Wednesday, November 26, 2014

Boards on Their Backs

WASHINGTON, DC – The recent governance controversy at JPMorgan Chase has masked a much larger issue. Regardless of Jamie Dimon’s victory in retaining his dual role as CEO and chairman of the board, the more important failure on display was that of the board of directors itself – a problem that affects almost all of the world’s megabanks.

This is completely obvious at JPMorgan Chase. The report of the recent bipartisan investigation, led by US Senators Carl Levin and John McCain, into the infamous “London Whale” trades provides just one example. There is also the litany of complaints and legal cases now surrounding the firm. It is difficult to see JPMorgan Chase escaping its past anytime soon.

But the problem is much broader: Not a single global megabank has a well-functioning board. Their members kowtow to CEOs, do not examine management decisions closely, and, with very few exceptions, rubber-stamp compensation requests.

Big banks’ boards are supine for three main reasons. First, and most important, there is no market for control over the biggest banks. One cannot build up a significant shareholding and use it to put pressure on boards – let alone pursue a hostile takeover. The London Whale is a case in point. The pressure brought to bear on JPMorgan Chase was completely inconsequential – nothing significant will change.

This is primarily because regulators – despite what they may claim – effectively protect megabanks from market discipline. “Systemic importance” has become an excuse for maintaining impenetrable entry barriers (yet another reason why executives want their firms to be regarded as too big to fail).

Second, most board members lack sufficient relevant expertise. Who on the current board of JPMorgan or Citigroup has real experience running a giant complex trading operation (which is what will make or break these companies over the next decade)? Who among them understands macroeconomic risks not in terms of the platitudes of the prevailing consensus, but as the tail risks – the low-probability, high-impact events – that always wag the dog of financial crisis?

Unqualified board members do not ask hard questions. And, five years after the largest financial crisis in almost 80 years, one can count the number of properly qualified board members – across all megabanks – on the fingers of one hand.

As a result, megabanks’ senior managers are not pressed to remove layers of opaqueness that shield their risk-taking from effective scrutiny. This helps to keep board members in the dark – and gives them a convenient excuse for not really understanding how the business works.

Effective governance is possible under various formal arrangements. In principle, a strong outside lead director can be just as effective as an independent chairman – a fair point that has been made in recent weeks.

But which huge banking conglomerate has such a lead director today? Which board members are willing and able to stand up to CEOs? That has certainly not been the recent experience at JPMorgan Chase.

Finally, regulators, too, have been rendered docile in the face of the megabanks’ CEOs. Regulators have the power to require that boards become more powerful – or at least minimally effective. For example, they could tighten the qualifications needed to become a bank director (in the United States, for example, the requirements are not serious). Instead, regulators stand idly by while bank boards remain self-perpetuating clubs, with membership regarded as little more than so much social plumage.

The regulators acquiesce because, simply put, they are afraid. Mostly, they are afraid that being tough on bank governance will somehow disrupt the flow of credit. It is a silly and baseless fear, but that is how modern regulators think and act – in a state of constant, irrational anxiety.

The banks in question are so large and so central to the functioning of economies that each of them is too big to regulate. Whenever small groups of individuals acquire that much power relative to the state and the rest of us, there is big trouble ahead. Power corrupts, and financial power corrupts the financial system.

The biggest banks were badly run in the years leading up to the crisis of 2008 – exhibiting a toxic mixture of hubris, incompetence, and excessive leverage – and their governance problems today are worse than they were in 2005 or 2007. The 2008 crisis was followed by a long, hard recession; we should not expect a different scenario now.

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    1. CommentedGunnar Eriksson

      All large banks should be required by society to present a mission for their operation with demonstrated strategies for its implementation. Large organizations consist of people and a mission will be a backbone for their daily actions. This course would be less scary for the political class and should in a later stage improve the ability to both legislate and enforce existing laws.
      For a bank a simplified mission should be “to absorb the savings of society (private and public) and transfer those to accessible credits for creative ventures at reasonable risk”. The better the organization fulfils the mission the more profitable it should be judged. Today the leftovers when executives have remunerated themselves are handed over to equity holders (that at the most are exposed to a minimal risk) as profit. Executives remuneration and dividends related to equity should be defined as cost for the operation.

    2. CommentedLiz Banker

      Had the per share value been low as it is with its nearest TBTF competitor, the outcome of last Tuesday's referendum on Mr. Dimon would have been different; (Exhibit A: BofA's acquisition of CW; Kenneth Lewis taking an early retirement rather facing very angry shareholders). The JPM Chase tally wasn't even close (unfortunately) but a wake-up call to Chase management for some organizational changes, will evolve. It's hard to fathom what qualifies some of these board members to occupy the round table; perhaps it functions more like a quasi-governmental agency of who you know more so than what you know; are lobbied in a similar manner; holds little accountability, minimal transparency, and lacks public interest. Senator Elizabeth Warren has retained the same publishing rights attorney as the ex-U.S. Treasurer Mr. Geithner for their respective accounts of TBTF, in 2014. That outta make for some interesting reading in the parallel universe.

    3. CommentedFrank O'Callaghan

      The big banks are not essential to the functioning of the economy. They are essential to it's dysfunction.

      These financial institutions have destroyed much wealth and mis-allocated more. They have consistently and grossly over-rewarded their own failures. They have generated great and increasing misery for a great many people who have had no part in the casino circus that has run amok with the past thirty years.

      Supine governments have betrayed their electorates in favour of these parasites. The boards of the banks are the creatures of the CEOs. They are less than a flimsy loincloth. They preserve dignity only with the collusion of those who deliberately look away.

      Galbraith long ago pointed out that the technocracy ruled the corporations. It is as true now but even more blatant.