The governance of risk management: The importance of directors’ independence and financial knowledge

• Author: Thouraya Triki,Georges Dionne,Olfa Maalaoui Chun
• Published date: 01 September 2019
• DOI: http://doi.org/10.1111/rmir.12129
• Date: 01 September 2019

© 2019 The American Risk and Insurance Association

Risk Manag Insur Rev. 2019;22:247–277. wileyonlinelibrary.com/journal/rmir

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247

Received: 7 April 2018

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Accepted: 6 October 2019

DOI: 10.1111/rmir.12129

FEATURE ARTICLE

The governance of risk management:

The importance of directors’independence

and financial knowledge

Georges Dionne

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Olfa Maalaoui Chun

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Thouraya Triki

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1

HEC Montréal, Montreal, Quebec,

Canada

2

Bloomberg LP, New York

3

International Fund for Agriculture

Development, Roma, Italia

Correspondence

Georges Dionne, Canada Research Chair

in Risk Management, HEC Montréal,

3000 Chemin Côte‐Sainte‐Catherine,

Montreal, QC H3T 2A7, Canada.

Email: georges.dionne@hec.ca

Abstract

We test the effects of the independence and financial

knowledge of directors on risk management and firm

value in the gold mining industry. Our original hand‐

collected database on directors’financial education,

accounting background, and financial experience allows

us to measure the effect of financial knowledge on risk

management activities. We show that directors’finan-

cial knowledge increases firm value through the risk

management channel. This effect is strengthened by the

independence of the directors on the board and on the

audit committee. Extending the dimension of education,

we show that, following unexpected shocks to gold

prices, firms with financially educated directors are

more effective in hedging than average firms in the

industry. Firms that hedge more also attracts highly

educated directors on their board and audit committee.

As a policy implication, our results suggest adding the

experience and education dimensions to the 2002

Sarbanes–Oxley Act and New York Stock Exchange

requirements for better governance.

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INTRODUCTION

In this article, we explore different dimensions of directors’financial knowledge and test

whether they add value to the firm through the channel of risk management activities. Given

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the importance regulators have provided to directors’independence, we also address the benefit

of independent directors on the board or the audit committee and whether this requirement

adds to firm value.

The board of directors’main role is to represent shareholders’interests. The board thus aims

to maximize the firm’s value. The board oversees the recruitment, compensation, and activities

of senior managers. Consequently, the roles of compensation and audit committees have

received particular scrutiny since the Enron case. The makeup of the Board and its committees

has also been discussed extensively because the prominence of nonindependent members on a

board or its committees may affect the way the board functions.

According to several observers (e.g., Healy & Palepu, 2003), Enron’s Board of Directors failed

in its role of protecting shareholders and contributed to the firm’s bankruptcy. Several board

members held information on Enron’s management practices such as very high compensation

of senior managers and of some board members, and disclosure of false statistics on the

company’s growth potential to increase the value of stock and options. These board members

chose to ignore them or did not disclose them to shareholders.

Researchers recently showed, using data from 31 countries, that managers’manipulation of

earnings is positively correlated with the benefits they derive from this practice (on the

manipulation of earnings by firms see Lev (2003) and the references in the article). The authors

were surprised to note the extent that Enron’s executive compensation committees kept silent

about data manipulation by senior managers. Were these directors really incompetent? Were

they in a conflict of interest because they were paid themselves by stock options? Did they have

holdings in other companies that were doing business with Enron?

Despite the regulatory attention given to corporate governance through the rules set by the

Sarbanes‐Oxley Act (SOX) and the New York Stock Exchange (NYSE) in 2002, a report of the

Organisation for Economic Co‐operation and Development (OECD) attributes the 2007

financial crisis to the failure of the boards in overseeing risk management systems. The OECD

report (Kirkpatrick, 2009) mentioned that one of the causes of this crisis was linked to limited

knowledge of risk management and a poor understanding of various risks to which the financial

institutions’boards of directors were exposed. Several of these firms used very complex

structured financial products like commercial paper (ABCP), CDOs (Collateral Debt Obligation)

and CDSs (Credit Default Swap). Often, board members were unaware that the company was

using these products, or that they were responsible for defining the risk appetite of the

enterprise. This diagnosis emphasizes that board members from firms exposed to major risks

need sufficient financial knowledge to oversee risk management effectively. Therefore, even if

several board members are independent, they may not have adequate expertise to monitor firm

risk management effectively.

The OECD report does not limit the importance of qualified board oversight or the need for

robust risk management to financial institutions. Drawing lessons from the 2007 crisis, the

report emphasizes the necessity of certifying a minimum level of financial knowledge for the

directors on boards and those composing the audit committees of all exposed firms to ensure

that they understand issues related to risk exposure and risk management.

We analyze the governance of risk management within North American gold mining

companies. We examine how board and audit committee members’independence and financial

knowledge could affect firm value via the risk management policy. We analyze very detailed

data on financial knowledge of audit committee members and board members for each firm,

measured by three components: financial training, financial experience, and accounting

education. Financial education is defined as holding a university degree in finance (BBA, MBA

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DIONNE ET AL.