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Home > Corporate Governance Viewpoints > Lessons from the Credit Crisis: Governing Financial Institutions

Corporate Governance Viewpoints

Lessons from the Credit Crisis: Governing Financial Institutions

by Jay W. Lorsch

Introduction

Jay W. Lorsch is an internationally recognized expert in boards and corporate governance. Here he argues that the lack of experienced bankers on bank boards was a major contributor to the 2008 financial crisis. He believes that the “independence” criteria played a big part in banks’ preference for nonbankers as nonexecutives, and must now be reconsidered. Lorsch also argues that US companies should keep the roles of chairman and CEO separate as is the case in the United Kingdom.

Lorsch is Louis Kirstein Professor of Human Relations at Harvard Business School and Chairman of the school’s global corporate governance initiative. He has taught in all of HBS’s educational programs. As a consultant, Lorsch’s clients have included Citicorp, Deloitte & Touche, DLA Piper Rudnick, Goldman Sachs, Tyco International, and Shire Pharmaceuticals.

Lorsch graduated from Antioch College in 1955. He has an MSc in business from Columbia University and a doctorate in business administration from HBS. From 1956–1959, he served as a lieutenant in the US Army Finance Corp. He is also a Fellow of the American Academy of Arts & Sciences.

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The Crisis and Financial Institutions

In the many commentaries about the credit crisis, blame has been placed squarely on the management of the failed financial institutions. While these leaders certainly bear some responsibility, the boards of directors to whom they report should not be let off the hook so easily. After all, boards are ultimately responsible for the performance of their companies.

In this essay I explore the lessons we should draw from these failures about the role of boards in overseeing complex financial institutions. I do so with two caveats. First, boards are not the only governance body that has failed. Government regulators, credit rating agencies, and accounting firms, among others, must also bear some of the responsibility. Second, knowing how boards of directors failed must largely be a matter of informed speculation on my part, since in the current legal environment the board members directly involved are not willing to talk about what went wrong. I say “informed speculation” because I have had the opportunity to consult for boards of such firms in more halcyon times.

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Boardroom Realities

While boards on both sides of the Atlantic are the ultimate legal authority in corporations, their ability actually to carry out this duty is constrained by several realities. The central factor among these is what directors know and understand about their companies’ plans, activities, and results.

To an extent, such knowledge can be affected by the number of times the directors meet. The less time directors spend in discussions together and with management, the less informed they may be.

However, a cursory examination of proxy statements reveals that, in 2007, the boards of the large Wall Street institutions did meet much more often than the average American company’s board—on average 10 times a year for the Wall Street firms, and six times for the typical company. Even more impressively, the audit committees of these financial institutions met an average of 11 times during 2007. All of this I believe is evidence that these directors were spending time trying to understand the complexity of their companies.

However, what directors understand about these institutions is obviously the result of more than just how much time they spend together. Another significant factor can be the depth of knowledge directors bring to the boardroom about financial markets, products, and institutions from prior career experience. Unfortunately, current rules and best practices make such transfer of knowledge unlikely. The emphasis in selecting board members in the United States is on finding individuals who are “independent.”

This generally means selecting directors who have no current or recent experience working for the company, its competitors or clients. The underlying idea is to create boards whose members have no conflicts of interest. While this is an understandable and worthy goal, a significant result is that most boards of financial institutions in the United States have few nonmanagement directors with prior experience in that industry.

Again, looking at the boards of the 12 largest Wall Street firms, each has at most two independent directors with prior financial experience. The other independent directors, experienced and accomplished as they may be in other industries and professions, start with a sizeable handicap.

Whether independent or not, and whether they have a prior experience of financial organizations, board members must rely on their management as the most important source of information about future plans and current company activities, risks, and results. There is no other way for directors to understand what is happening in their companies.

Trying to understand the debacles in these financial firms from outside the boardroom, it is not clear whether management understood the problems that their companies faced and chose to withhold this knowledge from the board, or else whether the top management itself did not understand the situation. However, it really doesn’t matter, because either way the directors, even those few who might have had deep knowledge of financial issues, were unaware of the storm that was about to break upon them.

The fact that these boards were unaware of the catastrophe that struck their companies until after it had occurred points to the fact that boards need knowledge for two reasons.

One is to understand and make judgments about how well their company has been performing, to look in the rear view mirror. Their failure in this regard is what many observers are most likely to criticize.

However, I believe that their more serious sin occurred many years earlier, as they approved (or should have approved) the strategic plans for their company. It was at this stage that they allowed their managements to set off in new directions, which eventually did so much damage to the companies and the wider economy. My hunch is that the reception for these innovative new “products,” if they were presented to the board by management, was as enthusiastic among the directors as it was among the managers proposing them.

With so little financial knowledge among the board members, my hunch is that they were reluctant or unable to raise any doubts about management’s “exciting” new ideas. At least this is too often the case in boards with which I am familiar. Further, it is unlikely that the directors understood the necessity to create monitoring systems, which would keep them aware of any new risks associated with the new-fangled innovations.

It may be unfair or even unreasonable to expect directors to have been able to predict or anticipate the failures in the financial system, when top executives, regulators, and academic experts with much greater knowledge were unable to do so.

Yet, I cannot ignore the fact that the boards of these institutions have a legal and moral obligation for the health of their company, including its equity value for shareholders, and the safety of investor assets entrusted to the company. While it is unhelpful to cast blame on these boards, I do want to consider what they can do going forward to prevent future calamities.

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Looking to the Future

Over the past two decades there have been plenty of ideas about boardroom best practices, including that they should have a preponderance of independent directors, the requisite committees, discussions among independent directors without management present, and board approval of strategic plans. While these innovations have been helpful to many boards, they did not go far enough to prevent the crisis that hit and, in some cases, nearly destroyed their companies.

Even assiduously adopting all these practices does not go far enough to prevent a recurrence of such problems, unless the independent directors have the information and knowledge to assess plans and results intelligently. Thus, I believe that attention needs to be focused primarily on solving this part of the problem.

I would start by requiring the boards of financial companies to have more independent directors who have deep knowledge and experience of the world of financial markets and institutions. I have in mind a principle similar to that used in the Sarbanes–Oxley Act’s definition of the competence required for members of audit committees.

Based on my own experience, I believe it is possible to find directors who meet both the test of independence and have deep financial understanding. Finding such individuals requires dropping the assumption that the best directors for these financial firms are prestigious CEOs or other comparable high-status individuals. It will also require corporate governance committees and any consultants they choose to use to search more carefully for candidates who meet both criteria.

Second, these boards should adopt an idea first proposed in 1972 by the late Justice Arthur Goldberg, who was on the board of Trans World Airlines. He asked that the board create a small staff to support it with analysis and interpretation of data. This proposal was rejected at the time, but I believe it is an idea whose time has come for complex financial institutions.

There is simply too much complicated data about performance and risks for independent directors to understand, even if boards do meet monthly and consist of more members with deep financial expertise. I envision a relatively small “staff” of young professionals with the relevant expertize.

Third, I believe that these boards should recognize that their company’s complexity requires them to have a chair who is not the CEO. While this idea is widely accepted in the United Kingdom and the rest of Europe, there is resistance to it in the United States.

However, it seems clear that boards which are meeting almost monthly, and which face such complicated issues, need a leader who has no other obligations within the company.

Some may see this proposal as a reheating of an old campaign from corporate governance reformers. However, I would remind the reader that I was one of the originators of the concept of a lead director, as an alternative to a separate chair for US boards. I am proposing the idea of a separate chair because I truly believe it is relevant for the boards of these complex financial institutions.

In doing so, I recognize that one requirement for its successful implementation is a very clear and explicit definition of the chair’s job. It should be to lead the board in its oversight duties. This includes assuring that the board has appropriate membership and committees, the right agendas, sufficient information, and overseeing the board’s staff proposed above, as well as presiding at board meetings. What the chair’s job must not entail is being a personal “boss” of the CEO, or usurping the board’s duties in this regard.

While I do not believe that these changes alone will prevent a repetition of the failures of so many financial institutions, I do believe that, along with improved regulatory oversight, they should vastly improve the odds that boards can be the guardians of their companies that society has the right to expect.

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Further reading

Books:

  • Carter, Colin B., and Jay W. Lorsch. Back to the Drawing Board: Designing Corporate Boards for a Complex World. Cambridge, MA: Harvard Business School Press, 2003.
  • Lawrence, Paul R., and Jay W. Lorsch. Organization and Environment: Managing Differentiation and Integration. Cambridge, MA: Harvard Business School Press, 1967.
  • Lorsch, Jay W., and Elizabeth McIver. Pawns or Potentates: The Reality of America’s Corporate Boards. Cambridge, MA: Harvard Business School Press, 1989.
  • Lorsch, Jay W., and Thomas J. Tierney. Aligning the Stars: How to Succeed when Professionals Drive Results. Cambridge, MA: Harvard Business School Press, 2002.

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