Board change and firm risk: Do new directors mean unstable corporate policies?

• Published date: 01 March 2022
• Author: Huiqun Feng,Jason Zezhong Xiao
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/corg.12399

ORIGINAL ARTICLE

Board change and firm risk: Do new directors mean unstable

corporate policies?

Huiqun Feng

1

| Jason Zezhong Xiao

2

1

School of Accountancy, Tianjin University of

Finance and Economics, Tianjin, China

2

Faculty of Business Administration, University

of Macau, Macau, China

Correspondence

Huiqun Feng, School of Accountancy, Tianjin

University of Finance and Economics,

No. 25, Zhujiang Road, Tianjin, China.

Email: miranda@tjufe.edu.cn

Jason Zezhong Xiao, Faculty of Business

Administration, University of Macau,

E22-3063, Macau, China.

Email: jasonxiao@um.edu.mo

Funding information

National Natural Science Foundation of China,

Grant/Award Number: 71802144; University

of Macau, Grant/Award Number:

SRG2019-00191-FBA

Abstract

Research Question/Issue: Given the contentious debate over whether the

appointment of new directors reduces firm risk, this study explores the effect of

board changes on firm risk.

Research Findings/Insights: Appointing new directors leads to firm risk. A regression

kink design shows that boards with more than 30% of new directors experience a

significant increase in firm risk for approximately two years. Moreover, the effect of

new directors on firm risk is more pronounced for firms with weaker corporate

governance mechanisms but is attenuated if the demographic gaps between the new

and existing directors are relatively larger. Additionally, the effect is moderated when

new directors have interlocking and academic experience. Further analysis reveals

that the appointment of new directors is associated with less consistent corporate

policies.

Theoretical/Academic Implications: We extend the theory of dynamic board

governance, providing a qualitative and quantitative description of the effect of

board change via a regression kink design, which shows that board change is an

important variable that upsets the balance of board governance, leads to higher

volatility of corporate policies, and increases the risk of corporate operations.

Practitioner/Policy Implications: The findings suggest that corporate management

should carefully assess the risk of board change. A large proportion of new director

involvement can create challenges in communication, understanding, and

cooperation, leading to inconsistent corporate strategies and policies, thus increasing

operating volatility. Moreover, this study offers insights to policymakers rethinking

board spills in their countries.

KEYWORDS

board change, corporate governance, demography, expertise, firm risk

1|INTRODUCTION

A board of directors (BoD) monitors management and makes strategic

decisions to protect shareholder interests (Forbes & Milliken, 1999;

Hillman & Dalziel, 2003). Nevertheless, in many circumstances,

directors have failed to fulfill their duties and thus have undermined

firm performance. Bringing in new directors is commonly thought to

solve this problem. According to PwC's 2018 Annual Corporate

Directors Survey,

1

almost half of the respondents said someone on

their board should be replaced by a newcomer. However, available

evidence on the impact of new directors on firm operations is sparse.

Thus, this study attempts to bridge this gap in the literature.

We investigate the impact of new directors on firm risk. The

focus on firm risk stems from economic and social psychology studies,

Received: 14 December 2020 Revised: 25 June 2021 Accepted: 28 June 2021

DOI: 10.1111/corg.12399

212 © 2021 John Wiley & Sons Ltd Corp Govern Int Rev. 2022;30:212–231.wileyonlinelibrary.com/journal/corg

suggesting that a team change causes high levels of flux in

coordination (Sah & Stiglitz, 1984). Summers et al. (2012) support the

view that a change in team members leads to conflicts in decision-

making and subsequent underperformance; however, there is no

systematic evidence of these effects. Further, new directors could

break the BoD balance and disrupt the board's decision-making pro-

cess, leading to an increase in operational uncertainties. Hence, the

appointment of new directors could result in greater firm risk.

China offers a good setting for investigating the research ques-

tions. First, Chinese listed firms exhibit more frequent and large-scale

board changes relative to firms in Western economies. According to

Compustat, the mean proportion of board changes in the United

States is less than 5%, relative to 17.8% in China. The high frequency

of board changes in China increases the statistical power to examine

our research question. Second, by conducting a single-country study,

we can control for country-level heterogeneities (e.g., culture and

legal systems), which may otherwise confound the relationship

between the appointment of new directors and firm risks.

Using a sample of 23,226 firm-year observations (2,689 unique

firms), we find that the appointment of new directors is associated

with higher firm risks, measured as stock return volatilities. The results

are robust to a series of sensitivity analyses, such as using alternative

samples and alternative measurements of key variables. The regres-

sion kink design (RKD) further reveals that firm risk increases signifi-

cantly when new directors comprise at least 30% of the board

members. This effect lasts for approximately 2 years. These findings

suggest that new directors do not substantially impact firm risk until

they comprise a reasonably high proportion of board members.

However, establishing causality is particularly challenging given

the endogenous nature of board changes (Adam et al., 2018;

Hermalin & Weisbach, 1998). A primary concern is whether the result

is attributable to reverse causality; that is, firms with higher risks are

more likely to appoint new directors to reduce future risks. Thus, we

use a propensity score matching (PSM) approach to create treatment

(i.e., firms with new directors) and control (i.e., firms without new

directors) groups, which mitigates the self-selection bias that arises

from observed heterogeneities. Then, there are omitted variable con-

cerns; that is, a firm may undergo dramatic reform, leading to a change

in the BoD and risk-taking level simultaneously. Therefore, we use

difference-in-differences estimation (DID) to examine this possibility.

The robustness checks support the findings.

We conduct several cross-sectional variation tests and find the

following: first, the new director effect is more pronounced for firms

with concentrated ownership structures and fewer institutional inves-

tors, suggesting that a weaker governance system exacerbates the

detrimental role of new directors in firm risk. Second, our investiga-

tion of the moderating effect of demographic characteristics showed

that the positive relationship between new directors and firm risk is

attenuated given a large demographic gap between new directors and

incumbent directors. Further, the effect of new directors on firm risk

is moderated when new directors interlock and possess academic

experience. Finally, we explore the possible channels through which

the appointment of new directors increases firm risk. Accordingly,

firms with new directors are associated with less consistent corporate

policies.

This study contributes to the literature in several ways. First, we

complement the growing literature on the role of directors in

corporate governance. Previous studies have focused mainly on the

static characteristics of directors, such as fault lines (Kaczmarek

et al., 2012), ethnic diversity (Bernile et al., 2018), experience (Dass

et al., 2013; Field & Mkrtchyan, 2017), and gender (Sila et al., 2016).

Although such studies provide useful insights into how director

characteristics translate into corporate outcomes, the effect of

dynamic board change on firm operations is largely neglected. One

exception is Crutchley et al. (2002), who introduced a scale-invariant

metric to measure board stability. We extend these studies by

showing that dynamic board change is an important variable; a change

in directors upsets the board governance balance, induces higher

corporate policy volatility, and increases the corporate

operational risk.

Second, we provide evidence of the impact and duration of

appointing new directors on firm risk. Previous research suggests that

board stability positively influences firm performance (Crutchley

et al., 2002), but the magnitude of board change necessary to have an

impact and the duration of the effect remains unclear. Using an RKD,

we demonstrate that a board change of at least 30% of new directors

significantly increases firm risk, which lasts for fewer than two years.

Third, we enrich the theory of board governance by examining

the situational nature of the effect of board change. We find that

shareholder power moderates the effect of board change on firm risk.

Prior studies have paid scant attention to these contexts. The upper

echelons theory (Hambrick & Mason, 1984) suggests that the demog-

raphy and expertise of directors influence the effectiveness of board

governance. We extend this idea by examining the moderating effect

of director demography and expertise on the relationship between

board change and firm risk. The results show that the gap

between the demography and expertise of new and old directors can

help explain the effect of board change on firm risk. These findings

provide further insights into how board changes interact with board

member characteristics in corporate decision-making.

2|LITERATURE REVIEW AND

HYPOTHESIS DEVELOPMENT

2.1 |Literature review

The BoD is the core of corporate governance and is significant in

corporate decision-making (Johnson et al., 1996). Agency and

resource dependence theories suggest that BoD processes affect

corporate decision-making. Per agency theory (Fama & Jensen, 1983),

the BoD makes decisions to protect investor benefits and prevent

power abuse. That is, the BoD monitors managerial decision-making.

Further, resource dependence theory suggests that the BoD plays an

advisory role (Hillman et al., 2000). That is, the BoD helps managers

develop optimal strategies and improve corporate operations.

FENG AND XIAO 213