As the high point of the financial crisis recedes, it is clear that the structure of big bank boards and the behaviour of their board directors must change if we are going to prevent similar disasters unfolding in the future. In particular, there are ten key governance lessons that need to be absorbed.
1. There really isn't any such thing as a free lunch
When banks offered retail customers with limited resources, mortgages with no down payments and zero interest, it looked like a free lunch. When these mortgages were repackaged, insured to get a triple-A rating and then resold to other banks with returns well above the London Interbank Offered Rate, it again looked like a free lunch.
Later, the cost of the lunch kicked in: Higher interest charges that customers couldn't afford disrupted the payments on derivative products, exposed their hidden risks and led to the financial meltdown. When it looks like a free lunch, buyer beware.
2. Bad growth is not the same as good growth
Following the herd and imitating the competition by investing in collateralized debt obligations is bad growth. Bad growth boosts the top-line, but reduces profitability and builds up hidden liabilities. It's not based on something distinctive and thus cannot earn superior returns.
It's even worse when you do not understand exactly what you are buying, as many second tier banks discovered after ploughing money into mortgage derivatives.
Good growth is based on superior capabilities that provide differentiation from the competition and, hence, sustainable higher returns. Bad growth, with returns less than the cost of capital, destroys the value of a company.
3. Financial leverage is indeed risky
Borrowing can provide the resources for huge ventures and high growth rates, as kings, oligarchs and bankers have shown over the centuries. When the returns look greater than the cost of borrowing, growth can be spectacular, as housing and construction booms in the US, the UK and Spain have shown.
But when such ventures go sour and returns drop, leverage brutally cuts the other way as the idle cranes in Dubai so dramatically illustrate. Driving growth with debt requires serious risk management.
4. When it matters, the risk will be greater than you think it is
The global dimension of this recession is the first on record and shows the interconnectedness of financial markets. When banks are flush, they can lend capital to projects anywhere in the world. But when a large bank like Lehman Brothers runs into trouble, the whole system is affected. Confidence dries up. Banks refuse to lend to one another. They need liquidity and have to withdraw it from one day to the next, even from healthy clients.
The systemic nature of this recession has shown that just when more leeway was required from banks, a liquidity crisis resulted in unexpected additional risks.
5. Risk management requires judgment
UBS was reputed to have one of the best risk management tools: a sophisticated mathematical modeling system. It was a trap; UBS was the European bank with the biggest losses from US mortgage derivatives. The problem, their new CEO reported, was not a failure to appreciate complexity, but the opposite. A lack of simplicity and critical perspective prevented the right questions from being asked.
Assessing how much risk a business can incur requires an informed judgment about how much debt can be serviced in bad times without endangering refinancing and investment in periods of good growth.
6. Hubris kills judgment
A chairman or CEO who dominates a board agenda stifles the debate and constructive criticism that leads to recognition of danger and ignores signals both inside and outside the frontlines of a business.
From mid-2005 to mid-2007, when banks bulked up on mortgage derivatives, those with the biggest losses – Citigroup, Merrill Lynch and UBS – had entrenched CEOs or chairmen who pushed their firms to take more risks with the company's capital and invest in apparently low risk, high-yielding derivatives.
The hubris of a CEO or a chairman can be a major risk to a company.
7. Judgment requires strong sparring partners with relevant industry expertise
Asking the right questions about exposure to major risks is the responsibility of top management and the board of directors. The board should know key company executives and develop a succession pipeline; middle managers should be rotated between different departments and functions and be well versed in using their own judgment as well as mathematical models to assess risk and prevent dominance by the top team.
Board directors must have relevant industry expertise to challenge management about the major risks facing the firm and the appropriate degree of risk to take. No matter how eminent board members are in their own field, they cannot raise the red flag on collateralized debt obligation risk with a triple-A rating without specialized knowledge.
Those banks with the biggest write-downs had almost no one on their boards with the financial industry expertise needed to credibly challenge their CEO or chairman. The same is true for almost all the institutions acquired by the government or another bank. Banks with more limited write-downs typically had boards with greater financial expertise.
8. Board members cannot be true sparring partners if the CEO and Chairman roles are combined
For board members to be true sparring partners, the chairman has to act as a facilitator – capable of encouraging alternative views, leveraging the contributions of diverse individuals, keeping an open discussion on track and bridging gaps when people are challenging one another.
An effective chairman reconciles opposing points of view and cuts to the heart of issues without bruising egos. The CEO, who has to lead the company and not act primarily as a facilitator, is a weak candidate for the position of chairman.
9. Shareholders, not consultants, should be brought in as additional sparring partners
It's impossible for even the most prestigious consultants to be objective because their fees depend on keeping the client happy. This is especially true of compensation consultants who are under pressure to recommend higher pay.
Executive teams and their boards should instead call on the shareholders for impartial advice. It's their money that is on the table. If anyone is going to act to prevent the next crisis, it's the shareholders. And if they get it wrong, at least part of the fall-out will be their responsibility, which is how it should be since they are the ultimate risk-takers.
10. Without real change, social legitimacy and reputation will be badly damaged
It's one thing to admit the need for change; it's another to actually bring it about. Bankers continue to award themselves massive bonuses, even though recent profits are largely due to cheap government funding.
As the economist Paul Krugman noted after Congressional hearings in early January 2010: "Do the bankers really not understand what happened, or are they just talking in their self-interest? No matter. The important thing looking forward is to stop listening to financiers about financial reform."
The man in the street is unlikely to be as civil in his reaction. It's time for real change in governance behavior in the executive suite and the boardroom.