Corporate Governance

Topics: Corporate governance, Management, Board of directors Pages: 42 (14611 words) Published: August 19, 2013
Journal of Banking & Finance 22 (1998) 371±403

Corporate governance and board e€ectiveness
Kose John a, Lemma W. Senbet
a b



Stern School of Business, New York University, New York, NY 10012, USA Department of Finance, College of Business, University of Maryland, Tydings Hall, College Park, MD 20742, USA

Abstract This paper surveys the empirical and theoretical literature on the mechanisms of corporate governance. We focus on the internal mechanisms of corporate governance (e.g., corporate board of directors) and their role in ameliorating various classes of agency problems arising from con¯icts of interests between managers and equityholders, equityholders and creditors, and capital contributors and other stakeholders to the corporate ®rm. We also examine the substitution e€ect between internal mechanisms of corporate governance and external mechanisms, particularly markets for corporate control. Directions for future research are provided. Ó 1998 Elsevier Science B.V. All rights reserved. JEL classi®cation: G30; G32 Keywords: Corporate governance; Corporate ®nance; Internal and external mechanisms of corporate governance

``E€orts to reform company government have concentrated on making managers afraid. It is time now to make boards greedy'' [The Economist, August 9, 1997]

* 1

Corresponding author. Tel.: 1 301 405 2242; e-mail: This paper was an invited paper on the occasion of the JBF 20th anniversary.

0378-4266/98/$19.00 Ó 1998 Elsevier Science B.V. All rights reserved. PII S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 0 0 5 - 3


K. John, L.W. Senbet / Journal of Banking & Finance 22 (1998) 371±403

1. Introduction Corporate governance deals with mechanisms by which stakeholders of a corporation exercise control over corporate insiders and management such that their interests are protected. The stakeholders of a corporation include equityholders, creditors and other claimants who supply capital, as well as other stakeholders such as employees, consumers, suppliers, and the government. The professional managers, the entrepreneur, and other corporate insiders (we will refer to them collectively as ``managers''), control the key decisions of the corporation. Given the separation of ownership and control (or stakeholding and management) that is endemic to a market economy, how the stakeholders control management is the subject of corporate governance. Thus, the primary reason for corporate governance is the separation of ownership and control, and the agency problems it engenders. In Section 2, we describe the various types of agency problems caused by the separation of ownership and control. Since di€erent types of capital contributors and other stakeholders have di€erent types of pay-o€ structures from the ®rm, the con¯icts of interest that develop and the agency problems they cause are di€erent. In this survey, we will depart from convention and not simply view corporate governance mechanisms as a means to ameliorate managerial agency problems arising from con¯ict of interest between managers and equityholders. We will examine the role of corporate governance mechanisms in dealing with other classes of agency problems. The topic of corporate governance has attained enormous practical importance for at least three reasons. First, the eciency of the existing governance mechanisms in advanced market economies has been the subject of debate. For example, Jensen (1989, 1993) has argued that the internal mechanisms of corporate governance in the US corporations have not performed their job. He has advocated a move from the current corporate form to a much more highly levered organization, similar to a leveraged buyout (LBO). On the other hand, legal scholars, including Easterbrook and Fischel (1991) and Romano (1993), view the US mechanisms and the legal system in a favorable light. Second, there is an ongoing debate on the relative ecacy of the corporate governance systems...

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