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SPECIAL ISSUE

THE FEDERAL RESERVE BANK
OF CHICAGO

DECEMBER 2003
NUMBER 197b

Chicago Fed Letter
Corporate governance: Implications for financial services firms
by Nisreen Darwish, associate regulatory economist, Elijah Brewer III, senior economist and economic advisor,
and Douglas D. Evanoff, senior financial economist and vice president

When corporate governance is effective, it helps safeguard shareholders, customers,
and employees without hindering appropriate risk-taking. But when it is ineffective, it
can have a disastrous impact on these key stakeholders and on the long-term viability
of the enterprise. This year’s Conference on Bank Structure and Competition brought
some of the nation’s top policymakers and bankers together to discuss corporate
governance reform and the role of financial firms and regulators.

On May 7–9, 2003, the Federal Reserve

Recent examples of
corporate malfeasance
have led to greater investor
skepticism and increased
uncertainty in the equity
and credit markets.

Bank of Chicago hosted its 39th annual
Conference on Bank Structure and
Competition. This year’s conference focused on the effectiveness and appropriate role of boards of directors,
shareholders, creditors (including
banks), financial regulators, accounting
standards, and disclosure rules in governing the behavior of corporate managers. Recently, a number of highly
publicized events have highlighted the
importance of having an effective corporate governance structure. Once-revered
companies such as Arthur Andersen,
Enron, Tyco, and WorldCom have been
severely damaged, in some cases beyond
repair, by failure to follow appropriate
corporate governance principles. Thousands of jobs and billions of dollars of
value have been lost. Financial ser vices
firms have been affected through their
credit exposures to firms that followed
questionable accounting practices, as
well as through their own corporate
governance practices.
In his opening remarks, Chicago Fed
President Michael H. Moskow emphasized that the recent examples of corporate malfeasance have “led to
greater investor skepticism and increased uncertainty in the equity and

credit markets.” This “uncertainty
affects asset prices and can negatively
impact the economy,” he added.
The corporate governance system can
be defined as the interactions among
shareholders, managers, boards of directors, and outside auditors and analysts, together with the laws, regulations,
and institutions that govern their actions. When this system is effective, it
helps safeguard shareholders, customers, and employees without hindering
appropriate risk-taking. But when it is
ineffective, it can have a disastrous impact on these key stakeholders and on
the long-term viability of the enterprise.
Key questions that were addressed
during the conference include:
• How should we reform our corporate governance structure?
• What should financial firms be doing to address these reforms?
• How should financial regulators respond? Is there the potential for
overreaction?
• What best governance practices exist in the industry? Are they transferable? Does the structure of bank
boards significantly affect the extent of corporate governance?

A special theme panel on these issues,
featured Susan Schmidt Bies, governor,
Board of Governors of the Federal
Reserve System; Elizabeth A. Duke,
vice chairman, American Bankers
Association, and senior vice president,
South Trust Corporation; Randall S.
Kroszner, member, President’s Council
of Economic Advisors and University
of Chicago; Katherine Schipper, member, Financial Accounting Standards
Board; and Kenneth Scott, Ralph M.
Parsons Professor of Law and Business
Emeritus, Stanford Law School. Other
sessions addressed the financial services regulatory and legislative agenda,
future directions for the financial markets, banking relationships and corporate behavior, and the potential for
extracting information from market
and accounting data.
In his keynote address to the conference, Federal Reserve Board Chairman
Alan Greenspan was optimistic about
both the future of financial services and
the state of corporate governance, notwithstanding recent events. Our system
of corporate governance “has evolved
over the past century to more effectively
promote the allocation of the nation’s
savings to its most productive uses. And,
generally speaking, the resulting structure of business incentives, reporting,
and accountability has ser ved us well.
We could not have achieved our current
level of national productivity if corporate
governance had been deeply flawed,”
said Greenspan. Moskow, in a session
on the private and public sector responses to corporate governance problems,
agreed that the U.S. system of corporate
governance is not deeply flawed. “I do
not believe that our system of corporate
governance needs a massive overhaul,
and any changes that we make must be
consistent with a fundamental reliance
on the market as the arbiter of a firm’s
performance.” He indicated that the
success of this system relies on two
fundamental economic principles:
1) The incentives of managers should
be aligned with the goals of the shareholders; and 2) the firm’s financial
condition should be sufficiently transparent to enable shareholders to evaluate the performance of managers
based on public information.

According to Moskow, the corporate
governance system should include
checks and balances to make sure that
funds are wisely and efficiently invested
by corporate managers. Kroszner concurred, adding that the system of checks
and balances should be readily observable by outsiders.
Markets versus rules and regulations

Cynthia A. Glassman, commissioner, U.S.
Securities and Exchange Commission,
who also spoke in the session on the
private and public sector responses,
cautioned against the unintended consequences of rules and regulations and
argued in favor of market-based solutions. “The nature of regulations is
that they have general applicability,”
said Glassman, “and it is difficult to
consider and craft a response that is appropriate to all situations.” Moskow also
discussed the consequence of relying on
regulation rather than the marketplace
to discipline and monitor managers’
behavior. “To be sure, the market will
occasionally make mistakes—but the
danger in replacing the market with
regulations is that regulations typically

more complex question is whether this
greater volume of information has led
to comparable improvements in the
transparency of firms.” He argued that
public disclosure and transparency are
not interchangeable, and that “transparency challenges market participants
not only to provide information, but
also to place that information in a context that makes it meaningful. Transparency challenges market participants
to present information in ways that accurately reflect risks. Much disclosure
currently falls short of these more demanding goals.”
Bies suggested that investors and creditors should be provided with the information necessary to understand the
risks that a firm is bearing and those that
it has transferred to others. Thomas
M. Hoenig, president, Federal Reserve
Bank of Kansas City, who spoke in a session on the financial services regulatory and legislative agenda, came to the
same conclusion, saying that “a critical
goal for us [regulators] to explore is how
to enhance market discipline by providing market participants with adequate,
timely, and accurate information for

We could not have achieved our current level of
national productivity if corporate governance had been
deeply flawed.
make even more mistakes than the market. Just recall the unintended effects
that the Glass-Steagall Act had on our
financial system and the 60 years it
took for us to repeal the harmful portions of that Act,” noted Moskow.
Glassman said that one of the most important jobs a manager of a public company has is accurate disclosure. “To
make sure that the disclosures fairly
present the company’s financial condition ... managers should spend their
time on the critical accounting judgments and corporate events that are
most important to ensuring clear and
accurate disclosure.” Greenspan noted,
however, that “although we have made
great strides in expanding the volume
of publicly disclosed information ... a

making decisions.” He indicated that
the bank supervisory agencies could
help in this area. Bank supervisory
agencies make use of proprietary and
internal information at each bank, as
well as confidential information on
customers that, in general, is not available to market participants. While acknowledging that the Securities and
Exchange Commission already requires
publicly traded banks to disclose any
significant news in a timely manner,
Hoenig argued that the release of significant or material examination findings could enhance market discipline.
“Disclosure of significant examination
findings could ... help make a bank’s
own disclosures more accurate and
more reflective of supervisory concerns. At the same time, the prospect

of having to make such disclosures would
provide banks with an added incentive
to monitor and manage their risk exposures carefully and to comply with
regulatory objectives,” said Hoenig.
While Hoenig examined steps that bank
supervisors could take to improve the
market access to information, Gary H.
Stern, president, Federal Reserve Bank
of Minneapolis, in the same session,
discussed how market information could
be used in the supervisory framework.
Stern said that market prices of equity,
debt, derivatives, and other financial
instruments contain valuable information on the riskiness of individual banks,
and the risk measures derived from
these prices provide useful information that adds to the existing knowledge of bank examiners.
Effective risk-management and
transparency practices

Bies discussed how developments in
risk-management practices could
strengthen corporate governance and
market transparency. Risk-management
processes are designed to identify risks
and report on the effectiveness of internal controls to senior management
and boards of directors. During the last
two decades, dramatic changes have
occurred in financial innovation, financial engineering, and risk-management
practices. Financial services firms have
altered their operations, shifting away
from the management of traditional
products, such as deposits and loans, to
management of nontraditional products, such as credit derivatives. These
nontraditional products have facilitated
the separation and reallocation of risks
to parties more willing and able to bear
them. An important part of this evolution has been the development of methodologies for measuring and monitoring
risk. “As companies have become increasingly diverse, and risk-management
tools more sophisticated,” said Bies,
“the time has come for companies, including financial firms, to look at risk
in a more formal way across the organization and in all its dimensions.”
Greenspan discussed the importance
of incentives for effective risk management. He challenged the view that

government regulation is essential to
ensuring efficacious risk management
and stated that “private regulation generally is far better at constraining excessive risk-taking than is government
regulation.” He noted that “market participants usually have strong incentives
to monitor and control the risks they assume in choosing to deal with particular
counterparties. In essence, prudential
regulation is supplied by the market
through counterparty evaluation and
monitoring rather than by authorities.”
CEO compensation and independent
directors

An aspect of the discussion on corporate
governance problems is how chief executive officers (CEOs) are compensated.
The use of equity-based compensation
(stock options and restricted stock) has
come under increasing public and
congressional scrutiny. While equitybased compensation contracts are intended to encourage executives to take
actions that are consistent with the expectations of shareholders, they have
not always accomplished this goal. This
has led to demands for greater transparency in executive stock option programs
and, in some cases, to elimination of
the programs.
In his luncheon speech, Jamie Dimon,
chairman and chief executive officer
of Bank One, argued that compensation has become excessive, indicating
that compensation levels are unrelated
to how well firms are performing.
“This, I put in the category of lack of
leadership. It hurts companies; it
hurts America; and [that’s] why it will
have legs in Washington,” said Dimon.
The tax code, which states that executive
compensation above $1 million must
be “performance-based” in order to be
tax deductible, encourages firms to pay
their top executives with stock options
rather than with cash. Moskow suggested several changes in the way firms compensate their top executives. “We can
begin by eliminating accounting rules
and tax laws that interfere with the manner in which boards of directors choose
to compensate executive officers. Boards
should design their executive compensation plans to reward managers for

exemplary firm performance, not to
exploit tax and accounting rules that
favor one type of compensation over
another,” said Moskow.
If stock options are to remain an important part of many executives’ compensation, Moskow argued that the contracts
should be redesigned to allow for variable strike prices. The current practice
of using fixed strike prices has led to
enormous increases in executive wealth
when the overall stock market rises as
it did during the 1990s. “Because these
options were not indexed to the market, this led to enormous—and let me
say quite unexpected—increases in the
wealth of some executives. And many
of them reaped these windfalls even
though the price of their firms’ stock
had underperformed those of their
peers,” said Moskow.
Linking the strike prices to the performance of the company’s stock relative
to a market or industry index, Moskow
said, “would insure that overall runups in the stock market do not benefit
managers whose companies are underperforming. It also would ensure that
overall declines in the stock market do
not penalize managers whose firms are
doing well relative to their peers. Indexing also will reduce the incentive to reset option strike prices at firms whose
stock price has declined.”
In her discussion on the oversight of
executive compensation, Glassman
Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; David
Marshall, team leader, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System. Articles may be reprinted if the
source is credited and the Research Department
is provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
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ISSN 0895-0164

suggested that the corporate board
could carry out its oversight role by providing appropriate incentives to management, and “compensation is the
biggest carrot the board has in terms of
incentives.” As a principle of good governance, Glassman further suggested
that “the compensation committee
should be comprised solely of independent directors” and by independent, she
meant the “true independence that
goes beyond the technicalities of
Commission rules or listing standards.”
According to Duke, “one of the biggest
issues concerning large, publicly traded
banks is the definition of director independence.” She stressed that the current
proposals discussing director independence fail to recognize that banks are
different. Banks are different, because
they “need a definition of director independence that recognizes that directors
should be able to do business with the
banks on whose boards they sit. Yet some
of the proposals would forbid bank directors from ‘purchasing’ their bank’s
products and services.” Duke cited the
example in which a director of Wal-Mart
is not prohibited from walking into the
store and buying something, and “similarly, a bank director should not be prohibited from doing business with the
bank under the same terms and conditions offered to the public.”
During his luncheon speech, Kenneth
D. Lewis, chairman, president, and CEO
of Bank of America, stressed that it is

more interdependence than independence that makes a board of directors
strong and effective. He said that while
“independence is a very useful tool for
insulating some functions from inappropriate influence or conflicts of interest … excessive independence also has
disadvantages.” Lewis defined excessive
independence as “the lack of a meaningful relationship between a director
and the company he or she is charged
with directing, or the lack of a strong
relationship between board members
and the CEO.” According to Lewis, “it
is dangerous to assume a direct correlation between ever-greater degrees of
board independence and improved
corporate performance.” It is not the
degree of independence from the company or chairman that determines
whether an individual is a strong and
effective director, but rather “it is their
character, values, strategic insight, business knowledge, and their ability to influence and work well with others. It is
their ability to create productive interdependence with their fellow directors.”
Scott pointed out that the current corporate governance problems extend well
beyond the structure of the board of
directors. “The general problem in
corporate governance is the principal
controlling the agent—the owners trying
to control the managers to act in the
interest of the principal or owners and
not be self-serving. The board is only one
device for achieving that kind of control
over management,” said Scott. He

concluded that one really has to look
at the structure of share ownership in
the firm and at the legal system.
Conclusion

This year’s Bank Structure Conference
highlighted the importance of having
an appropriate system of corporate governance for both financial and nonfinancial firms. Conference participants
were in general agreement that our system of market discipline and corporate
governance has ser ved us well, but the
recent examples of corporate misconduct have revealed areas where repairs
are needed. Bank super visory agencies
can play an important role by using internal data and market data in their
supervisory framework and encouraging the banking industry to be leaders
in strengthening the system of corporate
governance. “Banking super visors will
continue to encourage the banking industry to be leaders in strengthening
corporate governance, risk management,
and internal controls and in implementing transparent accounting and disclosure practices,” noted Bies.
The 40th annual conference will be
held May 5–7, 2004. The 2004 theme,
“How do banks compete? Strategy,
regulation, and technology,” will focus
on how commercial banks have repositioned themselves to compete under
new economic, technological, and regulatory conditions. For more information on the upcoming conference, go
to www.chicagofed.org.