Australia has learnt from the banking royal commission that AMP lied to the Australian Securities and Investments Commission on 20 occasions. The revelations seem unbelievable and have shocked the public. But there is also a simple reason not only for such behaviour - as well as why we should expect it as the norm. Moreover, it explains why the lead offenders are ASX-listed financial service companies under APRA regulation.
Just as fish rot from the head, the same is true of companies headed by boards. One might naively believe that shareholders can elect boards that look after their interests, but the ASX Corporate Governance Council (CGC) technically "recommends" (but in reality requires) that a majority of board members must not only be "independent" of management, but also "independent" of significant shareholders – a "lock the gate" clause designed to keep shareholders out.
Surely, one should not require directors to be independent of the very shareholders they are supposed to represent!
So much for the alignment of interest between the company and its shareholders that would normally protect shareholders and the firm's clients from rapacious management. Or the kind of conduct that has become the norm in the financial sector.
Worse still, the board nominating subcommittee must in turn be made up of "independents". These committees recommend more independents, squeezing out all the other more responsible categories of people that join boards.
There would be no problems here if "independents", who are part-time and largely professional directors with negligible share ownership, were also equipped to monitor management and to replace genuinely non-performing chief executives if it ever becomes necessary.
Unfortunately, this is largely not the case.
Indeed, their very independence means they cannot have any special knowledge or connection with the firm when joining the board. That mitigates against them being able to monitor management effectively or even provide worthwhile strategic advice.
In effect, even if these director-types were motivated to perform diligently, they lack the knowledge base and day-to-day involvement with the corporation and its business model.
The ASX CGC has anticipated that these unjustified rules might indeed be inappropriate, by inserting an "if-not why-not" escape clause that gives boards wriggle-room to avoid the worst aspects of this straitjacket imposed on shareholders.
For example, a non-financial firm can declare a significant shareholder to be an "independent" board member if they can provide justification.
But the APRA Act and the regulations specifying the obligations of APRA-regulated financial corporations require that the CGC board directives must be followed, but without the ability to depart from its rules by using the "if-not why-not" clause.
This helps to explain why the royal commission is one into banking and financial services – nowhere else in the economy.
In the United States, which saw subprime lending based on liar loans melt down into the 2008 global financial crisis, the mandated independent board structure is very similar to ours.
The one exception is that a significant shareholding does not automatically signify a lack of independence (from shareholders, presumably).
Based on a current joint investigation into the board structures of 891 banks in the US, Dietmar Leisen and I find the main driver of firm shareholder performance to be CEO pay incentives – where pay is highly sensitive to results. But monitoring by the rapidly increasing number of independent directors, and especially those with a high profile and prestige, is far from benign for the banks, offsetting the influence of effects of incentives and substantially curtailing the tenure of CEOs.
Moreover, CEO dismissal seems to largely occur for reasons other than shareholder performance – with shades of the very rapid turnover of CEOs and chairmen at the benighted AMP. Low tenure expectations for the CEO then forces these temporary incumbents to take a very short term view.
Hence the strong focus on subprime lending in the US – even though the CEO must have known the music would soon stop with shareholders left holding the parcel of nearly worthless subprime securities carefully constructed from poor quality loans. This extreme short-termism, with its exploitation of shareholders and customers for temporary gain, followed by a sharp share price correction when everything is revealed, comes across as a defining feature of both the catastrophic US subprime crisis and the royal commission's most startling revelations.
We found that highly incentivised CEOs reduce risk-taking with reduced leverage. But more independents raise leverage. That is overcome as CEO tenure increases, undoing the short-termism. By contrast, prestigious independent directors both reduce risk taking and discourage accounting manipulation.
But, the greater the tenure of the independents, the worse non-performing loans become.
What needs to be done? The government must repeal APRA's ban on the Corporate Governance Council's "if-not why-not" escape clause and require ASIC to force the dismissal of the ASX's CGC, whose interests are largely opposed to those of shareholders. Shareholder-friendly board rules are required to reinstate shareholder democracy with reasonable CEO tenure, and better CEO oversight.
It is not only boards and executives who are to blame and perhaps should face jail. It must be shared with the two institutions, ASX, and the regulator, APRA, since together they have locked shareholders out.
Peter Swan is professor of finance at the UNSW Business School.