Learning from the Past: Corporate Governance Before and After the Financial Crisis

greetings from New York City and Columbia Business School executive education I'm Scott Gardner and I'm here today with Professor Shiva Raj Kapoor for the learning from the past corporate governance before and after the financial crisis webinar before I introduce Shiva I'd like to go over a few quick logistics if you look at your screen a recording will be made available to you after the webinar if you'd like to tweet about the webinar please do so at hashtag CBS exec and finally most importantly please submit those questions to the Q&A box throughout the webinar and we'll get to as many of those as possible in the last 10 minutes thank you my pleasure to be here today with Professor Shiva Raj Kapoor he is the vice dean for research as well as holding the Kester and burns professorship at Columbia Business School he is a world-renowned expert on financial reporting issues earnings quality fraud executive compensation corporate culture and corporate governance he is passionate about bridging academic theory with policy setting and corporate practice and has a wide-ranging experience in solving applied business problems he also advises think-tanks advisory firms and professional and trade associations Shiva it's great to be with you today yeah my pleasure I'm happy to be with you now there's a lot of great material that we're gonna be looking at so let's start off with the first question I have for you all right now you I know you've been looking a lot deeply at Bank Board since the financial crisis let me ask you do you expect these Bank boards to change it's not obvious it's not obvious the banks are special animals in the sense that the usual modes of governance don't necessarily apply or don't necessarily work as well with banks so you know who would keep an eye on the company it's usually the shareholders but Bank shareholders are not necessarily accountable to taxpayers that's where most of the financing for a bank comes from right so a bank is typically financed out of deposits which you and I say go and leave in our neighborhood bank when was the last time we saw a bank run we don't see a bank because we have deposit insurance right because the federal government makes sure that if something goes wrong deposits of at least about 250 thousand dollars or actually recovered by the Federal Reserve and so as a result depositors have no real incentive to keep an eye on banks so banks end up taking more risks than they perhaps should and it's that's optimal for shareholders because it's heads you win tails I lose kind of situation right if the risk pans out then the excess is captured by the shareholders if the risk doesn't pan out at least if you're a big bank then the hope is that you know the federal government will swoop in knight-in-shining-armor to bail you out and we're here okay and then there are other issues you know things like the takeover market don't work very well it's very hard for an activist investor to jump in take control of the bank because again the regulator's get worried about say takeover of banks from say foreign investors or foreign governments so the takeover channel doesn't work as well as it perhaps would if this was some other company like say Procter & Gamble or some other some other is some other entity so it's it's not clear it's not clear that the other channels of governance work as well it's not clear that Bank board should change because if you were a cynic you would argue they did exactly the right thing right so by and large they made money for their shareholders they took a lot of risk but by and large they were protected from that risk at least for the for the big five or ten systemically important banks so with all the safety nets maybe they don't see it need to change yeah it's not obvious change is hard anyway right change well that's that's what makes the setting interesting because this is a fairly big shock the fairly big crisis and it's interesting to go and look at the data if we find that things haven't changed a lot even after such a big shock then it's time to ask some serious questions right so that's exactly what we try to do in this study okay right all right well so you know you and I have known you for a few years of sat in classroom with you I know that you've broken down it into four distinct remediation points remediation buckets so can we go through those one by one oh absolutely and this is our dense so we'll find go through this slowly and carefully so if you are an academic trying to look for change where do you start so we thought the four big areas that we should worry about our groupthink lack of banking experience among the directors lack of a time commitment so if you're on the board are you really engage do you have the time to pay attention to what happens and of course critically the risk management function okay so what does groupthink you know most of us have been in meetings where the loudest and the most opinionated people tend to sway the conversation in a direction that the others may or may not agree with and the others are scared of incurring the social costs of jumping in and trying to change the conversation so they by and large just grudgingly go with the so-called consensus decision the consensus decision is rarely consensus it's usually driven by two or three loud people yeah and a lot of that seemed to happen in Bank boards before the crisis so you know somebody thought look this is a money-making machine let's you know double up on CDOs which are these collateralized debt obligations everybody said okay maybe you know Who am I to object sounds fine I get my bonuses and we're okay so so that's what we're trying to address I guess after the crisis but the one big limitation as an academic is that I don't get to go into board meetings and boards don't keep minutes and even if they kept minutes I'm not sure they're reliable for obvious reasons so so the data is hard to find so the best we could do was to go and look at some external measures of say things like both turnover meaning have new directors come in since the crisis do we have a larger proportion of directors who are you know intellectually different more diverse now measuring intellectual diversity is so hard so we often look for things that are easier to measure do you have for instance more females on the board do you have you know fewer affiliated directors meaning characters were otherwise connected with the CEO or someone else on the board do you see people who are more perhaps racially diverse you see you know fewer Caucasian members on us boards and you could also measure things like sea or power meaning the rules require companies to tell us how much the top five people in the company get paid so you could measure the proportion of the CEOs pay to total pay and if the thinking is that you know if the CEO gets 30% of the total pay relative to say some other bank where a CEO gets 10% so the claim would be that the first bank CEOs say much more powerful so it's just a proxy for how much power the CEO perhaps hours yeah the balance or balance of power exact size so that's what we look at and we look at data before and after the crisis for all the US banks that we can find data for and as the slide suggests look for yellows because yellow suggests what changed turns out nothing changed and used on these five proxies for groupthink okay which is which is a bit disturbing so now let's talk about idea number two lack of banking experience so it turns out that many of the large US banks actually had say you know presidents of museums on the board and it's not super obvious what those people probably you know were able to contribute the banking is a highly technical business it's incredibly difficult to just explain what a derivative is or an OTC swap is or a CDO is or a CDO squared is so so the hope was that after the crisis you would see board members who have perhaps a bit you know bit more relevant experience bit more industry experience so the three things we look for here is you know do new directors have more prior banking experience right do they have more specialty finance experience so for instance if they've been involved in you know or corporate finance or Treasury or something along those lines and we could go and look at you know how did the companies where these people were board members or directors before they came to the bank how did those companies do so that's what I mean by track record in terms of say operating performance and stock performance and if we look at these three metrics at least there is some good news now we see more directors with more prior banking experience so some of these museum presidents I'm guessing have retired or rotated off the board to be replaced by people who have more relevant experience but if you look at these other two metrics that we discussed you know prior specialty finance experience or the track record of the directors of the Chairman who served elsewhere that doesn't seem to have changed a whole lot okay now let's talk about time commitment you know being on a board is very time consuming so but obviously I can't I don't I don't I don't get to see the the calendars of the directors who are on board so I can't measure that so we look for again somewhat indirect proxies so we go and measure the number of outside boards there are non-executive director sits on and the thinking is that if you're sitting on six boards chances are your attentions all scattered and it's pretty hard to focus on what goes on with one company so that's the intuition you can also look at the number of committee memberships the board member sits on the boards have all kinds of committees as you know the Audit Committee or the Compensation Committee the Risk Committee the ESG committee which is environmental social governance responsibilities so the more memberships you have perhaps the less time you can spend on a specific task so those are the two things we go measure and it turns out that if you look at outside directorships that really hasn't changed since the crisis people are still sitting on as many boards as they were before then after but it turns out the number of committee memberships they have has actually gone up and that's kind of sounds counterintuitive but it's happened because of the fourth point you know every bank now has a risk committee so the number of comedies have gone up and the risk committee is an important committee so you mark the key directors to be sitting on the risk committee so the number of committee memberships have gone up so that's a bit of a mixed signal so I don't know what to make of that so again the evidence is generally more oversight well at least the good news is with the risk management that's our fourth point all right now most boards virtually all the bank boards that we looked at do have an independent risk and reputation committee which is great it's gonna loops back in to our previous point that's why the number of committee memberships have gone up every Bank board now has a dedicated CRO which is a chief risk officer which is fantastic we also looked at the CRO status on the company and how do you measure that do they show up in the list of the top five most heavily compensated employees and it turns out as you can see that's not highlighted so if you look at the CRO status it's not obvious that CRO show up more frequently in the top five after the crisis will it do to be four but the good news here is that every bank now has a risk and a reputation committee every bank has a dedicated chief risk officer so if you look at the guest or the overall picture we've effectively looked at 21 measures in this chart here and of these 21 measures there's you know clear improvement on maybe four measures and one of the measures is a bit mixed so you know you can consume the evidence as you as you will this is the evidence but to me it's pretty modest so positive ish positive ish okay can we go to the next oh sure so yeah absolutely basically what does this all mean what does it talk about what this means well it's it's interesting so what does one make of the fact that five out of 21 measures of improved I would say it's it's modest because this was a this was a colossal shock you know this almost brought down Western civilization I would say right right so and frankly a lot of the blue rest squarely with the banks sadly so I was expecting to see more before looking at the data so I was a bit you know I was gonna encourage but a bit disappointed and then if you probe deeper you can also look at things like compensation right so how are these senior managers being paid these days in banks and here you know comparing the u.s. to Europe is kind of interesting and informative because if you if you compare the pay structure of the CEOs of the top five officers in Europe versus the u.s. it's kind of fascinating and predictable you know the US CEOs of banks or in general paid more on short-term measures more on financial measures like accounting and stock performance compared to Europe where they are in general paid on longer term measures and they tend to be non-financial so things like Bank culture is explicitly written in to compensation plans of many European banks not so much in the US and this is the other issue one of the big hard to measure intangible but a very important force in all this is corporate culture and what is culture when people are not looking over your shoulders what do you do right and it's so easy so easy to in a bank to have a culture problem right for example when you walk in and you you try to get a loan say for a house or froma for a car they make you sign the 30 page document do you ever read what is in that No so it's so easy to slip something in there right right so that's where culture comes in and people are not looking what do you do so has culture change or you know is are we now making sure that we don't necessarily take advantage of our customers because in the short run you can easily make money off them you can make bonuses and for five ten years later bad things happen you know many examples Wells Fargo is the latest for instance so has culture change that's again difficult for me to tell you know from the outside so you know so that's one an important element the keep an eye on going forward okay you know and of course the million dollar question we'll all this prevent the next crisis I hope we don't have one yeah right yeah well I well I hope people learn from the past you know institute new policies that will prevent that that's the hope I mean is it commensurate to you know other crashes that we've seen or other I mean like what the response rate was the percentage of positive videos that we saw that's that's that's a very good question so the last time we hired such a big crisis was probably the 1929 recession right and that was followed by a lot of regulation right right and whether regulation helped our artists frankly still being debated after so many hundreds of years yeah so it's never obvious yeah but I would say on balance regulation did help after the crisis in fact after the previous recession we hired something like Deposit Insurance you know you don't see the classic it's a wonderful life moment where people are running to the bank in time I don't kind of sadly the draw and get out of the bank but that creates its own problems unintended consequences now that you have Deposit Insurance you know it gives banks a little bit of a license to take more risk than they should because the depositors known keep an eye on them okay right so we have let's move on to the next talk about these some of these buckets in more detail so your based on your study you talked about succession planning and some best practices for that so you know what are we looking at here succession planning so it's always hard to be in a room in a meeting say run by the CEO and try to ask the CEO the following question you know do you have a succession plan do they get really threatened oh my god if you have a succession plan chances are I'm going to be fired you know and then you know in fact is there a COO is there a cool you can see that in politics yeah so the key is to kind of destroy the bench at least in politics all right so it's the board's responsibility to make sure that it is insists on a plan having a plan is half the battle right if you look at disclosures and companies barely fourth of these companies tell us about their succession plans so few best practices cannot review them very quickly insist on a plan if you are bored regularly look at the plan and make sure the CEO is told in no uncertain terms that this is good for the company this is good for the CEO if the CEO is plane crashes god forbid then what happens so there's a crisis a succession plan is invaluable right you know so but of course of course it's a matter of creating trust between the CEO and the board and that's not always that easy right so these things are likely to work well if you have a trusted incumbent CEO and a lead director whose job it is to go you know create and manage the succession plan right well if there's transparency to the CEO about why you're doing this then they're not gonna think it's a cool I mean just the less my friends okay yeah successful videos are insecure too well so let's move on to the next so groupthink is a problem what are some best practices for this we've already talked about the dangers of groupthink and one of the practices that I find to be pretty effective is you know when there's a contentious issue role-playing works well so I'm gonna make you an advocate for a proposal and I'm going to become the critic so once I play a role it kind of D personalizes the situation a little bit it becomes less emotional and we have a more honest intellectual debate about the pros and cons of a problem otherwise we get vested in one position and we sometimes get blindsided to the other problems associated with that proposal so role-playing helps brilliantly and the other thing that I often advocate is you know listen to people who disagree with you so short sellers so who are short sellers people who bet against your stock they actually put their money where their mouth is you know so they so they have bad news about their company that is they think they do and they're selling the shard before actually they're selling the stock with and they don't own it and the hope is that when the price falls they buy it back and they make money so one out-of-the-box idea would be get short sellers into your board room talk to them why do you feel bad about our stuff what are we missing what are you saying you know so that it's it's hot it's it's hard to do but I think it's extremely informative that it's imperative I mean it's my husband here how many times do we usually get people who disagree with us all right into our homes right yeah so it's kind of behaviorally hard confidence of a leader yeah it's playing a lot of parts enough so I mean that seems to be alright so the last part is time commitment how many hours can someone expect to dedicate to a board and there what are some best practices for that also lots of hours the terms are it's roughly about 250 hours a year so a 40-hour workweek I'm guessing we're looking at something like six to seven weeks so I would say hours a week that's quite a bit and as you know it's not sadly uniform right so you'll have these peaks and well exactly right we're able to parse it out life would but then people are also on six ports that's the problem exactly so so the best practice I would say would be more than three would be probably too many yeah and the time commitment is even higher if you're sitting on more you know committees and if you also happen to be the chairperson of the board so what are some best practices obviously don't overcome it that goes without saying and here's something else that I think is is useful advice people usually jump on the opportunity to be on a board but I would say you want to interview the board as hard as they will interview you so the you know the best asset that you have is reputation if you lose that then you'll know where so you know you need to do as much due diligence about the company as they would about you know about what your background and don't overcommit well a lot of good information we've got questions coming on cool important topic to people so can we answer absolutely let's do it all right so Jean wrote to us and you said you mentioned that you're making money profits to traditional shareholders book value but book book value seems to no longer connect to many markets or holders value this is an old linear view but we live in a nonlinear world now how are banks currently adapting their governance to fit in the world that we live in so it's a great question so at the risk of being a bit technical so let's think about this notion of market the book so what's the motion to market the book so the idea is you take what the market values you are and you compare that to the SoCon accounting value so the market the book of a company in general is ideally more than one which would say the firm has future prospects but if you look at European banks it turns out that the market to book ratio is actually less than one dollar Bank has been less than one for three four years now and how does one read that one way to read that is that the market thinks that the bank is destroying value the future is actually worse then what your current assets on your books tell you right the other interpretation of that metric would be the market is telling you that your assets are worth less so you should take an asset write down so the you know the the book falls it market the book and then market the book becomes closer to one or more than one so what does it take away in terms of this metric if market the book for a bank is less than one of any company is less than one for a long period of time the directors need to be really concerned and worried why does the market feel that you know in general the accounting assets of a company understate the company's true value so if the market thinks that the accounting numbers actually overstate its value we have a problem so it's actually a fairly serious signal to worry about if you're a director of a company whose market to book ratio is less than one Wow all right Ralph has asked this is I think it's a good question it goes back to the choosing of a board what types of red flags should we look for when interviewing for a prospective board seat I would also add my part of that like what are some things you you know that are not red flags you should be the qualities that you feel well you should be looking for you know the first thing I would say is pull out the 10k you know for the for overseas viewers 10k is the the annual report for a company try to understand how the company or the bank makes money what are the critical value drivers what are the critical cost drivers understand the company reasonably well and then probe directors about those pain points the second thing you know it's not all about obviously trust this crucial and you know do you have a good feeling about these people like anybody you like but your name's going to be on the on the proxy state right yeah so it's it's it's different from you know it's still it's still hard for instance if you're an Arthur Andersen employee after Enron I'll go find a job and you know it's not your fault yet that name is on your resume and on your asthma yeah so you lose reputational capital so understanding these people and if you don't have a good feeling about working with these people just walk away so am I guess why would somebody hire someone who is the head of a museum it's the assumption that this person is a financial edge I mean it was a just assumption of why is that why was that happening I don't know well you know I mean how many of us like to be challenged and nothing against people ran out of museum saying like what is that relevant to the board job I mean I'm in a classroom you know pretty much half the year sometimes with you how many of my students actually want to take exams how many of them want to take quizzes nobody likes to be evaluated nobody likes to be challenged so it's just much more comfortable to surround yourself with friends and family right and yeah you know people who look as though they are they have some reputation yet people who will probably not give you a hard time in the boardroom when it comes to the nitty-gritty you know why are you acquiring this company or why are we investing in this plant or you know why you're getting paid this much who wants those questions so my hypothesis would be it's just easier and more comfortable to be with people who are less likely to disagree with you right right but one of your you know one of your bits of advice was you have to have those people to challenge you I know it's easier said than done Oh seasons of the time but it is important it's simpler and we do that I think probably better than a khadeem that an industry right yeah all right Dan has asked in your study did you look at the changes to the second and third line of defense functions not just the existence of a CRO there's been significant change here and with regulatory oversight it's a fair point a lot of that information is not publicly available so people will often say things like you know management processes have become better you know they're just more I mean a whole bunch of things have changed dodd-frank for instance was was intended to fix some of these problems now dodd-frank has gone into a whole bunch of implementation issues the short answer to Ralph's question is that it's somewhat hard to know as an outsider and it was somewhat hard to trust insiders because they'll always tell you things are better so you know perhaps the best entity that's that can answer your question Ralph is maybe the Federal Reserve because they get to see data that we don't get to see so I'm hoping and praying that what you're saying is right for everybody's sake yeah hopefully so that we don't have another crisis right all right so Adisa has written California passed a law mandating a female director on the board passed a law mandating that right do you think this is the way to go it's a fascinating question you know and so if you're if you're the libertarian bent of mine you know I could argue maybe a knee-jerk response would be quotas are back the OBE you shouldn't have quotas and you know that creates all kinds of distortions but I often remind these people about say smoking when smoking was banned people complain and then a generation later you know people don't smoke voluntarily right so sometimes when you're in a baddy Calibri and in a bad spot you know some intervention may not be a bad idea and to give you some data to support that statement if you look at the rate at which females are displacing males at least on the boards of medium and small companies it'll probably take anywhere between 25 to 50 years if we don't intervene you know the the replacement rate is glacial extremely slow it's a little better with the large companies because they have much more pressure from institutional investors but if you just leave the medium and the small companies to their own devices it's going to take forever so maybe the Californian law despite its short term costs and there will be some short-term costs hopefully we will just push us to a slightly faster trajectory accelerate accelerate yeah so you know I'm violence I think it's not such a better do someone who wants this for their life doesn't have 2250 yeah so we wait around for that that's true yeah so if you're a female and if you want to be on a board move to California well hopefully other states there's a success there do you think other states will pick that up do you know this becomes political side yeah as you're but I'm hoping and yeah maybe New York will be next who knows I don't know yeah all right well you know we've got about 45 seconds left so you know what would you say is you know the couple key takeaways for the people that are watching here today a lot of people like a good key takeaway at the end so what do you what do you think ah and you know these are you know the risk of probably overstating this these are life lessons you don't want to over commit that's the time commitment point you want to do whatever you can to surround yourself with diverse thinkers celebrate this end however hard that might be because the scent is a very valuable piece of information about how you're doing and what does the last third thing I forgot there you hopefully these are two good takeaways yeah it all goes back to that leadership confidence in making these decisions that are good and sound in my mind you know when I'm hearing you talk it really is gonna depend it is it is a person issue not just a finance issue it is a person I like most things like my numbers are just a way to understand human interaction and drama in institutions yeah numbers are data but you have to sell story with it right there's an underlying human process that generates those numbers exactly exactly thank you so much for being with us a lot of great information I hope people found this very useful and again thank you for joining us for today's webinar thanks again for tuning in you you you

What is governance?

you hear the word governance a lot these days but what does it really mean and is it as important and serious as it sounds board governance or corporate governance simply refers to the job of a Board of Directors now if you look at the position boards holding corporations you can see that they are sandwiched between shareholders or some kind of ownership on one side and the CEO and staff on the other side since the ultimate authority for the company or organization comes from the ownership naturally the governance job of the board comes down to three things one have ongoing dialogue with the ownership to discern their expectations for what results the organization should produce to translate those expectations plus other information and the directors own perspectives and values into written criteria for success and three check to see that those criteria were met in a nutshell that's it board members can do other things like volunteer to help staff or get involved with fundraising or public relations but the boards core governance rule is ownership linkage policymaking and monitoring policy compliance now you can see why governance is so important the job of the board is at the front end of what happens in organizations sometimes a really strong CEO can compensate somewhat for a weak Board of Directors but for any organization to truly live up to its potential and achieve relevant results good governance is critical this is Susan Mogensen with brown dog consulting

The Governance Problem: How it Started

an excellent article appeared in the January 24th Globe and Mail's report on business it was an article by Janet mcFarland storming the boardroom sound fury and little else this article tells us about the frustration and disappointment with the pace or lack of true governance reform felt by shareholder and good governance advocate Bob monks he says when I hear the word reform I want to vomit because it means we've lost the battle of terminology he also says he's results-oriented and really doesn't see any material change in corporate governance despite all the disasters and Fiasco's we have seen in the past dozen or so years Bob I couldn't agree more so what is wrong with governance today anyway I believe it all starts out with a fundamental lack of common understanding around what governance is we can see how this problem developed when we look at the evolution of a typical company and the roles and relationships that form let's start with the humble business owner let's call him Joe Joe has an idea and starts a business he is the business owner operator chief bottle-washer and everything the business grows and Joe decides to hire staff now Joe is the business owner and a manager then at some point the business owner manager decides to get together with an investing partner or two to be able to grow the business now the business owner is a partner and probably still a manager as well then as this business gets bigger and bigger the owners or partners decide it is time to incorporate which requires forming a board of directors naturally since Joe started this whole thing he needs to not only be on the board of directors but it is accepted that he should be the chair of the board and of course maintain his role as the leader of the operational side of the organization in other words Joe must also be the CEO this sets up the problem however with the legal and fiduciary responsibilities of a Board of Directors comes the principle that board authority is group Authority no longer do you have a single individual at the top of the heap but a group of individuals who exercise authority as a group and yet we still have Joe who founded the business and therefore needs and wants to remain in charge of both the board and operations then even when Joe retires and someone new steps in somehow the same problematic configuration of having one person as both chair and CEO seems to stick Joe's two hats create a conflict how is it going to work when as CEO he is accountable to a Board of which he is the chair how will he exercised his board responsibilities when the scope of his power extends far wider and deeper than that of his fellow board members are the other board members simply playing an advisory or supporting role or are all board members truly governing as a group meanwhile what appears to be missing or forgotten in this picture ah the shareholders remember when Joe started out he was the head honcho because he owned the idea the product of business now who knows if the company went public or has owners beyond the board of directors we really need to know and understand that the head honcho the true head honcho in this whole picture is the legal ownership group or the shareholders whoever they may be and it is the Board of Directors that must ensure that the long term interests of the shareholders are effectively executed this is what governance is whether you have a singular business owner or a group of partners or a board of directors acting on behalf of shareholders one principle remains the same the ultimate authority in a company or organization starts and ends with the ownership from that premise the job of boards is to govern on behalf of ownership with all power and authority flowing through the board before it gets to the CEO this means boards need to engage with their ownership to translate expectations into written comprehensive and concise policy and to monitor policy compliance I think that the sooner everyone can agree that Authority flows from ownership to board to CEO to staff the sooner we can truly achieve governance reform and indeed see Bob monks happy this is Susan mogensen with brown dog consulting