Having directors with diverse skills doesn’t necessarily lead to better firm performance. Using US data, our research found that increasing the amount of skills on a board from 10 to 13 reduces firm performance by about 2.4%. The boards with more skills performed worse than boards with less.
In taking into account other research, our research suggest that boards whose directors share common skill sets have better firm performance because they can communicate effectively.
In theory, the optimal board combines monitoring and advisory roles to varying degrees. However, how individual director skills map into these roles is less well understood.
Research on board makeup has mixed answers when it comes to what contributes to success. For example, one study finds that directors with CEO experience increase firm value, while another found no such relationship. One reason for this could be that the usefulness of a director’s skills to a board depends in part on the other skills represented on a board.
US firms are now required to disclose the skills of their directors: in our study, this allowed us to assign skills to directors that would have been hard to characterise based on their employment history alone.
Using these disclosures, we found that the average director has three skills, out of the 20 we examined. The most common skill among directors is management skills (38% out of all assessed skills).
At the board level, there’s usually one director with finance and accounting skills. Boards also tend to have directors with management skills (90% of all boards).
Usually diversity of skills is found to be beneficial in decision making, as it brings greater resources to problem solving and could lead to a more complete analysis of an issue. However, different personal and professional backgrounds may lead to different ways in which team members interpret information and to multiple representations of a problem. In turn, this may lead to delays in decision making.
Research also suggests that diversity in a group could lead to failures, as it might cause the group (boards in our case) to be less integrated. This might also lead to a higher level of dissatisfaction and turnover among group members. For example, directors may be more likely to leave the board as they may not feel that they are part of a group.
Misunderstandings and disagreement can mean less effective decision making within multidisciplinary teams. Having boards with directors who have different beliefs may lead to disagreements within the board. As a result, the board invests inefficiently because directors anticipate future disagreements.
One of the reasons for diverse skilled boards performing worse could be because of the lack of common ground between board members. Directors need to be able share skills to be able to communicate effectively. There is evidence that groups with greater skill diversity communicate more formally and are less well integrated.
This then could hamper these groups’ ability to make better decisions for their firms. The negative association between diversity and communication isn’t just limited to skills or one’s previous industry or occupational experience. For example, in groups where members have different educational backgrounds, research shows an increase in turnover among group members.
Then there’s the opposite effect - skills shared by directors could lead to better communication and then improved firm value. One way to look at this is to group skills by their functions.
For example, governance and risk management skills could be grouped together under monitoring skills, whereas leadership and entrepreneurial skills could be grouped together under advising skills.
Our research provides some evidence that certain skills may appear together on the board. For example, we find that when there is a director with governance skills on the board, we are more likely to find another director with risk management skills on the board.
We are not suggesting that all firms should have a few skills on their boards. Our results suggest that firms should take a step back and think about how they choose their directors and how the communication among directors may be affected by having many skills on the board.
Also when firms appoint directors, they face many search problems. For example, US boards need to have at least one director on the board who is a financial expert and majority of board members need to be independent directors.
Add to these, governance regulations that may seek to, for example, increase gender diversity on the board (like the one implemented by Norway). Then a firm looking for a new financial expert director may need to find a director who would be a financial expert and an independent director, and someone who would also be increasing gender diversity on the board. In the presence of other frictions, like search costs, firms may not be able to cover all these dimensions at the same time.
Similarly, in trying to meet governance regulations focusing on one characteristic (like independence) or one objective (diversity) firms may not achieve the best match between new directors and the board. So governance regulations may not always lead to better company performance.
This article was first published on The Conversation.
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