Board Size and Corporate Risk Taking: Further Evidence from Japan

• DOI: http://doi.org/10.1111/j.1467-8683.2012.00924.x
• Author: Makoto Nakano,Pascal Nguyen
• Date: 01 July 2012
• Published date: 01 July 2012

Board Size and Corporate Risk Taking:

Further Evidence from Japan

Makoto Nakano and Pascal Nguyen*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Due to a greater diff‌iculty to achieve compromise, large decision-making groups tend to adopt

less extreme decisions. This implies that larger boards are associated with lower corporate risk taking. We test whether a

similar effect applies to the case of Japanese f‌irms. The result is expected to be weaker since Japanese boards form relatively

homogeneous groups. We further argue that growth opportunities moderate the relation between board size and risk

taking.

Research Findings/Results: Our results indicate that f‌irms with larger boards exhibit lower performance volatility as well

as lower bankruptcy risk. However, the effect is not as signif‌icant as in the US. The low cross-sectional variation in risk

taking among Japanesef‌irms is found to play a role. In addition, we show that the effect of board size is less signif‌icant when

f‌irms have plenty of investment opportunities, but much stronger when f‌irms have fewer growth options.

Theoretical Implications: Considering that risk taking contributes to f‌irm performance, our results offer a rationale as to

why larger boards might be associated with lower performance. However, they also suggest that this effect should be less

detrimental to f‌irms with signif‌icant investment opportunities.

Practical Implications: Firms should adapt their decision processes to their business environment. In particular, they may

need to adjust the size of their boards to the characteristics of their investment opportunity sets. Firms with fewer growth

options would gain most by operating with smaller boards. By restricting their ability to take risks, f‌irms could undermine

their growth potential and performance.

Keywords: Corporate Governance, Board Size, Risk Taking, Investment Opportunities, Performance Volatility

INTRODUCTION

Risk taking is critical to corporate success. Whilst it is

true that some f‌irms are likely to fail as a result of the

risks they take, few can expect to thrive without incurring a

certain degree of risk. But what determines cross-sectional

differences in risk taking? Agency theory asserts that man-

agers are reluctant to undertakerisky projects out of concern

for their personal welfare (Fama, 1980; Holmstrom, 1999;

May, 1995). By analyzing the decisions of a sample of plant

managers, Bertrand and Mullainathan (2003) establish that

the latter typically prefer not to take any risk. Focusing on

the differential effect of a change in legislation providing

greater protection from hostile takeovers, Low (2009) reveals

that managerswhose positions became more secure reduced

their risk taking. Conversely, Mishra (2011) demonstrates

that better monitoring through multiple large shareholders

is associated with higher risk taking. From these results, it

appears that agency conf‌licts play an important role in

explaining differences in risk across f‌irms.

Research in social psychology and organizational behav-

ior suggests a different perspective. Accordingto Kogan and

Wallach (1964) and Moscovici and Zavalloni (1969), the size

of the decision-making group tends to have a negative effect

on risk taking. Sah and Stiglitz (1986, 1991) argue that riskier

projects are less likely to be accepted because of the greater

diff‌iculty of reaching an agreement in large groups. Consis-

tent with this idea, Cheng (2008) shows that US f‌irms with

larger boards are associated with lower performance vola-

tility. Likewise,Adams and Ferreira (2010) reveal that larger

groups are less extreme in their betting decisions, while Bar,

Kempf, and Ruenzi (2005) establish that team-managed

mutual funds are less likely to deviate from their professed

investment styles compared to individual managers.

*Address for correspondence: PascalNguyen, Finance Discipline Group, University of

Technology Sydney,PO Box 123, BroadwayNSW 2007, Australia. Tel: +61 2 9514 7718;

Fax: +61 2 9514 7722; E-mail: pascal.nguyen@uts.edu.au

369

Corporate Governance: An International Review, 2012, 20(4): 369–387

© 2012 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2012.00924.x

In this paper, we try to address two questions. Our f‌irst

question is whether the negative effect of board size on

corporate risk taking extends to Japanese f‌irms. There are

various reasons to suspect that the outcome might be differ-

ent. Japanese boards are mainly populated with insiders

(Abegglen & Stalk, 1985; Aman & Nguyen, 2012; Jackson &

Moerke, 2005; Li & Harrison, 2008; Phan & Yoshikawa, 2000;

Viner, 1993). Their responsibilities are broader than in the

US. According to Japan’s Commercial Code, the board of

directors is not only in charge of overseeing the company’s

business, but also responsible for making decisions on the

way business is conducted. Decision making is usually more

collegial and involves greater effort at achieving consensus

(Crossland & Hambrick, 2007; Hofstede, 1980; Keys,

Denton, & Miller, 1994; Keys & Miller, 1984; Ouchi, 1981). In

addition, Wiersema and Bird (1993) underline the homoge-

neity in Japanese organizations and infer from this observa-

tion that managers with dissimilar prof‌ilesare more likely to

leave the f‌irm, thus further increasing the uniformity of

viewpoints already present in the organization. The Japa-

nese business culture is also characterized by a low degree

of individualism, especially relative to the US (Hofstede,

1980). At the board level, these characteristics (i.e., greater

uniformity in managerial prof‌iles and greater conformity in

displayed behaviors) have the consequence that a lesser

diversif‌ication of opinion is achieved by adding more direc-

tors. It thus follows that corporate risk takingin Japan might

not decrease as much in relation to board size as in the US

(Cheng, 2008).

Our second question is whether growth opportunities

play a moderating role in the relation between board size

and risk taking. The underlying model by Sah and Stiglitz

(1986, 1991) presumes that all decision-making units evalu-

ate the same number of projects. Only the size of the unit

varies. However, f‌irms have typically heterogeneous invest-

ment opportunity sets. Hence, there is no reason to believe

that the effect should be the same for a f‌irm with plenty of

attractive investments and another one with few invest-

ments available. In fact,we argue that the negative effect of a

large board should be weaker for high-growth f‌irms but

more severe for low-growth f‌irms. The reasoning is that

when a f‌irm has a large number of projects, these projects

can be allocated to and evaluated by smaller sub-groups of

directors so that each of these sub-groups are effectively

evaluating the same number of projects as the whole, but

smaller, board of a f‌irm with fewer projects. As a result, a

greater proportion of risky projects survive the screening

process.

Our empirical investigation involves several measures of

risk. In line with Cheng (2008), we f‌irst estimate the disper-

sion over time of a f‌irm’s performance using operating

prof‌its, market-to-book value of assets, and stock returns.

We then relate these risk indicators to the average board size

and other key f‌irm characteristics, such as f‌irm size and

leverage. But, since these risk indicators ignore the informa-

tion in within-f‌irm performance variations, our second

approach is to measure risk by the absolute deviation from

the f‌irm’s expected performance. Consistent with Adams,

Almeida, and Ferreira (2005) and Sanders and Hambrick

(2007), we then use panel regressions to relate these risk

measures to board size. This procedure is known as the

Glejser heteroskedasticity test (Glejser, 1969). As a robust-

ness check, we consider two indicators of bankruptcy risk:

Altman’s Z-score and Olson’s O-score whose calibration to

Japanese companies is provided by Xu and Zhang (2009).

Using a large panel of Japanese f‌irms listed on the Tokyo

Stock Exchange over the period 2003–2007, we f‌ind that

board size is negatively related to risk taking. However, the

relation is not as signif‌icant as in the US, which is partly due

to the low cross-sectional dispersion in risk taking among

Japanese f‌irms. We show that the effect of board size

depends on the f‌irm’s investment opportunity set. When a

f‌irm has plenty of investment opportunities, a larger board

does not necessarily resultin lower risk taking because many

risky projects can survive the screening process. On the

other hand, if the f‌irm has few investment opportunities, the

effect of a larger board is to cause a signif‌icant reduction in

the proportion of risky projects.1

The negative relation between board size and risk may

also ref‌lect an equilibrium in which both variablesare jointly

determined in response to the f‌irm’s environment (Herma-

lin & Weisbach, 2003). For example, f‌irms may consider

smaller boards to be better suited to risky business condi-

tions. In that case, decreasing the board’ssize will not induce

greater risk taking. On the other hand, the notion that risk is

related to the complexity of the f‌irm’s operations suggests

that risky f‌irms should operate with larger boards because of

their greater need for advice and monitoring (Coles, Daniel,

& Naveen,2008; Guest, 2008; Linck, Netter, & Yang, 2008). To

identify the exogenous variation in board size, we use the

f‌irm’s free f‌loat because shares dispersed in the public are

unlikely to involve board representation. At the same time,

variations in the free f‌loat should not affect the f‌irm’s gov-

ernance and incentives to take risk, especially since institu-

tional ownership is included in the risk regression. This

instrumental variable approach generates somewhat larger

coeff‌icients for board size. However, exogeneity tests indi-

cate that the difference with the OLS estimates is not statis-

tically signif‌icant.

This study adds to the growing literature on optimal

board structures. In a seminal paper, Yermack (1996) dem-

onstrates the higher performance of f‌irms with smaller

boards of directors. However, Coles et al. (2008) show that

this effect depends on the f‌irm’s characteristics. When f‌irms

have greater need for advice and monitoring, they actually

benef‌it from operating with bigger boards. This may explain

why earlier studies have found conf‌licting results regarding

the effect of board size on f‌irm performance (Dalton, Daily,

Johnson, & Ellstrand, 1999). In essence, these studies use

mixed f‌irms that benef‌it from the additional resources asso-

ciated with larger boards with other f‌irms for which larger

boards lead to higher coordination problems. In this paper,

our focus is on corporate risk taking. While Cheng (2008)

suggests that larger boards are generally detrimental to risk

taking, our f‌irst contribution is to show that this effect may

depend on the composition of the board. More accurately,

boards characterized by greater homogeneity, as is the case

in Japan, are less likely to affect the selection of risky projects

as their size increases. Our second contribution is to show

that the effect of board size depends on the f‌irm’s invest-

ments opportunities. To be more precise, larger boards may

not necessarily lead to lower risk taking and therefore lower

370 CORPORATE GOVERNANCE

Volume 20 Number 4 July 2012 © 2012 Blackwell Publishing Ltd