Changing the Culture of Financial Regulation: a Corporate Governance Approach

Changing the Culture of Financial Regulation: a Corporate Governance Approach Thesis submitted in accordance with the requirements of the University of Liverpool for the degree of Doctor in Philosophy by Steven Ronald Cairns September 2014 1 | P a g e For Rhonda and John 2 | P a g e Acknowledgements First and foremost, I wish to express my sincerest gratitude to my supervisors, Dr Rob Stokes and Prof Anu Arora. Their patience and support throughout the entire process has gone beyond what is expected of any supervisory team, and for that I am truly thankful. It is amazing to think that this whole journey began with an email conversation six years ago around a failed bank and an unsuccessful furore into the city. Six years, and a few more grey hairs later, we are at the end of what has been a rollercoaster journey towards completion. I would like to take this opportunity to thank my partner Sarah Montagu, I am sure it hasn’t been easy putting up with me throughout this whole process and her selfless attitude and unconditional support has been the rock that the thesis has been built upon. I love you and couldn’t have done it without you. My gratitude also extends to my friend Bleddyn Davies. I will always appreciate our conversations; they kept me focused on the task at hand. I want to thank my Nan, Elsie May Nash, who has always believed in me no matter what I have undertaken, and for her steak pies that have gotten me through more than one late night session in the library. My final, and most important, thanks must go to my parents Rhonda and John. There are no words to express my gratitude to you both for the sacrifices you have made over the years. You have always put the needs of myself and my brothers over your own, which is all any child can wish for from their parents. From long car journeys across the country for rugby matches, to ensuring my fridge is full of ‘healthy options.’ Whatever you have done you have always put my best interests first and I cannot thank you enough for that. I hope by dedicating this thesis to you both, it will go some way to showing you how grateful I am. 3 | P a g e Abstract The 2007-09 Global Financial Crisis has been described as the greatest crisis in the history of financial capitalism. The failure of the global financial system was triggered by the ‘Great American Real Estate Bubble,’ however it quickly developed into a global liquidity squeeze that left financial markets at the brink of collapse. The thesis argues that the general culture of banking prevalent at the time both caused and exacerbated the crisis. The Business Strategies were excessively risky, focusing on short-term gains, at the expense of financial security. It is therefore purported that to mitigate the risks of any future global financial crisis a fundamental change in the culture of banking is needed. Behavioural expectations and norms must be redefined and more prudent strategies inculcated. The thesis will show that the only way to hope to achieve such a cultural shift is to employ a holistic approach, encompassing supervision, regulation and crucially corporate governance mechanisms. Previous debates within the UK have tended to focus on macro and micro regulatory reform. However, it is purported that it was in many cases, risk monitoring and management practices within financial institutions that dramatically failed. Whilst prudential regulation is important, the thesis will show that it alone is insufficient to change the culture within the financial system; a multi-faceted approach is needed. The central argument to the thesis will show that corporate governance mechanisms must play a central part in the legal and regulatory response to the Global Financial Crisis, as part of a cohesive package of measures necessary to effect cultural change; it will do this by conducting a case study into the collapse and subsequent nationalisation of Northern Rock Plc. 4 | P a g e Contents i. Acknowledgements ............... ..............................................................Page 3 ii. Abstract.....................................................................................................Page 4 I. Changing the Culture of Financial Regulation: a Corporate Governance Approach Introduction................................................Page 6 II. Prudential Financial Regulation: Alone It Is Not Enough To Change Culture.....................................................................................................Page 15 III. Corporate Governance as a Vehicle for Supervision................Page 49 IV. The Duty of Skill, Care and Diligence............................................Page 55 V. The Duty to Promote the Success of the Company...................Page 92 VI. The Business Decision Rule...........................................................Page 137 VII. Remuneration Structures as an aid to Corporate Governance..........................................................................................Page 162 VIII. Northern Rock, a Case Study..........................................................Page 213 IX. Conclusion...........................................................................................Page 238 X. Bibliography.......................................................................................Page 240 5 | P a g e Chapter I: Changing the Culture of Financial Regulation: a Corporate Governance Approach Introduction 6 | P a g e Chapter I: Changing the Culture of Financial Regulation: a Corporate Governance Approach Introduction Introduction: The Global Financial Crisis 2007-09 The 2007-09 Global Financial Crisis saw the world’s financial systems go through what has been described as the greatest crisis in the history of financial capitalism.1 In short, there was a systematic failure of banking and financial systems across the globe. Whilst the origins of the crisis may be traced back to loosening of lending standards in the US, specifically, in the subprime mortgage market, its impact had quickly spread across the globe.2 The bursting of the ‘Great American Real Estate Bubble’3 was only the beginning of a global liquidity squeeze, the result of which has seen the collapse and bailout of some of the largest financial institutions in the world. In the US, the Government guaranteed debts to the total of around $2.3-2.8tn. The placing of both Fanny Mae4 and Freddie Mac5 into conservatorship can be seen as the apex of the problems, however the bankruptcy of Lehman Brothers, a company with a history stretching back over 160 years, is perhaps the most evocative consequence. In the US, a series of US Treasury bailouts and pledges (beginning in October 2008) have totalled more than $11.6 Tn.6 To put this into perspective, there has only been one other single event in the past century that has cost more than $1 Tn, after adjusting for inflation, and that was the Second World War.7 The UK has fared marginally better, with a support package totalling £1.162 Tn at its peak.8 The numbers, however, tell only part of the story. There have also been a plethora of public takeovers; intervention by Government through capital injections has resulted in the nationalisation of Northern Rock9 and Bradford & Bingley.10 The underwriting of shares by government has also resulted in the ownership of 70% of Royal Bank of Scotland and 43% ownership of Lloyds TSB/Halifax 1 Lord Turner, The Turner Review: A regulatory response to the global banking crisis (March 2009) Intro. 2 ibid. 3 John Coffee ‘What went wrong? An initial Inquiry into the causes of the 2008 financial crisis’ (2009) 9 JCL 1, 4. 4 Federal National Mortgage Association. 5 Federal Home Loan Mortgage Corporation. 6 Mark Pittman and Bob Ivry, ‘U.S. Bailout, Stimulus Pledges Total $11.6 Trillion’ Bloomberg (24 February 2009). 7 Heather Connon, ‘What it costs to save US banks: WW2, plus the New Deal, plus...’ The Observer (29 March 2009). 8 National Audit Office, The Treasury’s 2010-11 Accounts: the financial stability interventions (13 July 2011) 4. 9 February 2008. 10 September 2008. 7 | P a g e Bank of Scotland through the vehicle of the limited company United Kingdom Financial Investments (UKFI).11 The Culture of Banking The subprime mortgage market and the collapse and subsequent bailouts of Fannie Mae and Freddie Mac have caused a knock on effect across the globe.12 This bubble alone, however, cannot be held as the sole cause of such a catastrophic meltdown; its origins are both numerous and intricate. It has been argued that off the book accounting and the avoidance of disclosure of toxic assets were a cause.13 Lord Turner, former chairman of the Financial Services Authority, believed rapid credit extension was underpinned by major and continued macro imbalances, in the UK this was funded primarily by private sector inflows, particularly from the US. This import of capital into the UK funded rapid growth of credit, to the point where by 2007 18% of UK mortgage credit was funded through foreign investment purchases of UK credit securities.14 Further to this, bonus and incentive driven structures that focused on short term profit through raising the share price have also been criticised.15 It may be suggested that all of these contributory factors can be clustered around a single, unified cause: a failure in the general culture of banking at the time. This culture encouraged financial institutions to act with a short-term perspective and to make as much profit as possible to the detriment of credit quality and prudence.16 This short term

Load more