How do Independent Directors Influence Corporate Risk‐Taking? Evidence from a Quasi‐Natural Experiment

• Date: 01 September 2018
• Published date: 01 September 2018
• DOI: http://doi.org/10.1111/irfi.12144
• Author: Pornsit Jiraporn,Sang Mook Lee

How do Independent Directors

Influence Corporate Risk-Taking?

Evidence from a Quasi-Natural

Experiment

PORNSIT JIRAPORN AND SANG MOOK LEE

Pennsylvania State University School of Graduate Professional Studies, Malvern,

PA, USA

ABSTRACT

Motivated by agency theory,we explore the effect of independent directors on

corporate risk taking. To minimize endogeneity, we exploit the passage of the

Sarbanes–Oxley Act as an exogenous shock that raises board independence.

Our difference-in-difference estimates show that board independence dimin-

ishes risk-taking significantly,as evidenced by the substantially lower volatility

in the stock returns. In particular, board independence reduces total risk and

idiosyncratic risk by 24.87% and 12.60%, respectively. The evidence is consis-

tent with the notion that board independence represents an effective gover-

nance mechanism that prevents managers from taking excessive risk.

Additional analysis based on propensity score matching also confirms our re-

sults. Our research design is based on a natural experiment and is far more

likely to show causality, rather than merely an association.

JEL Codes: G32; G34

Accepted: 17 June 2017

I. INTRODUCTION

The issue of corporate risk-taking has captured a great deal of attention both in

the media and in academics. Excessive risk-taking by corporate executives, partic-

ularly in the financial industry,was often blamed for triggering the financial crisis

of 2008. As a result, it is crucial to understand the nature of corporate risk-taking

in order to prevent or lessen the likelihood of another crisis in the future. It is

generally believed that effective corporate governance can alleviate excessive

risk-taking by corporate executives. In fact, prior research has examined how

governance mechanisms influence corporate risk-taking. For instance, a number

of studies examine how executive compensation, a primary element of a firm’s

governance structure, affects risk-taking (Guay 1999; Coles et al. 2006; Low

2009; Dong et al. 2010; Armstrong and Vashishtha 2012; Hayes et al. 2012;

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12144

International Review of Finance, 18:3, 2018: pp. 507–519

DOI:10.1111/irfi.12144

© 2017 International Review of Finance Ltd. 2017