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Ironically, the more experts they have on their boards the more likely firms are to succumb to novel challenges

August 22, 2016

For more information, contact: Ben Haimowitz, (718) 398-7642, press@aom.org

In constituting a corporate board, how much expertise about its industry should a company seek? As much as possible, common sense would seem to suggest. In the words of a new study, "the idea that expert-dominated boards might have serious negative consequences for organizations clearly defies conventional wisdom."

 

Yet, defy it the new research proceeds to do. The study in the current issue of the Academy of Management Journal finds that in situations that engender uncertainty, "the higher the proportion of domain experts on a board, the higher the likelihood of organizational failure."

 

In sum, expert-heavy boards navigate familiar routes well enough but have an increased tendency to go awry once off the beaten track, the paper concludes from data involving more than 1,300 U.S. community banks over a period of 17 years. In the words of the study, "Despite the perception that the value of domain experts comes from their ability to manage uncertainty...ironically, it is precisely under conditions of uncertainty that a higher proportion of domain experts is associated with organizational mortality."

 

What accounts for this? Based on interviews with banking executives and findings of other researchers, the paper's authors, Juan Almandoz of IESE Business School in Spain and András Tilcsik of the University of Toronto, cite three factors that compromise experts’ effectiveness in addressing new or challenging circumstances. One is what they call "cognitive entrenchment," a lack of flexibility in responding to unfamiliar situations. A second is overconfidence, a characteristic that prior research has uncovered in experts as varied as physicists, psychologists, and CIA analysts. The third is "reduced task conflict," excessive deference of non-experts toward a cluster of industry-savvy board colleagues, the experts’ flaws in judgment notwithstanding.

 

The professors distinguish their study from the preoccupation with diversity that has traditionally characterized research on corporate board composition. "Consider two examples," they write. "First, a manufacturer of solar panels has a board of directors that includes five solar-energy experts, two lawyers, and two bankers. Second, the board of another firm in the same industry includes two solar-energy experts, five lawyers, and two bankers...In the literature on team diversity, these two boards would be typically coded as equally diverse in terms of the variety of professional backgrounds. Yet, these boards differ dramatically in the proportion of domain expert directors."

 

And, while there has been no shortage of research on diversity, they add, the role of domain expertise has been "largely overlooked."  The study therefore breaks notable ground in finding that "the proportion of domain expert directors [is] related to a vital organizational outcome – survival or failure – even after accounting for the influence of professional, tenure, and gender diversity on boards."

 

Profs. Almandoz and Tilcsik arrive at their findings by investigating the rate of bank failures in circumstances which banking executives they interviewed identified as entailing heightened uncertainty.

 

One situation involves rapid asset growth, when "the bank is likely to be operating in uncharted market territory, often facing decisions about previously unknown borrowers, lending areas, and sources of loans."

 

Another is associated with non-standard real estate loans – that is, loans for “other than ordinary family residential properties...includ[ing] land, construction, and development loans, farm loans, large multifamily residential loans, and other commercial real estate loans…Clients in such markets tend to be highly heterogeneous...in contrast to...regular family residential properties, which are characterized by a low degree of uncertainty because of the availability of detailed information about past patterns and risk factors."

 

The study's sample consists of 1,307 local banks founded from 1996 (before which biographical information on board members is spotty) through 2012. A local, or community, bank is defined as having its own legal charter, aggregate assets below $1 billion, and a business model that focuses on lending and deposit-gathering in the surrounding locality. Domain experts are directors with backgrounds in banking or real estate before joining boards – those in banking typically as executive vice presidents or higher and those in real estate as top executives of firms in property development or investment.

 

Of the 1,307 banks that were monitored, 124 (9.5%) failed, 1,015 survived, and 168 disappeared as a separate entity due to a merger or reorganization that did not involve a failure to meet depository obligations. Analyzing the relationship between organizational failure and the proportion of domain expert directors, the professors found that in the two circumstances cited above – where a bank's assets were rapidly increasing or a bank had a hefty portfolio of non-standard real estate loans – the rate of organizational failure increased significantly with the proportion of directors who were domain experts

 

The professors note, however, that for the sample as a whole "the proportion of directors who were banking or real estate experts had no significant main effect on bank failures...Rather, as we theorized...the relationship between the proportion of domain experts and the risk of bank mortality was contingent on the level of decision uncertainty."

 

And this relationship is quite clear. For example, in banks with relatively small portfolios of non-standard real estate loans (bottom 15th percentile), failure rates are similarly low whether real estate experts constitute 10% or 40% of board members. But in banks with relatively large portfolios of such loans (top 15th percentile), the failure rate is about three times higher when 40% of directors are real estate experts than it is when 10% fit that description.

 

The authors took care to ascertain that their results were not unduly influenced by the major financial recession of 2007-09, when many banks failed. As they explain, "our models accounted for year-to-year variation in economic conditions by controlling for the rate of GDP growth and the number of bank failures each year."

 

Could it be, though, that their findings are special to banking but not applicable to other industries? The professors concede that possibility but note that their conclusions resonate with earlier research dealing with solar-cell manufacturers, an industry quite different from banking. That earlier study found that management teams in which most of the executives were domain experts were less flexible than others in adapting to environmental shifts.

 

In conclusion, the authors caution that "most boards in our empirical context include at least two directors with prior banking experience to fulfill minimum regulatory requirements of financial expertise. Thus, our findings should not be taken to imply that boards with no domain experts whatsoever are optimal; rather, what our results point to is the importance of appointing a non-trivial number of directors with primary expertise beyond the focal domain, especially in boards that are likely to face a significant degree of decision uncertainty."

 

The paper, “When Experts Become Liabilities: Domain Experts on Boards and Organizational Failure," is in the August/September issue of the Academy of Management Journal. This peer-reviewed publication is published every other month by the Academy, which, with almost 20,000 members in 127 countries, is the largest organization in the world devoted to management research and teaching. Its other publications are Academy of Management Review, Academy of Management Perspectives, Academy of Management Learning and Education, Academy of Management Annals, and Academy of Management Discoveries.

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