Last seven articles in this series covered how macroeconomic development is assessed through a set of economic indicators. This article outlines the role of governance system in economic development. The efficiency of the governance system finally determines the level of economic development and its distribution among the public. This is well understood when countries are compared as to how some countries with resources lag behind whereas some countries emerge with foreign investments. Meanwhile, some countries which changed the governance system have emerged to develop fast. The countries who struggle with governance issues confront stagnation even with resources.
The words “governance” and “value” come from corporate literature. The value means the economic wealth created to owners of capital or shareholders who take risks of businesses. The governance means the management system that creates the value at maximum possible. Both are applicable to economic activities of all public and private sector organisations. However, the nature of capital, shareholders, risks, value and governance varies across organisations.
Shareholder Value
In private businesses, the shareholder value covers financial returns, i.e., dividends, profit/return on equity (ROE) and net worth (assets less liabilities) per share. The net worth is the base for market price of shares which fluctuates in response to information on business profile.
Economic development of a country is the value created in terms of national income, employment, capital stock and living standard as a joint result of the governance of all businesses, private and public. People are the shareholders. Instabilities in businesses and economic are caused by poor governance.
The governance is involved in three major conduits. They are the decision-making on business together with supervision, conduct of business with risk management and reporting of financial outcomes on business. Protracted lapses in any one or more can end up in scandals and collapses due to erosion of shareholder value and customer confidence. When instances are systemic, economies and regions also will confront crisis. The East Asian financial crisis 1997/98 and global financial crisis 2007/09 are two instances. The value/wealth can erode overnight or in few days, despite the decades taken to create it.
Governance in Private Sector
The corporate governance has its origin in the 19th century in Europe due to separation of ownership from control of companies following the formation of joint-stock companies. The owners or shareholders who were not involved in day-to-day operations of companies required assurance that those who control companies, i.e., directors and managers, were safeguarding their investments/capital and accurately reporting financial outcome of business so that shareholder value is created and protected. Therefore, most corporate governance practices and principles have evolved to protect the interests of shareholders from misdemeanours of directors and managers.
The current thinking recognizes company’s obligations to the wider society in the form of all stakeholders. However, this stakeholder-approach eventually becomes the shareholder value because the competitiveness and sustainability of the company has to be finally ensured by the shareholder value.
Accordingly, three conduits of the present corporate governance model are;
* the Board of Directors appointed by the shareholders as per the incorporation to take policy decisions on business with supervision,
* Chief Executive Officer (CEO) and senior management personnel appointed by the Board to carry on business in compliance with the Board’s policies and state regulations and
* framework for reporting of correct financial/monetary outcome of business in terms of profit/loss, assets and liabilities, cash flows and equity by using a set of accounting standards.
The value created to shareholders is the profitability as shown in financial outcomes. However, the operational inside of companies, especially of large and old ones, could be so complex that the tasks of the Boards and senior management are not easy ones. Power struggle between Chairman, CEO, Board members and senior management personnel and uncompetitive business models are the causes of business instabilities. Such complexities and dark corners are unearthed only at post-mortems of scandals.
Public Sector Governance
The public sector governance is about the size and quality of public service in the wider public interest. State businesses, regulations (including law and order) and supply of economic infrastructure are the broader components of the public service.
The three conduits of democratic governance system are;
* the elected President and members of the parliament as the public Board/Government,
* public servants appointed by government to deliver public service in terms of government’s policies/regulations/laws and
* financial reporting in terms of national budget, debt and national income/GDP estimates.
Shareholders are the public. Capital covers taxes, national resources/assets and currency stock. The tax and currency stock are estimated in finance. However, the value of most part of national resources, e.g., forest cover, reservoirs, stock of mineral resources, road network and reservoirs, is not estimated.
In respect of state enterprises, financial outcomes are reported similar to private companies. However, operational forms of the Board, senior public servants, product innovation, pricing, cost management and staff management are quite different from private sector due to certain national interest policies.
The power struggle inside the government is the main deterrent to the economic value of shareholders. The current constitutional conflict in Sri Lankan government is the fine example. The outcome of monarchy/authoritative public governance system is similar, except for the unelected governments.
Burning Issues in Governance
Inefficient Boards, conflict of interest and financial abuses/scandals are the key ones. All these will reduce the shareholder value and cause bankruptcies.
* Inefficient Boards
Although directors are appointed by shareholders, they are selected and nominated with the influence of the CEO. In most companies, Chairman of the Board and CEO are held by same person. Board directors generally approve what the CEO requests as he is the ground command. No effective supervision on business performance is carried out as directors are not on the ground. The Board not being skillful in composite to understand the company and business management is a major problem.
As some members of Board are members of many Boards because of their professional images, Board meetings become a routine. Therefore, CEOs are dominant while most scandals are attributed to CEO dominance. As such, the effectiveness and appropriateness of the present Board-based governance model are questioned although no alternative is suggested.
Same concerns are applicable to the government as well. In general, parliament/Cabinet makes decisions on subjects presented by the bureaucracy or the influential leaders of the government. Members go by political teams rather than objectivity on technical stuff. Therefore, nobody takes responsibility when decisions are turned-out to be detrimental or not implemented by the bureaucracy effectively. Therefore, governments also get into scandals and crises.
* Conflict of Interest
Conflict of interest is a situation of having vested/own interests against interests of the organisation. This results in offer of various favourable treatments on business transactions and positions to connected parties, i.e., members of the Boards and senior management members, their relations and friends, their businesses and connected entities of organisations. The conflict becomes unmanageable when large shareholders who have own business interests are appointed to Boards or management. In corporate sector, there are certain best practices and regulations to minimize the problem.
The public sector suffers from conflict of interest in all corners with no limit in practice or in underlying statutes due to privileges attached to public positions and authority. Conflicts prevailing in regulatory institutions are especially harmful since they unduly favour known/connected regulatees to secure competitive edges on businesses in the regulated market.
All such conflicts cause uneconomical financial outflows and reduce the share value. The incidence of corruption is a direct result of conflict of interest in both sectors. The attributes of integrity and loyalty of persons to their organisations are expected to minimize the problem.
* Financial Scandals
Abuses of corporate funds are the financial scandals. The two main sources of scandals are;
* the use of funds for personal benefits of Board members, senior management and staff through various remuneration systems and
* the creative accounting to inflate financial results by overvaluing incomes and hiding losses and risks.
The corporate literature is full of such scandals and resulting company collapses. The most recent remuneration scandal is Carlos Ghosn, the Chairman of Nissan Motor Corporation, who saved Nissan from near-bankruptcy in 1999 and created the motor conglomerate “Nissan-Renault-Mitsubishi Alliance,” and got jailed in November 2018 for indictments on concealing nearly US$ 45 mn of Nissan funds for private use. The scandals of Enron and WorldCom in 2002 in the US are the accounting scandals that showed non-existing assets with hidden liabilities.
All major corporate scandals have links to creative accounting resulted from various business valuation techniques and accounting judgements. Most scandals are connected to artificial fair values, judgement-based impairments and off-balance sheet accounting that have caused inflated profits and assets, despite actual near-bankruptcy conditions. They have led to several corporate failures such as Enron, WorldCom, Lehman Brothers, AIG and many more. Such inflation causes material cash outflows for executive remuneration and dividends that precipitate bankruptcies.
Creative accounting is alleged in the public sector too, especially in budgetary outturn, debt stock and national income/product estimates. State economic data lack standard data governance including internal controls and auditing. Therefore, the assessment of the economy through economic data such as inflation, GDP growth, international trade, credit and economic sectors is always alleged to be rosier.
As a result, economic decision-making in both private and state sectors lacks actual outlook and, therefore, significant volatilities and speculations are experienced in economic activities.
Similar to corporate failures, economies and governments also confront bankruptcies or financial/debt crises due to creative accounting. Instances of incumbent governments losing power at elections or otherwise, despite their rosy assessments, are government failures before crises hit.
Impact of Regulations
Regulations which are countless are intended to protect public interest over shareholder value. Consumer protection and industry stability are the key objectives. The confidence-building is the prime benefit of regulations, despite the moral hazard problem (people taking more risks with the expectation of state rescues). The best example is the banking regulation.
However, regulations protect shareholders too by minimizing market failures. Therefore, shareholders can be satisfied with protected shareholder value (although lower) and less efforts on corporate governance.
The Sarbanes-Oxley Act of 2002 in the US enacted in response to Enron and WorldCom scandals is a landmark regulation to promote governance. The section 404 of the Act imposes two requirements to guard financial reporting to prevent scandals. First is the company management to make a statement in the annual report covering its responsibility of establishing and maintaining adequate internal control structure and procedures for financial reporting and an assessment of their effectiveness for financial reporting. Second is the company’s external auditors to certify in the audit report the management’s internal control assessment.
In the capacity of Director of Bank Supervision in 2007, I had the opportunity to include this requirement in corporate governance regulations drafted by me for Sri Lankan banks. Regulations cover a set of principles-based rules for accountable bank governance. The objective is the financial system stability through public confidence building by good bank governance. Therefore, bank shareholder value was subordinated to the value of depositors and creditors. The bank regulatory/supervisory system also was aligned to promote the governance. These regulations which helped cleaning up the bank governance for national interest are now part of the law of land as endorsed by the Supreme Court in 2008.
The world development today is largely due to innovations and productivity created by unregulated and violated businesses. The best example is the modern information technology and e-commerce network created/led by few persons at own risks, free of direct regulations. If not for such inventions, the world development and living standards today would have been poorer. However, regulators now have commenced intervening in technology industry in response to recent concerns raised by few on privacy of information and abuses.
The problems of regulators are diverse.They think everybody in business is fraudulent and all business lapses are results of willful fraud or risks taken. They also think they can prevent recurrence of same. However, they fail not only to conduct themselves proper, but also to understand different risk appetites that govern businesses and evolving market mechanism with self-regulation that have created the world development so far. No record of specific achievement of regulators is available, except the countless lists of regulations.
Governance for Real Value
All economic activities whether businesses or public services have to improve the productivity which improves real value and livings standards of people if they are to sustain. Given resource limited relative to wants and needs of growing population, we need to mobilize and utilize resources (including creative destruction – displacing existing assets and jobs with new production and technology) at an increasing rate of productivity. It is this increase in productivity through new technology that has improved living standards of the world today.
However, both private and public sectors customarily evaluate their performance on financial/accounting results based on market price/valuations and business decisions taken thereon. Therefore, the real value gained through productivity enhancement is not assessed. As a result, organisational sustainability is always at risk due to governance issues outlined above and many more.
The law enforcement system, a part of the regulatory arm, prevails to punish those who are alleged for scandals and failures. The system goes after ex-post evidence selected to prove crimes and breaches. It does not pay any attention to underlying economics and real value. Therefore, businesses invariably collapse in the event of such investigations.
Concluding Remarks
In driving of governance and value creation, certain individuals with the authority or leadership matter. The delegation and consultative processes will only facilitate collection of ideas, but few authoritative persons are required to take initiatives and responsibilities. Therefore, the success of governance depends on integrity and loyalty of those persons to deliver the real value to shareholders and not the system of governance per se, whether democratic or authoritative.
Therefore, overall economic development largely depends on how both private and public sectors align their governance systems to improve the real value or the productivity in their business/operational models. Any regulatory/supervisory models based upon soundness assessment through accounting financial results will fail unless they are able to promote productivity-based sustainability of businesses.
Everybody gets appointed in the current governance system. Then, they attempt to amend and interpret the system for their own interests which causes business instabilities. Therefore, the best practice would be for them to present the governance system they wish for the value creation for approval of shareholders at the time they seek appointment, provided that no unmandated amendments are made during the elected period to serve own interests. Shareholders vote for value creation and not for open-ended power-seeking amendments to the governance system.
(The writer is a former Deputy Governor of the CB and a chairman and a member of 6 Public Boards with nearly 35 years of public service. He authored 5 economics and financial/banking books and more than 50 published articles.)
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