Corporate Governance in Microfinance Institutions: Board Composition and the Ability to Face Institutional Voids

• Date: 01 September 2014
• Author: A. Erin Bass,Subrata Chakrabarty
• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/corg.12071

Corporate Governance in Microf‌inance

Institutions: Board Composition and the Ability

to Face Institutional Voids

Subrata Chakrabarty* and A. Erin Bass

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We utilize institutional theory to examine corporate governance in microf‌inance institutions

(MFIs). Many MFIs operate at the bottom of the economic pyramid (BOP), which is usually agrarian, impoverished, and

plagued with institutional voids. We investigate the link between the composition of the boards of MFIs and the ability of

the MFIs to face institutional voids to ensure organizational viability.

Research Findings/Insights: We f‌ind that MFIs with boards that have more socio-economic expertise and female repre-

sentation are better able to lower the MFI’s costs of operating at the BOP. However, this relationship weakens when the

effectiveness of agrarian institutions at the BOP is low. When agrarian institutions are ineffective, the board of the MFI may

have diff‌iculty in helping the MFI reduce its costs of operating at the BOP. Agrarian crises arising from ineffective agrarian

institutions tend to aggravate the various institutional voids present atthe BOP, making it harder for the board to guide the

MFI around the institutional voids.

Theoretical/Academic Implications: We extend institutional theory to understand how boards direct and control f‌irms

operating at the BOP to face institutional voids. In some cases, a f‌irm can f‌ill an institutional void. However, because other

institutional voids exist, the board must also help the f‌irm develop workarounds to ensure organizational viability. We

extend existing literature on board composition to highlight how human capital and gender diversity of boards can help

improve the viability of f‌irms operating at the BOP.

Practitioner/Policy Implications: MFIs with high operating costs may benef‌it from electing a board with socio-economic

expertise and female representatives. Governmentsand policy makers can work toward building effective social, economic,

and political institutions to help create contexts that are favorable to f‌irms (such as MFIs) thatoften f‌ind it diff‌icult to operate

at the BOP.

Keywords: Corporate Governance, Bottom of the Economic Pyramid, Board Composition, Agrarian Institutions,

Microf‌inance

INTRODUCTION

Markets at the bottom of the economic pyramid (BOP)

differ greatly from those of developed countries. The

BOP represents nearly two-thirds of the world’s population,

or four billion people that live on less than US$1.25 per day

(UNDP, 2007). Further, BOP markets tend to be largely

agrarian, with the poor often surviving on agriculture-

related activities (Varman, Skålén,& Belk, 2012). Many social

and economic issues exist in BOP markets. Social issues

include poverty, lack of education and health services, and

gender inequality (Cheston & Kuhn, 2002; Robinson, 2001).

Economic issues include, among others, a lack of hard and

soft infrastructure, low per capita income, and underdevel-

oped entrepreneurial and business activity. Despite these

socio-economic issues, the BOP is recognized for its market

potential and opportunities for future economic develop-

ment (World Bank, 2011).

Many socio-economic issues at the BOP are manifested

from institutional voids. Institutional voids can be def‌ined

as absent or weak institutional arrangements that prevent

the effective functioning of society (Mair & Martí, 2009).

*Address for correspondence: Subrata Chakrabarty, Management Dept, University of

Nebraska - Lincoln, CBA 209, 1240 R Street, P.O. Box 880491, Lincoln, NE 68588-0491,

USA. Tel: +1-402-472-3915; E-mail: chakrabarty@gmail.com

367

Corporate Governance: An International Review, 2014, 22(5): 367–386

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12071

Institutional voids exist in the environment externalto a f‌irm

and are thus often outside the f‌irm’s control. These voids

create diff‌iculties and threaten organizational viability for

f‌irms operating at the BOP. Institutional voids prevent f‌irms

from engaging in eff‌icient economic exchanges and enforc-

ing contracts – both of which can contribute to the costs of

operating at the BOP (Khanna, Palepu, & Sinha, 2005). Firms

operating in these contexts must either f‌ill or “work around”

the institutional voids (Khanna et al., 2005: 64).

The microf‌inance industry emerged as a way to f‌ill the

institutional void in f‌inancial services at the BOP.

Microf‌inance institutions (MFIs) provide basic f‌inancial ser-

vices such as loans, savings, etc., to the poor who would

otherwise not have access to these services (CGAP, 2011).

MFIs connect impoverished borrowers with f‌inancial

markets and, in doing so, help address socio-economic

issues such as poverty and depressed economic activity

(Morduch & Haley, 2002; Schreiner, 2002). While MFIs help

f‌ill an institutional void in the f‌inancial sector, they often

struggle to work around the numerous other institutional

voids that persist at the BOP such as “the voids in a coun-

try’s product markets, its input markets, or both” (Khanna

et al., 2005: 73).

One possible source of guidance for f‌irms to work around

the numerous institutional voids could be effective corpo-

rate governance.Corporate governance of a f‌irm operating at

the BOP can be viewed as “the system, or the set of mecha-

nisms” that internally “direct and control” the f‌irm in the

prevalent social and economic context (Mersland, 2007: 10).

In this study, we ask: can effective corporate governance

help MFIs work around institutional voids and thereby help

lower their costs of operating at the BOP?

We address this question by examining a key facet of

corporate governance – board composition. We examine

board composition and its inf‌luence on the costs of operat-

ing at the BOP. We suggest that two facets of board compo-

sition – socio-economic expertise and female representation

– are associated with the board’s ability to lower the MFI’s

costs of operating at the BOP. We def‌ine socio-economic

expertise as the knowledge of f‌inance/banking services,

legal/non-f‌inancial services, and government/public ser-

vices that is held by members of the MFI’s board. We def‌ine

female representation as the number of females thatserve on

the MFI’s board. We def‌ine an MFI’s costs of operating atthe

BOP as the overall costs incurred by the MFI to provide and

administer loans to borrowers at the BOP.

We contribute to the literature on corporate governance of

MFIs in several ways. First, MFIs operatein BOP markets rife

with institutional voids. Effective corporate governance can

guide an MFI to work around institutional voids. Second,

we emphasize the importance of demographic and human

capital characteristics of board composition for MFIs.

Female representation (demographic characteristic) and

socio-economic expertise (human capital characteristic) are

important for furthering our understanding of corporate

governance at the BOP. Third, contextual differences exist

between the BOP and the more developed markets. In sum,

our study provides important insight about how corporate

governance can play a role in guiding f‌irms operating at the

BOP to simultaneously address socio-economic issues and

ensure viable operations.

LITERATURE REVIEW

Theoretical Perspectives of Corporate Governance

Research on corporate governance is multi-theoretic. The

theories offer varying lenses to understand the board’s

ability to direct and control the f‌irm. The focus of our study

is to understand board composition and the ability of boards

to direct and control MFIs that face institutional voids.

Therefore, we review some theories of corporate governance

in light of whether the context – of institutional voids – is

considered with regard to the ability of boards to direct and

control f‌irms. We highlight these different theoretical per-

spectives in Table 1.

Management Hegemony. The management hegemony

literature argues that “boards are a legal f‌iction dominated

by management” (Hendry & Kiel, 2004: 502). Boards often

serve to simply “rubber stamp”decisions made by the f‌irm’s

management (Hung, 1998). From this perspective, the roleof

the board is symbolic and is inf‌luenced by internal (mana-

gerial) pressure (Hung, 1998). As such, managers usurp the

direction and control of the f‌irm from the board (Mace,

1971). This perspective is concerned with the inner workings

of the f‌irm rather than how external institutions modify the

board’s ability to direct and control the f‌irm.

Agency Theory. Agency theory focuses on the contract or

governing relationship between the principal and the agent.

It centers on addressing and resolving (1) the conf‌licting

interests of the principal and the agent, (2) information

asymmetry, and (3) risk propensity concerns (Jensen &

Meckling, 1976). Agency theory, as applied to corporate gov-

ernance, implies that “the major roleof the board is to reduce

the potential divergence of interest between shareholders

and management, minimizing agency costs, and protecting

shareholders’ investments” (Hendry & Kiel, 2004: 503).

Agency theory providesinsight into how boards monitor the

behavior of managers. However, it does not take into

account how the external institutional environment can

modify the board’s ability to direct and control the f‌irm.

Stakeholder Theory. Stakeholder theory argues that

f‌irms are concurrently responsible to multiple stakeholders

inside and outside the f‌irm. These stakeholders include,

among others, employees, customers, shareholders, and

members of the community (Freeman, 1984). Thus, both

boards and the f‌irms they serve are inf‌luenced by the con-

f‌licting interests of these multiple stakeholders. The role of

boards is to coordinate, and if necessary negotiate, the inter-

ests of multiple stakeholders (Hung, 1998). From this view,

boards should be moral and philosophical guides for the

f‌irm (Hung, 1998). Stakeholder theory acknowledges that

boards and f‌irms are inf‌luenced by groups internal and

external to the f‌irm. However, it does not explicitly take into

account the possibility that the absence or ineffectiveness of

external institutions can strain the ability of boards to direct

and control f‌irms.

Stewardship Theory. Stewardship theory has conven-

tionally argued that management executives should be

368 CORPORATE GOVERNANCE

Volume 22 Number 5 September 2014 © 2014 John Wiley & Sons Ltd