The Risk of Financial Expertise on Bank Boards

At a Glance

• Financial expertise on bank boards is associated with greater willingness to take risk. Banks with a higher share of independent directors who have financial expertise tended to hold less capital, employ more leverage, and pursue strategies that exposed them to greater market risk prior to the financial crisis.
• Markets appeared to reward these riskier strategies initially. In the years leading up to 2007–2008, banks with more financially sophisticated boards slightly outperformed their peers, suggesting that investors initially viewed their greater appetite for risk as beneficial.
• The same risk exposure produced larger losses when the crisis arrived. During the financial crisis, banks with more financial experts on their boards experienced significantly worse performance, indicating that the risks encouraged during the boom left them more vulnerable when conditions deteriorated.
• Financial expertise may enable risk-taking rather than reduce it. Rather than acting primarily as a conservative check on management, financially knowledgeable directors may be more willing to support higher-risk strategies because they better understand complex financial instruments and shareholder incentives.

Read on for a full breakdown of the research findings and their implications for regulators, investors, and corporate boards.

In the aftermath of the 2007–2008 financial crisis, banks and other financial institutions were accused of having engaged in excessive risk-taking. In particular, calls for reform of the financial sector argued that the lack of financial expertise of board members played a major role in the crisis.

This claim may have been partially motivated by the truth. After year-end 2006, a quarter of all publicly traded U.S. commercial bank holding companies with over $1 billion in assets did not have a single financial expert among their independent directors. A commonly held belief emerged that the presence of more independent financial experts on the board would have limited the excessive risks taken by banks’ management and mitigated their fall during the financial crisis.

This proves not to be the case, however. The presence of financial experts among independent directors is, in reality, associated with more risk-taking in the run-up to the crisis. Specifically, a higher percentage of financial experts on a bank’s board is linked to a higher total risk of the bank’s equity and its real estate loan exposure before the crisis. More financial experts also correlate with lower Tier-1 and total risk-weighted capital ratios, meaning those banks generally held riskier assets. For example, a 1-standard-deviation increase in a measure of financial expertise is associated with a 34-point decline in a bank’s Tier-1 risk-weighted capital ratio—a significant drop compared to the average Tier-1 risk-weighted capital ratio of 10.4% among large banks.

Prior to the crisis, between 2003 and 2006, banks with more financial expertise slightly outperformed banks with less expertise. Yet financial expertise negatively correlated with banks’ performance during the 2007–2008 financial crisis especially for large banks, potentially reflecting decisions that were thought to maximize shareholder value but did not perform as expected when the crisis hit.

As financial expertise on the board is related to more risk-taking, banks with more independent financial experts will understandably underperform when the crisis hits. However, these results are still consistent with the board acting to maximize shareholder value in normal market conditions.

Taken together, these findings indicate that financial expertise is associated with more risk-taking that potentially benefited investors before the crisis but turned out to be detrimental during 2007–2008. In other words, during stable times, the presence of financial experts among independent directors led to higher risk-taking and slightly above-average performance. This positive association with risk-taking was rewarded by the market prior to the crisis but was penalized when the crisis hit.

These risk-taking patterns are not a result of powerful CEOs selecting independent financial experts to “rubber-stamp” strategies that satisfy their risk appetite, nor are they impacted by the government’s rollout of the Troubled Asset Relief Program (TARP). Though the likelihood of receiving TARP funds is associated with certain bank characteristics and board independence, it is not associated with the financial expertise of independent directors.

Rather, this riskier behavior could be explained by the fact that independent financial experts, with a fiduciary duty to shareholders, understand the residual nature of equity claims and will generally favor more risk-taking to generate better returns. Financial experts also might be more willing to let their bank participate in more risk-taking activities due to their familiarity with complex financial instruments.

Still, the question of how to “fix” financial firms and reform the industry remains a key issue for regulators. The Bank of International Settlements (BIS), in its 2006 report, “Enhancing Corporate Governance for Banking Organisations,” stressed that banks should have independent directors and that these directors should have sufficient knowledge of the main financial activities of the bank to “enable effective governance and oversight.” These results, however, challenge the common view among regulators that more financial expertise on the boards of banks should unambiguously lower their risk profile and are important considerations for policymakers as they examine governance reforms of the financial sector.

Read the full paper: Financial Expertise of the Board, Risk Taking, and Performance: Evidence from Bank Holding Companies