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Ideas for Leaders #672

In Uncertain Times It's Best to Have Fewer Industry Experts on a Board

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Key Concept

Having domain experts on boards is often touted as an advantage. New research shows, however, that too many experts from a company’s industry can actually hinder a board’s efforts in times of strategic uncertainty.

Idea Summary

With good governance recognized as a key factor in a company’s success, the recruitment of new members to a board is a highly important and consequential task. New research focuses on the often-overlooked criteria of domain expertise — that is, whether having experts in the sector or industry of the company on the board adds or detracts from the board’s effectiveness.

Intuitively, one might believe that expertise in the company’s area — having bankers on the board of a bank, for example — would only add relevant experience and knowledge to the board.

Past research, however, has revealed the potential disadvantages of having domain experts — people with long experience, old habits and set ideas about the industry — on a board. These disadvantages include: cognitive entrenchment, which refers to difficulty in recognizing and integrating new information and new perspectives; group overconfidence, since experts in the field are more likely to be overconfident about the accuracy of their judgements and predictions; and limited task conflict, which reflects a preference to avoid divergent opinions or viewpoints, which reduces the alternatives considered. These effects reduce innovative decision-making in favour of the tried-and-true, no matter what the circumstances.

In a new study, Juan Almandoz of the IESE Business School and András Tilcsik of the University of Toronto’s Rotman School of Business argue that a higher proportion of domain experts on a board is even more problematic in situations of what they call “decision uncertainty” — that is, situations or environments in which outcomes are difficult to predict and cause-and-effect relationships are limited or ambiguous.

Uncertain situations, they argue, call for more flexibility and openness to new ideas and new perspectives, not less. They call for bringing in new and diverse voices, not huddling around familiar peers offering familiar solutions. As a result, the negative impact of cognitive entrenchment, group overconfidence and limited task conflict is even more consequential in times of decision uncertainty.

Almandoz and Tilcsik use the banking sector — and specifically multi-sourced data related to U.S. community banks founded between 1996 and 2012 — to illustrate the correlation of a high proportion of domain experts on boards and bank failures during times of decision uncertainty.

The team analysed the histories and board composition of 1,307 local banks founded between 1996 and 2012; of that number, 1,015 banks survived in the time period covered, 124 failed, and 168 disappeared as a separate entity because of a merger or a reorganization. The banks labelled as failed were unable to meet their depository obligations and had to be taken over by the Federal Deposit Insurance Corporation (the government agency that guarantees no depositors will lose their money because of a bank failure).

The researchers then measured the level of decision uncertainty in which the banks operated based on three criteria:

  • Rapid asset growth. Rapid asset growth requires significant new lending, which means that through these loans, the bank is venturing into uncharted territory (e.g., unknown borrowers and market segments).
  • Involvement in non-standard real estate loans. Non-standard loans can be anything that is not the usual family residence loan, including loans for land, construction, farms, and commercial real estate fall. These types of loans are more risky and unpredictable.
  • Number of local competitors in the local area. Local banks compete for deposits, loans and capital most intently against other local banks. The more local banks exist, the more complex the competitive environment.

Using statistical modelling, the researchers then compared for the 1,307 banks in the database the relationships between:

  • the proportion of domain expert board members
  • the level of decision uncertainty in the environment (as reflected in the presence of the three criteria above) and
  • the success and failure of each bank.

The results of the statistical analyses showed no correlation between the proportion of experts on the board and failure of the banks when the elements that contribute to decision uncertainty are not present.

However, banks with high asset growth and/or who were involved with non-standard real estate loans were more likely to fail, the data showed, if they had a higher proportion of domain experts on their boards. (Banks competing with a high number of local competitors were only very slightly more likely to fail, therefore this factor was considered not conclusive.)

In sum, the results of their analysis confirmed that the greater the level of decision uncertainty, the more a high proportion of domain expert board members negatively impacts the performance of the bank.

Business Application

Recognizing the importance of good governance, a better understanding of the optimal composition of a board is vital to the ultimate success of a company. Much research has been conducted on diversity and other issues, but as this new research demonstrates, domain expertise can play a surprising role in whether a board is positioned to make the right decisions — especially in an uncertain environment.

If one assumes that there is no company or industry that is immune to uncertainty forever, this research seems to indicate that keeping the proportion of domain experts low on a board is always a good idea.

It should be noted that for U.S. banking, regulators usually require the presence of two bankers on every board, which leads to an important caveat: the researchers are not advocating for the complete absence of experts; they are simply cautioning against the assumption that more is better… when the opposite appears to be true.

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Authors

Institutions

Source

Idea conceived

  • August 2016

Idea posted

  • September 2017

DOI number

10.13007/672

Subject

Real Time Analytics