Does “Good” Corporate Governance Help in a Crisis? The Impact of Country‐ and Firm‐Level Governance Mechanisms in the European Financial Crisis

• Published date: 01 May 2013
• Author: Michael Carney,Marc Essen,Peter‐Jan Engelen
• Date: 01 May 2013
• DOI: http://doi.org/10.1111/corg.12010

Does “Good” Corporate Governance Help in a

Crisis? The Impact of Country- and Firm-Level

Governance Mechanisms in the European

Financial Crisis

Marc van Essen*, Peter-Jan Engelen, and Michael Carney

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine the effects of f‌irm- and country-level “good” corporate governance prescriptions on

f‌irm performance before and during the recent f‌inancial crisis, using a large sample of 1,197 f‌irms across 26 European

countries.

Research Findings/Insights: We proposea contextualized agency perspective suggesting that f‌irm- and country-level good

governance prescriptions designed to assure managerial oversight may not hold in a f‌inancial crisis. This is because f‌irms

can benef‌it from broadening managerial discretion so as to facilitate the exercise of initiative and decisive leadership.

Overall, our f‌irm- and country-level f‌indings support this argument. In a crisis, CEO duality is associated with better

performance. We also f‌ind that the use of incentive compensation and the existence of a wedge between ownership and

control rights negatively impacts on f‌irm performance in a crisis. Hierarchical linear modeling shows that 25 percent of the

heterogeneity in f‌irm performance is among countries, indicating the importance of including country-level institutions in

our analyses. In a crisis, we f‌ind that the general quality of the legal system and creditor rights protection are positively

related to f‌irm performance, but protection for equity investors is not.

Theoretical/Academic Implications: The f‌indings challenge the universality of good governance prescriptions and con-

tribute to the growing body of work proposing that the eff‌icacy of governance mechanisms may be contingent upon

organizational and environmental circumstances.

Practitioner/Policy Implications: The study offers insights relevant to policy and practitioner communities, showing that

governance mechanisms operate differently in crisis and non-crisis periods. The tendency to respond to a crisis with more

stringent rules may be counterproductive since such measures may compromise executives’ ability to respond appropri-

ately to systemic shocks. Practitioners are encouraged to optimize rather than maximize their governance choices.

Keywords: Corporate Governance, Board of Directors, CEO Compensation, European Countries, Executive Discretion,

Financial Crisis, Ownership

INTRODUCTION

How does “good” corporate governance inf‌luence f‌irm

performance in a severe f‌inancial crisis? Received

wisdom, based predominantly upon agency theory (e.g.,

Jensen & Murphy, 1990) and the law and f‌inance (e.g., La

Porta,Lopez-De-Silanes, Shleifer, & Vishny, 1998) literatures,

suggests that f‌irm- and country-specif‌ic good governance

prescriptions, including an independent and vigilant board,

the separation of key leadership roles, incentive alignment

between owners and managers, and legal protection for

creditors and minority shareholders, will enhance corporate

value in the normal course of events. But do these prescrip-

tions apply universally in all situations and for all types of

f‌irms? (Judge, 2012). Recent research suggests that the eff‌i-

cacy of governance prescriptions may be contingent on a

variety of factors, such as national economic development

(Chen, Li, & Shapiro, 2011), national institutions (Carney,

*Address for correspondence: Marc vanEssen, Sonoco International Business Depart-

ment, Moore School of Business, University of South Carolina,Columbiam, SC 29208,

USA. Tel: 803-777-5669; Fax:803-777-3609; E-mail: marc.vanessen@moore.sc.edu

201

Corporate Governance: An International Review, 2013, 21(3): 201–224

© 2012 Blackwell Publishing Ltd

doi:10.1111/corg.12010

Gedajlovic, Heugens, Van Essen, & Van Oosterhout, 2011;

Henrekson & Jakobsson, 2012; Renders & Gaeremynck,

2012), industry context (Chancharat, Krishnamurti, & Tian,

2012), ownership structure (Desender, Aguilera, Crespi-

Cladera, & Garcia-Cestona, 2012), and a f‌irm’s f‌inancial con-

dition and stage in its life-cycle (Dowell, Shackell, & Stuart,

2011). In this paper we contribute to contingency approaches

in comparative corporate governance (Desender et al., 2012)

by investigating which f‌irm- and country-specif‌ic gover-

nance mechanisms can help f‌irms maintain their f‌inancial

performance in a f‌inancial crisis relativeto their performance

in more routine, steady-state f‌inancial conditions.

The 2007–08 transatlanticcredit crisis has been the world’s

deepest since the Great Depression of the last century. The

origins of the present crisis were initially attributed to gov-

ernance failures in the f‌inancialsector. The collapse of the US

real-estate market and the subsequent failure to off‌load

subprime risks ultimately resulted in a credit crisis (Grego-

riou, 2009). Others implicate the use of novel and poorly

understood f‌inancial instruments such as collateralized debt

obligations. The use of high-powered incentive compensa-

tion for senior banking executives may have exacerbated the

problem. However, many scholars believe that inadequacies

in the wider corporate sector were a more probable cause of

the crisis. In this view, boards of directors were believed to

be inadequate in monitoring executives and evaluating the

risks they assumed (Muller-Kahle & Lewellyn, 2011). Others

pinpoint institutional failings governing risk management,

credit rating, and f‌inancial reporting standards that proved

ineffective in signaling underlying structural problems

(Conyon, Judge, & Useem, 2011). While the determination of

the probable multiple causes of the current crisis awaits a

comprehensive analysis, we aim to shed some light on the

problem by examining the eff‌icacy of good governance pre-

scriptions that are believed to have universal relevance. In

particular, our objective is to evaluate the robustness of

several f‌irm- and country-specif‌ic governance mechanisms

and the extent to which they have withstood the crisis, as

ref‌lected in the f‌inancial performance of publicly listed

f‌irms. To do so, we will examine the effects of f‌irm- and

country-level government mechanisms on f‌irm performance

before and during the recent f‌inancial crisis using a unique

large sample of 1,197 f‌irms drawn from 26 European coun-

tries. The sample represents a strong test of the hypothesis,

as it consists of large and mature public corporations,

for which good governance prescriptions are primarily

intended.

The basic logic informing this studydraws upon the mana-

gerial discretion literature (Finkelstein & D’Aveni, 1994; Wil-

liamson, 2007), which emphasizes the value of decisive

leadership in the context of uncertainty. To derive our

hypotheses we take several good governance prescriptions

derived from the agency theory and law and f‌inance litera-

tures, and we consider how a f‌inancial crisis may inf‌luence

the exercise of managerial discretion. Our hypotheses are

based on the premise thatcorporate governance mechanisms,

which are benef‌icial (or at least not harmful) in steady-state

conditions, mayhave more pernicious effects in the context of

f‌inancial crisis. In particular, we reason that the checks and

balances on managerial discretion performed by corporate

boards may prove overly restrictive and limit their initiative

in responding to crisis conditions (Burkart, Gromb, &

Panunzi, 1997; Finkelstein & D’Aveni, 1994). Furthermore,

we reason that particular types of ownership (Shleifer &

Vishny, 1997), executive compensation (Tosi& Gomez-Mejia,

1994), and country-level governance institutions (La Porta,

Lopez-De-Silanes, Shleifer, & Vishny, 1997; La Porta et al.,

1998) may function differently and have different perfor-

mance effects in steady-state and crisis conditions. This is

because both costs and benef‌its are associated with different

governance mechanisms and choices that are optimized for

steady-state conditions but may be misaligned in a crisis

(Dowell et al., 2011). In a f‌inancial crisis the costs associated

with any particular governance choice may exceed its ben-

ef‌its, which may signif‌icantly affect performance.

Our contribution to the existing literature is threefold.

Firstly, to our knowledge, this is the f‌irst study that focuses

on the impact of f‌irm-level and country-level governance

mechanisms on European f‌irms’ performance during the

recent f‌inancial crisis. We can observe that the quality of the

institutional environment in European countries is generally

well developed; nevertheless, there is signif‌icant variation in

national f‌inancial system architectures, which allows us to

test for the impact of cross-country differences (Renders,

Gaeremynck, & Sercu, 2010; Van Essen, Van Oosterhout &

Heugens, 2012c). Secondly, we use hierarchical linear mod-

eling to simultaneously model f‌irm- and institutional-level

variables, allowing us to determine how much different

levels of analysis explain f‌irm-performance differences in

steady-state and crisis conditions (Judge, 2011). Thirdly, our

study contributes to the growing body of literature that

points to the contingent quality of good governance pre-

scriptions and their inherent trade-offs with respect to desir-

able corporate outcomes (Aguilera, Filatotchev, Gospel, &

Jackson, 2008). Our study points specif‌ically to the need for

governance mechanisms to be evaluated with regard both to

their ability to function eff‌iciently in steady-state conditions

and to their robustness to f‌inancial shocks. We will proceed

in the following manner. In the next section, we develop

four theory-based hypotheses about the inf‌luence of f‌irm-

level and country-level governance characteristics on f‌irm

performance during both “steady state” conditions and

during f‌inancial crises. We then describe the sample, vari-

ables, and the hierarchical linear modeling approachthat we

employ. The empirical results are then presented, and we

conclude by pointing to the caveatsregarding the limitations

of our research and discuss the policy and managerial impli-

cations of our f‌indings, indicating avenues for future

research into the eff‌icacy of good governance prescriptions.

THEORY AND HYPOTHESES

A corporate governance system can be seen as a particular

conf‌iguration of internal and external mechanisms that con-

dition the generation and the distribution of residual earn-

ings in a country’s corporations (Shleifer & Vishny, 1997).

These mechanisms function at both the f‌irm and country

level of analysis (Judge, Gaur, & Muller-Kahle, 2010). In this

section, we develop a series of four hypotheses pertaining to

ownership concentration and identity, board structure and

composition, incentive compensation, and the quality of a

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