A Financial Times report in 2008 found that most directors at several large and troubled institutions had no significant experience in financial services 8. An undue deference to management by directors was also prevalent in banks such as Northern Rock, HBOS and RBS, where the boards did not adequately challenge the management’s pursuit of aggressive, high-risk strategies. It is for these reasons that Bank Negara Malaysia undertakes rigorous and frequent supervisory engagements with the boards of financial institutions. Such engagements are crucial to developing a better understanding of board dynamics and their effectiveness in their governance role. As a matter of practice, prospective directors of financial institutions in Malaysia are subjected to close scrutiny through rigorous interviews by the Bank. This approach was also recently adopted by the UK’s Prudential Regulatory Authority 9. Governance arrangements in financial institutions must also be reinforced by a corporate culture which values and reinforces considerations for risk, ethics and compliance at all levels of the financial institution. This starts with the right “tone from the top”, whereby the board and senior management shape the core values for the firm. A common theme in the findings across various inquiries into the crisis is a breakdown in culture, where a disregard for prudence and ethics was tolerated. In some cases, individuals bearing red flags were not only ignored, but punished. The Financial Crisis Inquiry Commission launched by the US government chronicles two such instances 10.

In order to avoid the misallocation of resources, these externalities have to be internalised either by aligning the incentives of the decision maker; introducing a more representative decision-making process; putting in place the appropriate institutional arrangements; having effectively enforced laws, rules and regulations; or occasionally, by societal norms. Secondly, sound financial governance encourages discipline in adhering to the budget constraint. All economic agents are bound by inter-temporal budget constraints, and adherence to it when making financial decisions is key to sustainability. This is particular relevant when the repercussions of financial decisions fall on parties who are not represented – for example, decisions that shift a large debt burden onto future generations. Thirdly, strong financial governance has robust external checks and balances. To ensure sound decision making, especially when externalities are involved, decision makers, and the decision making process, must be subjected to scrutiny by external parties. In this regard, accountability, transparency, and the empowerment of the external party to take consequential action are key to effective financial governance. All these principles apply fully to the management of public finances. Sound public financial governance is the legitimate use of authority in the management of a country’s financial resources with integrity to promote sustainable development. At the heart of it all, sound governance practices in the Government can be traced back to the concept articulated by French Enlightenment political philosopher (Baron de) Montesquieu in the 18th century.