It is now time to enforce the rules we have

ECONOMICS:A principles-based regulatory system must be introduced and then enforced rigorously, writes PAT McARDLE

IN THEORY, corporate governance is quite straightforward. Shareholders own the company but are too busy or otherwise unable to run it, so they delegate this function to management, headed by a chief executive. There is a potential conflict of interest between managers and owners, so responsibility is vested in a board consisting mainly of independent non-executive directors.

It meets regularly and controls management in the interests of the shareholders.

Unfortunately, this model has not worked very well in practice. It has frequently appeared that management is in control with shareholders and independent directors playing a subsidiary role. A succession of scandals in recent decades has prompted various attempts to redress the situation. In practice, these have resulted in the refinement of the Combined Code of Corporate Governance.

This is a voluntary code but it is enshrined in the Stock Exchange Rules and listed companies must either comply with it or explain why not. In practice, some of the explanations have not been very informative.

The recent banking crisis has again brought the code into focus and it is currently being reviewed with major questions to be addressed. Chief executives and directors have much to answer for and, unusually, high-profile lapses are being punished by forced resignations. However, there are many facets to the situation and the blame is widely spread.

Remuneration packages approved by non-executive directors look excessive in hindsight. Clearly, if everyone sets out to pay their executives at rates above the average there will be upward wage drift; however, what happened in reality was more like an inverted avalanche. There was also an excessive focus on short-term pay and bonuses, with the result that the interests of management were not well aligned with those of shareholders. In future, bonuses will likely be paid in instalments over a number of years, with clawbacks if performance deteriorates.

Competition in banking was excessive, witness the wafer-thin margins on mortgage lending, not to mention the rush to lend for property development. This was driven in no small measure by new entrants as banks from a range of countries sought to grab a piece of the Celtic Tiger. While the remuneration considerations already referred to no doubt played a significant part, it is not clear that the outcome would have been substantially different had pay been more constrained.

It would have taken a brave, some would say foolhardy, CEO and/or board to step off this merry-go-round. In the bush, the price for being caught out of the herd is certain death; within it, the prospects of survival usually look better. In order to guard against situations like this, we have regulation. However, regulation failed to curb ridiculous subprime lending in the US, it failed to control the rating agencies that gave credit ratings to mortgage-backed securities which were totally unwarranted and, closer to home, it failed to curb excessive lending.

The big question is where to now? A major reorganisation of the Irish regulatory structure has been signalled, but other than that we have little information. There is, moreover, a significant danger of a sub-optimal outcome.

Some years back, the US introduced the Sarbanes Oxley Act in response to a series of corporate and accounting scandals, notably Enron and WorldCom. However, it has been very controversial and is frequently criticised for introducing an overly complex and regulatory environment into US financial markets.

Last I heard, at least one of its two promoters was lobbying to have it watered down.

In the media, much of the blame for recent events is ascribed to principles-based regulation which is frequently equated with “light-touch” regulation. With hindsight, it is hard to argue that the regulation was not too light. However, this is not necessarily synonymous with it being principles based.

In my view, a principles-based approach is superior to a rules-based one. The US goes for the rule book whereas Ireland and Britain have embraced the principles approach. There have been banking crises and scandals in all three countries.

Rules-based systems are cumbersome, costly and may, in fact, be easier to avoid.

In the end, it all comes down to enforcement. As the former auditor of AIB, Eugene McErlean, observed last week, we have no shortage of rules and regulations. What was missing was a willingness to enforce them. The usual response of a regulator when things go wrong is to reach for the rule book and seek to expand it. It is an understandable reaction, but is not necessarily the most appropriate one.

Normally when major policy changes are contemplated we get a succession of Green and White papers designed to generate an informed debate. Recent events have shown that the economy cannot function without a viable banking system. However, we also have a vested interest in ensuring that it functions effectively.

Pat McArdle, chief economist, Ulster Bank, is a member of the Financial Services Consultative Industry Panel