A brain drain at bank boards raises questions about risk management

Geetanjali - stock.adobe.com

"Everybody serves somebody." 

Whether said by Bob Dylan or Paul in his letter to the Romans, this applies to the multiple layers of oversight in our banking system. Congress oversees our regulators who oversee our banks, and their directors oversee management who are charged with serving their shareholders and community.

But, who is overseeing our bank directors, usually handpicked by fellow directors?

Both House and Senate banking committees used televised hearings to publicly reprimand regulators and castigate CEOs of last year's three megabank failures, the equivalent of a congressional perp walk.

But, where was the comparable criticism of derelict directors who failed to properly oversee management?

Were the boards of these three megabanks, representing 10% of all banks over $100 billion, outliers? Or, was this indicative of a shortage of qualified directors at our biggest banks, possibly suggesting a big bank board brain drain?

In the aftermath of several hundred M&A deals in recent years, the potential pool of qualified directors should have expanded.

Banks typically have five to 13 directors, an average of eight, according to the Fed. With the number of banks falling by 800 in just the last five years, there is a pool of several thousand potential directors.

Just as some bank supervisors and managers are more experienced than others, so are some directors, especially those with a strong audit and risk management background.

Too many directors at the three big banks that failed last year were short on financial experience but long on business, political and social contacts.

For example, just three of the 12 Silicon Valley Bank directors had direct bank oversight experience, with most of the others having business, social or political connections. Besides citing their lack of "relevant large financial institution risk management experience," the Fed's postmortem highlighted "ineffective board of directors' oversight."

Those directors may have had a very weak financial education, but they were rewarded with very strong financial compensation of between $244,000 and $370,000 annually. No bank board, however, matched the political clout of Signature Bank, with the likes of Ivanka Trump, former Senator Alfonse D'Amato and former Representative Barney Frank.

Lesson learned: Big bank boards should focus on big bank brains rather than big names.

Even with the increased quantity of post-merger director candidates, there are at least three reasons to be concerned with their quality.

First, the greatly increased complexity and number of rules in the world's most heavily regulated industry requires a banking or financial background at least and an auditing and risk management background at best.

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You don't need a Ph.D. in finance to understand that banks with huge underwater Treasury portfolios should use derivatives to reduce duration in an increasing rate environment. But, how many directors at our biggest banks even know what a financial derivative is, much less how to use them to reduce risk?

Second, attendance at industry trade and other meetings by board members, oftentimes their only source of outside education, dropped precipitously after the pandemic. Trade show attendance is recovering but still 20% below pre-pandemic levels. If that was the only source of outside director education, that four-year absence would support the director brain drain argument.

Third, the increasing norm of virtual board meetings has decreased the input of knowledgeable independent directors who, under different circumstances, would be best positioned to challenge a CEO. This is especially the case with a dominant CEO, defined by the FDIC as one with "material influence over virtually all decisions involving the bank's policies and operations."

How many bad bank decisions were made with virtual boards since March 2020? SVB was known for its reliance on hi-tech virtual board meetings, but in-person meetings would not have mattered with their banking brain-drained board.

The regulatory reaction to the megabank failures was predictably piling on more regulations for the biggest banks. The Fed, the current leader of the regulatory wolf pack, proposed much tougher capital and liquidity rules. The FDIC proposed increased risk management governance responsibilities.

Regulators unfortunately forgot that while banks can increase financial capital, this is not the case with human capital. A bank board may be willing to take on new governance responsibilities, but they may be unable to do so with inadequate board bandwidth. No matter how hard they try, regulators can't square a circle.

There are more realistic fixes, all of which require increased director education and involvement.

The banking industry has made great progress with its financial literacy efforts for low- and moderate-income people, but what about financial literacy for board members with a low or moderate banking and finance background?

We require financial advisors to be certified in addition to receiving continuing education. Why aren't there similar requirements for bank board members, especially those at our biggest banks?

If directors are not going to industry or regulatory conferences for continuing education, then banks should hire outside experts for customized in-house training. Examiners and insurance carriers encourage such training, but the greatest beneficiaries are shareholders and the FDIC's Deposit Insurance Fund, which sustained $34 billion in losses from the three megabank failures.

Finally, short of requiring all directors to get back in the board room for monthly meetings, quarterly in-person attendance should be mandatory. Employees need to see their directors in person at the bank instead of in a mugshot on their website. If over half of workers would take a 20% pay cut to work at home, perhaps there should be a pay cut for remote directors?

Any of these brain-gain suggestions, like the regulatory proposals, will be met with resistance. No one likes to rock the bank board boat, but derelict directors at last year's three failed megabanks are proof that the status quo is not working.

Bank boards should be representative of their community, but we can't have good banks without good governance. This means good directors with a knowledge of banking and finance, especially in auditing and risk management, exercising their oversight function in the bank rather than on the internet.

An earlier version of this article incorrectly identified Barney Frank. He is a former member of the U.S.  House of Representatives.