Booms and Busts, Corporate Governance and Business Acumen [Nov 2008]
Executive Summary
One question that has, surprisingly, not been asked in the current financial crisis is why a crisis of this severity could occur after so much effort had been invested in reform of corporate governance. The corporate governance reforms of 2002 enshrined in the Sarbanes-Oxley Act passed by Congress were put in place to prevent fraud and abuse, and to increase investor confidence that companies were reducing their overall risk exposures. Yet they did not prevent the enormous problems that we are now seeing exposed not just in the US but globally, all due to a huge increase in risk exposure.
We show that the latest crisis is part of a broader trend of crisis cycles which have been occurring since at least the early 1980s. These crises reflect a common pattern where a set of financial innovations leads to an explosion of economic and financial activity which in turn leads to unforeseen problems. These unforeseen problems could not be prevented based on the-then current state of financial knowledge and risk factors due to the novelty of the innovations. The rapid leveraging of the financial innovation leads in each case to inappropriate financial behaviors which result in excessive risk and eventually leads to a financial crash. These crashes have been getting worse since the early 1980s.
This White Paper examines this failure of corporate governance and identifies what it sees as the fundamental reasons behind that failure. It identifies the fundamental failure as being due to an over-reliance on process and a corresponding lack of focus on developing good financial behaviors. Good financial behaviors create capital and bad financial behaviors inappropriately consume it.
