Does Strong Governance Mean Good Governance?

The importance of corporate governance is accepted. It reduces conflicts between owners and the custodians of their money, management. It limits managers from using the firm to serve their own ends, and prevents controlling owners from unduly taking over the firm. Good governance implies better monitoring, which is understood to improve financial performance. After the recent spate of high-profile governance failures, these principles have driven an increase in compliance regulation through vehicles like Sarbanes-Oxley and company law reforms.

What has been taken for granted up to now is that all corporate governance practices within a single country are more or less the same. A country’s investor protection mechanisms have been linked to access to finance, and higher valuations for all that country’s firms. However, different firms in the same country can and do adopt different governance practices. Country rules and company practices involve a certain degree of complementarily and even substitutability. But, the interaction between country governance regimes – e.g. legal protection for investors – and firm governance practices (and whether they are required or voluntary) has important consequences for policy makers who believe that intervention will improve firm performance across the board.

A study of over 7000 companies across 23 countries showed that a country’s level of minority shareholder protection; the outside representation on a firm’s board; and the existence of independent board committees, combine to influence firm performance. On the other hand, transparency and compensation were found to have no noticeable impact on firm performance at all.

The results indicated that corporate governance is most important to companies that rely heavily on external financing, where it acts as a signaling device of positive NPV projects. Thus highly financially dependent companies with strong governance practices were highly valued. However, the pay-offs of strong governance were less for small firms because any benefits were offset by the increased costs of monitoring, time and resources.

The study found substitution effects between the strength of legal protection offered by a country, and the corporate governance practices of firms within the country. Where firms had strong internal governance, the country’s level of investor protection was less important, and vice versa. Importantly, the study showed that too much regulation limits managerial initiative and results in lower returns and firm valuations. Clearly, strong regulation is not the same as optimal regulation.

From a regulatory perspective, the study showed that where strong firm governance practices were in place, adding increased compliance legislation is of little benefit to firms or shareholders. However, if firms in a country have generally weak codes of practice, improving regulation can indeed be beneficial.

To read the full article: “Corporate governance and regulation: Can there be too much of a good thing?” by Valentina G. Bruno and Stijn Claessens is available through the World Bank Policy Research Working Paper series (Working Paper 4140, 2007).