Corporate Governance and Control

Definitions

•  It deals with the collective action problem among the widely dispersed shareholders in monitoring and controlling the management.
  
•  It deals with the conflict of interests between investors and managers. It is also referred to deal with the principal and agent problem. 

It is generally assumed that the maximization of the shareholders’ wealth is the primary objective of the corporate governance.  Is it an efficient (economic) outcome???

 It is a Pareto efficient – if

·        The ‘firm’ is viewed as a nexus of contracts; more precisely, is viewed as the nexus of complete contracts with creditors, suppliers, clients and employees; and open contracts with shareholders who has claim on the residual returns

·        There are no principal agency problem i.e., the interests of the managers are optimally aligned to the interests of the multiple principals.

If the above two conditions are satisfied, the maximization of shareholders’ wealth is Pareto efficient. But there are some arguments: Managers exclusively working for the shareholders’ wealth maximization may lead to certain inefficiencies:

• Excess risk taking by the managers in the presence of high leverage
• Underinvestment in the case of the debt overhang.

Sound governance mechanism reduces the cost of equity, in a way good corporate governance is in the interests of the firm itself.  Then why do we need external regulation??

• Block holders (institutional investors) may keep the higher bargaining power with them.  Eg. Block holders may go for the anti takeover policies which will not benefit the small or minority shareholders.
• Managers may lobby for the more discriminatory powers.
• To ensure the interests of the all the stakeholders

Why do the investors dispersed so widely?             

• Individuals’ wealth in relation to the investments is small
• Investors may want to diversify their risk by investing their limited wealth in various firms
• Investors’ may concern for the liquidity – a large amount of stock is very harder to sell instantaneously in the secondary market.
• Regulations on individual shareholding

So dispersion is inevitable.         

There are two oversimplified corporate governance mechanisms.

1. Anglo-American Model (market based model) -

Nurtured by USA and UK.

• Accords absolute priority to the shareholders
• Shareholders monitor the performance of the management through market mechanism
• As shareholders are open contract holders and having less contractual protection, the rules are framed to protect them.
•  Short term perspective
• Criticized as it encourages the management to get obsessed with the performance appraisal and pursue short term goals over long term objectives.

2. Long term Large Investor Model (Bank based Model) –

Nurtured and followed mainly by Japan, to some extent by Germany.

• Managements are monitored by the large investors, financial institutions
• Financial institutions do participate in decision making process
• Ensures low cost of capital
• Long term perspective
• Other stakeholders have more protection than shareholders.

III. Possible Lessons from the Japanease (slump) bear market

Before deriving the possible implications of Japanese prolonged bear market for the present mess in the global financial system, I would like to investigate possible factors that caused the boom and eventual burst in the Japanese economic system.  Here I will be discussing the issue from the corporate governance perspective, whether the corporate governance mechanism added the flame to these extreme events of business cycle?

 The oversimplified corporate governance mechanisms are of two kinds, one is Anglo-American Corporate Governance Mechanism (Market based system), pioneered by USA and UK; Bank based Mechanism, nurtured and followed mainly by the Japan and Germany (Germany in the later years tilted towards market based system), is the another one. Market based system gives absolute priority to the shareholders over other stake holders. It presumes that the shareholders do monitor and impose the discipline on the management through market mechanism. It is also argued to be of having short term perspective as market gauges the performance of the management on the regular basis in terms of quarterly/half yearly accounting statements. Where as Bank based system measures the performance based on the long term growth perspective. It accords the governance mechanism to the financial institutions that monitor the performance of the managements.  In a way financial institutions posses the major stake in decision making process under Bank based system. 

 Bank based system, providing the financial institutions access to internal information to assess the potential projects, ensures the low cost of capital to the firms. This came handy to the Japanese corporate world during the bull phase of 1980s, where as the firms in the rest of the world were cautious over the investments in the light of high cost of capital.  In a way Bank based system added the flame to the Japan’s Bull Run during the second half of the 1980s.  But the same system tightened the necks of the Japanese firms during the crash and the prolonged period of bear markets (till date) as the banks became overcautious given their increasing NPAs. Thus Japanese corporate governance mechanism steepened the crash in the asset markets and contributed to the ever ending bear market conditions.

 Anglo-Saxon model, according the corporate governance to shareholders (who monitor the management performance through market mechanism) makes the management obsessed with the quarterly performance appraisals. With its short term perspective, Anglo-Saxon Model encourages the management to pursue the short term goals by forgoing the long term objectives. In a way such corporate governance model practiced in USA, UK, and Europe might have forced the yester year mighty corporations into the history and eventually caused the present mess in the global economy.

(Comments and Suggestions are welcome!!)