Lack of integrity played a huge role in the banking crisis.  Mark Goodridge explores what went wrong and why good governance has climbed to the top of the corporate agenda again.
 

The Walker Report, published late 2009, on corporate governance in UK banks and other financial organisations has catapulted the issue of integrity to the top of the corporate agenda again.  The last time I wrote a Topics article¹ on corporate governance was six years ago, folllowing on from Enron and Sarbanes-Oxley.  Yet here we are again, revisiting the very same topic.  Only this time, it's much worse, as the repercussions of the banking crisis have included a global recesssion.

When the collapse of the US sub-prime market was first reported in the UK, few seemed to recognise this as a harbinger of doom.  Within certain financial institutions, there may have been some individuals who began to sweat, but the economy did not tremble until our high street banks started to fail.  Northern Rock was the first UK casualty, and once the Royal Bank of Scotland, HBOS, and Bradford & Bingley needed to be bailed out by taxpayers, the full extent of the crisis became clear.  These failures in the financial sector and resultant ecomonic recession have highlighted a number of weaknesses in boards, and many of them can be traced back to the question of integrity.

What went wrong?
According to the FSA, the behaviour of senior management at big banks played a major role in precipitating the crisis.  It blamed specific decisions and strategies as the main cause of the banks' failure.²  But if these boards were not acting illegally, how did they come to make such disastrous decisions?  Incompetence?  Hubris?  Poor governance?  Lack of integrity?  Or simmply the belief that the 'good times' would never end?  Probably a mix of them all.  Of course, such boardroom weaknesses are not restricted to the banking sector.  Any organisation that pays only lip service to the UK's Corporate Governance Code (formally the Combined Code of Practice) may also be heading for a similar crisis.

 A dysfunctional board - as proven in the banking crisis - cannot lead a sound organisation.  Good governance demands that boards have a degree of introspection; that they have the ability to look objectively at themselves and question their own decisions and actions.  Herein lies the real difficulty.  Boards are made up of strong, successful individuals who generally are not prone to self doubt.  However, as a group, a board needs to be able to take a step back and make a dispassionate asessment of its behaviour.

So, there are two issues.  The first is the ability of a board to effectively evaulate its own performance, and the second is that of integrity (see How To Build Board Integrity below).  Board evaluation is the easier of the two to tackle.  There is legislation and codes of conduct to offer guidance and expert, independent facilitators to ensure the process is not merely a tick-box exercise.  It's the question of integrity that remains vexing.  Integrity in the boardroom is not merely about honesty it actually depends on honest relationships between board members.   Good governance can only happen when board members understand each othere's roles, where they are accepting of challenge and advice, and where they focus on what's right for the organisation and not personal agendas.

Organisation with integrity
How does one build an organisation with integrity?  I answered this question in the Topics article I wrote six years ago.  In it, I outlined how an organisation could design and implement corporate goernance structures, and develop the necessary culture of integrity.

In short, integrity is the cornerstone of good governance, and must be built into the fabric of how the board operates, as well as being a key aspect of the organisation's culture.  Integrity is about doing what is right for everyone, rather than a select group of stakeholders.  It's about taking the wider view, the long-term view, and ultimately, it's about taking responsibility.  Taking responsibility for decisions, for actions, and for consequences means the board is doing its job, and probably doing it well.

As the Walker Review states "... principal deficienceies in boards related much more to patterns of behaviour than to organisations,"³ and behavioural improvements can be achieved through "... clearer identification of best practice and more effective ... routes to implementation so that boards and their major owners feel ownership of good corporate governance."⁴ The report correctly makes it clear that regulation neither creates nor enforces the correct types of behaviour that will avoid another crisis.  After all, people will always find a way around the rules.  That is what happened in our financial institutions.  They bent rules, pushed boundaries, and ventured into grey areas to suit personal short-term gains.  No-one actually broke the law, but the lack of integrity has had long-term, and far reaching, consequences for us all.

Behaviour cannot be regulated; it all boils down to personal choice.  Although boards cannot be forced to act with integrity through legislation, they do have a moral obligation to act in a socially responsible and ethical way.  How then can boards define and establish good behaviour?  How do they implement integrity?

Drivers of integrity
In my previous article, I outlined five drivers of integrity:

1. Explicit business direction, goals and roles:  provides a sense of overall purpose and this provides the context within which each individual and team accomplishes their role.
2. Explicit values and ethics:  an explicit code of conduct and ethics that must be translated into practical policies and processes. These, in turn, become embedded into the organisational culture.
3. Explicit policies and processes:  creating a balance to so that the board is not tied up with rules and regulations, but there are sufficient checks in place to prevent reckless behaviour.
4. A culture of integrity:  for this to be created, there must be freedom to question the actions and decisions within the organisation, ensuring the right behaviour. Developing a culture of doing the right thing requires that the board must adopt the right behaviour themselves, before their employees will follow them (see ER Consultants approach in box below).
5. Systems of internal control:  this is not just about satisfying compliance with externally imposed rules, but the responsibility of executives in developing and maintaining organisational integrity.

But if we take into the recent banking crisis, and recommendations by the Walker report, this list seems now seems too short. As the Walker report states, "Board conformity with laid down procedures will not alone provide better corporate governance overall if the chairman is weak, if the composition and dynamic of the board is inadequate and if there is unsatisfactory or no engagement with major owners."⁵ If leaders do not act with integrity, there is little scope for their subordinates to do so. In order to achieve this, I have added the following to my list of drivers of integrity:

1. Selection of board members:  getting the wrong person for the job is an expensive mistake. Getting the wrong board member, whether executive or NED, can prove disastrous. Paolo Moscuzza explains how the right kind of assessment can ensure the right decision is made in his article "Risky Selection".
2. Getting the role of the SID right: the worth of this role has become increasingly recognised, but it is the SID's informal role of supporting the Chairman, and tracking the Chairman/CEO relationship which has the greatest impact on Board Integrity as Ian Odgers and Kit Bingham explain in their article "SID at the Heart of an Effective Board". 
3. Managing the relationship between the NEDs and the CEO:  Gary Ashton discusses the importance of getting this tricky balance of power right in his article "NEDs:  Stand Up to the CEO".
4. Getting executive remuneration right:  Chris Legge and Gerrit Aronson discuss this issue in "Top Team Remuneration:  A New Perspective".

As I pointed out in my original article, those executives who do not exercise great vigilance in ensuring that they build explicit measures of integrity into board and organisational development are running unnecessary and extremely dangerous risks. The banking crisis came from an accumulation of individual actions, each stretching the truth and integrity a little further. Avoiding a repetition is down to the senior executives in all organisations realising that they carry personal responsibility for integrity. From this a board can develop group integrity that can be filtered down through the entire organisation.

By revisiting my 2003 article, I am not claiming the gift of foresight.  The truth is, the issue of good governance and integrity never went away.  It was, unfortunately, pushed aside for too long in a sector where it was most necessary.  Let's hope the lesson is learned this time.

How to Build Board Integrity
ER Consultants has developed an approach that is geared towards improvement and development, rather than just taking a snapshot of a board's performance.  This covers the formal board role and processes as well as its performance and effectiveness, at a team and individual level.

Understanding the Board Role:

• Overall governance framework regarding the board, and its committees;
• Clarity of matters reserved to the board;
• Board composition, regarding diversity, the balance of independents, and experience;
• Shared knowledge and understanding of strategy, the business model, the issues, forces and risks that drive the organisation.

Board Process:

• Assessing the effectiveness of board committees;
• Review of board processes such as agenda/papers/minute management;
• Assessing the degree of shared understanding of how the organisation executes: systems of internal control; business and financial audit; business financing; executive remuneration, and succession.

Board Performance:

• Assessing the quality of the relationships between executive directors, NEDs, and key stakeholders;
• Agenda management - the ability to raise issues and get matters placed on the agenda;
• Dealing with the right issues in an effective manner - the degree of cohesion and alignment of the board, information management, and decision-making effectiveness.

Once the board has been assessed, we offer development services in the following areas:

• Board Development:  creating effective boards by creating common visions of roles, interfaces and accountabilities.
• Director Development:  coaching directors, providing external challenge, and acting as a sounding board.
• Executive Team Development:  coaching and facilitating top executives teams to build strong leadership platforms for culture development, business growth, and performance.
• Independent Director (NED) Development:  coaching, and creating forums for cross learning and challenge.

For more information, contact Mark Goodridge
 

References:

1. "Creating the Organisation With Integrity", Topics, October 2003, http://www.erconsultants.co.uk/ot/board_development/creating_organisation_integrity
2. "Financial Service Authority to Investigate Bankers' Failures", Dan Milmo,  12th April 2009. http://www.guardian.co.uk/business/2009/apr/12/fsa-investigation-rbs-hbos-lloyds
3. "A Review of Corporate Governance in UK Banks and Other Financial Industry Entities, Final Recommendations", David Walker, November 2009, Page 13, Paragraph 1.
4. "A Review of Corporate Governance in UK Banks and Other Financial Industry Entities, Final Recommendations", David Walker, November 2009, Page 11, Paragraph 1.
5. "A Review of Corporate Governance in UK Banks and Other Financial Industry Entities, Final Recommendations", David Walker, November 2009, Page 9, Paragraph 3.