Corporate Governance

Handout 6

The effects of corporate governance on firm performance

A corporate governance is a system/mechanism that is intended to solve the conflict of interests between shareholders and management. In theory, these corporate governance systems can improve firm performance by increasing the incentive for management to shareholders values. We have discussed whether various corporate governance systems can be viewed as the system to alleviate the conflict of interests.

For example, we discussed if the main bank system or the existence of large shareholders can be viewed as systems/mechanisms to solve the conflict of interests, and we have shown that these systems can be properly viewed as corporate governance systems. However, we have not much discussed if these corporate governance systems can indeed enhance firm performances. Todays topic is whether these corporate governance systems could enhance firm performance.

1.

2.

1.

2.

We have already seen some results. We saw that The introduction of Chief-Officer system in Japan has not improved firm performance The existence of large foreign shareholders improves firm performance in Japan. Today, we investigate the following. Whether the main bank system has a positive effect on firm performance. Whether a reduction in the size of the board would improve firm performance.

The effect of main bank system on firm performance

As noted already in Handout 3, the main bank system in Japan has been considered as an alternative corporate governance system. In particular, dispatching a director to its client (by the main bank) has been viewed as a monitoring mechanism that substitutes the US style market-force based disciplinary mechanism.

In handout 3, we showed that, when a firm experiences low performance in terms of ROA, its main bank is likely to dispatch a senior directors to the firm . This result indicates that the dispatch of a bank-director can be viewed as a monitoring system. However, we have not discussed whether the dispatch of a bank-director by the main bank would actually enhance the firms performance. First, we discuss whether or not this would indeed enhances firm performance.

The effects of bank-dispatched directors on the firm performance

The discussion will be based on Saito and Odagiri (2008). Saito and Odagiri examined if a new appointment of a senior director would improve the industry adjusted ROA. Consider the change in industry adjusted ROA (ROA)it=(ROA)it+1-(ROA)it where (ROA)it is the industry adjusted ROA of firm i at year t. The basic idea is to examine if the dispatch of a bank director would increase (ROA)it. If so, we can conclude that the dispatch of bank director improves firm performance.

The simplest method is to estimate the following equation. (ROA)it= 0+ 1(Bank director)it Where (Bank director) is a dummy variable that indicates if the main bank dispatched a director to the firm i in year t. There are two problems with this method. 1. The bank director is likely to be dispatched when the firm performance is bad. And there is a tendency that, when firm experience a bad performance, the performance improves on the subsequence period (this is called mean-reversion). Then we cannot distinguish between the effect of bank-director from the meanreversion effect.

Second, the effects of bank-dispatched directors may be different at different firm performance levels. For example, the dispatch of a bank director may be more effective when the firm is performing poorly than when the firm is already performing well. To mitigate these problems, Saito and Odagiri estimates the following.

(ROA)it= 0+ 1(ROA)it + 2(Bank director)it + 3(Bank director)it(ROAit- ROA) Where ROA is the sample average of ROA. In this equation 1 captures the mean-reversion effect. The coefficients 2 and 3 captures the effects of a dispatch of bank director on the change in ROA, that is; (ROA).
Saito and Odagiri included several more variables. Details are omitted here.

The effect of a bank-dispatched director now depends on the ROA at the beginning of year t. The effect of bank directors on (ROA)it is given by The effect =
2

3(ROAit- ROA )

The results.
Variable Constant ( 0) (ROA) ( 1) (Bank Director) ( 2) (Bank Director) (ROA- ROA) ( 3) Coefficients 0.0516 (0.0404) -0.1502*** (0.0117) 0.2827 (0.0918) -0.2757** (0.1123)

1. The coefficient for ROA is negative and significant. This indicates that the meanreversion is at work: When firm performance is bad in year t, there is a tendency for the performance to improve, or to go back to the mean.

The results.
Variable Constant ( 0) (ROA) ( 1) (Bank Director) ( 2) (Bank Director) (ROA- ROA) ( 3) Coefficients 0.0516 (0.0404) -0.1502*** (0.0117) 0.2827 (0.0918) -0.2757** (0.1123)

2. The coefficient for (Bank Director) is positive, but not significant. This means that, when the firm is performing on average, the dispatch of bank director may not improve the firm performance.

The results.
Variable Constant ( 0) (ROA) ( 1) (Bank Director) ( 2) (Bank Director) (ROA- ROA) ( 3) Coefficients 0.0516 (0.0404) -0.1502*** (0.0117) 0.2827 (0.0918) -0.2757** (0.1123)

3. The coefficient for (Bank Director)(ROA- ROA is ) negative and significant. This means that, when the firm is performing badly, a dispatch of a bank director positively affect the firm performance. To see this point, see next slide.

The magnitude of the effect.

The previous slides show that, when the firm is performing badly, a dispatch of a bank director improves firm performance. Firm performance does not necessary improve when a bank director is dispatched to a firm which is already performing well. Lets see by how much a dispatch of bank directors can improve firm performance measured by industry adjusted ROA. See next slide

The sample average of ROA is 0.74 (that is, ROA =0.74) Consider a firm whose industry adjusted ROA is -3.32% (this is the sample average of ROA for the firms who experienced negative ROA). If the main bank dispatches a director to this firm, then the ROA is expected to increase during the year by ) 2 + 3(ROAit- ROA =0.2827-0.2757*(-3.32-0.74) =1.402 Thus, the dispatch of bank director is expected to improve ROA by 1.4%.

Summary
When a firm is performing badly, a dispatch of a bank director will improve the firm performance. When a firm is already performing well, a dispatch of a bank director does not necessarily improve firm performance. Thus, Saito and Odagiris study shows that the main bank system can enhance firm performances

The effect of board size on firm performance

It has been argued that a board with too many directors negatively affect corporate performance since efficient decision making is difficult in a large board. Jensen (1993) points out the great emphasis on politeness and courtesy at the expense of truth and frankness in boardrooms and states that when boards get beyond seven or eight people they are less likely to function effectively and are easier for the CEO to control.

There has been many studies in the US that show that the size of the board has a negative impact on firm performance. For example, Yarmack (1996) shows that when a board size doubles, the Tobins q (market to book asset ratio) would fall by as much as 0.23. Today, we will investigates if the size of the board has a negative effect on firm performance in Japan. The discussion is based on Nakayama (1999). This is one of few studies that investigate this topic in Japan.

Does the size of the board matter in Japan?

Nakayama (1999) investigates the effect of board size on the efficiency of manufacturing firms in Japan. The empirical methodology used in his paper is slightly different from what we have seen previously. I will provide a short description of the methodology first.

Nakayama first estimate efficiency score for each firm by estimating a stochastic production function. Second, Nakamura checks if the board size has a negative effect on the estimated efficiency of each firm. To describe the above method, consider that the production technology of firms can be described by the following production function Q=F(L,K) Where Q is the output, L is the amount of labor, and K is the amount of capital. To make things more simple, consider that for a moment, a production function that depends only on L. Then we have, Q=F(L)

Suppose that the production function, Q=F(L) has the following shape.
Q

If a firm is operating efficiently, then the firm should be operating on the production function, like this.

However, if the firm is not operating efficiently, the firm would be operating under the production function, like this.
Q

The firm is not operating on the production function.

For this firm, we can define efficiency score as OP/OA.

Q P Efficiency score = OP/OA

If the firm is perfectly efficient (that is, operating on the production function), the efficiency score will be one. If there is any inefficiency, the efficiency score will be lower than 1. L O

Therefore, the basic idea of Nakamuras study is to estimate the efficiency score for each firm, then check if the size of the board has a negative effects on the efficiency. More specifically, Nakamura estimates the following production function Qi= 0+ 1log(Li)+ 2log(Ki)+ i-ui Where Qi is the value of output (sales), Li is the number of workers, and Ki is the value of the fixed asset for ith firm. The term i is the error term and ui is the efficiency score to be estimated. We make a certain distributional assumption of i and ui to estimate the efficiency score.

Data
The data is 32 manufacturing firms for the period between 1992-1998, from Mitsubishi Research Institutes kigyo-no keiei bunseki.

The distribution of the board size

Relative frequency

The number of directors in a board

The results
There are two steps. First step is to estimate the production function. By estimating production function, as a by product, you can estimate the efficiency score for each firm. The below is the estimated coefficients for production function.
Production function estimation Variable Log(L) Log(K) Constant Coefficient 0.909*** (0.098) 0.150*** (0.03) 1.906*** (0.093) This is the estimated results of so-called Cobb-Douglas Production function. As a by-product, we can estimate the efficiency score for each observation. [Details are omitted]

As a by-product of the production function estimation, we obtain the estimates for the efficiency score for each firm for each period. Nakamura then estimates the following. (Efficiency score*100)it = 0+ 1(Number of directors)it+ 3(Sales)it

The results
The effect of board size on the efficiency of manufacturing firms (Dependent variable is Efficiency Score*100) Variable The number of directors Sales Coefficient -15.594** (7.662) 20.634 (3.846)

As can be seen, the number of board has a negative and statistically significant effect on the efficiency of the firms. For each additional board will reduce the efficiency score by as much as 15.6%. This results show that, like in the US, a large board has quite large and negative effect of firm performance in Japan.

Several questions
A good board: 1: Small 2: Independent 3: And at the same time, interested in protecting shareholders value. 4: And at the same time, being able to work as a team Is this possible to find such a team of people?

Does the morality of individual directors matter? If so, how much does that matter? Should a director not pursue its own interest?

References
Saito, T and Odagiri H (2008) Intra-Board Heterogeneity and the Role of Bank Dispatched Directors in Japanese Firms: An Empirical Study. Pacific-Basin Finance Journal, 16, 572-590 Nakayama, Yoshinori (1999) Yermack, David (1996) Higher market valuation of Companies with a small board of directors. Journal of Financial Economics 40, 185-211