New research by scholars from the University of South California has provided some support for those who are skeptical of the role that good corporate governance plays in improving corporate performance. The study by David Erkens, Mingyi Hung and Pedro Matos followed the performance of 296 financial institutions with assets of more than $10 billion during the period 2007 to 2008. The study concluded that none of the typical practices that are supposed to measure good corporate governance actually helped companies perform better.
Really? None! Can that possibly be? But the authors insist that their research showed that boards with expert directors fared no better than those without, and that companies that separated CEOs from chairmen were similarly no more likely to prosper than those that did not. Other presumed indicators of good governance such as the involvement of institutional shareholders and independent directors were even negatively correlated to company performance.
What could possibly lead to these counterintuitive results? The authors provide their own potential explanation by arguing that preceding the financial crisis, financial institutions were under pressure from institutional shareholders to take additional risks in order to improve returns. Likewise independent directors were more likely to encourage companies to raise more equity capital even when share prices were faltering. So rather than independent directors improving corporate governance, they actually detracted from it.
But are the results of this study really that counterintuitive? Are there not other reasons why the results of this study may not reinforce the merits of adopting good corporate governance practices. Could the problem really be inherent in trying to draw conclusions from arguably inadequate or inappropriate measures of good corporate governance? And could a problem also not lie in trying to draw too many conclusions about corporate governance in one type of firm (financial institutions) during an unusual and extraordinary event (the global financial crisis)?
So what of this idea that this study, and others like it, may be trying to measure corporate governance in the wrong way. What of this idea that board independence and the separation of the role of CEO and chairman are not good proxies for good corporate governance? What if, for example, the authors had used institutionalized risk management as a way of representing good corporate governance? And what if the authors had studied the correlation between this measure of corporate governance and resilience of share value rather than just share value during the crisis?
Beyond this challenge of trying to find adequate proxies for good corporate governance, there is another potential impediment to research that tries to draw simple correlations to share price. While share value may be an easily identified measure of company health, it is only one measure. And I would argue it is not a very good measure, at least not when examining corporate governance. There is a presumption that markets (i.e. shareholders) have the ability and interest to analyse and understand how companies implement good corporate governance and reflect their approval through demand for the stock. But many shareholders, including sophisticated institutional shareholders, focus on a very narrow number of indicators of good corporate governance: independent board members, the separation of CEO and chairman, effective and frequent communication with shareholders. Many shareholders also have very little understanding about how corporate governance is conducted and institutionalised at the firm other than through these same basic corporate governance measures such as board independence etc.
But these traditional measures of good corporate governance may not really be the best way to ensure and promote the objective inherent in good corporate governance. Maybe good corporate governance is not really about these relatively simple indicators used in this study; measures such as the presence or number of independent directors. Maybe good corporate governance is rather about something much more complex and difficult to measure.
In fact, the authors recognize these difficulties and the confusion and contradictions that they create. The authors acknowledge that another financial crisis in another part of the world at another time illustrated that there was a positive correlation between corporate governance and company performance. During the Asian financial crisis of 1997-1998, there is evidence that increased external monitoring of companies produced better performance.
So what could explain this apparent contradiction? As always, there can be many explanations in our attempt to find measures and proxies for corporate governance as well as measures of a healthy and sustainable company. And here the authors of the study acknowledge a problem in the skepticism about corporate governance that most would take away having read their study.
The counterintuitive results of the study raise the question of whether traditional measures of corporate governance are adequate to protect companies from taking excessive risks. As the authors note, good corporate governance cannot be viewed as a simple box ticking exercise. Policies on board independence cannot immediately overcome entrenched preferences for risk-taking, corporate culture, and institutional lack of capacity for identifying and analyzing risk. Independent directors are, for example, only one measure of board objectivity and not an indicator of the quality of a board’s decision-making. If objectivity comes with lack of expertise, then the objectives of good corporate governance will have been thwarted.
So what if the authors had studied something else: the correlation between a firm’s institutionalized risk management and share value? Instititutionalised risk management would include issues such as whether the firm has a risk management team, whether that risk management team focuses on non-traditional risk beyond financial risks, whether there is a separate committee of the board dealing with risk beyond the audit committee, whether the firm attempts to define risk environments and risk tolerance, and whether risk managers have direct access to CEOs or directors. If these measures had been used as proxies for good corporate governance, would the results of the study have been the same?
I would argue that this study should not be used to bolster skepticism of the benefits of corporate governance, and I suspect that the study’s authors would not want their research to be used in any way that reaches premature or inappropriate conclusions. The study should be used to further question the adequacy of how we understand and quantify corporate governance. Corporate governance cannot be a box-ticking exercise about numbers of independent directors and separating the roles of chairman and CEO. These practices will- to some degree and with important caveats- remain ways to prima facie improve corporate governance. But these good corporate governance practices may not always work, particularly if there are more meaningful impediments to good corporate governance at the firm, including the absence of ways of identifying and analyzing risk through what I call institutionalized risk governance.
The study should also prompt us to continue to question whether share value is the best measure with which good corporate governance will, or should, correlate. Perhaps a better measure of the impact of good corporate governance is the resilience of a company’s share value over a meaningful period of time, and not just one crisis.
Skepticism about the benefits of corporate governance is surely healthy. Skepticism about anything is healthy. However, our research program and research tools should assist us in working through this skepticism before the skepticism turns prematurely into cynicism. And as cynicism about the merits of any rules or regulation or interference with corporate practice has been ascendant, even following the recent global financial crisis, we must ensure that our research is actually asking the right questions and using the right assumptions. Understanding the benefits and practices of good corporate governance will remain a challenge but let us not be too skeptical before we have right to be.
I so agree, and really like the idea that the presence or absence of appropriate risk management is a good of way of judging the quality of governance. We know there is a huge risk management deficit in North America.
So many times I have seen the boxes ticked (separate CEO and Chair, majority independent directors, etc etc) only to find on further examination that the board is not remotely doing its job. A separate Chair is going to do more harm than good if he does not understand his role and cannot stand up to a dominant CEO. Independent directors are a waste of space if they do not ensure that they are adequately informed and can constructively challenge senior management. One needs to drill deeper to assess the quality of governance.
Could not agree more about the importance of risk management extending beyond share price and financial management.
Whilst our Australian economy is going well, we are very dependent on a two channel growth strategy, those being mining and tourism. Beyond these small business runs a very distant third.
The big end of town (mining conglomerates) have shown themselves to be very risk averse. An example is the proposed mining tax proposed by our previous Prime Minister, Kevin Rudd. The minute this was proposed, notification of cancellation of projects, potential job losses and economic downturn in the economy were dire predictions. Now if that is how boards and CEO’s operate in risk management, what hope for internal governance efficacy.
To me as a risk practitioner, particularly in the area of systemic risk management, minimal or little effort is dedicated to examining the real drivers of risks in an organisation. Much of the risk management is focussed on the balance sheet or output delivery or reduction in the cost per unit item.
It’s my belief that the systemic causes of poor governance in an organisation is firmly seated around risk management leadership and the ability to examine the internally generated risks within an organisation. Additionally, dedicating time to discussion of these things appears to be a low priority on the agenda of many senior executives and I daresay boards. When was the last time you heard a comment about a board or executive group dedicating a day to discuss the internally generated risks in an organisation with the objective of tackling governance issues in the organisation. There is a plethora of examples in the risk management arena to suggest that this will lead to a richer outcome to influence governance in the organisation.
As a leader in an organisation I would expect first and foremost that my board and executive would have outstanding leadership skills and the individual competencies in financial and corporate management would be secondary to this. A mentor of mine who is now a retired naval officer once told me that “successful organisations surround themselves with successful leaders” and I see plenty of evidence of that in many successful organisations across the globe. They invest in leadership, have frank and fearless discussions and the governance transparency in the organisation is obvious.
My philosophy here is
Don’t leave management of risk to middle managers
Dont rely on paper driven policy to drive effective governance
Open the doors to the executive and board and encourage transparent governance
Demand that the executive and board actively engage on governance and internally generated risks with robust discussion. Conflict can be good for the organisation.
Look seriously at the qualities of the people in the executive and ask “how much could I rely on this individual to help me lead governance in my organisation?”