After every crisis, academics, policymakers and other observers reflect on what went wrong and what could have been done differently. This in turn leads to some reforms to laws and regulations. In the wake of widespread, multi-country corporate governance failures in the 1990s and 2000s (Enron, Tyco and Xerox in the U.S., for example, Maxwell, BCCI and Polly Peck in the UK, Parmalat in Italy and Ahold in the Netherlands), the call was for company law reforms and better corporate governance practices. The recent global financial crisis has led to many new regulations, and the revamping of existing ones, covering banks, derivative and capital market transactions and other forms of financial services.
In the immediate aftermath of any crisis, there is an understandable rush to adopt regulations that respond to the immediate symptoms with the expectation that they can solve the underlying problems and prevent new ones. Regulation comes with pros and cons, though, and the challenge is to get it just right and avoid overkill.
Some people view America’s corporate sector as over-regulated, with excessive and poorly written regulations suffocating what’s often considered the home of laissez-faire. The Sarbanes-Oxley Act of 2002, a law aimed at preventing Enron-style corporate frauds, has, for example, been criticized as making it more difficult to list shares on an American stock exchange and increasing the costs of compliance. The Dodd-Frank Act of 2010, weighing in at 848 pages, is frequently cited as another example of excessive regulation. The related “Volcker Rule,” which limits proprietary trading by banks, includes 383 questions that are broken down into 1,420 sub-questions.
While there is some merit to all sides of these debates, it is clear that even well-intentioned rules can leave much to be desired. It’s simply impossible to take all contingencies into account and especially difficult to predict how people will respond to incentives incorporated into regulations. Just acknowledging that is a step forward.
Regulators might do well to take a cue from the medical profession and promise first to “do no harm.” That would mean using basic principles and taking simple measures when information is lacking or ambiguous (Claessens and Kodres, 2016). With experience, regulations could then be adapted to better align incentives with goals. This would be especially important in a financial system and a corporate sector that are continuously evolving due to technological advances, globalization and new forms of trading and interactions between banks and markets. Such changes in financial systems require revisiting regulatory approaches while taking a broad view and maintain a system-wide perspective (Claessens, 2016).
The recent financial crisis has overshadowed important issues in the corporate sector that are largely unresolved. They include weaknesses in corporate governance that enable managers to influence their own pay in ways that lead to widespread distortions in compensation arrangements (Bebchuk, 2009). That’s just one example of how hard it is to get regulation right.
In our 2010 Journal of Financial Intermediation article “Corporate Governance and Regulation: Can there be too much of a good thing?” we tried to address this question more generally by analyzing the effects of both corporate governance practices and legal requirements on performance for about 2,350 companies from 23 countries. We found that there are gains, but also explicit and implicit costs,associated with formal corporate governance requirements.
Specifically, we studied whether corporate governance rules can interact with corporate governance practices and lead to higher or lower corporate valuations. The question, in other words, is whether firm valuation is related to the level of corporate governance practices in place. Many companies adopt strong corporate governance not because it is required, but because it is in their own long-term interest. As governance rules are tightened, the marginal benefit curve shifts higher, because the environment is more supportive, but the marginal cost curve shifts down. Whether on net – that is, when the marginal cost and benefit curves intersect – the return from improving corporate governance practices goes up or down is ambiguous. For example, an increase in investor protection from, say, Sarbanes-Oxley is not necessarily associated with an increase in firm value, since the marginal cost of improving corporate governance can exceed the marginal benefit. By studying firms’ actual corporate governance practices and cross-country differences in rules, we can tease out these relative gains and costs.
In our study, we find companies that have strong corporate governance and operate in stringent legal environments show a valuation discount relative to companies that have strong governance but operate in more flexible legal environments. This is consistent with the hypothesis that over-monitoring and less flexibility in country regulations can generate costs, harm managerial initiative and lead to relatively lower returns and valuations. On the contrary, stronger country-level investor protection does not necessarily reduce the valuation discount of companies with weak corporate governance practices. These results suggest the existence of a threshold level above which stronger regulation has either negative effects for company outcomes (when the company is well governed) or neutral effects (when the company is poorly governed). In addition, we find that board independence and the existence and independence of board committees positively affect company performance in any legal regime, whereas less entrenched boards and better governance transparency practices have a significant performance impact only for companies operating in low investor protection countries.
Overall, our study argues that a straitjacket of very prescriptive corporate governance rules can, besides being costly in terms of direct outlays, impose indirect costs, limit managerial freedom of initiatives and thereby negatively affect the efficiency of investments and companies’ cost of capital. Thus, stronger legal protection does not necessarily increase performance. Our evidence has important policy implications, as it suggests that policymakers need to decide whether to regulate given current practices and, if so, how to regulate most effectively to improve companies’ performance and shareholders’ returns. For many observers, corporate governance is often considered motherhood and apple pie (or gelato): You cannot have too much of a good thing. However, we show that relentless “helicopter parenting” style regulation can produce negative externalities and outcomes that may be more harmful than beneficial. Or, as our 2010 article argues, “There can be too much of a good thing.”
Bebchuk, Lucian. 2009. Pay without performance: The unfulfilled promise of executive compensation. Harvard University Press.
Bruno, Valentina, and Stijn Claessens. 2010. Corporate governance and regulation: can there be too much of a good thing? Journal of Financial Intermediation 19 (4), 461-482.
Claessens, Stijn, and Laura Kodres, 2016, The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions, IMF working Paper, 14/46, forthcoming in Edward Balleisen, Lori Bennear, Kim Krawiec, and Jonathan Wiener (Eds.), Policy Shock: Regulatory Responses to Oil Spills, Nuclear Accidents, and Financial Meltdowns, Cambridge University Press.
Claessens, Stijn, 2016. Regulation and structural change in financial systems. Paper presented at the 2016 ECB forum on Central Banking, Sintra, Portugal. https://www.ecbforum.eu/en/content/programme/overview/programme-overview.html.
The Economist, February 18 2012. Over-regulated America. http://www.economist.com/node/21547789.
This post comes to us from Associate Professor Valentina Bruno at American University’s Kogod School of Business and Stijn Claessens, who is a senior adviser at the Federal Reserve Board. It is based on their article, “Corporate Governance and Regulation: Can There Be Too Much of a Good Thing?” which is available here. Views expressed in this post are those of the authors and should not be attributed to the Board of Governors of the Federal Reserve System or any other institution.