Improving The Corporate Governance In Irish Financial Institutions After The 2008 Financial Crisis

The 2008 financial crisis proved that healthy economy can only be built on well-functioning financial systems. As Ireland joined EU, easy access to cheap funding, inflow of foreign banks with new products, increased securitization and competition among financial players (overrelying on speculative property market) created herding - unhealthy game with unexpected consequences. The best practice of banks governance mechanisms has fallen short. Anglo and INBS were particularly focused on aggressive lending and competition causing crisis and subsequent collapses. Anglo, as a relationship bank with small branch network and limited number of C&P sector customers, has had high concentration of loans to related entities (loan syndicating). The bank didn’t provide cheap loans, but its strong point was quick approval (needed for property developers). To protect the business relationship it was ready to provide higher-risk loans, including problematic applications, relying on leveraged personal guarantees. That was posing risk to the bank capital sustainability.

Lending policies were treated as guidelines rather than rules. Loans were not adequately classified and reporting of credit risk was poor. The bank board was large, but its CEO and number of experienced bankers left in 2005, what caused the governance principles to be misinterpreted to promote increased lending. The CEO was appointed as a Chairman of the Board, what was another contraversion of governance principles. The new Board members were experienced, but not experts in banking and were heavily reliant on senior management in risks assessment. Management as a bank shareholder, was focused on reaching sales targets for two incentives: remuneration/bonuses and increase of share price. That was causing potential conflict of interests and information asymmetry in a way of obtaining sale. Although Internal Audit was strong, FR requested to put in place the culture of risk awareness. With lack of FR sanctions, little action was taken by the bank believing the current system is sufficient to meet the challenges. The competition for the balance sheet growth caused that the property lending growth outpaced the GDP growth in many cases.

Increase in the availability of credit, caused substantial increase in property values. Market competition led to lowering credit standards among banks as a way of profitability. In some banks this strategy was adopted by the boards, in others - target growth was left in the hands of management, not realizing the risks, as many banks were managed by people with less experience of compliance, credit and risk management. The bank strategies run to higher growth and profits, but also higher bank valuations impacting security value (overreliance on ‘Equity Release’). INBS was especially focused on providing extremely high LTV loans to property developers for purchase of sites (zoned, but requiring planning permissions). It was risky business model, where loans were secured on assets and financed externally. INBS goal was demutualization and sale to spread the cash for management and Board, so its ‘tone from the top’ dictated little care for environment. INBS loan approval process standards were poor, files bad and loans were not properly classified, internal audit was raising concerns. In flat INBS organizational structure, small number of staff was managing large commercial loan book and reporting to ‘power of one’ - Managing Director. The INBS had Asset and Liability Committee as well Audit Committee, but no Nominations and Risk Committees, which could challenge risk appetite or check compliance with credit policy. The committees and functions lacked independence due to reporting directly to MD. Board had only 3 NEDs, staff rotation was usual and board members had little practical banking experience. INBS did not build robust organizational structures and RMFs, as it was no evidence of: internal risk limits, concentration risk, the adequacy of security. Cost-income ratio had declined substantially before crisis, but no rating agencies concerned about it. FR made frequent requests to improve governance, but with small actions. Board was relying on the bias of past performance and was sure that the choice of trusted borrowers and profitable property developments projects will be sufficient to manage risks.

Desire for independence (to prevent takeover by other domestic or foreign bank) as well as pressure to increase bank share price and capital level, were the main reasons of willingness to accept higher risks and provide excessive lending among banks. When the lending grew rapidly, bank deposits were not sufficient to cover the funding, so banks were borrowing heavily on cheap EU wholesale (short-term and international) markets. This funding structure made banks more vulnerable (liquidity risk was accumulated). Authorities, due to lack of previous crisis experience, were predicting ‘soft landing’ and banks were believing that wholesale funding will be always available. Although the governance structures and procedures in AIB, BOI, EBS or IL&P were in place this time, its effectiveness has changed over period. Increased competition in the mortgage market led to falling: margins and share price. The smaller banks (EBS & IL&P) decided to increase lending to compensate for the fall in margins. When deposits were not sufficient, they called for wholesale markets. Banks started to lower credit standards and accept dominant sales cultures of its staff, who were lacking credit and risk expertise. Risk functions became flexible to facilitate targets and Internal Audit was limited to inspections only. In bigger banks (AIB, BOI) the major driver of growth became C&P lending to experienced property developers. Large property exposures were managed by retail rather than specialist corporate lending divisions (as transfer to other division would reduce the profitability). That contributed to high level of loan impairment in both AIB and BOI. Difficulty in credit risk management was additionally caused by inadequate IT systems. Large loans were not supervised properly due the volume of business growth and credit procedures were relaxed.

The herding, groupthink, lack of transparency and banking knowledge, were the major causes of poor governance mechanisms, acceptance of “silo strategies” and fall of the banks. The collegiate and team work was just job requirement, so banks let themselves to be steered by the competition and profits into risks. Lack of policy change by authorities, further enabled those bad bahaviours. The fall of Anglo and INBS (in spite of excellent pre crisis financial statements) as well as many banks scandals, reduced public trust and confidence in financial systems, reporting and auditing. In order to prevent directors frauds and agency conflict1 the banks have been requested to comply with different corporate governance codes. The majority of Irish banks have small separation of control and ownership - they are directed, owned and managed by the same individual or group.

Two main approaches to corporate governance regulations are: principles-based (the UK model) and rules-based approach (the US model): The governance in Ireland evolved as principles-based and banks were subject to the UK Corporate Governance Code, which is set of principles. Under same directors had to describe in their own words how they have applied the general principles of corporate governance. The recent changes across EU regime2 however, are forcing banks into rules-based approaches as a way to improve trust and accountability. In March 2009, the FSA chief executive, Hector Sants called for more intensive supervision: FR and CB have been heavily criticized for inaction prior financial crisis which was coming from misinterpretation of the principles-based approach, running to deterioration of banking standards. The aspiration of CB is that the limitations of principles-based regulation will be addressed via PRISM’s risk assessments. There are ongoing discussions around advantages and disadvantages of the principles-based and rules-based approaches at the time of transformation process. Both approaches call for independent NEDs, audit, remunerations and nominations committees of the board. Transparency, accountability and requirement of separation of CEO and Chairman are things in common. Main challenge on the way of implementation of proper corporate governance regulation in Irish banks is the fact, that most of them are State owned companies and subject to Code of Practice for the Governance of State Bodies (2016) still over and above CBI Corporate Governance Regulation.

Principles-based approach have no minimum standard of practice. Principles rise over time to influence a set of practices to the expectation of majority. If anyone believes practices have issue, then there is a problem of confidence in actions. Principles-based approach is flexible, innovative, subject to self-regulation and voluntary compliance, but requires a high degree of trust between participants to be effective.

Rules-based approach requires all members to present minimum standards of practice. To get approval, the standards have to be essentially the minimally acceptable. That can result in not always excellent standards. Rules-based approach requires more effort from regulator than from subject.

The major goal of improving the corporate governance in Irish financial institutions lies in supporting not only domestic, but first of all international confidence of Ireland as a suitable place to do the business and invest. Irish financial institutions boards have important role to support this Government agenda.