Diversity and the Boardroom 2014: Part II

 

Notwithstanding the empirical benefits of diversity, America's boardrooms continue to be the last bastion of white male supremacy. As demonstrated above any progress in this area can only be termed glacial. As I noted in Diversity and the Boardroom 2012, it has been 50 years since discrimination was outlawed, yet there really is no sound explanation for continued under-representation on this front other than the reality of crony capitalism. The apex of the American economy is still dominated by an old boys club.

Since that posting, more empirical evidence has emerged that well-managed diversity in the boardroom enhances corporate performance. Thus, one recent study found performance reflected the benefits of diversity when a critical mass of women were present in the boardroom:

Based on critical mass theory and with the help of a hand-collected panel dataset of 151 listed German firms for the years 2000–2005, we explore whether the link between gender diversity and firm performance follows a U-shape. Controlling for reversed causality, we find evidence for gender diversity to at first negatively affect firm performance and—only after a “critical mass” of about 30 % women has been reached—to be associated with higher firm performance than completely male boards. Given our sample firms, the critical mass of 30 % women translates into an absolute number of about three women on the board and hence supports recent studies on a corresponding “magic number” of women in the boardroom.

This critical mass of women on the board is also associated with greater innovation according to another recent study:

Academic debate on the strategic importance of women corporate directors is widely recognized and still open. However, most corporate boards have only one woman director or a small minority of women directors. Therefore they can still be considered as tokens. This article addresses the following question: does an increased number of women corporate boards result in a build up of critical mass that substantially contributes to firm innovation? The aim is to test if ‘at least three women’ could constitute the desired critical mass by identifying different minorities of women directors (one woman, two women and at least three women). Tests are conducted on a sample of 317 Norwegian firms. The results suggest that attaining critical mass – going from one or two women (a few tokens) to at least three women (consistent minority) – makes it possible to enhance the level of firm innovation. Moreover, the results show that the relationship between the critical mass of women directors and the level of firm innovation is mediated by board strategic tasks.

And, finally, in the perhaps the most comprehensive study of diversity in the boardroom to date Credit Suisse looked at the performance of 2400 firms worldwide over a six year period. Credit Suisse found that:

in a like-for-like comparison, companies with at least one woman on the board would have outperformed stocks with no women on the board by 26 percent over the course of the last 6 years. However, there is a clear split between relative performance over 2005 to 2007 and the post 2008 performance. In the middle of the decade when economic growth was relatively robust, there was little difference in share price performance between companies with or without women on the board. Almost all of the outperformance in the back-test has been delivered post 2008, since the macro environment deteriorated and volatility increased.

Clearly, more work is needed to understand the underlying mechanisms of diversity benefits and the best means of unlocking the benefits of diversity. In particular, it is difficult understand the critical mass needed for the full optimal level of diversity benefits in terms of gender diversity versus ethnic diversity. Learning to manage diversity in the boardroom may take years to fully understand. After all virtually no firms have a critical mass of African Americans (or other ethnic minorities) on the board. Nevertheless, I no longer think it tenable to maintain that the business case has not been established.

Further, those on the wrong side of this issue will ultimately be proven even more wrong in coming years. The OCC, the FDIC, the Fed, the NCUA, the SEC and the CFPB jointly released proposed standards for assessing the diversity policies of regulated entities under section 342 of the Dodd-Frank Act. The standards are available in full here. Among the items the joint standards address are board and senior management diversity. This means that many regulated entities will be assessing their diversity practices under the scrutiny of federal regulators across the entire business enterprise, including the boardroom. As such diversity is sure to increase beyond its current crony capitalism constraints in the boardroom. This in turn will create a more robust foundation for diversity research.  

In my opinion, this will simply illustrate more powerfully the truth behind the fundamental logic of diversity as a key driver of innovative and critical thinking.

Diversity and the Boardroom 2014: Part I

In 2000, I published Diversity and the Boardroom and in 2001 I followed up with A General Theory of Cultural Diversity. Since then I have written about diversity repeatedly and I have closely followed developments in the best learning on diversity management and the potential of diversity in terms of group cognition and functioning. I consistently argued that the best means of interpreting the impact of the value of diversity in the boardroom was through the lens of diversity management as a general means of improving innovation and group cognition. In my view, there is simply incontrovertible evidence that diverse groups (meaning groups which include a wide array of perspectives and experiences) necessarily outperform homogenous groups in terms of inquiry and innovation.

Therefore, it is no surprise that yet another recent study found this exact benefit of diversity:

A growing body of research is making links between diversity and the economic performance of cities and regions. Most of the underlying mechanisms take place within firms, but only a handful of organization-level studies have been conducted. We contribute to this underexplored literature by using a unique sample of 7,600 firms to investigate links among cultural diversity, innovation, entrepreneurship, and sales strategies in London businesses between 2005 and 2007. London is one of the world's major cities, with a rich cultural diversity that is widely seen as a social and economic asset. Our data allowed us to distinguish owner/partner and wider workforce characteristics, identify migrant/minority-headed firms, and differentiate firms along multiple dimensions. The results, which are robust to most challenges, suggest a small but significant “diversity bonus” for all types of London firms. First, companies with diverse management are more likely to introduce new product innovations than are those with homogeneous “top teams.” Second, diversity is particularly important for reaching international markets and serving London's cosmopolitan population. Third, migrant status has positive links to entrepreneurship. Overall, the results provide some support for claims that diversity is an economic asset, as well as a social benefit.

Another recent study corroborates this finding by looking at diversity inside the firm and linking it to patents:

In this paper, we investigate the nexus between firm labor diversity and innovation by using data on patent applications filed by firms at the European Patent Office and a linked employer–employee database from Denmark. Exploiting the information retrieved from these comprehensive data sets and implementing proper instrumental variable strategies, we estimate the contribution of workers’ diversity in cultural background, education and demographic characteristics to valuable firm’s innovation activity. Specifically, we find evidence supporting the hypothesis that ethnic diversity may facilitate firms’ patenting activity in several ways by (a) increasing the propensity to (apply for a) patent, (b) increasing the overall number of patent applications, and (c) by enlarging the breadth of patenting technological fields, conditional on patenting. Several robustness checks corroborate the main findings.

Of course, as always, diversity must be well-managed which means, among other things, that managers must attend to goal orientation, as this recent study shows: 

As workforce diversity increases, knowledge of factors influencing whether cultural diversity results in team performance benefits is of growing importance. Complementing and extending earlier research, we develop and test theory about how achievement setting readily activates team member goal orientations that influence the diversity-performance relationship. In two studies, we identify goal orientation as a moderator of the performance benefits of cultural diversity and team information elaboration as the underlying process. Cultural diversity is more positive for team performance when team members' learning approach orientation is high and performance avoidance orientation is low. This effect is exerted via team information elaboration.

Certainly, not every study finds the benefits of diversity. That is not surprising. I have always maintained that diversity must be well-managed. Tokenism, hostile environments, and marginalization will not unlock the benefits of diversity.  Just throwing people from diverse backgrounds together will not alone lead to enhanced financial performance. Nevertheless, there is powerful evidence of the benefits of diversity (critical thinking, deeper inquiry, innovation, etc.) when diverse voices are empowered and incentivized to act in groups productively.

In my next post, I will review recent evidence on the value of diversity in the specific context of the boardroom.

The 17th Annual Rainbow PUSH Wall Street Project Economic Summit: African Americans and Corporate Board Membership

     In his book, TheReckoning, Randall Robinson described a story told to him by the Reverend Jesse Jackson, Sr. When Jackson was running for President of the United States, he encountered an elderly white woman in the lobby of a hotel.  The woman pressed a dollar into his hand and said, “I never would have been able to lift those heavy bags.  Thanks again and here’s a little something for you.”

     I attended the 17thAnnual Rainbow PUSH Wall Street Project Economic Summit this week at the Sheraton Hotel in New York City.  Reverend Jesse Jackson, Sr., Founder and President of Rainbow PUSH, opened one of the first days’ panels entitled “Opportunities for Minorities on Corporate and Non-Profit Boards.  John Rogers, Jr., CEO & Chief Investment Officer of Ariel Investments moderated the discussion with the General Counsel of McDonald’s Corporation; the Senior Vice President and Community Affairs Manager of Government and Community Relations at Wells Fargo Bank; the Founder and CEO of Women in the Boardroom; and the President and CEO of The Prout Group, Inc., a small boutique executive search firm.

     The panel discussion was substantive and insightful.  Panelists discussed a Black Enterprise magazine publication that lists the companies with no African Americans serving on their boards.  They explained that smaller and mid-size firms are less diverse than Fortune 500 firms, and discussed the fact that almost all if not every board of a technology company is all white.  While listening to the discussion I thought about the media attention paid to the fact that when Facebook and Twitter went public, they did so with an all-male board.  Soon after both companies completed their IPOs, a woman was nominated and elected to each board.  I rarely, however, hear discussion of, or public outcry about boards that are all white, or boards that have no African Americans or Latinos.

     When I left the panel discussion for a moment, while walking toward the hotel’s main lobby, I overheard an exchange between a young white woman and an African American man dressed in a suit and tie.  “Do you work here?”, she asked him.  When he said “no”, she did not look embarrassed.  She looked annoyed.  She rolled her eyes to the ceiling, perhaps frustrated by her inability to get someone who worked at the hotel to direct her to where she needed to be.

     The conference attendee’s exchange with the young woman, and Jesse Jackson’s encounter as described by Randall Robinson, are familiar experiences for many Black and Latino professionals.  I call them professional misidentifications and I write about them in a book chapter entitled “Workplace Racial Discrimination” in “Law and Economics:  Toward Social Justice”, edited by Dana L. Gold.  I have experienced many of these misidentifications.  Dressed in a white robe, I, an African American woman, was mistaken for a bathroom attendant at a spa.  While visiting the Central Park Conservancy garden a woman thought I was a park attendant even though the park attendants wear green uniforms.  (I was wearing blue that day.)  At a movie theater, while I waited for a friend, a man approached me and brusquely asked where the men’s room was.  “Why would I know where the men’s room is?”, I responded.  “Because you look like you work here.”, he said.

     Many Black Americans experience these professional misidentifications.  I have heard stories from Black lawyers mistaken for mailroom workers, or defendants; Black doctors mistaken for orderlies; black business executives mistaken for secretaries.  These exchanges offer insight into the assumptions that some white Americans make about the type of work that African Americas do, and where they belong.  It is likely that these assumptions impact public reaction to corporate boards that have no African Americans serving.  African Americans belong in hotel lobbies helping with luggage and helping guests get to their desired location.  African Americans clean parks, spa bathrooms and movie theaters.  African Americans serve white Americans.  They do not serve on corporate boards.

      I returned to the Wall Street Project Summit the next day and I had a chance to conduct a short interview with Jesse Jackson.  I’ll tell you about the interview and more about the conference in my next post.

The Value of ERM

In prior posts, I have extolled the virtues of a professionalized, independent and comprehensive risk management function that ultimately rests with board of directors. The goal of this vision of Enterprise-Wide Risk Management (ERM) is the accurate disclosure of risk to investors which in turn implies that the enterprise is operated and governed in accordance with the risk profile supplied to investors. I have termed this the "Holy Grail" of corporate governance because this should avert the massive risk-mismanagement that drove all elements of the Great Financial Crisis of 2008 ranging from AIG's reckless gambling on subprime mortgages to the knowing predatory lending carried out by Angelo Mozilo at Countrywide. If the market had adequate disclosure of the true risks (including leverage) undertaken by firms like AIG, Countrywide, Lehman, Fannie Mae and others (see video above), then such activities would have led to the swift de-capitalization these firms and much of the crisis would have been short-circuited.

Yet, this fails to account for all the benefits of sound ERM programs. Articulating and managing the risks facing the firm, on a comprehensive basis, is apt to minimize net agency costs and enhance financial performance. Recent studies conclude that high-quality ERM programs enhance financial performance and firm value.

Thus, for example, a new study in the Journal of Risk and Insurance finds:

that the use of economic capital models [to measure insolvency risk] and dedicated risk managers improve operating performance. Requiring the dedicated risk manager report to the board of directors or to the chief executive officer (CEO) also increases value. The following combination of enterprise risk management initiatives yields the greatest increase in firm value: a simple economic capital model, a dedicated risk manager that is a cross-functional committee, and requiring the risk manager report to the board or CEO.

This paper is significant because it highlights the best ERM practices for unlocking enhanced value. For purposes of structuring corporate governance, the key finding is that a dedicated risk officer operating through a risk management committee that includes cross-functional expertise which has direct board or CEO access is associated with the most effective ERM programs in terms of financial performance. 

Another very recent study in Contemporary Accounting Research made a similar finding:

Using ERM quality ratings of financial companies by Standard & Poor's, we find that higher ERM quality is associated with greater complexity, less resource constraint, and better corporate governance. Controlling for such characteristics, we find that higher ERM quality is associated with improved accounting performance. Results show a market reaction to signals of enhanced management control from initial ERM quality ratings and rating revisions, and a stronger response to earnings surprises for firms with higher ERM quality. Focusing on the recent global financial crisis, our analysis suggests that there is no relation between ERM quality and market performance prior to and during the market collapse. However, returns of higher ERM quality companies are higher during the market rebound. Overall, results reveal that firm performance and value are enhanced by high-quality controls that integrate risk management efforts across the firm, enabling better oversight of managers' risk-taking behavior and aligning that behavior with the strategic direction of the company.

The empirical record has now clarified that ERM adds value, and firms that implement high-quality ERM programs outperform firms that do not. There is also growing evidence that firms with superior ERM capability weather crises better than firms with less ERM capability. The gains from sound ERM programs can boost firm value (measured through Tobin's Q) as much as 20 percent.

Of course, each firm has unique risks and therefore risk management needs. But the ideal ERM mechanisms are becoming clearer for larger firms or firms with higher complexity. Further, for sophisticated financial firms it appears that the steps the Fed and the OCC have taken to insist on greater ERM capabilities in the financial sector are backed by solid empirical data. Certainly improvements are possible, but the banking agencies are definitely moving in the right direction. All of these recent developments (new regulatory insights and new empirical data) should cause all public firms to rethink their corporate governance structures.

CEOs do not favor ERM initiatives because ERM necessarily limits CEO autonomy over risk management (and manipulation). Beyond that small group of individuals robust ERM initiatives mean more stable financial markets and superior corporate performance. Policymakers, judges, legislators and board directors should fully embrace ERM programs and encourage greater ERM capabilities.

Both OCC and Fed Now Embracing ERM

I have long argued that Enterprise-Wide Risk Management (ERM) holds the potential to revolutionize corporate governance. Thus, in 2008, I argued (along with co-author Betty Simkins) that the SEC should require that pubic firms: 
 

provide qualitative disclosures regarding their approach to enterprise risk management including: 1) whether there is a comprehensive enterprise-wide risk management function; 2) the extent of board involvement in that function; 3) whether the CEO controls that function; 4) the breadth of expertise available to address firm risks; and 5) any differences between management and risk managers regarding the firm’s current risk profile.

I later extended this argument in 2009 and advocated mandatory risk management committees that were independent of management and included risk-management expertise at least for the the largest and most systemically important financial firms.

On January 16, 2014, the OCC took a giant leap in this direction and combined with prior regulatory releases by the SEC and the Federal Reserve (which acted pursuant section 165(h) of the Dodd-Frank Act) the stage is set for a more rationalized corporate governance law and regulation. Here are the requirements of the new risk management guidelines in the OCC's own words:

The proposed guidelines set forth the minimum standards for the design and implementation of an institution’s risk governance framework and provide minimum standards for oversight of that framework by the board of directors.  The guidelines include provisions regarding:

• The roles and responsibilities of those organizational units that are fundamental to the design and implementation of the risk governance framework.  These units are front line units, independent risk management, and internal audit.  Together, these units should establish an appropriate system to manage risk taking.
• A comprehensive written statement that articulates the bank’s risk appetite, which serves as a basis for the risk governance framework.  This statement should include both qualitative components and quantitative limits.
• Board of directors’ oversight of a bank’s compliance with safe and sound banking practices. The board should ensure that the bank establishes and implements an effective risk governance framework that complies with the guidelines.
• Active board oversight of a bank’s risk-taking activities.  This includes establishing accountability for management’s adherence to the risk governance framework.  The board should also evaluate management’s recommendations and decisions by questioning, challenging, and, when necessary, opposing, management proposals that could lead to excessive risk taking or pose a threat to safety and soundness.
• Composition of the board of directors.  A board of directors should have at least two independent members who are not part of the bank’s or the parent company’s management.

The OCC’s risk management guidelines apply to all banks with over $50 billion in assets. Therefore virtually every large bank in the U.S. will now be required to adopt some form of ERM.

These new requirements are additional risk management mandates to those the Fed proposed in late 2011. The Fed’s ERM mandates apply to all systemically important financial institutions with a primary focus on bank holding companies with over $50 billion in assets. The Fed's proposal mandates an independent risk management committee, risk management expertise and an ERM function that is independent of the CEO.

The SEC, for its part, already requires that all public firms disclose their risk management practices to investors pursuant to the mandatory disclosure requirements applicable to such firms. These regulations took effect in 2009. 

Taken together, it is clear that a new paradigm is emerging in corporate governance, and ERM is at the center of that paradigm. To the extent that independent risk management committees emerge that directly supervise a chief risk officer and more risk management expertise is brought to bear in the public firm (and the financial sector in particular), perhaps corporate governance can evolve toward a regime that gives investors more precisely the risk profile they bargain for. That would be a major improvement. After all, deeply deficient risk management pervaded all aspects of the Great Financial Crisis of 2008.

ERM as refined by the OCC and the Fed holds the potential to define a new "best practices" in corporate governance for communication of a firm's risk profile and the control of risks within the firm to meet that profile.

Law review article forthcoming. . .