Insights Executive Education
Paradise questioned
Corporate governance in an era of turmoil
T
he financial crisis left many econo-
mies, including our own, in a disas-
trous twilight. Among the casualties
of the crisis are debunked ideas and
practices, failed institutions and tattered
reputations.
Smart Business talked to Timur Gk, an
instructor in the Department of Finance at
Northern Illinois University, about corpo-
rate governance mechanisms, risk manage-
ment practices and what the future may
hold.
What is corporate governance?
Corporate governance is the set of rules
that shape and constrain how effectively
corporate managers deliver on their prom-
ises to investors in general and sharehold-
ers in particular. The rules may be explicit
or implicit; they may be defined by laws,
regulations and social norms. For instance,
in the U.S. the fundamental promise is to
enhance the value of the firm. The financial
crisis is partly the outcome of failed gover-
nance mechanisms that led to the violation
of that fundamental promise.
How do we ensure that promises made are
promises kept?
The basic problem is that shareholders to
whom promises are made have limited
involvement in corporate decision-making,
are less informed about corporate actions,
and rely mostly on boards of directors to
manage and monitor corporate manage-
ment. Rules and sanctions support this sys-
tem, but they alone cannot solve our prob-
lem. As any effective parent, teacher or
supervisor can tell us, the linchpin of the
system is incentives, and in the corporate
world, a big part of that is compensation.
Poorly structured compensation schemes
have led CEOs of several large financial
firms to take on ever greater risks to boost
their short-term compensation at the
expense of the long-term viability of their
firms and indeed of the entire system.
Corporate boards of directors approved
and oversaw the compensation schemes.
We must revisit how compensation
schemes are designed and how perform-
ance is monitored and rewarded.
Insights Executive Education is brought to you by Northern Illinois University College of Business
Timur Gk
Instructor, Department of Finance
Northern Illinois University
What are some of the issues beyond per-
formance and rewards that led us to where
we are today?
Closely tied to the failure of performance
and reward mechanisms is the failure of
corporate risk management. At the quanti-
tative level, no one can any longer ignore the
fundamental shortcoming of models that
were built on the assumption that volatili-
ties and market declines that we experi-
enced over a matter of days were supposed
to happen once every million years! So, a
top priority is to develop and deploy better
quantitative tools. We also have to be much
more diligent about systemic risks.
However, better models and a heightened
awareness of systemic risks are unlikely to
keep us out of trouble. Even with our limit-
ed tool-set, there were warnings about trou-
blesome trends, such as the real estate bub-
ble. Why were these warnings not heeded?
This brings us to structural failures. Faulty
corporate governance systems allowed
some financial institutions to take on ever
more risk while senior managers side-
stepped or dismissed risk managers and
boards of directors remained on the side-
lines. Others were culpable as well: policy-
TIMUR GK is an instructor in the Department of Finance at Northern Illinois University. Since 2006, he has been the regional director
in Chicago of the Professional Risk Managers International Association (PRMIA.org). Reach him at (815) 753-6395 or tgok@niu.edu.
2009 Smart Business Network Inc. Reprinted from the March issue of Smart Business Chicago.
makers, regulators, rating agencies, wishful
investors. Global imbalances exacerbated
the problems.
How should we address failures at so many
levels?
We must address many issues simultane-
ously. We need more effective regulators,
and we also need to revisit what role, if any,
rating agencies should play in the future.
As a first step, the balkanized U.S. regula-
tory system should be streamlined.
Subsequently, we should begin to see
greater regulatory scrutiny. The focus
should be on better regulation and not nec-
essarily more regulation. At a moment like
this, it is altogether too easy to overlook the
vital role financial markets and innovations
have played in creating vast material wealth
in Western nations. We must understand
fully why the system malfunctioned.
What about firms?
Firms must take an integrated view of
corporate governance and risk manage-
ment. This puts the onus on corporate
boards to provide better oversight. Board
audit committees or a subset must directly
oversee corporate governance as well as
corporate risk management practices.
Under the direction of the board, corpora-
tions must take an integrated view of risk
financial, operating, hazard and strategic
risks. We refer to such an integrated
approach as enterprise risk management.
We also need better risk management train-
ing and skills, tighter controls and account-
ability, and better reporting.
What are some broader implications?
Incentives and trust are two pillars of the
free market system incentives to deliver
on promises and trust that promises will be
kept and, ultimately, enforced. This is an
opportunity for us to mend the system by
replacing what is broken and to restore con-
fidence in the system by dispelling the aura
of private gains and social losses. <<