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

by R. Christopher Small for The Harvard Law School Forum, June 27th, 2011.

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. (continue reading… )

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