Corporate Accountability

Poor corporate governance is the most widespread reason why a business gets into trouble. Substandard management manifests itself in many ways: for instance, by paying only lip service, or no attention at all, to forecasting and planning; failing to take account of changes in the marketplace and to position the company against market forces; falling behind advances in technology; and lacking sensitivity to product obsolescence. The consequence is top management turnover. The average tenure of a chief executive in America declined from nearly nine years in 1890 to just over seven in 2001,’ The Economist suggests.¹

The first question relating to the title of this chapter is: what makes a market economy? In a nutshell, the answer is the six freedoms: freedom to enter the market, engage in competition, exit the market, set prices, make profits and, eventually, freedom to fail. There are, of course, other basic characteristics of a market economy, such as the need for market sensitivity, customer orientation, and rapid deliverables from research and development (R&D).

In 1927, AT&T funded the first big corporate retirement plan, but it was much later that the large-scale pension fund business saw the day. Between this first step of the late 1920s and in the last four decades of the twentieth century came the government-sponsored national pension-and-health plans, of which the French Social Security of 1936 is one of the first holistic examples. Whether private or public, pension plans are a social safety net and their financing takes one of two forms: Because of their function as savings vehicles for old age, pension funds (as well as life insurance companies) should primarily invest in the safer financial assets of a longer-term nature, with bonds given preference over stocks because equities have higher volatility. This choice, however, is not the general case. According to European Central Bank (ECB) statistics, at the end of 2002,

Corporate governance has been defined in Chapter 1, which also mentioned that this term tends to mean different things to different people. Chapter 2 positioned corporate governance within the context of a market economy. Chapter 3 was a case study on pension management that is found wanting, and therefore both in the US and in Europe the social safety net is at risk.

In July 2003 the market carried the news that fraud and other kinds of economic crime have struck more than a third of US companies. At the origin of this information has been a survey by PricewaterhouseCoopers, the CPA, and Wilmer Cutler & Pickering, a law firm. Of 91 companies whose executives completed the survey, some 35 percent responded that in the previous two years they had been victims of: The way it is usually defined, economic crime encompasses a range of illegal activities, including cybercrimes. A good question is who pays for it. While three out of four of US respondents to the aforementioned survey had insurance coverage, less than half obtained from their insurers recoveries for the crimes to which they were subjected. Hence, in the last analysis, the shareholders paid the bill.

A key notion underpinning the economy in which we live is that value is no longer built exclusively around the production of material goods. Increasingly, economic value depends on services and their utilization both within and outside the design, manufacturing, distribution and maintenance of a variety of goods and processes addressed to other companies and to consumers.

If the case of Citibank’s salvage from the edge of the abyss was the most significant financial event of 1990, and that of Long-Term Capital Management of 1998, from 2003 financial history books will retain two case studies: that of the Federal Home Mortgage Association (see Chapter 8), and the 28 April 2003 settlement of the ten best-known banks on Wall Street with the Securities and Exchange Commission (SEC)—to the tune of $1.4 billion (see section 4).

The case studies we have followed in the preceding seven chapters have provided plenty of evidence that companies fail for not one, but several reasons. This evidence has made the point that the most frequent, and most basic, reason is mismanagement. In competition for No. 1 position is doubtful assets. Poor management is instrumental in damaging an institution’s assets because of The main case study in this chapter concerns the Federal Home Mortgage Loan Corporation, better known as ‘Freddie Mac’. It was established by the US Federal Government in 1970 (more on this in sections 3 and 4). In the 1990s, like so many other institutions which were supposed to be prudent, Freddie Mac overleveraged itself — and in the first years of the new century it went overboard with derivatives.

In a way that parallels the rebirth of West Germany from the ruins of World War II, the hard-working Japanese saw to it that their economy had a spectacular recovery which spanned the better part of two decades: 1945 to 1965. Then started a new phase, which has lasted roughly a quarter of a century: 1965 to 1989, characterized by world expansion of Japanese entities, in finance as well as in manufacturing and trading.

A case study on the accountability of senior management of financial institutions must consider at least three issues which correlate although, at the same time, each of them is self-standing and vital on its own merits: profitability, control of risks being assumed, and financial staying power. The profitability of European Union (EU) banks weakened in 2003 as it did in 2002 and 2001, mainly because of increased loan-loss provisions and reduction in non-interest income.