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Boards should run the banks, not regulators

One major lesson from the economic bubble and ensuing credit crunch is that banks and other institutions cannot fulfil their corporate governance responsibilities effectively until their boards take ownership of strategy and the valuation of strategy, and conduct "strategy audits" in the same way they are required to audit financial accounts.

The Financial Services Authority's new code on how major banks should implement and maintain remuneration policies consistent with effective risk management are a significant step if we are to avoid a repeat of the financial crisis. The FSA found that there was excessive focus in pay on short term results and on metrics that were not risk-adjusted.

Linking bankers' pay more closely with long-term risk-adjusted performance is all part of a continuing process to highlight measurement of a firm’s strategy and strategic value alongside measures of accounting value and market value. Each has a role within the framework of a holistic approach to corporate governance.

Less than a year after the banking system nearly collapsed, it remains clear that some of the City’s biggest institutions were highly dysfunctional in their approach to corporate governance. Sir David Walker’s recent review of governance in UK banks concludes there was significant failure by non-executive directors, who did not see the risks that were coming up or monitor them adequately. He concludes that non-executive directors need to become more expert and better informed, more challenging and less collegial, and to devote more time to the job.

In any organisation, good governance centres on control through rigorous scrutiny of the current and future strategy and the financial consequences for stakeholders. Yet when it comes to strategy and the valuation of strategy, too many boards are seduced into endorsing corporate action by faith in executive prowess, rather than making sound strategic and financial judgements of their own.

Welcome as are Sir David’s recommendations about board challenge and the establishment of board risk committees, and the FSA’s about the new responsibilities of remuneration committees, banks and other institutions cannot fulfil their governance responsibilities effectively until their boards take ownership of strategy and the valuation of strategy, and conduct "strategy audits" in the same way they are required to audit financial accounts.

Effective board strategy audit would have helped mitigate much of the shareholder and taxpayer value destruction caused by the banking crisis. For example, it was RBS’s and Lloyds TSB’s ill-conceived acquisition strategies that led to the need for taxpayer bail-out, rather than the underlying financial health of each group prior to this course of action.

What we have seen are examples of "group think" where, at their worst, boards are content to tick boxes instead of individually and collectively taking responsibility to challenge and systematically “audit” strategy in the interests of shareholders, customers and other stakeholders.

One major lesson from the economic bubble and ensuing credit crunch is the need for boards to focus on strategy and strategic valuation as an integral part of corporate governance.

The Combined Code on corporate governance requires companies to look at financial accounting issues and at their relationship with the market. It does not identify strategy and strategic value or require that boards are well versed in it or take full ownership of it. The assumption must be either that boards do so naturally and well, or that strategic value is not as important a factor in entrepreneurial management as market value and financial accounting value. Neither position is, in my view, correct.

Strategic planning as practised in many organisations tends to turn a vital concept into a bureaucratic process, the outcome of which is often what the CEO wants to see. Many boards have strategy committees, but they often tend to be useful talking shops where excessively pre-packaged information, revealing interesting and persuasive logic but concealing genuine rigour, is routinely “rubber stamped”. Many boards lack access to the capability, analytical power or independence necessary to allow them to robustly challenge the strategy and its valuation as presented to them by the chief executive. Members are prevented from governing effectively as they are unable to develop an informed view owned by the board as a whole. The checks and balances needed for good governance are missing in this critical respect.

An important part of the solution, supporting the findings of Sir David Walker on governance and the FSA on remuneration, is for boards to audit the strategy and the strategic valuation of the firm. The audit should be carried out every two years (more frequently when the external environment is subject to especially rapid change) by a board that is competent to undertake the task and with the support of independent experts.

Strategy and the valuation of strategy are central to the good governance of the UK banking industry, and of companies generally. Strategy audit should take its place alongside financial audit as an equally important and explicit requirement.