.p.A., Intesa San Paolo S.p.A., Italcementi S.p.A., L'Espresso S.p.A., Lottomatica S.p.A., Luxottica S.p.A., Mediaset S.p.A., Mediobanca S.p.A., Mediolanum S.p.A., Mondadori S.p.A., Monte dei Paschi di Siena S.p.A., Parmalat S.p.A., Pirelli S.p.A., Banca Pop. Di Milano S.C.R.L., Prysmian S.p.A., Saipem S.p.A., Seat Pagine Gialle S.p.A., Snam S.p.A., Telecom Italia S.p.A., Terna S.p.A., Ubi S.c.p.a., Unicredit S.p.A., Unipol S.p.A. Year 2010 A2A S.p.A., Ansaldo STS S.p.A., Atlantia S.p.A., Autogrill S.p.A., Azimut S.p.A., (31/12/2010) Banco Popolare S.C., Banca Monte dei Paschi di Siena S.p.A., Banca Popolare di Milano S.c.r.l., Bulgari S.p.A., Buzzi Unicem S.p.A., Campari S.p.A., Diasorin S.p.A., Enel S.p.A., Enel Green Power S.p.A., Eni S.p.A., Exor S.p.A., Fiat S.p.A., Finmeccanica S.p.A., Fondiaria-Sai S.p.A., Generali Assicurazioni S.p.A., Impregilo S.p.A., Intesa Sanpaolo S.p.A., Italcementi S.p.A., Lottomatica S.p.A., Luxottica S.p.A., Mediaset S.p.A., Mediobanca S.p.A., Mediolanum S.p.A., Parmalat S.p.A., Pirelli S.p.A., Prysmian S.p.A., Saipem S.p.A., Snam S.p.A., Telecom Italia S.p.A., Terna S.p.A., Tod's S.p.A., Uni Banca S.c.p.a., Unicredit S.p.A.

419 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

THE IMPACT OF INNOVATION AND TECHNOLOGY ON MICROFINANCE SUSTAINABLE GOVERNANCE

Roberto Moro Visconti*, Maria Cristina Quirici**

Abstract

Technical or social innovation, concerning also the creation and commercialization of new products, strategies and management, has a deep actual - and especially trendy - impact on microfinance institutions (MFIs), contributing to reshape their business model, with an impact on their overall risk profile. Innovation is mostly an opportunity even for MF risk mitigation, considering its pervasive impact on risk factors. This original analysis is addressing, in a multidisciplinary and innovative comprehensive way, apparently weakly related topics such as MF governance, and IT issues, within recessionary cycles. This hardly investigated frontier faces key trendy issues, which are likely to deeply reengineer the relationship among different stakeholders, as it has already happened, on a different and more sophisticated scale, with traditional banking. To the extent that technology (with access to Internet, social networks, cashless electronic payments, etc.) reshapes the equilibriums among different stakeholders, it is likely to have important – albeit under-investigated - corporate governance consequences, softening the conflicts of interest among stakeholders and reinforcing the business model, making it more resilient during recessions, with positive externalities on both sustainability and outreach.

Keywords: Stakeholders, ICT, Risk Management, Outreach, Mobile Banking, Cashless Society, Social Networks, Recession

* Department of Business Administration, Università Cattolica del Sacro Cuore, Milano, Italy Tel. + (39)-0289072549 Fax + (39)-0289073293 Email: [email protected] ** Department of Economics and Management, University of Pisa, Italy Email: [email protected]

1. Introduction innovation and sustainability and outreach, Microfinance (MF) is spreading everywhere in the incorporating risk, is even less explored. world, some 30 years after Yunus’ pioneering The topic of this paper is so original and intuition, but at the same time is rapidly changing, interesting, especially forecasting the potential impact with new opportunities, mainly induced by of innovation, which may significantly improve MF innovations, but also with unprecedented threats, such scalability, making it profitable, strengthening as mission drift – the irresistible temptation to sustainability and pushing outreach towards deeper abandon social objectives, looking for wealthier financial inclusion. Risk mitigation is also likely to clients – or worldwide recession contagion (see improve both sustainability and outreach. Engels, 2010; Moro Visconti, 2014). Technology (represented by M-banking, mobile Technical or social innovation, concerning also payments, PDAs …), cutting through complexity, the creation and commercialization of new products, “deatomizes” the business model, making it sounder strategies and management, has a deep actual - and and more resilient to external shocks, albeit requiring especially potential - impact on microfinance initial investments on both sides, concerning not only institutions (MFIs), contributing to reshape their MFIs but also increasingly sophisticated clients. business model, with an impact on their overall risk Technology stands out as a big disrupting factor, profile. which segments haves from haves not, so creating a Innovation is mostly an opportunity even for MF market barrier among different MFIs, where only the risk mitigation, even if with some possible unwanted strongest are fit for upgrading. side effects. Whereas the impact of risk factors on MF banana skins (Moro Visconti, 2012) are a microfinance is still an under investigated field, “slippery” metaphor for risk and are monitored with somewhat forgetting that money intermediation is a worldwide survey. Even if “managing technology”, intrinsically a risky business, the link between the classified risk factor closer to technological

420 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 innovation, appears in a mid ranking position, its link among different industries, considering that the with other risk factors - starting from top ranking financial sector, where MFIs are broadly collocated, credit risk – is worth being investigated, albeit being influences and is also influenced by all the economic sometimes surreptitious, since risk factors are likely sectors, which represent the real world underlying its to have an epidemic domino effect, self igniting and backing financing. fulfilling each other. Technology is possibly the most powerful M-banking, shortening the organizational chain transmittable tool within a globalized world, subject with its space-less and timeless virtual branches, to unprecedented and often uncontrollable movements stands out as an interesting device to soften the of capitals, goods, people and their know-how, a human resources bottleneck, tackling technological common denominator which represents the risk, even if it needs a strong investment background. “software” behind any “hardware” transfer, with a Both sustainability and outreach are based on a demiurgic impact that makes it a cornerstone of going concern scenario which enables the MFI to internationalized economic value. survive and prosper, avoiding both equity and cash To the extent that MFIs are located in an burn out. institutional framework of many (often confusingly This original analysis shows structural and and informally) interacting financial intermediaries, evolving patterns, providing intriguing insights for they can both influence and mostly, be influenced by improvements, in order to soften development technological pollination, mainly in the form of spill- bottlenecks, enhancing MF sustainability and over and trickle down from bigger and sounder outreach with suitable technology, within a dynamic institutions. corporate governance context. Growing technological innovation follows the The paper is organized as follows: being the first Darwinian development pattern of MFIs, which need article on this broad issue, we try to analyze a large being increasingly backed by IT sophistication. framework, starting from technological pollination of Information and communication technologies ideas and devices and proceeding with the impact of (ICT) are an important driver in the maturing technology on corporate governance mechanisms, microfinance industry. MF Providers - both non-profit involving the stakeholders that rotate around the MFI. MFIs and for-profit banks - provide financial services Since technology and innovation reshape the to the poor, which are unbanked, in order to eradicate equilibriums among different stakeholders, they are poverty and to promote economic development in likely to have important corporate governance developing nations. As the industry matures, MFIs consequences on MFI; this hardly investigated thesis face an increasingly competitive environment that may well be extended to other industries. forces them to balance the dual goals of outreach and MF risks are then investigated, considering in sustainability. In this context, ICT may be both the particular the impact of innovation, which fully instigator of the new environment and the potential reengineers the organizational system within the MFI, solution to MFIs survivability. In this sense, simplifying and expanding its business model, with Kauffman and Riggins, 2012, propose research positive consequences on both sustainability and direction on the role of ICT in the microfinance outreach. Risk factors are to be included in MF industry, with special attention given to the industry's business planning, where technology and innovation stakeholders and to the value chain of MF services. are again to be considered for their potentially Providing financial services to poor people is powerful impact. costly and this in part because these clients exchange Technology is a big disrupting factor, which small amounts of money, live in sparsely populated segments haves from haves not, so creating a market areas and rarely have documented credit histories. barrier among different MFIs, where only the According to some studies (Ivatury, 2006) MFIs, strongest are fit for upgrading. Sponsoring equity- handling small transaction for dispersed population, holders increasingly acknowledge the importance of have operating costs of 12-15 % of assets, while the IT contributions and technical managerial training, similar ratio for banks rarely exceeds 5 %. So, but there is still an enormous effort to make, innovative operating methods are required to reduce involving thousands of small and unskilled MFIs, too transaction and managerial costs. It is so necessary to unsophisticated and fragile for scaling up, unless find delivery channels that are inexpensive to set up, a properly assisted. wider range of financial services according to poor Concluding remarks contain a summary of the characteristics, in order to handle transactions at low main findings and implications of this paper, with cost. some tips for further research avenues. "Direct banking" technology channels -such as Internet banking, automated teller machines (ATMs) 2. Applying Information Technology to or point-of-sale (POS) terminals make possible to Microfinance reduce the cost of process transaction at only one-fifth of the cost of a branch teller. These terminals can be MFIs are subject to a continuous contagion, both set up at a cost of less than 0.5 % the cost of setting horizontal - among different countries, which export up a typical bank branch. ideas, projects but also problems – and vertical,

421 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Obviously, it is necessary to consider the Kumar et al., 2010, highlighted that the MFIs particular conditions characterizing places and habits world largely uses unsophisticated backend systems, of poor people. Most of them, particularly those while the m-banking world uses very sophisticated working in the informal economy and in rural areas, backend systems. But also according to other studies - where also electricity could be absent, earn and spend particularly Rozzani et al., 2013, in their literature in cash: to handle a cash transaction outside of a bank review - many MFIs are still facing difficulties in branch MFPs may use or an ATM (that can accept, using sophisticated technology. Hence, technology is store and dispense cash, but requiring a "always-on" often said to be one of the biggest obstacles faced by telecommunication connection to a bank's central modern MFIs worldwide. service), or a POS device placed in an outlet where Making use of mobile phones can also drive the cash is kept on hand. expansion of insurance coverage in low-income According to CGAP, 2006, 62 financial markets (Prashad et al., 2014), increasing the institutions in 32 countries report using technology efficiency of transactions across the entire value channels (including at first place ATM, and POS chain. devices, only in a little part mobile phones) to handle The successful use of technology in MFIs stands transactions for poor people; moreover, nearly 75 % as an exception rather than a ruling, despite the falling of the respondents were banks, operating both in large cost of hardware and connectivity (CGAP, 2013); markets (India, Brazil and South Africa) and in small Kulik and Molinari, 2004, found that the main reason markets (e.g. Namibia, Guatemala or Malawi). Surely, for the poor performance of MFIs is the lack of access most respondents to CGAP's survey use technology to technology; Mishra and Chowbwy, 2009, underline channels for automatic basic transactions, to reduce insufficient availability and use of technology in processing costs and to give customers added Indian Microfinance; Frankiewicz, 2003, argues that convenience, gaining new ones in areas where setting the emergence of information technology can be a up a branch is too costly (CGAP, 2006). strategic tool for MFIs. These results consent many different In other words, these studies put in evidence consideration, but two in particular: that, despite the accessibility of technology, in MFIs 1) most survey respondents are banks and only there is a problem in developing adequate in a little part are MFIs: and this because most MFIs Management Information Systems (MIS) (see could be not well suited to develop technology Ahmad, 2005; Sahoo and Sahoo, 2013) with delivery channels, being lacking the strong core consequent difficulties in managing their credit information systems, substantial financial and delivery to clients and in gatherings data of clients. management resources and membership in electronic But this lack has deep consequences in MFIs payment association required for such initiatives management's ability to have a timely and proper (Ivatury, 2006); decision-making process. The implementation of an 2) most survey respondents use ATMs, and this appropriate MIS lies at the heart of a MF business, suggest that they target customers in urban and semi- being a necessary requisite for MFIs' management urban areas. In fact, even if now telecommunication both to monitor the effectiveness, sustainability, and electricity infrastructure are more widespread and quality and efficiency of their loan portfolio and to increasingly available in developing countries - manage general administrative tasks, thanks to an because of falling hardware coast and growing easy access to all critical management information. support infrastructure - in many places, above all rural MIS increases productivity, lowers transaction cost areas, they are not available. and reduces the risk of failure, but most of the MFIs The most developing technology channel is now have yet to realize the importance of its use to achieve M-banking: in countries where debit and credit cards, outreach and sustainability. As strong core MIS can POS devices and ATMs and bank branches are deliver cost-effective integration of data, channels and nonexistent, using mobile phone may be a lower-cost processes, easing a consolidated view of the whole way to expand access to financial services, opening portfolio, the implementation of the right MIS basic accounts for customers who previously were becomes really one the most important strategic aim excluded from the formal financial system. Many for MFIs, which would allow also a better integration studies can demonstrate the continued growth of the of MFIs with the other elements of the financial mobile money industry, which really represents an sector. emerging new banking business model (Kumar et al., 2010; Hanouch-Rotman, 2013; Ehrbeck, 2013; 3. The Impact of Technology on Corporate Tarazi-Breloff, 2010, Srivastava, 2014). Some Governance Issues examples of particular success of M-banking are BanKO in the Philippines and M-PESA in Kenya. In Technology may contribute to soften corporate particular, M-PESA, turning out to be a real game- governance issues and related risk factors, which changer, has nearly fully penetrated the market, severely hamper MF development, starting its useful reaching at least 84 % of Kenyans living below $2 per application from double checking against undeclared day (see Ehrbeck, 2013). and otherwise hardly detectable multiple borrowing.

422 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Corporate governance issues represent, even with the bank’s money or not to get fully engaged in within the MF industry, the very backbone of firms, the project for which they have been financed. A intrinsically shaping their workings and likely attitude milder, but highly frequent form of moral hazard is to survive and prosper. represented by microcredit misallocation, using it for Corporate governance is concerned with the set consumption rather than for investment purposes. of processes, customs, policies, laws, and institutions Multiple borrowing is another frequent possibility, affecting the way the MFI is directed, administered, which is eased when computerized banking credit and ultimately controlled, including the relationships records are missing - typically coordinated by central among the stakeholders that rotate around it that are banks. represented by the providers of capital and debt Strategic bankruptcy consists in false (equity-holders and debt-holders) versus the clients of information that the borrower gives about the microcredit (borrowers), since micro-depositors are outcome of his financed investment, stating that it has considered as debt-holders. failed even if it is not true only in order not to give Conflicts of interest among different back the borrowed money. Poor borrowers generally stakeholders arise when they pursue different goals - have little or no collateral, so they might have little and this is what normally happens, following the reason to avoid strategic default. “mors tua, vita mea” Roman motto (your death is my These classical corporate governance problems life) - and any attempt to minimize them, aligning are well known in traditional banking, and they their interests with cooperative behaviors, can be of naturally bring to suboptimal allocation of financial great help in the reduction of corporate governance resources and to capital rationing problems that problems. No conflicts, no governance puzzles (Moro frequently affect even potentially sound borrowers, if Visconti, 2011). they are not able to differentiate themselves from Conflicts of interest derive from market those who bluff. imperfections and deviations from theoretical Cross-borrowing is another potential conflict of rationality and fairness. Stakeholders may indeed interest between lenders and borrowers, sourcing once behave opportunistically, with conflicts of interest again from information asymmetries: it is an against other stakeholders, to the extent that they have overlapping strategy, according to which poor clients divergent priorities and objectives. Opportunistic borrow from an intermediary to pay back older loans behaviors are of course much more common and contracted with others. It is an evident symptom of tempting for borrowers, and that is the reason why repayment difficulty, which is hopefully temporary lenders typically tend to be overcautious. The but in many cases structural. This arbitrage or corporate governance framework is necessary in order “shopping” disguising strategy can take place in to understand how the various players are supposed to underdeveloped countries and/or in informal markets behave and why, in order to get useful insights about where intermediaries are not enabled to cross and the mitigation strategies against harmful conflicts of check IT databases with recorded credit histories. interest. Standard banks in developed countries normally Adverse selection is a typical problem in money react trying to reduce information asymmetries, using lending, and it occurs even in traditional banks, when credit scoring analyses, monitoring and asking for - not knowing who is who - they cannot easily guarantees (in the form of sizeable collateral with discriminate between risky and safer borrowers, so intrinsic market value). applying to anybody the same interest rates, with Since MF borrowers are normally unable to give unwanted and undeserved implicit subsidy to the any worthy guarantee, these problems normally are worst borrowers, which in many cases disincentives even more acute in a context that has also to take care honest ones from asking for loans. Reduction of of greater information fallacies, even due to IT and information asymmetries might contribute to reduce other technological deficiencies and weak judicial unfair extra charges, with reputable customers being systems (see Armendariz De Aghion, Morduch, 2010, able to send a believable signal to the MFI about the Chapter 2). reliability of potential joiners. Technology and IT As a consequence, it is of crucial importance for applications, with written, storable, monitored and the success of MF to find any attempt or device to transmittable flows of data, stand out as a key device identify a solution that can contribute to mitigate to soften info asymmetries, improving the whole these conflicts of interest between the lending bank value chain and making it more transparent and and the micro-borrower. accountable, to the benefit of all the stakeholders A synthesis of the impact of technological (micro-lenders, micro-borrowers, micro-insurers, devices in softening corporate governance concerns is equity-holders, debt-holders, local and central represented in Table 1. authorities, etc.) that rotate around the MFI. Moral hazard is a classical “take the money and run problem”, since borrowers might try to abscond

423 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 1. The Impact of Technology on Corporate Governance Issues

Conflict of interest / Brief description deviating behaviour The micro-lender finds it difficult to discriminate between risky and safer micro- Adverse borrowers. Clearing systems and computerized credit histories help softening this selection problem. A classical “take the money and run problem”, since micro-borrowers might try to Moral abscond with the bank’s money or not to get fully engaged in the project for which hazard they have been financed or misallocate money for other purposes. Again ICT devices may ease cross checking and tracking of operations. False information that the borrower gives about the outcome of his financed Strategic investment, stating that it has failed even if it is not true only in order not to give back bankruptcy the borrowed money. Cross checking and ICT controls soften these problems. Poor clients, taking profit from information asymmetries, borrow from an Cross intermediary to pay back older loans contracted with others. Clearing systems borrowing coordinated by Central banks, if operating in real time, consistently downsize the issue.

4. Impact of Innovation on children, also in booming underdeveloped countries, Microfinance Risks are likely to exchange money mainly with electronic devices, such as M-banking, ATM, etc. Transactional Technology and innovation may profoundly reshape components of the e-payments, along an increasingly risk factors in any industry, including MF. automated value chain, are now becoming The Microfinance Banana Skins surveys explore commodities, supplanting traditional bank the risks that the worldwide MF industry faces, intermediation. Unfair competition, cutting regulatory considering both the current hazards and their trends corners, may so come from shadow banks or other (fastest rising risk factors). informal intermediaries, threatening financial Managing technology is a key factor. It is stability. sufficient to see how ICT has changed the banking Cheap, reliable and transparent cashless virtual industry, to understand its current (and potential) wallets, even using M-phone apps, store details of impact on the less sophisticated - but increasingly payments and may quickly build up otherwise missing similar - MF industry. Small loans towards many poor credit histories. The world of payments is changing clients are among the main economic weaknesses of and the titans of Internet are mastering it, threatening the MF industry, bringing to low marginality and old fashioned bank dominance. inability to implement economies of scale. Conferencing tools, such as Skype or other Technology so becomes crucial to cut staff costs, instruments, linked with social networks (Facebook, making the business less labor intensive, and to foster Linkedin, Twitter, WhatsApp, Youtube, etc.) may outreach (with mobile banking, computerized data consistently reduce information asymmetries, with an bases for credit scoring, back office efficiency with unprecedented impact on corporate governance proper computerized bookkeeping, etc.). traditional concerns. And digital divide, due to The impact of innovation and management unavailability of IT technologies and access to technology on the main MF risk factors is Internet, is rapidly shrinking, even in the poorest summarized in table 2. areas, opening new markets. Innovation will probably drive towards an increasingly cashless society, where digital native

424 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 2. Impact of Innovation on MF Risks

Microfinance Impact of innovation and management technology biggest risks IT technology can have a significant impact in detecting and monitoring credit 1 Credit risk quality, with credit scoring and sharing of information. 2 Reputation Friendly and accessible technology can improve reputation. Technology creates digital divide between haves and haves not; competition 3 Competition increases with comparability, speediness and other innovative products and processes. Early innovators get competitive lead and may disrupt older players. 4 Corporate governance It may soften conflicts of interest, as illustrated in the dedicated paragraph 5 Political interference Little if any impact. Little if any impact. Regulator supervision and audit may become easier (if all 6 Inappropriate regulation information is available faster), but new audit skills will be required owing to the speed of movement of mobile transfers of money. 7 Management quality Technology increases skills and productivity. 8 Staffing Staff competencies change Staff is more productive but more expensive. 9 Mission drift Temptation to reach wealthier and more technological clients may increase. 10 Unrealisable Technology changes strategies, with mixed impact on any potential outcome. expectations Technology is a specific issue of quality of management; according to CSFI (2011) “the problem of getting technology right is moving up the risk scale. MFIs face tough decisions on the management of their IT systems and their delivery 11 Managing technology strategies in the near future. (…) A microfinance analyst said it was a case of «Invest in technology or cease to exist in five years». Concerns about this Banana Skin were strongest in Africa and the European Union”. Technology and digital procedures may strongly contribute making the business model more scalable, cutting variable costs (with an increase in fixed IT costs, 12 Profitability which may raise the break-even point) and easing monitoring; productivity should also improve. The “dirty job behind” is likely to be profoundly changed by technology and 13 Back office computerized systems of recording; it may also be centralized and dematerialized, with economies of scale and experience. Written and recordable IT procedures are a key starting point for transparency 14 Transparency and softening of information asymmetries. Technology and innovation may have a deep impact on management, reshaping 15 Strategy and rethinking strategies, reconsidering the whole value chain, target products and clients, etc. Technology improves awareness and accountability, with a potential impact even 16 Liquidity on liquidity, which may be better handled and foreseen. Little impact, even if technology may reduce segmentation factors among 17 Macro-economic trends different MFIs, so making them less insulated from macroeconomic shocks, but also creating opportunities for better reaction to positive trends. Fraud is linked to (lack of) transparency (# 14), and may be more easily detected 18 Fraud with IT procedures, allowing for better monitoring. As mentioned earlier, speed of movement of money may make fraud detection more difficult and too late. New products and especially innovative product delivery (e.g., M-banking and its 19 Product development endless by-products) may be conceived as a result of innovation. Little if any impact, even if shareholders may change, giving room to ICT 20 Ownership players. They do not depend on technology but again may be better detected and handled. 21 Interest rates If costs reduce, NGO MFIs, at least, may cut interest rates, driving down industry rates. IT decreases the interest burden (Song et al., 2014). 22 Too much funding Overfunding can be accounted and monitored with proper IT bookkeeping. 23 Too little funding Same as above (# 22). 24 Foreign exchange Linked to macroeconomic trends (# 17) and interest rates (# 21).

425 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

5. Microfinance, Recession and Corporate stakeholders, as it has already happened, on a Governance different and more sophisticated scale, with traditional banking. Recession has a big impact on governance Experience teaches that technology needs being mechanisms, altering the equilibriums among conceived, designed and implemented with a mixed different stakeholders and increasing the risk of approach, both top down and bottom-up and with investment returns; any governance improvement is horizontal integration of the MFI with external ICT highly welcome and recommended. Lessons from providers, with synergistic and scalable outsourcing. recessions teach that with no governance, there is no Technology is already having a disrupting impact on money for growth or bare survival (Moro Visconti, corporate governance mechanisms, especially in less 2011; Ferguson, 2013). sophisticated countries (Claessens and Yurtoglu, Corporate governance sets the rules of 2013). cohabitation and the behavior of the different The interaction of top down and bottom-up stakeholders that pivot around the MFI (borrowers, strategies is particularly interesting in the MF arena lenders, shareholders, supervisory authorities …). As and may deserve further research: in synthesis, it may pointed out by Kostyuk et al., 2011, and by Wright et suffice noting that top down approaches try to address al., 2013, corporate governance mechanisms greatly development issues with a worldwide methodology, differ across the world, reflecting country specific centrally planned, which may benefit from economies attitudes. These differences impact also on MF of scale but not be particularly fit for peculiarities and structures and may be exacerbated during recessions, “biodiversities”. threatening MFIs sustainability and outreach Technology mostly follows a top down potential. Recession brings to credit criticalities, approach, since inventions such as M-phones may be liquidity constraints, etc., forcing MFIs to reshape and working everywhere, irrespectively of their original reengineer their business models, in order to make conception; but technology needs to be constantly them stronger and more resilient. adapted to a less-than-ideal playground, where the The key idea behind this paper is that innovation aforementioned “biodiversities” do matter, up to the and technology have a great impact on MF point of making the difference between success and governance, as it has already happened in traditional failure; a bottom-up approach, starting from the very banking, affecting – hopefully for the better – all the bottom of the social pyramid, is so complementarily stakeholders. Recessionary times have a cathartic needed. effect, forcing MFIs to boost efficiency and in this Even MF marketplace – playfield – is painful and uneasy process, IT and other increasingly virtual and intangible, so requiring technological issues have crucial importance. growing technology, opening the way to new To the extent that technology is expensive and products, providers and users. often uneasy to procure and engineer, entry barriers And new products, including distance learning are likely to increase and many smaller MFIs, (with didactic videos in local languages, explaining intrinsically fragile and far from reaching sufficient the basics of MF) or geomatic applications (which can scalability (first of all, to cover fixed costs with improve land titling, allowing for the introduction of enough intermediation margins), may find it difficult MF housing products), may provide deeper outreach, to survive. strengthening the value chain that links MFIs to their Trendy governance impact, still to be fully fragile clients, increasing awareness and focus on detected (since the process is still in progress and it is viable strategies. Marketing risks are intrinsic in new uneasy to analyze) is likely to be substantial, on both products, since it is difficult to predict the reaction of quantitative and qualitative sides, since it may change customers. the relationships and equilibriums among existing Out of the pocket technology (smart-phones with stakeholders, introducing also new players (such as germinating apps are like mobile phones some years TLC operators, indispensable in M-banking). ago, originally unaffordable but then rapidly and Plasticity and flexibility of MF structures is a cheaply spreading) is an entry barrier for both wanted characteristic in order to make them resilient providers (MFIs, backed by their technological to external potentially disrupting shocks, such as partners) and clients (users). recessions. Rapidly proliferating peer-to-peer (P2P) lending schemes, mainly represented by not intermediated Conclusion mobile payments, outside the official (highly regulated) banking system, may completely reshape This paper is addressing, in a multidisciplinary and the financial landscape, with unprecedented innovative comprehensive way, apparently weakly opportunities mixed with unknown concerns, related topics such as MF governance, and IT issues, especially in financially unsophisticated countries. within recessionary cycles. This hardly investigated Ancillary governance issues are just consequential, to frontier faces key trendy issues, which are likely to the extent that stakeholders are going to be deeply deeply reengineer the relationship among different affected by these new financial paradigms.

426 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Any technological device that can soften reincarnating déjà vu scenarios, which deserve proper information asymmetries, increasing consciousness, is investigation and subsequent mitigation. likely to bring strategic added value, even with cost reduction; examples may include real time References information on the MFI’s conditions (interest rates; size of loans and repayment schedule, etc.), 1. Ahmad, A. (2005), Management Information Systems benchmarking comparisons regarding both credit (MIS) for Microfinance, The First Microfinance Bank institutions (alternative MFIs, branch locations, etc.) Ltd., Islamabad, Pakistan. and market trends in the specific industry sponsored 2. Andreoni, A. (2011), “The Technology of Microcredit. by MF loans. Even if MF apps are still to be State of the Art and prospects of development in Italy”, proposed, as soon as smart-phones and tablets will Bancaria, Vol. 2, pp. 56-70. reach a sufficient critical mass, the pattern will rapidly 3. Armendariz De Aghion, B. and Morduch, J. (2010), The change and scale up. Economics of Microfinance, MIT Press, Cambridge, Massachusetts, USA. Diffusion of technology is easier in crowded 4. Ashta, A. and Assadi, D. (2009), “Does Social Lending towns, where there is a critical mass for incorporate Social Technologies? The use of Web 2.0 infrastructures and networks, but may be somehow Technologies in online P2P lending”, CEB working even more useful in under-populated rural areas, in paper No 09-056, the middle of nowhere. Potential for outreach is http://ideas.repec.org/p/sol/wpaper/09-056.html. enormous, but it has to be properly supported, 5. Ashta, A. ed. (2011), Advanced Technologies for especially if tackling the poorest, who suffer for an Microfinance, IGI Global, Hershey, Pakistan. increasingly harmful digital divide, and consequent 6. CGAP (2006), Annual Report 2006, lack of opportunities. http://www.cgap.org/publications/cgap-annual-report- 2006. The economic and social impact of branchless 7. CGAP (2013), Microfinance Gateway 2013, M-banking still needs further investigation, http://www.microfinancegateway.org/p/site/m/template. considering also innovative aspects such as rc/1.26.24543/. information asymmetries reduction, which may have a 8. CGAP (2014), Annual Report 2013, positive impact even on final clients, strengthening http://www.cgap.org/publications/cgap-annual-report- their business models and so enabling micro- 2013. borrowers to establish better links with their 9. Claessens, S., and Yurtoglu, B.B. (2013), “Corporate sponsoring MFIs; we may think, for instance, about a Governance in Emerging Markets. A Survey”, real time device to communicate in real time Emerging Markets Review, June, pp. 1-33 10. Courvisanos, J. (2011), “Environment, Innovation and wholesale and retail prices of tradable commodities, Sustainable Development: Introduction to an key information for farmers, small shop owners, etc., Interdisciplinary Approach”, Journal of Innovation which may shorten the whole intermediation chain, to Economics, Vol. 2 No. 8, pp. 3-10. the advantage of producers and consumers. Even P2P 11. CSFI (2011), Microfinance Banana Skins 2011, micro-lending increasingly depends on technological www.cgap.org/p/site/c/template.rc/1.9.49643/. platforms. 12. Easterly, W. (2006), “Planners vs. Searchers in Foreign The impact of technology may be measured with Aid”, Asian Development Bank, differential analysis on MFIs, considering their http://people.usd.edu/~clehmann/courses/Ideas/Easterly. accounts before and after the introduction of pdf. 13. Ehrbeck, T. (2013), How Financial Innovation Helps innovative devices; to the extent that technology can the Poor Improve Their Lives, reduce fixed costs and improve the scalability and http://www.huffingtonpost.com/tilman-ehrbeck/how- flexibility of the business model, economic margins financial-innovation_b_3321062.html. are likely to expand and cash flows should increase, 14. Engels, P. (2010), Mission Drift in Microfinance, with positive side effects on both sustainability and Ibidem-Verlag, Stuttgart, Germany. potential outreach. For MFIs, technological upgrade is 15. European Microfinance Network (2012), The use of to be considered a key strategic issue in the next technology in microfinance, http://www.fgda. org/dati/ years, with a likely digital divide between haves and Content Manager /files/ The-use- of- technology-in- haves not. New research avenues may conveniently Microfinance.pdf 16. Ferguson N., (2013), The Great Degeneration, Penguin, investigate on these ‘savings & phone’ not trivial London issues, supported by appropriate empirical evidence. 17. Frankiewicz, C. (2003), Information Technology as a The role of new coming stakeholders such as big strategic tool for microfinance in Africa, Proceedings of ICT players also needs to be further investigated, the AfriCap Seminar, Nairobi, Kenya. considering the potential positive impact of their 18. Freeman, L. and Zopa, (2006), “Zopa: A Gigantic partnering for development in Telco-led M-banking, Opportunity - Are You Watching P2P Lending? You but also the possible – likely – abuses that naturally should Be”, The Credit Union Journal, November. characterize stronger players. 19. Hanouch, M. and Rotman, S. (2013), “Microfinance and Mother Nature, representing the under-banked Mobile Banking: Blurring the Lines?”, CGAP Focus Note, n. 88, poorest, may be once again threatened by Father http://www.cgap.org/publications/microfinance-and- Profit, with significant governance implications, mobile-banking-blurring-lines.

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20. Hartarska, V. and Mersland, R. (2012), “Which 32. Moro Visconti, R. (2014), From Microfinance to governance mechanisms promote efficiency in reaching Business Planning. Escaping Poverty Traps, Ibidem- poor clients? Evidence from rated microfinance Verlag, Stuttgart, Germany. institutions”, European Financial Management, Vol. 18 33. Moya, M., Akodo, R., Mukooza, M., Kaliba, A.R. and No. 2, pp. 218-239. Mbarika, V.W. (2012), “Impact of Investment in 21. Ivatury, G. (2006), “Using Technology to Build Information and Communication Technology on Inclusive Financial Systems”, in CGAP Focus Note, n. Performance and Growth of Microfinance Institutions in 32, http://www.cgap.org/publications/using-technology- Uganda”, Applied Econometrics and International build-inclusive-financial-systems. Development, Vol. 12 No. 2. 22. Iyengar, K.P. and Singh, V.K. (2010), “Information 34. Nyapaty, K. (2011), Stakeholder Analysis of IT Technology and Microfinance Institutions: challenges Applications for Microfinance, in Ashta, A. ed., and Lessons Learned”, Journal of Electronic Commerce Advanced Tecnologies for Microfinance, IGI Global, in Organizations, Vol. 8 No. 2, pp. 1-11. Hershey, Pakistan, Chapter 1. 23. Kauffman, R.J. and Riggins, F.J. (2012), “Information 35. Powers, J., Magnoni, B. and Knapp, S. (2008), “Person- and Communication Technology and the Sustainability To-Person Lending: Is Financial Democracy A Click of Microfinance”, in Electronic Commerce Research Away?“, Microreport # 130, and Application, Vol. 11, No. 5, pp. 450-468. http://www.microlinks.org/library/person-person- 24. Kostyuk, A.N., Gerner-Beuerle, C., Apreda, R., eds., lending-financial-democracy-click-away-microreport. (2011), Corporate Governance: An International 36. Prashad, P., Leach,, J., Dalal, A., Saunders, D., (2014), Outlook, Virtus Interpress, Sumy. “Mobile phones and microinsurance”, in Entreprise 25. Kulik, N. and Molinari, P. (2004), Sustainable Development and Microfinance, vol. 25, n. 1, March Microfinance and Technology, Ford Motor Company 37. Rozzani, N., Rahman, R.A., Mohamed, S.I. and Yusuf, Fellowship, Dearborn, Minnesota, USA. S.N.S., (2013), “Applying Technology: Issues in 26. Kumar, K., Mckay, C. and Rotman, S., (2010), Microfinance Operations”, in Middle-East Journal of “Microfinance and Mobile Banking: the Story So Far”, Scientific Research, Vol. 17 No. 3, pp. 374-381. CGAP Focus Note, n. 62, 38. Sahoo, S. and Sahoo, A.K. (2013), “Microfinance http://www.cgap.org/publications/microfinance-and- Providers (MFPs) and Management Information mobile-banking-story-so-far. Systems (MIS): a Strategic Prospective”, in PARIPEX- 27. Mersland, R. and Øystein Strøm, R. (2009), Indian Journal of Research, Vol. 2 No. 3, pp. 245-246. “Performance and Governance in Microfinance 39. Shah M. and Clarke S. (2009), “E-Banking Institutions”, Journal of Banking & Finance, Vol. 33 Management: Issues, Solutions, and Strategies”, No. 4, pp. 662-669. www.igi-global.com/chapter/banking- 28. Microfinance Gateway (2008), “Open Up Your Virtual technologies/8649, pp.30-55. Wallet: The buzz about online microlending”, 40. Song, I., Lui, C., Vong, J., (2014), “Lowering the http://www.microfinancegateway.org/p/site/m/template. interest burden for microfinance”, in International rc/1.26.9154/. Journal of Process Management and Benchmarking, n. 29. Mishra, B.L. and Chowbwy, M. (2009), Impact 2 assessment of technology adoption in microfinance in 41. Srivastava, A. (2014), “Mobile banking and sustainable India, Centre for Microfinance Research, Bankers growth”, in American Journal of Economics and Institute of Rural Development, Chandragupt Institute Business Administration, issue 3. of Management, Patna, India. 42. Stetenfeld, B. (2008), “P2P Lending: Treat or 30. Moro Visconti, R. (2011), “Global recession and Opportunity?”, Credit Union Magazine, Vol. 74 No. 1, microfinance risk governance in developing countries” pp. 32-36. Risk Governance and Control Journal, Vol. 1 No. 3, pp. 43. Tarazi, M. and Breloff, P. (2010), Nonbank E- 17-35. MoneyIssuers, 31. Moro Visconti, R. (2012), “Is African Microfinance http://www.cgap.org/publications/nonbank-e-money- Different? Evidence from Banana Skins, African issuers. Journal of Microfinance and Enterprise Development, 44. Wright, M., Siegel, D.S., Keasey, K., and Filatotchev, I. Vol. 2 No. 2, pp. 25-45. eds., (2013), The Oxford handbook of corporate governance, Oxford University Press, Oxford

428 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

CORPORATE GOVERNANCE STANDARDS IN CROSS-BORDER INVESTING: LESSONS LEARNED FROM CHINESE COMPANIES LISTED IN THE UNITED STATES

Hugh Grove, Maclyn Clouse*

Abstract

This paper will examine five Chinese company stocks that have been listed on United States exchanges with either initial public offerings (IPOs) or reverse mergers, often called reverse take-overs (RTOs). Their shares were initially well received in the market, especially as China’s economy continued to grow at rates much higher than the rest of the world’s countries, with increasing stock prices creating significant gains for their investors. However, in spite of these firms’ apparent compliance to the U. S. regulations, there is now evidence of fraud, poor auditing, and a lack of corporate governance and control. The resultant stock price declines have led to billions of dollars of losses for investors, and some of these Chinese firms have subsequently been delisted by U. S. stock exchanges. In this paper, we will show that had auditors, boards of directors, and financial analysts been more diligent and responsible, these problems could have been identified earlier than they were. Perhaps some of the investors’ losses could have been prevented.

Keywords: Corporate Governance Standards, Cross-Border Investing, China, the USA

* Accounting and Finance Professors, respectively Daniels College of Business, University of Denver, 2101 S. University Blvd. Denver, Co 80208 Email: [email protected]

1. Introduction to a much greater extent. For example, the financial In the United States, many of the standards for and economic problems of a relatively small country corporate governance regulation and enforcement like Greece have caused major problems for the have been developed after major scandals and European Union, as well as the United States stock financial crises. The Sarbanes Oxley Act of 2002 was market. As another example, the failures and near passed in response to the corporate and accounting failures of some United States financial institutions scandals in 2000-2002 involving firms such as Enron, had major adverse consequences for the financial Tyco International, Adelphia, and WorldCom. The act markets in the rest of the world. set new or enhanced standards for boards, The impacts and the associated problems of this management, and public accounting firms. These increased globalization are now evident in the world’s standards dealt with certifications of the accuracy of investment markets. As more and more stocks of the financial statements, the independence of outside foreign companies are listed on international auditors, and an increased oversight role for boards of exchanges, the risks of the lack of corporate directors. governance, control, and risk management are Eight years later in 2010, the Dodd Frank Wall increased. For example, while foreign firms that list Street Reform and Consumer Protection Act was on a United States stock exchange have to comply passed in response to the financial institution failures with Sarbanes Oxley and Dodd Frank, the regulations and financial crisis of 2007-2010. This act brought of their home countries may dilute some of the changes to financial regulation to promote financial regulatory protection expected from these United stability by improving the accountability and States acts. transparency in the financial system and by protecting This paper will examine five Chinese company financial consumers. stocks that have been listed on United States Unfortunately, neither of these acts completely exchanges with either initial public offerings (IPOs) prepared the U.S. for the corporate governance, or reverse mergers, often called reverse take-overs control, and risk management issues that have come (RTOs). Their shares were initially well received in with increased globalization. An important lesson the market, especially as China’s economy continued learned from the 2007-2010 crisis is that the world’s to grow at rates much higher than the rest of the financial and economic markets are now interrelated world’s countries, with increasing stock prices

429 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 creating significant gains for their investors. number from the Muddy Waters Research website However, in spite of these firms’ apparent compliance and listing a false address.. to the U. S. regulations, there is now evidence of The five Chinese companies analyzed in this fraud, poor auditing, and a lack of corporate paper are Longtop Financial Technologies, China governance and control. The resultant stock price MediaExpress, Harbin Electric, China-Biotics, and declines have led to billions of dollars of losses for Deer Consumer Products. The only IPO was Longtop investors, and some of these Chinese firms have as the other four companies were RTOs. Longtop subsequently been delisted by U. S. stock exchanges. represented over one-half ($2.4 billion) of the $4.1 In this paper, we will show that had auditors, boards billion market cap destruction by these five of directors, and financial analysts been more diligent companies and over 10% of the $21 billion market and responsible, these problems could have been cap destruction by Chinese companies listed in North identified earlier than they were. Perhaps some of the America. As a result of possible Chinese financial investors’ losses could have been prevented. reporting frauds, some of these companies were delisted by U.S. stock exchanges, some of their 2. Major U.S. Listed Chinese Company auditors quit, investors filed class action lawsuits, and Frauds the U.S. SEC pursued investigations. Brief circumstances of each of the five firms follow. On April 4, 2011, Luis Aguilar, one of the five commissioners of the U.S. Securities and Exchange 3. Longtop Financial Technologies Ltd. Commission (SEC), reported that there were 150 reverse merger transactions between 2007 and early On October 23, 2007, Longtop Financial 2011 in which Chinese companies merged with U.S. Technologies Ltd. went public on the New York domiciled shells to obtain a listing on a U.S. stock Stock Exchange (NYSE) and sold 10.4 million exchange. A reverse merger or RTO is a backdoor American depositary shares at $17.50 per share, strategy in which a Chinese or other non-public raising $182 million. By the end of the first day, the company buys a public U.S. shell company and stock had risen to $32.40 per share. Goldman Sachs assumes its stock ticker, thus avoiding an S-1 and Deutsche Bank led this initial public offering registration statement for an IPO as required by the (IPO) with Deloitte Touche Tohmatsu, a “Big 4” audit SEC and related expensive investment bank and other firm, serving as the auditors. Longtop was a Chinese fees. A shell company is practically extinct but it is software developer and technology services provider incorporated and, in some cases, its listed stock is based in Xiamen, China. It provided technology maintained by an owner or speculator for sale to an services and created both standardized and custom- interested party. designed software for banks in China, including three Shell companies are marketed to Chinese of the four largest state-controlled banks: China companies as a quick and easy way to obtain an Construction Bank, Agricultural Bank of China, and overseas listing without SEC scrutiny. An example of Bank of China. Morgan Stanley led a 2009 secondary such scrutiny was the Groupon IPO. The SEC offering of more shares. In November 2010, required three revisions or amendments to Groupon’s Longtop’s market capitalization peaked at $2.4 billion S-1 registration statement, primarily to eliminate the (56 million shares at $42.86). gross (versus) net revenue method and to eliminate On April 26, 2011, Andrew Left of Citron Groupon’s newly created profitability metric: Research, a short seller, published a report on his Adjusted Consolidated Segment Operating Income website, accusing Longtop of widespread fraud: (ACSOI) which really meant just keep adding back “Citron introduces a story that has all the markings of enough expenses until a net loss is converted into a a complete stock fraud - with off balance sheet net profit! Groupon’s estimated IPO of $30 billion transactions that created outsized margins and subsequently became an actual IPO of $16.5 billion. management with backgrounds unsuitable to run a The following five major Chinese IPO and RTO public company. The most obvious risk factor in the companies had listed on U.S. stock exchanges, and China space, and the factor that has linked so many of they represented approximately 20% ($4.1 billion) of these collapsed stocks, is obviously that the story is the $21 billion market capitalization (cap) destruction too good to be true. In this report, Citron outlines by Chinese companies listed in North America. several concerns which should be considered by the These five firms were all mentioned in an article auditors as they prepare Longtop’s annual audit. It is about five major short sellers who published research the opinion of Citron that every financial statement reports exposing Chinese financial reporting fraud. from its IPO to this date is fraudulent…read on to One of these short sellers, listed as Muddy Waters understand.” Research, said that his success had made him and his Major topics in Citron’s report were margins far wife a target for threats, and he had recently moved in excess of competitors, an unconventional staffing his main base to the West Coast from Hong Kong but model, key management background misdeeds, non- did not exactly say where. Also, he increased security transparent management transactions, and a note to measures, including removing his firm’s phone analysts: “Citron says do what you are paid to

430 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 do…Start ANALYZING. The last thing Wall Street time to confess, let the auditors figure out the needs is more discounted cash flow analysis based on necessary restatements, and let the real Longtop asking for management’s forecasts. Citron challenges Financial Technologies stand up.” you to answer these concerns without starting with the On May 17, 2011, Deloitte did not say why but phrase: after discussions with management. Do expanded its procedures related to cash, the largest Longtop’s margins truly pass the smell test in cost- balance sheet item. Cash totaled $423 million or 57% competitive China? Does the staffing story make of Longtop’s assets. Within hours of beginning this perfect sense to you? How about management’s stock new round of cash confirmations to bank gifts? If not, what are the risks of massaged revenue headquarters, rather than to the local branches that recognition and/or the ugly implications of related had previously confirmed Longtop’s cash balances, party impacts on acquisitions, cost accounting, and Longtop stopped the confirmation process and told stock transactions?” Citron’s report also noted the banks that Deloitte was not really its auditor. nonsensical answers the company had given which Despite these Longtop efforts, Deloitte learned that left critical investors thinking “they are just making it Longtop did not have the cash it claimed and that up as they go along.” Also, Citron and other short there were also significant bank borrowings not selling research firms were asking why Longtop included on Longtop’s books. In the U.S., electronic needed such large amounts of cash and they were audit confirmations have been adopted by more than even questioning whether such cash existed. 8,000 accounting firms and all of the Top 10 banks. On April 28, 2011, Longtop’s Chief Financial In China, the Big 4 and other auditing firms and the Officer (CFO) tried to reassure financial analysts that Big 4 banks need to get together to work out a system the fraud claims were bogus. He wrapped himself in for online confirmations. the prestige of his company’s auditor, Deloitte, a “Big On May 20, 2011, Longtop’s chairman told 4” audit firm, saying that those who questioned Deloitte’s Eastern Region Managing Partner that Longtop were “criticizing the integrity of one of the “there were fake revenue in the past so there were top accounting firms in the world.” He also said that fake cash recorded on the books.” The chairman did his relationship with Deloitte was “very close, third not answer when questioned as to the extent and only to his relationship to his family and the CEO.” duration of the discrepancies. When asked who was On May 4, 2011, Longtop’s CFO resigned his involved, he answered: “senior management.” Such post as head of the audit committee of the heavily irregularities resulted in Deloitte resigning and the anticipated Renren IPO. Also, a Morgan Stanley NYSE suspending trading of Longtop’s stock. The analyst wrote: “Longtop’s stock price has been very final trade on the NYSE was at $18.93 for a market volatile in recent days amid fraud allegations that capitalization of $1.1 billion versus the peak of $2.4 management has denied. Our analysis of margins and billion just six months earlier. cash flow gives us confidence in its accounting On May 22, 2011, Deloitte sent a resignation methods. We believe market misconceptions provide letter to the chairman of Longtop’s Audit Committee a good entry point for long-term investors.” At the who was also the CFO of NYSE-listed Xinyuan and a time of these reports, Deloitte was in the process of director of NASDAQ-listed eLong. Deloitte wrote completing its Longtop audit for the fiscal year that “we bring these significant issues to your ending March 31, 2011. It had previously given attention in the context of our responsibilities under unqualified or clean audit opinions to Longtop for six Statement on Auditing Standards (SAS) No. 99, consecutive years and apparently was well on its way Consideration of Fraud in a Financial Statement to providing a seventh clean opinion. Audit. The reasons for our resignation include: 1) the On May 9, 2011, Citron Research posted another recently identified falsity of Longtop’s financial Longtop report: “How could anyone charged with records in relation to cash at bank and loan balances verifying the accuracy of Longtop’s Financials look at and also now seemingly in the sales revenue, 2) the these documents and dismiss the reasonable concern deliberate interference by the management in our (not to mention professional skepticism) that audit process, and 3) the unlawful detention of our Longtop’s largest expense line item is being audit files. These recent developments undermine our transacted through a related party with full ability to rely on the representations of the transparency?...Lastly, it is Citron’s opinion that management which is an essential element of the believing an unrelated third party ran your human audit process; hence our resignation.” resource business to make $30,000 a year (according May 25, 2011, a lawsuit, alleging Longtop to filings) is as crazy as believing that a Chairman of a overstated profit margins and concealed adverse facts, company would just give away $80 million in stock to was filed by the New York-based Rosen Law Firm. his employees because money doesn’t really mean This firm had previously filed about 20 investor suits that much to him (as per the CFO’s explanation). We against Chinese companies listed in the U.S. by hope this can end any debate as to whether the reverse mergers or reverse take-overs (RTOs). At company has been deceiving its investors. It is not least 370 reverse merger companies had obtained U.S. the time to host any more conference calls or cover listings since 2004. ups. The excuses have run their course. It is now

431 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

On August 29, 2011, the New York Stock 2010. The company also claimed double the revenue Exchange delisted Longtop Financial Technologies per television screen as its competitors. Limited finding that the American depositary shares On February 3, 2011, the short seller, Muddy were no longer suitable for continued listing and Waters Research, alleged more improprieties. Among trading. them, it said the company only booked $17 million in November 11, 2011, the SEC charged Longtop revenue for 2009 with the SAIC (State Administration with failing to comply with its reporting obligations for Industry and Commerce of the People’s Republic because it failed to file an annual report for its fiscal of China) while reporting $95.9 million in its 10-K year that ended March 31, 2011. Furthermore, report to the SEC. It also said that the company was Longtop’s independent auditor stated in May 2011 lying when it claimed to have a deal with Apple. that its prior audit reports on Longtop’s financial On February 7, 2011, the company released a statements contained in annual reports for 2008, 2009 letter, basically reaffirming its financial statements and 2010 should no longer be relied upon. The SEC and operating practices. previously had filed a subpoena enforcement action On March 11, 2011, NASDAQ halted trading in against Deloitte Touche Tohmatsu CPA Ltd. in China Media Express shares, pending a company Shanghai for failing to produce documents related to announcement. the SEC’s investigation into possible fraud by On March 13, 2011, another short-seller, The Longtop, the audit firm’s longtime client. Financial Investigator, posted a video that it claimed was a tour of the China MediaExpress offices. The 4. China MediaExpress Holdings, Inc. video featured sleeping employees, empty offices, and a business that was not the growth machine that China On October 18, 2007, China MediaExpress Holdings, MediaExpress claimed. Inc. did a reverse merger or reverse take-over (RTO) On March 14, 2011, both the company’s CFO to become a publicly traded company in the U.S. Its and Deloitte resigned. Based upon these resignations, business consisted of placing television screens on the company then filed a notice of late filing for the Chinese buses in China and selling advertising on 12/31/2010 financial statements with the SEC. China such screens. It was in the development stage until MediaExpress shares then traded at $11.88. 2009. Subsequently, the company admitted that Chinese On December 4, 3009, the company engaged branch bank managers had falsified cash Deloitte Touche Tohmatsu, Hong Kong, a Big 4 audit confirmations, just like the Longtop scandal. firm, to serve as its independent auditor, effective On May 1, 2011, NASDAQ delisted China immediately upon this same-day dismissal of its prior MediaExpress’s shares. auditors, who had issued clean audit opinions on the On March 1, 2012, the SEC deregistered China 2008 and 2007 financial statements. MediaExpress’s securities. On March 10, 2010, Deloitte issued a clean audit On January 31, 2013, a Hong Kong arbitration opinion for the 12/31/2009 financial statements. panel ruled that China MediaExpress was a fraudulent However, Deloitte was not engaged to re-audit the enterprise and awarded a shareholder $77 million in 2008 or 2007 financial statements but only to review damages. the retrospective adjustments to the 2008 and 2007 On June 1, 2013, the SEC charged China financial statements to revise earnings per share MediaExpress and its CEO with misleading investors. calculations which it said were appropriate. Also, the The SEC asserted that the company misrepresented its nine month, September 30, 2010, financial statements cash on hand: the 2009 annual report reported cash of were the last ever issued to the SEC by China $57 million but was actually $141,000 and in the third MediaExpress. quarter of 2010, the cash was reported as $170 million On January 28, 2011, China MediaExpress but was actually $10 million. The company’s audit shares traded at a 52-week high of $23.97. Australian committee hired a forensic accountant from Hong short seller, John Hempton, noted a key red flag for Kong to investigate and the company’s CEO offered a China MediaExpress: how exactly could such a $1.5 million bribe to the investigator which was simple business model earn the company $31 million rejected and reported to authorities. on $57 million in revenue for the third quarter of 2010? He called it, “the fattest margin and fastest 5. Harbin Electric, Inc. growth Media Company I have ever seen.” On January 30, 2011, Citron Research explicitly On August 20, 2005, Harbin Electric became a public called China MediaExpress a “phantom company.” company in the U.S. after completing an RTO. While digging into industry reports on mass transit Headquartered in Harbin, China, Harbin Electric advertising in China, Citron found no references to developed and manufactured electric motors, China MediaExpress. Articles that listed industry including rotary motors, linear motors, and specialty competitors didn’t list China MediaExpress, despite micro-motors. The company had manufacturing the fact that the company claimed $155 million in facilities in Xian, Weihai, Harbin, and Shanghai, revenue for the nine months ended September 30,

432 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

China. It was a development stage company until He found out that this customer barely did any 2005. manufacturing of electric car-seat adjusters and that On October 1, 2010, the Harbin Electric CEO what little electric business it did was primarily with a and a private equity firm made a $750 million buyout China-based unit of Johnson Controls. This customer offer to take the company private. said that 98% of its business was selling manual, not On June 16, 2011, Citron Research posted a electric, car-seat adjusters and its total sales were $27 report on Harbin Electric, claiming a buyout loan million in 2009 and $30 million in 2010. Thus, the fraud and the documents to prove it. It said that the electric motor sale to this customer that Harbin future of Harbin’s stock price was currently propped asserted “represents a big disconnection.” on the crutch of a purported $24 per share buyout On November 1, 2011, NASDAQ suspended offer from its Chairman/CEO who owned 40% of the trading of Harbin Electric stock and filed a common stock. It stated that the Harbin notification of removal of listing and registration with Chairman/CEO had a history of fraudulent loan the SEC. guarantee documents. It claimed the offer was a sham On November 3, 2011, Harbin Electric with the CEO obtaining a signature loan for $400 completed closing of its going private transaction and million to buy out the remaining 60% of publicly-held became a privately-held company. No final details of shares at a 40% premium. The purported lender bank, the $750 million transaction were provided. China Development Bank, had become associated On December 1, 2011, the company’s auditor, with China stock frauds, most recently the Sino- Frazein Frost, agreed to be shut down by the SEC Forest fraud. Citron questioned what bank would without admitting guilt. This firm had issued clean provide hundreds of millions of dollars in high-risk audit opinions for Harbin’s financial statements from financing to fund a huge premium to pay off U.S. 2006 through 2010. The SEC said the reason for the investors. Citron said that Harbin Electric’s SAIC auditor shut-down was improper professional conduct filings showed losses for both 2009 and 2010 while its in connection with the annual audits and quarterly SEC filings showed profits of $20 million and $77 reviews of the company’s financial statements. million, respectively. Citron also claimed that the company had significantly understated its liabilities 6. China-Biotics, Inc. and overstated its revenues in SEC filings as compared to its SAIC filings. On August 10, 2006, China-Biotics became a public On June 25, 2011, Asian Times reporter also company in the U.S. after completing an RTO and questioned this buyout offer, saying the NASDAQ was in the development stage until 2007. It was a stock price was still stubbornly stuck at about $15 per Shanghai-based maker of probiotic yogurt cultures. share. He pointed out that in recent months, bashing On August 30, 2010, Citron Research issued a and shorting Chinese RTOs had become something of very negative report on China-Biotics which stated: a cottage industry. As a result of RTO transgressions, “It would be easy to look at the gross discrepancies investigations, and short-sellers’ attacks, Bloomberg’s between the company’s SAIC and SEC filings. It Chinese Reverse Merger Index had declined over would also be possible to show pictures of the half- 40% in the last year. He wrote that “for some finished over-budget manufacturing facility side-by- Chinese RTOs, the trip to Wall Street has turned into side with company claims that it was already in a prolonged swim in a sewer of suspicion, innuendo, production or the photos of their current production disdain, and exposure and prospects of U.S. financing facilities the size of a bathroom where the acidophilus that, if available, would be grudging, onerous, and pills drop out of a machine two by two. Most expensive. It is therefore not too surprising that compelling, it would be simple to question how a Harbin Electric’s CEO might decide to extract his company who sells the bulk of their product through company from the RTO morass by taking it private.” distributors, who then purportedly resell them to Wal- On September 22, 2011, another short seller Mart (as claimed by China-Biotics), can generate wrote about the customer footnote in Harbin EBITDA margins of 40-45% when their competition Electric’s 2010 annual report, saying that his firm is at 27% max.” reads such footnotes to seek insights about revenue On September 14, 2010, Citron Research issued concentration and potential threats to corporate another report. It said that it had been writing about balance sheets and cash flow statements from stock fraud the last nine years and admitted that it has problematic receivables. He found that Harbin did made research mistakes but has never been wrong not have the customer volume that was claimed in this about a fraud. Thus, “Citron is confident to state footnote which disclosed that Jiangsu Liyang Car Seat China-Biotics is a fraud. If we are lying, then please Adjuster Factory was its second largest customer, sue us and we will prove it in court. Or, put out a accounting for 10% ($22 million) of 2009 revenues press release defending yourself and explicitly blame and 16% ($19 million) of 2008 revenues. This short Citron Research, and we will sue you proactively to seller hired an American investigator living in Beijing prove that you are committing securities fraud on the to conduct interviews with this customer, posing as a investing public.” Citron questioned the network of buyer for a fictional American auto parts wholesaler. 111 retail stores claimed by China-Biotics in years’

433 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 worth of SEC filings and determined that their list of have $160 million in the bank in its June 2010 SEC “branded stores” were not stores; 95% of them were filing yet reported interest income of just $87,876 just supermarkets and retail outlets that carried China- (0.0005%) while interest rates on free cash balances Biotics products on small shelf space or did not carry in China earn 1% for 3 month to 1 year term deposits. such products at all. Citron then hired two private Citron also noted large differences in the 3/31/2008 investigators to take pictures and prove what Citron SAIC and SEC filings which were too large just to be knew. Citron noted that China-Biotics claimed to due to different reporting standards as follows:

SAIC SEC Cash $ 100,000 $ 64,300,000 Accounts Receivable 1,000,000 13,200,000 Revenues 500,000 42,300,000 Gross Profits 200,000 30,000,000 Net Income (1,200,000) 17,500,000

Such large discrepancies between SAIC and audit opinions for all three year but refused to certify SEC financial reports have served as warning signs or the March 31, 2011 numbers. Also, on this day, red flags for potential fraud among other Chinese NASDAQ delisted the China-Biotics stock. companies as well. Citron concluded: “As far as On July 18, 2011, an investor lawsuit was filed lying to the Chinese government but not the SEC, you against China-Biotics. want us to believe that management who lives and On October 8, 2013, China-Biotics asked the pays taxes in China, where white collar crime can be SEC to reinstate its securities registration which was punishable by death, will lie to the Chinese revoked in 2012 by the SEC because the company government but they will not lie to the SEC?” failed to file some of its required financial reports. For example, Zeng Chengjie, a Chinese The company said it had hired a new auditor, filed all businessman, was executed on July 12, 2013 by lethal of its missing reports, and was now fully up-to-date in injection for illegal fundraising and financial fraud. its filings. An attorney from the SEC’s enforcement He allegedly defrauded more than 57,000 investors division urged the SEC commissioners not to reinstate out of $460 million of which he had already returned the company, saying that the company had refused to $280 million, or 60%, at the time of his execution, as identify when its filings would become current and compared to Bernie Madoff’s lifetime jail sentence had taken over a year to fix these issues. As of June, for his $50 billion Ponzi scheme. 2013, the SEC had filed more than 65 fraud cases and On September 15, 2010, China-Biotics released deregistered the securities of more than 50 companies, a press release commenting on its stock. The including China-Biotics. company didn’t defend their alleged stores claim explicitly but instead stated that there were “market 7. Deer Consumer Products, Inc. rumors” and blamed the shorts for stock price declines, similar to Enron’s strategy. Citron On September 10, 2008, Deer Consumer Products, commented: “Don’t forget the old adage: at every Inc. became a public company in the U.S. after poker game there is a sucker, and if you don’t know completing an RTO. The company was a who the sucker is, it is you!” manufacturer of blenders, juice makers, soymilk On June 15, 2011, NASDAQ halted trading in makers, and rice cookers. Its auditor was Goldman, China-Biotics stock when the company failed to file Kurland and Hohidin LLP, a favorite auditor for its 10-K annual report with the SEC. Chinese RTOs per Alfred Little, a short seller. On June 24, 2011, China-Biotics’s CFO resigned On June 1, 2009, the company was up listed to and its auditor, BDO Limited, also resigned, citing NASDAQ. It had been a development stage company irregularities it discovered that “likely constitute in 2007. illegal acts.” BDO said that its auditors, attempting to On March 9, 2011, Alfred Little issued his first review online bank records, were directed by staff of report on Deer Consumer Products. He wrote that the China-Biotics to “access a suspected fake web site” company had impossibly high gross margins and that supposedly belonged to the bank in question operating margins at the same time as very low selling where the company kept one of its major cash expenses. Also, the return on investment was accounts. In its 3/31/2010 balance sheet, the impossible on a $40 million plant. He had hired an company had reported $156 million in cash which independent third party research group in China. was approximately 150% of its market cap. Also, They counted the number of brands and prices at BDO stated that the company had forged sales various Suning stores, mentioned as one of Deer’s documents and misstated interest income and failed to product sellers in its December, 2010 financial take “appropriate remedial actions.” BDO had been statement notes. The researchers found that Deer the company’s auditor for the last three financial products were not available at these stores. Also, years, March 31, 2008-2010, and had issued clean Little challenged Deer’s revenue recognition policy

434 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 on a “commission basis” at other distributors’ stores used by one or more illegal short sellers in the short and asserted that Deer should wait to recognize seller sale scheme.” Deer claimed that the purported revenue until its products were sold in these stores, reports of Alfred Little were “published in collusion not at the point of shipment to these stores, which he with short sellers to intentionally create fear in the called “channel stuffing” and not permissible under general public to drive down Deer’s share price.” The U.S. generally accepted accounting principles press release also asserted that all of the allegations in (GAAP). Accordingly, he noted a disconnection the supposed Alfred Little reports were false and that between net income and operating cash flow. the company intended to seek sanctions against the On March 14, 2011, Alfred Little issued his law firm that filed the lawsuit. second report on Deer Consumer Products. He On September 6, 2011, Chinese officials claimed Deer had substantially inflated both sales and confirmed that both Harbin Electric and Deer profit margins and had failed to disclose direct Consumer Products committed multi-million dollar competition from entities related to its chairman. His land fraud. Both companies had listed their land right report was organized into the following sections: uses under intangible assets, starting in 2007 for high profit margins are impossible, extensive 10-city, Harbin Electric and 2010 for Deer. 60-store channel check confirms very weak domestic On August 13, 2012, NASDAQ halted trading in retail sales, questionable revenue recognition inflates Deer Consumer Product shares. Alfred Little had sales and accounts receivable, 2009 SAIC filing hired an independent third party to visit Deer’s two shows a much smaller and less profitable business, Yangjiang factories. He took pictures and noted that and direct competition from Deer’s chairman who is there was no sign of any production activity or an unconsolidated related party. workers, other than security and maintenance On March 21, 2011, Alfred Little issued his third personnel. report on Deer Consumer Products. He wrote: On October 2, 2012, NASDAQ delisted Deer “Virtually every fraudulent company I have Consumer Product shares for the following reasons: uncovered finds ways to steal money from its U.S. 1) Deer had made false and misleading disclosures investors. Deer appears to be no exception.” In its regarding the operational status of its manufacturing 10Q filed November 10, 2010, Deer disclosed that it facilities in Yangjiang, China, 2) Deer had failed to had purchased $22.2 million of land use rights for provide complete responses to NASDAQ staff’s construction of a new factory (inflated to $23.2 questions regarding the Company’s customers, million under Intangible Assets). Little stated that his suppliers, and shippers, and 3) Deer was involved in a legal team in China discovered that the direct scheme to illicitly transfer corporate funds to a group purchaser of this land right use was a new subsidiary of stockbrokers through a bogus consulting contract. recently set up by Deer and that official records On March 10, 2013, an investor filed a class showed a purchase price of $11.3 million, not $22.2 action lawsuit against Deer’s auditor, Goldman million. He wrote: “It was insane for Deer to buy Kurland and Mohidin, who had issued clean audit land to build a new factory when it still had a lot of opinions for Deer’s financial statements in 2007 excess capacity. Existing facilities can support $320 through 2010. The lawsuit alleged that Deer’s million in revenue versus $174 million revenue revenues were overstated in 2009 and 2010. estimated for 2010. So it was of little surprise to me On April 1, 2013, a partial settlement of the to find Deer exaggerated the cost of this land purchase securities class action lawsuit against Deer was by almost 100%. The money was either diverted reached for $2,125,000. (stolen) for some other purpose or the cash never existed in the first place - either scenario at Deer is 8. NYSE Key Corporate Governance possible.” Principles On April 30, 2011, a securities class action lawsuit was filed against the company and certain In 2010, the NYSE-sponsored Commission on directors and officers. Plaintiffs charged that Deer had Corporate Governance issued a report that identified misrepresented its financial performance, business key corporate governance principles for boards of prospects, and financial condition to investors, citing directors as well as management and shareholders. inconsistent Chinese regulatory filings versus U.S. Written in the context of the significant developments regulatory filings and GAAP. in corporate governance and control since 2000, the On May 2, 2011, Deer issued its own press report addresses the roles and responsibilities of release and asserted that it had “evidence of boards of directors, management, and shareholders. continuing illegal short selling in its stock and also (New York Stock Exchange Commission on asserted that its common stock has been manipulated Corporate Governance, September 23, 2010, available in collusion among naked short sellers.” The press at http://www.nyse.com/pdfs/CCGReport.pdf.) The release also asserted that the class action lawsuit was specific principles that apply to the analysis of the part of the attempted manipulation. Deer further five Chinese companies in this paper are listed below. asserted that “the supposed analyst, Alfred Little, is a 1. The board’s fundamental objective should be fictitious character whose phony identity is a disguise to build long-term sustainable growth in shareholder

435 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 value. Thus, policies that promote excessive risk- China MediaExpress Holdings, Inc. taking for short-term stock price increases, and compensation policies that do not encourage long- There were differences in the performance numbers term value creation, are inconsistent with good reported to the U.S. SEC and the China SAIC. There corporate practices. were large misrepresentations of cash on hand and 2. While the board of directors’ responsibility other accusations of fraud, including videos showing for corporate governance is well-recognized, less so is no activity at the corporate office. There were the critical role played by management, which has the allegations of industry reports that did not confirm the primary responsibility for creating a culture of magnitudes of their presence in the industry and their performance with integrity. Management’s role in revenues. When their auditor hired a forensic corporate governance includes, among other things, accountant to investigate the accusations and establishing risk management processes and proper allegations, the CEO offered a bribe to the internal controls, insisting on high ethical standards, investigator. ensuring open internal communications about potential problems, and providing accurate Harbin Electric, Inc. information to both the board of directors and the shareholders. There were differences in the performance numbers 3. Good corporate governance should be reported to the SEC and to SAIC. There were integrated as a core element of a company’s business allegations that they did have the customer volume strategy and not be viewed simply as a compliance that they reported. The Chinese government obligation. confirmed that they were involved in a multi-million 4. Transparency is an essential element of dollar land fraud. There were claims that a buyout corporate governance. offer from the Chairman/CEO was fraudulent. In addition to having the influence and control that he 9. Did the Five Chinese Companies did as both the Chairman and the CEO, he also owned Violate the NYSE Key Corporate 40% of the common stock; this can cause concerns Governance Principles? about too much power for one person to have. Their auditor was shut down by the SEC for improper Unfortunately, the answer is a resounding yes! For all professional conduct regarding audits and quarterly five of the Chinese companies, there were numerous reviews. examples of business practices that were unsustainable, and many of them were also China-Biotics, Inc. fraudulent. In all five companies, management did not create a culture of performance and integrity. They There were extremely large differences in the also did not have the proper internal controls, nor did performance numbers reported to the SEC and SAIC. they exhibit ethical standards. Corporate governance As was true in all the instances when these numbers did not appear to be part of their business strategy. were different, the numbers reported to the SEC were Transparency did not exist. In addition to fraudulent always better, which would help to keep the stock statements and activities, there were deliberate price up. There were questions about their margins attempts to conceal the truth. There was no instance and revenues and the ability to generate the revenues. of any board involvement to correct any of the The Chinese government confirmed that they were activities. Some of the evidence that supports these involved in a multi-million dollar land fraud. Their conclusions is detailed below for each of the five CFO resigned, and their auditor resigned after having companies. issued three years of clean audit reports.

Longtop Financial Technologies Ltd Deer Consumer Products, Inc.

There were allegations of widespread fraud in the There were differences in the performance numbers financial statements, including the misrepresentation reported to the SEC and SAIC. There were allegations of cash on hand, as well as borrowings not shown on of non-existent sales distribution channels which the books. The Chairman of the Board admitted to the raised questions about revenues, selling expenses, and auditor that there had been fake revenue and fake margins. There was no sign of production at any of cash, but he would not answer specific questions, the production facilities. The Chairman was a related other than blaming senior management. There were party in entities that were in direct competition with non-transparent management transactions. The auditor the company. resigned; one reason stated was that management interfered with the audit process. Lessons Learned

Most investors recognize that cross-border investing brings additional risks, such as exchange rate risk,

436 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 political risk, the risk of different accounting systems, 7. “Auditing Cash in China,” P. Gillis, China Accounting and the risk of gathering information about a Blog.com, April 20, 2011. company that may be thousands of miles away. There 8. “The Audacity of Chinese Frauds,” F. Norris, The New is one more risk that must be considered as well. This York Times, May 26, 2011. 9. “Longtop Teaches Deloitte How to Discover A Chinese paper has shown the importance of corporate Stock Fraud. Again,” B. Bishop, digicha.com, May 22, governance standards in cross border investing. These 2011. standards and their enforcement may vary across 10. “China-Biotics Mentioned Negatively At Citron countries. A foreign-based company whose stock is Research,” R. Nachman, Benzinga.com, August 30, listed on a U.S. exchange has to comply with that 2010. exchange’s rules and regulations regarding corporate 11. “Another Day…Another Chinese Scam Stock,” M. governance and control. However, the exchange’s Weinschenk, Wall Street Daily Insider, March 16, 2011. influence can all be negated if there are not strong 12. “Another Day…Another Chinese Scam Stock,” M. corporate governance and control efforts in the home Weinschenk, Wall Street Daily Insider, March 16, 2011. 13. Citron Research Report, “Harbin Electric: Loan Fraud country. and the Docs to Prove It,” June 16, 2011. The five Chinese companies analyzed in this 14. “Another Sewer Swim for Harbin Electric,” P. Lee, paper had poor auditing, boards that did not get Asia Times, June 25, 2011. involved, and boards and management that violated 15. “Harbin Electric: The Annuals of Fraud,” R. Boyd, the NYSE’s key corporate governance principles. seeking alpha.com, September 22, 2011. Also, the NYSE, NASDAQ, and other major global 16. Citron Research Report, “China-Biotics is a Fraud— stock exchanges now have corporate governance Now Sue Citron—We Dare You,” September 14, 2010. listing requirements that follow these principles. 17. “China’s Bernie Madoff Was Executed for Fraud---and (“Corporate Governance Listing Requirements: Nobody Told His Family,” R. Lu, The Atlantic, July 16, 2013. Protecting Investors From Fraudulent Financial 18. Citron Research Report, “China-Biotics is a Fraud— Reporting,” K. Aljifri, H. Grove and L. Victoravich, Now Sue Citron—We Dare You,” September 14, 2010. Corporate Ownership and Control, 2014, Winter, 19. “China-Biotics Fraud Casting Doubt on All Chinese Volume 11, Issue 2.) Cross- border investors need to RTOs,” I. Bezek, seeking alpha.com, June 24, 2011. realize that it is also necessary to identify the risk of 20. “Deregistered Chinese Company Asks U.S. SEC for a ineffective corporate governance and control in the Second Chance,” S. Lynch, Reuters, October 8, 2013. foreign home country. If any reminder of this strategy 21. “Deer in Headlights: Latest Alleged Chinese Reverse is necessary, just ask the shareholders of these five Merger Fraud,” T. Durden, zerohedge.com, March 9, Chinese companies about their $4.1 billion loss of 2011. 22. “The Problems With Deer Consumer Products,” A. wealth because of this additional risk. Little, seekingalpha.com, March 17, 2011. 23. “Deer Consumer Products Report,” A. Little, References sbwire.com, March 21, 2011. 24. “Are Short Sellers Fabricating the Accounting Fraud 1. “The Missed Red Flags on Groupon,” A. R. Sorkin, The Allegations Involving U.S.-Listed Chines Firms?” New York Times, October 17, 2011. dandodiary.com, May 3, 2011. 2. ”The Shorts Who Popped a China Bubble,” D. Bases, R. 25. “Chinese Government Officials Confirm HRBN and Vlastelica, C. Baldwin, and M. Bendeich, Reuters, DEER Committed Multi-Million Dollar Land Fraud--- August 5, 2011. Time for U.S. Regulators to Act,” A. Little, 3. Citron Research Report, “Citron Reports on Longtop labemp.wordpress.com, September 6, 2011. Financial,” April 26, 2011. 26. “Deer Consumer Products Shares Halted After Factories 4. “The Shorts Who Popped a China Bubble,” D. Bases Idled,” A. Little, seekingalpha.com, August 14, 2012. et.al., Reuters, August 5, 2011. 27. “The Bell Tolls For Deer Consumer Products,” A. 5. “The Audacity of Chinese Frauds,” F. Norris, The New Little, seekingalpha.com, October 10, 2012. York Times, May 26, 2011. 6. Citron Research Report, “Longtop Financial Final Proof of Undisclosed Related Party Transactions,” May 9, 2011.

437 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

UNIVERSAL CORPORATE GOVERNANCE STANDARDS: RECOMMENDATIONS FOLLOWING THE GLOBAL FINANCIAL CRISIS

Ronald H Mynhardt*

Abstract

Corporate governance can be defined as: the set of processes, customs, policies, laws and institutions affecting the way a company is directed, administered or controlled. Suggestions were investigated that the global financial crisis revealed severe shortcomings in corporate governance. Research was conducted to establish whether these suggestions are accurate. The study found that it appeared that corporate governance has failed and action needs to be taken. The study recommends that a world supervisory body on corporate governance be established. It also proposes that a summit be called to discuss and create such an authority. In addition, the formulation of a set of universal corporate governance standards for implementation by the members was suggested.

Keywords: Board of Directors, Corporate Governance, Corporate Governance Standards, Global Financial Crisis, Regulatory and Supervisory Activities, Shareholders, Stakeholders, Sustainability

* University of South Africa, PO Box 392, Unisa 0003 Tel: +27 12 429 4927 Fax: +27 86 640 0793 Email: [email protected]

1. Introduction South African Reserve Bank, for instance, conducted a review process to assess compliance with corporate The global financial crisis revealed severe government principles on banking institutions in shortcomings in corporate governance. The existing South Africa (SARB, 2004). Despite all the efforts, standards failed to provide the checks and balances the world economy still experienced its most that companies need in order to cultivate sound dangerous crisis since the Great Depression of the business practices (OECD, 2011). 1930s in the year 2008 (Yale, 2013). In recent years, the financial markets have seen The global financial crisis caused severe damage the increased regulation and supervision of especially and casualties in the United States, which included the banks. Foremost was the Basel Committee on entire investment banking industry, the US’s biggest Banking Supervision (“the Basel Committee”) (BIS, insurance company, the two enterprises chartered by 2013). The Basel Committee issued several papers. In the US government to facilitate mortgage lending, the April 2005, for instance, after lengthy discussions and US’s largest mortgage lender, largest savings and loan much debate with banks and regulators around the bank, and two of the largest commercial banks. In world, the Basel Committee issued the final paper addition, other industries such as the automotive titled “Compliance and the compliance function in industry were also affected. banks” (BIS, 2005). The paper provided detailed The question everybody asked was, “What compliance principles to which banks were expected caused this crisis?” (Intosai, 2010). Everyone tried to to adhere in order to enhance compliance in banks and find the culprits. Shareholders, the public and banking groups. politicians pointed fingers everywhere. Directors of The Committee’s paper (BIS, 2005) stipulated troubled companies found themselves directly in the specifically that the board of directors of a bank is line of fire. Governments and even central banks were ultimately responsible for their particular bank’s accused as they had the responsibility of upholding compliance with all relevant acts and regulations. It financial stability through proper supervision and further stipulated that compliance should become part regulation of the financial markets and its institutions of the culture of a bank (BIS, 2005) and that the (Intosai, 2010). bank’s compliance function should be adequately While few economists and other analysts resourced (BIS, 2005). predicted the financial crisis, almost everyone offered Further regulatory and supervisory initiatives an explanation as to why it had happened. The followed in various countries (SARB, 2004). The reasons provided ranged from too much foreign

438 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 money flowing into the US to the availability of easy Nisa (2009) mentions that corporate governance credit and bankers bundling up these loans and selling standards differ from company to company and this is them to investors who could not understand the even worse from country to country. The governance complexity and risks of these financial instruments standards in companies and countries are compiled (Intosai, 2010). Yale (2013) is however of the opinion based on the companies’ own objectives and the that the root of the crisis might very well lie in one political, economic, legal and social history of a fundamental human instinct: GREED. country. In view of this, the question arises as to Numerous scholars and experts are of the whether it is possible to have a set of universally opinion that the lack of proper corporate governance acceptable corporate governance standards. was to blame for the financial crisis (FDIC, 2009) As a result of the statements made by Lieberman where corporate governance can be defined as “The (2013), Chambers (2009) and Nisa (2009), a study set of processes, customs, policies, laws and was conducted amongst high-profile financial institutions affecting the way a corporation is executives from around the world with the objective directed, administered or controlled” (Oliver, to ascertain whether corporate governance was to 2012:1). blame for this failure in corporate governance and The boards of directors of companies were why it might be indeed necessary to reform global amongst other accused that they were too complacent corporate governance standards. in allowing their management and staff to engage in The second objective of the study was to use, risky behaviour, adopting compensation programmes amongst other, the results of the study to propose an that encouraged risky behaviour, giving in to pressure initiative that could be used specifically to enhance from shareholders to exceed prior results, and failing corporate governance in the world. to monitor the business and assess its risk profile (Lieberman, 2013). Lieberman (2013) is however of 2. Research Methodology the opinion that it seems questionable whether it is appropriate to blame directors for failing to predict The research was firstly aimed at obtaining and prevent the crisis. information about whether it is indeed necessary to Bird (2008) mentions that people have different reform global corporate governance standards. opinions whether corporate governance can and Secondly, the purpose was to obtain possible should be blamed. Bird (2008) says that some people solutions. The target population included selected believe that corporate governance failed in significant experts in the financial field from around the globe. respects in preventing the latest financial crisis whilst The experts interviewed included bankers, central other people believe that corporate governance bankers, accounting experts, board members and mechanisms perform their intended functions in senior management from different institutions. important respects and that there is not a significant The research focused firstly on a review of need for reforming corporate governance. current corporate governance frameworks used in the It is however important to bear in mind that in different countries around the world. The purpose of recent decades, a large part of the emphasis in this was to ascertain the extent of current frameworks. corporate governance has been designed to align the Secondly, the selected experts were interviewed interests of the board and executives with those of the to obtain specific information regarding corporate equity owners (Lieberman, 2013). Executives often governance. To achieve this goal, a questionnaire and fell pressured to produce short-term profitability, semi-structured interviews were used. The interviews which could have resulted in a liquidity crisis that conducted were strictly confidential and, at their could jeopardise the entire long-term ownership explicit request, none of the experts interviewed were interests of the shareholders. Enron, the FINOVA named. Group, Inc., and Lehman Brothers are perfect The following questions were used in the examples of this (Lashinsky, 2001). questionnaire: Ferguson (2012:1) offers another possible reason 1. Do you think corporate governance was to blame for the global financial crisis when he argues, for the global financial crisis? “Those who believe this crisis was 2. Do you think that the supervisory coverage with caused by deregulation have misunderstood regard to corporate governance is sufficient? the problem in more than one way. Not only 3. Does your supervisory team have enough was misconceived regulation a large part of knowledge about corporate governance? the cause. There was also the feeling of 4. Does your institution report to multiple impunity that came not from deregulation but supervisors? from non-punishment.” 5. Do these supervisors apply the same rules? It is however significant to note that numerous 6. Are there too many rules? scholars and experts are calling for improvements in 7. Does your supervisor practice risk-based corporate governance (World Bank, 2013). Chambers supervision? (2009) is another example of these scholars calling for 8. Is there a need for a new global supervisory drastic reforms in corporate governance. architecture?

439 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

9. What solutions can you offer? since the adoption of its Action Plan for Modernizing European Company Law and Enhancing Corporate 3. International Perspective Governance in the EU. Yet, candidate and potential candidate countries are not always conversant with EU An international perspective on the current corporate corporate governance requirements and governance frameworks was researched with the recommendations. purpose of identifying these frameworks and The EU has ordered a review of the Corporate ascertaining their contents and also possible use in a Governance Framework, but on closer inspection of new future dispensation. According to the European the Green Paper, it appears that important corporate Corporate Governance Institute (ECGI) (2013), there governance issues such as decision-making by boards, are 106 individual countries in the world that have directors’ responsibility, directors’ independence, some type of corporate governance framework. conflicts of interest or stakeholders’ involvement have An analysis of these codes yielded the following been left out of the Green Paper (Eur-lex, 2013). results: It can be concluded that just more than half the  106 countries out of a possible 193 (World countries in the world have recognised corporate Atlas, 2013) have some type of corporate governance governance as important and they have some sort of framework; framework in place. In some cases, these frameworks  the countries with frameworks are spread are fairly old and very little similarity was found around the globe, with the majority in Europe; amongst the different codes leading to the application  the earliest codes/frameworks were published of different standards throughout the world. in 1995;  the latest codes were published in 2013; 4. Research Findings  the content and reach of these codes differ vastly, mainly in the areas of applicability and local As mentioned in the research methodology above, the legislation; focus was firstly on a review of current corporate  the codes are mainly applicable to governance frameworks used in the different countries institutions within the borders of a particular country around the world. The purpose was to ascertain the with little cross-border reach; and extent of current frameworks. Secondly, the selected  enforcement of these codes also differs experts were interviewed to obtain specific information regarding corporate governance. between countries, from “comply or else” to “comply Figure 1 below details in graphical format the or explain” to “apply or explain”. research findings. On the x-axis, Figure 1 shows the On a regional basis, the European Union (EU) participants’ answers to the different questions as a has instituted a Corporate Governance Framework but percentage. The blue bar indicates a “yes” answer, the the IFC (2008) states, burgundy bar a “no” answer and the green an The European Union (EU) has achieved a great “uncertain” answer. The questions asked are shown deal in terms of addressing disclosure, shareholder on the y-axis marked as Q1 to Q8. protection, and board structures and responsibilities

Figure 1. Research findings

9 8 7 6 5 Response 4 3 2 1 0 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Questions asked

440 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Do you think corporate governance was to Are there too many rules? (Q6) blame for the global financial crisis? (Q1) Respondents were again vocal about this question. It appeared that there was still no consensus on the Half of the respondents indicated that there were too issue of whether a lack of corporate governance was many rules and regulations even within one single to blame for the global financial crisis. The majority supervisory body. Respondents requested fewer rules of the respondents (60%) were however of the to comply with and that these rules should not be opinion that inadequate corporate governance was to overly complicated. Some respondents expressed the blame. view that these rules should not impede on their ability to do business. Do you think that the supervisory coverage with regard to corporate governance is Does your supervisor practice risk-based sufficient? (Q2) supervision? (Q7)

The respondents were divided on whether they The majority of the respondents (70%) were experienced adequate supervision by their supervisory supervised according to a risk-based approach instead authority. It is interesting to note that the majority of a rules-based approach. The respondents were of the the respondents replied “no” and that there were an opinion that the risk-based approach was more equal number of “yes” and “uncertain” responses. efficient. This could be an indication that the respondents were not satisfied with the supervision conducted by their Is there a need for a new global supervisory supervisor as far as corporate governance was architecture? (Q8) concerned. By way of the questionnaires, the respondents called Does your supervisory team have enough for a new global supervisory architecture as far as knowledge about corporate governance? (Q3) corporate governance is concerned. There was no consensus about the exact structure of a new global The respondents were divided on whether their supervisory architecture. supervisory team had adequate knowledge. It is interesting to note that the majority of respondents What solutions can you offer? (Q9) replied “no” and that there were an equal number of “yes” and “uncertain” responses. This could be an During the interviews, the respondents offered the indication that the respondents were not sure about following possible solutions to make corporate the experience of their supervisory team as far as governance more efficient in the world economic corporate governance was concerned. system:  Reduce the number of international and Does your institution report to multiple national organisations setting and applying rules – for supervisors? (Q4) the sake of the consistency and efficiency of the regulated sector, the fewer the number of bodies The majority of the respondents (80%) indicated that setting and/or enforcing fewer rules, the better. they reported to multiple supervisors mainly as a  The formulation of a set of universal rules result of their activities and interactions in the and regulations – all institutions that perform the financial markets. Only 20% of the respondents same economic function within a marketplace, reported to one supervisor only. irrespective of charter choice or name, should be regulated in an equivalent manner. Do these supervisors apply the same rules?

(Q5)  Supervision must be risk-based – ensure that rules and supervisory techniques are indeed Respondents were quite vocal about this question. efficacious and risk-based. Half of the respondents indicated that their  Improve quality of implementation by the supervisors did not apply the same rules. The result regulatory bodies – supervisors should be well was that financial institutions had to comply with prepared for their job. different sets of rules that increased the cost of  Implement corporate governance risk compliance. Respondents furthermore indicated that management as part of the organisation’s risk there were also different reporting requirements which management regime – ensure that corporate also placed an additional burden in the financial governance risk is identified, monitored, reported on institutions’ information technology infrastructure and and corrective action taken. cost. The respondents all agreed on the above- mentioned possible solutions but could not agree which will be the best under the current circumstances. However, all agreed that something drastically had to be done.

441 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

5. Recommendations In view of the aforementioned, this article proposes: In view of the above, this paper makes the following  the formulation of a world supervisory body recommendations with regard to corporate focusing on corporate governance in organisations; governance: and Current there are several supervisory bodies that  the formulation of a set of recommendations “govern” specific regulatory aspects in the world that can be used by the aforementioned supervisory financial markets, such bodies as the Bank for body to compile a world-wide set of corporate International Settlements (BIS) and the Financial governance standards. Action Task Force (FATF). The BIS was established in 1930 and is the World supervisory body on corporate oldest international financial organisation in the world governance (BIS, 2013). The mission of the BIS is to foster international monetary and financial cooperation, and This article proposes that a world supervisory body on serves as a bank for central banks. Sixty central banks corporate governance be established and be called the and monetary authorities are currently members of the Corporate Governance Supervisory Authority BIS. (CGSA). The formulation of a body such as the The BIS pursues its mission by (BIS, 2013): CGSA could have, amongst other, the following  promoting discussion and facilitating advantages: collaboration among central banks;  establishing a more transparent and stable  supporting dialogue with other authorities financial system; that are responsible for promoting financial stability;  providing countries’ financial institutions  conducting research on policy issues with guidance on establishing an efficient corporate confronting central banks and financial supervisory governance regime; authorities;  mitigating corporate governance risk on a  acting as a prime counterparty for central global scale; banks in their financial transactions; and  limiting the potential for bad behaviour by  serving as agent or trustee in connection with instituting rules to reduce potential fraud and conflict international financial operations. of interest; and In addition, the BIS hosts several secretariats  providing guidelines to stay compliant with such as the Secretariat of the Basel Committee on rules, regulations and laws. Banking Supervision, the Committee on the Global Financial System, the Committee on Payment and The following should be salient features of the Settlement Systems, the Markets Committee, the CGSA: Central Bank Governance Group, and the Irving Fisher Committee on Central Bank Statistics (BIS, Establishment 2013). The FATF (FATF, 2013) is an inter- The CGSA should be a supervisory body established governmental body established in 1989 by the by its members. Members could be any country that ministers of its member jurisdictions. FATF set has already contributed or that wants to contribute to standards and promote effective implementation of ensuring international financial stability. It is legal, regulatory and operational measures for suggested that the establishment of the CGSA be combating money laundering, terrorist financing and facilitated by one of the current international other related threats to the integrity of the supervisors or bodies such as the World Bank, BIS or international financial system. FATF. The FATF is therefore a “policy-making body” which works to generate the necessary political will to Structure and legal standing bring about national legislative and regulatory reforms in these areas. The FATF developed a series The CGSA should be an international non-profit of recommendations that are recognised as the organisation established by its members. The international standard for combating money recommendations should be applied to its members by laundering and the financing of terrorism. the CGSA on an “adapt-or-explain” basis. Other important tasks of the FATF include monitoring the progress of its members in Mission implementing the FATF measures, reviewing money laundering and terrorist financing techniques and The CGSA’s mission should be to establish sound counter-measures, and promoting the adoption and corporate governance principles to maintain financial implementation of appropriate measures globally stability in world markets. (FATF, 2013).

442 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Objectives members. It is further proposed that these recommendations be included in the criteria when a The following should be the specific objectives of the country rating is performed. CGSA: There are numerous topics upon which the final  to contribute to financial stability by setting corporate governance standards (recommendations) and maintaining international corporate governance could be based but the following, in no particular standards in the form of recommendations; order, are proposed as possible topics to be included  to promote the implementation of these in the initial debate: international corporate governance standards; and  to collaborate with other similar supervisory Ethical behaviour bodies in promoting world-wide financial stability. In the business world, ethical behaviour is the Tasks cornerstone of a business and means applying principles of honesty and fairness to relationships The following would be the initial tasks of the CGSA: with other staff and customers (Hill, 2013). Ethical  setting and maintaining international businessmen make an effort to treat everyone with corporate governance standards; whom they come into contact as they want to be  assessing and monitoring members’ treated themselves. adherence to the set international standards; Ethical behaviour forms one of the cornerstones  identifying and engaging with non-member of good corporate governance as ethical procedures countries with the objective to implement the CGSA and principles of conduct can be regarded as a form of standards in those countries; self-regulation, placing the responsibility to act professionally and ethically with the organisation.  responding to significant new threats, developments or needs; Composition of the board  engaging with individual financial institutions on corporate governance; The boards of companies are the main management  providing training on corporate governance structures in such companies. Boards consist of to its members; and groups of individuals who have been elected as  constantly researching new initiatives to representatives of the stockholders to establish improve corporate governance. corporate management-related policies and to make As the CGSA settles into its role, new tasks of decisions on major company issues. refinement to current tasks could emerge. The boards of companies are often described as private clubs and not representative democracies Membership (Gross, 2010). Increasing levels of boardroom regulation and risk have also placed greater demands CGSA members should be the countries to agree to on non-executive directors of companies meaning that work together to form the CGSA. Members should selecting candidates with the right knowledge, commit to: experience and skills is of the utmost importance.  continuous support of the CGSA; There is no consistency and agreement between  work together with other members to meet companies world-wide on how the selection of non- the objectives of CGSA; executive directors should be conducted. In addition,  implement and actively promote the in their annual reports, these international companies corporate governance standards in their own were silent on the selection criteria of non-executive countries; directors. Selecting board members with the right  participate actively in the assessment of other knowledge, experience and skills is of the utmost members; importance.  participate actively in continuous research into corporate governance matters; and Role and activities of the board  continuous funding of the CGSA based on a pre-determined formula. The board is ultimately accountable and responsible for the affairs and performance of the company. It Corporate governance recommendations should act fairly and independently to ensure that all relevant information is available to stakeholders as The very first task after the establishment of the and when needed. Therefore the board should retain CGSA is the formulation of a set of universal full and effective control over the organisation and be corporate governance standards (recommendations) involved in all decisions which materially affect the for implementation by members. These universal financial, social, legal and environmental standing of standards would be the benchmark against which the company. members could measure themselves and also other

443 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Managing stakeholders External and internal audit

Financial institutions should respect the rights of Corporate governance depends to a large extent on the stakeholders and enable stakeholders to exercise their efficiency of external and internal audit activities rights by effectively communicating information what (Mitra, 2012). The auditor, external or internal, does is relevant, timely, understandable and easily not have direct corporate governance responsibility accessible. Stakeholder relationships that are but rather provides assurance on the information mismanaged have fewer favourable consequences for aspects of the governance system. companies. Ojo (2009) is of the opinion that the external Stakeholder management is a difficult process auditor’s primary role is to verify whether the for organisations as it requires investment and financial information given to investors is reliable and commitment. It is important to note that satisfied accurate. The external auditor expresses an expert stakeholders get what they need and identify the opinion on the fairness of the financial statements in company as an overall positive experience. all material respects, a company’s financial position, results of operations, and cash flows. Committee structures for each and every risk Advtech (2013) mentions that the internal identified auditor examines and evaluates the company’s procedures and systems, including internal controls, The board has to establish a number of committees to disclosure procedures and information systems, assist it in discharging its responsibilities. The type of ensuring these are functioning effectively. As an committees established should be in line with risks independent assurance function, the auditor also faced by the particular company. Typical committees provides assurance with regard to the effectiveness of could include an audit committee, a risk committee, a risk management, compliance and governance governance committee and a compliance committee. activities. These committees should be chaired by independent non-executive directors, supported by the Liaison with supervisors and regulators company secretary or his or her delegate, and free to take independent professional advice as and when The mission of supervisors and regulators is to necessary. safeguard the integrity and soundness of the markets. In order to achieve this, supervisors and regulators Management structure follow specific programmes to supervise the companies under their jurisdiction. Companies should create a management structure The role of regulation in influencing the which is directed towards the achievement of development of corporate governance principles has organisational goals. The structure of an organisation become an important policy issue and should receive can help or hamper its progress toward accomplishing attention. The regulator and the supervisor should these goals. This structure should support activities therefore play a more active role in establishing such as task allocation, coordination and supervision. standards and rules to make corporate management Specific management structures cannot be practices in organisations more accountable and promoted but should be constructed according to a efficient. company’s specific needs. The structure should however ensure efficient corporate governance and Sustainability streamline operations, and it should be able to incorporate multiple jurisdictions, improve It is accepted world-wide that sound corporate performance and focus on sustainability. governance practices enhance shareholder value and by conducting the company’s affairs with integrity it Risk and compliance management will ensure the long-term sustainability of the business (Seardel, 2013). An effective corporate Companies should introduce effective risk and governance system employed in a company can assist compliance management structures and activities. in creating the confidence and trust necessary for the Hobbs (2012) is of the opinion that this should be company’s existence in the market economy. affected by an organisation’s board of directors, Corporate governance and the complexity of management and other personnel. It should be applied sustainability call for global cooperation, based in a strategy setting across the organisation. It should mainly on the coordination of strategies and adopting be designed to identify potential events that may of the best decisions. affect the entity and manage risk to be within its risk appetite and provide reasonable assurance regarding What should happen next? the achievement of entity objectives. This article proposes that a summit be called to discuss and create the CGSA. The author is of the

444 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 opinion that the World Bank or a similar world body _Is_it_to_Blame_for_the_Banking_Crisis [Access should take the lead in this. At this summit, all the date: 18 Augustus 2013]. issues on the formulation, membership and funding of 10. ECGI (European Corporate Governance Institute) the CGSA should be discussed. (2013).Index of Codes, http://www.ecgi.org/codes/all_codes.php [Access Conclusion date: 21 August 2013]. 11. Eur-lex (2013).A Corporate Governance Framework Suggestions that the global financial crisis revealed for European Countries, http://eur- severe shortcomings in corporate governance were lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2 investigated. Research in this study has found that 013:257E:0056:0061:EN:PDF [Access date: 18 July boards of directors were amongst other accused that 2013]. they were too complacent in allowing their 12. FATF (Financial Action Task Force) (2013).About management and staff to engage in risky behaviour, Us, http://www.fatf-gafi.org/pages/aboutus/[Access adopting compensation programmes that encouraged date: 21 December 2013]. risky behaviour, giving in to pressure from 13. FDIC (Federal Deposit Insurance Corporation)(2009), shareholders to exceed prior results, and failing to Corporate Governance in the 2007–2008 Financial monitor the business and assess its risk profile. Crisis: Evidence from Financial Institutions In order to enhance corporate governance in Worldwide, companies around the world the formulation of a world supervisory body on corporate governance http://www.fdic.gov/bank/analytical/CFR/bank_resear should be established and be called the Corporate ch_conference/annual_9th/Matos_P.pdf [Access date: Governance Supervisory Authority. It was also 21 September 2013]. proposed that a summit be called to discuss and to 14. Ferguson, N. (2012), The Reith Lectures – BBC create the CGSA. In addition, the formulation of a set Radio,http://www.bbc.co.uk/programmes/b01jmxqp/f of universal corporate governance standards eatures/transcript [Access date: 19 Augustus 2013]. (recommendations) for implementation by the 15. Gross, D. (2010), Corporation Killers, members was suggested. http://www.thedailybeast.com/newsweek/2010/02/02/ corporation-killers.html [Access date: 12 December References 2013]. 16. Hill, B. (2013), Advantages of Ethical Behaviour in 1. Advtech, 2013, Corporate governance, Business, http://smallbusiness.chron.com/advantages- http://www.advtech.co.za/sustainability/corporate- ethical-behavior-business-21067.html [Access date: governance [Access date: 21 December 2013]. 18 July 2013]. 2. Bird, J. 2008, A crisis so severe, The world financial 17. Hobbs, K.(2012). Establishing an Enterprise Risk system is affected. Management (ERM) Framework http://www.globalissues.org/article/768/global- 18. Enterprise, http://www.clearrisk.com/risk- financial- management-blog/bid/56487/Establishing-an- crisis#Acrisissoseveretheworldfinancialsystemisaffect Enterprise-Risk-Management-ERM-Framework- ed [Access date: 21 December 2013]. Enterprise[Access date: 12 December 2013]. 3. BIS (Bank for International Settlements)(2001), 19. IFC (International Finance Corporation) (2008), The Quarterly Review, June, EU Approach to Corporate Governance, http://bis.org/publ/r_qt0106.htm [Access date: 21 http://www.ifc.org/wps/wcm/connect/f515ff804af4fc7 December 2013]. da869b9b94e6f4d75/IFC_EUApproach_Final.pdf?M 4. BIS (Bank for International Settlements)(2003), OD=AJPERES [Access date: 1 December 2013]. Consultative Paper on Compliance and the 20. Intosai (2010).The Causes of the Global Financial 5. Compliance Function in banks, Crisis and Their Implications for Supreme http://bis.org/publ/bcbs/103.htm [Access date: 21 21. Audit Institutions, December 2013]. http://www.intosai.org/uploads/gaohq4709242v1final 6. BIS (Bank for International Settlements)(2005), subgroup1paper.pdf [Access date: 24 November Compliance and the Compliance Function in 2013]. 7. Banks, http://bis.org/publ/bcbs/113.htm [Access date: 22. Lashinsky, A. (2001), The Enron Scandal, 21 December 2013]. http://whatreallyhappened.com/WRHARTICLES/enro 8. BIS (Bank for International Settlements)(2013), The n.html [Access date: 19 Augustus 2013]. BIS, http://www.bis.org/about/profile.pdf [Access 23. Lieberman, R.(2013), Corporate Governance Lessons date: 21 December 2013]. from the 2008 Financial Crisis: Assessing the 9. Chamers, C. (2009), Another Day, Another Culprit: Effectiveness of Corporate Governance Through a Corporate Governance – Is it to Blame for the Look at Troubled Companies, Banking Crisis? http://www.jsslaw.com/article_details.aspx?id=99#sth http://www.academia.edu/4419774/Another_Day_An ash.ukEX59CE.dpuf [Access date: 18 October 2013]. other_Culprit_Corporate_Governance_-

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24. Mitra, S, (2012), Role of auditors in corporate 30. RSA (Republic of South Africa)(1990). Banks Act governance in The Light of Satyam scam No. 94 of 1990, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=21 http://www.acts.co.za/banks_act_1990.htm [Access 28528 [Access date: 18 October 2013]. date: 1 September 2013]. 25. Nisa, S. (2009), The Divergent Corporate Governance 31. SARB (South African Reserve Bank)(2004), Banks Standards and the Need for Act Circular 4/2004, 26. Universally Acceptable Governance Practices, http://www.resbank.co.za/internet/Publication/Circ+4 http://www.ccsenet.org/journal/index.php/ass/article/v +of+2004.pdf [Access date: 7 December 2013]. iew/1087/0 [Access date: 17 August 2013]. 32. Seardel (2013).Corporate Governance and 27. OECD (Organisation for Economic Co-operation and Sustainability, http://www.seardel.co.za/corporate- Development) (2011), Corporate Governance and the governance [Access date: 13 December 2013]. Financial Crisis, 33. World Atlas (2013), Countries in the World, http://www.oecd.org/daf/ca/corporategovernanceprinc http://www.worldatlas.com/nations.htm [Access date: iples/corporategovernanceandthefinancialcrisis.htm 18 July 2013]. [Access date: 12 September 2013]. 34. Word Bank (2013), Raising the bar on corporate 28. Ojo, M, 2009, The Role of External Auditors in governance, Corporate Governance: Agency Problems and the http://web.worldbank.org/WBSITE/EXTERNAL/TO Management of Risk, PICS/EXTFINANCIALSECTOR/0,,contentMDK:22 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=14 180291~menuPK:6122987~pagePK:210058~piPK:21 27899[Access date: 12 September 2013]. 0062~theSitePK:282885,00.html [Access date: 18 29. Oliver, B. (2012). Corporate Governance, July 2013]. http://www.financialmarketsjournal.co.za/8thedition/p 35. Yale Global Online (2013), Causes, rintedarticles/corporategovernance.htm [Access date: http://yaleglobal.yale.edu/special_report/728[Access 12 December 2013]. date: 12 December 2013].

446 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

THE EFFECT OF THE FINANCIAL CRISIS ON RISK DISCLOSURES: A COMPARATIVE STUDY OF U.S. AND CANADIAN CORPORATIONS

Michael Maingot*, Tony Quon**, Daniel Zéghal***

Abstract

The effect of the financial crisis on enterprise risk management (ERM) disclosures was examined through a content analysis of the 2007 and 2008 annual reports of S&P 500 and S&P- TSX Composite companies in the energy, materials, industrials, and consumer discretionary sectors. Fourteen types of risk were tracked and categorized. The total number of risk disclosures by S&P 500 companies hardly increased at all from 2007 to 2008, while the total number of risk disclosures by TSX companies increased slightly. Overall, the 2008 financial crisis has not had a major impact, if any, on risk disclosures by major non-financial U.S. and Canadian corporations.

Keywords: Financial Crisis, Risk Diclosure, Canada, the USA

* Telfer School of Management, University of Ottawa, 55 Laurier Avenue East, Ottawa, ON, K1N 6N5 Canada ** Telfer School of Management, University of Ottawa, 55 Laurier Avenue East, Ottawa, ON, K1N 6N5 Canada Email: [email protected] *** Telfer School of Management, University of Ottawa, 55 Laurier Avenue East, Ottawa, ON, K1N 6N5 Canada

Acknowledgements

We acknowledge financial support from the CGA Canada - Accounting and Governance Research Centre in the Telfer School of Management at the University of Ottawa.

1. Introduction strategy (FEI, 2013). The global economic downturn and distressed The world is suffering from a severe financial and financial markets have put pressure on companies to economic crisis which started in 2007 from the have stronger corporate governance, board oversight collapse of the housing market in the US, and which and risk management. The companies that manage ultimately affected major economies worldwide risk in a way that is tailored to changing market (Magnan and Markarian, 2011). In the wake of this conditions and aligned with their overall business crisis, Enterprise Risk Management (ERM) has strategy will emerge as the biggest winners gained substantial momentum as a potentially (O’Riordan, 2011). effective response to risk management challenges There is a growing demand for better reporting (Paape and Spekle, 2012). As the leading approach to of business risks. The demand for better risk reporting managing and optimizing risks, ERM determines how has intensified markedly in response to the global much uncertainty is acceptable within an financial crisis of 2007 and beyond. There is a organization, providing companies with a strategic widespread view that reporting of risks ahead of the risk analysis that cuts across business units and crisis failed to provide adequate disclosures and departments and considers end-to-end processes. By information about the risks (ICAEW, 2011) adopting ERM, a company gains the ability to align Investors need to understand the risks that a its risk appetite29 and risk tolerance30 with business company takes to create value and they want to have information on the sustainability of current value-

29 Risk appetite is the amount of risk, on a board level, an process, remains a key challenge for many firms (Accenture, entity is willing to accept in pursuit of value. It reflects the 2011; Ernst & Young, 2012). entity’s risk management philosophy, and in turn, influences 30 Risk tolerance is closely related to risk appetite. COSO the entity’s culture and operating style. Many entities (2004) indicates that it is the acceptable variation relative to consider risk appetite qualitatively, with such categories as the achievement of an objective. Thus, in setting an high, moderate, low; while others take a quantitative organization’s risk tolerance, its management must consider approach, reflecting and balancing goals for growth, returns the relative importance of all the related objectives and then and risks (Moody, 2008). Risk appetite, which post- crisis align those tolerances with its overall risk appetite (Moody, emerged as a critical foundation of the risk management 2008).

447 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 creation strategies (Beretta and Bozzolan, 2004). Top opportunities" or "risks and rewards" (ICAEW, 2011). managers must therefore be in a position to assure Balancing risks and rewards have always been a investors that risks and uncertainties are well challenge for companies. This has become more managed (De Loach, 2000). This requires not only the pronounced today against the background of the implementation of firm-wide risk management global financial crisis and the great uncertainty in the systems but effective communication about risks that global economy (Price Waterhouse Coopers, 2009; affect a firm’s strategies (Beretta and Bozzolan, Tjaden, 2013). Effective enterprise risk management 2004). (ERM) has emerged as a key, if not the most Maingot, Quon and Zeghal (2012) examined the important, priority for companies (Protiviti, 207; 2007 and 2008 ERM disclosures of non- financial Accenture, 2011; Ernst and Young, 2012). Since the companies on the S&P TSX Composite Index. The financial crisis, weaknesses in ERM practices became hypothesis was that the 2008 financial crisis would painfully visible and companies are currently under have an impact on risk disclosures assuming that a significant pressure to strengthen their risk heightened awareness of risks would be reflected in management systems and to take appropriate actions the annual reports. Contrary to expectations, they to improve stakeholder value protection (Paape and found that the 2008 financial crisis had only a minor Spekle, 2012). impact on the risk disclosures of major non-financial Organizations that take risks and manage risks Canadian corporations. well are more likely to achieve or exceed their The objectives of this study are: objectives (AICPACICA, 1999; Lamm-Tennant and (a) to examine risk disclosures by non-financial Lightfoot, 2010). As mentioned, risk can be viewed as U.S. companies and to determine the impact of the both an opportunity and a threat. In the past, 2008 financial crisis on these disclosures; organizations tended to take a defensive position (b) to examine risk disclosures by non-financial towards risks, viewing them as situations to be Canadian companies and to determine the impact of minimized or avoided. Increasingly, organizations the 2008 financial crisis on these disclosures; have come to recognize the opportunistic side and the (c) to compare the number of risk disclosures by value-creating potential of risk (CAS, 2003; Nocco these U.S. companies with Canadian companies in the and Stulz, 2006; Lamm-Tennant and Lightfoot, 2010). same sectors. Interest in ERM has grown rapidly in recent To facilitate the sectoral comparison between the years with regulators, professional bodies and rating two countries, we selected the four largest non- agencies, like Standard & Poor’s, calling for its financial sectors in Canada in terms of their adoption (Arena et al., 2010; Paape and Speklé, representation on the S&P TSX Composite Index and 2012). In response to this demand, an increasing examined the annual reports of the companies from number of companies is adopting ERM (Protiviti, these four sectors that were listed on the S&P 500 and 2007; Accenture, 2011; Ernst and Young, 2012), but on the S&P TSX Composite Indices. its implementation remains poorly integrated (Mikes, The paper proceeds as follows. Section 2 2005, 2009; Power, 2007). discusses the relationship between ERM, corporate The practice of risk management has shifted in a governance and internal control, and Section 3 fundamental way. In the past, companies managed examines the requirements for the disclosure of ERM risk by "silos", in which different types of risk - information by US and Canadian corporations. strategic, business, credit, market, operational - were Section 4 outlines the research methodology and managed by different organizational units separately Section 5 presents the results and data analysis. (Lam, 2006; Fabozzi and Drake, 2009). However, a Section 6 summarizes the basic conclusions. paradigm shift in managing risk has occurred. Instead of looking at risks from a silo-based perspective, the 2. Erm, Corporate Governance and trend is to take a holistic approach towards managing Internal Control an organization’s risk which has become known as enterprise risk management (Gordon et al., 2009). According to the AICPACICA (1999), risk is the This new approach views all risks together, within a chance of something adverse occurring that will have coordinated and strategic framework (Lam, 2006; an impact on the achievement of objectives. It is Nocco and Stulz, 2006). While there is no right way measured in terms of likelihood and consequences. to manage risk, there is a strong consensus that ERM The challenge for companies is how best to disclose should be integrated throughout the organization. This the risks they face in a way that is clear and sufficient, adds reality to management, as well as engaging more focusing on information that is material to investors, of the organization in an integrated process while not exhaustive or overwhelming (CICA, 2008). (Conference Board of Canada, 1997). People mean different things when they talk about Gordon et al., (2009) suggest that a general "risk" in the context of risk reporting and risk argument gaining momentum in the literature is that disclosure. Usually, they mean risk in the negative the implementation of an ERM system will improve sense of a possibility of incurring losses or reduced firm performance (Barton et al., 2002; Lam, 2003; profits. Sometimes they talk about "risks and Stulz, 2003; CAS, 2003; Nocco and Stulz, 2006; Hoyt

448 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 and Liebenberg, 2009; Paape and Speklé, 2012; Quon et al., 2002). The professional literature indicates that et al., 2012). However, empirical evidence confirming the COSO (2004) ERM document is relatively well this relation between ERM and firm performance is understood, especially by the companies striving to quite limited and is not based on a robust measure of implement it (Sobel and Reding, 2004). Canadian ERM (Gordon et al., 2009). By adopting a systematic companies have largely adopted the COSO (2004) and consistent approach to managing all the risks ERM framework (Martens, 2005), and it has become confronting the organization, ERM is presumed to a world-level template for best practice (Power, lower a firm’s overall risk of failure, to increase its 2007). In developing its ERM framework, COSO performance and, in turn, to add value to the (2004) recognizes that the appropriate ERM system organization (Gordon et al., 2009). will likely vary from firm to firm. In essence, COSO There are many definitions of ERM. The holistic suggests a contingency perspective toward the approach to risk management and an organization’s appropriate ERM system for a particular organization performance value is reflected in the definition given (Gordon et al., 2009). by the Casualty Actuarial Companies need to align corporate governance Society Committee on Enterprise Risk with risk management (Sobel and Reding, 2004). Management: While there are many definitions of corporate "ERM is the discipline by which an organization governance (The Cadbury Report, 1992; The Dey in an industry assesses, controls, exploits, finances, Report, 1994), there is one presented by the OECD and monitors risks from all sources for the purpose of that provides a definition that captures the sense of increasing the organization’s short- and long-term corporate governance within the framework of ERM. value to its stakeholders" (CAS, 2003, p. 8). OECD defines corporate governance as: However, the more popular definition of ERM, "A set of relations between a company’s used in the literature, is the one that was published in management, its board, its shareholders, and other September, 2004 by the Committee of Sponsoring stakeholders. Corporate governance also provides the Organizations of the Treadway Commission (COSO, structure through which the objectives of the company 2004): are set, and the means for attaining those objectives "Enterprise risk management is a process, and monitoring performance are determined" (OSFI, effected by an entity’s board of directors, 2013). management and staff, applied in a strategy setting Enterprise Risk Management is increasingly across the enterprise, designed to identify potential becoming a key element of good corporate events that may affect the entity, to manage risk to be governance. Some companies have developed within its risk appetite, and to provide reasonable sophisticated and institutionalized ways to ensure that assurance regarding the achievement of entity risk is identified and analyzed. Others have no risk objectives" (COSO, 2004, p. 2). management capacity (Adamson, March 22, 2011). The COSO (2004) framework is presented as a While it is impossible to eliminate risks, companies cube, with eight factors - internal, environment, have been developing processes and policies to objective setting, event identification, risk assessment, improve how risks are identified and analyzed. It is risk response, control activities, information these techniques of risk management that are communication and monitoring - in one dimension, increasingly becoming a key component of good the four environments of strategic, operations, corporate governance. reporting and compliance in a second dimension, and The board of directors, senior management, the four organizational levels of subsidiary, business external auditors and internal auditors are the unit, division and entity-level in a third dimension. "cornerstones of the foundation on which effective According to Burton (2008), the COSO (2004) corporate governance must be built", (IIA, 2002). document depicts ERM in a managerial and Sobel and Reding (2004) include "risk owners". These prospective light, normatively defining specific are people in a corporation who are responsible and elements for its implementation, and advocating that it accountable for managing risks. Some large should benefit decision-making and management organizations, especially in banking and insurance, control. ERM can be different things in different appoint a Chief Risk Officer (CRO) or other senior organizations or even within the same organization at executive. Others have risk management committees different times (Arena et al., 2010). Power (2009) or other coordinating mechanisms (Lindsay, 2003; notes the danger of ERM lapsing into "rules-based Lawlor, 2012; Caldwell, 2012). The formation of a compliance", and failing to become embedded in risk committee or the appointment of a CRO sends managers’ decision-making and business processes. A out a strong message that the company is taking risk culture of risk management should be embedded management seriously (Lawlor, 2012). throughout the organization (Bruno-Britz, 2009). What is the appropriate role of the board in The goals of ERM, as presented by COSO ERM? According to Caldwell (2012), traditional (2004), are to create, protect and enhance shareholder models support the view that boards should not be value by managing the uncertainties surrounding the involved in day-to-day risk management. Rather, achievement of the organizational objectives (Barton through their risk oversight role, directors should be

449 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 able to satisfy themselves that effective risk 157, FASB (2006). FASB (2006) formally defines fair management processes are in place and functioning. value and frames its measurement and disclosures of The risk management system should allow risk. FASB (1998) Accounting for Derivative management to bring to the board’s attention the Instruments and Hedging Activities, SFAS, 133, company’s material risks. Management is directly requires mandatory disclosures of financial responsible for ERM. The board should, however, instruments use and risk exposure to financial and assume ultimate responsibility for corporate market risks reported in the footnotes of the financial governance (Sobel and Reding, 2004). The board statements. This standard has been revised by the plays a pivotal role in approving the overall strategy FASB in 2008. and risk appetite, and oversees senior management. It The NYSE Corporate Governance rules now should probe, question and get answers from include explicit requirements for NYSE registrant management to ensure that risk has been fully audit committees to assume specific responsibilities considered in the strategic and business planning with respect to risk assessment and risk management, process (Lindsay, 2003; Sheath, 2010). including risks beyond financial reporting (NYSE Beasley et al., (2008) found that ERM is having 2003). They require that the audit committee discuss impacts on the internal audit function and that these guidelines and policies that govern the process by impacts are greatest when the organization has a more which risk assessment and risk management is complete ERM framework in place. Complete ERM undertaken. Discussions should address major adoption is a significant undertaking and can provide financial risk disclosures and the steps the board has numerous opportunities for internal audit taken to monitor and control such exposures, involvement. including a general review of the company’s risk The AICPA (2010) Audit Committee Brief management programs. The NYSE rules permit the explores the relationship between ERM, corporate creation of a separate committee or subcommittee to governance and internal control (IC). Corporate be charged with the primary risk oversight function governance functions essentially to enable an (Harvard Law School Forum, 2009). organization to reach long-term goals and objectives. In July, 2009, the SEC proposed new rules to ERM exists as a subset of corporate governance, and improve corporate disclosures regarding risk, ICs as a subset of ERM. ICs focus on a smaller scale compensation and corporate governance matters. This within the company, sometimes ignoring the strategic became effective on February 28, 2010. Companies objectives that ERM includes. Knight (2006) argued are now required to implement these new disclosures that corporate governance; ERM and IC are in proxy and information statements, annual reports interrelated and interdependent. He further claimed and registration statements. These disclosures are that corporate governance may be regarded as the glue designed to better enable shareholders to evaluate the which holds an organization together in pursuit of its leadership of public companies and increase corporate objectives. accountability by increasing transparency in the following areas: 3. Disclosures of Erm Information by (a) Risk - by requiring disclosure of the board’s U.S. and Canadian Corporations role in risk oversight and compensation risks. (b) Governance and Director Qualifications - by The mandatory disclosures of risk reporting by the requiring more disclosure about director background Financial Accounting Standards Board (FASB), the and qualifications (SEC, 2009). Securities and Exchange Commission (SEC), and the In Canada, mandatory accounting rules are set New York Stock Exchange (NYSE) are examined by the Canadian Institute of Chartered Accountants here. The FASB and the NYSE require companies to (CICA). In particular, the CICA Handbook Section provide information about their exposure to risk, 3860 requires that firms disclose any information that financial and market risk disclosures and financial assists users of financial statements to assess the risks instrument disclosures. The US GAAP regulations related to financial instruments. These risks include require detailed disclosures for fair value accounting price risk (currency risk, interest rate risk and market (FVA) of financial instruments (FASB, 2006). In the risk), credit risk, liquidity risk and cashflow risk. US, FVA was a default option in accounting for some (Canada adopted International Financial Reporting assets prior to 1993 (i.e. lower of cost or market). In Standards (IFRS) on January 1, 2011 for listed 1993, the FASB, through SFAS No. 115 mandated companies. The IFRS on Fair Value, IFRS 13, is that some securities be accounted for at their fair applicable after January 1, 2013). The US GAAP value, thus directly affecting a firm’s balance sheet regulations therefore require more specific, detailed and income statement. According to Magnan (2009), disclosures for fair value of financial instruments the main rationale for SFAS 115 was the reduction of (FASB, 2008), and accounting for derivative gains trading by financial institutions’ managers (i.e. instruments and hedging activities (FASB, 1998). the ability to choose how and when unrealized securities portfolio gains are recognized into the income statement). This was replaced by SFAS No.

450 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

3.1 Management Discussion and Analysis The MD&A requirements, both in the US and Risk Disclosures Canada, are for information that cannot be standardized. The SEC’s guidance states: Risk disclosures in the Management Discussion & "The MD&A requirements are intentionally Analysis (MD&A), both in the US and Canada are flexible and general. Because no two registrants are voluntary. The US Securities and Exchange identical, good MD&A disclosure for one registrant is Commission (SEC) requires publicly traded not necessarily good MD&A disclosure for another. companies to disclose "risk factors" in their annual The same is true for MD&A disclosure of the same reports (10-K) and to update them in their quarterly registrant in different years." 10-Q reports, if they change. The factors to be Canada has requirements for the MD&A similar disclosed, defined in the SEC’s prospectus to those in the US (ICAEW, 2011). requirements are "the most significant factors that make the offering speculative and risky" (ICAEW, 3.2 Sarbanes - Oxley Act 2011). Both in the US and Canada, securities exchange The US Sarbanes-Oxley Act of 2002 (SOX, 2002) regulators require that registrant firms disclose certain raised the attention devoted to internal controls information, including risk, mainly in the MD&A (section, 404). It has imposed numerous requirements sections of the 10-K reports in the US and in the on companies and boards, CEOs, CFOs and auditors’ annual reports in Canada. In the US, the SEC requires certification of quarterly and annual financial companies (a) to identify any known trends, or any statements. While not directly tied to risk oversight, known demands, commitments, events or compliance should directly map into risk management uncertainties that will likely affect the company’s (Magnan and Makarian, 2009; Harvard Law School liquidity (Regulation S-K, Item 303, paragraph Forum, 2009; ICAEW, 2011). (a)(2)). (b) to describe any known material trends in the registrants’ capital resources, and (c) to describe 3.3 Prospectus and Annual Reports any known trends or uncertainties that will impact on net sales or revenues or income from continuing Firms disclose more about risks in their prospectuses operations. than in their annual reports and do so without The motivation for the requirements is the risk excessive boilerplate (ICAEW, 2011). There is a view that users of the company’s financial statements will that prospectus disclosures about risks are rightly draw unwarranted conclusions about the future from more extensive than those found in the annual report the historical information in the statements (ICAEW, since it is not expected that the annual report would 2011). keep up to the disclosure requirements found in the The Ontario Securities Commission (OSC) in prospectus. The risk considerations are wide-ranging. Canada requires companies to disclose certain Topics include environmental, pricing, foreign information in the MD&A section of the financial exchange, labour relations, competition and all other statements. The MD&A requires that the company: relevant maters (AICPACICA, 1999; Beretta and "discuss important trends and risks that have Bozzolan, 2004). affected the financial statements, and trends and risks According to ICAEW (2011), the prospectus is that are reasonably likely to affect them in the future." an attempt to raise money from people who are It is neither necessary nor useful to provide deemed to be in a state of ignorance about the disclosures about every risk and uncertainty that a business. The annual report addresses those who have company faces. It is important for MD&A preparers already decided to become investors in the business first to identify a complete set of risks and then and, therefore, they can be reasonably assumed not to consider those that merit disclosure (CICA, 2008). be in a state of ignorance about it. Therefore, it should The MD&A should be written for current and not be surprising to find that annual reports currently prospective investors to help them decide whether to disclose less about risks than those found in invest or continue to invest in the entity. It should prospectuses (AICPACICA, 1999; Beretta and provide a narrative description "through the eyes of Bozzolan, 2004; ICAEW, 2011). management". In terms of the content of risk disclosures in the MD&A, it is important to provide 4. Research Methodology investors not only with an explanation of each risk and the likelihood that it will materialize, but also an The 2007 and 2008 annual reports of 189 S&P 500 indication of how its materialization could affect the Index corporations in the energy, materials, company’s business and its performance. Investors industrials, and consumer discretionary sectors were are also interested in understanding management’s examined, particularly the Management’s Discussion risk tolerance. They want to know about actions or and Analysis (MD&A) and the Notes to the Financial strategies, if any, that a company has taken or Statements. implemented to mitigate identified risks (CICA, The focus on these four sectors facilitated 2008). sectoral comparisons with 127 Canadian corporations

451 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 listed on the S&P TSX Composite Index. These four risks and the average number of risks disclosed, sectors comprise more than 81% of the 156 non- before and after the financial crisis; financial companies on the S&P TSX (for 2007 and  the number of TSX corporations disclosing risks 2008). and the average number of risks disclosed, before and Fourteen different types of risks were identified. after the financial crisis; These were categorized into three groups:  differences in the percentages of S&P 500 and • Financial: Foreign Exchange, Interest Rate, TSX corporations disclosing risks and in the average Credit, Market, Economic number of risks disclosed; • Business: Political, Technology, Government  changes in the market capitalization of companies Regulation, Weather, Seasonality on the S&P 500 and TSX Composite Indices. • Operational: Environmental, Operational, It should be noted again that this study looked Supplier, Natural Resource only at the S&P 500 and TSX corporations in the Using content analysis, we identified instances energy, materials, industrials, and consumer where each type of risk was mentioned in the annual discretionary sectors. reports; this mode of analysis has been widely used in the accounting research literature, particularly for 5.1Risk Disclosures by S&P 500 examining social and environmental disclosures Corporations (Milne and Adler, 1999; Zeghal and Ahmed, 1990). The Number of Companies Disclosing 5. Results and Analysis Risk by Type of Risk

The number of disclosures is an indication of how Table 1 displays, by type of risk, the number (and diligently companies respond to the requirements proportion) of S&P 500 companies disclosing each of described previously. While only financial and market fourteen types of risk in 2007 and 2008. For each of risks are mentioned specifically in these requirements, the three general categories of risk, the overall all important risks are to be disclosed. number is the number reporting at least one of the In this section, we examine: risks under that category.  the number of S&P 500 corporations disclosing

Table 1. Number of S&P 500 Companies Disclosing Risks by Type of Risk, in 2007 and 2008

2007 2008 Type of Risk Number Relative Number Relative Frequency Frequency FINANCIAL RISKS Foreign Exchange 163 86% 167 88% Interest Rate 175 93% 183 97% Credit 143 76% 144 76% Market 188 99% 188 99% Economic 189 100% 189 100% Overall 189 100% 189 100% BUSINESS RISKS Political 149 79% 151 80% Technology 95 50% 95 50% Govt Regulation 189 100% 189 100% Weather 98 52% 98 52% Seasonality 87 46% 87 46% Overall 189 100% 189 100% OPERATIONAL Environmental 161 85% 161 85% Operational 52 28% 52 28% Supplier 81 43% 83 44% Natural Resource 24 13% 25 13% Overall 182 96% 182 96%

452 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Overall, all 189 S&P 500 companies reported at types of risk classified as Operational Risks were least one type of risk in both 2007 and reported least frequently, with only environmental 2008. The number of companies disclosing risks risks being disclosed by more than half of all increased the most for interest rate risk (+4%, from companies. 175 to 183), and the second most for foreign exchange risk (+2%, from 163 to 167). No other type of risk The Average Number of Risk Disclosures increased by more than 2. However, if we were to by Sector treat the proportions as independent estimates from random samples (which they are not), then none of Table 2 shows, by sector, the mean and standard these increases would be statistically significantly deviation of the number of risks reported by S&P different from zero. Whether the differences are of companies in 2007 and 2008 (the maximum number practical significance is a subjective judgment. of risks that can be reported by any company is 14). The five types of risk classified as Financial On average, companies in the energy sector reported Risks were reported most frequently, with both more risks than each of the other three sectors. If the market and economic risks being reported by virtually companies in each sector were treated as a random all companies. The five types of risk classified as sample (which they were not), then the differences Business Risks were reported as a group somewhat between the energy sector and each of the other three less frequently, with only government regulation risk sectors would be highly statistically significant (p < being reported by all companies. Finally, the four 0.003).

Table 2. Average Number of Risks Disclosed (out of 14) by S&P 500 Companies by Sector, in 2007 and 2008

Sector Number of S&P 2007 2008 500 Companies Mean Standard Mean Standard Deviation Deviation Energy 40 10.6 1.7 10.7 1.7 Materials 29 9.2 1.7 9.4 1.7 Industrials 54 9.3 1.8 9.3 1.8 Consumer Discretionary 66 9.2 1.8 9.3 1.7 Average 189 9.5 1.8 9.6 1.8

Overall, the number of risks disclosed increased 2007 and 119 (94%) in 2008. slightly from 9.5 in 2007 to 9.6 in 2008, an increase In the Financial Risks category, the number of of 1%). Broken down by sector, the increase is companies disclosing risks increased the most for highest in the materials sector and is non-existent in credit risk (from 101 to 110 or +7%), and the second the industrials sector. most for interest rate risk (from 98 to 103 or +4%) and for economic risk (from 108 to 113 or +4%). In 5.2 Risk Disclosures by TSX Corporations the Business Risks category, the greatest increase in the number of companies disclosing risks was for The Number of Companies Disclosing political risk (from 73 to 77 or +4%). In the Risk by Type of Risk Operational Risks category, environmental risk increased the most (from 98 to 101 or +3%); in the Table 3 displays, by type of risk, the number (and Financial Risks category, foreign exchange risk proportion) of TSX companies disclosing different increased from 119 to 122 or +2%. No other type of types of risk in 2007 and 2008. risk increased by more than 2. However, if we were to Overall, all 127 TSX companies reported at least treat the proportions as independent estimates from one type of risk in both 2007 and 2008. Moreover, random samples (which they are not), then none of Financial Risks were reported by all companies. Of these increases would be statistically significantly the four types of risk classified as Operational Risks, different from zero. Whether the differences are of 121 (95%) of companies reported at least one type of practical significance is a subjective judgment. risk. Of the five types of risk classified as Business Risks, 118 (93%) reported at least one type of risk in

453 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 3. Number of TSX Companies Disclosing Risks by Type of Risk, in 2007 and 2008

2007 2008 Type of Risk Number Relative Number Relative Frequency Frequency FINANCIAL RISKS Foreign Exchange 119 94% 122 96% Interest Rate 98 77% 103 81% Credit 101 80% 110 87% Market 91 72% 92 72% Economic 108 85% 113 89% Overall 127 100% 127 100% BUSINESS RISKS Political 73 57% 77 61% Technology 28 22% 30 24% Govt Regulation 108 85% 110 87% Weather 28 22% 28 22% Seasonality 23 18% 22 17% Overall 118 93% 119 94% OPERATIONAL Environmental 98 77% 101 80% Operational 116 91% 116 91% Supplier 30 24% 31 24% Natural Resource 10 8% 10 8% Overall 121 95% 121 95%

The Average Number of Risk Disclosures companies in the materials sector reported fewer risks by Sector than each of the other three sectors. If the companies in each sector were treated as a random sample Table 4 shows, by sector, the number (and standard (which they were not), then the differences between deviation) of risks reported by TSX companies in the materials sector and each of the other three sectors 2007 and 2008 (the maximum number of risks that would be highly statistically significant (p < 0.005). can be reported by any company is 14). On average,

Table 4. Average Number of Risks Disclosed (out of 14) by TSX Companies by Sector, in 2007 and 2008

Sector 2007 2008 Number of TSX Standard Standard Companies Mean Mean Deviation Deviation Energy 45 8.7 1.7 8.8 1.6 Materials 44 6.8 2.3 7.3 2.0 Industrials 20 9.1 2.3 9.4 2.3 Consumer 18 8.8 1.7 8.9 1.6 Discretionary Average 127 8.1 2.2 8.4 2.0

Overall, the number of risks disclosed increased second highest in the industrials sector (from 9.1 to slightly from 8.1 in 2007 to 8.4 in 2008, an increase 9.4). These increases cannot be considered as of 3.7%. Broken down by sector, the increase is statistically significant, but whether the increases are highest in the materials sector (from 6.8 to 7.3) and of practical significance is a subjective judgment.

454 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

5.3 Comparison of Risk Disclosures for disclosing risks, with a positive difference denoting a S&P 500 and TSX corporations proportion of S&P 500 companies and a negative difference denoting a higher proportion of TSX Differences in the Percentages of companies. The standard errors of the differences are Companies Disclosing Risks by Type of estimated, treating the two groups of S&P 500 and Risk TSX companies as random samples (which they were not). Table 5 displays, by type of risk, the difference in the relative numbers of S&P 500 and TSX corporations

Table 5. Differences in the Percentages of S&P 500 and of TSX Companies Disclosing Risks by Type of Risk, in 2007 and 2008

2007 2008 Type of Risk Difference Standard Error Difference Standard Error FINANCIAL RISKS Foreign Exchange -8% 3.3% -8% 2.9% Interest Rate 16% 4.2% 16% 3.7% Credit -4% 4.7% -11% 4.3% Market 27% 4.0% 27% 4.0% Economic 15% 3.2% 11% 2.8% Overall 0% 0.0% 0% 0.0% BUSINESS RISKS Political 22% 5.3% 19% 5.2% Technology 28% 5.2% 26% 5.3% Govt Regulation 15% 3.2% 13% 3.0% Weather 30% 5.2% 30% 5.2% Seasonality 28% 5.0% 29% 4.9% Overall 7% 2.3% 6% 2.1% OPERATIONAL Environmental 8% 4.5% 5% 4.4% Operational -63% 4.1% -63% 4.1% Supplier 19% 5.2% 20% 5.2% Natural Resource 5% 3.4% 5% 3.4% Overall 1% 2.4% 1% 2.4%

Overall, the relative number of disclosures was statistically significant. higher for S&P 500 companies than for TSX Only the difference in the relative number of companies. Broken down by type of risk, the credit risks reported changed by a noticeable amount, difference was greatest for operational risk by far, from 4% higher for TSX companies in 2007 to 11% with the proportion of TSX companies a +63% higher higher in 2008. than that of S&P 500 firms. All of the remaining differences that were more than very minor showed a Differences in the Average Number of larger relative number of disclosures for S&P 500 Disclosures by Sector than for TSX companies. The differences in the percentages were 30% for weather risk, 27% to 28% Table 6 shows, by sector, the difference in the relative for market, technology, and seasonality risks, 22% for number of risk disclosures between S&P 500 and political risks, 19% for supplier risk, and 15%-16% TSX corporations, with a positive difference denoting for interest rate, economic, and government regulation a higher number for S&P 500 companies and a risks. If these differences were treated as coming from negative difference denoting a higher number for TSX independent random samples (which they were not), companies. then all of them would be considered to be highly

455 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 6. Differences by Sector in the Number of Risk Disclosures between S&P 500 and TSX companies in 2007 and 2008

2007 2008 Number of S&P Number of TSX Sector Standard Standard 500 Companies Difference Companies Difference Error Error Energy 40 1.90 0.37 45 1.90 0.36 Materials 29 2.40 0.47 44 2.10 0.44 Industrials 54 0.20 0.57 20 -0.10 0.57 Consumer 66 0.40 0.46 18 0.40 0.43 Discretionary Average 189 1.40 0.24 127 1.20 0.22

For each of the four sectors, the relative number 5.4 Changes in Market Capitalization of risk disclosures by S&P 500 companies was higher than by TSX companies. However, these differences Table 7 shows the market capitalization (in billions of were much greater for the energy and materials dollars) of companies on the S&P 500 in 2007 and sectors than for the industrials and consumer 2008. The differences between the means and discretionary sectors. The differences in the energy medians indicate how skewed the market and materials sectors would be considered very highly capitalizations are. These differences are the greatest statistically significantly different from zero, if they for companies in the energy sector and the skewness had come from independent random samples (which is highlighted by the sizes of the standard deviations. they did not).

Table 7. Market Capitalization ($ billions) of S&P 500 Companies

2007 2008 Median Mean Stdev Median Mean Stdev Energy 19.7 44.9 89.6 9.62 28.8 69.8 Materials 8.67 14.00 11.92 4.96 8.95 12.51 Industrials 13.04 26.93 50.91 8.48 15.89 24.44 Consumer 11.25 18.47 19.38 6.36 13.08 15.87 Discretionary

Table 8 shows the market capitalization of between the means and medians again indicate how companies (in billions of dollars) on the S&P TSX skewed the market capitalizations are. Again it is the Composite in 2007 and 2008. The differences energy sector with the highest skewness.

Table 8. Market Capitalization ($ billions) of S&P TSX Composite Companies

2007 2008 Median Mean Stdev Median Mean Stdev Energy 2.32 8.79 14.35 1.27 6.08 10.09 Materials 2.13 5.27 9.34 .93 4.00 8.30 Industrials 1.76 3.88 5.22 1.25 2.91 4.70 Consumer 2.16 4.86 6.10 1.70 3.64 5.38 Discretionary

Both tables show how much the market Conclusions capitalization dropped from 2007 to 2008. The markets reacted very quickly to the 2008 financial The working hypothesis was that the 2008 financial crisis. crisis had an impact on risk disclosures by major corporations on the S&P 500 since it was thought that a heightened awareness of risks resulting from the crisis would be reflected in the annual reports.

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Contrary to expectations, a comparison of annual Vol. 35, pp. 659-675. reports before and after the financial crisis found that 6. Barton, T.L., Shenkir, W.G. and Walker, P.L. (2002) the 2008 financial crisis hardly had any impact on the Making Enterprise Risk Management PayOff: How risk disclosures of major U.S. corporations in the Leading Companies Implement Risk Management. Financial Times/Prentice Hall PTR, Upper Saddle energy, materials, industrials, and consumer River, N.J. discretionary sectors. This finding corroborates earlier 7. Beretta, S. and Bozzolan, S. (2004) A Framework for findings based on the risk disclosures of non-financial the Analysis of Firm Risk Communication, The Canadian companies on the S&P TSX Composite International Journal of Accounting, Vol. 39, No. 3, pp. Index (Maingot, Quon and Zeghal, 2012). 265-288. Overall, the average number of disclosures 8. Beasley, M.S., Clune, R. and Hermanson, D.R. (2008) increased from 9.5 to 9.6 (+1.0%) for S&P 500 The Impact of Enterprise Risk Management on the companies, and from 8.1 to 8.4 ( +3.7%) for TSX Internal Audit Function, Journal of Forensic companies (the maximum number of disclosures per Accounting, Vol. IX, pp. 1-20. 9. Bruno-Britz, M. (2009) The Age of EM. Bank Systems company is 14). The average number of disclosures & Technology, Vol. 1, (February), p. 20. per company was higher, but the increase from 2007 10. Burton, E.J. (2008) The Audit Committee. How should to 2008 was smaller for S&P 500 compared to TSX it handle ERM? The Journal of Corporate Accounting companies. This suggests that the S&P companies &Finance, Vol. 19, No. 4, pp. 3-5. followed the requirements for reporting more 11. Cadbury, A. (1992) Report of the Committee on the diligently. Clearly, these increases were not of a Financial Aspects of Corporate Governance, London, magnitude that one might have expected after a major Gee. financial crisis. 12. Caldwell, J.E. (2012) A Framework for Board Oversight Broken down by type of risk, the proportion of on Enterprise Risk, CICA, Toronto. 13. Canadian Institute of Chartered Accountants (CICA) companies disclosing risks was generally higher for (2008) Building a Better MD&A Risk Disclosure, S&P 500 than for TSX companies, except for foreign Toronto. exchange, credit and operational risks. For each of the 14. Casualty Actuarial Society (CAS) (2003) Overview of four sectors, the average number of disclosures was Enterprise Risk Management. higher for S&P 500 than for TSX companies. 15. Committee of Sponsoring Organizations (COSO) of the However, these differences were much greater for the Treadway Commission (2004) Enterprise Risk energy and materials sectors than for the industrials Management-Integrated Framework. and consumer discretionary sectors. 16. Conference Board of Canada (1997) A Conceptual We conclude that the small increases in the Framework for Integrated Risk Management, Ottawa. 17. De Loach, J.W. (2000) Enterprise-wide management: number of risk disclosures by S&P 500 and TSX Strategies for Linking Risk and Opportunities, Prentice- companies after the financial crisis did not make the Hall, London. readers of the annual reports more aware of the 18. Dey, P. (1994) Where Were the Directors, Toronto increased risks that companies faced in the wake of Stock Exchange, Toronto. the 2008 financial crisis. Given the precipitous drop in 19. Ernst and Young (2012) Progress in Financial Services market capitalization from 2007 to 2008, one might Risk Management, Ernst & Young, pp. 1-81. have thought that this might be reflected in the risk 20. Fabozzi, F.J. and Drake, P.P. (2009) Finance, Capital profiles of companies. That this was not the case may Markets, Financial Management and Investment be more indicative of the reluctance of companies to Management, John Wiley & Sons, Hoboken, New Jersey. be totally transparent than of companies not being 21. Financial Accounting Standards Board (FASB) (2008) aware of increased risks. SFAS, 133: Accounting for Derivative Instruments and Hedging Activities, Norwalk, CT: FASB. References 22. Financial Accounting Standards Board (FASB) (2006). Statement of Financial Accounting Standards No. 157 : 1. Accenture (2011) Report on the Accenture 2011 Global Fair Value Measurements, Norwalk, CT : FASB. Risk Management Study. 23. Financial Accounting Standards Board (FASB) (1998) 2. Adamson, R. (2011) Corporate Governance, Risk Accounting for Derivative Instruments and Hedging Management and Corporate Social Responsibility in Activities, SFAS 133, Norwalk, CT: FASB. Emerging Markets: A Symbiotic Relationship, Simon 24. Financial Executives International (FEI) (2013) Is ERM Fraser University, SFU Business. Right for Your Organization? February, pp. 1. 3. American Institute of Certified Public Accountants 25. Gordon, L.A., Loeb, M.P. and Tseng, C-Y. (2009) (AICPA) Audit Committee (2010) Adding Value, Not Enterprise Risk Management and Firm Performance: A Bureaucracy: Linking Governance, Enterprise Risk Contingency Perspective, J. Account. Public Policy, Management and Internal Controls. Vol. 28, pp. 301327. 4. American Institute of Certified Public Accountants 26. Harvard Law School Forum on Corporate Governance (AICPA) and Canadian Institute of Chartered and Financial Regulation (2009) Risk Management and Accountants (CICA) (1999) Managing Risk in the New the Board of Directors, Economy, CICA, Toronto. http://blogs.law.harvard.edu/corpgov/2009/12/17) 5. Arena, M., Arnaboldi, M. and Azzone, G. (2010) The 27. Hoyt, R.E. and Liebenberg, A.P. (2009) The Value of Organizational Dynamics of Enterprise Risk Enterprise Risk Management. Working Paper. Management, Accounting Organizations and Society, 28. Institute of Chartered Accountants in England and

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Wales (ICAEW) (2011) Reporting Business Risks: 43. New York Stock Exchange (NYSE) (2003) NYSE Meeting Expectations. Corporate Governance Rules, NYSE, New York. 29. Knight, K.W. (2006) Risk Management: A Journey not 44. Nocco, B.W. and Stulz, M. (2006) Enterprise Risk a Destination. Paper presented at the Executive Management: Theory and Practice, Journal of Applied Meeting, 20 May, Hotel do Frade and Golf Resort, Corporate Finance, Vol. 18, No. 4, pp. 1-13. Brazil. 45. Office of the Superintendent of Financial Institutions 30. Lam, J. (2003) Enterprise Risk Management: From (OSFI) (2013) Guideline: Corporate Governance, Incentives to Controls, Hoboken, New Jersey, Wiley. January, Ottawa. 31. Lam, J. (2006) Enterprise-Wide Risk Management and 46. O’Riordan, F. (2011) Governance and Risk in a Global the Role of the Chief Risk Officer, ERisk, 25 March, pp. Economy, CA Magazine, June-July, pp. 52-54. 1-5. 47. Paape, L. and Spekle, R.L. (2012) The Adoption and 32. Lamm-Tennant, J. and Lightfoot, D. (2010) Creating Design of Enterprise Risk Management Practices: An Value by Integrating Risk Management with Capital Empirical Study, European Accounting Review, Vol. Management and Overall Business Strategy (on line) 21, No. 3, pp. 533564. 33. Lawlor, B. (2012) Board Risk Committees, 48. Power, M. (2009) The Risk Management of Nothing, Accountancy Ireland, Vol. 44, No. 6, pp. 40-42. Accounting, Organizations and Society, Vol. 34, pp. 34. Lindsay, H. (2003) 20 Questions Directors Should Ask 849-855. About Risk, CICA, Toronto. 49. Power, M. (2007) Organized Uncertainty: Designing a 35. Magnan, M.L. (2009) Fair Value Accounting and the World of Risk Management, Oxford University Press. Financial Crisis: Messenger or Contributor? Accounting 50. Pricewaterhouse Coopers (2009) Extending Enterprise Perspectives, Vol. 8, No.3, pp. 189-213. Risk Management (ERM) to Address Emerging Risks. 36. Magnan, M.L. and Markarian, G. (2011) Accounting, 51. Protiviti (2007) Survey of C-Level Executives with the Governance and the Crisis: Is Risk the Missing Link? Nation’s Largest Companies, Protiviti Inc. European Accounting Review, Vol. 20, No. 2, pp. 215- 52. Quon, T.K., Zéghal, D. and Maingot, M. (2012) 231. Enterprise Risk Management and Business 37. Maingot, M., Quon, T.K. and Zeghal, D. (2012) The Performance, Problems and Perspectives in Effect of the Financial Crisis on Enterprise Risk Management, Vol. 10, No. 3, pp. 95-103. Management Disclosures, International Journal of Risk 53. Sarbanes-Oxley Act, of 2002. SOX (2002) Public Law Assessment and Management, Vol. 16, No. 4, pp. 227- No. 107-204. Government Printing Office, Washington, 247. D.C. 38. Martens, F. (2005) Trends in Corporate Governance and 54. Securities and Exchange (SEC) (2009) SEC Approves the Role of Risk Management, Enterprise Risk Enhanced Disclosure about Risk, Compensation and Management: Rethinking Risk in the 21st Century, pp. Corporate Governance (on line) 1-5. CGA Accounting Research Centre, University of 55. Sheath, R. (2010) Risk Governance - Getting it Right, Ottawa. Accountancy Ireland, Vol. 24, No. 4, pp. 16-18. 39. Mikes, A. (2009) Risk Management and Calculative 56. Sobel, P.J. and Reding, K.F. (2004) Aligning Corporate Cultures, Management Accounting Research, Vol. 20, Governance with Risk Management, Management No. 1, pp. 157-180. Accounting Quarterly, Vol. 5, No. 2, pp. 1-9. 40. Mikes, A. (2005) Enterprise Risk Management in 57. Stulz, R. (2003) Rethinking Risk Management: The Action. Centre for the analysis of risk and regulation Revolution in Corporate Finance, fourth ed. Blackwell (CARR) discussion paper report series, no. 35. Publishing. 41. Milne, M.J., and Adler, R.W. (1999) Exploring the 58. Tjaden, T. (2013) Risk Disclosure: To Reveal or Not to reliability of social and environmental disclosures Reveal, CGA Magazine, July-August, pp. 19-22. content analysis, Accounting, Auditing and 59. Zéghal, D. and Ahmed, S.A. (1990) Comparison of Accountability Journal, Vol. 2, No. 2, pp. 237-256. Social responsibility information disclosure media by 42. Moody, M.J. (2008) ERM: What’s Your Appetite, The Canadian firms, Accounting, Auditing and Rough Notes Company, February. Accountability Journal, Vol. 3, No. 1, pp. 38-53.

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LET MANAGEMENT DRIVE THE DESIRED ORGANIZATIONAL CULTURE AND CULTURE SHIFT

Sanjana Brijball Parumasur*, Patsy Govender**

Abstract

This paper recognizes the need for an evolution of management thought and a shift in the management paradigm. It aims to show how managers can drive the desired organizational culture and culture shift in an environment dictated by complexity, risk, attitudes and behaviours, amongst others. It uses the Competing Values Framework (CVF) to determine the dominant leadership model, focus, direction and organizational culture. A sample of 202 managers was drawn using stratified random sampling based on managerial level (top, senior, middle). Data was collected using a self-developed measuring instrument and analyzed using descriptive statistics in terms of the dynamics of the CVF. Results indicate that the management cadre displays dominance in the monitor and mentor leadership roles, and the organization operates predominantly in the Internal Process Model with a dominant hierarchy culture. Based on these results and taking cognizance of the old and new management assumptions, a model is designed to reflect ‘what’ the leadership has to do and ‘how’ they can bring about a management paradigm shift in the new ever-changing and globalized corporate environment.

Keywords: Managerial Roles, Organizational Culture, Management Assumptions, Management Paradigm Shift, Dynamic Systems

* Discipline of Human Resource Management, School of Management, IT and Governance, College of Law and Management Studies, University of KwaZulu-Natal (Westville Campus), Private Bag X54001, Durban, 4000, South Africa Tel.: +27 31 260 7176 E-mail: [email protected] ** Discipline of Human Resource Management, School of Management, IT and Governance, College of Law and Management Studies, University of KwaZulu-Natal (Westville Campus), Private Bag X54001, Durban, 4000, South Africa Tel.: +27 31 260 7335 E-mail: [email protected]

1. Research Paper

In today’s work climate, the intensifying pressures environmental changes are likely to outperform those compel managers to follow consistency and have a cultures that display rigidity and unresponsiveness to continuous mind-set for long-term organizational ‘external jolts’ (Gomez-Mejia, Balkin & Cardy, success. Culture and its impact on performance seem 2004). A culture shift is a prominent feature for to emerge during ‘externally induced change’, such as today’s organizations that are tasked with multiple competition, technology, the economy or regulatory perspectives that embrace functional rationality as the changes (Childress, 2009). Hence, new strategies and focal point. Leadership culture is people’s meaning aligning shifts in structures must be in place in order which they create, including the tools that they have to be a winner in the marketplace (Childress, 2009). A to mould shared direction, alignment and commitment compelling need exists for strategy, human talent, in the organization (McGuire, Palus, Pasmore & effective management principles and processes for Rhodes, 2009). The business focus is on reshaping high involvement and performance. Thus, a culture strategy and reorganizing, yet less attention is paid to shift dictates the fundamental requirements necessary reshaping the culture (Childress, 2009); and the for business operations. Quinn, Faerman, Thompson mindset, skills and processes of the old strategy may and McGrath (2003) make reference to the use of not suit the new environment. Sometimes the old organizational culture as ‘a lens’ for understanding culture serves as an ‘anchor’ that brings the change and diagnosing the effectiveness of an organization’s process and the implementation of a strategy design, including effectiveness and performance. implementation to a standstill (Childress, 2009). The Managers need to create a corporate culture so study detours from a reactive to a proactive stance by that quality products and services, process and people outlining managers’ well intended efforts to drive the are central (Bank, 1993). Companies that make desired organizational culture and culture shift. cultural adjustments to align themselves with

459 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Previously, a layered hierarchy with fragmented According to Pinto (2012), the old paradigm is jobs was the norm. The difficulty for executives to dominant, centralized, hierarchical, had rigid budgets, deal with culture (if it matters) is that, firstly, most short-term solutions and top-down goal-setting, senior executives lack skill or training to deal with whereas the new paradigm highlights cooperation and culture as their schooling reflected on functional trust, decentralization, inspirational managers, long- excellence and business metrics which was perceived range optimization, participation in goal-setting and as traditional. Secondly, with years spent in the teamwork, amongst others. Management mistakes, organization there is familiarity blindness, and lastly, perpetuated by old paradigms includes withholding the corporate culture is a reflection of the senior team management information, decision-making that is top- with leadership shadowing (Childress, 2009). Senior down, inflexible policies, failure to collaborate, managers need to provide role models and make the dodging blame, avoiding communication (face-to- new culture with processes, reporting lines, skills and face), resisting change, not prioritizing properly, behaviours important. For effective culture change, micromanagement and misunderstanding motivation the following principles need to be understood (Pinto, 2012). Leader sensitivity was considered as (Childress, 2009): weak whereas today sensitivity is the road to building  Top senior executives need to have an adaptive organization (Pinto, 2010). group/team experience to understand the new culture.  Tie culture to a new object to affect all Conventonal wisdom indicates that the correct employees. structure of a business gives the ‘efficiencies,  Spend adequate time by understanding the innovation and agility’ for organizational success and strengths and weaknesses of the present culture before sustenance (McGuire, Palus, Pasmore & Rhodes, implementing a culture change. 2009). Operational decisions are becoming  Have a culture audit in place to measure and complicated and ambiguous, and top managers and track the change. teams are facing difficulty to agree on outcomes to  Indicate a vision of the new culture to move forward (McGuire et al., 2009). They are unable include behaviours, reporting structures, skills and to deal with difficulty in understanding tasks, skilled core processes, amongst others. leaders fail to collaborate, they are constrained and  Obtain the views of customers, clients, operate in “silos and defaulting to traditional suppliers and others about your culture. boundaries and turf battle” (McGuire et al., 2009: 3). According to McCrimmon (2010), in post-industrial  There must be a perceived need for change that will be compelling to employees. organizations, all employees need to engage in managing, knowledge workers know better than their  Senior executives need to lead the process managers (more like partners), and complexity makes and not outside consultants. management more vital. With organizations evolving  A culture change needs ‘open, feedback-rich in the present times, management must be re-invented coaching’, including personal learning at all levels, and re-defined to reap the benefits of knowledge mainly at the top. workers’ full potential and act as culture builders to  A culture change ‘takes hold faster’ with a foster innovation via support mechanisms and natural work group. promote a new vision (McCrimmon, 2010). Also, the  With a scorecard, everyone will know where old paradigm is associated with one right the change process is at all times. organizational structure, there is one way to manage Doz and Prahalad (1991 cited in Carnall, 2007) people, innovation comes from your own industry, outline that organizational solutions (based on and cheap labour is a main competitive advantage, centralization or decentralization) will not meet the amongst others. Alternatively, the new paradigm is to complex modern environment; differentiated and test the organization structure that fits the task, lead integrated processes and structures are needed with people, innovations are likely to be external, and effective information flow. cheap labour will not prove a substantial advantage Managers need to engage in the fulcrum of (Drucker, 2013). business initiatives including empowerment, Some change projects have failed because skills teamwork, information flow, time management and were rewarded which were not appropriate in the customer satisfaction, and extend their gaze to new current business environment (Childress, 2009). The domains. Building a winning culture requires setting author opines that performance measurement and expectations, aligning leaders around a common evaluation, employee compensation, the organization vision and needed behaviours, focusing on delivering of work ‘silos or cross-functional’ has a tremendous the business agenda by instituting a culture of impact on corporate culture, but it can be overlooked. accountability, managing culture and encouraging The different leadership cultures serve different leaders to ‘walk the talk’, and communicating and purposes. With a hierarchy of culture each advancing celebrating victory (Rogers, Meegan & Tanner, culture is able to deal with greater complexity in 2006). leading and obtaining the commitment of others (McGuire, Palus, Pasmore & Rhodes, 2009). When

460 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 executives create a change, they receive sustainable hierarchy (internal maintenance) it is a need for results. This includes acceleration in implementing stability and control. With adhocracy (external business strategies, speed in response to challenges, positioning) a high level of flexibility and stronger organizational capabilities, the development individuality is the focus, whereas with the market of talent and culture, the sustenance of culture, culture (external maintenance) concentration is on effective cross-boundary work and leadership and stability and control. Hence, managers need to first organizational transformation (McGuire et al., 2009). change and therefore, new managerial roles are Carnall’s (2007) simplistic view of both old and critical to drive the desired culture and culture shift. new cultures indicates that the old culture reflects on The roles of the mentor, facilitator, monitor, co- hierarchies, boundaries, internal focus, and ordinator, director, producer, innovator, and the paternalistic second guessing, controlling, analysis broker (Quinn et al., 2003) put into perspective the and risk aversion. The latter (new culture), intended to expectations of a person in a leadership position and promote networking focuses on teams, connections, the fusion of competencies fosters effective external focus, empowerment, action and calculated functioning. Quinn et al. (2003) shed light on the risk taking or innovation, amongst others (Carnall, various roles: 2007). Hence, a vibrant work culture stimulates  The mentor role involves understanding self performance by coordinating human behaviour too. and others, communicating effectively and developing New employees (new ideas) may ‘overwhelm’ employees to facilitate their mobility (Ragins & the established culture but it is management’s task to Scandura, 1997). learn what is needed to drive the desired culture and  In the facilitator role, the manager builds to focus on bold motives for key milestones to be teams, uses participative decision-making and accomplished. With organizational hiring, manages conflict. management can plan and shape the culture for long  The monitor role is concerned with managing term goals. The management paradigm has shifted, information through critical thinking, managing and new management roles and competencies are information overload and core processes. needed. Competencies that set forth the knowledge  The co-ordinator manages projects, designs and skills needed to achieve performance are work and manages across functions. embedded in ‘leadership values’ that are prominent in  The director role involves developing and tumultuous times (Dye, 2000 cited in Zairi & Jarrar, communicating a vision, setting goals and objectives, 2001). designing and organizing. The organizational culture framework  In the producer role, the focus is on working (Competing Values Framework) developed by productively, fostering a productive work Cameron and Quinn (1999) indicates whether an environment, managing time and stress/balancing organization has a predominant internal or external competing demands. focus and whether it aims for ‘flexibility and  The broker role entails building and individuality’ or ‘stability and control’. The four maintaining a power base, negotiating agreement and dominant culture types of clan, adhocracy, market and commitment and presenting ideas. hierarchy prevails within this framework which can  The innovator role involves living with build an organization’s culture profile. Organizational change, thinking creatively and managing and emphasis on core managerial components, for implementing organizational changes. example, customers, stakeholders, employees and When comparing the old and new management leadership tend to outperform organizations without assumptions, essential differences are highlighted these cultural characteristics (Kotter & Heskett, 1992; (Harehall, undated) (Table 1). Wagner & Spencer, 1996). Other authors have Anthony (1994 cited in Senior & Fleming, 2006) alternate labelling of the models in the quadrant, that suggests that some methods of instituting culture is, group, developmental, hierarchical, and rational change depend on education and persuasion and in cultures (Denison & Spreitzer, 1991, cited in Lincoln, other cases, coercion to bring attitude change. Yet, 2010); collaborate, create, control, and compete others rely on bringing changes to ‘recruitment, (Cameron, Quinn, De Graff, & Thakor, 2006, cited in selection, promotion’, including reward and Lincoln, 2010); and clan, adhocracy, hierarchy, and redundancy policies to adjust the workforce market cultures (Cameron & Quinn, 2006). composition, and keep those with the ‘desired beliefs, By using the “Organizational Culture values and attitudes’ linked with the desired culture’ Assessment Instrument (OCAI)” developed by (Dobson, 1988 cited in Senior & Fleming, 2006). In Cameron and Quinn (1999), the profile of an driving the desired organizational culture and culture organization can be identified as clan, hierarchy, shift the pervasive nature of organizational culture adhocracy and market. With the clan culture (internal cannot be emphasized (Wilson & Rosenfeld 1990, maintenance) the focus is on flexibility, concern for cited in Senior & Fleming, 2006). people, including customer sensitivity, whereas with

461 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 1. Old And New Management Assumptions

Old management assumptions New management assumptions  McGregor’s Theory X applies which states that  McGregor’s Theory Y applies which states that people do not like to work, are lazy, and this is people like work and find it to be self-fulfilling. associated for command and control thinking.  The task of leaders is to build and channel  The alignment of organizational goals is via employees’ commitment to organizational goals. instructions that are clear and concise.  Leaders notice that about 90% of the result stems  A system is established and employees are from the system’s design and they serve as designers of expected to adhere to the established system. systems to enhance staff performance.  Once documented, a system is fixed. Variation  There are growing and decaying elements. There is is not recognized in data presentation and variation and statistics to gather knowledge from data interpretation. and to avoid misinterpretations.  According to complexity theory, the one cause  One cannot identify the cause of a result with of failure can be isolated. One develops knowledge certainty. Knowledge relates to acquisition and via experience. development via the application of the scientific  Staff can be motivated with rewards and method. punishment. Survival of the fittest.  Continued use of extrinsic motivators will diminish  Abundance theory applies and states that a commitment. More is accomplished via cooperation. limited resource within a market compels  Markets can be created. Dictates how all the parts competition. Problems can be broken down into inter-relate which constitutes the whole. The aim is to parts. discover the truth, and there is never one answer with  When learning or making decisions reference is the new culture. made to conscious logical thought. With ‘action  When judging present situations reference is also versus thought’ leaders tended to think short term. made to stored memory. The focus is on thinking and concentration with the long term.

It is the way managers operate that they will 2. Research Methods influence the dominant culture in an organization. Without execution of a culture in the past, it is not Participants expected that desired results will be achieved unless the organizational culture is changed (Quinn, A sample of 202 managers (top, senior, middle) was Faerman, Thompson, McGrath & St. Clair, 2011). drawn from a population of 400 managers in a public This paper recognizes the need for an evolution of sector organization in KwaZulu-Natal, South Africa management thought and a shift in the management using a proportionate stratified random sampling paradigm. It aims to show how managers can drive technique based on managerial level (top, senior, the desired organizational culture and culture shift in middle) in order to ensure adequate and suitable an environment dictated by complexity, risk, attitudes representation of employees from the various and behaviours, amongst others. It emphasizes ‘what’ structures of management. According to Sekaran’s the leadership has to do and ‘how’ they can bring (2003, p. 294) population to sample size table, the about a management paradigm shift in the new ever- corresponding minimum sample size for a population changing and globalized corporate environment. of 400 is 196, thereby confirming the adequacy of sample size for the study. The adequacy of the sample for the computation of Factor Analysis was further determined using the Kaiser-Meyer-Olkin Measure of Sampling Adequacy (0.768) and the Bartlett’s Test of Spherecity (2975.330; p = 0.000), which respectively indicated suitability, adequacy and significance. The results indicate that the normality and homoscedasticity preconditions are satisfied. The composition of the sample is reflected in Table 2:

462 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 2. Composition of Sample

Biographical Variable Percentage Managerial Level Top Managers 19.8 Senior Managers 41.9 Middle Managers 38.4 Age <30 years 2.3 30-39 years 14 40-49 years 40.7 +50 years 43 Race Black 22.1 White 41.9 Indian 32.6 Coloured 3.4 Tenure 0-5 years 10.5 6-10 years 16.3 11-15 years 17.4 16-20 years 17.4 21 years and over 38.4 Gender Males 83.7 Females 16.3 TOTAL 100

Measuring instrument Procedure

Data was collected using a self-developed, closed- The questionnaires were administered to middle, ended, precoded questionnaire comprising of two senior and top managers in the Skills Development sections. Section A assessed the biographical data of Department in the target organization and managers managerial level and was measured using a nominal could either respond by posting back the scale with precoded option categories. Section B questionnaire in the attached self-addressed envelope evaluated the eight managerial roles, as identified in or electronically to the researcher. Data was collected the Competing Values Framework, using 40 items over a three month period. which where measured using a 1 to 5 point Likert scale ranging from strongly disagree (1) to strongly Statistical analysis agree (5). Based on the Competing Values Framework, the The validity of the questionnaire was assessed using designed questionnaire enables the researcher to Factor Analysis. A principal component analysis was determine the dominant leadership roles and from that used to extract initial factors and an iterated principal derive the dominant leadership model, which provides factor analysis was performed using SPSS with an insight into the prevailing organizational culture. Orthogonal Varimax Rotation. When an item had two The measuring instrument was designed based or more loadings >0.5, only that with the highest on recurring themes that surfaced when conducting loading was considered to be significant. Eight the literature review on the leadership roles. This factors with latent roots greater than unity ranging ensured face and content validity. Furthermore, in- from 1.9 to 4.52 were extracted relating to each of the house pretesting was adopted to assess the suitability leadership roles respectively, thereby confirming that of the instrument. Pilot testing was also carried out the items and the questionnaire validly measures the using 12 subjects, selected using the same procedures various leadership roles. The reliability of the and protocols adopted for the larger sample. The questionnaire was determined using Cronbach’s feedback from the pilot testing confirmed that the Coefficient Alpha. The overall alpha coefficient of questionnaire was appropriate in terms of relevance 0.893 was obtained and item reliabilities for the 40 and construction and adhered to the principles of items ranged from 0.887 to 0.894, thereby reflecting a wording and measurement. very high level of internal consistency of the items and hence, a high level of reliability.

463 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Descriptive statistics, using frequency analyses, 3. Results percentages, mean analyses and standard deviations were utilised to assess the extent of leadership roles Staff members were required to respond to the items displayed by the management cadre, to determine the assessing leadership roles using the 5 point Likert dominant leadership model and the prevailing culture scale, which were analysed using descriptive statistics type/s. (Table 3).

Table 3. Descriptive Statistics: Assessing Prevailing Leadership Roles of the Management Cadre and Leadership Models

LEADERSHIP MEAN 95% CONFIDENCE VARIANCE STANDARD % TO WHICH ROLE IS ROLE INTERVAL FOR MEAN DEVIATION BEING FULFILLED Lower Upper Bound Bound Facilitator 3.2563 3.1637 3.3489 0.439 0.6624 65.13 Mentor 3.6593 3.5795 3.7391 0.326 0.5710 73.19 Innovator 3.6269 3.5551 3.6986 0.266 0.5160 72.54 Broker 3.6129 3.5359 3.6899 0.306 0.5536 72.26 Producer 3.3950 3.3064 3.4836 0.406 0.6370 68 Director 3.2766 3.1787 3.3745 0.496 0.7040 65.53 Co-ordinator 3.5497 3.4617 3.6378 0.397 0.6301 70.99 Monitor 3.7990 3.7183 3.8797 0.334 0.5775 75.99 Combined Means for Quadrants of the Competing Values Framework Mean Human Relations Model (Facilitator Role and Mentor Role) 3.4578 Open Systems Model (Innovator Role and Broker Role) 3.6199 Rational Goal Model (Producer and Director Role) 3.3358 Internal Process Model (Co-ordinator Role and Monitor Role) 3.6744 Combined Means depicting focus and orientation Internal/External Internal focus and integration (Mentor, Facilitator, Monitor, Co-ordinator) 3.5661 External focus and differentiation (Innovator, Broker, Producer, Director) 3.4779 Flexibility/Control Flexibility and discretion (Facilitator, Mentor, Innovator, Broker) 3.5389 Stability and control (Mentor, Co-ordinator, Director, Producer) 3.5051

It is evident from the mean values (from which  Leaders are able to construct statements and the percent to which the role is being fulfilled is react to that of others effectively (89.6%). derived) in Table 3 that the management cadre in this  Leaders do not lose sight of outputs (81.7%). public sector organization is displaying the various  Innovator role: creative thinking enables leadership roles in varying degrees, which in managers to formulate new ideas (82.2%). descending level are:  Broker role: networking is used as an  Monitor role (Mean = 3.7990; 75.99%) important skill at all levels (89.1%).  Mentor role (Mean = 3.6593; 73.19%)  Co-ordinator role: managers use specific  Innovator role (Mean = 3.6269; 72.54%) skills to plan/monitor projects (87.1%).  Broker role (Mean = 3.6129; 72.26%) Weaknesses:  Co-ordinator role (Mean = 3.5497; 70.99%)  Leaders not convinced that:  Producer role (Mean = 3.3950; 68%)  Most decision in the organization are by  Director role (Mean = 3.2766; 65.53%) negotiations (23.8%) (BR).  Facilitator role (Mean = 3.2563; 65.13%)  The organization strives to optimize time & In order to assess areas of strengths and minimize stress management (21.8%) (PR). weaknesses in each of the aforementioned leadership  The organization provides an effective team- roles amongst the management cadre in this public building environment (21.8%) (FR). sector organization, frequency analyses were  Individuals work productively (20.3%) (PR). conducted for each.  Participatory decision-making takes place Strengths: (19.8%) (FR).  Monitor role:  Every effort is made to translate  Critical thinking allows leaders to formulate organizational goals into sub-goals at various levels of clear arguments (95%). the organization (15.9%) (DR).

464 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

 Employees’ competencies are developed by roles (Mean = 3.3358) to the least extent. Evidently, delegating more responsibilities to them and by the current cohort of managers needs to develop the providing feedback to them (14.4%) (MeR). combined producer and director roles.  Leaders felt that routine shifts their focus Table 3 therefore, indicates that the dominant away from possible outcomes (21.8%) (IR). leadership model in this public sector organization is Table 3 also indicates the mean values of the therefore, the Internal Process Model and the one with combined leadership roles that make up each quadrant the least presence is the Rational Goal Model (Figure in the Competing Values Framework. It is evident 1). from Table 3 that managers are currently fulfilling Table 3 also provides insight into the focus and their roles in the Internal Process Model, namely, co- orientation of the leadership and the organization. ordinator and monitor roles (Mean = 3.6744) to the The organizational preference is negligibly more greatest extent, followed by the roles in the Open towards flexibility and discretion (Mean = 3.589) Systems Model, namely, innovator and broker roles rather than stability and control (Mean = 3.5051). (Mean = 3.6199), and then the roles in the Human Furthermore, it is evident from Table 3 that the Relations Model, namely, mentor and facilitator roles leaders in the organization have a more internal focus (Mean = 3.4578). It is evident from Table 3 that and integration (Mean = 3.566) rather than an external managers are currently fulfilling the roles in the focus and differentiation (Mean = 3.4779). This is Rational Goal Model, namely, producer and director clearly depicted in Figure 1.

Flexibility and Discretion (Mean = 3.603) Innovator 3,8 External=Focusand3.490) (MeanDifferentiation 3.6269 3.6593 3,7 Mentor Broker = 3.625) = 3,6

3,5 3.6129

(Mean (Mean 3,4

3.2563 3,3 3,2 Facilitator 3,1 Producer

3.3950

3.7990

Monitor Director Internal Focus and Integration Integration and Focus Internal 3.2766

 Task, procedures 3.5497  Rules, protocols  Systems Coordinator  Methodologies Stability and Control (Mean = 3.512)  Standardization  Predictability  Multiple mngt. levels  Resistance to change

Figure 1. Dominant leadership model, focus, orientation and organizational culture

It therefore, follows that the various quadrants and models of leadership, prevail in varying organizational cultures, corresponding to the four degrees in this public sector organization with the

465 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 most dominant being the hierarchy culture Merging the new management assumptions of characterized by tasks, procedures, rules, protocols, Harehall (undated) and Senge (1990) with the systems, methodologies, standardization managerial roles and the cultural orientations of the predictability, multiple management levels and Competing Values Framework of Quinn et al. (2003) resistance to change, followed sequentially by the provides insights into the manner in which managers adhocracy culture, the clan culture and lastly, the need to fulfill their roles and what action is needed in market culture. the modern corporate environment. However, the dominant culture in this In order to develop Quinn et al.’s innovator and organization runs counter to the needs of modern broker roles and enhance an open systems model, the organizations and the manner in which they should be new leader needs to: led. Whilst these managerial roles are still relevant,  be effective in working within a dynamic the way in which they should be undertaken need to system (Harehall, undated). Apart from systems change dramatically. The weaknesses identified are changing constantly, there is often a delay between testimony to the poor management focus and actions and results which makes it harder to assess emphasizes the need for an evolution of management cause-effect relationships. Leaders need to constantly thought (Wren & Bedeian, 2009) and a shift in the aim for improvement (Deming, 1986) and to realize management paradigm. that improvement leverage often lies in that part of the system that tends to hinder growth and, in 1. Discussion of Results understanding dynamic rather than detail complexity (Senge, 1990). Senge (1990) believes that problem- Interpretation and recommendations solving requires being able to see where the high leverage or ‘the tipping point’ is; where a change with The leadership can drive the desired cultural a small effort leads to a substantial and lasting orientation by displaying the whole array of improvement. leadership roles and by balancing the competing  realize that results are outcomes of a wide leadership demands by developing paradoxical range of influences many of which cannot be capabilities. However, engaging in behavioural measured (complexity theory) (Harehall, undated). complexity and being ambidextrous is just not enough Hence, systems can only be improved and not when leading in the current ever-changing corporate optimized. The aim is to constantly strive to reduce environment. A shift in the management paradigm is variation which will eliminate the need for inspection clearly needed. In order to make dramatic (Deming, 1986) and to reduce conflict and instability improvements it is necessary to change the way of to the inputs to the system thereby attaining system thinking because the greatest breakthroughs come stability. with breaking the old ways of thinking (Covey, 1991).  draw on the sub-conscious when thinking. Covey (1991) emphasizes that principle-centered The sub-conscious retains memory of past events and leadership is a holistic leadership paradigm that feelings and enables employees to engage in radiant encapsulates the principles of fairness and thinking and the power of association by using compassion and utilizes the talents of employees to diagrams, flow maps, mind maps and cause-effect bring about increased efficiency as well as striking diagrams. It is important to ensure that thinking improvements in personal and organizational patterns and paradigms do not reject new thinking. effectiveness. Seven chronic problems that plague  take cognizance of the contributions of organizations include the lack of shared vision or everyone (thinking: adversarial versus co-operative) values, no strategic path, poor alignment, wrong style, (Harehall, undated). There is never one answer; poor skills, low trust and the lack of self integrity instead it is important to design the best solution by (Covey, 1991). Therefore, leaders need to become incorporating everyone’s contribution by using more enlightened to overcome these problems by thinking models like lateral thinking, six thinking continuously learning in the context of practice hats, brainstorming, as transformation is every (McGregor, 2000), changing hearts, being service employee’s job (Deming, 1986). De Bono (1995) oriented, radiating positive energy, building trust, stresses the need to move away from traditional believing in other people, revising the structure and thinking (perception, judgement and action) to being synergistic. Senge (1990) stresses those parallel thinking (numerous perceptions, various organizations that learn how to uncover people’s parallel possibilities which are explored and validated commitment and develop the capacity to learn and then action is taken). throughout the organization will be effective. The benefit of adopting the new management Having outlined ‘what’ the leadership has to do, paradigm in this quadrant: Far superior designs of the critical question is ‘how’ can leaders do this in the systems that challenge people’s creativity and capture new ever-changing and globalized corporate all employees’ thinking potential thereby enhancing environment? results.

466 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

In order to develop Quinn et al.’s producer and  Understand variation and statistics in order to director roles and enhance the rational goal model, the gain knowledge from data (Harehall, undated) and new manager needs to: recognize that there is variation (special/inherent) in  realize that people like work, view it as a everything. Leaders must be able to present data in form of self-fulfillment and will take responsibility graphic form so that trends and variation can be (Harehall, undated). However, conventional theory readily identified. They must have knowledge of believes that the average man is naturally indolent, statistical process control to enable future lacks ambition, avoids responsibility and prefers to be achievement to be predicted. led (McGregor, 2000). Innovation and the  Challenge their mental models. Mental development of opportunities play a pivotal role in the models are deeply seated assumptions, generalizations long-term survival strategy of the organization. The or image that impact on the actions that we take. ideas come from the total intelligence of the Powerful mental models often inhibit progressive employees of the company. behaviours and insights into new markets (Senge,  Recognize that people come to work wanting 1990). Leaders need to acquire and develop to do a good job and take pride in their work and knowledge through the PDSA cycle – Plan (P), Do leadership has to build and channel that commitment (D), Study (S) and Act (A) and encourage employees by distributing information widely, taking decisions to change their shared mental models through near the work face, listening and changing attitudes institutional learning (Senge, 1990). Wheatley from compliance to instructions to commitment. (2006a) maintains that people fear chaos and view it Leaders need to help employees to develop their as a loss of control yet surrendering to chaos triggers personal mastery and become committed to their own creativity to attain new levels of order and lifelong learning (Senge, 1990). The emphasis is on understanding; hence, chaos creates the situation for self-control and self-direction (McGregor, 2000) new order to emerge. rather than external control of human behaviour. The benefit of adopting the new management  Create markets, not necessarily at the paradigm in this quadrant: System stability and expense of competitors, by anticipating the needs of maximization of the whole system which crystallizes future customers. the vision of the organization, enhances co-operation  Take time to think deeply and concentrate on and teamwork and leads to greater personal and the long term (Harehall, undated) by exposing organizational learning. themselves to extensive training and new thinking. In order to develop Quinn et al.’s facilitator and They need to prepare plans on sound information to mentor roles and enhance the human relations model, get accurate prediction of the future such that the new manager needs to: information serves as an organizing force, thereby  Note that employees survive and progress by preventing paradigm blindness (inability to see co-operation; not competition (Harehall, undated). information that threatens the environment) The fundamental building blocks that evoke the (Wheatley, 2006a). bundles of potential in people are relationships and The benefit of adopting the new management not individuals (Wheatley, 2006b). Time is spent on paradigm in this quadrant: This mindset harnesses a designing and developing teams, which thrive through pro-active, enabling culture with fewer tiers of co-operation and the reduction of conflict. The management, full commitment to organizational existence of trust is the fundamental ingredient in goals, increased creativity of people to achieve a relationships and dictates the bottom-line results of dynamic competitive advantage. business (Covey, 1991; Senge, 1990). This enhances In order to develop Quinn et al.’s co-ordinator teamwork and innovation blossoms as suppliers and monitor roles and enhance the internal process surpass contractual requirements to build relationships model, the new manager needs to: and customers provide feedback which can be  Design systems to enable staff to perform. incorporated to improve service delivery. More can Leaders need to design capable systems and break be accomplished through shared vision, meaning and down barriers between departments that serve each values as it inspires people to act creatively, take other (Deming, 1986) and gain input from employees risks, invent and produce (Wheatley, 2006b) and by listening. In the new paradigm, leaders need to galvanizes an organization (Senge, 1990). build organizations where people expand their ability  Recognize inner drive patterns and structure to understand complexity, crystallize vision and work to best capture that energy (Harehall, undated). enrich shared mental models (Senge, 1990). They need to design the system to allow expression of  Understand that the whole is not the sum of inner needs of employees to secure positive the parts; it is how the parts inter-relate that motivation or design the system to smother characterizes the whole (Harehall, undated). Hence, employees’ desires to contribute. to optimize the whole, leaders must be able to sub- The benefit of adopting the new management optimize some of the parts. The fundamental aspect of paradigm in this quadrant: Better use of the abilities systems thinking is leverage (Senge, 1990). of the employees which results in a win-win situation for all parties.

467 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Figure 2 vividly reflects ‘what’ managers in the they need to do it. new corporate environments need to do and ‘how’

Dynamic systems (delay bet. action & results, improvement leverage in part of system that tends to limit growth) Complexity theory (results due to range of influences: major issues unmeasureable; system can only be improved, not optimized; reduce variation/conflict/instability to inputs, create self organizing systems – less need for leaders to be kept informed/to interfere) Thinking – the sub-conscious (retains memory of past events & feelings, engage in radiant thinking & power of association [diagrams, flow maps, mind maps, cause & Competition (survival through effect diag.], ensure thinking patterns or co-operation, not compet. paradigms don’t reject new thinking) – time spent on designing & devel. teams – thrives through co-operation & reduction of conflict – 3.4578 3.6199 innovation, customer feedback – service; win-win situation)

3.6744 3.3358

Systems (leaders design systems to enable staff to perform – employees (customers) determine capabilities of system – gain input by listening: in touch with work face) Thinking – Analytical versus Holistic (how parts inter-relates characterizes the whole – consider interrelationships than each element to maximize the whole – aids vision, co-operation & teamwork)

Figure 2. Transition to the new Management Paradigm: ‘What’ leaders need to do and ‘How’

2. Recommendations and Conclusion is that by implementing the ‘what’ leaders need to do and ‘how’ they need to do it as depicted in Figure 2, In order to deal with constant change, organizations leaders will be able to channel the desired have to charter a new way forward. Furthermore, a organizational focus, orientation and culture and a new management paradigm is needed to effectively new management paradigm that nurtures continuous overcome current chronic organizational problems. improvement and personal and organizational This means that the leadership cannot be engulfed in a effectiveness. quagmire of protocols and operating procedures, bureacracy, and chains of command that imprison References themselves and cause paradigm blindness. Instead, the leadership needs to make constant improvement 1. Bank, J. (2000). The Essence of Total Quality their pivotal purpose and harness a pro-active, Management. Second Edition. Europe: Prentice Hall. enabling culture. This can be done by creating 2. Cameron, K.S. & Quinn, R.E. (1999). Diagnosing and superior designs of systems that capture employees’ changing organizational culture. Reading: Addison- thinking potential and challenge their creativity Wesley. thereby ensuring full commitment to organizational 3. Cameron, K.S. & Quinn, R.E. (2006). Diagnosing and goals and achieving a dynamic competitive advantage changing organizational culture: Based on the competing values framework. San Francisco: Jossey- and, a win-win situation for all parties. System Bass. stability and maximization of the whole system also 4. Carnall, C. (2007). Managing change in organizations. crystallizes the vision of the organization, enhances Fifth Edition. England: Pearson Education. co-operation and teamwork and leads to greater 5. Childress, J.R. (2009). The principia project … personal and organizational learning. The implication Understanding Corporate Culture and Culture Change

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– Thoughts and lessons from 30 years of experience A Competency Framework. Third Edition. New York: helping senior leaders shift and reshape corporate John Wiley & Sons. culture. London. 19. Quinn, R.E., Faerman, S.R., Thompson, M.P., McGrath, 6. Covey, S.T. (1991). Principle-centered leadership. M.R. & & St. Clair, L.S. (2011). Becoming a Master New York: Summit Books. Manager: A Competing Values Approach. Fifth Edition. 7. de Bono, E. (1995). Parallel Thinking: From Socrates United States of America: John Wiley & Sons, Inc. to de Bono Thinking. London: Penguin. 20. Ragins, B.R. & Scandura, T.A. (1997). The way we 8. Deming, W.E. (1986). Out of the crisis. Second were: Gender and the termination of mentoring Edition. Cambridge, Massachusetts: MIT Press. relationship. Journal of Applied Psychology, 82, 945- 9. Gomez-Mejia, L.R., Balkin, D.B. & Cardy, R.L. (2004). 953. Managing Human Resources. Fourth Edition. New 21. Rogers, P., Meegan, P. & Tanner, S. (2006). Building a Jersey: Pearson Prentice Hall. winning culture. Bain and Company. 10. Harehall. (undated). Comparison between Old and 22. Senge, P.M. (1990). The Fifth Discipline. New York: New Management Assumptions. [Online]. Retrieved Doubleday/Currency, 1-15. on 17 December 2013 from the World Wide Web: 23. Senior, B. & Fleming, J. (2006). Organizational http://www.harehall. co.uk/cvo.html Culture. Third Edition. England: Pearson Education 11. Drucker, P.F. (2013). Management Paradigms: Old and Limited. New. Building Pharmaceutical Brands. Retrieved on 19 24. Wagner, D.B. & Spencer, J.L. (1996). Organizational December 2013 from the World Wide Web: culture and effectiveness in higher education: a test of http://buildingpharmabrands.com/ the Culture Type” and “Strong Culture” hypotheses. 2013/01/20management-paradigms-old-and-new/ Educational Evaluation and Policy Analysis 16(3), 219- 12. Kotter, J.P. & Heskett, J.L. (1992). Corporate culture 241. and performance. New York: The Free Press. 25. Wren, D.A. & Bedeian, A.G. (2009). The Evolution of 13. Lincoln, S. (2010). From the Individual to the World: Management Thought. Sixth Edition. United States of How the Competing Values Framework Can Help America: John Wiley & Sons, Inc. Organizations Improve Global Strategic Performance. 26. Wheatley, M.J. (2006a). Leadership and the New Emerging Leadership Journeys. 3(1), 3-9. Science: Discovering Order in a Chaotic World. Third 14. McCrimmon, M. (2010). A new Role for Management Edition. San Francisco, California: Berrett-Koehler in Today’s Post-industrial Organization. Ivey Business Publishers, Inc. Journal online, July/August 2010. 27. Wheatley, M.J. (2006b). Leadership Lessons for The 15. McGregor, D. (2000). The Human Side of Enterprise. Real World. Leader to Leader Magazine, Summer, 1-3, Reflections. 2(1), 6-15. Retrieved on 19 December 2013 from the World Wide 16. McGuire, J.B., Palus, C.J., Pasmore, W. & Rhodes, Web: G.B. (2009). Transforming your organization. Global http://www.margaretwheatley.com/articles/leadershiples Organizational Development White Paper Series. sons.html Centre for Creative Leadership. 28. Zairi, M. & Jarrar, Y.F. (2001). Measuring 17. Pinto, J. (2012). New Management Paradigms. USA: organizational effectiveness in the NHS: Management Automation World. style and structure best practices. Total Quality 18. Quinn, R.E., Faerman, S.R., Thompson, M.P. & Management, 12(7-8), 882-889. McGrath, M.R. (2003). Becoming a Master Manager:

469 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

CHANGES IN MONETARY POLICY AFTER THE CRISIS - TOWARDS PREVENTING BANKING SECTOR INSTABILITY

Aleksandra Szunke*

Abstract

The instability of the banking sector has become the subject of wider scientific research during the global financial crisis. The financial crisis of the first decade of the twenty-first century began in the U.S. subprime mortgage market and quickly spread to the whole banking sector in the United States as well as in many countries of the global economy. Among five major American investment banks - Lehman Brothers went bankrupt, Bear Stearns and Merrill Lynch were taken over by other banks, and Goldman Sachs and Morgan Stanley were transformed into commercial banks, which were covered by the supervision and regulations of the central bank - the Federal Reserve System. The consequences of the global financial crisis also affected British banks, including The Royal Bank of Scotland, Lloyds Bank, Halifax, Abbey Bank, Barclays Bank and NBC Bank. In Iceland, during the global financial crisis which affected the Icelandic banking sector, three largest banks: Glitnir Bank, Landsbanki and Kauphting were nationalized, which means that the control was taken over by their government. It has caused, that reflections and scientific research on financial stability were replaced by the study of instability in particular in relation to the banking sector. The main aim of the study is to identify the general framework of the response system of central banks on the phenomenon of banking sector instability, in the context of preventing it in a long term. Current - the traditional system proved to be ineffective, because it did not prevent the spread of the factors that led to the destabilization of the banking market.

Keywords: Monetary Policy, Crisis, Banking Sector, Instability

* Department of Banking and Financial Markets, University of Economics in Katowice, Poland, ul. Bogucicka 14, 40-226 Katowice, Poland Mobile: +48 608209790 Fax: +48 322577405 Email: [email protected]

1. Identification of banking sector disrupts the appropriate functioning of the financial instability system. However, each of the researchers refers these shocks to different areas. This indicates that the term In the previous economic theories emphasized that of financial instability is broad and includes both the financial stability (Crockett, 1997; Lager, 1999; Foot, perturbations occurring throughout the financial 2003; Padoa-Schioppa, 2002; Schinasi, 2004), system, as well as its particular segments. However, identified with the equilibrium, is the natural state of in economic theories, the instability of banking sector the financial system. It was believed that the market separately is considered and analyzed very rarely. mechanism, or appropriate government intervention Researchers mainly concentrate on the financial will restore the stability of the financial system. instability in general – when it comes to the whole However, with the growing number of crises in the system. The importance of the phenomenon of global economy in the 80s and 90s. twentieth century banking sector instability has been revealed during the [1], many economists has focused his research on the global financial crisis, when banking sector was analysis of financial instability (table 1). significantly affected by the global destabilization. Considerations on financial stability replaced This substantiates the need for in-depth studies of the searching for answer to the question what is the banking sector instability and identification of the financial instability and what may cause factors that may cause increasing risk of this destabilization of the financial system. phenomenon. A characteristic feature of economists’ considerations over financial instability is that they pay attention to the some kind of ‘external shock’ that

470 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 1. Definitions of financial instability by various researcher

Year of Researcher Definition of financial instability publication Financial instability occurs when shocks to the financial system interfere F. S. Mishkin 1999 with information flow so that the financial system can no longer do its job (Mishkin 1999) of channeling funds to those with productive investment opportunities. Financial instability is a heightened risk of a financial crisis, which is E. Davis (Davis, associated with the collapse of the financial system, entailing inability to 2001 2001) provide payments services or to allocate credit to productive investment opportunities. Financial instability is a situation characterized by three basic criteria: some important set of financial asset prices seem to have diverged sharply R. Ferguson from fundamentals, (Ferguson, 2003 market functioning and credit availability, domestically and perhaps 2003) internationally, have been significantly distorted, aggregate spending deviates (or is likely to deviate) significantly, either above or below, from the economy’s ability to produce. Financial instability are those conditions in financial markets that harm or J. Chant 2003 threaten to harm an economy’s performance through their impact on the (Chant 2003) working of the financial system. W. Allen, Financial instability are episodes in which a large number of parties - G. Wood households, companies or governments, experience financial crises which 2006 (Allen, Wood, are not warranted by their previous behavior and where these crises 2006) collectively have seriously adverse macro-economic effects. Source: Own work.

Perturbations in the banking sector or the (Kokoszczyński, 1994) also point out that an unstable problems of individual banking institutions do not banking system is unable to maintain financial always have to be considered as a threat to the liquidity, and individual banks are unable to cover the stability of the whole banking market, if they are a losses and risks - which inseparably accompany their single phenomenon and there is no contagion effect. activity - from the equity (Rogowski, Mesjasz, 2012). Moreover, some of disturbances in the functioning of Thus, the banking system instability relates to the the banking sector do not have to be transformed into banking system as a whole, but also of its individual a crisis. However, intensification of factors disrupting participants. For the National Bank of Poland, the its functioning can lead to instability of the banking instability - from the point of view of individual sector and create a risk of instability of the financial banks, is associated with a situation when they are not system. In turn, instability in the long term may cause efficient and solvent, do not have an appropriate level the outbreak of the banking crisis, which means total of capital to absorb losses and are characterized by collapse of the sector. Although the phenomenon of inadequate liquidity to conduct its operational activity banking sector instability is still not fully studied, continuously and without any help from the outside there is a considerable number of publications dealing (National Bank of Poland, 2000). with escalating instability in the form of banking In the literature, there are not one commonly crises. They were repeatedly a main topic of the used definition of the phenomenon of banking sector projects and analysis of institutions, which aim at instability. Literature studies also indicate the small maintaining the stability of the financial system, number of publications relating to the transformation including International Monetary Fund [2], and many of the modern banking sector from the point of view economists, such as: F. S. Mishkin [3], G. G. of this phenomenon. In the study assumes that the Kaufman [4], V. Sundarajan and T. J. T Baliňo [5], banking sector instability is the situation with the M. Iwanicz-Drozdowska (Iwanicz-Drozdowska, medium- and long-term liquidity problems of many 2002), A. Sławiński (Sławiński, 2009) and A. banking institutions and a significant deterioration in Ostalecka (Ostalecka, 2009). their financial results, which precludes the appropriate European Central Bank referring to the issue of functioning of the entire sector. The phenomenon of banking sector instability indicates that the banking banking sector instability is also associated with sector is unstable when it is not able to effectively excessive lending of banks, which in the situation of allocate resources among the various sectors of the difficulties of settlement of liabilities by borrowers, economy in a timely manner, properly assess and involves the need to recapitalize or nationalize manage the risk or eliminate shocks. The results of banking institutions. The symptom of instability is the research of Polish economists: J. K. Solarz also an increase in accounts receivable at risk in the (Solarz, 2001) and R. Kokoszczyński banking sector and the surplus of liabilities over the

471 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 market value of bank assets (Iwanicz-Drozdowska,  deterioration in generated financial results, 2002). Furthermore, the instability causes the loss of  decreasing their profitability, confidence to banking institutions (confidence crisis),  insolvency in the medium term, and withdrawal of contributions by depositors, which  increase in receivables at risk in the loan portfolio, may lead to bank run. Banking sector instability can  decreasing of capital adequacy ratios, not be identified with the instability of the financial  high-leverage activities, system. The instability of the banking sector is in fact  significant increase in the volume of lending in a special form of financial instability. During the relation to the deposit activity, global financial crisis, the instability of the banking  increase in systemic risk, market has become a cause of disturbance in the  confidence crisis in banking sector. whole financial system. These are only the main features of the Although, there are not carried out extensive instability of the banking sector, which may be research of the phenomenon of banking sector associated with the other dysfunctions, completely instability, it can be seen that the concept is not clear. disturbing the proper functioning of the market. In fact, the characteristics of banking sector instability The instability of the banking sector may take a have not been clearly formulated. However, the various form from the point of view of different authors of papers in the field of financial instability groups of stakeholders: bank’s managers, indicate that the instability in relation to the banking shareholders (investors), depositors, borrowers, sector and individual banks, is reflected by the central bank, supervisory authority, government following specific features: (scheme 1). They interpret banking sector instability  problems of liquidity and insolvency of banking in different ways. institutions,

Unstable banking system • negative assessment of the financial statements and indicators from the viewpoint of bank's characterizing its activity, the level of profit, total assets and capital management

Unstable banking system •lack or low level of paid dividends, the decline in stock prices, from the viewpoint of deteriorating image of a bank and its competitiveness on the market shareholders

Unstable banking system •low credit rating of banks, lack of confidence to interest payments, from the viewpoint of guaranteed in the agreement and to return the invested deposit, and depositors also the lack of possibility of early payment of invested funds

Unstable banking system •irregularity in meeting financial needs, high requirements for potential from the viewpoint of borrowers in creditworthiness assessment borrowers

•lack of maintaining by commercial banks the appropriate level of Unstable banking system from equity, established in law regulations, as well as failure to meet the viewpoint of central bank prudential standards, set out by applicable law, including the law established by central bank and its authorities

Unstable banking system from •failure to meet the banks' capital requirements and to adapt to the viewpoint of supervision regulations, imposed by supervisors at the national and international authority scale

•inefficiency in meeting companies' financial needs Unstable banking system from •contagion effect, which causes that dysfunction is transferred also to other segments of the financial system, which also reduces the the viewpoint of government efficiency of the whole economy

Scheme 1. Definitions of banking sector instability by various groups of bank’s stakeholders. Source: Own work

The phenomenon of banking sector instability is institutions. It negatively impacts also on the whole considered as a threat not only for banking economy, because (Fetisow, 2002):

472 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

 bankruptcy of one bank (especially large) or a responsibility) (Pyka, 2010b). The objective of problem of the whole system, affects the reduction of maintaining financial stability of most central banks confidence to the banking system and impedes the in the world was not written explicitly in the official transformation processes, implemented involving legal document of functioning of central banks or in banking system, as well as the adversely impacts on other law acts. In addition to Bank of England and the economy of the country and cooperating Swiss National Bank, where was de jure countries; responsibility for financial stability. Burdening  unstable banking system inhibits investment monetary authority of an additional goal - financial processes in the economy and slows economic growth stability, is now one of the most discussed topics. or leads to the recession; Preliminary research of the monetary policy  difficult financial situation of banks is during the escalation of banking sector instability of transferred on the financial condition of others XXI century indicates that the initiatives were late, as institutions; well as had an uncoordinated and random character  the collapse of banking system liquidity (Pyka, 2010a). They were Implemented ad hoc, destabilizes the payment system of the country; without clear and understandable rules. The monetary  instability of the banking system affects the authorities focused on monitoring the consequences supply (quantity and quality) of financial services. of the implemented instruments and on this basis, This justifies the need to search for methods of took further interventions. In fact, there were not restricting and preventing banking sector instability. developed common rules of conduct of central banks Central banks as institutions which guarantee the to the instability of the banking sector, both in terms stability of the banking sector through its instruments of prevention of this phenomenon, as well as reducing can impact on the conditions of functioning of the effects already identified instability in the short banking market. Therefore, tools of modern central and long term. The significance of the research of banks should be adapted to the specifics of the counteracting banking sector instability due to the fact banking sector of the twenty-first century, as well as that early prevention of this phenomenon may be threats that may destabilize the functioning of the essential for the appropriate functioning of the banks, banking institutions. as well as other segments of the financial system and Main pillars of system of response of central the real economy. During the global financial crisis, banks on the banking sector instability central banks have used available instruments to Changes in the way of achieving the objectives reduce the negative effects of instability. However, of monetary policy that have occurred in recent years, analyzing the effectiveness of the initiatives of the determine the evolution of the place and role of monetary authorities in the world, it is noted that the modern central banks, including the development of current response system should be modified. The instruments through which they may impact on the traditional system of response of central banks on the conditions of the functioning of the banking sector. banking sector instability includes only two aspects The main goal - a priority of central banks has (scheme 2): become in fact maintaining financial stability in a short-term restriction of banking sector long term (Pyka, 2010a; Szczepańska, 2008). So far, instability - through standard and non-standard the monetary authorities have recognized financial monetary policy instruments, stability as a public good, about which has to be take long-term restriction of banking sector instability care regardless of monetary purposes (de facto - through instruments of regulatory discipline.

SHORT-TERM RESTRICTION LONG-TERM RESTRICTION OF BANKING SECTOR OF BANKING SECTOR INSTABILITY INSTABILITY

BANKING SECTOR INSTABILITY

t

MONETARY REGULATORY POLICY DISICIPLINE INSTRUMENTS

Scheme 2. Traditional system of response of central banks on the banking sector instability. Source: Own work

473 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Traditional system of response of the monetary Looking at the global financial crisis of the twenty- authorities has focused only on two pillars, including first century, it is concluded that the existing pillars of restriction of consequences of identified instability in the traditional response system of central banks have short and long term. However, the experience of the been, are and will be used to reduce the negative past three decades, and in particular the global effects of instability. They are the basic instruments of financial crisis, show that this system was ineffective, central banks used to stabilize the banking sector. because central banks could not early counteract However, with the increasing frequency and scale of instability of the banking market. periods of instability, it is appropriate to complement Challenge is therefore identifying the elements the traditional system, and at the same time central of the modern system of response of central banks on banks’ tools, of the preventive aspect – early warning the banking sector instability. The potential responses system, based on a mechanism for regular monitoring of central banks on the instability and their effects are of the banking sector (scheme 3). The early warning not subject to of scientific research. Construction of a system would allow central banks to prevent the coherent, multi-elements system of response in short causes of banking sector instability and particular and long term, as well as counteracting the problem of banking institutions, as well as decrease the areas banking sector instability, represents a new approach generating risk, so as not to lead to an instability. to the objective of maintaining financial stability.

LONG-TERM SHORT-TERM COUNTERACTING RESTRICTION OF RESTRICTION OF BANKING BANKING SECTOR BANKING SECTOR SECTOR INSTABILITY INSTABILITY INSTABILITY

BANKING SECTOR INSTABILITY t

MONETARY REGULATORY EARLY POLICY DISICIPLINE WARNING INSTRUMENTS SYSTEM

Scheme 3. Modern system of response of central banks on the banking sector instability Source: Own work

The modern system of response is a three-pillar research around the world, so that this study does not set of instruments of central banks of a preventive devote them too much attention (IMF, 2013). nature, as well as limiting the effects of the potential The second pillar of the response system takes instability. These pillars include three group of into account the analysis of the significance of interventions: regulatory discipline instruments, supporting central  instruments to reduce the consequences of banks in reducing instability in a long term. instability in a short term - standard and non-standard Regulatory discipline are initiatives, as well as monetary policy tools, regulatory and institutional standards of central banks,  instruments to reduce the instability of the which aim at increasing the safety of the banking banking sector in a long term - the instruments of sector in a long term and preventing excessively risky regulatory discipline, activities of banks. Regulatory discipline is  prevention instruments - aimed at characterized by that (Jackowicz, 2007): counteracting instability.  is carried out by special financial supervisory Modern response system of central banks authorities, central banks, deposit guarantee includes primarily methods of reducing the instability institutions, of the banking sector in a short term, such as standard  its methods and scope are defined in the and non-standard monetary policy instruments. They legislation (licensing rules, prudential standards, are traditional tools through which central banks can financial law) (Pyka 2010a), impact on the condition of individual banking  monitoring is based on information that is institutions. The analysis of standard and non- publicly available or confidential, that banks are standard (unconventional, extraordinary) monetary required to prepare, policy instruments in the context of reducing the  impact tools have an administrative nature. instability of the banking sector during the global Finally, the third pillar creates an early warning financial crisis is the subject of numerous scientific system, which is a set of indicators which will be a

474 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 source of information for central banks about the  indicators of the condition of the banking condition of the banking sector. This study indicates institutions, based on data included in the financial the proposals for indicators, from which some have an statements of the individual entities, such as aggregate character (composite indicators), and a part loans/deposits, capital adequacy ratios, banks’ - the individual (unitary) nature. These indicators take effectiveness indicators, financial leverage; into account both the situation of the whole banking  indicators of the condition of the banking market, economic and financial condition of sector, such as LIBOR-OIS spread, financial individual banks, as well as the size of the risk condition indices; associated with the banking activity.  systemic risk indicators, such as the MSE or Among these indicators should be considered the SRISK indicators. following measures (scheme 4):  credit risk indicators, such as aggregated indicators of Credit Default Swap, the Markit iTraxx indices;

INDICATORS OF BANKING SECTOR INSTABILITY

Indicators of the Indicators of the Systemic risk Credit risk indicators condition of the condition of the indicators banking institutions banking sector

Scheme 4. Selected indicators of banking sector instability Source: Own work

These indicators refer to various aspects of the and instrumental framework of monetary authorities functioning of the banking sector, enabling accurate go beyond the traditional understanding of the verification of the condition of the banking functions of central banks, strongly associated with institutions and the whole banking sector. However, prevention activities, as well as regulatory and they require empirical verification from the point of supervisory initiatives. view of their usefulness in the early warning system of central banks. This analysis is currently the subject Literature of further, detailed research. 1. Allen W., Wood G.: Defining and achieving financial Summary stability. Journal of Financial Stability, June 2006. 2. Caprio G.., Klingebiel D.: Episodes of Systemic and The global financial crisis has revealed the need to Borderline Financial Crises. World Bank, Washington D.C., 2003. search for changes in the conduct of monetary policy. 3. Chant J.: Financial Stability as a Policy Goal. Essays on Until then, the central banks have focused on Financial Stability, Technical Report No. 95, Bank of minimizing the possible perturbations of the banking Canada, September 2003. sector. Current conditions of the banking market with 4. Crockett A.: Why is financial stability a goal of public a growing number of threats, increasing the risk of policy? Federal Reserve Bank of Kansas City, instability, require undertaking new methods or “Economic Review”, No. 4, 1997. activities, which may be a form of predictors for 5. Davis E.: A Typology of Financial Instability. central banks, warning against possible risk. The Oesterreichische Nationalbank (Central Bank of study presents a proposal of system of response of Austria), Financial Stability Report No. 2, 2001. 6. Ferguson R.: Should Financial Stability Be an Explicit modern central banks, which would constitute a Central Bank Objective? Monetary Stability, Financial useful tool for monetary authorities to prevent and Stability and the Business Cycle: Five Views, BIS reduce the phenomenon of banking sector instability. Paper, No. 18, September 2003. The three-pillar, coherent system of response on 7. Fetisow G. G.: Ustojcziwost bankowskoj sistiemy. the banking sector instability of the global economy, Finansowaja Akademija pri Prawitielstwie Rossijskoj will allow central banks to cope with the negative Fiedieracji, Kafiedra Bankowskogo Dieła, Moscow consequences of occurring instability, as well as 2002. counteracting this phenomenon by early warning 8. Foot M.: What is “financial stability” and how do we system. The modern response system creates a new get it? The Roy Bridge Memorial Lecture, Financial Services Authority, April 2003. paradigm of central banking, in which the institutional

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9. IMF: Financial crises: characteristics and indicators of 24. Schinasi G.: Defining Financial Stability. IMF Working vulnerability. "World Economic Outlook ", May 1998, Paper No. WP/04/187, October 2004. Washington D.C. 25. Sławiński A.: Causes of global banking crisis. In: Social 10. IMF: Global impact and challenges of unconventional Science against the crisis on the financial markets. monetary policies. IMF Policy Paper, Washington D.C. Economic and Social College of Warsaw School of October 2013. Economics, Warsaw 2009. 11. Iwanicz-Drozdowska M.: Banking crises. Causes and 26. Solarz J. K.: International financial system. solutions. PWE, Warsaw 2002. Comparative and institutional analysis. Warsaw, 12. Jackowicz J.: Market discipline during integrating Manager and Banker Library, 2001. financial markets of European Union. „Bank and 27. Sundarajan V., Baliňo T. J. T.: Banking crises: cases Credit” No. 10, 2007. and issues. IMF, Washington D.C. 1991. 13. Kaufman G. G.: Banking and currency crisis: a 28. Szczepańska O.: Financial stability as a goal of central taxonomy and review. Loyola University of Chicago bank. Theoretical and comparative study. Scholar, Working Paper, November 1999. Warsaw 2008. 14. Kokoszczyński R.: Money and Capital Market Reforms in Poland. In: The development and reform of the [1] According to G. Caprio and D. Klingebiel after financial system in Central and Eastern Europe. Bonin 1980, there were 69 banking crises in developed and J., Székely I. P. (ed.), Edward Elgar Publishing 1994. developing countries. Successive crises were characterized 15. Lager J.: Monitoring Financial System Stability. by more and more new features and the increasing scale Reserve Bank of Australia Bulletin, 1999. and frequency of occurrence. This was due to the increasing 16. Mishkin F. S.: Global Financial Instability: Framework, interdependence of the global financial system (Caprio, Events, Issues. Journal of Economic Perspectives, Vol. Klingebiel, 2003). 13, No. 4, 1999. [2] IMF defines banking crisis as actual and potential 17. Mishkin F. S.: The economics of money, banking and run on banks, or their bankruptcy, which cause the financial markets. HarperCollins, London, 1995. suspension by banking institutions settling liabilities or – to 18. National Bank of Poland: Financial stability report in avoid it - require recapitalization them on a large scale by Poland. Unpublished, Warsaw 2000. governments (IMF, 1998). 19. Ostalecka A.: Banking crises and methods for their [3] Financial crisis is a situation, when there are overcoming. Difin, Warsaw 2009. serious distortions on the financial market, manifesting by a 20. Padoa-Schioppa T.: Central Banks and Financial significant decline in asset prices and the bankruptcy of Stability: Exploring a Land in Between. Presented several financial and non-financial institutions (Mishkin, during „Second ECB Central Banking Conference”, 1995). Frankfurt am Main, October 24-25, 2002. [4] Banking crisis is a situation characterized by bank 21. Pyka, I. (2010a), Central bank on modern money run, collapse of financial institutions or large government market. C.H. Beck, Warsaw. intervention and a significant undermining of the security of 22. Pyka, I. (2010b), New paradigm of central banking. In: other institutions (Kaufman, 1999). Economics, Finance. Modern challenges and [5] According to V. Sundarajan and T J. T. Baliňo, development trends. (ed.) J. Harasim, T. Kraśnicka, 4th financial crisis is a situation when market value of the Scientific Forum of University of Economics in assets of a large group of financial institutions is less than Katowice. Publishing House of the University of their liabilities, which leads to run or changes in their Economics in Katowice, Katowice. portfolios, the collapse of some financial institutions and 23. Rogowski W., Mesjasz Cz.: Definitions of financial government intervention (Sundarajan, Baliňo, 1991). stability. In: Corporate governance and stability of financial sector. P. Urbanek (ed.), published by University of Łódź, Łódź 2012.

476 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

CLAN GOVERNANCE AND LANDLESS SOCIAL CAPITAL: AN ANTHROPOLOGICAL STAKEHOLDERSHIP MODEL

Roberto Moro Visconti*

Abstract

Traditional corporate governance models in Western countries have been severely shaken by the still ongoing recession, whereas in developing countries backward and unrefined stakeholdership models have provided an involuntary shelter from financial shocks. Clan governance rotates around informal relationships, which concern also untitled land, intrinsically unfit for collateral lending. Comparison between the West and the Rest does not suggest automatic dominance of formal governance patterns, but rather painfully converging standards, under the centripetal influence of disordered globalization, which may flatten cultural differences, up to the point of spoiling valuable “biodiversities”.

Keywords: Nexus of Contracts, Property Rights, Culture, Poverty Traps, Family Governance, Microfinance, Globalization

* Department of Business Administration, Universitä Cattoliea del Sacro Cuore Via G. Cardueei, 32 20123, Milano, Italia Tel. +(39)-0289072549 Fax +(39)-0289073293 Email: [email protected]

Beyond Western Corporate Governance capital. The corporate governance mechanisms provide this assurance”. Traditional corporate governance refers to the system A core issue of corporate governance is by which corporations are directed and controlled, concerned with the agency problem, sometimes within a typical Western-style institutional system. referred to as separation of ownership from control, Governance issues are so typically concerned with within firms that can be interpreted as a Coasian corporations, whose codified structures specify the nexus of contracts among different resource holders. distribution of rights and responsibilities among Agency relationships arise whenever an investor, different stakeholders (directors, managers, acting as a principal, delegates a managing agent to shareholders, creditors, auditors, regulators, perform some service. debtholders, suppliers, clients, etc.). Since these relationships are not necessarily According to a seminal survey (Shleifer and harmonious, conflicts of interests may easily arise, Vishny, 1997) “corporate governance deals the ways and so agency theory is primarily concerned with the in which suppliers of finance to corporations assure binding mechanisms and incentives that principals themselves of getting a return on their investment. may use with agents to get their money back, possibly How do the suppliers of finance get managers to with a fair and risk-adjusted gain. return some of the profits to them? How do they make In an ideal world where managers already own sure that managers do not steal the capital they supply all the money they need for investments, principals or invest it in bad projects? How do suppliers of would coincide with agents and no agency conflict finance control managers? At first glance, it is not would arise; the problem surges whenever specialized entirely obvious why the suppliers of capital get managers lack the money they need for investments, anything back. After all, they part with their money, but also when financiers need the managers’ expertise and have little to contribute to the enterprise and professional skills to properly manage their afterward. The professional managers or money: mutual convenience is the natural glue behind entrepreneurs who run the firms might as well any agreement. abscond with the money. Although they sometimes According to agency theory (see Kostyuk et al., do, usually they do not. (...). In fact, the subject of 2011), in imperfect labor and capital markets, corporate governance is of enormous practical managers will inevitably seek to maximize their own importance”. And again ’’people who sink the capital utility at the expense of shareholders. Agents- need to be assured that they get back the return on this managers have the ability to operate in their own conflicting self-interest rather than in the best interests

477 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 of the firm. This happens as a consequence of overtake corruption, so composing otherwise asymmetric inside information (since they know troublesome governance issues. Cultural differences better than shareholders whether they are capable of and legacies, so meaningful in order to discriminate meeting the shareholders' objectives) and between different clans (an ethnic surrogate for physiological uncertainty (since myriad factors corporations), are then considered, again stressing contribute to final outcomes, it may so not be evident their governance implications. whether the agent directly caused a given outcome, The mystery of hidden capital - formally present positive or negative). but in practice not accountable (for instance, as a Critiques of traditional governance research consequence of missing land titling) - is then based on agency theory have noted its “under- sequentially considered, together with its governance contextualized” nature and its inability to compare consequences: no titling, no possibility to issue accurately and explain the diversity of corporate guarantees against debt underwriting, which often governance arrangements across different institutional becomes a sort of mission impossible, with dire contexts (Wright et al., 2013). economic consequences. Problem solving hints, The utopian landscape of complete contracts and starting from land reform, are then proposed, within a comprehensive regulation, ideally able to cover with practical scenario, where unconventional governance their legal provisions all the possible states of the issues are discussed. world, has to realistically face an imperfect context, Some concluding remarks consider cultural where unforeseen and risky events are always governance implications of erratic globalization, possible and likely to occur. Catching up economies, acting as a powerful catalyst of standardization, where set free from outdated colonial ties, experiment the flattened West tries, not always for the best, to variegated governance models and their still unstable homologate the polyhedral Rest, within a disordered equilibriums, ignited by experimental enthusiasm, are clash of competing civilizations (Huntington, 1993). still to be codified by enduring critical experience. Better governance brings to greater access to Tribal Social Capital financing (Claessens and Yurtoglu, 2013), a key development booster. Social capital derives from meta-economic social The aforementioned framework is the standard gatherings such as family or ethnic clans and it refers playfield of corporate governance issues, within to local connections and forms of association that typical corporations; lesser attention is however express trust and norms of reciprocity and support traditionally dedicated to informal economic within and between communities. It includes also gatherings, such as family clans, which are not legally social networks, which represent an opportunity incorporated, especially in under-investigated deriving from structures of linked individuals, developing countries. But this lack of formal increasingly even on the Internet, by several different boundaries does not mean that undetected problems possible kinds of interdependency. Some authors do not exist: they are simply disguised and ill equate social capital with trust and trustworthiness represented. whereas others appear to regard social capital as a Balanced experience suggests that the edge of form of social networks (Durlauf, 2002), considering chaos is dangerously close to both excessive also its impact towards stakeholders (Garriga Coats, governance order and antithetic libertarian disorder. 2011). Starting from this empty space in the current People that are engaged in forms of association academic literature, this paper tries to fill a vacuum, develop a social framework of common cultural analyzing how “clan governance” works and which values, ties and beliefs, and they develop a common are the main problems behind this unconventional - social anesthesia that, with its membership but impressively common - scenario. entitlement, partially relieves them from a painful The interdisciplinary contents of this eclectic existence. Social - associational - capital is concerned paper goes beyond the traditional pathway of standard with the mutual embeddedness of social and corporate governance issues, being linked to economic life (Bordieu, 1977), where gifting, sharing, anthropological methodologies that describe unusual solidarity and reciprocity are considered as core governance patterns, such as those concerning ethnic values and the clan acts as a defensive and protective clans in developing countries. Non-conventional structure. Partial vested interests of a clan bring attention is also dedicated to property-related nexuses however to parochialism and exclusion for non of contracts, which matter when missing, as it is the members, with huge governance implications. case in most developing environments. Clan belonging becomes a crucial matter, The paper is organized as follows: after a discriminating between acritical inclusion and general description of social capital, derived from indefinite outcast. informal ethnic clan relationships, its survival Separation of ownership and control, so legacies, normally taking place in unforgiving meaningful in traditional corporate governance, is environments, are critically examined. Social trust is here much less clear cut. then thoroughly examined as a necessary mean to

478 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Within informal societies, social capital is the at the core of any country's development. At its most connecting economic glue among otherwise scattered elemental level, this boils down to a matter of trust". stakeholders, presiding over un-codified governance Harrison and Huntington, 2000, p. 299, point out that enforcement. Social capital, with its intangible and "societies with a narrow radius of identification and non monetary contents, greatly differs from market- trust are more prone to corruption, tax evasion, and oriented traditional equity of Western corporations. nepotism" and a shortsighted and limited Governance implications are substantial and environment, that is suspicious and mistrustful ontologically rooted in nexuses of hardly comparable towards innovation, openness and transparency, economic and social contracts. According to Bowles hardly looks development friendly. and Gintis, 2002, communities can provide less costly solutions to various principal / agent and collective Family Clan Survival Legacies goods problems than can markets or government interventions; community social capital, as underlined In hard and unforgiving environments, where struggle by Glaeser et al., 2002, derives from the aggregation for survival leaves little space for other more of individual decisions. sophisticated worries (including governance Togetherness scans the step from personal to ruminations), people, who typically belong to a collective action and responsibility. In each clan there common family or tribe, live together in is a respectful leader, which rules an informal board comprehensive clans, scattered over vast and hostile of directors. Culture - as well as shared cultural norms territories. Nurturing the family stands out as the first and behaviors - is also greatly influenced by family ancestral commandment, reminding that its perimeter ties, whose perimeter is variable and changing, and concept gets wider in non European cultures, because of the disrupting social impact of migration, going far beyond the elsewhere dysfunctional nuclear demographic changes or instruction. Family ties are entity of mother-father-children. Small groups allow formed and changed with marriage and - later on - its to flee danger more easily and to flexibly adapt to fertility rate impacts. Especially in traditional perils, constantly moving to allegedly safer places. societies, each union strengthens existing network ties Tribalism is questioned to be a stumbling block to and forges new ones, as Munshi reports (Banerjee et progress (Calderisi, 2006, p. 85) and ethnic ties in al., 2006, p. 397), since marriage is a permanent bond Africa or elsewhere are a magnified expression of and divorce is hardly an exit option. family loyalty, since they work as a safety net in times Intra-community ties, connected with bonding of distress and they somewhat soften the effort social capital, are particularly strong and pervasive in towards growth. closed rural environments, where contacts with the Sharing and solidarity come out as culturally external world are rarefied. In such a context, rooted survival values within clans, standing out as a backward cultures are particularly likely to perpetuate supreme ethical canon, out-casting with a permanent intergenerational poverty, difficult to eradicate from ostracism those who do not comply with these its ancestral legacies. unwritten codes of conduct. Individualism, which is The social "glue" of capital depends on the so highly prized in the Western world symbolizing degree of cohesion (Boytsun et al., 2011), affiliation fragmented governance, in poor environments and sense of belonging within the clan members - as epitomizes unhappy and often lethal exclusion. The Reinikka reports "fractured, heterogeneous popularity of group lending - as a key microfinance communities (...) have little capacity for collective feature - in underdeveloped countries is a cultural actions" (Easterly, 2008, p. 187). Mutuality and consequence of different life styles, with an intrinsic gratuity are the true lasting glue of social capital. and often under exploited potential. Both social capital and cultural values are so Within a community, social learning process let different not only within underdeveloped countries, that information, knowledge and behaviors are but also comparing the Rest with the West, where diffused among its members, following an imitative autonomy and individualism are core cultural aspects pattern within the social network where the process - in poor countries, being alone is an unaffordable takes place. The degree of openness of the community habit, putting survival even more at risk. In Western towards the outside world shapes the level and the countries unbound individualism is often projected intensity of social learning but also its cultural towards selfish and empty goals, and it disrupts social stability, since new ideas and habits have to interact values and self-nourishes with a solipsistic ego, that is with the historical background, possibly in a smooth so different from the rural mutuality of most and gradual way. Unprecedented models and underdeveloped countries. It is the ephemeral triumph experiences may bring to cultural shocks and loss of of the unbound Prometheus, passing from old identities, especially if they are suddenly imposed by physical chains to new intangible ones, concealed by the neighbors within the community or the outside an apparent freedom. changing environment, even with traumatic events Moyo, 2009, p. 58, claims that "social capital, by (natural calamities, epidemics, wars ...). Such models which is meant the invisible glue of relationships that and experiences are hard to detect at the moment but holds business, economy and political life together, is

479 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 they have long lasting side effect, preventing agency theory, stewardship theory, social capital integration. theory, and transaction cost economics. Harrison, 1985, notes that "there is evidence that When community belonging is more important the extended family is an effective institution for than individual merit, it is hard to approach a market survival but an obstacle to development". And Lipset economy - both parasitism and selfishness are easy and Lenz add up that "solidarity with the extended temptations. Transactions always bear social costs and family and hostility to the outsider who is not a are difficult to design, regulate and check, especially member of family, the village, or perhaps the tribe can outside the discriminating perimeter of the social produce a self-interested culture" (Harrison and network. Huntington, 2000, p. 119). If only we think about so Meritocracy becomes a very relative concept and many underdeveloped countries and their socio- it seriously risks being drowned in static cultures economic ethnic ties, that are culturally so deeply which pursue an egalitarian status quo. People are rooted, we may begin to understand why progress and selected according to their membership, not to their development are so difficult to start up and keep intrinsic value or merit, and this fact favors a brain going. drain of the smartest that have a strong incentive to Social capital is strongly - but not exclusively - get out of the backward and -sometimes- brutal family linked to ethnicity, a concept that encompasses tribes, clan. Civic sense is also neglected and common good enlarged family clans, races and nationalities, as it outside the family boundaries is hardly recognized as broadly refers to a group identity, speaking the same a cultural value. Bad choices are often persistent and language, typically being native from the same place, culturally rooted. often showing somatic differences with other Castes represent the deepest formal and ethnicities, with rooted culturally distinctions and substantial division between ethnic groups, each with different ritual traditions. its own social capital ranking position in the society, as it is sadly exemplified by Brahmins, the architects Beyond Social Trust: from Amoral and guardians of the Indian caste system, which Familism to Corruption seems almost impossible to disrupt, due to its ancestral pervasiveness and inculturation. The stronger the ties within the family clan, the Social capital and networks can have positive weakest the relationship outside it - trusting strangers externalities on outside parties to the extent that they becomes difficult and interacting with them requires are not discriminatory, otherwise they can promote high transaction costs, whereas within the family intolerance, racism (a “cultural” influence afraid of entourage nepotism and corruption are the norm. In diversity?), exclusion and even violence to non- the Republic (book 5, 464), Plato abolishes the family members. Indifference is a silent and subtle form of for the guardians, to avoid nepotism and amassing of violence, especially towards the poorest. private wealth. Like it or not, family ties, especially Social trust is a by-product of social capital. A those between parents and children, are the main society's ability to compete globally is conditioned by forces that underline institutionalized social classes, high-trust or low-trust, and the latter is typical of shaping family governance. underdeveloped countries less effective in shaping In a society of amoral familists, no one will and governing large and complex social institutions further the interest of the group or community except (Fukuyama, 1995). as it is to his private advantage to do so - corruption Corruption produces highly unbalanced effects and deviance from meritocracy grow up an automatic on the stakeholders that, willing or not, pivot around and unsurprising effect. Family is a value to preserve, it. And private gain at public expense is the most to the extent that it does not fall into amoral familism, probable gloomy outcome - "all animals are equal, but so harmful even in developed countries and being a some animals are more equal than others" is the well primary cause of their stagnation (Banfield, 1958). known statement of George Orwell’s "Animal Farm". Clan governance shows a radically different Corruption is nurtured by asymmetric and stakeholdership paradigm, with less clear cut principal distorted family or clan ties and it develops in secrecy - agent dichotomy, a pivoting theoretical concept and lawlessness, within a private club where only the within Western governance principles. Family strict beneficiaries, necessary to develop it, are governance of Western companies, typically less carefully admitted - the larger the association, the sophisticated than that of listed public companies, is higher the danger that embarrassing information leaks less dissimilar to clan governance. According to out. Arrengle et al., 2007, in family firms two forms of The poor and underserved, being almost by social capital coexist: the family’s and the firm’s. definition powerless, are unsurprisingly severely hit Eddleston et al., 2010, show that trust is a by corruption and its highly detrimental effect on governance mechanism and theoretical construct of development, with its well known negative impact on particular relevance for family firms, encapsulating investment and consequent lower economic growth. some of their advantages and pitfalls. Trust is also According again to Lipset and Lenz, corruption linked to theoretical governance frameworks such as is harmful to development also because it

480 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 concentrates resources where bribes are more trivial real estate bubble in the U.S., which triggered a efficiently collected and managed (larger, hard- to- sub-prime domino effect. manage projects such as big infrastructures or natural The issue of landownership and distribution is resources exploitation fields), diverting funds from particularly complicate and paradoxical; it occurs in other traditional pro-growth areas, such as education, backward rural places, since everybody’s untitled land where expenditures, efforts and results are more risks becoming nobody’s territory, bringing other visible and accountable, making corruption much author to wonder “whose land is it, anyway?” more difficult to spread and prosper (Harrison and (Maathai, 2009). Uneven titling may however deepen Huntington, 2000). social differences between full proprietors and illegal Microfinance is a good tool in order to go tenants. beyond family ties, as it has proved effective even Land property guarantees are the cornerstone of outside the clan boundaries. Group lending, a basic bank lending, above all for what concerns mortgages. building block of microfinance, is a well known In Western countries we are used to mortgage-backed example of united social network, where the poor help loans, to the point that we often tend to undervalue themselves, reengineering powershift, and struggling their importance, which is nevertheless daily together for mutual survival. perceived by the many that can afford to buy a real estate property only if a mortgage bank acts as a The Mystery of Hidden Capital: an provider of finance. Informal Nexus of Property Contracts The problem with so many developing countries, especially in scattered rural areas, is that land titling is Hernando De Soto’s Mystery of Capital is a simply missing and consequently the land and the celebrated and original book that tries to explain (as it often poor constructions above it are just unofficially is reported in its subtitle) “why Capitalism Triumphs occupied by its informal owners, following ancestral in the West and Fails Everywhere Else" - a thesis customary rules - and this very land is hardly useable substantially consistent with Landes' (1998) historical as a guarantee, since they cannot demonstrate to have Eurocentric approach. According to the Peruvian a real and officially recorded property. Houses can be economist “the poor inhabitants of [underdeveloped] built either on the sand or on a rocky surface, this nations— five-sixths of humanity—do have things, being a biblical metaphor for ephemeral versus long but they lack the process to represent their property lasting investments. Social capital is so linked not and create capital. They have houses but not titles; only to clan ties, but also to the presence of informal - crops but not deeds; businesses but not codified and so not enforceable - property rights. statutes of incorporation. It is the unavailability of Many developing countries have inherited their these essential representations that explains why legal framework from their colonial past, but since people who have adapted every other Western their independence the world has consistently invention, from the paper clip to the nuclear reactor, changed and a managing class of trained civil servants have not been able to produce sufficient capital to is in most cases still missing and highly wanted. Good make their domestic capitalism work. This is the institutions are needed to protect increasingly mystery of capital”. complex property rights and private property - a right Capital is described as the igniting force behind but also a gift to be shared - is a critical institution for productivity of labor and in underdeveloped countries, fostering economic development. Colonization and “most of the poor already possess the assets they need then decolonization have brought to erratic and unfair (...) but they hold their resources in defective forms: land redistribution, arbitrarily expropriating and houses built on land whose ownership rights are not recomposing the puzzle of rural entitlements, whereas adequately recorded, unincorporated businesses with the interests of poor peasants have always been undefined liability, industries located where financiers dominated by more powerful groups of pressure. and investors cannot see them” (De Soto, 2003, p. 5). It takes many complex steps and significant Wealth of the poor exists, but it is paradoxically financial resources to legally start up a business or hardly exploitable. When land and property have clear own a house in different parts of the modem world. titles, reducing litigation and frauds, their value and The records of who-owns-what are often puzzling fungibility dramatically increase, easing an otherwise and, if they are improperly kept, they can bring to almost impossible intermediation, and following long legal disputes. Where the poor are opposed to levered value patterns. large landowners, the latter are typically favored by The land issue is central in corporate their influence on not always impartial courts. To the governance, since it traditionally represents a key extent that the poor mistrust courts, they hardly look funding asset of the corporation, with well known for justice, bearing a high cost of abuses from formal bankability effects, bypassing misappropriated authorities and with a huge - albeit hardly visible - property concerns. And when these assets are missing social cost. or not fungible, their absence matters and pains, as it Tenure security is important, and land titling is is shown also by the still unsolved worldwide much desired by farmers, who otherwise are recession, ignited in 2007-2008 by an apparently condemned to be mere sharecroppers. Excessive

481 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 fragmentation of land is however another problem, The property trap has serious drawbacks which worsened by demographic booms, which should hinder development: lack of land property makes it carefully be avoided, since even in agriculture unavailable as collateral, preventing the diffusion of economies of scale matter. financial products which elsewhere prove useful even Systems of land titling greatly differ across the for the poor, such as housing microfinance, with a world, and land titling is a form of privatization out of progressive build approach. Housing is both a shelter collective sharing which creates a property-owning and a commodity, but if land and real estate properties society that can be sadly exemplified by communism, are not properly owned, they become both a under which people were equal and all poor. Land precarious shelter and an untradeable commodity, rights also affect investments, even considering the destroying much if not most of their intrinsic potential subject to which guarantees may be granted. It is value. And the poor typically do not have other unsurprisingly mainly the poor those who lack land valuables - otherwise they would not be destitute. tenure and they are consequently prevented from Poor housing may bring to a housing trap. investing. Private property has also other well-known The value of land as a guarantee derives also by aspects but anyway complex ones. They strongly two predominant characteristics: contribute to the well being of its owners and they are • land is more fungible than many other assets; transmittable and inherited through generations, • land’s value is consistently less volatile than following an ideal relay race where wealth passes the value of so many other assets. from father to son, accumulates or depreciates if improperly managed and it profoundly contributes to Collateral Governance, Beyond the the overall welfare. The right to free inheritance, Property Trap which was denied by communist regimes but is hardly practicable even elsewhere (even if it is formally The equation “no real (land) guarantees, no money” is allowed), is fundamental to encourage propensity to so common in Western banking dealings that we are get engaged in long term investments, beyond one’s hardly used to understand the importance of its hopeful life span. missing presence in developing countries. Hidden or untitled (real estate) capital is often Unsophisticated and embryonic leverage, acting as a accompanied by the presence of ... invisible poor, chained Prometeus, is linked to basic assets’ structure, whose birth has never been recorded or recognized. where both intangibles and fixed assets are Officially nonexistent poor do not have any certified underrepresented. Asset & liability governance identity and consequently they are not able to sign equilibriums follow this basic pattern, engineered by contracts with their official name, to have a passport undifferentiated multirole stakeholders. or other documents, including electoral certificates or Illiterate informal landowners, whose rights to welfare cards. As a matter of fact, non-existent poor occupy the land are hardly opposable as prescribed, are marginalized, deprived of their primary rights and lack any formal title of property (Lanjouw and Levy, exposed to frauds and blackmails (when looking for a 2002), and so they are hardly able to convert their job or trying to purchase durable goods ...). property capital into a working guarantee. Comparison between countries with different And the fact that little (if any) real estate taxes property laws is uneasy and raises Hamlet questions, are applicable to unrecorded properties, may initially wondering if un-titling is really worse than property sound as good news for lucky tax non-payers, even if backed levered titling. no tax collection means lower resources for infrastructures - whose role is decisive even for Conclusion property value enhancing (a home with no road connections is hardly valuable) - and especially it This brief and eclectic paper shows that standard brings no incentives for cadastral mapping and Western corporate governance issues, synthesized in checking, with negative impacts on the overall the introduction, clash with the silent and informal development which go far beyond the land issue. world of still developing countries, which rotate The creation and progressive accumulation of around social capital and family clan stakeholders, capital - the fuel behind development - would never with unwritten ties and nexuses of tribal contracts, have been possible in Western countries without the especially in rural areas. contribution of land injections or other assets in kind Contact between the West and the Rest is often (real estate properties, gold or other precious metals, accidental, and interactions between the two models sometimes equipment and furniture). They form are fortuitous and erratic, following the capricious indeed the initial capital, and they make the ignition pendulum of globalization. Governance of a wealth multiplying process possible, where “biodiversities” represent a shelter against massive physical capital is successfully combined with labor homologation, somewhat preserving the Rest from the and intangible skills, levered by asset-backed viral contagion of still ongoing Western recession. guarantees. Forward- looking confrontation may however bring to mutual enrichment, for instance if looking for a

482 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 balanced compromise between ‘far West style‘ no 6. Bowles, S. and Gintis, H. (2002), “Social Capital and regulation and the unintelligent design behind Community Governance”, The Economic Journal, Vol. overregulation (Ferguson, 2013), which demands 112 No. 483, pp. 419-436. watchful policy scrutiny. Hardly measurable social 7. Boytsun, A., Deloof, M. and Matthyssens, P. (2011), capital factors widen both segmentation and “Social Norms, Social Cohesion, and Corporate information asymmetries, so weakening the Governance”, Corporate Governance: an International correlation among governance entities, together with Review, Vol. 19 No. 1, pp. 41-60. their induced viral contagion. 8. Calderisi, R. (2006), The Trouble with Africa: Wiy Capital, especially if represented and backed by Foreign Aid Isn't V\£>rking, Palgrave Macmillan, New real estate property and its consequential legal titling, York. is still the engine of levered economic growth in the 9. Claessens, S., and Yurtoglu, B.B. (2013), “Corporate Western world, since the English industrial revolution Governance in Emerging Markets. A Survey”, (Ferguson, 2011), even if the still ongoing Emerging Markets Review, June, pp. 1-33 unprecedented recession, accidentally ignited by sub- 10. De Soto, H. (2003), The Mystery of Capital. Wiy prime bubbling mortgages, has shown the limits and Capitalism Triumphs in the V\fest and Fails Everywhere follies of financial sophistication, suggesting “back to Else, Basic Books, New York. earth” humble but vital warnings. 11. Durlauf, S. (2002), “On the Empirics of Social Capital”, Links and synergies between corporate The Economic Journal, Vol. 112 No. 483, pp. 459-479. governance systems in Western and developing countries may be found for example in microfinance 12. Easterly, W. (2008), Reinventing Foreign Aid, MIT institutions, where guarantees for debt underwriting press, Boston. are cash flow based, in the absence of worthy 13. Eddleston, K. A., Chrisman, J. J., Steier, L. P. and Chua, collateral. The very fact that microfinance proved J. H. (2010), “Governance and Trust in Family Firms: resilient during the recent recession (Moro Visconti, An Introduction”. Entrepreneurship Theory and 2009; Moro Visconti, 2011) is another point in favor Practice, 34: 1043-1056. of its scalable application. 14. Ferguson N., (2011), Civilization: TheV\fest and the Family governance is another insightful bridging Rest, Penguin, London. issue, to the extent that Western family businesses can 15. Ferguson N., (2013), The Great Degeneration, Penguin, share their know-how with clan governance London. paradigms, tightening their common denominators. 16. Fukuyama, F. (1995), Trust: The Social Virtues and the Key governance issues such as corporate control, Creation of Prosperity, Free Press, New York. accountability, management monitoring, audit, 17. Garriga Cots, E., (2011), “Stakeholder Social Capital. A regulation, best practices, risk management, etc., New Approach to Stakeholder Theory”, Business which occupy since decades the discussion arena in Ethics-a European Review, October, issue 4 Western countries, are still incubating in less 18. Glaeser, E.L., Laibson D. and Sacerdote, B. (2002), “An sophisticated societies, backwarded in their informal Economic Approach to Social Capital”, The Economic financial systems. Journal, Vol. 112 No. 483, pp. 437-458. Spicy cultural differences, albeit endangered by 19. Harrison, L.E. (1985), Underdevelopment Is a State of flattening globalization, still deserve careful analysis Mind: The Latin American Case, University Press of and preservation and may conveniently pattern new America, Lanham. research avenues, trying to sort out the Best from the 20. Harrison, L.E. and Huntington, S.P. (2000), Culture uneasy comparison between an ailing West and its Matters: How Values Shape Human Progress, Basic unfitting Rest. Books, New York 21. Huntington, S.P. (1993), “The Clash of Civilizations?”, References Foreign Affairs, Summer.

22. Jacoby, H.G. and Minten, B. (2007), “Is Land Titling in 1. Arregle, J.L., Hitt, M. A., Sirmon, D. G. and Very, P. Sub-Saharan Africa Cost-Effective? Evidence from (2007), “The Development of Organizational Social Madagascar”, The\Abrld Bank Economic Revia/v, Vol. Capital: Attributes of Family Firms”, Journal of 21 No. 3, pp. 461-485. Management Studies, 23. Kapuscinski, R. (2003), A reporter’s Self portrait, SIW 2. 44: 73-95. "Znak", Krakow. 3. Baneijee, A.V., Benabou, R. and Mookherjee, D. 24. Kostyuk, A., Braendle U.C., and Apreda R., (2011), (2006), Understanding Poverty, Oxford University Corporate Governance, Virtus Interpress, Sumy press, Oxford. 25. Kreps, D. (1990), "Corporate Culture and Economic 4. Banfield, E. (1958), The Moral Basis of a Backward Theory," in Alt, J. and Shepsle K., eds., Perspectives on Society, Free Press, Chicago. Positive Political Economy, Cambridge University 5. Bordieu, P. (1977), Outline of a Theory of Practice, Press, New York. Cambridge University Press, Cambridge.

483 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

26. Landes, D.S., (1998), The V\fealth and Poverty of 30. Moro Visconti, R. (2011), “Global recession and Nations: Wiy Some Are So Rich and Some So Poor, microfinance risk governance in developing countries”, Norton & Company, New York. Risk Governance and Control Journal, 1, 3 27. Lanjouw, J.O. and Levy, P.I. (2002), “Untitled: A Study 31. Moyo, D. (2009), Dead Aid: Wiy Aid Is Not V\£>rking of Formal and Informal Property Rights in Urban and How There Is a Better \Nay for Africa, Penguin Equador”, The Economic Journal, Vol. 112 No. 482, pp. books, London. 986-1019. 32. Shleifer, A. and Vishny, R.W. (1997), “A Survey of 28. Maathai, W. (2009), The Challenge for Africa, Corporate Governance”, Journal of Finance, Vol. 52 Pantheon, New York. No. 2, pp. 737-783. 29. Moro Visconti, R. (2009), “Are Microfinance 33. Wright, M., Siegel, D.S., Keasey, K., and Filatotchev, I. Institutions in Developing Countries a Safe Harbor eds., (2013), The Oxford handbook of corporate Against the Contagion of Global Recession?” governance, Oxford University Press, Oxford. International Finance Revia/v, 10, 389- 438.

484 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

THE APPLICATION OF SYSTEMS ANALYSIS TO ENHANCE THE PERFORMANCE OF LOGISTIC SYSTEMS IN SUPPORTING ECONOMIC GROWTH AND DEVELOPMENT

W J Pienaar*

Abstract

This paper provides guidelines on how decision-makers can choose capital projects on the basis of economic and financial criteria by applying a systems-analysis approach. Project appraisal, selection and prioritisation criteria are listed, followed by a description of the way in which the result of each appraisal technique should be interpreted. Criteria that should be adhered to in the selection of mutually exclusive projects and the prioritisation of functionally independent projects in order to maximise net output in the long run are supplied. Applications of the proposed investment decision rules are illustrated by examples. Two techniques are proposed that may be used as additional decision-making instruments when evaluated projects show similar degrees of long-term financial viability. Five performance areas that collectively best represent successful organisational logistics performance are detailed.

Keywords: Benefit:Cost Ratio, Capital Recovery Period, First-Year Rate of Return, Incremental Benefit:Cost Ratio, Independent Projects, Indivisible Projects, Mutually Exclusive Projects, Net Present Value

* Stellenbosch University, Department of Logistics, Private Bag X1, Matieland 7602, South Africa Tel: 27 21 808 2251 Fax: 27 21 808 3406 Email: [email protected]

1. Introduction Systems analysis is a dynamic problem-solving and decision-making process that encompasses the Sustained economic growth and development are identification, study and evaluation of interdependent dependent on productive regional specialisation, the parts and their attributes that function in an ongoing continued improvement of production efficiencies and process and that constitute an organic whole (APICS the profitable exchange, or trade, of goods, services 2005: 114). Various alternative solutions to a problem and information. Profitable trade presupposes local and approaches to an overall design are considered in surplus production of those goods that might be more order to arrive at an acceptable system with optimum efficiently produced in a region in exchange for goods performance in terms of specific criteria. produced more efficiently elsewhere. This The systems-analysis process comprises the prerequisite level of comparatively or relatively following seven consecutive steps: advantageous efficiency stems from the economies of 1) Define objectives and determine the levels of scale achievable from labour specialisation (including service that are needed to achieve the objectives (i.e. division of labour and development of skills), problem description). technological specialisation, productive utilisation of 2) Conceptualise the existing operating system regional natural advantages and large-scale and environment through research and simulation of production. Logistics is an integral component of the status quo (i.e. systems modelling). economics, enabling, inter alia, regional specialisation 3) Generate technically feasible alternative (and thereby economic growth) through the efficient solutions (i.e. generate alternative solutions). and effective distribution of resources and outputs. 4) Apply optimisation and assessment The systems approach is ideal for the solution of techniques to determine the viability of the logistical problems where the need for goods, services prospective investment options and operating and information (demand related); production and procedures (i.e. evaluation). distribution capacity (supply related); and the 5) Select the most viable investment options and operating environment vary with time. operating procedures (i.e. system selection).

485 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

6) Organise the implementation of the chosen PWOC =present worth of cost system (i.e. implementation). j C 7) Formulate and apply appropriate performance t  t measures in order to judge the success of operating t0 (1 i) = present worth of all project the system (i.e. monitoring and review). implementation costs If monitoring and review show that a permanent n gap is developing between the performance and the (M U)t  t objectives of a system, it means that a fundamental tk (1 i) system problem requiring more than short-term action = present worth of all facility has been identified. Hence, the cycle of analysis will maintenance costs and user costs start anew. In this paper the economic and financial Net Present Value (NPV) Technique assessment aspects of steps 4 through 7 of the systems-analysis process pertaining to logistics This technique provides an economic performance systems are detailed (Pienaar 2011). All concepts measure that is used to select the best alternative marked with an asterisk, are defined in the glossary of among the mutually exclusive projects. terms. Net present value (NPV) is a technique whereby the present worth of investment cost (= C ) is 2. Systems Analysis Step 4: Project subtracted from the present worth of all future project benefits (= B) (i.e. annual savings relative to the null Evaluation alternative plus the consumer surplus gained through additional usage induced by the proposed facility). Various cost-benefit techniques can be used to The present worth of both costs and benefits is evaluate the economic justification of candidate calculated by using the official social discount rate. projects of a logistics system. In this section four All projects reflecting a positive NPV are techniques are explained, namely: (1) present worth economically viable, while the project alternative with of cost (PWOC) technique; (2) net present value the highest such value is most suitable for (NPV) technique; (3) benefit/cost ratio (B/C) implementation as this will maximise net benefit for technique; and (4) internal rate of return (IRR) society as a whole. technique. The technique can be expressed thus: Evaluation techniques to determine the viability n B j C of a project are usually based on the following three NPV  t  t specific criteria:  (1 i)t  (1 i)t Minimum total cost, which can be determined tk t0 through the present worth of cost (PWOC)* technique where: (expressed as an absolute monetary amount). NPV = net present value of benefits n Net advantage, which is determined by the net Bt present value (NPV) technique (expressed as an  (1 i)t absolute monetary amount). tk = the present worth of benefits (3) Relative advantage, which is usually determined either by the benefit:cost ratio (B/C)* Benefit/Cost Ratio (B/C) Technique technique or the internal rate of return (IRR)* technique (expressed in relative terms; the former as a This technique provides an economic performance ratio and the latter as a percentage). measure that is used for the selection of the most advantageous project(s) by determining the ratio Present Worth of Cost (PWOC) Technique between the present worth of the future project benefits and the present worth of the project This technique selects the lowest cost alternative investment costs. All proposals with a ratio value among mutually exclusive projects*. All economic greater than one are viable, while the one with the costs (i.e. the opportunity costs) associated with the highest ratio value is economically the most provision, maintenance and use of each possible advantageous. However, when mutually exclusive alternative project are discounted to their present projects are compared, incremental analysis must be worth. Given the objective of economic efficiency, used to identify the best alternative. the alternative that yields the lowest PWOC is The method can be expressed as follows: regarded as the most beneficial proposal. This n B j C method can be expressed as follows: t t  t  t j (1 i) (1 i) C n (M U) B/C = tk t0 PWOC  t  t  t  t t0 (1 i) tk (1 i) where: where: B/C = benefit/cost ratio

486 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Internal Rate of Return (IRR) Technique most advantageous way of solving a specific operational problem. This technique provides an economic performance Project prioritisation is the arrangement of all measure that is used for the selection of the most functionally independent projects* in order of priority advantageous project relative to the null alternative. according to their respective degrees of viability. The The distinctive feature of this technique is that its projects will be prioritised from most to least application does not entail a singular discounting attractive up to the point where the capital budget has procedure with one official rate only. Future benefits been exhausted. ("returns") for the period under review are discounted A project which yields a B/C ratio value greater to the beginning of the period. The sum of these than 1 always has a positive NPV, and an IRR which discounted amounts is compared with the discounted exceeds its opportunity cost of capital. Provided the project investment cost. Different rates of discount are initial costs of projects do not differ, any one of the selected iteratively and applied until at a certain rate four evaluation techniques discussed may be used to the sum of the annual discounted returns equals select the best alternative among a number of discounted investment costs. This rate is then referred mutually exclusive projects. The alternative with the to as the internal rate of return. smallest PWOC will have the highest B/C ratio, The project with the highest internal rate of highest IRR and highest NPV. However, if the initial return can be regarded as the most advantageous, costs differ significantly (which is generally the case), although the actual criterion is to compare the rate incremental analysis should be used to identify the thus obtained with the opportunity cost of capital as most suitable alternative. represented by the prevailing real or social discount The PWOC and NPV techniques cannot be used rate. If it exceeds the prevailing social discount rate, to prioritise independent projects. The absolute value the alternative is economically viable. However, when of a project's benefits depends on its scope. The mutually exclusive projects are compared, benefits of a large project may, for instance, have a incremental analysis must be used to identify the best larger absolute value than the benefits of a smaller alternative. project, whereas the relative return of the larger The method can be expressed as follows: project may be considerably lower than that of the IRR = r smaller project. Hence it is better to use the IRR and n B j C B/C ratio techniques for the prioritisation of t t independent projects, also taking into account the  (1 i)t  t When tk = t0 (1 i) results of the investment timing analyses. The reduction of user cost afforded by new where: facilities can generate additional demand over and IRR = internal rate of return above normal demand. In such cases, the criterion of r = rate at which the left-hand and right-hand lowest total cost presents a contradiction in terms sides of the equation are equal. which complicates the interpretation of the answer indicated by the PWOC technique. Furthermore, this 3. Systems Analysis Step 5: System answer does not give an indication of the scale of the benefit offered by an alternative, unless the answer is Selection subtracted from the PWOC of the existing alternative. This difference is equal to an alternative’s NPV. Selection criteria It is the creation of net benefit that is of interest

to the decision maker, because it is benefit that The selection and prioritisation of projects based on contributes to wealth, and, therefore, to economic investment appraisal usually takes place with welfare. To support informed decision making, reference to the following general criteria: further analysis in this work focuses on the evaluation (1) All projects must be evaluated in the same techniques which take cognisance of project benefits. manner. In the sections that follow, the principles of (2) All alternatives, i.e. the whole range of selecting divisible and indivisible projects with a technically feasible projects, should be evaluated. fixed budget and with a variable budget size are (3) The benefits of a project must exceed its discussed. investment cost.

(4) The investment cost of a chosen project must Divisible projects be within the limits of the budget.

The financial choice of a specific project for Consider first the situation where all projects are implementation involves two steps, namely, project divisible, i.e. they can be increased or decreased by selection and project prioritisation: very small increments. Although this is not a realistic Project selection involves the selection of the assumption, it allows us to illustrate the basic best mutually exclusive project, or in other words, the rationale of project selection.

487 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Fixed budget size for the last euro spent on alternative public and private projects. Public projects are extended or Suppose that the decision maker must be advised how restricted and private projects are restricted or best to allocate a given amount, say €1 million, extended until the benefit from the last euro spent in between two proposed projects, X and Y. The either sector is equal. Thus, public investments are problem is similar to that of an individual who must increased until the last euro spent yields a euro’s allocate his personal budget. First, one must worth of benefits. determine the cost (C) involved in providing each service and the benefit (B) to be derived from each Indivisible projects service. Then outlays must be allocated between X and Y in order to maximise the net benefit from the It is assumed above that investment may be divided budget (NB), i.e. to derive the largest excess of total between projects, or broad categories, X and Y, so benefits over costs (B - C). With C limited by the that benefits may be equated for the marginal euro size of the budget, the task is to maximize B. spent on each. With specific allocation within public corporations, choices must be made among indivisible Variable budget size projects. These projects involve lump-sum amounts and are not smoothly expandable. If, for example, the More broadly viewed, budgeting indicates that the choice has to be made between a road linking points problem is not merely one of compiling a given A and B and another linking A and C, where the budget, but also of determining its size. The distance between A and B is twice the distance government must thereby decide how resources are to between A and C, no marginal extension appears be distributed between private and public use. possible. This situation contrasts with, for example, Therefore, one has to drop the assumption of a fixed the construction of an access road into a developing budget and integrate project choices along with the region, which may be expanded by small increments. process of determining total budget size(s). Within a fixed budget, the opportunity cost of pursuing a public Fixed budget size project consists of the benefit forgone by not pursuing the best other public project. But in a variable budget Consider a fixed budget situation. Suppose that the situation the opportunity cost of public projects must government has €1 million to invest in different be considered as the lost benefits from private infrastructure facilities, and that it may choose among projects which are forgone because resources are projects A to G, as shown in Table 1. The cost of each transferred to public use. project is represented by its required investment The task now is to maximize (B - C), including amount. The benefit assessment gives the total benefit benefits and costs of both public and private projects. for each project. This condition is met by equating marginal benefits

Table 1. Project choice with indivisible projects and a fixed budget

Project Present value of Present value of Net benefits: B/C B/C ranking benefits: B investment cost: C B-C ratio (€ 000) (€ 000) (€ 000) A 215 70 145 3,1 1 B 180 115 65 1,6 4 C 300 210 90 1,4 5 D 190 170 20 1,1 7 E 565 435 130 1,3 6 F 720 430 290 1,7 3 G 685 285 400 2,4 2

In dealing with this case, one can consider maximised by choosing projects A, G, F and C. In this various decision rules. Let rule 1 be to rank projects in case, the total investment cost is €995 000; gross line with their B/C ratio and move down the order benefits are €1 920 000; and net benefits equal €925 until inclusion of a further project would exceed the 000. An amount of €5 000 is not invested. Rule 3, budget limit. Projects A, G, F and B are then chosen. finally, might be to minimise the residual not The total investment cost is €900 000; total (i.e. gross) invested, subject only to the constraint that projects benefits are €1 800 000; net benefits equal €900 000; must have a B/C > 1. In this case, the choice is for and €100 000 of the available budget remains. As an projects B, D, F and G, with a cost of €1 000 000, alternative, let rule 2 call for that mix of projects benefits of €1 775 000 and net benefits of €775 000. which yields the largest net benefit. By trying various No funds remain. combinations, one finds that net benefits are

488 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Comparing the merits of the three rules shows outlays on both uses. One now proceeds by the rule that it is evident that rules 1 and 2 are superior to 3 that a public project is worth undertaking as long as because both realise greater benefits at a smaller its benefits exceed its investment cost. The investment cost. Choosing between rules 1 and 2 is justification for the rule is that the cost of investing n more difficult. Rule 1 is reasonable, because it calls euros in the public sector is the loss of n euros of for the choice of projects which yield the highest benefits – a loss which results from not investing n return per euro of the constrained resource (i.e. the euros in the private sector. The rule may be postulated available budget). Rule 2 offends this principle by that a project should be undertaken so long as (B - C) choosing project B over C. Yet by moving from rule 1 > 0. to rule 2, additional benefits of €120 000 are gained at an additional investment cost of €95 000. Net benefits 4. Application of Investment Decision rise by €25 000, and although the incremental B/C Rules ratio* is only 1,26, it is still a viable proposition. Rule 2 will clearly be preferred if the fixed budget case Mutually exclusive projects treats any unutilised funds as worthless. Taking a broader view and allowing for a possible transfer to Whenever the opportunity prevails to solve a specific another budget, one notes that rule 2 will be better problem with the investment timing of the solution only if other budgets cannot offer projects with a B/C project not being challenged by any independent ratio above 1,26. projects elsewhere, the NPV measure is the preferred selection criterion. Suppose, for example, that €1 Variable budget size million has been allocated to rectify a specific problem situation, that unused funds cannot be If the budget size has no fixed limit, the problem is transferred to other projects and that a choice has to once more one of weighing public against private uses be made from the three viable alternatives shown in of resources. Since one is now dealing with Table 2. indivisible projects, this can no longer be done by balancing the benefits derived from incremental

Table 2. Present value of benefits and investment costs for three alternative projects

Project Present value of Present value of Net present value of B/C ratio benefits (euros) investment cost benefits (NPV) (euros) (euros) A 1 080 000 600 000 480 000 1,80 B 1 400 000 800 000 600 000 1,75 C 1 620 000 1 000 000 620 000 1,62

Regardless of the fact that alternative C shows alternative A to alternative B and a move from the smallest relative return, it maximises absolute alternative B to alternative C will both be beneficial: benefit by having the greatest NPV. Incremental B/C analysis using Table 2 shows that a move from

B/CB:A=(1 400 000 – 1 080 000) ÷ (800 000 – 600 000)= 1,6 B/CC:B=(1 620 000 – 1 400 000) ÷ (1 000 000 – 800 000)= 1,1

Therefore, a move from alternative A to Independent projects alternative C will yield the greatest net benefit. Note that in a mutually exclusive situation, incremental When a choice has to be made among a number of analysis will always indicate that the alternative with independent projects, given a fixed budget, the B/C the greatest NPV is the best project. ratio measure is the preferred criterion. Suppose, for example, a public corporation with a fixed budget of €1 million has to make a choice among 16 independent projects, five of which are indicated in Table 3.

489 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Table 3. Present value* of benefits and costs for a number of independent projects

Project Present value of Present value of Net present value of B/C ratio benefits (euros) investment cost (euros) benefits (NPV) (euros) A 70 000 30 000 40 000 2,33 B 270 000 150 000 120 000 1,80 C 84 000 45 000 39 000 1,87 D 128 000 60 000 68 000 2,13 ...... P 180 000 90 000 90 000 2,00

In this situation the B/C ratio criterion is the (iv) From the projects under consideration preferred measure to apply. The project with the initially, select the one with the highest B/C ratio. highest B/C value is chosen first, followed by the one (v) Reconsider the selection of the best project in with second-highest B/C value, and so on until the each group of mutually exclusive projects by, firstly, budget is exhausted. Therefore, the five projects in reviewing all the more expensive projects and noting Table 3 will be chosen in the order A, D, P, C and B. the incremental B/C ratios. Within each group of This way the benefit per euro spent is maximised. mutually exclusive projects the project with the highest incremental B/C ratio is identified and Mutually exclusive and independent compared with the rest of the independent projects. projects Secondly, the available budget is adjusted to reflect the effect of the projects already chosen, and all Suppose the objective of the decision maker is to remaining projects that exceed the balance of the maximise benefit subject to the restriction of a fixed budget are omitted. budget, and that both mutually exclusive and (vi) Repeat steps (iv) and (v) for as long as independent projects are under consideration. In this possible. The iteration process ends when the budget case, a method of project assessment based on the is exhausted or when no acceptable projects remain incremental principle is recommended. The method for consideration. consists of the following seven steps: (vii) Consider adjustments to chosen projects (i) Determine the size of the budget. Where the when the budget is not completely exhausted and a size of the budget has been given, this requirement small adjustment in a chosen project may provide is met. Where some degree of freedom exists as to the incremental benefits. total amount available, then the amount can be The following example demonstrates this expanded incrementally, and the marginal benefits procedure. Suppose a corporation has €1 million to compared with the marginal expenditure to determine spend on capital projects, and 13 possible projects are whether any expansion of the budget is justified. proposed to replace six unsatisfactory facilities (A to (ii) Eliminate all projects that exceed the budget F). The projects under consideration are summarised limit and all projects that do not satisfy the minimum in Table 4. Projects A1 and A2 are two mutually acceptance criteria, as set out above. exclusive; B1, B2 and B3 are mutually exclusive; D1 (iii) Determine which project has the highest to D4 are mutually exclusive; and F1 and F2 are B/C ratio within each group of mutually exclusive mutually exclusive. Groups A, B, C, D, E and F are alternatives and then leave out the rest of the possible independent. projects in the group.

Table 4. Present worth (PW)* of benefits and costs, and benefit:cost ratios of a number of projects

Project PW of benefits (€ 000) PW of investment cost (€ 000) B/C ratio A1 180 150 1,20 A2 490 350 1,40 B1 210 100 2,10 B2 328 160 2,05 B3 351 180 1,95 C 270 200 1,35 D1 180 120 1,50 D2 432 240 1,80 D3 630 360 1,75 D4 816 480 1,70 E 90 40 2,25 F1 260 130 2,00 F2 304 160 1,90

490 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

There is no project that exceeds the budget limit from each group of mutually projects the one with the of €1 million and, furthermore, there is no project highest B/C ratio is chosen; the projects that are with a B/C ratio of less than 1. All projects are, selected for the next step are the following: therefore, included in further analysis. Subsequently,

Project PW of benefits (€ 000) PW of investment amounts (€ 000) B/C ratio A2 490 350 1,40 B1 210 100 2,10 C 270 200 1,35 D2 432 240 1,80 E 90 40 2,25 F1 260 130 2,00

From these six projects E is chosen. There is more expensive projects in the B group are now now €960 000 left in the investment budget, with five considered in terms of their incremental B/C ratios, as remaining projects to choose from. B1 is subsequently shown: chosen, which leaves €860 000 in the budget. The

Project Incremental benefit (€ 000) Incremental cost (€ 000) Incremental B/C ratio B2B1 118 60 1,97 B3B1 141 80 1,76

Although B1 is preliminarily chosen, B2B1 (B/C B2B1>1) and more beneficial than B/C B3B1. deserves consideration because it is financially viable The remaining five projects are as follows:

Project PW of benefits PW of investment B/C ratio (€ 000) amounts (€ 000) A2 490 350 1,4 B2B1 118 60 1,97 C 270 200 1,35 D2 432 240 1,8 F1 260 130 2,0

Subsequently, F1 is chosen, which leaves €730 The remaining five projects are now as follows: 000 in the budget. Now consider the more expensive F project (F2).

Project PW of benefits (€ 000) PW of investment amounts (€ 000) B/C ratio A2 490 350 1,4 B2B1 118 60 1,97 C 270 200 1,35 D2 432 240 1,8 F2F1 44 30 1,47

Choose B2B1 and €670 000 remains. The remaining five projects are as follows: Consider B3 against B2.

Project PW of benefits (€ 000) PW of investment amounts (€ 000) B/C ratio A2 490 350 1,4 B3B2 23 20 1,15 C 270 200 1,35 D2 432 240 1,8 F2F1 44 30 1,47

Choose D2 and €430 000 remains. The five remaining projects are as follows: Consider a more expensive D project. D3D2 is incrementally the most beneficial project.

491 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Project PW of benefits (€ 000) PW of investment amounts (€ 000) B/C ratio A2 490 350 1,4 B3B2 23 20 1,15 C 270 200 1,35 D3D2 198 120 1,65 F2F1 44 30 1,47

Choose D3D2 and €310 000 remains. The remaining five projects are as follows: Consider the more expensive D project (D4). A2 falls away because its investment cost exceeds the available budget (€350 000 > €310 000), and A1 is instead placed on the priority list.

Project PW of benefits (€ 000) PW of investment amounts (€ 000) B/C ratio A1 180 150 1,2 B3B2 23 20 1,15 C 270 200 1,35 D4D3 186 120 1,55 F2F1 44 30 1,47

Choose D4D3 and €190 000 remains. eliminated project cannot be incorporated at the cost Choose F2F1 and €160 000 remains. of any chosen project in order to increase the net C is eliminated because of an insufficient benefit attainable through better utilisation of the balance in the budget. budget. Choose A1 and €10 000 remains. This is not the case, and the final choice of Because €10 000 in the budget remains projects is as follows: unutilised, the last step is to ascertain whether the best

Project PW of benefits (€ 000) PW of investment amounts (€ 000) NPV (€ 000) B/C ratio A1 180 150 30 1,20 B2 328 160 168 2,05 D4 816 480 336 1,70 E 90 40 50 2,25 F2 304 160 144 1,90

1 718 990 728

5. Systems Analysis Step 6: worth of the investment cost involved, expressed as a Implementation percentage. If the FYRR is higher than the prescribed discount rate, then the project is timely and should go First-Year Rate of Return technique ahead right away. If the FYRR is lower than the prescribed discount rate, but the NPV is positive, Project viability per se does not reveal the optimum commencement with project implementation should timing of project implementation. For the timing of be postponed. In the situation where budgetary project implementation, the project should be constraints limit the construction programme, the analysed with a range of investment timings to FYRR can be used as an aid to prioritise the projects establish the one that yields maximum viability. A showing similar degrees of viability. project may be viable, but it may be a better project if Suppose that the present worth of the investment it were delayed by one year. Delaying implementation is C0, i is the annual discount rate expressed as a would defer the capital expenditures, but lose a year’s decimal fraction, and the net benefits in the following benefit. years are N1, N2,..., NT, where T is the time horizon. When benefits are expected to grow Then the PW of the project would be: continuously in the future, the First-Year Rate of

Return (FYRR)* technique can be applied as an NNN12 T investment timing criterion. The FYRR is calculated C0  2 ...  T . by dividing the year-one worth of the benefits (1i ) (1  i ) (1  i ) accruing in the first year of operation (i.e. the year subsequent to project completion) by the present If implementation is delayed by one year, the PW of the project would be:

492 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

constraints limit the construction programme, the C0 NN21T   21 ...  T  . CRP technique can be used as an aid to prioritise (1i ) (1  i ) (1  i ) those projects showing similar degrees of viability (more so if their initial costs do not vary significantly) Ignoring the PW of the benefits in the final year, on account of their capital recovery period. NT+1, the gain from a year’s delay is: 6. Systems Analysis Step 7: Control

C0 N1  C0  . Control includes monitoring and reviewing (1ii ) (1 ) performance to ensure that (1) the logistics process satisfies customers effectively; (2) the organisation’s This will be positive if resources are deployed efficiently; and (3) corrective action is taken when performance is not in line with N goals and objectives (see Figure 2). A continuing 1  i. C challenge for logistics managers is to develop and 0 maintain an effective set of measures to inform decision making and support the achievement of The quantity on the left of this expression is the financial success. Both financial and non-financial FYRR. If the FYRR is less than the rate of discount measures should be pursued. Since financial results and the benefits of one year’s delay exceed the costs within organisations are generally made known deep then the project should be delayed. In doing so, the into the following financial period, they have little value of the project will increase. Delaying may also value for day-to-day operational logistics have other advantages in that more information may management. A more immediate method of become available, or some adverse and unforeseen controlling logistics performance is needed to monitor factor may emerge. daily activities. This analysis focuses on the employment of non-financial measures that can be Capital Recovery Period technique used to (1) monitor and review logistics performance; and (2) that are capable of providing diagnostics for By taking into account the time value of money, the use in problem resolution and improvement processes. Capital Recovery Period (CRP)* technique provides a Performance measures should satisfy three basic yardstick for estimating the period over which the requirements: project’s investment will be recouped. The quicker Collectively they should measure the this return, the greater the preference for a project. performance of the whole system. The CRP is the period over which the discounted They should be quantifiable. benefits are equivalent to the investment cost. The They should be statistically reliable, and capable CRP technique can be expressed as follows: of being obtained within a relatively short period at reasonable cost. CRP = n Logistics measurement systems have been traditionally designed to include information on five n N types of performance: (1) customer service; (2) When C  t 0  (1 i )t logistics quality; (3) cost; (4) asset management; and tk (5) personnel productivity (Bowersox et al. 1999: 26). The first two of these performance areas are mainly Where: focused on logistics effectiveness, while the latter three are concerned primarily with logistics CRP = capital recovery period efficiency. Several measures can be designed and n = number of years over which the discounted implemented to specifically manage each of the benefits are equivalent to the capital investment logistics activities (shown in Figure 1), such as C0 = present worth of the investment cost transport, warehousing and inventory control. t = any particular year in the CRP Research suggests that leading-edge organisations are k = first year of operation (i.e. the year following the focused on performance measurement across these end of the construction period) five areas, which collectively serve as a representative Nt = year-end value of benefits in year t platform on which competitive position, value-adding I = annual rate of discount expressed as a decimal capabilities and supply chain integration can grow fraction (Fawcett & Cooper 1998: 341; Gunasekaran & Kobu As it is an instrument to show how long it will 2007: 1995). take to recover total investment, the CRP technique The opinion of 27 representatives involved in does not purport to be a direct measure of viability. It logistics performance measurement was solicited is useful, however, for indicating the potential risk of regarding the matter. The respondents all confirmed projects – the sooner an investment is recovered, the that, in their opinion, the five performance areas sounder the project. In situations where budgetary

493 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014 mentioned above as a whole can sufficiently represent (3) Logistics cost organisational logistics performance in South Africa. Logistics cost (LC) is the direct reflection of The representatives were further asked to rank the five monetary input required to accomplish specific diagnostic measures that are most indicative of logistics output, or availability/readiness to provide eventual financial success within each logistics acceptable logistics service. According to the performance area. Their average ranking per area is respondents, the following logistics cost measures are summarized subsequently (Pienaar 2013). applied most: (1) Customer service Comparison of actual LC versus budgeted LC In order to determine whether the desired goods, LC as a ratio of sales revenue services and information are consistently made LC per unit delivered available at the designated place and time, and in the Cost per logistics function (e.g. coordination of required condition and quantity, feedback should be inbound traffic, transport, warehousing, inventory obtained directly and explicitly from the customer. In control) doing so, the following measures were judged to be Comparison of current LC to historical cost most critical: standard (in real terms) Percentage of consignments delivered at the In general, the respondents indicated although right (i.e. designated) place logistics cost as a performance measure is not Percentage of consignments delivered on time inherently diagnostic, however, it (1) alerts systems (i.e. at the designated time) analysts to expeditiously pursue diagnostic Percentage of consignments delivered damage investigation; and (2) gives guidance and often free (i.e. in the required condition) provides prognostic clues for the analysis of asset Percentage of consignments delivered complete performance and personnel productivity (including (i.e. in the required quantity) untoward human behaviour). Percentage of orders fulfilled and invoiced (4) Asset management accurately Asset management is concerned with the (2) Quality utilisation of the organisation’s mobile equipment Logistics quality is closely related to the (e.g. vehicles and handling equipment), durable objective of achieving optimal customer service. installed and stationary assets (e.g. workshop Whereas customer service refers to how effectively equipment), and current assets in the form of customers’ desires are conformed to, logistics quality inventory (i.e. merchandise). The following measures refers to how efficiently (or cost effectively) were indicated as being the most important: customers’ desires are met. From this perspective, the Fixed-asset output: Examples for vehicles: Ton- following measures were indicated as being most km per period, container-km per period, deliveries per important: period, fuel consumption rates, tyre wear  Damage frequency Fixed-asset time utilisation (FATU) ratio =  Frequency of credit claims by customers Actual working time ÷ Total number of hours  Frequency of product returns by customers available (Downtime ratio = 1 – FATU)  Ratio of orders sorted, packed, shipped and Inventory turnover (A = Units sold in a period delivered accurately ÷ Average units in stock during the period  Ratio of orders documented and invoiced Inventory turnover (C) = Sales revenue in a accurately period ÷ Average inventory at sales price during the In (i) above, damage excludes faulty products period that erroneously leave production/manufacturing and Inventory turnover (B) = Cost of goods sold in a enter distribution. The reason for this exclusion is that period ÷ Average inventory at cost during the period production and manufacturing are not logistics Respondents indicated that measure (iv) is activities. Of the 27 respondents, 25 representatives generally applied when dealing with finished goods confirmed that their organisations monitor damage (which are time sensitive) and that measure (v) is in frequency. Twenty of the respondents indicated that general applied when dealing with raw materials and they monitor damage incurred per individual logistics semi-finished goods (which can often be stockpiled). activity, for example during storage, materials (5) Personnel productivity handling and transport. In order to analyse the nature Personnel productivity refers to the quantity of and cost consequences of product damage frequency, output divided by the amount of human resources all of the respondents confirmed that they also record input employed to produce the output. The following the number of credit claims and the number of human resources-related productivity measures were product returns. Note that measure (iv) above refers to indicated to be mostly considered in logistics functional (i.e. physical) logistics quality, and that management: measure (v) refers to administrative logistics quality. Comparison of actual achievement versus target achievement Number of units delivered per human resources cost amount

494 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

Number of units carried/delivered per processes to fulfil customers’ needs in South Africa. warehouse/transport employee Corporate Board: Role, Duties and Composition 2013; Average order cycle time 9(2): 12-21. Comparison to historical standard Note that measure (iv) is not a ratio – it represents the average time duration between the Glossary of Terms reception and fulfilment of orders. Benefit:cost (B/C) ratio: The present worth of the benefits Conclusions of a project divided by the present worth of its investment costs. (All proposals with a ratio value greater than 1 are The systems analysis approach is ideal for the viable.) Capital Recovery Period (CRP): The period over solution of logistical problems where, firstly, the which the discounted benefits of a project are equivalent to demand for goods, services and information, its investment cost. secondly, the supply of production and distribution First-Year Rate of Return (FYRR): The benefits of a capacity, and, thirdly, the operating environment vary project accruing in the first year of operation (i.e. the year with time. The aim of systems analysis is to subsequent to project completion) expressed as a percentage methodically solve problems that entail the of the worth of its investment costs at the time of project identification, study and evaluation of interdependent completion. parts and their attributes that function in an ongoing Incremental B/C ratio: The difference between the process and that constitute an organic whole. present worth of the benefits of a larger alternative project and the present worth of the benefits of a smaller project, Controlling the execution of logistics activity is divided by the difference between the present worth of the achieved through applying appropriate performance investment costs of the larger alternative project and the measures that reliably indicate when the logistics present worth of the investment costs of the smaller project. system requires adjustment to bring its performance in (The incremental B/C ratio is a measure that can be used to line with the organisation’s goals and objectives. The select the most beneficial mutually exclusive project. When success in achieving the latter can adequately be the incremental B/C ratio between two alternatives exceeds attained through effectively monitoring and reviewing a value of 1, a move from the smaller project to the larger performance in the following areas of a business project will be beneficial.) logistics system: (1) customer service; (2) logistics Independent projects: Projects that fulfil different functions. They do not form alternatives to one another and quality; (3) cost; (4) asset management; and (5) are, therefore, not mutually exclusive. The selection of a personnel productivity. Logistics systems analysts certain (functionally) independent project can at most who are proficient in applying the above-mentioned postpone, but not exclude, the selection of another eight operations research tools and the six identified (functionally) independent project. techniques to optimise the performance of a logistics Indivisibility: The nature of a factor of production system are most likely best suited to construct and which is only supplied in discrete amounts, not increasing maintain the system’s control process. or decreasing in quantity continuously. Energy or liquid raw materials, for example, are divisible but a piece of capital References equipment will be available only in minimum-sized quantities.

Internal rate of return (IRR): The discount rate that 1. APICS – The Educational Society for Resource will equalise the present worth of the investment costs of a Management. 2005. APICS Dictionary, 11th edition. project and the present worth of its benefits, i.e. the discount Alexandria, VA. rate at which the net present value (NPV) of a project will 2. Bowersox, D.J., Closs, D.J. & Stank, T.P. 1999. 21st equal a value of zero, or the B/C ratio will equal a value of Century Logistics: Making Supply Chain Integration a 1. (A project that yields an IRR greater than the discount Reality. Oak Brook, IL: Council of Supply Chain rate is regarded as viable.) Mutually exclusive projects: Technically feasible Management Professionals. projects that will fulfil the same function if implemented. 3. Fawcett, S.E. & Cooper, M.B. 1998. Logistics Because they are substitutes or alternatives, the selection of performance measurement and customer success. any one of the proposals will exclude the need for others. Industrial Marketing Management 27(4): 341–357. Net present value (NPV): The difference between the 4. Gunasekaran, A. & Kobu, B. 2007. Performance present worth of a project’s benefits and the present worth measures and metrics in logistics and supply chain of its investment costs. (If the present worth of a project’s management: A review of recent literature (1995–2004) benefits exceeds the present worth of its investment costs, it has a positive NPV and is, therefore, regarded as viable.) for research and applications. International Journal of Present worth (PW): The worth of a specified future Production Research 45(12): 2819–2840. value or of specified values occurring in different time 5. Pienaar, W.J. 2011. Application of systems analysis and periods expressed as a single amount at the present moment operations research methodology in the execution and (i.e. year zero). (Present worth is also known as ‘present control of business logistics processes. Corporate value’.) Ownership and Control 2011; 9(1) : 196-202. Present worth of costs (PWOC): The sum of the 6. Pienaar, W.J. 2013. Overview of procurement need present worth of the investment costs and the recurring costs (i.e. all operating costs). specification and the organisation of supply chain

495 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

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496 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

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497 International conference: "Corporate Governance: a Search for Advanced Standards in the Wake of Crisis" Milan, Italy, May 8, 2014

International Conference “Corporate Governance: a search for advanced standards in the wake of crisis” in Nuremberg (Germany)

Date: 25 September, 2014

Conference Organizers:

 University of Erlangen-Nuremberg  Publishing house “Virtus Interpress”  Financial Reporting, International Center for Banking and Corporate Governance

Conference Concept:

Global financial market became an outrageous battlefield between various companies. Under pressure of the competition, in their seek for higher efficiency, market control and competitive strengths yesterday’s inveterate enemies merge, weaker ones become victims of hostile takeovers. Those who are independent enough - permanently enhance their governance and risk management systems. Regulators on their side wish to increase market stability and efficiency through new reforms and stricter rules of the “game”. In such conditions it is vital for the companies, rulemakers and other engaged players to choose right strategy on the way to their aims. How corporate governance can influence performance and efficiency of the companies. What issue regulators should address to impact financial market activity more effectively? What are the main enemies of financial performance and efficiency? The conference is going to gather experts in the field of economics and finance to discuss these and other important issues of financial markets operation. It will provide the platform for academics and practitioners to analyze current challenges for the financial market and outline possible scenarios of its development.

Key Topics:

 Corporate governance – financial performance link  M&As and efficiency  Shareholders’ value maximization  Influence of executive remuneration on performance  Role of control in efficiency management  Insider trading issues  Transparency, accountability and misreporting  Consulting and Audit  Risk management and corporate governance  Financial markets regulation  etc

Important deadlines: Submission of the paper: by July 1 Acceptance of papers: by July 21

Contact: [email protected], [email protected]

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