The competence asymmetry

Written by YRK Reddy | Updated: Oct 27 2007, 05:39am hrs
Northern Rock, the bank that tottered in the UK recently, is one that was chaired until last week by the famous genetic specialist Matt Ridley, the author of Genome and Nature Via Nurture. Nothing wrong about this, as many believe that the duty of an independent chair is mainly to bring about a consensus on issues the management is well familiar with. Further, most directors programmes assert that the critical action of an independent director is to ask that dumb or nave question without fearthough it is often confusing whether the emphasis is on dumbness or fearlessness. Independent directors, at times, are given a short induction to understand the business model, but are otherwise left to learn at board meetings.

There are many common features of corporate failuresinefficiency of management, technical mismanagement, poor ethical standards, poor internal controls and risk management, ineffective board oversight, inactive shareholders, tunneling/self-dealing by dominant shareholders, pure greed and the like. Theoreticians may also point out the information asymmetry implicit between the management and boards, which can lead to ineffective controls and supervision. Information asymmetry implies that non-executive directors (particularly independent ones) do not know as much truth as managements (and executive directors) do about business transactions, performance, results, risks and threats.

There are many suggestions to fix the information asymmetrybetter design of information systems, due diligence and third party reviews, apart from auditing systems and specialised committees such as for audit and risk management. Some leads may now come forth from the work on mechanism design and implementation theories that have been recognised through the Royal Swedish Academys Prize in Economic Sciences, 2007, for Leonid Hurwicz, Eric Maskin and Roger Myerson. The mechanism design will attempt at an optimal systemwide solution to a problem with self-interested agents with private information about their preferences for different outcomes. Micro-economists may suggest revelation conditions and incentive-compatibilities that would bridge the information asymmetry and progress to better governance.

I have a problem with the information asymmetry arguments that suggest that they can indeed can be fixed satisfactorily. The main issue is that most independent directors are just not competent enough to match the managements and executive directors on most matters, given the same information. They may be very good in their own fields and may have huge reputations as lawyers, bankers, finance specialists, accountants, administrators, academicians, and may have mastered the board etiquette and language. Yet, their insights into the business processes of the company will never be sufficient. It is probable that the selection criteria of such independent directors are often configured in such a way that they meet the reputation needs more than vigilance requirements. Independent directors, in most cases, are just the garb adopted to claim that the company has a proper oversight mechanism.

Lest the above sounds cynical, there are two compelling arguments and some evidence in support of the above assertion. First, most companies do not have an advance design of the profile of boards and directors; they have organisation designs, job profiles and competence profiles for managers, but not for independent directors. This makes vast space for discretion. Second, there is no competence mapping of directors to ensure that they not only are fit and qualified, but have the attitude and motivation to fulfill their duties. The typical criteria used are qualifications, past background, achievements and chemistry, rather than competence in its wider meaning.

The evidence I had occasion to administer pre-training knowledge assessments and post-training learning assessments to check the baseline knowledge on corporate governance and compare it with the levels of learning achieved after the training. This was in respect of directors involving large corporations in eight countries. The results Independent directors, as a cluster, know less on corporate governance matters than executive directors and managers, and have fared worse in terms of knowledge acquisition. Arguably, the important challenge is not information asymmetry. It is competence asymmetry.