REVIEWING THE REVIEWS: TOWARDS A ‘BUNDLES APPROACH’ TO CORPORATE GOVERNANCE INDICES

1. REVIEWING THE REVIEWS: TOWARDS A ‘BUNDLES APPROACH’ TO CORPORATE GOVERNANCEINDICES Gerhard Schnyder – King’s College London gerhard.schnyder@kcl.ac.uk October 12, 2012 LCCGE – Birkbeck, University of London

2. Motivation & Argument • Reviewing the reviews • The bundles approach to CG • Lessons from the bundles approach for CG index construction Plan

3. Several relatively recent studies closely look at existing academic and commercial ‘composite’ measures of CG • GMI, RiskMetrics/ISS CGQ, The Corporate Library, AGR • G-Index (Gompers et al. 2003), E-Index (Bebchuk et al. 2005), Gov-7 (Brown & Caylor 2006) • ‘Ranking the rankings’  Daineset al. 2010; Renders et al. 2010; Baghat et al. 2008; Bebchuck et al. 2005 • Reviewing the ‘reviews’  what are the criticisms of composite measures? • Reviewing the solutions  what are the implications of the proposed solutions in particular for comparative studies and from a ‘bundles’ perspective? • Better solutions? Motivation & Argument

4. Findings: • Composite measures of CG are bad at predicting performance • Different measures do not correlate with each other (while claiming to measure the same underlying construct) So what’s wrong with the rankings? • Lack of theory behind index construction  all CG mechanisms equal weighting? • Naivetyof academic ‘tick-and-sum’ and ‘kitchen-sink approaches’ to index construction (Bebchuk et al. 2005) • Non-transparentnature of algorithms used to compute commercial measures Reviewing the Reviews1

5. Findings: • Methodological problems rendering link CG – performance elusive: • Endogeneity problem: performance affects subsequent CG choices (well performing firms anticipate capital increases  improve CG to maximise share price) • Selection bias: Most studies focus on largest firms = by definition also the best performing ones  not representative sample of population + little variance  statistical power weak(Renders et al. 2010)  Note that this critique does not explain why findings are inconsistent across studies, given that they are all affected by the same selection bias • Reviewing the Reviews2

6. Solutions: • Use more sophisticated statistical methods to find correlation with performance State of the art: instrument variable approach & 2SLS instead of OLS; recursive partitioning etc • Use simpler measures of CG (since complex ones don’t work)  Bebchuket al. 2005: E-Index (6 vars) based on G-Index (24 vars)  Most contentious vars + the ones that correlate with performance!  Bhagat et al. 2008: $-value of median independent director’s stockholdingspredicts performance better than any composite measure Reviewing the Reviews 3

7. Basic idea: CG mechanisms may not matter individually, but in combination with others • Rediker & Seth 1995 coined the term ‘bundles of CG mechanisms’ (bundles concept = well-developed in HRM) • Rediker & Seth 1995: Monitoring by outside directors, blockholder monitoring, managerial shareholdings, mutual monitoring by inside directors  substitution effects: E.g. Companies with a large external blockholder use fewer incentives for managers than companies with dispersed ownership • Zajac & Westphal 1994: Companies with incentives structures have fewer other CG mechanisms in place • Yet, others find complementarities: Rutherford & Buchholtz 2007, Rutherford et al. (2007): BoD and incentive structures = complements: you need effective boards to make PFP schemes work…with weak boards, they become self-service shop for top execs The ‘Bundles Approach’

8. Bundles are contingent on… • …firm characteristics (Ward et al. 2009) and… • …on organisational environment (Filatochev 2007). Cf. Aguilera et al. 2008; 2012 etc. • Firm-level contingencies: • Ward et al. 2009 BoD monitoring & incentive pay: = substitutes in well-performing firms: BoDcan choose to monitor less by granting more incentive pay to executives = complementsin poorly performing firms: e.g. external institutional shareholder putting pressure on the BoD to align shareholder and management interests = ‘decoupled’ in companies on the verge of bankruptcy: BoDsmonitoring capacity declines, because non-executive directors leave and are not replaced and CEOs tend to entrench themselves  bundles may ‘unbundle’in extreme situations The Contingency of Bundles

9. Better statistical methods • Using simpler measures Fundamental problem: Risk of tautology: single out variables that impact performance, define corporate governance in terms of these variables then investigate whether CG matters for performance! e.g. ISS  weighting more those items that impact performance; Bebchuk et al. (2005) only include variables that impact peformance Reviewing the solutions in light of the bundles approach 1

10. Example: Aggarwal et al. (2009: 3133): “One can reasonably disagree both with the governance attributes ISS focuses on and with the index we compute. […] However, if the index were to convey no information, we would simply find that the index we use is not related to firm value” • The link between corporate governance and firm value is both the research question and the fundamental axiom • NB: maybe there is nothing wrong with the measures and what we find is proof that CG does not matter for performance!  This is rarely acknowledged due to the strength of ‘agency theory’ and ‘efficient market hypothesis’ paradigm in financial economics Reviewing the solutions….2

11. Lack of rigour in index construction: Bebchuk et al. 2005: low correlations between items of the E-Index (between 0.1 and 0.31)  Bebchuk et al.: Good thing, because each item adds a new dimension of CG = methodologically questionable (Cortina 1993) Risk of excessive information loss: Bundles: if a single CG mechanism does not affect performance, it may still do in combination with others  this information is lost Comparisons: what matters in one country may not matter in another  functional equivalents  More sophisticated rather than simpler measures needed Reviewing the solutions….3

12. Kitchen-sink approach may be better than univariate measure  Ashby’s ‘law of requisite variety’ v./ lexparsimoniae Index construction: • Inductive approach: Use cluster or factor analysis not regression on performance to figure out what matters • Mid-range theories based on comparative CG and CG systems literature  what is the role of the BoD, transparency, etc. in different countries? • Laws on the book vs. laws in practice: degrees of implementation (symbolic implementation etc.)  multi-level variables needed • Index of weakly-correlated variables?  sub-indicators with strong correlations (modular approach) (cf. Myajima 2007) • Endogeneity problems of CG mechanisms: Distinguish choice variables v./ from ‘legally-imposed’ variables Lessons from the bundles approach

13. Too complex? Too ambitious? Not feasible? • Not everything can or should be quantified and we still need qualitative research • Yet, what is the alternative? • Contiuing use of G-index or E-index; of La Porta et al.’s legal index  despite overwhelming evidence that these indices are limited in their validity, problematic in different respects, or plain wrong! • Quantitative research needs to be based on more robust measures • Make things as simply as possible, but not simpler  complex empirical phenomena like CG require complex measures not simple ones! • More thought/research needs to go into developing indices that are useful for comparative bundles research Is this madness?