As the recent financial crisis threatened the City, were the banks' non-executive directors too slow to raise the alarm? And what does any reluctance to challenge risky decisions say about the state of UK corporate governance?

Nobody saw this coming," says a non-executive director of one High Street bank, referring to the crisis that has brought many UK financial institutions to their knees and prompted a £500bn rescue package from the government and the nationalisation of Bradford & Bingley and Northern Rock.

The question is: should they have seen it coming? And, more specifically, did the banks' non-executive directors exercise the scrutiny and oversight that is required of them under the Combined Code on corporate governance? The code states that non-executives "should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible".

Even if the non-executives were satisfied, that satisfaction was clearly ill-founded. It is a failing that poses a big question mark over the calibre of non-executives on bank boards, and even over the robustness of the UK's corporate governance structures themselves.

But the banks and their non-executives seem to be hiding behind defensive "group think". "If just one organisation had been affected then you could argue that it had been mismanaged," says Sir George Cox, an experienced non-executive director and former director general of the Institute of Directors. "But when the whole sector has been affected, it points to a systemic issue. The entire industry can't have had incompetent boards, particularly when it's had its pick of non-executive directors."

If there is a systemic issue, some point to a disdain for corporate governance that our biggest banks have shown during the past few years of high shareholder returns.

"They seem to think they are somehow above corporate governance because they are the great lubricators of business life," says Peter Waine, co-founder of executive search firm Hanson Green. "Corporate governance itself hasn't failed—the banks have failed corporate governance by not complying with it."

For example, says Waine, while it is generally accepted that small boards are the most effective, many bank boards are big and unwieldy, with two tiers of non-executives, "some of them in the inner sanctum and some not". It is, he says, a ridiculous and old-fashioned structure, "redolent of where other FTSE companies were 10 or 15 years ago".

Waine has met many bank chairmen over the past few weeks, he says. "When I ask them about whether they minuted any concerns about what was going on in their organisations 12 months ago, about half say they started to question things then, but half didn't."

But while the banks have performed "very below standard on the corporate governance side", Waine cannot understand why non-executives from outside financial services accept the situation, particularly when they see effective corporate governance elsewhere. "Many good executives and non-executives from outside financial services seem to leave their brains behind when they join the board of a financial services company," he concludes.

The kudos of a top bank non-executive job seems to dull people's objectivity and critical faculties, admits a former building society chief executive, who is now a bank non-executive himself. "If you are from a retail or an engineering background, for example, and you are surrounded by sharp, big-time banking executives and a very experienced banker as chairman, it takes a lot of courage to challenge them and say this doesn't feel right," he says.

"It takes even more courage to persist in that challenge when it feels uncomfortable, when the rest of the board are putting lots of pressure on you, and when you don't want to look an idiot or to offend people."

The Combined Code states that "where directors have concerns that cannot be resolved about the running of the company or a proposed action, they should ensure that their concerns are recorded in board minutes. On resignation, a non-executive director should provide a written statement to the chairman, for circulation to the board, if they have any such concerns."

But non-executives would find this crucial challenger role easier if they had the courage of their convictions, says a former bank director. He explains the absence of non-executive resignations in the run-up to the banking crisis as a result either of their capitulation to bullying executives or to a lack of understanding about the products banks were selling and the risks they were running.

Research by Cranfield School of Management this year into the role, contribution and performance of UK directors found that non-executives often nod things through in the belief that the executives know best. In a business such as financial services, with its vast array of complex products, the temptation to do that must be high.

"But if you don't understand something, you shouldn't buy it," says the former building society chief. "And if you realise that the executives don't understand it either, that should set even louder alarm bells ringing." He suggests that the risk was compounded in stricken banks by audit committees not scrutinising treasury operations diligently enough, and then by remuneration committees rewarding executives for their risky behaviour. "Rewarding people for taking risks that you don't understand just encourages even greater risk-taking," he says.

But the complexity of banking is no excuse for not understanding it, says the ex-bank director. "The way to assess whether new and highly complex credit derivatives and other treasury products carry an acceptable level of risk, and to ensure the risk is being properly managed, is to seek independent specialist advice," he says.

But because banks are better these days at managing credit risk-banks will lose less money in this recession through bad debt than they did in the last one, he predicts-people have been lulled into a false sense of security. "So most non-executives, whether from a financial services or non-financial services background, probably haven't taken independent advice."

Another big area of risk that has gone largely unchallenged is liquidity mismatches—that is, the ratio between deposits and lending. Most big banks had too many short-term deposits and too much long-term lending.

"The fact that the government is now saying the banks need to have a higher capital-to-lending ratio suggests that banks have exposed themselves to too much liquidity risk in the past," says the former bank director. "But it is unlikely that non-executive directors would have flagged that up as a risk, given that it was the norm in the industry, and they wouldn't have been listened to if they had tried."

Where banks offered more generous lending criteria, such as 125 per cent mortgages, is an area that non-execs could and should have challenged. "Also, allowing an individual to continually refinance to fund a string of buy-to-let properties, based on the perceived rise in value of each of those properties, was about helping them to build a rental stream on straw," he says. "I wonder why non-executives at places such as Bradford & Bingley didn't ask more questions about that."

Sir George Cox, until the end of last year the senior independent director at Bradford & Bingley, has some answers. "Non-executive directors at Bradford & Bingley oversaw a board that was endeavouring to do what its stakeholders wanted," he says. "It was government policy to encourage credit and home ownership, and customers wanted competitive mortgages. The average customer swaps mortgage providers every three years.

"Most significantly, shareholders wanted to see growth in the bottom and top line, and the way for Bradford & Bingley to compete with big banks was to specialise in areas such as buy-to-let mortgages. If we were criticised for anything it was that we were too conservative and that we should have been more aggressive, like Northern Rock, who were held up as the model. The Financial Services Authority was crawling all over us, as it was over every financial institution, and getting us to stress test our model, to see how things like high unemployment and high interest rates might affect the mortgage market. The model stood up to even the most pessimistic scenario."

But what triggered Bradford & Bingley's liquidity crisis was not mortgage defaults, but the drying up of the wholesale banking market, claims Cox. "The current UK mortgage market cannot be supported by retail savings alone, which is the traditional building society model. You need to borrow in the wholesale market, raising large lump sums over short periods. When the sub-prime crisis hit the US, inter-bank lending stopped overnight. We had looked at what would happen if the wholesale market closed for a month, but it was inconceivable that it might close for a year."

Andrew Kakabadse, professor of international management development at Cranfield School of Management and co-author of the damning Cranfield report on UK directors, agrees that "the non-executive directors in the banks were doing their job very well".

He says: "They were helping the banks drive the shareholder value and economic and political value the shareholders and government wanted. The sub-prime issue is a small problem compared with the derivatives and options problem, where banks built up a series of IOUs, but off balance sheet, so no one could see the level of debt. That was judged to be the nature of modern banking and no one dared say the emperor was wearing no clothes.

"We were all complicit in a system that is broken. In a mature market, shareholder value returns of nine to 11 per cent are not sustainable indefinitely, and we have been building up a financial edifice of short-term returns that would inevitably be followed by a collapse. Boards can only work within the infrastructure they have, and it is that infrastructure that is wrong. Non-executives were doing the job they were supposed to do, and the government allowed the system to continue, knowing that it was unsustainable and waiting for it to hit the buffers."

But others believe that such a judgement is too generous to non-execs, who stand accused of complacency during the period of high shareholder returns by the banks. "The non-executives should have blown whistles and challenged assumptions," says Waine.

Sarah Wilson, chief executive of corporate governance expert Manifest, agrees. "A big issue is that boards are in thrall to the chief executive," she says. "And because there is insufficient diversity, group psychology sets in and there is no incentive to rock the boat. Every big organisation, including banks, should have a psychotherapist on the board to stop people becoming 'captive' and losing their objectivity."

Some people question whether non-execs would have performed better had they been paid more, but others argue that would have made them even less independent. "Non-executives in big banks are paid a lot of money," says the former building society boss. "The question should be turned on its head: are banks getting value for money from their non-execs?"

But if pay isn't an issue, time is. "It takes longer than a three-hourly monthly board meeting to understand the complex issues in a business such as banking, which is constantly changing," he continues. "It requires a significant time commitment to keep abreast of regulations, not to mention the bank's own strategy, products and services."

Waine claims that the key qualities a non-exec needs are curiosity, courage, the right chemistry for the corporate culture and the competence and confidence to challenge complicated issues. "But it is difficult to exercise those in a corporate culture that is not receptive."

Banks will have to improve their corporate governance quickly if they are to return to a more prudent and sensible lending strategy and create the kind of sustainable shareholder value the government is now demanding of them. "Bank boards will have to be stronger and non-execs will have to raise their game," says Michael McKersie, assistant director of capital markets at the Association of British Insurers.

Perhaps the most important role non-execs can play in this new regime is to help executives counter the pressure for ever higher quarterly returns that contributed to the crisis in the first place. David Paterson, head of corporate governance at the National Association of Pension Funds, points out that under the Companies Act 2006, directors have a duty to all their stakeholders—including customers, employees, suppliers and the environment, as well as shareholders—at odds with a focus on short-term results.

"Whatever executives say, pension funds are interested in long-term, sustainable returns, and it is up to companies to make the case for that," he says. "Non-executives can help by generating more discussion aimed at balancing the organisation's responsibilities to all its stakeholders, as well as its short- and long-term interests"

A survey by search firm Directorbank canvassed the views of more than 400 directors about the qualities of an outstanding chairman. "The key attributes—strong leadership and common sense, primarily—would have stood the banking community in good stead through its recent crisis," says chief executive Elizabeth Jackson.

The most effective chairmen are charismatic, patient, good communicators and listeners, and supportive, the survey adds. They also possess gravitas, and their previous business experience will have taught them how to weather storms, offer sound advice and manage boardrooms with potentially competing priorities.

Chairmen have a clear sense of direction, can take the strategic view and get to the key issues quickly. But they understand the difference between their role and that of the chief executive, whom they allow to get on with the job. Chairmen are also candid, unafraid of asking a "silly" question and readily immerse themselves in the company from the outset, learning how it functions from the bottom to the top.

They are good "people people", able to quickly gain shareholders' confidence, bring directors together, act as mentor and coach and have a good public presence and network of contacts.

"A chairman doesn't necessarily need to be from the same sector, but needs some sort of kinship with it, so will be from a related industry," says Jackson. "But their external perspective can be very helpful in allowing them to challenge received wisdoms."

The chairman also needs to ensure that directors are responsible and accountable to their stakeholders, adds Jackson. "They need to keep plugging away at those messages, but not to the point that box-ticking and red tape strangle the executives. A careful balance is required and, as we have seen, there is a very thin line between getting things right and getting them horrendously wrong."