Investor Protection and Firm Governance: Substitutes or Complements?
24 August 2007 at 9:57 am Peter G. Klein 4 comments
| Peter Klein |
The new institutional economics often treats the institutional environment and institutional arrangements as substitutes. In countries with stable legal institutions, relatively efficient courts, and reasonable default rules for contract terms, for example, contracts tend to be less complete. If contracting parties can trust the courts to fill in the gaps, why bother to write out every contingency? Likewise, if a country has an efficient external capital market, firms can be small and specialized, relying on the capital markets to allocate resources among business units, but if the external capital market performs poorly, diversified business groups may arise to exploit their internal capital markets.
It is thus surprising to learn, from a new paper by Reena Aggarwal, Isil Erel, René Stulz, and Rohan Williamson, that firms tend to establish better mechanisms for corporate governance in countries that already have strong rules for investor protection. “[O]ur evidence suggests that firm-level governance attributes are complementary to rather than substitutes for country-level investor protection, so that better country-level investor protection makes it optimal for firms to invest more in internal governance.” The better the institutional environment, in this case, the more effort agents put into designing efficient institutional arrangements.
Clearly more work is needed to understand the interactions between “macro” and “micro” institutions. What are some other good papers in this area?
Entry filed under: - Klein -, Institutions, Strategic Management, Theory of the Firm. Tags: .
1.
Brian A'Hearn | 28 August 2007 at 9:32 am
I do not know any good papers to recommend, and had been hoping for comments by other readers.
The issue seems an important one to me, related to the Big Question of whether institutions determine only the interesting details of form or have a pervasive impact on the performance of an economy. I like the way you framed the issue in terms of substitutes and complements.
The abstract of the paper you cited says it is based on “an index which increases as a firm adopts more governance attributes”. What does that mean exactly? I thought of governance as being more of a qualitative than a quantitative concept.
2.
Peter Klein | 28 August 2007 at 3:04 pm
Brian, that is a good question. The paper constructs a governance index based on data provided by Institutional Shareholder Services (ISS). From the paper: “ISS started providing the Corporate Governance Quotient (CGQ) for U.S. companies in 2002 and for international companies in 2003. The CGQ rankings are a relative measure of a firm’s investment in internal governance, i.e., its adoption of governance attributes, and indicate the firm’s investment in governance relative to firms in its industry or within an index in which the firm is included. To compute these indices (which we do not use in this paper), ISS collects information on governance attributes for a large number of U.S. and foreign companies.” Here are the items used:
I’ve seen other governance indexes in the literature too. You can read about them here.
3.
Brian A'Hearn | 29 August 2007 at 8:27 am
So “governance” here seems to mean “protection of shareholder interests against management interests”. In that context, it makes sense to talk about a quantity or degree of governance. I had thought the term governance was neutral, and simply meant the arrangements by which a corporation is controlled.
Thanks for the details.
4.
Peter Klein | 30 August 2007 at 12:06 pm
That’s a good point. It demonstrates how much the basic framework of agency theory is taken for granted in most of thlis literature.