We are undergoing one of the biggest financial crises since the Great Depression. This crisis follows hard on the heels of the Long-Term Capital management debacle in 1998 and the Enron debacle of the early 2000’s. Wasn’t Sarbanes Oxley supposed to fix all this? Wasn’t good corporate governance the new mantra for the 21st century? How come with the biggest corporate governance push of all time, we are now in yet another financial crisis? Is there any possibility that these two trends could be linked?

It is starting to appear that the benefits of the movement for good corporate governance may have been massively outweighed by the damage it has caused. Indeed it may even be that the movement towards good corporate governance and Sarbox was instrumental in causing the credit crisis by leading to overconfidence by investors in corporate managerial quality. In this view, corporate governance reforms caused over-investment in a variety of exotic investment classes which layered on top of the housing crisis to cause the financial equivalent of a perfect storm.

The Enron to End All Enrons?

Why should the credit crisis have occurred in the first place? The root cause of the Enron debacle was risky financial behavior that was covered up by using off-balance sheet entities to disguise the losses. Why then, did auditors, lawyers, accountants, the SEC and the ratings companies ignore the massive liabilities contained in the Structured Investment Vehicles of the investment banking grandees such as Citigroup, UBS, Bear Stearns, Lehman Brothers and the like?

Why would good corporate governance overseers ignore the massive risks inherent in the ever-more exotic instruments devised by Wall Street? Wasn’t this their job? Wasn't this why they were – and are still – being paid enormous sums by every public company to avoid major risks? Wasn’t the good corporate governance movement all about achieving complete transparency so that corporate managers could never hide major risk again from investors and shareholders?

Weren’t the consulting and audit companies there to advise us if anything seemed wrong? Isn’t there a now-enormous corporate governance industry that was encouraged to form by the Feds precisely to ensure that an Enron could never happen again? Weren’t there new legal and accounting rules and regulations in place to ensure that this industry had the right guidance and road map to guide the huge armies of lawyers, accountants and consultants who now oversaw companies and their financial systems? Didn’t Congress devise these rules so that we could never be blindsided so totally again?

What is it in the compensation systems of these companies that could lead to the managers benefiting at the expense of the shareholders? Why would a compensation system be designed that could lead to shareholders losing while managers made out big-time? Aren’t compensation systems such as these prone to lead to systemic risk?
Weren’t auditors, corporate governance specialists, lawyers and accountants, and the ratings companies supposed to point this out as part of their responsibility for good corporate governance? What factors could possibly have led them to overlook these risks? Why did the honorable few whistle-blowers get canned and ignored, even by the corporate governance guardians? Wasn’t the SEC supposed to be making them all do their job?

Good Corporate Governance Increases Moral Hazard?

So let me attempt to answer just a few of the above questions.

The knowledge that there are systems in place to protect against systemic risk provides confidence for those who want to increase risk (in order to get higher returns) that they will have a safety net preventing these risks from getting out of hand. This leads to even greater risk taking. When profits go down, this leads to even more risky behavior because everyone believes that the risks are ultimately contained.

This risky behavior results in reduced moral hazard since corporate managers believe that they have systems in place that will protect them if things go wrong, which is, they believe, very unlikely. Investors similarly become more confident that with apparently sophisticated corporate governance systems in place, they cannot get burned so they increase the riskiness of their investments and bets.

Compensation systems reward those who take the biggest risks, since there is a tacit understanding that even if the company has a problem, the employees, including the CEO, will still make out big.

In short, the perception that there is a corporate safety net in place because of the existence of a huge corporate governance oversight encourages even more risky behavior. The safety net encourages companies to develop compensation systems which increase systemic risk. These processes lead to reduced moral hazard in turn increasing risky behavior even further.

Sarbox took away a key prop for maintaining moral hazard at a suitably high but appropriate level. If everyone thinks that corporate governance systems lead to low risks of default and problems, they undertake more risky behavior.


Recommendations

Review your corporate governance to see if it is still having the same impact in your own companyReview your corporate governance to see if it is focusing more on form rather than function and actual behaviorsTake a critical approach to your corporate governance and outside advisors to see if they really have the right incentives to tell you when things are going wrong