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23 May 2012
AFM Response to TSC Inquiry into Corporate Governance
1. I am writing in response to this consultation paper, on behalf of the Association of Financial Mutuals. The objectives we seek from our response are to:
· Express our views on effective corporate governance in financial services; and
· Stress that there is a risk that proposals intended for systemically important organisations are also filtered down to smaller firms in a disproportionate way.
2. The Association of Financial Mutuals (AFM) was established on 1 January 2010, as a result of a merger between the Association of Mutual Insurers and the Association of Friendly Societies. Financial Mutuals are member-owned organisations, and the nature of their ownership, and the consequently lower prices, higher returns or better service that typically result, make mutuals accessible and attractive to consumers.
3. AFM currently has 57 members and represents mutual insurers and friendly societies in the UK. Between them, these organisations manage the savings, protection and healthcare needs of 20 million people, and have total funds under management of over £85 billion.
4. The primary focus of the inquiry is into systemically important financial institutions; however, legislation and regulation in the UK tend to apply with very little variance or concessions to organisations that- like members of AFM- should not be considered to be systemically important. In addition, AFM operates a corporate governance Code that is an annotated version of the FRC’s UK Corporate Governance Code. For both these reasons, we consider that our views should be of interest and relevance to the Committee. We equally urge the Committee to consider how its recommendations are either ring-fenced to apply to only a targeted group of firms, or else that care is taken to consider how they might be adopted as recognisable good practice, and thus be expected to apply by a wider group of financial institutions- in particular to firms with customer members as owners.
5. The Annotated Corporate Governance Code for Mutual Insurers has been operating in the UK since 2006, and adherence to the Code is a condition of membership of AFM. Hence, even small mutual insurers have adopted most of the principles designed initially for the largest FTSE 100 companies. The high levels of compliance we see are a clear indicator that the sector aspires to high standards of governance, and of course is entirely consistent of a sector where there is no overarching conflict of interest between customers and owners (because they are one and the same).
6. Answers to specific questions in the consultation are attached. We would be pleased to discuss further any of the issues raised by our response.
Yours sincerely,
Martin Shaw
Chief Executive
Association of Financial Mutuals
Answers to specific questions
Board structure and composition
1. What outcomes should corporate governance in the financial services sector seek to achieve?
2. Are Board structures effective? For example, should UK financial institutions consider adopting alternatives to the unitary Board structure?
3. Does the UK approach to regulation and supervision of financial services incentivise Boards to perform their role effectively? Is more intrusive regulation a substitute or complement to effective corporate governance? Is a "comply or explain" approach an effective framework for governance?
In our assessment, effective corporate governance is critical to the effectiveness of any organisation. The Board defines not just the strategy of the organisation, but also the culture, and the style and approach to governance is central to that.
Corporate governance should ensure the basis by which the organisation seeks to secure the best interests of all stakeholders. This includes their obligations to customers as well as the rights of owners, but also includes: business partners, regulators, and taxpayers. An effective Board structure must therefore be capable of understanding the expectations of all stakeholders, as well as providing knowledge and expertise of the business.
The unitary Board structure in the UK has proved an effective vehicle for a long time. By contrast, in the Netherlands, good practice envisages a discrete Supervisory and Management Board. We can see risks and opportunities in this, so dual Boards need to operate with clearly defined roles (as per the Dutch Code). In insurance for example, the Financial Services Authority requires with-profits providers to run a separate with-profits Committee, with responsibilities to ensure that the with-profits fund is operated in the best interests of the with-profits policyholders. However, this produces tensions in the system- where there is too great a risk of overlap.
The UK approach to regulation of corporate governance is of course already multi-agency, with both the FSA and the Financial Reporting Council defining requirements, and with legislative oversight from Treasury. In addition, we are seeing increasing focus on governance requirements in Europe.
The comply-or-explain process enables firms to consider how best to apply the main governance principles to their organisation, and accepts that there are practical reasons why some principles have less relevance to some organisations. For example, small mutuals would find the requirement to annually re-elect their Board onerous, and leave them exposed to risks in continuity, as well as capture by a relatively small number of individuals. In addition, some mutuals operate via a delegate system, rather than one-member-one-vote, so the approach to engagement is necessarily different. The more that governance is standardised, the greater the risk that business diversity is undermined.
UK supervisors now focus on ‘judgment-led’ as well as ‘more intrusive’ regulation. In particular, judgment-led regulation puts the onus on the Board to best consider how to deliver regulatory outcomes, so rather than substituting effective corporate governance, we consider it reinforces it.
Corporate culture
4. What type of corporate culture should financial services firms seek to foster? In what way can this be encouraged? How effective are Boards at shaping corporate culture within their institutions?
Financial organisations should seek to develop a culture that is clearly communicated throughout the company and readily understood by the staff. It should seek to align the interests of the Board and the staff with those of the owners. It should emphasise that the organisation is run in the best interest of customers, and that for financial services in particular that means taking a long-term view. Whilst we would not expect individual organisations to take an economy-wide view, they should understand and communicate their role in the wider community.
The culture should reinforce the value of openness, transparency and fairness in all proceedings, and should ensure that rewards are made for doing the right thing, and for doing things right.
Impact of previous reviews and new regulatory developments
5. What difference would the proposals in the Independent Commission on Banking's report on the Boards of ring-fenced banks make to corporate governance in these institutions?
6. What benefits, if any, come from EU regulatory engagement with corporate governance issues?
7. What impact has the Walker Review (2009) had on corporate governance and corporate behaviour in financial services?
There has been a wealth of new regulatory initiatives in corporate governance since the financial crisis. Each has sought to provide a fit with other developments, and on the whole this has been achieved without too much duplication or inconsistency.
The strong focus on governance has unquestionably resulted in higher standards and a better understanding of best practice. It has though led to significant increases in costs, and for mutual organisations these have reluctantly been passed onto the customer. There has also been a risk of planning blight, with a steady stream of new provisions that makes compliance more difficult. We have also seen regulators try to move more quickly than good sense and infrastructure allows: for example, FSA introduced a new Significant Influence Functions regime in 2010, but has had to delay full implementation indefinitely due to shortcomings in its own systems.
Non Executive Directors
8. Should non-executive directors bear greater liabilities than under current law? Should executives in FTSE 100 companies be able to hold non-executive positions in other firms?
9. Is the existing FSA approval process for significant influence functions (SIF), including non-executive directors, effective?
There is a balance needed between making NEDs more accountable, and in ensuring that people with the right skills and experience are not deterred from taking on an NED role. Similarly there is a balance between ensuring executives provide sufficient focus on their core role, and widening their experience by holding a NED role elsewhere.
In either case we do not believe the answer is legislation, but stronger self- and statutory regulation to ensure that appropriate practices are undertaken. This is the role we would expect of FSA’s new SIF regime once it is fully operational: it is too early to tell how effective the SIF regime has been in raising the quality of NEDs. We hear reports that a number of applications have been refused/ withdrawn as a result of FSA's intervention, and this is positive. We hear also however that the process is too bureaucratic and in some cases (all Approved Persons, not just NEDs) has resulted in unnecessary delays to key appointments, creating a governance and regulatory risk in firms being unable to fill vacancies in a timely fashion.
The role of shareholders
10. Should shareholders be required to exercise a stronger role in systemically important financial institutions? What are the key barriers to greater shareholder activism by institutional investors in financial institutions? What risks are associated with it?
11. Is it realistic to expect sovereign wealth funds and hedge funds to undertake a more active role?
Most organisations would be keen to see their owners take an active role in key decisions for the future: be those owners institutional shareholders, individual shareholders, members (in mutuals), or taxpayers within (part) state-owned organisations. Strong endorsement of the progress and strategy of the organisation by its owners is an effective foundation for effective management.
In the last few weeks we have seen a significant increase in shareholder activism. The ‘Shareholder Spring’ has demonstrated that where owners have a concern, they are adept at using the AGM to voice those concerns and to vote down the Board where deemed necessary.
Before recent events it was more legitimate to question whether shareholders could act decisively; instead the question is now about whether they are being given the right issues to debate or influence. The Shareholder Spring has been focused on executive remuneration and the poor returns for shareholders: in a capitalist system it is inevitable that the primary focus will be quite narrow and self-serving. It is not therefore apparent from recent events that shareholders would be able to, or should be expected to, take a more paternalistic view of the long-term interests of the organisation, its customers, or indeed the national interest.
Remuneration
12. What role should institutional investors, remuneration consultants, employees and others play with respect to remuneration in the financial services sector?
13. Is there a case for introducing still greater transparency for senior executives with respect to remuneration in the financial services sector?
14. Should there be further reform of the remuneration arrangements of senior executives in the financial services sector? Should this extend to those highly paid individuals who sit below executive level?
15. The Chairman of the Financial Services Authority has argued that there may be a case for changing the personal risk return trade-off for bank executives. He has suggested either a 'strict liability legal sanctions or an automatic incentives based approach. What are the merits and drawbacks of these proposals? Are there other ways to achieve the same objective?
Remuneration practices have been held under close surveillance in financial services. The challenge that remuneration committees seek to achieve is to ensure that rewards are unequivocally linked to corporate performance. It is our strong view that corporate success and high earnings should go hand-in-hand, and that as a result high pay should not in itself be criticised.
It is important that remuneration policy establishes a clear and unambiguous set of goals, that are targeted towards the long-term value of the organisation. There needs to be greater transparency on how firms define such longer-term value- whether that be shareholder or member value- and how the performance measures used within remuneration schemes align with these. Short-term rewards in particular enable individuals to earn significant pay by taking decisions and/ or producing results that may result in longer-term harm to the business.
Equally executives and staff should not assume they have the same risk/ reward profile as partners in a business: risks in a large company should be lower and so should rewards, compared to an entrepreneur. Equally, executive pay should be seen to move in the same direction as shareholder returns, ensuring there is no perceived conflict of interest. The same may be inferred for staff at higher levels who do not sit on the Board but nevertheless enjoy a very high level of remuneration.
Governance of risk
16. Has the management of risk in firms improved since the financial crisis?
We have seen a massively increased focus in risk management over the last few years. This has been led by the widespread adoption of the Chief Risk Officer as a key role within organisations, as well as the focus on risk management through regulation such as via Basel or Solvency II.
Increased attention to, and improved techniques for risk management now enable firms to better model the robustness of the firm in different operating conditions. For insurance in particular this has had a significant impact on corporate strategy, and the mitigation of risk.
In addition, the financial sector has experienced increased regulatory focus on the need for regular stress testing since the crisis, and FSA has created rules that require firms to conduct Reverse Stress testing at least annually. This has helped firms and the regulator better understand and mitigate the risks that they face.
Diversity and background
17. What is the relationship, if any, between Board diversity and company performance in the financial service sector?
There are different dimensions to diversity; traditionally this might include gender, race, age and affluence. The challenge for any Board should be to embrace all of these but also to ensure that it properly represents the interests of all stakeholders in the organisation, including owners, staff and customers. It is important therefore that Board’s recognise diversity of skills, to encourage a range of views and to avoid the trap of group think.