So Much for Expertise

By Cydney Posner

A recent paper analyzes how independence and financial expertise of directors affect risk taking and performance. While the article primarily examines banks and bank directors, its conclusions may be informative for non-bank companies.

Commentators have frequently observed, without any serious challenge, that one of the causes of the recent financial crisis was excessive risk-taking by banks, financial institutions and others. In light of the responsibility of boards to oversee the conduct of companies, many commentators have characterized the crisis as, among many other things, a failure of internal risk governance mechanisms, especially at the board level. Some contend that the lack of financial expertise among board members was a major contributing factor in this failure. The paper, Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?, written by three professors from Ohio State, Boston College and Georgetown, examines the level of risk taking and performance of commercial banks during the period from 2003 to 2008 (which includes the financial crisis) in relation to the financial expertise of the banks' independent directors. The purpose of the study was to test "the conjecture that, because of their understanding of more complex financial instruments and transactions, more financial experts among independent board members leads to more effective risk-taking behavior in financial institutions."

Over the period studied, the authors found that the percent of independent directors on the board increased from 73% in 2003 to almost 80% in 2008. Similarly, during the same period, the average percent of financial experts (determined according to standards used in the study) among independent directors also increased from 21% in 2003 to 27% in 2008. However, at the time the crisis began, approximately 25% of the financial institutions did not have any financial experts among their independent directors.

So what's the bottom line? This study found, first, that larger and more independent boards were associated with lower risk profiles. No big surprise there. According to the authors, this result "suggests that more independent boards are also acting in the interest of other stakeholders, such as regulators who are concerned with the safety of the bank." The more interesting conclusion was that, during the crisis, both stock performance and changes in firm value were worse for large banks with more financial expertise among its independent directors. While the banks whose boards had high levels of financial expertise may have performed somewhat better prior to the crisis, their stock price performance during the crisis was so poor that it caused their stock performance over the full sample period to be significantly worse than those banks with less financial expertise at the board level. Even more interesting was the conclusion that the higher the level of financial expertise among independent directors the more risk-taking behavior both before and during the financial crisis, using market-based risk measures.

What to make of all this? It certainly seems to shoot a pretty big hole in the theory that increasing a board's financial expertise would reduce otherwise excessive risk-taking. The authors posit two theories for their results: first, it's possible that independent financial experts, with a fiduciary duty to shareholders, were acting to maximize shareholder value by pursuing riskier strategies, therefore becoming more vulnerable during the crisis. The second possible explanation is that financial experts were more willing to allow their banks to participate in more risk-taking activities because they were more familiar with -- and therefore less concerned about --the sort of complex risky financial instruments that were being bought and sold. As a result, they may not have challenged the basic assumptions or asked the fundamental critical questions that a less financially sophisticated director might have asked. And, as these firms increased in size and complexity, the financial experts on the board "provided the support and/or necessary encouragements to allow the banks to expand their risk taking activities. As a result, the large commercial banks with relatively more financial expertise were penalized more severely at the onset of the crisis." For you cynical types, the authors state that they did "not find evidence for a reverse causality channel explanation of our results, whereby a powerful CEO would choose a higher risk profile and select independent financial experts to rubber stamp his strategy." (Reverse causality channel? Where are the plain English police when you really need them?)

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