Risk Management and Corporate Governance

By Kirsty McHugh, OUP UK

One of the main areas in corporate governance that has caught the headlines recently is risk management. There is a widely held perception that in recent years many boards have not managed the risks associated with their businesses well – whether that was because they did not identify the risks fully or whether because having identified the risks, they did not take appropriate action to manage them. In the below post, Professor Chris Mallin explains more about this. She is Professor of Corporate Governance and Finance & Director of the Centre for Corporate Governance Research at the University of Birmingham, and blogs with fellow OUP author Bob Tricker at Corporate Governance. She is the author of Corporate Governance, the third edition of which has just been published. Her other blog posts can be found here.

The Financial Reporting Council (FRC)’s Review of the UK’s Combined Code published in December 2009  states that ‘One of the strongest themes to emerge from the review was the need for boards to take responsibility for assessing the major risks facing the company, agreeing the company’s risk profile and tolerance of risk, and overseeing the risk management systems. There was a view that not all boards had carried out this role adequately and in discussion with the chairmen of listed companies many agreed that the financial crisis had led their boards to devote more time to consideration of the major risks facing the company.’ The FRC therefore proposes to make the board’s responsibility for risk more explicit in the Code through a new principle and provision. Moreover it also intends to carry out a limited review of the Turnbull Guidance on internal control during 2010. Many companies, and especially those in the financial sector, have already established risk committees whilst other companies especially smaller companies, may combine the consideration of risk with the role and responsibilities of the audit committee.

The UK’s Alternative Investment Market (AIM) expanded rapidly during the 12 years following its inception in 1995. Then from 2007 onwards it went into decline. David Blackwell, in his article ‘Signs of recovery seen after years of famine’  states that ‘Hundreds of companies have left the market, the number of flotations has collapsed and fines for Regal Petroleum and others – albeit for regulatory infringements dating back years – have once again sullied the market’s reputation’. Nonetheless he points out that 2009 saw an improvement with the AIM index rising by 62 per cent over the year compared to a rise of 22 per cent in the FTSE 100.

The lighter regulatory touch on AIM has both attractions and drawbacks. On the one hand, companies find it easier to gain a London listing (albeit on AIM rather than the main market); on the other hand, this may bring concomitant risks for investors as they will be investing in companies which may well be riskier than their main market counterparts.

Family firms are the dominant form of business in many countries around the world and range from very small businesses to multinational corporations. Richard Milne in his article ‘Blood ties serve business well during the crisis’ points out that the attributes of a typical family business will have stood it in good stead during the recent financial crisis: ‘Long-term thinking, conservative, risk-averse: the very characteristics of the typical family business seem to be the ones needed in the economic crisis of the past two years’. Given that they tend to be more conservative, family firms will take less risks, for example, by not over extending themselves with their gearing (leverage).

Many banks and financial institutions were widely criticised because of the perceived overly generous bonuses paid to some executive directors and senior management at a time when the world is suffering the consequences of a global financial crisis precipitated by bankers who did not seem to fully appreciate the risks involved with some of the products they were trading in. And yet already we see banks again paying out enormous bonuses. Megan Murphy in her article ‘Tycoon attacks return of bankers’ bonuses’ quotes Guy Hands, the private equity tycoon, who is highly critical of these big bonuses and speaks of bankers ‘taking home “wheelbarrows of money” on the back of taxpayers’ support’. Moreover he is quoted as saying ‘It cannot be right to continue with a system that allows risk to be taken in the knowledge that, if things go right, bankers will take on average 60-80 per cent of the profits generated through compensation and, if they go wrong, shareholders and ultimately the government will pick up the costs’.

Managing risk is, of course, relevant to all parties in the business and financial world as the article by Sophia Grene ‘Managing risk is the main task ahead’ illustrates. In her article, Sophia points out that ‘many financial models failed in the past two years as markets demonstrated they did not behave according to conventional assumptions’ and that ‘the main challenge for asset managers in the coming decade is understanding, managing and communicating risk’.

Managing risk and managing it well is an important consideration for boards of directors, whether in main market firms, second tier markets, or family firms. Firms, and especially those in the banking and financial sector, need to pay particular attention to executive director remuneration packages which should not encourage adverse decision-making in terms of the impact on risk, that is, remuneration packages should be designed so that they do not lead to unacceptable risk-taking which may be to the detriment of the long-term sustainability of the company and potentially, as we have already seen, the wider economy.