One much discussed question in the academic study of modern finance is: “does corporate governance really matter?” That question was the title of a classic paper on the subject by David F. Larcker of the Graduate School of Business, Stanford University, and two colleagues, in 2004.
I hope to say something about that question, but I’ll also make an epistemological point in what follows.
Let’s start by defining the question: does the whole nest of surrounding relationships between the board and management on the one hand, and those between the board and shareholders on the other, really have an impact on corporate performance? Larcker et al argued that it doesn’t matter very much. Or, in their cautious language, “the typical structural indicators of corporate governance … have very limited ability to explain … organizational performance.”
Many more recent studies have drawn a different conclusion, though: that good practices can reduce the “agency problem” (that is, the wariness on the part of actual or potential investors as to whether the managers are going to be acting as faithful stewards of their interests), and that that makes the agents more trustworthy in the marketplace lowers the cost of capital, improving the bottom line of the enterprise. This is an argument with intuitive appeal. But as I have just pitched it, it is far too abstract a statement.
Indeed, the whole controversy illustrates the dubious character of wide-ranging generalizations. There is no Big Picture: not on this, and not on any number of other issues. There are only details. The big picture that may eventually come into focus will only do so after a lot of work yet undone.
Four EM Countries
A new paper, by Bernard S. Black (pictured above) and others, does some of this work. It focuses on firms within four emerging market countries: Brazil, India, the Republic of Korea, and Turkey. Further: the authors divide the broad issue of “corporate governance” into its component parts, so that the question is “which aspects of corporate governance matter” in the nations under review.
They conclude that the most important component of corporate governance is what you might think if you stick to the heart of the agency issue: financial disclosure. Firms that disclose data, especially financial data, in ways that meet international accounting standards and that are immediately accessible to investors, do better as measured by Tobin’s q than firms that do not.
Likewise, board independence is a positive, and is significant, especially in Brazil and Korea.
In India, board independence correlates only weakly with Tobin’s q, but the authors think this may be due to the high legal minimum for board independence in that country. If everybody does it, then it ceases to be a distinguishing factor.
Red Herrings
Other features of corporate governance, though, are red herrings. Board procedures, such as how often a year the board meets, whether it regularly evaluates the performance of the CEO, etc.: these points do not affect Tobin’s q. Perhaps more surprisingly, “related party transactions” don’t affect Tobin’s q in any of these four countries.
Why the heck not? To mere untutored common sense, related party transactions, with all the conflicts they present, would seem as grave an agency issue as inadequate disclosure.
The article doesn’t suggest an answer to “why not?” – It only observes that as a statistical matter “the rest of a broad country governance index” after disclosure and board independence are accounted for “has no predictive value in any of our four countries.”
One of the inferences that may be drawn from this study is that it is very risky to draw a big macro picture about what good is actually done by ‘good corporate governance.’ The only safe answer is “it depends.” It depends on country, on the minimum legal standards in place, on the specific corporate governance matter at issue, and likely a number of other facts, such as industry, capitalization, depth of analyst coverage, etc.
Another conclusion is that such a Big Picture as may eventually emerge awaits a lot of further detailed studies. This is pointillism. Each scholar in each careful study may paint one dot on a Seurat work, and only after a lot of dots are placed on the same canvas will anyone be in a position to step back and see a Sunday in the park.