The Cost of Rubber-Stamp Directors

All other bank employees have someone to report to, someone who reviews the decisions they make. But who reviews the decisions of the chief executive officer?

In far too many instances the answer is: nobody.

This becomes an extremely serious problem when the CEO does not want to hear any bad news. In such cases, the CEO is flying blind in decision-making.

This is made worse by the conceit with which many top officers react to the possibility of using consultants, such as real estate experts who might help in restructuring bad loans. These services are often spurned by CEOs whose egos won't let them acknowledge the need for outside advice.

Passive Boards

What about the board members? Aren't they there to evaluate the decisions of the top manager and maintain ultimate control?

Sure, in theory. But in actuality, most bank boards do precious little but approve what they are told to approve.

The very way board members are chosen makes this likely. Many board members are inside officers. Their jobs and benefits depend on the CEO, whom they therefore won't buck in a board meeting.

As for outside board members, many are chosen because they are friends of the CEO, so their independence is suspect. Others are top local names who like the salaries and perks and are unwilling to upset the apple cart, lest they fail to be renominated the next year -- as well they might if they give the CEO trouble, since the CEO usually dominates the nomination committee, whether a member or not.

Lazy Eyes

There are many horror stories about the ineffectiveness of boards. Mine include the major bank whose CEO, now deposed, held four board meetings per year -- including one at a resort. This is hardly a way for a top officer to get supervision.

A friend of mine, a bank regulator, tells this horror story:

A thrift hired a hot-shot trader in mortgage-backed securities who lost a substantial portion of the institution's capital in several months. When the banking authorities took depositions from board members, it was immediately obvious that they had no inkling of what was going on.

One member stated: "The reports he gave us were just too thick. I couldn't take the time to read them."

I have reached the conclusion that board members should not receive fees and the full medical coverage that some institutions provide. If they were paid only in stock and stock options, so their remuneration was tied to the fate of the bank, they might have a little more interest in what they were approving.

The Market Strikes Back

What about the discipline on the CEO that comes from the marketplace?

This can be more effective than the discipline of board disapproval.

When Manufacturers Hanover's credit rating was dropped from A to triple-B, John McGillicuddy, the CEO, was reported in The Wall Street Journal as saying that the higher cost of borrowing was likely to be $180 million a year!

But even market discipline can be parried by a CEO who is willing to generate one-time profits by "gains trading" -- selling quality assets to gain immediate revenue -- or who uses relaxed procedures in calculating loan-loss reserves.

In sum, a bank can hide earnings problems by "creative accounting" for a considerable amount of time.

Washington Fills the Vacuum

And cash flow problems can also be hidden. Instead of paying out money when cash flow is negative, the bank simply adds the discrepancy to the deposit accounts of its customers and makes it look like growth -- though the deposits cost the bank more than assets earn.

Well, if the board, the officers, and the marketplace do not impose discipline on the CEO, who does?

Occasionally, lawyers representing shareholders in class actions have successfully opposed poor bank policies. But these successes are few, and the cases take considerable time to develop and carry through. They are useless as day-to-day discipline.

Ultimately, unless the government provides discipline, no one does. This is one reason that regulators, supervisors, and lawmakers are taking a role in decisions that formerly were management's sole province.

This was almost inevitable. But sad to say, once government comes in, it never leaves.

This growing role of government is one legacy that we and future generations of bankers will inherit from CEOs who feel that once they make up their minds about something, that is the way it is going to be -- with no ifs, ands, or buts.

Mr. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.

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