Centre for Economic Policy Research

Discussion and Roundtables 101

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Another important factor in strengthening the position of shareholders is the
role played by independent, non-executive directors. The Higgs review of the role
and responsibilities of non-executive directors recommended that independent
non-executive directors should play a stronger role on company boards; that more
attention should be paid to their suitability, skills and training; and that the 
definition of independence should be drawn more tightly. One or two of the 
recommendations – relating to the role of the company chairman – have 
generated some lively discussion. But most recommendations have been almost
universally accepted.
More broadly, the UK Government is actively encouraging constructive 
shareholder activism: one topical strand is the so-called ‘rewards for failure’, i.e.
managers who are able to walk away from corporations with large pay-offs.
Transparency is at the core of the UK system where the concept of ‘comply or
explain’ underpins the corporate governance regime. As the EU now focuses on
corporate governance action plans, Sassoon hoped that ‘comply or explain’ will
be adopted as a basic approach by the Commission. Under this approach, agreed
principles and guidelines for corporate governance are set down (for example that
audit committees should comprise only non-executive directors). The ‘comply or
explain’ principle requires that companies either comply with this guideline, or
otherwise explain why they have chosen not to. This has the dual advantage over
more rigid, rules-based systems insofar as it still permits companies to adopt 
structures and procedures that they feel best suit their needs, while providing the
necessary transparency to keep shareholders and potential investors fully
informed. As a result the market will decide if they think companies’ strategies 
are justified. 
Although several key measures can be brought in voluntarily, there are some
areas where new legislation or regulation has been necessary. Among these is the
regulation of the audit profession through a new professional oversight board and
enhanced financial reporting council that, among other things, examines the 
corporate annual reports. A Financial Services Authority (the UK financial 
regulator) consultation document on equity analysts is currently under 
discussion, again seeking to give investors greater confidence in market 
information. It does not go as far as the SEC but identifies many of the same 
problems. It is more principles-based and slightly less rule driven and allows 
global firms to operate under a somewhat more permissive regime.
To conclude, Sassoon stressed the UK view that the market has a primary role
to play in dealing with conflicts of interest to ensure that they do not create severe 
distortions. In the long run the market will penalize those that try to exploit 
conflicts of interest, but careful regulation and oversight can and should minimize
these opportunities without restricting the flow of high quality information that
the market needs.
Lars Nyberg 
Sveriges Riksbank
Lars Nyberg was concerned that overreaction may create a bigger problem than
those posed by conflicts of interest. The market is currently adapting to now
apparent misconduct and it is important to let that process take place. The
European process, however, particularly worried Nyberg because directives tend to
be written with the largest rather than the smallest common denominator. The
trouble is that public confidence has to be restored quickly, even the market will
eventually sort out its problems. Markets tend to forget, however, which is a point
that the Report should stress. The better are market conditions, the quicker they
102 Conflicts of Interest in the Financial Services Industry

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forget. The question is how to make sure that best practice is adopted and does
not slowly deteriorate over time. What has really to be put into regulation and
what can be solved in other ways? Conflicts of interest are very old, they have
been neglected for a very long time, and in fact they were out of fashion as 
recently as three years ago. 
One remedy, outlined by the Report, might be to strengthen internal rules and
procedures in financial institutions. This approach is inline with the market 
orientation. Supervision, as argued by the Report, may come afterwards to ensure
that these rules are not forgotten. Indeed, quite a lot can be achieved through
appropriate codes of conduct or ethical standards.
Nyberg then turned to investment banking. The Report states that separation is
desirable. For a central banker, this is an extraordinarily good idea because the
central bank would not like to pay out more than is really necessary if something
happened in the banking system. Why should risks from underwriting and 
investment banking be included? On the other hand, this is hardly an issue in
most European countries, especially in Scandinavia where the investment 
banking part of the big local banks is relatively small and has not really 
generated conflicts of interest. Incentives to exploit the conflicts of interest may
simply be very low.
Finally, Nyberg talked about the mutual life insurance sector, not dealt with in
the Report but where the same type of principal-agent problem arises. In this 
sector, the customers are really the owners of the company, without necessarily
being aware of it. If it is already difficult for a specialist to understand the balance
sheet of these institutions, it is impossible for an ordinary customer. In addition
the commitments are so far away that it remains impossible to know what will
happen in the long run. This is the reason for regulating this sector, but the 
industry itself already solves a lot of the principal-agent problems that have been
uncovered in many European countries.