The uncertain relationship between governance and performance

by Professor Brainbridge, November 24th, 2010.

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. (continue reading… )

 

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