How Do Independent Directors Affect Corporate Risk-Taking?

Excessive risk-taking by corporate executives is often blamed for triggering the financial crisis of 2008. Therefore, it is crucial to understand the nature of corporate risk-taking so as to prevent, or reduce the likelihood of, a future crisis. In theory, managers, who represent shareholders, are expected to act in the best interest of the shareholders and only take risks that maximize shareholder wealth. In reality, managers may take either too little risk or too much.

First, managers may adopt corporate policies and strategies that are too conservative, because their human capital is invested in the company. A high degree of risk-taking increases the chances of the firm going bankrupt, and of managers losing their jobs. Managers are risk-averse and therefore favor more conservative policies. On the other hand, managers may take too much risk. This is because the vast majority of executive compensation contracts make pay contingent on firm performance. The lure of higher pay can encourage managers to take more risk.

One of the critical responsibilities of boards of directors is to ensure that the degree of corporate risk-taking by managers is optimal for shareholders and does not reflect managers’ own risk aversion. It is generally believed that boards are more effective with independent outside directors, who tend to be more objective than directors who work for the company. That’s one reason that the Sarbanes-Oxley Act (SOX) requires boards to have a majority of independent directors. Boards with more independent directors are more likely to bring the degree of risk-taking closer to the level that maximizes shareholder wealth.

The best way to determine the effect of board independence on corporate risk-taking is to run a randomized experiment, where firms are assigned varying degrees of board independence. Then, an inference can be made about the relation between board independence and the degree of risk-taking. Unfortunately, such an experiment is impossible, because researchers can’t tell firms what to do. It is possible, however, to use a natural experiment based on SOX. Enacted in 2002, SOX required boards with a majority of inside directors to shift the balance by bringing in more independent directors, while not requiring any changes to boards already in compliance with the law.

We measure the degree of risk-taking by measuring the volatility of daily stock returns. Firms with riskier policies and strategies have more volatile stock returns than firms with more conservative policies. Using a number of econometric tests, we find that firms forced to increase the number of independent directors on their boards take significantly fewer risks.  In particular, board independence diminishes total risk and firm-specific risk by 24.87 percent and 12.60 percent, respectively. Our results are consistent with the argument that managers tend to take excessive risk. However, the more stringent monitoring brought about by increased board independence forces managers to take significantly less risk. Because our research design is based on a natural experiment, it is more likely to show a causal effect of board independence on risk-taking. In other words, board independence causes, and is not merely associated with, less risk-taking.

Our research makes several contributions to the literature. First, we show that board independence is a significant governance mechanism that helps reduce excessive risk-taking. Second, our research improves our understanding of the effects of SOX, which also include decreased corporate risk-taking. Third, we contribute to the literature on causation by showing how a natural experiment like the passing of a law can establish causation and not just correlations or associations.

This post comes to us from professors Pornsit Jiraporn and Sang Mook Lee at Pennsylvania State University. It is based on their recent article, “How Do Independent Directors Influence Corporate Risk-Taking? Evidence from a Quasi-Natural Experiment,” available here.

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