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Have weaknesses in corporate governance been appropriately addressed?
Besides the bursting of the stock market bubble and geopolitical uncertainties, corporate governance and accounting scandals have played an important role in denting investor confidence in the last few years. While the stock market has regained substantial ground, underlying concerns about governance and accounting remain latent, and a renewal of such shocks would be seriously detrimental. Further reforms in this area would be conducive to strengthening the foundations for sustained growth and underpinning the integrity of financial markets. In response to widespread corporate malfeasance, the 2002 Sarbanes Oxley Act stiffened penalties for fraud, enhanced both auditor independence and regulation of the accounting profession and increased both disclosure requirements for public companies and the responsibility of their executives for financial reporting. Considerable progress has been made in implementing the legislation, and early assessments of the reform’s impact are largely positive, though concerns have been voiced that some provisions of the Act - such as the requirement for chief executives to certify financial statements - would adversely affect business behaviour. In addition, the listing requirements of the major stock exchanges have been strengthened with respect to corporate governance provisions. However, renewed scandals in recent months (involving the New York Stock Exchange and the mutual funds industry) have demonstrated that there is still unfinished business in the area of corporate governance reform:
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Guaranteeing the independence and strengthening the oversight of corporate boards. The still complaisant attitude of compensation committees is an indication that more needs to be done by investors, the exchanges and the authorities.
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Enhancing shareholder rights by providing access to the director nomination process, as proposed by the Securities and Exchange Commission, which should allow investors to vote for and remove individual directors.
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Pressing ahead with governance reforms in the mutual funds industry given its major role in the US economy.
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Ensuring that regulatory agencies are provided with sufficient resources to complete the reform agenda and to upgrade enforcement, while encouraging them to become more pro active in their operations.
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Reforming incentive-based executive compensation to further enhance managerial performance. Requiring the expensing of stock options would make compensation more transparent and avoid inappropriate incentives facing managers, such as boosting earnings in the short term at the expense of long term outcomes.
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Achieving greater harmony between US and international accounting standards and resolving questions about auditor oversight, thereby reducing pressures for the extraterritorial application of US regulatory oversight in this area.
What should be done to address problems affecting housing finance companies and corporate pension plans?
Two of the leading government sponsored enterprises (GSEs), Freddie Mac and Fannie Mae, which have become major players in financial markets, have also been investigated for accounting irregularities. In view of their rapid growth and systemic importance, their regulation and supervision needs to be tightened, and the Administration has made proposals to this end, including relocating the regulatory authority to the Treasury Department. But reforms should go beyond that by eliminating their special status. This status has led to the market perception of an implicit government guarantee and hence slightly lower borrowing costs, allowing them to expand strongly and move into activities beyond their original mandate of supporting the secondary market for residential mortgages. In any case, the marginal funding advantage is an inefficient way of promoting homeownership - most of the benefits go to the shareholders of the two GSEs - and such promotion is separately undertaken by multiple tax preferences granted to owner occupied housing. Altering the GSEs’ status, however, may not be sufficient to eliminate their implicit government guarantee. Without reducing the size of the GSEs’ portfolios, investors may still perceive them as “too big to fail”. Limits could be placed on the growth of their mortgage-related asset portfolios, so that mortgage-backed securities traded in public markets, and not GSE debt, become the dominant source of secondary-market funding for mortgages.
Given their adverse impact on corporate finance and potential risks to plan participants and the Pension Benefit Guaranty Corporation (PBGC), weaknesses in the regulatory framework applicable to defined benefit corporate pension plans need to be addressed. They have allowed substantial under funding and have led to a huge financial deficit of the PBGC. The Administration has made proposals to improve liability measurement, disclosure and safeguards against under funding by financially troubled companies. A more comprehensive reform of the system will be necessary though, because its problems are partly structural, reflecting its poor incentive characteristics. In doing so:
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It would be ill advised to provide funding relief, as is being discussed in Congress, with no simultaneous offsetting action to address systemic under funding associated with lax funding rules.
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It would be prudent to use a conservatively low discount rate to calculate pension obligations, while aiming at greater accuracy and transparency.
The government pension insurance agency should be given greater flexibility so as to charge higher premiums to firms generating more risk to the system.
Private pension under-funding and PBGC financial position
Single-employer programme, fiscal year
Source: Pension Benefit Guaranty Corporation.
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