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What makes boards of directors (in)efficient? Impact of board diversity on company performance

Published: March 8, 2013 | 12:00 pm
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CORPORATE GOVERNANCE

Merima Zupčević Buzadžić, International Finance Corporation (IFC)

Boards of directors have recently been subject to increased criticism, in particular in the wake of the recent global economic and financial crises, as it is believed they failed the test when it came to timely detection of downward trajectories in financial performance of companies and to adequate monitoring of risks to which companies were exposed (both internal and external risks).  Especially in developed economies, high levels of remuneration for board members became common practice in many companies, especially financial institutions – however this did not generally lead to meaningful contributions by such board members to supervising work performed by management. Indeed, these sizeable remuneration packages were, in some instances, seen as compensation for exercising as minimal interference as possible, relinquishing most responsibilities for the business to management. Perhaps the most dramatic example was the formerly unimaginable downfall of the Lehman Brothers investment group in the United States.

Following the fall of Lehman, it was observed that boards of directors of other major companies that failed in the first decade of the 21st century, shaking global capital market stability and investor confidence, suffered from similar deficiencies in terms of composition and profile as Lehman.  Numerous studies were conducted in an attempt to arrive at the answers to the following seemingly simple question: what were the attributes of the boards of these companies that were critical to their failure to properly oversee companies and their management and to conduct adequate strategic planning including a strong risk management oversight component. The answer is, of course, highly complex and this article will limit itself to two considerations: boards lack diversity in the skills that would allow a board to properly discharge its functions effectively and responsibly, and lack diversity in terms of gender balance (as well as ethnic and racial diversity).

An accepted premise in corporate governance theory states that, in order for each board of directors to properly discharge its role, certain core skills must be represented on it. These are primarily financial expertise, knowledge of the legal and regulatory framework relevant to the company’s operations, and knowledge of the relevant industry and market. It is increasingly being stated that, beyond the stated expertise, boards of larger companies and financial institutions in particular should also have expertise in the fields of risk management, auditing, and human resource management. Assuming that not all of these skills are to be found in a single person (considered highly unlikely), it is accordingly recommended to companies owned by a single individual to surround themselves with experts who will be able to provide comprehensive advice and participate in developing corporate strategy, each from her/his particular area of expertise. In addition to skills diversity, focus is also progressively being placed on the benefits of increased gender balance at senior company levels and on boards.

Research points to the beneficial effect of gender diversity on boards in terms of the practice of better governance practices, through greater diversity in opinion, experience, competences, skills and approaches to risk.  This can have a positive impact for better-informed decisions, more efficient oversight over financial management, improved shareholder responsibility and a more effective approach to managing risk.[1] Research conducted by Catalyst from 2007 demonstrated a correlation between greater representation of women on boards and the following financial indicators: return on equity (better, on average, by 53 percent), return on sales (by 42 percent) and return on investment (by 66 percent). The timeframe for the study was four years.[2] Yet, in 2010, boards of the largest publicly traded companies in the European Union had around 12 percent of women members, and in 2012 the figure was around 14 percent.

It is frequently remarked that one of the key reasons for the lower number of women who assume, and could assume, positions on boards is their career development up to that point. Namely, research shows that the number of women in senior management positions is significantly lower than the number of men in corresponding positions, meaning that women frequently do not develop the required skills for board membership even in the advanced years of their careers.  In some countries, the issue has been, or is being, addressed by the introduction of quotas to compel companies to appoint a specific percentage of women on their boards (at any rate in listed companies). Opinions on the merits of this approach differ however: some see this as a case of state interference in the private sector, while others believe that there is no alternative for strengthening the role played by women in the private sector, at least at this time.

Norway represents perhaps the most prominent example, where the state has introduced a quota of 40 percent of women on each board of stock exchange-listed companies. Sweden has introduced a recommendation (still in the sphere of voluntary action) for public companies to have 25 percent of women on boards.  There is also a well-publicised ongoing initiative at the level of the European Union led by Ms. Viviane Reding, Vice-President of the European Commission, urging companies across Europe to commit to having 30 percent of boards composed of women by 2015, and 40 percent by 2020.[3]

The current situation is however very different from the one that advocates of greater representation of women on boards would like to see. Currently less than 10 percent of board members globally are women, while a positive trend is noted in that about 60 percent of companies have at least one woman on their board.


[1] Smith, N., Smith, V., and Verner, M., (2009) “Women in Top Management and Firm

Performance”. Working Paper 08-12. Available at: http://www.hha.dk/nat/wper/08-12_vsmev.pdf

[2] Catalyst (2007) “The Bottom Line: Corporate performance and women’s representation

on boards”. Available at: http://www.catalyst.org/file/139/bottom%20line%202.pdf

Figure 1: Multi Category Aggregate Global Percentages[1]

The arguments offered by those less in favor of diversity (of all types) on boards can be summarized as follows:

-       Greater differences in opinion can lead to more conflicts and a failure to promptly reach decisions, which can be risky when decisions must be reached quickly;

-       If one or a few social groups are prevalent in a particular sector, representatives of other groups cannot adequately contribute to the work of the board if their experience to date is not adequate to deliver substantial contribution to the work of the board; and

-       Research to date on the benefits of diversity may not be considered conclusive and insufficient time has passed for conclusions to be reached.

Indeed some research focused on the US has indicated no relationship (beneficial or adverse) between performance and gender or ethnic diversity.[2] Such research would go in favor of the more ‘traditional’ theory that the only diversity that matters on a board is the diversity pertaining to skills and experience.

Ultimately, it is for companies to assess whether it would be beneficial for their business to have particular skills which are currently not represented on their board. Their focus should be not only on appropriate supervision over management and an efficient process for developing corporate strategy, but also on the impact that board composition has on the motivation of executives in the company and employees, as well as larger investors whose funding they wish to attract. Investors are placing an ever growing number of requirements on companies before they invest, and these often include a board of directors with a diverse representation of skills and opinions, as well as members of both genders.

Merima Zupčević Buzadžić is a Project Officer with IFC’s Corporate Governance Program in Europe and Central Asia, based in Sarajevo, Bosnia and Herzegovina.  She advises companies and financial institutions throughout Europe and Central Asia in improving their corporate governance practices.

 

About IFC

IFC, a member of the World Bank Group, is the largest global development institution focused exclusively on the private sector. We help developing countries achieve sustainable growth by financing investment, mobilizing capital in international financial markets, and providing advisory services to businesses and governments. In FY12, our investments reached an all-time high of more than $20 billion, leveraging the power of the private sector to create jobs, spark innovation, and tackle the world’s most pressing development challenges. For more information, visit www.ifc.org.

 

IFC Tbilisi office:

Phone: +995 (32) 223 43 00/01/02

 

Boris Janjalia is a Project Officer with IFC’s Corporate Governance Program in Europe and Central Asia, based in Tbilisi, Georgia.  He advises companies and financial institutions throughout the Caucasus and Central Asia in improving their corporate governance practices.

 

 


[1] Governance Metrics International, 2011 Women on Boards Report

[2] David A. Carter, Frank D’Souza, Betty J. Simkins, and W. Gary Simpson, (2010) “The Gender and Ethnic Diversity of US Boards and Board Committees and Firm Financial Performance”. Corporate Governance: An International Review, 18(5): 396-414

[1] David A. Carter, Frank D’Souza, Betty J. Simkins, and W. Gary Simpson, (2010) “The Gender and Ethnic Diversity of US Boards and Board Committees and Firm Financial Performance”. Corporate Governance: An International Review, 18(5): 396-414

 


 

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