Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?

The following post comes to us from Bernadette Minton of the Department of Finance at Ohio State University, Jérôme Taillard of the Department of Finance at Boston College, and Rohan Williamson of the Department of Finance at Georgetown University.

In our paper, Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance? which was recently made publicly available on SSRN, we examine how board independence and the percentage of financial experts among independent directors relate to risk taking and performance of commercial banks during the period from 2003 to 2008, which includes the most recent financial crisis. During the most recent financial crisis, banks and other financial institutions have been accused of engaging in excessive risk taking. Because boards are ultimately legally responsible for all major operating and financial decisions made by the firm, the recent crisis has been viewed by many as a general failure of board governance in the banking sector.

The composition of the board of directors should be a reliable proxy of how well the board can process information provided by insiders and advise as well as monitor the bank’s risk taking practices in the best interests of its shareholders. This study highlights the fact that larger and more independent boards are associated with lower levels of risk taking. We also document, on average, low levels of financial expertise among independent directors. Although many calls for reforms pinpoint the lack of financial expertise of the board as a reason behind the crisis, we show that during the crisis both stock performance and changes in firm value are worse for large banks with more financial expertise among its independent directors. Large banks are defined in this study as those with a bigger balance sheet than the median commercial bank at the onset of the financial crisis.

To explain this result, we investigate the behavior of banks leading up to the crisis. Interestingly, we find that the level of financial expertise among independent directors is positively related to risk taking both before and during the financial crisis using market-based risk measures. We also show that board independence and expertise are not related to increased real estate exposure at the onset of the crisis but are related to financing decisions; namely, more financial expertise is linked to lower Tier-1 capital ratios at the beginning of the crisis. These results are driven by large banks in our sample. Lastly, there is weak evidence that the higher risk taking levels of commercial banks with more independent financial expertise is related to better stock performance in the year prior to the crisis. However, the stock performance over the full sample period is significantly worse for banks with more financial expertise among their independent directors. Our results are robust to alternative measures of independence and financial expertise as well as including S&Ls and investment banks in the sample and excluding the largest U.S. banks from our sample.

Overall, our results challenge the regulators’ view that more financial expertise on the boards of banks would unambiguously lower their risk profile. In particular, the presence of financial experts among independent directors is related to more risk taking in the run-up to the crisis. This favorable attitude towards risk-taking was not penalized by the markets prior to the crisis but led to significant underperformance when the crisis hit. For the large commercial banks, more financial experts among independent directors led to significant underperformance. We do 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.

Our results could be explained by the fact that independent financial experts, with a fiduciary duty to shareholders, understand the residual nature of the equity claims and will generally favor more risk taking. Another explanation could be that external financial experts are more willing to let their bank participate in more risk-taking activities due to their familiarity and understanding of complex financial instruments. We leave the task of testing these different conjectures for future research.

The full paper is available for download at here.

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One Comment

  1. Per Kurowski
    Posted Thursday, December 8, 2011 at 4:08 pm | Permalink

    Here we are, immersed in a monstrous crisis that could take the Western World as we know it down, only because our banks created excessive exposures to triple-A rated securities and sovereigns, considered so infallible by the regulators that they authorized the banks to build up these exposures against only 1.6 percent in capital… and we are calling it “excessive risk-taking”.

    What a laugh! If anything it was excessive risk-aversion by the regulators that led the banks to overcrowd perfectly safe-havens.

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  1. […] the performance of financial experts on boards of trustees.  According to a paper entitled, “Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?” large banks with more financial experts on the board performed worse in the financial crisis […]