Skepticism, savvy needed in the boardroom

The subprime-mortgage fiasco has revealed several flaws in the financial system that must be corrected if similar disasters are to be avoided in the future. But those flaws aren’t likely to be corrected by a mandate from Washington, which is focused on regulating mortgage lending. Any attempts at correction by Congress could have disastrous results, because they could hamstring financial innovation and weaken the U.S. financial system and the economy.

The financial community must heal itself. One key step would be to institutionalize skepticism within boards.

Ineffective boardroom oversight at some of our nation’s largest financial companies — The Bear Stearns Cos. Inc., Citigroup Inc., Countrywide Financial Corp. and Merrill Lynch & Co. — was probably the greatest weakness revealed by the near-meltdown.

Clearly, no board member at those institutions pressed hard for answers on the tough questions.

In part, boards are weak because so many are built on cronyism.

But an even bigger reason for director flabbiness is that investment innovation has outrun board knowledge. Few board members know enough to ask the right questions about the models that support financial derivatives or the failed risk-control programs that led to much of the trouble.

Moreover, even if they asked the right questions, directors wouldn’t have had enough understanding of the models to challenge the answers they received.

Simply and inelegantly stated, most board members at big financial firms don’t know enough math to do their jobs. Today’s financial world is built on sophisticated mathematical modeling and complex formulas whose oversight requires a high degree of mathematical fluency.

Yet mathematical genius alone won’t guarantee disaster avoidance, as evidenced by the spectacular collapse of Long-Term Capital Management LP of Greenwich, Conn., which boasted two Nobel laureates on its board.

What is needed on the board level is knowledge coupled with skepticism.

In fact, it may be necessary for major financial institutions to institutionalize skepticism by setting up small groups of quantitatively oriented employees whose task is to challenge the assumptions and mathematics underlying new financial products or procedures.

Clearly, some institutional reform is needed, as Wall Street has ignored those few who expressed doubts or issued warnings about excesses in 1987, 1999-2001 and now in 2007.

Reform must come from within, and soon, or Congress will do more than tighten the reins on subprime lending. It may be tempted to tie up Wall Street, and neither Wall Street nor the rest of us will like the unintended consequences of that.