Diversity in corporate boards is a hot topic. We contribute to the debate on the role of diversity by empirically documenting that greater national cultural diversity in corporate boards leads to lower performance at UK firms accounting for more than 95 percent of the market value of London Stock Exchange-listed companies. The negative impact is economically significant, with a reduction in return on equity of 1.43 percent for firms with higher levels of cultural diversity (those at or above the 75th percentile) versus firms with lower levels of cultural diversity (those at or below the 25th percentile). Why do we observe such a strong negative relationship?
In the academic literature, diversity is often referred to as a double-edged sword, meaning it can have positive and negative effects. In terms of positive attributes, diversity is seen as a means to bring different perspectives to the board, which will ultimately lead to better decision making. In the case of cultural diversity, these different perspectives may refer to different world views, different approaches to problem solving, and also variations in market-specific and cultural knowledge. In terms of negative attributes, diversity creates communication difficulties and may lead to personality clashes. Differences in points of view may be interpreted as personal attacks or the promotion of hidden agendas, which may lead to reduced effort and commitment to the group. In addition, diversity may reduce trust. These negative aspects are observed in the context of cultural diversity, where trust among members of the same culture is higher than among members from different cultures. Our empirical finding of the negative relationship between cultural diversity in corporate boards and firm performance indicates that cultural diversity makes boards less efficient.
There are several possible reasons why companies don’t address the negative effects of cultural diversity. First, in multicultural teams, conflicts may be hard to identify, as cultural differences are not easily observed. Second, diversity is generally assumed to be a good thing, and the positive aspects of diversity are often promoted by media, shareholders and regulators. For instance, the 2014 UK Corporate Governance Code articulates the importance of diversity beyond gender and race. Firms may try to improve their public image and conform to public expectations by adopting more culturally diverse boards. Indeed, over the sample period in our study (2002-2014), we observe that the percentage of firms with at least one foreign-national board member increased from 57 percent in 2002 to 72 percent in 2014.
Fortunately, the news is not all bad. Further analysis shows that the negative effects disappear in firms that have a high need for cultural diversity, because, for example, they have large amounts of foreign sales or operations abroad. We also observe that firms that operate in many different business segments do not experience the negative effect of cultural diversity, suggesting that the advantages of having different knowledge sets required to run complex businesses offset the negative aspects associated with cultural diversity.
Finally, we observe that the negative impact of cultural diversity is more prevalent among independent directors. This observation can be explained in the context of the literature on organizational learning and culture. A strong culture at an organization can be used to overcome national cultural differences among directors who are also members of management. Since independent directors are not part of that culture, the frictions that come with cultural differences can be harder to resolve. Directors who serve as company executives also meet more regularly than independent directors, thus improving their ability to recognize and deal with cultural differences and increase levels of trust.
Can firms benefit from cultural diversity in corporate boards? Our findings indicate that unlocking the positive aspects of cultural diversity on corporate boards can be difficult. The relevance of foreign directors’ knowledge and expertise to the firm’s needs seems to be the key to making cultural diversity an asset. Having cultural diversity on boards, however, might also require dealing with disruption and other negative consequences and may require initiatives that improve communication and promote integration among board members. For practical purposes, our results provide a warning about idealizing cultural diversity and highlight the need for selecting board members based on their expertise and the needs of the company.
This post comes to us from Professor Bart Frijns, Senior Lecturer Olga Dodd and Helena Cimerova, a post-doctoral fellow, at Auckland University of Technology, New Zealand. It is based on their paper, “The Impact of Cultural Diversity in Corporate Boards on Firm Performance,” forthcoming in the Journal of Corporate Finance and available here.