An honest board makes an honest company

From a lecture given by Daniel Hodson, the Professor of Commerce at Gresham College, on the regulation of financial institutions
Click to follow
The Independent Online

It is possible that the Equitable Life could have been saved had there been a modern governance structure in place, appropriate to a life company with over a million policyholders, over the decades in which the seeds of its destruction were sown. The story is relatively simple: the Equitable Life had been selling guaranteed annuities as part of their pension package since 1957, in effect fixing the amount of future pension that a sum invested today could buy, regardless of the performance of markets or, indeed, of variations in life expectancy in the meantime.

It is possible that the Equitable Life could have been saved had there been a modern governance structure in place, appropriate to a life company with over a million policyholders, over the decades in which the seeds of its destruction were sown. The story is relatively simple: the Equitable Life had been selling guaranteed annuities as part of their pension package since 1957, in effect fixing the amount of future pension that a sum invested today could buy, regardless of the performance of markets or, indeed, of variations in life expectancy in the meantime.

Both turned against them - bond yields fell and life expectancy increased, forcing down the yield at which annuities could be bought. They consequently found that if they were to meet the contractual expectations of the relevant policyholders, a substantial deficit would be incurred, which could only be filled by reducing the bonuses made available to unguaranteed policyholders. The board therefore set about disclaiming a substantial part of the guaranteed element of the policies, but failed to convince the courts. Consequently the fund is now closed and a great institution laid low.

Much of the sad tale turns round actuarial judgements, which argues of course for greater actuarial knowledge among nonexecutive directors on relevant financial boards. This responsibility is undoubtedly more pronounced with financial institutions, and it is certainly not an area where the regulator is in the position to take a leading role. Arguably, the tone adopted should be associated with the highest ethical values.

A clear illustration of this is the behaviour of the building societies, and many other retail depositories, until the early 1990s in relation to the introduction of "new" accounts. Building societies had been in the habit of simultaneously attracting new deposit funds and reducing their overall cost of liabilities by creating a new deposit product, often only marginally different from one already existing, with a great song and dance and very competitive pricing. The investors' money would pour in, but it was of course expensive, and the trick then was to gradually and subtly reduce the interest rate payable on comparable "old" product, playing on the inertia of the old depositors, who would take a while to catch up. Some, usually the weakest, never did, and were in effect ripped off for years.

I was working at the Nationwide in the late Eighties and early Nineties, and we were as guilty as any other society of using this technique. But we got caught out at two levels. First, the personal money columns caught on to what was going on, resulting in horrendous publicity. And second, we acquired a chairman from outside the industry, Sir Colin Corness, who was flabbergasted at what had been going on for years, and ordered it stopped. With hindsight, it is clear that the practice was unfair, and the relevant boards should have called a halt a long time earlier.

Also, I find it impossible not to take examples from the Barings collapse, illustrating as it does not just corporate governance failures, but also regulatory supervision failures, at a number of different levels, and how proper governance structures might have saved the bank.

The conclusion, as all the world knows, was inevitable and violent, and the story continues to this day. It was clear that there was no in-depth understanding of the risks involved in derivatives trading at Barings' board level, either executive or non-executive. In particular, the proper application of a risk review as currently prescribed should have underlined the specific risk involved. Also, regular and routine management information should have drawn the inherent loss in each to the attention firstly of management, and then of the board.

The board's role is critical in setting the cultural and ethical environment in which the institution is operating.

Comments