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Moving beyond the rhetoric of corporate governance:

Where does ethics fit into the scheme of things?

by Simon Longstaff

Although the Malaysian economy has fared better than most during the turbulent times sweeping the region, the strains have been real enough.

In a climate of harsh economic conditions it is easy to see why people would argue, as some do, that continued talk of 'corporate governance' should be set aside as an 'optional extra' – a luxury that cannot be afforded by directors and managers having to focus on more immediate challenges. Even if sincerely held, such views are wrong.

It is precisely in times such as these that people feel compelled to take greater than usual risks in order to secure their position. In a sophisticated and integrated economy, such as Malaysia's, this additional risk is not isolated to the balance sheet of individual corporations. Rather, it permeates the system.

This is not just a matter of speculation. Poor standards of corporate governance can be directly linked to a pattern of: over-valued assets, inappropriate lending and a raft of other factors giving rise to unstable 'bubble economies'. So, how might this problem be addressed? One response would be for the Malaysian banking system, as a whole, to establish a prudential framework designed to encourage companies to move beyond the rhetoric of corporate governance and adopt sound practice.

I refer to the 'banking system' because it will only be through a coordinated response that the potential scale of systemic risk can be limited. The idea is a fairly simple one.

First, Bank Negara would establish and publish a framework of basic standards for corporate governance. Bank Negara on its own account could develop these standards or they could be the result of a consultative and collaborative process that would draw together and refine earlier models. With luck, this standard might become the common benchmark adopted by regulators such Bank Negara, the Registrar of Companies and so on.

Ideally, the framework would be a set of general principles supported by as small a number of detailed provisions as possible. This would then allow companies to adopt a variety of responses to the framework. That is, companies could choose to travel along different paths – providing only that they all led to the same destination! I imagine that any list of measures to be covered in the standards would include the following. That:

• the board be appropriately structured with the proper mix of executive and non-executive directors,
• the board effectively operate the recommended range of standing committees – especially, an executive committee, a remuneration committee and an audit committee,
• the audit committee have independent access to the external and internal auditors,
• the minutes of standing committees be circulated to all directors in a timely manner,
• potential and real conflicts of interest be properly disclosed,
• conflicts of interest be properly addressed,
• all other forms of disclosure, in relation to matters such as related party transactions, be made in the appropriate form and manner,
• directors be diligent in attending meetings,
• directors be subject to an annual review of their performance,
• There be full disclosure of the identities of people whose interests are ultimately represented by 'nominee' directors,
• appropriate policies and delegations be put in place by the board,
• the board satisfy its statutory reporting obligations,
• ... and so on.

The framework having been established, Bank Negara would then require that the standards be adopted by the banks it supervises at two separate levels.

First, it would be mandatory for the boards of the banks to apply the standards to their own activities. This would help to encourage a basic level of confidence in the governance of the banks themselves. Each bank would be required to make an annual report outlining the steps that it had taken to give effect to the basic principles.

In addition to this, an independent body charged with responsibility for reviewing corporate governance practice would audit each bank, from time to time. Bank Negara could perform this function or it could sub-contract the function to other regulators or to certified practitioners in private practice.

There is nothing especially novel in the approach so far. It is at the second level that matters become more interesting. Bank Negara could also require banks to include a corporate governance 'rating' when doing their credit assessment of companies to whom they might lend. One might imagine a system in which the level of sound corporate governance was scored in a series of bands from AA+ to CC–. Bank Negara would then use information about the corporate governance rating of companies receiving funds from each bank when setting prudential standards, such as capital adequacy ratios, for each bank.

Banks would still be free to lend money to companies with poor standards of corporate governance. However, the choice to do so would need to take into account the prospect of additional regulatory costs!

Once again, it would be up to individual companies to decide on the standard of corporate governance they wished to adopt. Likewise, they could vary the means by which the standards are to be achieved. Given this, there would be a need for an organisation (or group of organisations) able to provide an independent assessment of each company's standing. One imagines that the auditing profession would see this as an opportunity to develop new skills.

The value of this proposal lies in the fact that it is, for the most part, a voluntary scheme that links risk to reward. Of equal importance, it focuses on the way in which access to finance can drive corporate behaviour in a way that is far more immediate in its effect than even the loftiest exhortation.

Finally, this approach is justified as a matter of public policy in that it will help to drive unnecessary risk from the economy. Some risks must be taken in order to generate appropriate returns. This is a fundamental feature of sound business practice and it would be foolish to propose a form of regulation that further depressed economic behaviour.

However, the risk associated with poor standards of corporate governance is not of this kind. Lack of disclosure, incompetent directors, directors who advance their own interests (or those of their friends) over those of the company as a whole – all of these are risks that we would be better off without as they add no value.

The current economic conditions have been disastrous for many. Some of what has occurred may not have been preventable – especially given the critical influence of people and institutions operating abroad. However, if the pain already experienced is to count for anything, then it must be in terms of the opportunity it presents to learn from past mistakes and prevent avoidable errors in the future.

That is why we should embrace this time as an opportunity for bold thinking about how best to strengthen the systems that regulate the economy and, in doing so, reinforce the foundations for renewed prosperity.

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