Corporate governance and risk management

In recent years, there has been a lot of attention on corporate governance and risk management. The aim was to get businesses to act responsibily and to avoid taking large risks that are not authorised by the shareholders.

Management consultants made a lot of money providing advice to boards of directors to teach them on these exotic matters. Regulators asked the boards to spend a lot of time and money on these matters.

What happened?

We still have the problem with the Special Investment Vehicles (SIV) set up by the large, "well managed" banks. These SIVs borrowed money on short term (where the interest rate is low) and invest them in long term risky assets (to get a high return). In good times, they made profit on the spread, i.e. the difference between the cost of funds and the return on risky assets.

When the subprime problem arose, investors did not want to refinance the short term borrowings. This caused a "credit crunch" to the SIVs. They were not able to pay their borrowings.

If the SIVs had to sell their assets to repay the borrowings, it would cause a collapse in the asset markets. The large banks that set up the SIVs decided to provide several billions of dollars of funding to take over the SIVs, and to write off billions of dollars in losses.

Lesson: After spending a lot of time and money on corporate governance and risk management, these banks still commit a large blunder in taking the risk of the SIVs.

A "common sense" approach would have prevented this mess. Do not borrow short and invest long. It does not require a complicated process of corporate governance or risk management.