Of late we have seen several articles in the media bemoaning the toothlessness of corporate governance in the US, in the wake of the Wall Street excesses of recent past. A book that I found that analyzed the excesses of the past decade pretty well and offered a lot of good suggestions is “Money for Nothing” by John Gillespie and David Zweig. Written with flair, and an understanding of how deep-rooted the issues are, the book is a great read for anyone who wishes to understand the financial markets collapse from a corporate governance lens.
This was the topic of one of the papers I submitted for Prof. Werbach’s ethics class, focused on JP Morgan and their recent ethical transgressions. The rest of the post highlights one of the sections from that paper, specifically focused around behavioral economics issues that impact how a corporate board of directors get influenced by behavioral principles and how that impacts judgments made in the board room. This is also a shout out to Dan Ariely and Startuponomics. It has been a year since the first conference and we have the second one coming up this weekend. This is also a quick snapshot of several topics from behavioral economics as highlighted by Zweig and Gillespie, and Ariely.
Several studies such as those by Dan Ariely show that the more removed we are as humans from real dollars, the higher the proclivity is to cheat. This means that in the financial world with exotic derivatives and other financial instruments, the likelihood of cheating would be far more than say at the cashier’s desk at the bank. Part of good management and governance at a firm such as an investment bank would involve being cognizant of these quirks in human behavior and having processes that safeguard the firm and its shareholders from extreme risk-taking behavior from different business units.
Several suggestions abound in behavioral economics literature in reminding people about ethical behavior in the best possible ways with least intrusion. Some of the more successful ones include having honor code like agreements that employees are reminded of periodically or having disparate groups of people working together on a particular project. The compensation committee within the board would be well served to look into executive compensation and manager incentive structure through these lenses and take appropriate action.
From the work of Dr. Kahneman on prospect theory, we could infer how boards should watch out for loss aversion and optimism bias, which could lead them to blindly support CEO decisions to pour money into failing projects or be overly optimistic about an enormous price tag presented for an acquisition. The Monte Carlo fallacy makes them believe that prior experience might change the present outcome of results (like the third acquisition working out better despite two spectacular failures), or face fundamental attribution error problems where they might give undue credit to the management for a good year.
Even when being watchful for how behavioral psychology might influence them, board members might still fall prey to issues such as self-serving bias which makes them ascribe failures to the environment than to the choices that they or the management made, confirmation bias that makes them interpret facts to suit their pre-conceived notion of a situation and the endowment effect that makes them value decisions or investments that they made more than what it is actually worth. As Prof. Irving Janis showed in his groundbreaking work on groupthink and group polarization boards tend to gravitate towards consensus, and at the same time marginalize independent thinkers whose opinions might sway from the “norm”. Prof. James Westphal’s work on board behavior clearly illustrate this tendency towards homogeneity and consensus and silent assent as well.
Zweig and Gillespie outline a host of great suggestions that the government and regulatory agencies should look into to fix some of these problems, including having a pool of independent directors that are setup by the government and sit on different boards, and a budget for a director training program to train directors in the complexities of several aspects of their fiduciary duty, specifically around compensation, risk and audit.
For a conscientious board member, there is no easy solution to this other than self-awareness on the part of the board member to make himself cognizant of these behavioral influencers and be wary of undue influence by any of these behavioral psychology traps. If you are a “behavioral economics” aware CEO, you could use these to your advantage in the board room as well ;), so attend the conference this weekend and learn more!