BOARD TO DEATH

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By Jeremy Kress

By any measure, corporate directors lead exceptionally busy lives. Many directors hold full-time executive positions, and most serve on the board of at least one other company. Academics and policymakers debate whether directors’ outside professional commitments enhance or detract from their governance abilities. Directors, on one hand, might acquire valuable knowledge and practice by serving in governance capacities at other firms. On the other hand, however, busy directors might lack time to carefully review reports, assess strategy and risk, and attend board and committee meetings for all of the companies with which they are affiliated.

The drawbacks of director busyness are especially severe for large, complex financial institutions because of the unique governance demands imposed on their boards. Through a series of case studies—including JPMorgan’s London Whale trading loss and Wells Fargo’s fraudulent accounts scandal—I explore how director busyness inhibits the oversight of management, increases the risk of firm failure, and could cause the next financial crisis.

Financial institutions pose several unique corporate governance challenges. The combination of high leverage and short-term funding, for instance, can trigger sudden liquidity and solvency crises. In addition, explicit and implicit government guarantees discourage a financial institution’s creditors from monitoring the firm’s risk-taking, thereby weakening a traditional corporate governance mechanism. These unique characteristics create the need for a financial institution’s board of directors to establish effective risk monitoring systems within the firm. Robust risk monitoring, however, is precisely the type of oversight that busy directors are ill equipped to provide.

My research identifies three specific ways in which busy directors impair risk oversight. First, directors with many outside commitments are less inclined to participate actively in corporate decision-making. Busy directors, for example, are more likely to miss board meetings, and board committees comprised of busy directors meet infrequently. Second, directors with many outside commitments tend not to challenge management; as a result, firms with busy directors are more susceptible to managerial self-dealing, misconduct, and excessive risk-taking. Third, busy directors experience attention shocks that distract them from company business. When a firm with which a director is associated experiences a major event—e.g., a merger or reorganization—the director’s time commitment to that firm increases substantially. The director, in turn, neglects his or her other board memberships.

My original case studies demonstrate how busy directors detract from corporate governance in practice. Consider, for example, JPMorgan’s London Whale trading loss. As chair of JPMorgan’s risk committee, James Crown bore responsibility for establishing and overseeing the firm’s enterprise-wide risk management framework. At the same time, however, Crown had many other professional duties: he served as the lead independent director of both Sara Lee Corp. and General Dynamics Corp., and he ran his family’s multi-billion dollar investment fund. Just as JPMorgan’s traders began building their ill-fated derivatives positions in early 2012, Crown was busy conducting a search to replace Sara Lee’s CEO, overseeing a spin-off of Sara Lee’s non-core businesses, and developing strategies for General Dynamics to cope with $1 trillion in recently-enacted defense budget cuts. While Crown attended to these crises, JPMorgan’s risk management infrastructure failed to detect the escalating risks in the bank’s credit derivatives portfolio, leading to $6 billion in losses and more than $1 billion in fines for inadequate risk monitoring.

The situation was similar with Wells Fargo’s fraudulent accounts scandal. Wells Fargo’s directors failed to respond to red flags regarding sales practices violations, at least in part, because they were among the most overcommitted bank directors in the country. Nine of Wells Fargo’s 13 independent directors served on at least three public company boards. Risk committee chair Enrique Hernandez was particularly busy, sitting on the boards of four public companies and serving as CEO of a multinational, private company. Wells Fargo’s directors were so busy that they rarely met as a full board or in their committees. Every year from 2012 to 2015, for example, Wells Fargo held fewer board and risk committee meetings than any of its peer banks. In sum, while Wells Fargo’s employees opened millions of fake customer accounts, its board was missing in action as they attended to their other professional obligations.

All of this is not to say, of course, that JPMorgan and Wells Fargo necessarily would have averted their crises had their boards been less overcommitted. I argue, however, that JPMorgan and Wells Fargo would have been more likely to detect and address nascent risks if their boards—and especially their key directors—had been less busy.

Despite the dangers of director busyness, many financial institution boards remain alarmingly overcommitted. My paper provides empirical data on the boards of the largest and most complex U.S. financial institutions—firms whose misconduct or excessive risk-taking could inflict harm on the broader economy. When compared to the directors of all S&P 500 firms, I find that the financial institution directors are significantly less likely to sit on only one public company board and more likely to sit on at least three public company boards. The boards of a few financial institutions are especially overcommitted. Nearly two-thirds of Citigroup’s independent directors, for example, hold three or more board seats.

Recognizing the risks of overcommitment, the European Union has adopted regulations limiting outside employment and board seats for financial institution directors. The United States, by contrast, has not addressed the problem. I recommend a series of reforms designed to alleviate director busyness among large, complex U.S. financial institutions. My suggestions range from stricter proxy advisory “overboarding” thresholds to regulatory caps modeled after the EU reforms. I also recommend safeguards to ensure that these reforms do not deplete the pool of qualified and interested director candidates. I suggest, for instance, increasing directors’ pay to compensate them for foregoing other professional opportunities. In addition, I would apply the most stringent regulatory caps only to directors with key leadership positions on the boards of the largest and most complex financial institutions—about 30 directors in total.

Deterring misconduct and excessive risk-taking by large, complex financial institutions requires that their directors have sufficient time and attention to execute their governance roles effectively. The reforms I outline will enhance oversight of management and thereby help preserve the safety and soundness of the financial system.

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