Does Uncertainty About Economic Policy Prompt Boards to Change?

Economic policy uncertainty (EPU) measures the ambiguity that government officials introduce into fiscal, regulatory, or monetary policy (Baker, Bloom, and Davis, 2016).[1] EPU is intended to be a comprehensive measure of uncertainty, capturing ambiguity about a firm’s operating environment rather than serving simply as an early indicator of a recession or a weak economy. EPU spikes around close presidential elections, wars, the September 11 attacks, the collapse of Lehman Brothers, and the COVID-19 pandemic.

In our forthcoming paper in The Financial Review, we consider how boards of directors alter their structures to handle exogenous changes in uncertainty. EPU may pressure firms to ensure that their boards can monitor and give advice effectively in a changing environment. As Institutional Shareholder Services (ISS), Glass Lewis, and others emphasize, uncertain times magnify the importance of effective corporate governance while increasing the demands on directors’ time.

Prior academic research finds evidence of a trade-off between directors’ duty to monitor management and their responsibility to provide strategic advice. Exploring this potential trade-off is particularly interesting in the context of EPU. Exogenous changes to risk may shift the demand for board advising and monitoring, implying that advising and monitoring trade-offs may also change in response to EPU.

Board structure refers to the composition of boards and characteristics of the directors, including: the number of directors serving on the board; the percentage of independent, inside, executive, or female directors; and the busyness of independent directors,. The conventional wisdom is that boards rarely change their composition or the way they operate. However, the academic literature provides compelling evidence that board structures do evolve as the demand for monitoring or advising changes. For example, Linck, Netter, and Yang (2008) show that firms alter their board structures to mitigate agency conflicts.[2] Cicero, Wintoki, and Yang (2013) show that board structures change frequently to make boards more efficient economically.[3] Essentially, directors structure their boards to balance the costs and benefits of monitoring and advising.

Uncertainty is associated with fewer strategic corporate decisions on investments, mergers, or strategic alliances. If a board believes its company will make fewer such decisions, during times of uncertainty it may shift its structure to provide less advising capacity. In addition, the importance of monitoring may be magnified with EPU. Rising agency costs associated with uncertainty calls for greater monitoring. Likewise, uncertainty makes it difficult for boards to assess and evaluate CEO performance and increases their need for monitoring capabilities (Frye and Pham, 2020).[4] Thus, boards are likely to make monitoring a higher priority than advising in times of increasing uncertainty.

Using a large sample of publicly traded firms from 1996-2018, we show that boards do place greater emphasis on monitoring during times of uncertainty. We find that an increase in EPU leads boards to reduce their size, which may limit their capacity for advising but increase their monitoring efficiency. We also find that the mix of directors shows an increased focus on monitoring abilities. Specifically, boards increase the percentage of independent directors while decreasing the involvement of insiders and outside executives who are generally associated with advising. We find that the busyness of the directors decreases when EPU rises, which again supports an emphasis on monitoring rather than advising because busy directors may shirk their monitoring responsibilities.

Additionally, we show that several firm or industry specific factors moderate the effect of EPU on board changes. In general, boards that are already structured for enhanced monitoring make few or smaller changes to their board structures compared with firms with weaker monitoring structures.

Overall, we show that the exogenous environment affects director decisions. Boards enhance their own monitoring capacity to deal with ambiguity, supporting the idea that boards give their monitoring role priority over their advising role in times of increasing uncertainty.


[1] Baker, S. R., Bloom, N. & Davis, S. J. (2016). Measuring economic policy uncertainty. Quarterly Journal of Economics, 131, 1593–1636.

[2] Linck, J. S., Netter, J. M. & Yang, T. (2008). The determinants of board structure. Journal of Financial Economics, 87, 308-328.

[3] Cicero, D., Wintoki, M. B. & Yang, T. (2013). How do public companies adjust their board structures? Journal of Corporate Finance, 23, 108-127.

[4] See Frye, M. B., & Pham, D. T. (2020). Economic policy uncertainty and board monitoring: Evidence from CEO turnovers. Journal of Financial Research, 43, 675-703.

This post comes to us from professors Melissa B. Frye at the University of Central Florida and Duong T. Pham and Rongrong Zhang at Georgia Southern University. It is based on their recent article, “Board Monitoring and Advising Trade-offs Amidst Economic Policy Uncertainty,” available here.