CEO AND ALLOCATING CAPITAL

CEO and Allocating Capital

CEO and Allocating Capital

Introduction

Like their companies, financial sector boards of directors and CEOs have been battered by the credit meltdown. The witch's brew of high leverage, poor risk management, creation of toxic assets and poor business judgments-all made more poisonous by excessive short-term executive pay-are seen as their unprecedented failures and have eroded credibility, melted trust and made financial re-regulation of some shape and size inevitable.

CEO and Allocating Capital

But, today more than ever, the admonition-physician heal thyself-applies to financial service, indeed to all, corporations. As Lloyd Blankfein, Goldman Sachs CEO, said recently in a speech to the Council of Institutional Investors: “…the past year has been deeply humbling for my industry…the loss of public confidence…will take years to rebuild….decisions on compensation…look self-serving and greedy in hindsight. Financial institutions have an obligation to the broader financial system…Meaningful change and effective reform are vital and should naturally emanate from the lessons learned.”

Four fundamental, interrelated governance changes inside corporations are essential to enhance properly targeted accountability and increase the confidence of investors and other stakeholders.

Boards of directors must redefine the role of the CEO—and then choose a leader who meets the new spec. The CEO's first foundational task is to achieve a core balance between taking economic risk (promoting creativity and innovation) and managing economic risk (within a systemic framework of financial discipline) over a sustained period of time. The second foundational CEO task is to fuse this high performance with high integrity—tenacious adherence to the spirit and letter of formal rules, voluntary adoption of ethical standards that bind the company and its employees, and employee commitment to core values of honesty, candor, fairness, reliability and trustworthiness which together address legal, ethical, reputational and public policy risk.

Boards and business leaders must institute new management development processes for corporate P&L and functional leaders that, at early stages in their careers, put strong emphasis not just on achieving commercial goals but on developing the experience and skills to do this through balanced risk-management and performance with integrity. This should be a talent management imperative as individuals rise within the corporation and face greater challenges in all dimensions.

Boards must completely redesign compensation systems to reward these redefined foundational CEO and top leadership behaviors. Measurements for durable, sustainable economic performance, sound risk management and high integrity embedded in daily business operations must be developed and must form the basis for compensation paid out not just annually but systematically over time.

Board “oversight of strategy” should focus on the highest priority risks and opportunities along these three dimensions of the redefined CEO role and redesigned compensation —economic performance, risk management and integrity—with reviews both of this year's efforts and also of results over a longer time horizon. These issues should be core agenda items for the boards of a growing, sustainable and durable companies.

Although corporate rhetoric might suggest that these fundamentals are recognized, corporate reality is, generally, that they are not. For example, within the financial sector itself, voices like Blankfein's are increasingly heard, ...