Evidence to Walker Review on Corporate Governance

In 2009 Sir David Walker was asked to inquire into and report on the Corporate Governance of Financial Instititions after the failure of a number of major banks. The following is our evidence to his inquiry.

Corporate Governance and the Role of Non- executive Directors

As the financial crisis has unfolded it was inevitable that the first people to be blamed were the senior executives in the troubled banks. Their high risk strategies left the economy floundering. But the executives were answerable to a main board, with a non executive chairman and other non executive members, brought in from outside, who were supposed to hold the executive directors to account.

Northern Rock’s Adam Applegarth, had to get his high risk policy past a board of non-executives which included Sir Derek Wanless, ex Group Chief Executive of National Westminster Bank plc and a member of the Board for Actuarial Standards at the Financial Reporting Council and also Rosemary Radcliffe former member of the global board of accountants, Price Waterhouse Coopers and ex Complaints Commissioner for the Financial Services Authority.

The board keeping watch on RBS’s Fred Goodwin included Sir Steve Robson, a former private secretary to the Chancellor of the Exchequer and Treasury civil servant responsible for the Finance and Regulation Directorate, along with Peter Sutherland a former attorney general of Ireland and European Commissioner responsible for competition policy. He is chairman of BP and Goldman Sachs International.

Failure on the scale we have seen can have been nothing but an embarrassment to these people and something they would have wanted to avoid at all cost. These are not shrinking violets. Not the sort to melt before a domineering chief executive and they would clearly have been able to read a balance sheet. So what went wrong and are there some inbuilt problems in the present operation of bank boards?

Any shortcomings are unlikely to be about knowledge or experience. In the cases above, the non execs clearly had that in bucket loads. The failings are probably at a much more human level, like the difficulty of speaking out with an opposing view when your peers seem to be of one mind.

Recent research in the Netherlands suggests there are real neurological reasons why we tend to follow the group and anyone who has sat on a board will know that there is pressure to reach a consensus.

This means that any doubts which, if fully debated, might produce strong arguments against, can be put to one side in an effort to reach agreement. If a non exec disagrees too fundamentally they must inevitably think about resigning, which in itself won’t change the course of the company.

This pressure to agree supports earlier research work from the 1970’s by Irving Janis on what is known as Groupthink. The theory sought to explain poor decision making from groups and drew up some general observations. Janis identified this ‘Pressure for Conformity’, describing how members viewed any opposition as disloyalty. And also the ‘Illusion of Unanimity’ where members perceive falsely that everyone agrees with the group's decision; silence is seen as consent.

And how familiar do the following observations by Janis sound in relation to recent bad bank outcomes?

1. The Illusion of Invulnerability: Members ignore obvious danger, take extreme risks, and are overly optimistic.

(In the present crisis the banks increasingly relied upon risky and complex financial instruments to fund their lending believing the party would never end)

2. Collective Rationalization: Members discredit and explain away any warning contrary to group thinking.

(Note the whistle blower at HSBC who claims he was dismissed after pointing out the dangers)

There are some other fundamental issues that I think need to be addressed which go beyond what Janis describes. One of the most obvious is that the bank executives are full time whilst the non-execs put in perhaps two days per month. This means that the executives are much more familiar with what is really happening in the organisation and with each others’ thinking and come to each meeting with a united front. The non execs on the other hand rarely have an opportunity to discuss issues with one another beforehand and so find it difficult to develop an independent line of thought.

The executives also have a much greater awareness of all the facts and figures, whilst the non execs must make do with edited highlights. To get through busy agendas this comes in the form of reams of management information upon which they must make a decision. They are unlikely to have time to speak first hand to those at the sharp end of the organisation; instead information is filtered through the executives.

The non executives are also disadvantaged by not being helped as much as they might by those other controls on wayward management, the regulator and the auditors.

In the big banks the executives regularly meet with Financial Services Authority supervisors and correspond with them. The supervisors can obviously advise on how the organisation is meeting the rules but also provide extremely important information about how the organisation compares with its competitors and warn if they are becoming a risky ‘outlier’. But the non execs do not have ready access, if any, to FSA supervisors.

The auditors will spend a considerable time with a company going through the books with management but the access of the non execs to their findings and their wider wisdom about the marketplace is more restricted. The execs use them to crunch and confirm the numbers but the non execs need them to quantify the risks.

So I see a number of important steps as being necessary if the great and the good who sit on the boards of our banks are going to keep a check on the senior management.

First I think board meetings must have an atmosphere in which different views and disagreement are seen as positive and encouraged. Non executives should have more opportunity to discuss matters without the presence of the executives, so they can share their thinking and develop alternative views. This may well mean more meetings before and after main board meetings.

Second, non executives should have far more opportunity to meet FSA supervisors and to work with them. They both have the same objective of monitoring the performance of the organisation and they should share their thinking.

And this should apply to auditors too. At present the auditors are paid by the bank to undertake the audit on its behalf. Perhaps we should move to a position where the audit is done on behalf of the Regulator and the non execs. Certainly meetings of the non executives and supervisors would benefit from greater contributions from auditors.

This is a difficult balance requiring a skilled board chairman, because any board must work cooperatively in the interests of the organisation. If we encourage non execs to talk together outside board meetings and to others outside the bank, this could create a rift between execs and non execs. But at present I fear non execs risk being in thrall to the executives, cut off from each other by the infrequency of their meetings, isolated from those other arms of governance, the regulators and the auditors, and too reliant on the executives for the information upon which they must make decisions.