The Impact of Internal Corporate Governance Mechanisms on the Performance of Firms: Evidence From the UK and Germany

Abstract

This thesis examines the effectiveness of corporate governance regulations in the UK’s and Germany’s corporate governance systems. The UK and Germany are chosen for this study because they exhibit different board structures, legal systems and capital markets. The differences and similarities across these two corporate governance systems provide an opportunity to explore the effectiveness of firm-level and country-level corporate governance regulations in different corporate governance systems. Using a sample of 120 firms from the UK and Germany for the period 2007-2011, this thesis investigates: (a) the relationship between internal corporate governance mechanisms and the performance of firms; and (b) the types and quality of explanations reported for non-compliance with the corporate governance codes. Unlike previous studies, this study focuses on compliance and the explanations reported for non-compliance with a corporate governance code. The concepts of ‘comply’ and ‘explain’ are claimed to be the two most important pillars of an effective corporate governance system. Using an index-based approach, this thesis develops a ‘comply or explain’ index for each firm in the sample. The index captures the level of compliance as well as the quality of explanations reported for non-compliance with the corporate governance codes. Furthermore, a generalised method of moments (GMM) model is used to investigate the govemance-performance relationship and a mechanistic (quantitative) content analysis method is applied to examine the quality of explanations reported in response to non-compliance with the corporate governance codes. The results from the univariate analysis reveal that the UK and Germany exhibit significant differences in terms of compliance with the corporate governance codes, board structures and ownership structures of firms. The results for govemance-performance relationship show that the ‘comply or explain’ index is significantly and positively associated with the operating performance of German firms, while in the UK, the ‘comply or explain’ index has a positive impact on the market valuation (Tobin’s Q) of UK firms. However, the impact of the ‘comply or explain’ index is statistically not significant for the accounting-based measure of firm performance in the UK, and for the market-based measure of firm performance in Germany. The results provide some evidence that the quality of corporate governance (measured by the ‘comply or explain’ index) has positive implications for firms’ performance in both countries. The findings are different for the accounting-based and market-based measures of firm performance, and the mixed empirical evidence is supported by the different theories of corporate governance. For instance, board structure (the percentage of non-executive directors) is positively associated with the operating performance (ROA) of UK firms and with the market valuation (Tobin’s Q) of German firms. However, board structure is negatively associated with the market-based measure of firm performance in the UK. The positive and negative impact of board structure on different measures of firm performance can be explained through the lens of agency theory and stewardship theory, respectively. The results for blockholders’ ownership show that non-institutional blockholders have a positive impact on the performance (ROA and Tobin’s Q) of German firms. Institutional blockholders’ ownership is positively associated with the operating performance of firms in the UK. However, the impact of institutional blockholders’ ownership is negative for the market-based measure of firm performance in both countries, which raises concerns about the monitoring role of institutional shareholders in both countries. The results from the content analysis of 600 corporate governance reports show that non-compliant firms across the UK and Germany do exploit the ‘explain’ option and flexibility granted by the ‘comply or explain’ principle. The explanations reported in response to non-compliance are largely uninformative and the content of such explanations mostly remained similar over the time and across the firms. Overall, the mixed empirical evidence on the relationship between governance and firm performance indicate that the governance-performance relationship cannot be examined through the lens of a single and universal theory of corporate governance. A multiple theoretical perspective could be very helpful in examining the governance-performance relationship in different corporate governance systems. In fact, investigating the complex governance-performance relationship using multiple theories and multiple methods may take us closer to developing a more comprehensive theory of corporate governance.