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The Bad Side of Good Governance

One of the foundations of good governance is the use of high-powered incentives, typically stock options or annual bonuses, as a way to align the interests of senior managers and shareholders. But the authors found that firms using compensation incentives fared much worse during the Great Recession—which they think is likely because executives took excessive risks and tried to maximize their own short-term pay in the face of a rapidly declining economic situation.

All that said, some aspects of good governance did indeed pay off during both the pre-crisis period and the downturn itself. Namely, the better the quality of a country’s legal system, the better that firms in that country performed, the authors found. Similarly, the level of creditors’ rights protection, which had no measurable impact during normal financial times, had a positive influence once the economy began to sink, when such laws clearly instilled investors with enough confidence to continue backing companies.

The authors had expected to find that relational owners, such as families or parent corporations, would be able to prop up their firms during adverse periods. But no such evidence emerged, probably because relational owners are prone to overmonitoring and meddling in senior management’s decision-making process. Like too-vigilant boards, owners with an incentive to interfere could inhibit the managers they appointed to make the big strategic calls.

The authors note that financial downturns often result in regulations requiring more complex and stringent disclosure rules. But this continued strengthening of governance practices could be too much of a good thing when crises actually occur.

For example, the authors point to their finding that stock options and variable payment plans for executives have largely neutral effects in a normal economic climate, but prove damaging in downturns. This is especially worrisome because equity-based pay packages have been found to increase executives’ leveraging of a firm’s capital. The level of firm leverage—or debt against assets—had the largest negative impact on firm performance throughout the Great Recession, the authors found. In tandem, therefore, leverage and high-powered incentives “may prove to be a particularly combustible recipe in adverse financial circumstances,” the authors write.

As financial systems around the world become more intertwined with each passing year, a company’s ability to respond to contagious economic shocks is likely to become more and more important. Accordingly, boards may need to rethink their approach to governance.

“The implication is that corporate governance prescriptions could be better optimized for periods of munificence, where the primary emphasis is upon maximizing shareholder wealth,” the authors write, “and for periods of adversity, where the emphasis may need to shift toward restoring stability and re-establishing corporate resilience.”

Bottom Line:
Some widely lauded elements of the good governance approach actually proved harmful during the Great Recession. Boards should ensure that their top managers have enough leeway and authority to respond quickly to changing circumstances.

Author Profile:

  1. Matt Palmquist is a freelance journalist based in Oakland, Calif.


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