Are big-bank directors too distracted to govern?

Editor’s note: An earlier version of this blog post appeared on a Harvard Law School forum before the Fed’s proposed guidance was released.

Last month, the Federal Reserve proposed new supervisory guidance that purports to strengthen expectations for the directors of large U.S. banks. As Fed Gov. Jerome Powell has stressed, the proposal reflects the Fed’s view that directors should spend more time on their core responsibilities, such as setting risk tolerance and overseeing risk management.

The Fed’s proposal, however, fails to address a critical shortcoming: The directors of the United States’ biggest banks are too busy to fulfill these governance responsibilities. Many directors serve on multiple boards and hold full-time executive positions. While these outside commitments provide valuable learning and networking opportunities, they also limit the time and attention that directors devote to bank governance.

In an academic paper forthcoming in the Boston College Law Review, I argue that the Fed should impose limits on bank directors’ outside professional commitments to ensure that board members are not too distracted to govern. I point to Wells Fargo’s fraudulent-accounts scandal and JPMorgan Chase’s London Whale trading loss as evidence that busy bank directors inhibit the oversight of management and increase the risk of firm failure.

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My research identifies three specific ways in which busy directors impair risk oversight. First, directors with many outside commitments are less inclined to participate actively in corporate decision-making. Busy directors, for example, are more likely to miss board meetings, and board committees made up of busy directors meet infrequently. Second, directors with many outside commitments tend not to challenge management; as a result, firms with busy directors are more susceptible to managerial self-dealing, misconduct and excessive risk-taking. Third, busy directors experience attention shocks that distract them from company business. When a firm with which a director is associated experiences a major event — e.g., a merger or reorganization — the director’s time commitment to that firm increases substantially. The director, in turn, neglects his or her other board memberships.

Consider, for example, the London Whale trading loss. As the then-chair of JPMorgan Chase’s risk committee, James Crown bore responsibility for overseeing the firm’s risk management framework. At the same time, however, Crown had many other professional duties: He served as the lead independent director of both Sara Lee Corp. and General Dynamics Corp., and he ran his family’s multibillion-dollar investment fund. Just as JPMorgan’s traders began building their ill-fated derivatives positions in early 2012, Crown was busy conducting a search to replace Sara Lee’s CEO, overseeing a spinoff of Sara Lee’s noncore business lines, and developing strategies for General Dynamics to cope with $1 trillion in recently enacted defense budget cuts. While Crown attended to these crises, JPMorgan’s risk management infrastructure failed to detect the escalating risks in the bank’s credit derivatives portfolio, leading to $6 billion in losses and more than $1 billion in fines for inadequate risk monitoring.

The situation was similar with Wells Fargo’s fraudulent accounts scandal. Wells Fargo’s directors failed to respond to red flags regarding sales practices violations, at least in part, because they were among the most overcommitted bank directors in the country. Nine of Wells Fargo’s 13 independent directors served on at least three public company boards. Enrique Hernandez Jr., then the chair of the risk committee, was particularly busy, sitting on the boards of four public companies and serving as CEO of a multinational, private company. Wells Fargo’s directors were so busy that they rarely met as a full board or in their committees. Every year from 2012 to 2015, for example, Wells Fargo held fewer board and risk committee meetings than any of its peer banks. In sum, while Wells Fargo’s employees opened millions of fake customer accounts, its board was missing in action as directors attended to their other professional obligations.

All of this is not to say, of course, that JPMorgan Chase and Wells Fargo necessarily would have averted their crises had their boards been less overcommitted. I argue, however, that both institutions would have been more likely to detect and address nascent risks if their boards — and especially their key directors — had been less busy.

Despite the dangers of director busyness, many bank board members remain alarmingly overcommitted. My paper provides empirical data on the boards of the largest and most complex U.S. financial institutions — firms whose misconduct or excessive risk-taking could inflict harm on the broader economy. When compared to the directors of all S&P 500 firms, these financial institution directors are significantly less likely to sit on only one public company board and more likely to sit on at least three public company boards. The boards of a few financial institutions are especially overcommitted. Nearly two-thirds of Citigroup’s independent directors, for example, hold three or more board seats.

Recognizing the risks of overcommitment, the European Union has adopted regulations limiting outside employment and board seats for financial institution directors. The United States, by contrast, has not yet addressed the problem.

The Fed’s proposed guidance is a critical opportunity to establish that big-bank directors must limit their outside commitments. The Fed should prohibit big-bank directors from serving on the boards of more than three public companies — the threshold at which directors’ professional commitments begin to detract from their governance responsibilities, according to an empirical study. More stringent limits should apply to a firm’s lead independent director, risk committee chair, and audit committee chair. These key directors are critical to effective risk management and should be uniquely focused on the firm. Accordingly, the Fed should limit a bank’s key directors to serving on the board of one other public company and should not permit a current public company executive to serve in one of these pivotal leadership roles.

There is, of course, a tension between trying to attract the strongest and most highly qualified bank directors and limiting their outside professional commitments. Director candidates already complain that serving on a bank’s board is unattractive due to onerous regulations and potential liability. Imposing limits on directors’ outside commitments might further dissuade well-qualified candidates from serving. The Fed, however, can limit the depletion of qualified and interested director candidates by applying the most stringent regulatory caps only to the key directors of the largest banks — about 30 directors in total. Banks, moreover, can ensure a consistent supply of well-qualified candidates who are willing to comply with limits on their outside commitments by increasing directors’ pay to compensate them for forgone professional opportunities.

Deterring misconduct and excessive risk-taking by large, complex financial institutions requires that their directors have sufficient time and attention to execute their governance roles effectively. By adopting limitations on directors’ outside commitments, the Fed can enhance oversight of bank management and thereby help preserve the safety and soundness of the financial system.