Board Monitoring and Firm Risk

Abstract

An extensive finance literature has suggested that independent (outside) directors monitor firm management and thereby increase firm value. Monitoring by a firm's independent directors is, however, costly and the level of board monitoring should be endogenously determined as a function of firm characteristics. We show that a negative relationship between board monitoring and uncertainty is a direct implication of principal-agent models and arises because monitoring is less efficient in uncertain environments. Our model also shows that there is a positive relationship between the level of board monitoring and the output of the firm. We empirically examine the relationship between board monitoring and firm risk using a broad sample of firms over a five year period from 1997 to 2000. We find that board independence and monitoring is negatively related to firm risk and is positively related to output level. We also find a strong time trend with the level of board monitoring increasing over the sample period from 1997 to 2001. Firms, therefore, have responded to shareholder demands for increased board oversight even before the formal requirements imposed by the Sarbanes-Oxley act of 2002. In our empirical analysis we control for the CEO's bargaining power and the level of shareholder rights. We find that firms in which the CEO has longer tenure and greater equity ownership, have less board monitoring activity. We also find that board monitoring and shareholder rights are substitutes and there is a negative relationship between the level of board monitoring and shareholder rights. Overall, our theoretical and empirical results support the notion that the board of directors and its composition is endogenously determined as a function of firm characteristics.