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Board independence contributed significantly to woes of major financial institutions in recent crisis, study suggests

Where were the boards?

It was a question asked insistently in the wake of the 2007-08 financial crisis, as critics accused directors of financial institutions of being asleep at the switch, and directors protested that there was little they could have done to stem inordinate managerial risk-taking. Still, while virtually no major financial company emerged from the worldwide debacle unscathed, some firms did a lot worse than others.

Now a new study of 296 major financial institutions across the world probes the role of their directors in  determining how shareholders fared in the crisis. It finds that boards not only were frequently ineffectual but commonly undermined stock performance -- and did so, ironically, through actions taken on behalf of transparency and good corporate governance.

Presented recently at the Annual Meeting of the American Accounting Association, the new research reveals that the financial firms that suffered the greatest stock-price declines tended to be those with the most independent boards, despite the fact that board independence has come to be widely viewed as a touchstone of enlightened company management.

In another surprise, the study also finds that, contrary to what is widely believed, the amount of financial expertise of board members had little or nothing to do with firms' financial performance during the crisis. Neither did it matter whether or not the CEO also served as board chairman (the many critics of CEO duality notwithstanding), or whether the board had a risk committee.

What did make a significant difference, though, was the amount of company stock owned by institutional investors, with greater institutional ownership translating into poorer stock performance.

"Firms with higher institutional ownership took more risk prior to the crisis, which resulted in larger shareholder losses during the crisis period, and firms with more independent board members raised more equity capital during the crisis which led to a wealth transfer from existing shareholders to debt holders," write the study's authors David Erkens, Mingyi Hung, and Pedro Matos of the University of Southern California.

They conclude that, "while the optimal level of risk-taking and equity capital for financial institutions is unknown, our findings cast doubt on whether regulatory changes that increase shareholder activism and monitoring by outside directors will be effective in reducing the consequences of future economic crises."

What accounts for the propensity of independent directors to raise equity capital when companies' share prices are sinking? The professors explain:

"In contrast to corporate insiders, who are primarily concerned about their job security at the firm, and therefore have an incentive to hide bad news to avoid being replaced by shareholders, independent board members are primarily concerned about their reputation in the market for directorships. Prior research finds that outside directors hold fewer board seats after serving in companies that file for bankruptcy or privately restructure their debt. Thus, independent directors have an incentive to avoid the reputational cost of a bankruptcy by pressuring firms to raise equity capital. Moreover, prior research suggests that independent directors build their reputation as monitors in the market for directorships by requiring firms to have more transparent financial reporting. During the crisis period transparent reporting implied the timely recognition of losses related to subprime mortgages. Because the recognition of losses led to lower capital adequacy ratios, firms had to resort to raising equity capital to avoid regulatory intervention when they recognized losses related to subprime mortgage-related assets."

The study's findings derive from an analysis of the stock performance of 296 global financial institutions with assets exceeding $10 billion over the seven quarters from January 2007 through September 2008. The sample consisted of banks, brokerages, and insurance companies in 30 countries, including 125 in the U.S. and 131 in Europe. The percentage of independent directors averaged 82% for the sample as a whole, ranging on a countrywide basis from 64% in the UK to 93% in Switzerland. Institutional ownership averaged 67% in the US and 27% in Europe, and stocks of the companies studied declined on average by about one third in both places.

The professors found the proportion of independent directors on boards to be inversely related to companies' stock returns over the 21 months covered by the study, with 10 percentage points more independence (for example, 80% versus 70%) translating into an almost 4% lower return. Board independence proved to have a significant effect on equity-capital raising, even when the professors controlled for writedowns of subprime-mortgage-related assets. In addition, when the 57 firms that raised equity capital are eliminated from the sample, the significant relationship between board independence and stock returns disappears, which, in the words of the study, "suggests that the inverse relation between stock returns during the crisis and board independence is driven by equity capital raisings."

To further substantiate this effect, the professors analyzed the impact of equity-capital-raising on the price of credit default swaps, instruments to insure investors against a company's default on debt. A company's announcement to issue equity could result in a rise in CDS price by signaling losses to come, or it could occasion a drop in the insurance price by signaling a wealth transfer from existing shareholders to debt holders. The study finds the latter effect to have significantly outweighed the former.

In summing up the study, Prof. Erkens notes that "when we launched this research, we suspected that board independence and institutional ownership both contributed to companies' problems by encouraging managers to take excessive risks on behalf of high shareholder returns. Our findings suggest this was true for institutional investors, but board members seem to have had little effect in either encouraging or discouraging managerial risk. Overall, independent directors didn't make much difference as monitors in the lead-up to the crisis, and, when the crisis struck, board independence tended to run counter to the interests of shareholders. Considering the importance that has been assigned to independent directors as guardians of shareholders' interests, their role here comes as something of a surprise and ought to prompt some sobering thoughts about their value as monitors in circumstances when monitoring counts most."

The study, entitled "Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide," was among hundreds of scholarly presentations at the Annual Meeting of the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. More than 3,000 scholars and practitioners attended the meeting in August in San Francisco.

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