Balancing act
1 Sep 09
How effective is good governance in reducing volatility? ICAS is about to publish research carried out by Dr Azizah Abdullah and Professor Mike Page which explores the links between governance and performance during turbulent conditions
by Dr Azizah Abdullah and Professor Mike Page
There have been profound changes in the ways in which large companies are directed and controlled over the past two decades. Listed companies now have half the board composed of independent directors; audit and nominations committees are universal; and, companies report on their governance and internal control. Such apparatus does not come without cost, so it is worthwhile to ask the question whether well governed companies perform better than apparently less well governed ones.
In research to be published by ICAS, we investigate how corporate governance was related to performance for large commercial and industrial companies from the peak of the stock market cycle in 1999-2000, through the trough in 2002-2003 to the beginnings of the upswing into the next cycle in 2004. This period is superficially very similar to the period bracketing the current “credit crunch”. During this volatile time, companies experienced very turbulent external conditions yet their governance was relatively stable.
There was a consistent trend towards smaller boards. In the initial phase of governance change starting in 1992, prompted by the Cadbury Report and then the Combined Code, large listed companies (FTSE 350) increased their board sizes by appointing non-executive directors. In the phase covered by our research, board sizes reduced as companies removed executive directors from boards in order to increase the proportion of independent non-executives, as required by the updated Combined Code. By 2004, the average board size had reduced to nine members made up of four executives and five non-executives, four of whom were independent.
Performance is volatile, but governance changes only slowly. We found that any relationship between governance and performance was time specific. For example, independence and board size were associated with high market to book ratios in the first half of the period, but not in the second half of the period. There was no consistent relationship between corporate governance characteristics and measures of overall performance.
Strangely, this is one of those cases where no news is good news. Suppose there was a clear relationship between good corporate performance and “good” corporate governance. It would mean that companies with “poor” governance could, apparently, increase shareholder value by moving to a better structure. The lack of such opportunities suggests that companies have moved towards good governance where it is of benefit to shareholders. Conversely, if there was a clear relationship between relatively poor performance and “good” governance, it would suggest that the costs of good governance exceeded the benefits to shareholders.
But the picture was not so reassuring when we looked at the relationship between risk and governance. We found little evidence that governance was effective in reducing the volatility of share prices or the chance of large adverse share price movements. As with the financial sector in the credit crunch, independent directors seem not to be a protection against companies adopting risky strategies. We also found that companies where the directors owned a large proportion of the shares tended to have a lower proportion of independent directors, even allowing for other factors such as size and industry. We think this area deserves further research and scrutiny by regulators.
Corporate Governance and Corporate Performance: UK FTSE 350 Companies will be published by ICAS (£15) in September and the full report and executive summary will also available to download free of charge from the ICAS website (www.icas.org.uk/page). This research was funded by The Scottish Accountancy Trust for Education and Research (SATER)
Mike Page is professor of accounting at the University of Portsmouth and Azizah Abdullah is a lecturer in accounting at Universiti Teknologi Mara, Malaysia.