Apr 12

Bank governance: rejecting the check list

Morality and psychopaths

We all have a guilty secret. Confession is good for the soul, so in this post-Easter period, let me come clean about mine. It happened in the spring of 2008.

Shamsad Akhtar, the outstanding governor of the central bank of Pakistan at the time, was under attack from the government and her reappointment for another three year term looked uncertain. In an attempt to bolster her position, while I was on a visit to Karachi, she insisted I interview her on Pakistan state television. For 40 minutes we were filmed discussing monetary policy, provisions for bad loans, interest rate increases and the like. This was broadcast that very evening in the fifth largest emerging market by population. Villagers in the lawless regions on the frontiers with Afghanistan, the military in their secure compounds and government ministers in their mansions all shared one sentiment only: paralysing tedium.

Shamsad Akhtar’s term was not renewed.

Just as I bored a nation of over 170 million to tears, so I yawned audibly when I picked up the Group of Thirty’s report entitled Toward Effective Governance of Financial Institutions. What could this august body add to the barrage of work on the subject? In fact, it adds wisdom and common sense – the latter a much underrated virtue – in an exceptional report.

Having interviewed thirty six of the world’s largest financial institutions (FIs), plus regulators and supervisors, the G-30 are wary of excess prescription as a solution. This column has obsessively attacked box-ticking and is rather chuffed at having an eminent body corroborate its humble opinions.

Below is a summary of the G-30 conclusions. The italics are my own.

Governance is an ongoing process, not a fixed set of guidelines and procedures. Diversity of governance approaches across FIs is a virtue, not a vice. Each institution operates under unique circumstances. Greater homogeneity would likely lead to poorer governance because the constraints that would have to be introduced to ensure homogeneity would reduce FIs’ freedom to optimise.

To delve deeper and deeper into the details of all parts of the business may be a choice some boards will make, but endless detail is not a prerequisite for board effectiveness. Boards will need to dig deep selectively.

Board independence is not evidenced by the number of times a director says no to management. It is a about a value-additive contribution. Having smaller boards that require greater time commitment from their members is better than having larger boards requiring only modest time commitment. If a risk is too complicated for a well-composed board to understand, it is too complicated to accept. The best board in the world cannot counterbalance a weak internal control and risk management architecture.

Supervisors need a deep and nuanced understanding of each FI and need to broaden their perspectives to include strategy, people and culture. This requires regular interaction among senior people in supervisory agencies and boards and board members. But they must accept that they will at best have an incomplete picture and must not try to do the board’s job.

Any arrangement can fail, but failures are more often caused by undesirable behaviour and values than by bad structures and forms. Values and culture are the bedrock for the effectiveness of a FI’s governance culture.

The only sentence that was fully, and correctly, italicised in the G-30 report was this one: Values and culture drive people to do the right thing even when no one is looking.

In Jonah Lehrer’s How we Decide, a fascinating book on how the brain makes its choices, he undermines the notion that we make our moral decisions based on a rational weighing of competing claims. Instead, neuroscience experiments show that within milliseconds of being confronted with a moral dilemma our unconscious generates an emotional reaction, which we subsequently rationalise.

Psychopaths often have above average IQs and reasoning ability, notes Lehrer. The reason they are dangerous appears to be a broken amygdala, a section of the brain that propagates aversive reactions like fear and anxiety. This helps explain why Norweigan mass murderer Anders Behring Breivik, who is currently on trial, appears incapable of experiencing remorse and horror. For him, murder was a logical choice to further his aims. Psychopaths who are on parole are four times more likely than other prisoners to commit crimes after being released.

The emotional part of the brain helps us distinguish right and wrong by being sensitive to the plight of others, Lehrer explains. These moral circuits can only be found in the most social primates, humans being the most evolved. As Harvard professor Joshua Greene puts it, monkeys don’t understand tax evasion, but they do understand that it is morally wrong to push your buddy off a cliff. This implies that religious rules like the Ten Commandments are simply a codification of existing ethics. Man is by nature a moral creature.

Even in circumstances where amorality is rewarded, the brain’s longstanding moral instincts can override the different expectations. Lehrer illustrates this with an example from World War II, where an army survey showed that less than 20% of American troops shot at the enemy, even when under attack. When faced with a personal moral decision, to kill another human being, these soldiers were incapacitated by their emotions.

Army training was revamped after WWII to increase the shooting rate. In the Korean War, 55% of the troops fired and by the time of the Vietnam War, this was almost 90%.

We have a tendency to believe rational thought is better than an impulsive decision, not least because it is the basis of philosophy stretching back to the Greeks. Lehrer shows us that the emotional component of our brain is just as valid.

Numbers appear to be the ultimate instruments of rationality, which is why we are so often taken in by them. The idea that our complex, uncertain world can be reduced to statistics and algorithms is deeply comforting. And false. Numbers to be adhered to by FIs in the form of leverage ratios and loan exposures are, as the G-30 emphasise, no substitute for values and culture.


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