How do Corporate Governance Mechanisms Influence Firm Performances

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Corporate governance has become a major topic of debate and policy development in the worlds of business, politics, and academia, in the UK and throughout the world. These debates and policy outcomes have important implications not only for business, but the wider economy and society. Recent events of the financial crisis exposed material shortcomings in the governance and risk management of firms, particularly within the financial sector Led to the development of Walker Review – provides the basis for the analysis. Critical Areas of Corporate Governance Role of Board of Directors Compensation issues Monitoring by outside majority shareholders All above are solutions that help to mitigate conflicts of interests – see agency costs.

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Key Literature:

Public Policy

In order to improve corporate governance practices and the efficiency of corporate governance mechanisms, a number of initiatives have been developed in recent years to enhance the transparency and quality of corporate financial and non-financial disclosure, to increase levels of shareholder engagement, to improve the effectiveness and accountability of boardrooms, and to foster a long-term investment culture. Outline – developments of codes – e.g. Cadbury Code, Walker Review etc The academic literature suggests that information flows are a fundamental prerequisite, cornerstone, or driver of corporate governance and that in turn the informational environment of the firm affects strategy and performance. The starting point for most analysis is that ‘information asymmetry’ (Akerlof 1980) is pervasive in firms and has negative effects in terms of uncertainty, adverse selection, moral hazard, and opportunism. In turn, this leads to higher transaction costs, the false pricing of assets, the misallocation of resources, and lower liquidity. Because of market failures and fears of competitive disadvantage, the state has intervened with laws to make firms disclose.

Agency Conflicts

Perhaps not surprisingly, no universally accepted consensus exists as to what ‘good’ corporate governance means. The economics and finance literature is focused on the problems of agency relations between shareholders and managers which result from the separation of ownership and control, particularly in large corporations. Information asymmetry – Akerlof (1980) Berle-Means (1932) paradigm.

Board of Directors

Agency theory: This stream of research identifies situations in which shareholders’ and managers’ goals are likely to diverge and examines mechanisms that can mitigate managers’ self-serving behaviour (Shleifer and Vishny 1997). Boards of directors described as “the apex of the internal control system” (Jensen 1993: 862) Board’s core function as a monitoring and control mechanism, A review of corporate governance literature reveals that a conflict of goals between a firm’s CEO and its shareholders typically revolves around three main underlying issues: CEO compensation, risk to the firm, and corporate control. Board Composition and performance Agency theory – which addresses inefficiencies that arise from the separation of ownership and control (Fama 1980; Fama and Jensen 1983;Jensen and Meckling 1976) High engangement in Board processes Board Independence From the agency theory perspective, boards of directors (and particularly independent or outside members) are put in place to monitor managers on behalf of shareholders (Lynall et al. 2003) Consistent with agency theory, a board comprised of independent directors (e.g., board members who are not dependent on the current CEO or organisation) is more likely to provide an effective oversight of the firm’s CEO and other executive directors. Independent directors are generally believed to be more effective in protecting shareholders’ interests, resulting in higher firm performance (Baysinger and Butler 1985; Baysinger and Hoskisson 1990). Separate CEO and Chairman Many researchers believe that the dual board leadership structure seriously compromises the independence of the board. The tenets of agency theory would suggest that such centralised leadership authority will lead to management domination of the board and result in poor performance (Fama 1980; Fama and Jensen 1983; Lorsh and MacIver1989; Molz 1988; Shleifer and Vishny 1997). Education/experience More recent resource-dependence, behavioural and socio-cognitive views on corporate boards have extended agency research by suggesting that pro-active behaviour by non-executive directors depends not only on the extent of board independence, but also on the strategic perspective and base of experience they bring to the organisation. (Carpenter 2002; Carpenter and Westphal 2001) In addition to control functions, the board may also play service and strategic roles in the decision making process (Pfeffer 1972; Pfeffer and Salancik 1978; Provan 1980), Pye (2001) suggests that in order to ‘add value’ to the board, non-executive directors are expected to bring a background of executive experience of running other firms. Boards that are composed of lawyers, financial representatives, top management of other firms, public affairs specialists, etc. may be more effective in terms of bringing important expertise, experience and skills to facilitate advice and counsel. This research emphasises that board structural characteristics (e.g., the proportion of independent directors, separate CEO and Chairperson) are less relevant compared to the quality of the board’s cumulative human capital. A number of studies argue that board diversity in terms of directors’ professional experiences should lead to more efficient service/expertise/counsel roles of the board and, as a result, to better performance (Carpenter 2002; Baysinger and Butler 1985; Baysinger and Hoskisson 1990; Kaplan and Reishus 1990; Wagner et al. 1998; Westphal 1999). Board Size Walker Review – Bank board sizes have risen disproportionately in recent years. In achieving the desired balance between expertise and independence, the board size should not be obliged to expand when the recruitment of financial industry expertise is deemed not to be independent. Contrasting views Larger boards will be associated with higher levels of firm performance (Dalton et al. 1999; Pfeffer 1972; Pfeffer and Salancik 1978; Provan 1980). Daily et al.(2002), and Daily and Dalton (1992; 1994) find positive effect of board size on financial performance in large samples of firms in the USA. Golden & Zajac (2001) and Andres & Vallelado (2008) find a non-linear (inverted U-shape) relationship between board size and firm performance. However, agency researchers are more sceptical about the effects of board size on the monitoring capacity of independent directors (Jensen 1993). When boards become too big, agency problems (such as director free-riding) increase within the board, and it becomes more symbolic and less part of the management process (Hermalin and Weisbach 2003). Yermack (1996) reports that there is a significant negative relationship between board size and Tobin’s Q. Judge and Zeithaml (1992) report that large boards are less likely to be involved in strategic decision making, a finding also supported by Goodstain and Boeker (1991). Thus organisational outcomes of board size remain an empirical issue. Tenure (Directors Contract length) Age?? Boeker (1992), Pfeffer (1983) and Finkelstein and Hambrick (1996) argue that greater tenure of board members is associated with greater rigidity, increased commitment to established practices and procedures, and increased insulation towards new ideas. However, Hambrick and Mason (1984) and Hambrick and D’Aveni (1992) suggest that longer tenure provides directors with much more comprehensive access to a richer stock of remembered information, relative to what novice can access. Golden and Zajac (2001) in their study of strategic change in U.S. hospital find a curvilinear relationship between the average tenure and strategic restructuring: as average board member tenure increases, its effect on strategic change is positive for boards with lower levels of tenure, and negative for boards with higher levels of tenure. Generally, existing research considers board diversity and limits on board members’ tenure and age as ‘good’ corporate governance drivers. Share Ownership – institutional investors A large number of studies grounded in agency theory suggest that large-block shareholders have both the incentive and influence to assure that managers and directors operate in the interests of shareholders (Daily et al. 2003). Therefore, their presence among the firm’s investors provides an important driver of ‘good’ corporate governance that should lead to efficiency gains and improvement in performance Hoskisson et al. (1994) show that large block shareholders help mitigate against poor strategy, such as diversification, to evolve into poor performance, therefore decreasing the magnitude of restructuring. Hill and Snell (1988) find that ownership concentration is positively correlated with R&D expenditures, specialization and relatedness in a sample of 94 firms in research intensive industries. Some researchers have indicated, however, that concentrated shareholding may create a tradeoff between incentives and entrenchment (La Porta et al. 2000a; Short 1994). In particular, lack of diversification and limited liquidity mean that large shareholders are affected adversely by the company’s idiosyncratic risk (Maug 1998). To compensate for this risk they may use an opportunity to collude with managers or shift wealth from minority shareholders to themselves. For example, Pound (1988) argues that large institutional investors and unaffiliated blockholders are likely to side with management (the strategic-alignment hypothesis). Likewise, blockholders may be influenced by other existing business relationships with management (the conflict-of-interest hypothesis) Ownership concentration per se may negatively affect the value of the firm when majority shareholders have a possibility to abuse their position of dominant control at expense of minority shareholders (Bebchuk 1994; Stiglitz 1985).

Remuneration – Executive Pay

Particularly interesting in light of recent financial crisis This section is concerned with the impact that corporate governance initiatives have had on the remuneration of UK executives. Over the late 1980’s and early 1990’s, the levels of executive pay were felt by many to increase dramatically and unjustifiably (Smith and Szymanski 1995). Whilst the Cadbury Report (1992) made several recommendations on good practice, the general opinion was that it did not go far enough with regards to executive pay. The implementation of incentive schemes to promote shareholder value is underpinned by agency theory. Classic agency theory shows a relationship where the owners (principals) of companies, namely the shareholders, delegate the management of the company to hired persons (agents) (Jensen and Meckling 1976; Fama 1980). These agents take the form of management and in particular the higher echelons of company management, i.e. the board of directors. The separation of ownership from control leads to information asymmetries, and leaves room for self-serving opportunist behaviour by the agent (Berle and Means 1932). Within the agency theory literature, executive pay is a key mechanism for helping to minimize agency costs in order to align the incentives of managers with the interests of shareholders. (Eisenhardt 1989). In response to this and in order to recruit and retain competent executives, companies within the UK design compensation strategies to incorporate long-term incentives (Conyon et al. 2000b; Conyon 2000). These compensation strategies involve the use of two main types of incentives, namely the executive share option scheme (ESOS) and the long-term incentive plan (LTIP). The Combined Code (2003, p 12) states that: “A significant proportion of executive directors pay should be structured so as to link rewards to corporate and individual performance”. Lack of disclosure

Financial Sector

Distinguish financial sector from general firms Capital structure – Banks hold illiquid assets and issue liquid liabilities thus create liquidity for the economy. Dependent Variable: Tobin’s Q (proxy for firm performance)

Independent Variables:

Board Size Board structure/composition – % of independent directors Board efficiency Separation of CEO and Chairman Level of education of non-executive directors – proxy for monitoring quality of board members Share ownership Remuneration – stock options Risk – stock price volatility Regulation – financial audit

Hypothesis

Board size has an impact upon firm performance?

Time Period

Comparison sample, in order to incorporate financial crisis into empirical research Is failure in corporate governance really to blame for financial crisis?? 2006 – Evidence of corporate governance 2007/2008 – Firm Performance Lagged effect reduces problem of two way causality

Regression Analysis

Will regression show that corporate governance mechanisms implemented in 2006 positively/negatively affect firm performance in 2007/08? Cross-sectional regressions for UK financial sector company performance from July 2007 to December 2008 corporate governance mechanisms measured at the end of fiscal year 2006 A cross-sectional regression is a type of regression model in which the explained and explanatory variables are associated with one period or point in time.

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How do corporate governance mechanisms influence firm performances. (2017, Jun 26). Retrieved November 26, 2022 , from
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