Over on Twitter, I see a claim that ""there is lots of research now that shows that well governed companies outperform poorly governed ones." Well, yes, but.
In theory, good corporate governance practices should make firms more profitable and productive, in turn contributing to the overall health of the economy. Curiously, however, the evidence for a causal relationship between corporate governance and either firm performance or stock returns is sketchy and conflicting. As Brian Cheffins recently wrote: "Corporate governance is not the primary determinant of share prices, as reflected by the fact that academic testing of the hypothesis that good corporate governance improves corporate financial performance has yielded inconclusive results."
The absence of conclusive evidence for a causal relationship between governance practices and stock returns does not disprove the claim that good governance leads to good performance, of course. Public companies provide substantial—and ever increasing—disclosures with regard to their governance practices. As a result, assuming the capital markets are efficient, those practices should be fully impounded by stock market prices. Only a change in a firm’s governance practices—for good or ill—should result in the cumulative abnormal returns that stock prices studies would identify.
Yet, the absence of conclusive evidence is compounded by findings from the financial crisis that best governance practices were actually associated with poorer performance during the crisis. A study by 3 USC business school professors of 296 financial institutions in 30 countries found that board independence and high institutional investor ownership, which are usually assumed to be good practices, were associated with poor stock performance during the crisis. David Erkens et al., Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide (Sept. 2010). They further found that financial institutions with more independent boards were more likely to raise equity capital during the crisis, which ultimately resulted in a wealth transfer from shareholders to creditors. As for institutional ownership, higher levels thereof were associated with greater risk taking, which ultimately resulted in greater losses.
The financial crisis also taught us that what constitutes good corporate governance depends on which constituency’s interests one is seeking to advance. Governance regimes that advantaged shareholders harmed taxpayers.
A bank borrows short term by taking in deposits and then lends long term. This system of fractional reserves, pursuant to which banks retain only a modest fraction of their deposits as liquid assets, makes banks vulnerable to runs. Deposit insurance was developed to help prevent runs by assuring depositors that they would be able to get their money back even if the bank failed, but it created a moral hazard. The presence of deposit insurance reduces the incentives of depositors to monitor the riskiness of the decisions bankers make. If the bank takes on risky trading for its own account, the depositors won't care, because the taxpayer will step in via the FDIC and make them whole (up to a very generous cap). Shareholders won't care because they are protected by the corporate law rule of limited liability. If the deal is profitable, they reap the benefits; if the deal fails, the taxpayer steps in to clean up the mess. The trouble, of course, is that when decision makers face only the consequences of a risk paying off and not those of the risk going south, they take on socially undesirable amounts of risk.
Even financial institutions not part of the deposit insurance regulatory scheme often had artificially low costs of capital that allowed them to take risks that were socially unacceptable. Fannie Mae and Freddie Mac infamously benefited from an implicit guarantee. Although they were nominally private entities, investors and creditors believed that the government would not let them fail. The same was true of truly private financial institutions that had become “too big to fail.” Their creditors and investors believed that the government would bail out the financial system. Hence, they were willing to accept discounted investment returns because they believed the government would make them whole regardless of whether the bank's risks paid off or not.
At the same time we were creating incentives financial institutions to take risks, we were compounding the problem creating mechanisms for shareholders to pressure managers to do so. Performance-based compensation schemes, increased venues for shareholder activism, and the like were all regarded as good practice. But they further encouraged managers to take socially undesirable risks.
In sum, the governance/performance story is more complicated than it might seem.
