Almost exactly two years ago, the "perfect storm" of a decade of excess credit, excessive leverage, and uncontrolled expansion by financial institutions precipitated the financial crisis. A common thread was that the boards of these financial firms were oblivious to the risk build-up.

The behaviour of boards of directors must change to prevent future crises. This is a global problem with application for boards everywhere from the Middle East, to North America and in between.

Here's a question to consider — what do you get when you put a room full of CEOs from different industries together in a corporate board room and ask them to govern a company? Several answers could apply, but what accompanied the financial crisis was a breakdown in risk management at the top.

Boards of supervising directors have two primary functions: supporting the creation of long-term economic value, while at the same time controlling the conduct of business in the interest of shareholders and other stakeholders. These two functions are inherently at odds. Looking at the composition of most boards, it should come as no surprise that so many boards fail to perform. Boards typically are made up of a collection of CEOs and top executives from different industries.

Expertise

They can provide strong input from a leadership point of view, but often do not have enough specific industry expertise and become far too supportive of management to exercise their controlling mandate, particularly when it comes to overall risk assessment. This is especially so in companies where the owners/shareholders are not present at the board table except once a year at the annual general meeting.

Who should be on the board to prevent a governance crisis?

Companies across different industries need to continue addressing their boards' composition with the following requirements in mind:

n Board directors must have relevant industry expertise to advise management on major business issues and the appropriate degree of risk to take. For example, no matter how successful they were in their own companies, banking board members lacking financial expertise had no way of knowing there might be hidden risk buried in collateralised debt obligations with a triple-A rating.

  • The boards of companies with widely dispersed ownership are continually at risk of being dominated by the concerns of either management or board members to the detriment of the shareholders' interest. Rather than paid advisors, boards have to be continually open to input from the owners.
  • There is still a widespread tendency to fill the board with high profile executives often running large corporations, or divisions of their own. The job of a CEO is more than a full-time job and it is unrealistic to assume that he will have enough time to devote to understand the full complexity and underlying issues facing the boards of other large companies, especially if they are in completely different industries.
  • Board members have to be flexible with a broad enough perspective to take on different roles and tasks as required.
  • The moment of truth for a board comes when management starts destroying long run value, because it can no longer adapt to the changing conditions, or makes decisions that involve taking large, often hidden risk, or engages in behaviour causing critical stakeholders to withdraw their support. It is at these times that board members have to be willing to raise the red flag. This requires board members with sufficient confidence in their judgement to be strong sparring partners of the CEO and Chairman.

Lessons

Globally, there are encouraging signs that lessons have been learned about the importance of board composition in the banking industry. There has been a move to strengthen the critical monitoring function of the board in respect to risk management by bringing in more people with real expertise.

Examples are provided by Switzerland's two largest banks: Credit Suisse and UBS. Credit Suisse faced some tough times a decade ago due to emerging market debt. As a result, it re-constituted its board, brought in more industry expertise and strengthened its risk management committee. UBS had been flying high — its board members were all very comfortable. All that changed when the financial crisis hit and Credit Suisse far better weathered the storm than their Swiss rival.

Now we see UBS applying the same lessons as Credit Suisse. Post-financial crisis, UBS has completely re-constituted its board with several new members who have real industry expertise. What about your company? Will its board be reformed before the next crisis hits?

"No change without a crisis" is no way to continue into the future. Following the five recommendations will help prevent the next governance crisis.

 

The writer is the Sandoz Family Foundation Professor of Governance, Strategy and Change at IMD, business school based in Switzerland.