1. I
We review the recent corporate governance literature that
examines the role of nancial reporting in resolving agency
conicts among a rm’s managers, directors, and capital
providers.
1
We view governance as the set of contracts that
help align managers’ interests with those of shareholders,
and we focus on the central role of information asymmetry
in agency conicts between these parties. In terms of the
firm-specific information hierarchy, the literature typically
views management as the most informed, followed by outside
directors, then shareholders. We discuss research that examines
the role of nancial reporting in alleviating these information
asymmetries and the role that nancial reporting plays in the
design and structure of incentive and monitoring mechanisms
to improve the credibility and transparency of information.
Most of this research is large-sample and does not pay
1
Certainly, nancial reporting provides valuable information in other
contracting relationships beyond those involving capital providers (suppliers,
customers, auditors, regulators, tax authorities, etc.). In this article, we conne
our discussion to contracts involving capital providers for three reasons:
(1) they are a major focal point in the literature, (2) the literature on agency
conicts between managers and capital providers constitutes a natural,
interconnected subset of articles that lends itself to a relatively cohesive
discussion, and (3) we wish to keep the scope of our review manageable.
particular attention to industry-specific characteristics that may
inuence a rm’s governance structure. For example, the
firm-specific governance structure and nancial reporting
systems of nancial institutions and other regulated industries are
expected to be endogenously designed. e design is also
expected to be conditional on (in other words, take into account)
the existence of certain external monitoring mechanisms (for
example, regulatory oversight and constraints), which may either
substitute for or complement internal mechanisms, such as the
board. Similarly, the rationale for regulation in certain industries
(for example, the existence of natural monopolies) is also
expected to inuence rms’ governance structures. ese and
other dierences between rms in dierent industries suggest
that inferences drawn from studies spanning multiple industries
may not necessarily hold for specic industries or research set-
tings.
2
e same point can also be made about extrapolating
inferences drawn from U.S. rms to their international counter-
parts. Dierent countries have their own (oen unique) laws,
regulations, and institutions that inuence the design, operation,
and ecacy of a rm’s governance mechanisms as well as the
output of its nancial reporting system.
2
Further underscoring this concern, it is not uncommon for governance
studies to exclude rms that belong to historically regulated industries, such
as nancial institutions and utilities.
FRBNY Economic Policy Review / August 2016 107
Christopher S. Armstrong, Wayne R. Guay, Hamid Mehran, and Joseph P. Weber
T R F
R T
C G
Christopher S. Armstrong is an associate professor of accounting and
Wayne R. Guay the Yageo Professor of Accounting at the Wharton School of
the University of Pennsylvania; Hamid Mehran is an assistant vice president
at the Federal Reserve Bank of Ne w Yor k ; Joseph P. Weber is the
George Maverick Bunker Professor of Management and a professor of
accounting at the MIT Sloan School of Management.
[email protected]penn.edu
[email protected]penn.edu
hamid.mehran@ny.frb.org
is article draws on Armstrong, Guay, and Weber (2010). e authors are
grateful to Douglas Diamond for helpful discussions. e views expressed are
those of the authors and do not necessarily reect the position of the Federal
Reserve Bank of Ne w Yo rk or the Federal Reserve System.
To view the authors’ disclosure statements, visit https://www.newyorkfed.org/
research/author_disclosure/ad_epr_2016_role-of-financial-reporting
_armstrong.html
108 Financial Reporting and Transparency in Corporate Governance
We also highlight the distinction between formal and
informal contracting relationships, and discuss how both
play an important role in shaping a rm’s overall governance
structure and information environment. Formal contracts,
such as written employment agreements, are oen quite
narrow in scope and are typically relatively straightforward
to analyze. Informal contracts, govern implicit multiperiod
relationships that allow contracting parties to engage in a broad
set of activities for which a formal contract is either impractical
or infeasible. For example, the complexity of the responsibilities
and obligations of a rm’s chief executive ocer make it di-
cult to dra a complete state-contingent contract with the board
that species appropriate actions under every possible scenario
the rm could face. Consequently, although some CEOs have
formal employment contracts, these contracts are necessarily
incomplete and relatively narrow in scope. As a result, the board
and the CEO develop informal rules and understandings that
guide their behavior over time.
Much of the governance literature emphasizes informal
contracting based on signaling, reputation, and certain
incentive structures. e general conclusion in this literature
is that nancial reporting is valuable because contracts can be
more ecient when the parties commit themselves to a more
transparent information environment.
Another key theme of this article is that a rm’s gover-
nance structure and its information environment evolve
together over time to resolve agency conicts. at is, certain
governance mechanisms and nancial reporting attributes
work more eciently within certain operating environments.
Consequently, one should not necessarily expect to see
every rm converge to a single dominant type of corporate
governance structure or compensation contract, or to adopt a
similar nancial reporting system. Instead, one should expect
to observe heterogeneity in these mechanisms that is related to
dierences in rms’ economic characteristics. In our opinion,
the corporate governance literature seems to be unduly
burdened by the normative notion that certain governance
structures can be categorically labeled as “good” or “bad.”
3
In Section 2, we briey discuss the general nature of con-
tracts related to governance and the properties of nancial
reporting that are relevant to various governance structures.
Section 3 discusses the role of information asymmetry and
credible commitment to transparent nancial reporting in
corporate governance. In Section 4, we discuss the relation-
ship of regulatory supervision and oversight to the governance
3
Governance structures frequently characterized as categorically (or
unconditionally) bad include a board with a high proportion of inside
directors, a CEO who also serves as chairman of the board, a CEO with
relatively low equity incentives, and relatively weak shareholder rights.
structure of rms in the banking and nancial services
sectors. We also discuss how certain governance mechanisms
can facilitate the production of information and enhance
transparency, which may in turn contribute to nancial stabil-
ity. Section 5 provides brief concluding remarks.
2. T R F R
C G
We view corporate governance as the subset of a rm’s
contracts—both formal and informal—that help align the
interests of managers with those of shareholders. erefore,
corporate governance consists of the mechanisms by
which shareholders ensure that the interests of the board of
directors and management are aligned with their own.
4
We
also view this denition to be broad enough to encompass all
of the rm’s contracts that assist in aligning the incentives
of the rm’s shareholders, directors, and managers. For
example, when a rm’s creditors have the right to monitor
the rm’s nancial reporting, those creditors may help align
the interests of managers and shareholders; therefore, a debt
contract that allows such monitoring could constitute a
governance mechanism.
Corporate governance research typically focuses on one
of two types of agency problems that give rise to a conflict
of interest between managers and shareholders. The first
type arises when the interests of the board of directors and
shareholders are assumed to be aligned (that is, the board
is composed of individuals who make decisions that are
in the best interest of shareholders), but the interests of
management are not aligned with those of the board and
shareholders. Research on this type of conflict includes
studies that examine executive compensation plans, incen-
tive structures, and other monitoring mechanisms used to
ensure that managers act in the interest of shareholders.
5
The second type of agency problem arises when the
interests of the board and management are assumed to be
aligned with each other (that is, the board is composed of
directors who are beholden to the CEO), but their interests
are not completely aligned with the interests of sharehold-
ers. Research on this type of conflict includes studies on
4
This definition is broadly consistent with the views of authors such
as Jensen (1993), Mehran (1995), Shleifer and Vishny (1997), Core,
Holthausen, and Larcker (1999), Holderness (2003), and Core, Guay, and
Larcker (2003).
5
See, for example, Ahmed and Duellman (2007), Carcello and Neal (2003),
and Francis and Martin (2010).
FRBNY Economic Policy Review / August 2016 109
board independence, entrenched CEOs, and shareholder
actions to influence, challenge, or overturn board decisions
(such as shareholder proxy contests, class action lawsuits,
and “say-on-pay” proposals).
6
Corporate governance mechanisms that have the potential
to reduce these agency conicts include both formal and
informal contracts. Formal contracts—including corporate
charters, employment contracts, exchange listing require-
ments (such as board independence rules), and executive
stock ownership guidelines—constrain the contracting
parties’ behavior and specify certain responsibilities and
requirements in the event of certain foreseeable contingen-
cies. ese contracts, however, tend to be relatively narrow in
scope. Informal contracts constitute a broad set of unwritten
or implicit arrangements that allow the contracting parties
to engage in activities that would otherwise be either pro-
hibitively costly or infeasible to memorialize in a formal
contract. Many important governance functions are carried
out via informal contracts. Boards establish reputations
regarding their independence from management, their
expertise in advising management, and their work ethic.
Reputations develop over time, in part on the basis of board
characteristics such as the proportion of inside versus outside
directors, the size of the board, the expertise of directors, and
the number of board meetings, as well as by the consistency
of the board’s decision-making processes and its stewardship
of shareholder value. As we explain below, various attributes
of a rm’s nancial reporting play a key role in both formal
contracts (in part because these contracts are sometimes
based on nancial reporting numbers) and informal con-
tracts (because of the importance of nancial reporting and
credible disclosure in establishing reputations and sustaining
working relationships).
A key objective of this article is to highlight the important
role that nancial reporting plays in reducing the infor-
mational advantage of managers over outside directors,
shareholders, and other stakeholders (for example, regulators).
6
See, for example, Klein (2002b), Zhao and Chen (2008), and Duchin,
Matsusaka, and Ozbas (2010).
Managers typically have better firm-specific information than
outside directors and shareholders, but they are not always
expected to truthfully report information that is detrimen-
tal to their personal interests, such as information about
poor performance or their consumption of private benets
(Verrecchia 2001).
Boards, which largely consist of outside directors, and
shareholders, are therefore typically assumed to be at an infor-
mational disadvantage when monitoring managers. Jensen
describes these informational problems as follows:
Serious information problems limit the eectiveness
of board members in the typical large corporation.
For example, the CEO almost always determines the
agenda and the information given to the board. is
limitation on information severely hinders the ability
of even highly talented board members to contribute
eectively to the monitoring and evaluation of the
CEO and the company’s strategy. (1993, 864)
Indeed, in the absence of information asymmetries, boards
would likely be able to mitigate many, if not most, agency
conicts with managers. e reason is that boards retain con-
siderable discretion to discipline managers and could therefore
take immediate action upon receiving new information. us,
one potential role for nancial reporting is to provide outside
directors and shareholders with relevant and reliable infor-
mation to facilitate their mutual monitoring of management
and, in the case of shareholders, their monitoring of directors.
Further, to the extent that nancial reporting serves to reduce
information asymmetries, one expects to observe correspond-
ing variation in the governance mechanisms that are associated
with nancial reporting characteristics.
3. T R I
S C B
e board of directors plays a key role in monitoring
management and in constructing mechanisms that align
managers’ objectives with shareholders’ interests. A large
body of theoretical and empirical literature examines
the role of boards in performing two broad functions:
(1) advising senior management, which requires expertise
and firm-specific knowledge, and (2) monitoring senior
management, which additionally requires independence
from management.
7
e ways in which boards are structured
7
For example, see Fama and Jensen (1983), Raheja (2005),
Boone et al. (2007), Drymiotes (2007), Lehn, Patro, and Zhao (2009),
Linck, Netter, and Yang (2008), and Harris and Raviv (2008).
Corporate governance consists of the
mechanisms by which shareholders
ensure that the interests of the board of
directors and management are aligned
with their own.
110 Financial Reporting and Transparency in Corporate Governance
to achieve these goals—especially the latter—has been the
subject of considerable research, with the distinction between
outside and inside directors being the most commonly
examined dimension of board structure.
Corporate boards typically consist of both outside
and inside directors.
8
For example, in a broad sample of
U.S. rms that were publicly traded between 1990 and 2004,
Linck, Netter, and Yang (2008) found 67 percent to be the
median percentage of outside directors on a board. Outside
directors are typically experienced professionals, such as
CEOs and executives of other rms, former politicians and
regulators, university deans and presidents, and successful
entrepreneurs. e value of having outside directors on the
board derives, in part, from their broad expertise in areas
such as business strategy, nance, marketing, operations,
and organizational structure. Further, outside directors can
bring an independence that carries with it an expectation of
superior objectivity in monitoring management’s behavior.
eir diligence in this respect may stem partially from the
monetary incentives associated with serving as a director
(Yermack 2004), but possibly even more important may be
their desire to enhance, cultivate, and protect their signicant
personal reputational capital.
Inside directors, who are typically executives of the rm, can
facilitate eective decision making because they are a valuable
source of firm-specific information about constraints and
opportunities (see, for example, Raheja [2005], Harris and Raviv
[2008], and Adams, Hermalin, and Weisbach [2010]). As Jensen
and Meckling (1992) note, the allocation of decision (or control)
rights within an organization is a fundamental building block of
organizational structure. And because it can be costly to transfer
information within the corporate hierarchy, it can be ecient
to assign decision rights to the individuals who possess the
information necessary to best make decisions, even in the face of
agency conicts (Aghion and Tirole 1997). In addition to their
decision-making responsibilities, inside directors can also be
particularly helpful in educating outside directors about the rm’s
activities (Fama and Jensen 1983). Inside directors, who typically
hold relatively large amounts of the rm’s stock and options, as
8
Pursuant to Item 470(a) of Regulation S-K of the U.S. Securities and
Exchange Commission, rms must disclose whether each director is
“independent” within the denition prescribed by the exchange on which the
rm’s shares are traded. Directors are typically classied as insiders, outsiders,
and aliates (or gray directors). Insiders are current employees of the rm,
such as the CEO, CFO, president, and vice presidents. Outsiders have no
aliation with the rm beyond their membership on its board of directors.
Aliates are former employees of the rm, relatives of its CEO, or those who
engage in signicant transactions and business relationships with the rm as
dened by Items 404(a) and (b) of the regulation. Directors on interlocking
boards are also considered to be aliated, where interlocking boards are
dened by Item 402(j)(3)(ii) as “those situations in which an inside director
serves on a non-inside director’s board.”
well as have their human capital tied to the rm, may also have
stronger incentives than outside directors to exert eort and to
maximize shareholder value.
At the same time, however, inside directors are potentially
conicted in their incentives to monitor because of their lack of
independence from the CEO and a desire to protect their own
private benets.
9
Further, even though well-informed outside
directors are likely to be more eective in advising the CEO,
insiders may be reluctant to share their information if it will
be used to interfere with the CEO’s strategic decisions (Adams
and Ferreira 2007). is scenario is particularly true if the
information could be used to discipline the executives or to
curtail their private benefits.
Holmstrom (2005, 711-2) provides a succinct charac-
terization of the issues related to information ow between
management and outside directors:
Getting information requires a trusting
relationship with management. If the board
becomes overly inquisitive and starts questioning
everything that the management does, it
will quickly be shut out of the most critical
information flow—the tacit information that
comes forward when management trusts that
the board understands how to relate to this
information and how to use it. Management will
keep information to itself if it fears excessive board
intervention. A smart board will let management
have its freedom in exchange for the information
that such trust engenders. Indeed, as long as
management does not have to be concerned
with excessive intervention, it wants to keep
the board informed in case adverse events are
encountered. Having an ill-informed board is also
bad for management, since the risk of capricious
intervention or dismissal increases.
9
However, see Drymiotes (2007) for a situation in which an increase in
the number of inside directors might actually improve the eciency of the
board’s monitoring role. In his model, outside directors have an incentive to
shirk their monitoring duties and to shortchange the CEO with respect to
his performance ex post. Inside directors, who represent the CEO’s interests,
can commit themselves to expending monitoring eort ex post, thereby
increasing the CEO’s incentive to exert productive eort.
Outside directors can bring an
independence that carries with it an
expectation of superior objectivity in
monitoring management’s behavior.
FRBNY Economic Policy Review / August 2016 111
us, a key advantage of inside directors is also a key
disadvantage of outside directors: the dierential cost and dif-
culty of obtaining adequate information with which to make
decisions. Such information transfer between insiders and
outsiders is not trivial, and it is the focus of much of the liter-
ature on corporate governance. Outside directors are typically
busy individuals who already have other demands on their
time. It is unrealistic to expect that an outside director can
or will invest the time and eort necessary to become as well
informed as the rm’s executives. Further compounding these
informational problems is the fact that outside directors must
largely rely on the executives they are monitoring and advising
to provide them with the information necessary to facilitate
eective corporate governance, although auditors, regulators,
analysts, the media, and other information intermediaries
may also assist outside directors in this regard.
Bushman et al. (2004, 179) summarize the trade-offs in
choosing the relative proportion of inside and outside direc-
tors on a board:
An important question of board composition
concerns the ideal combination of outside and inside
members. Outsiders are more independent of a rm’s
CEO, but are potentially less informed regarding rm
projects than insiders. Insiders are better informed
regarding rm projects, but have potentially distorted
incentives deriving from their lack of independence
from the firm’s CEO.
us, a board composed entirely of insiders may not be
eective because of the potential for allowing managerial
entrenchment. Conversely, a board with no insiders may not
be eective if the directors have a limited understanding of
the rm with no way to remediate this informational dis-
advantage. Although researchers have advanced a variety of
hypotheses related to the optimal mix of inside and outside
directors (Hermalin and Weisbach 2003; Adams, Hermalin,
and Weisbach 2010), we focus our discussion on those
related to the information environment. In general, these
information-based hypotheses predict that when outside
directors face greater information acquisition and processing
costs, they will be less eective advisors and monitors, and are
less likely to be invited to sit on boards.
Regarding the board’s advisory role, a common prediction
is that in rms with signicant investment opportunities
and complex investments—such as substantial research and
development (R&D), and intangible assets—considerable
firm-specific knowledge may be necessary to eectively
advise management. In these situations, the informational
advantage that insiders have over outsiders may impede
the advisory role of outside directors and lead to a greater
proportion of inside directors (see, Coles, Daniel, and
Naveen [2008]).
With respect to the board’s monitoring and oversight
responsibilities, hypotheses frequently emphasize that the
rm’s operations and information environment inuence the
monitoring costs and benets of certain board structures.
Specically, it has been argued that rms in more uncertain
business environments—such as high-growth rms with
substantial investment in R&D, intangible assets, and earnings
and stock price volatility—are more dicult (that is, costly)
to monitor, in large part because of greater information
asymmetries between managers and outside directors (see,
for example, Demsetz and Lehn [1985]; Gillan, Hartzell, and
Starks [2006]; and Coles, Daniel, and Naveen [2008]). Because
it is costly for outside directors to acquire and process the
information necessary to eectively monitor managers, rms
characterized by greater information asymmetry between
managers and outsiders are predicted to have a higher propor-
tion of inside directors.
A growing body of empirical literature examines the
relation between information processing costs and board
structure.
10
Information acquisition and processing costs are
generally thought to increase with information asymmetry, where
information asymmetry (and monitoring diculty in general)
is typically measured using proxies such as the market-to-book
ratio (or Tobin’s Q), R&D expenditures, stock-return volatility,
rm size, number of analysts, analyst forecast dispersion, and the
magnitude of analyst forecast errors.
Across a variety of research designs and samples, empirical
evidence generally supports the idea that the proportion of
outside directors is lower at rms with greater information
asymmetry between insiders and outsiders, and at rms where
idiosyncratic (that is, firm-specific) knowledge is more likely
to be important (see, for example, Linck, Netter, and Yang
[2008]; Lehn, Patro, and Zhao [2009]; and Cai, Qian, and
10
See, for example, Boone et al. (2007), Coles, Daniel, and Naveen (2008),
Linck, Netter, and Yang (2008), Lehn, Patro, and Zhao (2009), and Cai, Qian,
and Liu (2009).
It is unrealistic to expect that an outside
director can or will invest the time and
effort necessary to become as well
informed as the rm’s executives.
112 Financial Reporting and Transparency in Corporate Governance
Liu [2009]). Although the empirical evidence is largely con-
sistent, establishing the direction of causality of this relation
is more elusive.
A recent study by Armstrong, Core, and Guay (2014)
attempts to discern the direction of causality by examining
regulatory requirements that require certain rms to increase
their proportion of outside directors. ey nd evidence that
a mandatory increase in the proportion of outside directors
is associated with a decrease in information asymmetry, as
measured by an increase in the frequency and precision of
management forecasts and an increase in coverage by nancial
analysts. Armstrong, Core, and Guay (2014) interpret their
results as evidence that rms can and do alter certain aspects
of their transparency to accommodate the information
demands of independent directors.
In a related study, Duchin, Matsusaka, and Ozbas (2010)
nd that regulations that increase the proportion of outside
directors resulted in lower rm performance when information
acquisition costs are high. In other words, because some rms
optimally have a smaller proportion of independent directors,
regulators should use caution when considering whether to
require rms to decrease insider representation on their boards.
e results of these studies are inconsistent with the
view oen articulated by researchers that boards with a
higher percentage of outside directors facilitate better gover-
nance by acting to ensure lower information asymmetry with
management. e results instead suggest that rms’ inherent
information transparency, which is largely dictated by char-
acteristics of their operating environment, drives the choice
regarding the optimal proportion of outside directors.
Another aspect of board structure that has received
attention in the literature is the CEO’s role on the board—
particularly whether the CEO is also the chairman of the
board, as is currently the case for about 60 percent of the
rms in the Standard & Poor’s 500 index. Brickley, Coles, and
Jarrell (1997) argue that the prospect of becoming the chair-
man of the board acts as an incentive mechanism for CEOs,
suggesting that more successful and talented CEOs are more
likely to be awarded chairmanship of the board. A prediction
more closely related to our discussion is that because CEOs
typically have the most detailed firm-specific information,
CEOs are more likely to be delegated greater control at rms
with greater information asymmetry between insiders and
outsiders (Brickley, Coles, and Linck 1999).
Some studies also predict that the CEO’s ability inuences
the evolution of board independence. In particular, CEOs
with superior ability and a history of strong performance may
acquire signicant bargaining power, which they can use to
surround themselves with loyal directors, thereby reducing
the independence of the board (Hermalin and Weisbach
1998). At the same time, shareholders may decide that more
board independence is necessary to monitor a powerful CEO,
particularly when information asymmetry has the potential to
lead to agency conicts (although the feasibility of structuring
a strong independent board in this situation is an empirical
question). Collectively, these CEO-related hypotheses do not
lead to an unambiguous prediction about the relation between
information transparency and the combined roles of CEO
and chairman. Accordingly, it may not be surprising that
Linck, Netter, and Yang (2008) fail to nd a signicant relation
between information asymmetry and the incidence of the
combined roles of CEO and chairman.
Even if we accept the premise that outside directors
require high-quality information to perform their monitor-
ing and advisory roles, they are unlikely to know precisely
the extent of their information disadvantage; hence they
must rely on credible commitment mechanisms to ensure
that the information environment is transparent. at
raises the question of how managers can credibly pledge to
truthfully convey (or how they can be compelled by outside
directors, shareholders, and other parties to so convey) their
private information about the rm’s activities and nancial
health. Leuz and Verrecchia (2000) provide a lucid discus-
sion of the important distinction between a commitment
to disclosure and voluntary disclosure. e former is an
ex ante decision to provide information regardless of its
content, whereas the latter is an ex post decision of whether
to provide information aer observing its content. e
authors discuss a commitment to disclosure in the context
of a rm’s cost of capital, but their arguments translate to the
governance setting, in which boards require mechanisms
to compel managers to disclose information regardless of
whether doing so is in the managers’ interests.
e accounting literature on board structure has identied
several mechanisms that entail a commitment to transparent
nancial reporting, including:
• committing to report timely nancial
accounting information in general (for example,
earnings timeliness);
CEOs are more likely to be delegated
greater control at rms with greater
information asymmetry between
insiders and outsiders.
FRBNY Economic Policy Review / August 2016 113
• making a more specic commitment to report
information about losses in a timely manner (for
example, conservative nancial reporting);
• hiring a high-quality auditor who reports to an
independent audit committee;
• inviting nancially sophisticated outsiders to sit
on the board, and;
• maintaining or encouraging the monitoring
eorts of more active investors.
3.1 Timeliness of Financial Reports
Bushman et al. (2004) note that outside directors require
timely information to assist them in carrying out their
monitoring and advising responsibilities, and timely
nancial reporting in general, and the timely reporting of
earnings in particular, have the potential to help satisfy these
informational demands. However, the authors discuss the
diculty in formulating a prediction with respect to the
relation between the timely reporting of earnings and board
structure. On one hand, the foregoing theoretical arguments
suggest that outside directors are likely to be less eective at a
rm that has not made a commitment to reduce information
asymmetry between insiders and outsiders. us, one might
expect to nd a positive relation between the proportion of
outside directors and timely nancial reporting (as a proxy for
low information asymmetry).
11
On the other hand, Bushman
et al. also argue that low transparency can increase the scope
for agency conicts between shareholders and managers,
thereby necessitating a greater proportion of outside directors
to monitor management in situations where earnings
are less timely.
With regard to the latter argument, it is instructive to
consider how outside directors can be eective monitors
in the face of low transparency. One possibility might be
that low transparency is “correctable” and that outside
directors will work to improve transparency so that they
can more eectively monitor and advise management. If
11
Financial accounting properties such as earnings timeliness may or may not
be good proxies for information asymmetry between managers and outside
directors. Earnings timeliness is likely to be inuenced by both rm- and
industry-specic characteristics as well as by manager-specic characteristics.
us, low earnings timeliness does not necessarily imply that a company has
substantial information asymmetry between managers and outside directors.
For example, even when managers are doing their best to convey their private
information, they may be unable to credibly convey relevant and reliable
information about their rm through the nancial reporting process if their
rm is growing fast in an uncertain business environment.
this were true, however, the negative relation between earn-
ings timeliness and outside directors should be temporary
(observed only until the outside directors correct the
transparency problems). Possibly as a result of these con-
icting forces, Bushman et al. (2004) fail to nd a signicant
relation between earnings timeliness and the proportion of
outside directors.
3.2 Conservative Financial Reporting
Ahmed and Duellman (2007) also recognize the tension that
outside directors require high-quality timely information
to eectively monitor and advise managers, but, at the
same time, that managers may have incentives to distort or
conceal their private information. In contrast to the focus of
Bushman et al. on the overall timeliness of earnings, Ahmed
and Duellman emphasize the timeliness with which “bad
news” is reported. Bad news can reasonably be viewed as
central to the informational conict between management
and outside parties (including outside directors), as it will
paint management’s performance in an unfavorable light.
(See, for example, discussions by Watts [2003]; Ball and
Shivakumar [2005]; and Kothari, Shu, and Wysocki [2009].)
In the accounting literature, the term “conservatism” is
ascribed to the property of accounting reports that subjects
bad news to a lower verication standard than good news and
thus provides more timely recognition of bad news than good
news in earnings. e more timely recognition of bad news is
achieved through a variety of reporting rules and choices that
commit managers to recognize and disclose difficult-to-verify
information about losses more quickly than information
about gains. For example, a decline in the value of inventory,
goodwill, and other long-lived assets is recognized in a timely
manner (such as recording an impairment charge), but a com-
mensurate increase in value is recognized only when it is easy
to verify—typically when there is an external arm’s-length sale
or exchange. us, it seems reasonable to characterize conser-
vatism as the set of nancial accounting rules and conventions
that facilitate more complete and timely corporate disclosure
by committing managers to report bad news sooner than it
might otherwise surface (Guay and Verrecchia 2007).
Notwithstanding issues related to the measurement of
conservatism, which are not unique to their paper, Ahmed
and Duellman (2007) find that the degree of conservatism
in accounting earnings is greater for rms with a higher
proportion of outside directors. is result is consistent with
the hypothesis that timely recognition of bad news aids these
directors in carrying out their monitoring and advisory roles.
114 Financial Reporting and Transparency in Corporate Governance
is result does not, however, speak to the direction of cau-
sality. us, shareholders may choose to appoint more outside
directors when the rm’s accounting is relatively more conser-
vative (thus providing the timely information outside directors
require to eectively govern); or instead, outside directors may
facilitate the timely recognition of bad news through their
eorts to elicit such information from management.
3.3 e Audit Committee of the
Board of Directors
Outside directors on the audit committee are likely to bring
greater independence in monitoring management’s nancial
reporting activities and, like outside directors in general,
they are thought to require more information transparency
to fulll their responsibilities. However, regardless of their
eorts, outside directors on the audit committee are unlikely
to understand the rm’s nancial reporting process as well as
inside directors do.
Klein (2002a, b) examines hypotheses similar to those in
Bushman et al. (2004) but in the context of outside directors on
the audit committee rather than on the board as a whole. Klein
(2002a) predicts and nds that more complex rms, and rms
with greater uncertainty and growth opportunities, are less likely
to have outside directors on the audit committee. is result is
consistent with outside directors being asked to serve only in set-
tings where there is sucient information transparency to allow
them to eectively fulll their advising and monitoring roles.
Klein (2002b) and Krishnan (2005) document that the
proportion of outside directors on the audit committee is
negatively related to the incidence of internal control prob-
lems, as publicly disclosed on U.S. Securities and Exchange
Commission (SEC) Form 8-K when a change of auditor
occurred. e results in these two papers are consistent with
outside directors having both an incentive and the ability to
monitor the nancial reporting process, and with outside
directors curtailing earnings management that is not in
shareholders’ interests. However an alternative interpretation,
which is also consistent with the collective evidence, is that
management and shareholders recognize the need for their
corporate nancial reporting process to be transparent when
they invite more outside directors to sit on the board (or
that outside directors will agree to join the board only when
the rm has made a commitment to transparent nancial
reporting). is alternative interpretation emphasizes
shareholders’, and potentially management’s, incentives to
proactively mitigate agency conicts that arise when nancial
reporting is not transparent. Empirical evidence also indicates
that shareholders recognize the diculties that directors face
in monitoring the nancial reporting process and provide
greater remuneration to audit committee members when
monitoring demands are greater.
12
3.4 Adding Outside Financial
Experts to the Board
In the wake of several high-profile accounting scandals in
the early 2000s and the passage of stricter disclosure rules
in the Sarbanes-Oxley Act of 2002, the role of nancial
experts on boards of directors became a timely issue in
accounting research. Financial experts are thought to have
better capabilities with respect to monitoring and advising
on nancial reporting and disclosure issues than their
non-expert counterparts.
Although we are not aware of a well-accepted denition
of “nancial expert” in the academic literature on corpo-
rate governance, it seems intuitive that a director with a
background in public accounting, auditing, or nancial oper-
ations—such as a chief nancial ocer (CFO), controller, or
treasurer—would possess nancial expertise.
13
However, the
Sarbanes-Oxley Act uses a broader denition of how a direc-
tor can obtain nancial expertise. e denition includes,
for example, experience in managing individuals who carry
out nancial reporting and nancial operations. As a result,
the Sarbanes-Oxley denition of “nancial expert” includes
individuals such as CEOs and company presidents who do
not necessarily have expertise in analyzing nancial reports
or accounting practices.
In the absence of regulatory requirements, a rm will
presumably invite a nancial expert to sit on its board for one
of the following reasons: (1) management requires advice on
corporate nance or nancial reporting strategy, (2) man-
agement wants to credibly commit itself to more intense
monitoring of corporate nance or nancial reporting strate-
gies, or (3) shareholders (for example, blockholders) pressure
or require management to add an expert to the board because
of concerns about insucient monitoring. In the rst case, an
outside nancial expert can perform an advisory role only if
the rm’s nancial reporting and information environment
12
Engel, Hayes, and Wang (2003).
13
In the SEC’s Regulation S-K, Item 401, the qualications of an audit
committee nancial expert include an understanding of accounting standards
and nancial statements; an ability to assess the general application of
accounting principles; experience in preparing, auditing, or analyzing
nancial statements; an understanding of internal control over nancial
reporting; and an understanding of audit committee functions.
FRBNY Economic Policy Review / August 2016 115
are transparent. us, one might expect a positive relation
between information transparency and the presence of nan-
cial experts on the board. In the second and third cases, an
outside nancial expert may be asked to sit on the board when
the rm’s nancial reporting and information environment
are not suciently transparent and additional monitoring
and advice from a nancial expert will make it more so. In
this scenario, one might expect to observe a negative relation
between information transparency and the presence of
nancial experts that becomes positive over time as a result of
a nancial expert’s actions to increase transparency. us, in
cross-sectional tests, one could nd a negative, positive, or no
relation between information transparency and the presence
of nancial experts on the board.
Empirical research on these hypotheses is mixed but
generally supports the prediction of a positive—although
not necessarily causal—relation between information
transparency and the presence of financial experts on
the board. Xie, Davidson, and DaDalt (2003) show that
board and audit committee members with corporate or
financial expertise are associated with lower discretionary
accruals (which the authors assume are used by managers
to reduce transparency). Agrawal and Chadha (2005) find
that the frequency of an earnings restatement is lower
in companies with an outside financial expert director
on either the board or the audit committee. In addition,
Farber (2005) finds that firms subject to an SEC enforce-
ment action have fewer financial experts on their audit
committees. And Krishnan (2005) and Hoitash, Hoitash,
and Bedard (2009) show that the financial expertise of
audit committee members is negatively related to the inci-
dence of internal control problems.
When interpreting the results of these studies, it is
important to note that a positive relation between the
presence of a financial expert on the board and transpar-
ency in financial reporting does not necessarily imply
that financial experts cause greater transparency. Having a
financial expert on the board may improve transparency,
but instead it can also signal that a firm’s financial report-
ing practices are of high quality. In particular, financial
experts will presumably investigate the firm’s financial
reporting practices before agreeing to sit on the board
and will do so only if the financial reporting practices are
deemed to be of acceptable quality. In addition—or perhaps
simultaneously—having a financial expert sit on the board
can signal that management is committed to transparent
financial reporting practices and is actively seeking advice
and monitoring to achieve this objective. (Of course, the
financial expert may be reluctant to accept a position that
requires significant effort to ensure or establish transpar-
ency.) In work consistent with this signaling hypothesis,
DeFond, Hann, and Hu (2005) find a positive stock price
reaction when a director with accounting expertise is
appointed to the audit committee, although this result is
not found for nonaccounting experts who meet the broader
Sarbanes-Oxley definition of a financial expert (see
also Engel [2005]).
In a related vein, recent research examines the role of
the CFO in transparent financial reporting. The CFO is a
key individual with substantial decision-making authority
over financial reporting, and therefore it seems reasonable
to predict that a fastidious CFO with appropriate incentives
could have a positive influence on the quality of financial
reporting.
14
Bedard, Hoitash, and Hoitash (2014) provide
evidence of higher financial reporting quality when the
CFO holds a seat on the board of directors. This finding
suggests either that board membership of CFOs enables
other directors to better monitor the financial reporting
process or that high-quality financial reporting is indica-
tive of a high-quality CFO who is likely to be valuable on
the board. Li, Sun, and Ettredge (2010) find that firms with
internal control weaknesses as defined in Sarbanes-Oxley
(sec. 404) have CFOs with lesser professional qualifications,
and that newly hired CFOs with greater qualifications are
associated with improvements in auditor opinions about
internal control weaknesses.
14
As evidence supporting the incentives of CFOs to maintain high-quality
financial reporting systems, Hoitash, Hoitash, and Johnstone (2012) and
Wang (2010) document that CFOs of firms with weak internal controls
receive lower compensation. Further, Wang (2010) and Li, Sun, and
Ettredge (2010) show that CFOs of firms with internal control weaknesses
experience a higher rate of forced turnover.
Empirical research on these
hypotheses is mixed but generally
supports the prediction of a
positive—although not necessarily
causal—relation between information
transparency and the presence of
nancial experts on the board.
116 Financial Reporting and Transparency in Corporate Governance
3.5 Outside Directors as a Mechanism
to Mitigate Agency Conicts with
Creditors and Other Contracting Parties
A number of recent papers explore the notion that in
addition to mitigating agency costs between managers
and shareholders, outside directors can also help resolve
agency conicts between managers (acting on behalf of
shareholders) and other stakeholders, such as creditors,
employees, customers, and suppliers. Outside directors may
do so given their reputational capital, which may temper their
willingness to follow managers in taking ex post opportunistic
actions—including nancial reporting decisions—that benet
managers and shareholders but are detrimental to other
stakeholders (see, for example, Fama and Jensen [1983],
Gerety and Lehn [1997], and Srinivasan [2005]).
Further, outside directors and other external parties have
many of the same informational demands. For example, rms
that use transparent nancial reporting to credibly convey
timely and reliable information to outside directors can simul-
taneously convey this information to external stakeholders and
contracting parties. At the same time, inside directors, most of
whom are executives with substantial equity ownership, may
have diculty convincing stakeholders that management will
not distort nancial reports when it is in management’s interest
to do so. us, while outside directors are commonly viewed
as champions of shareholders’ interests in their monitoring
of managers, it may be that outside directors are also more
willing, ex post, to take actions that are counter to sharehold-
ers’ interests when such actions conict with the interests of
other contracting parties.
15
is, of course, does not mean
that outside directors are exante detrimental to shareholders.
Rather, shareholders may maximize value ex ante by commit-
ting to constitute a board that will internalize other contracting
parties’ interests ex post, thereby reducing agency conicts and
contracting costs with these other parties.
15
Adding to the richness of this perspective is the legal view that directors
are generally regarded as having a primary duciary responsibility to
shareholders rather than to the rm’s other contracting parties. Huebner
and McCullough (2008) note that in 2007 the Delaware Supreme Court
summarized the duties of directors as follows: “It is well established that
the directors owe their duciary obligations to the corporation and its
shareholders. While shareholders rely on directors acting as duciaries to
protect their interests, creditors are aorded protection through contractual
agreements, fraud and fraudulent conveyance law, implied covenants of
good faith and fair dealing, bankruptcy law, general commercial law and
other sources of creditor rights. Delaware courts have traditionally been
reluctant to expand existing duciary duties. Accordingly, ‘the general rule
is that directors do not owe creditors duties beyond the relevant contractual
terms.’ ” (North American Catholic Educational Programming Foundation,
Inc. v. Gheewalla, 930 A.2d 92 [Del. 2007])
Carcello and Neal (2000, 2003) allude to this role for
outside directors by arguing that outside directors take
actions to protect the independence of the auditor and
the integrity of the nancial reporting system even when
it might not be in shareholders’ interests to do so. Bhojraj
and Sengupta (2003) explicitly examine the role of outside
directors in reducing agency conicts with creditors. ey
document that rms are able to borrow at lower rates when
they have a higher proportion of outside directors on the
board. Anderson, Mansi, and Reeb (2004) also nd this rela-
tion between the cost of debt and overall board independence,
as well as a negative relation between the independence of the
audit committee and the cost of debt.
ese results are consistent with two non-mutually
exclusive explanations. One is that causality runs from
outside directors to the cost of debt: e independence and
personal reputational concerns of outside directors induce
them to monitor and constrain managers’ ability to engage
in self-interested actions. If these self-interested actions are
detrimental to either the value of the rm as a whole or to
the value of creditors’ claims in particular, the proportion of
outside directors is expected to be negatively related to the
cost of debt. e second possibility is that because outside
directors require timely information to eectively monitor
and advise management, rms that are more informationally
transparent are able to attract a greater proportion of outside
directors to sit on the board. And if a more transparent
information environment facilitates less costly contracting
with creditors, one again expects to nd that the proportion
of outside directors is negatively related to the cost of debt.
(Note, however, that this latter possibility does not imply that
outside directors cause a lower cost of debt.)
3.6 Active Investors
Jensen (1993, 867) discusses the merits of active investors as a
governance mechanism:
Active investors are individuals or institutions
that simultaneously hold large debt and/or equity
positions in a company and actively participate in
its strategic direction. Active investors are important
to a well-functioning governance system because
they have the nancial interest and independence to
view rm management and policies in an unbiased
way. ey have the incentives to buck the system
to correct problems early rather than late when the
problems are obvious but dicult to correct.
FRBNY Economic Policy Review / August 2016 117
To make ecient investing decisions, active investors
require timely and reliable information that enables them to
monitor management’s actions and to participate in the rm’s
strategic direction. Further, as Jensen (1993) notes, active
investors have the nancial incentives and clout to inuence
management’s decisions regarding the timeliness and reliabil-
ity of the information conveyed to outsiders. ese arguments
suggest that information transparency and the presence of
active investors are complementary and should therefore be
positively correlated.
In an alternative hypothesis, proposed by Demsetz and
Lehn (1985) and Bushman et al. (2004), active investors and
other eective monitors are most valuable in situations with
relatively low information transparency, which leads to a
negative relation between transparency and the presence of
active investors. Shleifer and Vishny (1997) oer a competing
view, suggesting that investors with a relatively large share
of a company’s equity or debt (blockholders) can inuence
management and secure private benets at the expense of
diuse shareholders and creditors. And if timely and reliable
disclosures constrain the ability of blockholders to secure
such private benets, one expects a negative relation between
blockholders and information transparency. erefore,
determining the direction of causality of the negative relation
between active investors and information transparency may
require further tests. Specically, do active investors gravitate
to low transparency rms because that is where their monitor-
ing ability is most valuable? Or do these investors instead seek
rms with low transparency in an attempt to secure private
benets to the detriment of diuse shareholders? Perhaps
reecting an amalgamation of these conicting eects,
the empirical evidence is mixed on the relation between
various types of active investors and the degree of informa-
tion transparency.
16
16
See Bushman et al. (2004), Farber (2005), Agrawal and Chadra (2005),
Bhojraj and Sengupta (2003), and Ashbaugh, Collins, and LaFond (2006).
Active investors also operate in the market for corporate
control, where active investors may choose to acquire a
controlling interest in a rm in an attempt to resolve extreme
agency conicts. Ferreira, Ferreira, and Raposo (2011) empha-
size the role of the information environment in facilitating
the market for corporate control as an alternative to board
monitoring. ey nd that price informativeness, measured
by the probability of informed trade, is negatively associated
with board independence, and that this result is stronger for
rms with more institutional investors and greater exposure to
the market for corporate control. ese ndings suggest that
liquid markets with informative security prices can facilitate
monitoring by investors, which can sometimes substitute for
monitoring by outside directors.
e role of nancial reporting in facilitating activity in
the market for corporate control has recently gained atten-
tion from researchers seeking to understand how potential
acquirers obtain the information necessary to make ecient
investment decisions. Zhao and Chen (2008) advance a
so-called quiet-life hypothesis to explain why weakening the
market for corporate control might be associated with greater
transparency in nancial reporting. ey argue that when
managers are protected from discipline from the market for
corporate control, there is less reason to engage in earnings
management to distort the information environment. In a
nding consistent with this hypothesis, they show that rms
with staggered (or classied) boards, which make a hostile
takeover more dicult, have a lower incidence of accounting
fraud and smaller absolute abnormal accruals. In a related
paper, Armstrong, Balakrishnan, and Cohen (2012) find that
rms improved the quality of their nancial reporting follow-
ing the passage of state antitakeover laws, which weakened the
ecacy of the market for corporate control.
3.7 e Diculty in Identifying “Good”
and “Bad” Governance
Underlying our discussion of nancial reporting and agency
problems is the broad notion that contracting costs and
frictions limit the extent to which contracting parties can
mitigate these agency problems. e cost of transferring the
relevant nancial and nonnancial information to outside
directors and shareholders is one such friction. e costs
and benets of transferring information between managers,
directors, and shareholders dier across rms, industries,
and countries, as well as over time; so one should expect
rm-, industry-, and country-specific variation, as well as
time-series variation in governance mechanisms. In other
Active investors have the nancial
incentives and clout to inuence
management’s decisions regarding the
timeliness and reliability of the information
conveyed to outsiders.
118 Financial Reporting and Transparency in Corporate Governance
words, since the most ecient, value-maximizing governance
structure can dier both across rms and over time, it is
usually unproductive to seek one-size-fits-all best practices in
corporate governance.
We recognize that many studies (as well as many
researchers) explicitly or implicitly take a dierent view
of time-series and cross-sectional variation in governance
structures, labeling certain structures (for example, a
high proportion of outside directors and high-powered
pay-for-performance compensation plans) as being uncondi-
tionally “good” (strong) or “bad” (weak). Our understanding
of this literature leads us to conclude that bad (weak)
governance is broadly intended to mean that serious agency
conicts exist between shareholders and managers, and
that some (oen unarticulated) contracting cost or friction
prevents shareholders from implementing good, or at least
better, governance mechanisms that would mitigate these
agency conflicts.
In many cases, however, this view ignores the extensive
economic arguments and empirical evidence showing that
rms considered to have bad governance may have some-
times, in fact, appropriately (and endogenously) selected the
most ecient governance structure given the circumstances.
For example, many papers designate rms with a relatively
high proportion of outside directors as having a good
governance structure, implying that rms with the highest
proportion of outside directors have the best governance.
ese and other normative labels are ascribed to dierent
rms even though, as described above, extensive theory and
empirical evidence indicate that a board with relatively few
outside directors is sometimes optimal.
We also emphasize that the mere existence of an agency con-
ict, or the observation of an action that might be a symptom
of an unresolved (or residual) agency conict (such as earnings
management or even accounting fraud) does not imply a
deviation from shareholders’ preferred governance structure. As
Jensen and Meckling (1976) point out, no governance structure
is likely to eliminate all agency conicts. us, researchers
should expect to observe symptoms of residual agency con-
icts in the actions of executives even at what seem to be well
governed rms.
17
Guay (2008) makes a related point regarding
17
As an example, consider that as directors hire and re CEOs over time,
successful CEOs become more powerful as an increasing function of their
success and tenure. It is tempting to view agency conicts related to powerful
CEOs—such as perquisite consumption, empire building, and accounting
distortions—as indicative of a breakdown of the governance system. However,
as Hermalin and Weisbach (1998) note, a successful CEO will gain bargaining
power that can be used to extract rents, such as high annual pay or large
perquisites. For example, Baker and Gompers (2003) nd evidence consistent
with successful CEOs being able to bargain for less independent boards.
erefore, what might look like an agency problem stemming from a
boards’ delegation of control rights to CEOs. In widely held
corporations, it is well understood that shareholders delegate
substantial decision rights to the board of directors, in part
because of the considerable information acquisition and coor-
dination costs that shareholders would have to incur to make
many key decisions themselves. In turn, and for many of the
same reasons, it is ecient for the board of directors to delegate
many, if not most, decision rights to executive management,
even while recognizing the possibility that managers will some-
times take self-interested actions at the expense of shareholders.
An alternative way of characterizing these points is
to suggest that the notions of good and bad corporate
governance should, at a minimum, be conditioned on a con-
sideration of a rm’s relevant economic characteristics, such
as its operating and information environment and its use of
complementary and substitute governance mechanisms. Only
then can one begin to make statements about whether certain
governance structures are good or bad.
18
We also note that
this procedure should also entail a certain symmetry: Aer
conditioning the analysis on the appropriate economic char-
acteristics, one must consider that too much or too little of a
particular governance mechanism may render a rm’s gover-
nance structure “bad.” For example, rms can have too few or
too many outside directors, and in both cases, this should be
considered “bad.”
For a rm with a conditionally unusual governance
structure, a natural question to ask is, why does it have
that structure? A broad interpretation of the governance
literature suggests at least three possibilities: (1) Some
economic determinant of the governance structure or some
firm-specific variation in the costs and benets of certain
governance structures is unknown to the researcher and
not captured in the governance expectation model (that is,
Footnote 17 (continued)
suboptimal governance structure ex post (that is, aer the CEO has achieved a
period of success) could have been optimal from an ex ante perspective (when
the CEO was originally hired).
18
However, see Brickley and Zimmerman (2010) for a further cautionary
discussion about potential problems with even this type of conditional
benchmarking.
Since the most efcient, value-maximizing
governance structure can differ both
across rms and over time, it is usually
unproductive to seek one-size-fits-all best
practices in corporate governance.
FRBNY Economic Policy Review / August 2016 119
certain variables are omitted from the model). (2) Economic
frictions prevent shareholders at some rms from instituting
the desired (“good”) governance structure, or alternatively
the frictions slow down the process (recognizing that it can
take time for shareholders and boards to learn about evolving
governance structures). (3) Shareholders behave heuristically
or irrationally and do not attempt to implement governance
mechanisms that maximize shareholder value.
e rst of these possibilities was the focus of our forego-
ing discussion, and we emphasize that research has already
shown that nancial reporting characteristics are important
determinants of governance structures. We encourage
researchers to ensure that their governance models are appro-
priately specied and incorporate these determinants. e
third possibility may be relevant, but the heuristic/irrational
perspective is beyond the scope of this article.
19
It is the
second possibility, that frictions inhibit the adoption of certain
governance structures, that warrants further discussion.
If shareholders recognize that certain governance structures
are better (that is, more ecient) than the existing struc-
tures—which seems to be the case if one accepts the common
argument that good and bad governance structures can be
identied with relative ease—it begs the question, what are
these frictions that prevent shareholders from making adjust-
ments, and how do they vary across rms and over time?
To begin, we suggest that the stage of a rm’s life cycle is
likely to be important in explaining observed governance
practices. Early in their life cycle, most rms are closely held,
with equity ownership concentrated among entrepreneurs,
venture capitalists, private equity rms, or other institutional
and sophisticated investors. ese owners have strong incen-
tives to implement an optimal governance structure to ensure
that they maximize the price at which they eventually sell
their claims to outside investors. Further, at this stage of devel-
opment, the selection of governance structures may be less
hampered by frictions—including regulations—that exist in
widely held rms (although there may be frictions stemming
from the process by which owners learn about the merits of
alternative firm-specific governance structures). Over time,
however, rms change. Closely held rms become widely
held, creating a variety of frictions, informational demands,
and free-rider problems with respect to adjusting governance
structures. Growing rms mature. Firms that originally had
19
For researchers who view heuristic or irrational behavior as a probable
explanation for observed governance structures, frictions in the market for
corporate control seem to be a fruitful area for research. at is, if groups
of irrational shareholders persist in controlling rms with suboptimal
governance structures, an obvious question is, what are the frictions that
prevent a well-functioning market for corporate control from acting as a
correction mechanism?
diculty conveying information related to their operating
strategy and potential for creating value nd that nancial
reporting systems and other disclosure mechanisms are better
able to reduce informational asymmetries between managers
and outside investors.
We encourage researchers not only to identify and quantify
the costs and frictions that prevent or impede rms from
adjusting their governance structures, but also to examine
how these frictions vary cross-sectionally and over time. e
determinants of cross-sectional variation in frictions are likely
to include organizational structure, ownership structure,
information asymmetry between managers and shareholders,
and geography. An example of the inuence of geography
is provided by Knyazeva, Knyazeva, and Masulis (2013),
who show that rms located near smaller pools of pro-
spective directors have fewer independent directors and
less-experienced directors overall and that this friction can be
costly. Similarly, John, Knyazeva, and Knyazeva (2008) argue
that the geographic distance between a rm’s headquarters
and its investors aects the rm’s information environment
which, in turn, aects the rm’s dividend policies.
. G B O
F I
In this section, we discuss how some of the key concepts
developed in the previous section apply to banks and other
nancial intermediaries. We place a particular emphasis
on how certain features that are unique to nancial
institutions—and banks in particular—influence their
governance structures. In the course of our discussion, we
also highlight some important aspects of nancial institutions’
governance that have not been examined in the academic
research that was the focus of our earlier discussion. Much of
the research on the governance of nonnancial rms abstracts
away from the inuence of regulations.
In the nancial services sector, however, regulatory over-
sight is an integral part of bank operations. Consequently,
regulatory oversight and compliance play a prominent role in
the governance of banks. In addition, much of the regulatory
supervision that is unique to banks takes the form of regu-
lators communicating with and gathering information from
directors who are largely out of sight to external parties such
as equity and credit analysts.
Ultimately, the set of governance mechanisms found
in banks is likely to reect not only those mechanisms
implemented by shareholders to resolve agency conicts
with directors and managers, but also those instituted by
120 Financial Reporting and Transparency in Corporate Governance
bank regulators to serve the interests of various public
constituencies. Banks are thus beholden to a larger set of
stakeholders—many of whom may have disparate objectives
and incentives that can conict with those of the banks’ man-
agers, directors, and shareholders. e more complex set of
agency conicts that arise in banks pose additional challenges
for researchers. For example, regulatory capital requirements
oen constrain the assets and investments of nancial
institutions. e shadow cost of these and other regulatory
constraints can be high in certain cases, such as when banks
attempt to make acquisitions and divestitures (such as selling
o branches), or when regulators evaluate a bank’s compliance
with statutes.
20
e presumed objective of many laws, regulations, and
oversight—whether explicit or implicit, observed or unob-
served—is the public’s interest in safe and sound nancial
institutions. e public’s interest in the soundness of the
banking system stems from banks being unique nancial
intermediaries in the economy, as well as being insured depos-
itory institutions. Banks provide liquidity as well as access to
the U.S. payment system. e recent nancial crisis serves as
a reminder that the failure of a large, interconnected nancial
institution can rapidly propagate throughout the nancial
system and can result in far-reaching adverse eects on the
domestic and global economy. Although the public expects
safety, investors demand performance, which necessarily
entails taking risks. e tension between these two objectives
is a ripe topic for future research.
A related challenge for researchers—especially during the
last three decades—has been to understand what is special
about banks and other nancial institutions in the evolving
economic, political, and regulatory landscape (and in the
context of the theory of the rm). at challenge also applies
to understanding the structure of nancial rms and their
conduct in response to deregulation and subsequent reregula-
tion.
21
A better understanding of these issues is important for
eective and informed public policy.
20
For example, under the Community Reinvestment Act (CRA), regulators
are required to consider a bank’s record of providing credit to low- and
moderate-income neighborhoods and individuals when considering
the bank’s application for a merger or acquisition. Building on this idea,
Bostic et al. (2005) test the hypothesis that banks contemplating mergers
or acquisitions act strategically by increasing their lending to low- and
moderate-income individuals to inuence regulators. Bostic et al. nd
evidence that is consistent with this type of strategic behavior. us, the
dynamic interaction between banks and regulators makes it dicult to
generalize some of the ndings from earlier studies on governance, board
structure, and conduct (such as evidence on economies of scale and cost
eciency in banking).
21
For example, the Riegle-Neal Interstate Banking and Branching Eciency
Act of 1994, which eliminated restrictions on interstate banking and
branching; the 1999 Gramm-Leach-Bliley Act, which repealed the
e evolving nature of banking, regulation, and the public’s
expectations for safe nancial institutions adds an addi-
tional layer of complexity when examining the governance
and information environments of these institutions. Some
of the more pressing questions that need to be addressed
are given below:
• Are the internal and informal governance
mechanisms of banks a substitute for, or a
complement to, supervision and regulation?
• Should boards—whose mandate is to ensure
eective internal governance of a nancial
rm—consider bank regulators as partners
or adversaries? Similarly, should regulators
consider bank boards to be their partners? If so,
what are the potential benets and costs of such
a relationship?
• What economic models could shed light
on issues such as delegation of authority,
assignment of responsibility, and design of
incentive-compatible tasks?
To help frame these and other important questions, we
highlight several unique features of bank governance that have
been emphasized in banking studies.
4.1 What Is Dierent about the Governance
of Banks and What Governance
Structure Is Most Efficient?
Earlier research has documented a number of prominent
dierences between the governance structures of nancial
and nonnancial institutions. For example, relative to their
nonnancial counterparts, banks tend to have larger boards,
more outside directors and more committees, less equity-based
compensation and insider ownership, less block ownership by
institutions, and more CEOs who also serve as chairman of the
board.
22
ese dierences do not necessarily imply that these are
ecient arrangements for the nancial stability of the banking
system. ey may be transitory, and the optimal governance
structure for shareholders may deviate from the structure that
would be optimal from a social welfare perspective.
Footnote 21 (continued)
1933 Glass-Steagall Act; and in the wake of the global nancial crisis, the
2010 Dodd-Frank Act, which imposed extensive regulations on banks.
22
See, for example, Adams and Mehran (2003), Hayes et al. (2004), Core
and Guay (2010), Adams and Mehran (2012), and Mehran, Morison, and
Shapiro (2012).
FRBNY Economic Policy Review / August 2016 121
Moreover, previous evidence on structure gathered in
periods when bank bailouts were expected, may well have
become outdated because of subsequent regulatory reforms in
the Dodd-Frank Act and elsewhere. ose reforms may have
moderated expectations about the likelihood of future bailouts
and increased expectations about the likelihood of “orderly
resolutions” of distressed nancial institutions. It is therefore
possible, and perhaps even likely, that nancial institutions will
alter their governance structures going forward, either volun-
tarily or by law. Indeed, early evidence from 2014 proxy lings
(Form DEF-14A) with the Securities and Exchange Commission
suggests that the number of banks choosing to have a standing
risk committee at the board level has risen.
e Dodd-Frank Act’s introduction of so-called living
wills and its explicit prohibition against future bailouts are
two of the law’s key elements that are likely to inuence the
dynamics of governance mechanisms. We conjecture that
these regulatory changes are likely to aect stakeholders’
perceptions of the risk associated with banks and may also
aect banks’ cost of capital. Consistent with this idea, Mehran
and Mollineaux (2012) discuss how the new regulations aect
equity analysts’ risk perceptions. In particular, they argue that
banks are likely to enhance their voluntary disclosure and pro-
actively seek ways to ensure that they pass the annual stress
test of capital adequacy required under Dodd-Frank. ese
actions should, in turn, expand the information available to
bank stakeholders, including investors, as we note below.
We also suggest that annual stress testing, one of the more
conspicuous aspects of recent reforms, may provide dierent
incentives for nancial institutions’ various stakeholders.
e test is likely to both reduce the incentive for informa-
tion production by analysts (Mehran 2010; Goldstein and
Sapra 2013) and enhance management’s incentives to make
voluntary disclosures. Regarding the second point, just as
rms that expect to miss earnings targets frequently make
preemptive announcements, banks may benet from pro-
actively disclosing negative information about their capital
conditions before regulators release the news aer their
annual review.
23
In doing so, management can inuence how
stakeholders interpret the negative test results and potentially
ameliorate the negative consequences the rm may face in
the equity and credit markets. Further, regular voluntary
disclosures could be perceived by investors as a commitment
to transparency (the benets of which are discussed in Guay
and Verrecchia [2007]) and as an indication of a cooperative
relationship between management and regulators.
4.2 Banks’ Information
Environment and Opacity
e ecacy of capital markets in monitoring the health and
riskiness of nancial institutions is an important research
question—particularly in the wake of the recent nancial
crisis. Extant research that compares the transparency of
banks with that of nonnancial rms provides mixed results.
24
For example, Morgan (2002) examines bond analyst ratings
and nds that the dispersion of ratings is larger for banks
than for other rms. He interprets this nding as supporting
the notion that banks’ assets are “opaque.” In contrast,
Flannery, Kwan, and Nimalendran (2004) report that banks
and nonnancial rms have equity bid-ask spreads of similar
magnitude; the authors, in general, do not nd empirical
support for the notion that banks are more opaque than
nonnancial firms.
Other research examines whether security prices of banks
react dierently to news about corporate developments and
nancial condition than do securities prices of nonnancial
rms. One potential reason for a dierential reaction is the
inuence of bank regulators on both bank strategic decisions
and bank disclosure. For example, investors may dierentially
react to equity issuances, given that banks typically issue
equity to maintain regulatory capital, whereas nonnancial
rms tend to do so to fund investment opportunities. e
reactions to news about poor nancial health may also dier
because of investor uncertainty about the regulatory response
to the news—for example, regulators may intercede on the
bank’s behalf, or prevent or require certain corrective actions,
or suppress or encourage certain disclosures. e results from
23
At the same time, rms may also have incentives to strategically time
their disclosure of negative information. For example, if it is likely to reduce
the price a rm expects to receive from a pending sale, then it may delay
disclosure until the sale is completed.
24
See Beatty and Liao (2014) and Bushman (2014) for a comprehensive
review of the literature on nancial reporting and transparency in nancial
institutions.
The Dodd-Frank Act’s introduction of
so-called living wills and its explicit
prohibition against future bailouts are
two of the law’s key elements that
are likely to inuence the dynamics of
governance mechanisms.
122 Financial Reporting and Transparency in Corporate Governance
this literature are generally mixed. e main nding is that the
market reaction is more pronounced for rms that face larger
information asymmetries.
25
Flannery, Kwan, and Nimalendran (2013) extend these
ideas, examining whether the greater opacity of banks relative
to nonnancial rms varies with the state of the economy.
eir results indicate that although banks and other rms
exhibit similar degrees of opacity during periods of stability,
banks are relatively more opaque during nancial crises,
where opacity is measured using bid-ask spreads and the price
impact of trades. ese results raise a question about the roles
of managers, investors, creditors, and regulators in inuencing
transparency at various points in time. e following scenario
discusses and illustrates these roles and the incentives that the
various parties face.
Suppose that three parties are involved in the production
of information in the banking sector: bank managers, equity
and credit analysts, and regulators. Now consider each party’s
incentives for information disclosure.
• Bank managers: Bank management is expected
to be reluctant to release timely bad news if it
perceives that its disclosure could result in a shi
of its control rights to regulators, creditors, or other
stakeholders. us, bad news might be concealed
from regulators, which would make early discovery
of problems harder for regulators. Bad news would
also likely reach other stakeholders relatively late.
us, the amount of managements’ adverse private
information could be large during normal times
and even larger during times of crisis.
• Analysts: Given the asymmetric nature of the
payos to equity and debt securities, equity
analysts are likely to be more active than credit
analysts in their coverage of a rm when its equity
price is high. Conversely, when the equity price
is low, equity analysts are likely to be relatively
passive and credit analysts relatively active. In
fact, many rms are unlikely to have equity
analyst coverage in the six months prior to their
bankruptcy lings (Mehran and Peristiani 2006),
while credit analysts may begin to devote eort
to valuing the assets-in-place in anticipation
of a sell-off or other forms of restructuring.
However, credit analysts have less of an incentive
to evaluate banks in nancial distress because of
their expectation of regulatory supervision and
intervention as well as the potential for a bailout.
25
See, for example, Ryan (2012) for an overall review of this literature on
market reactions to news; Cornett et al. (2014) regarding news of stock
issuances; and Gupta, Harris, and Mehran (2015) for news of mergers and
acquisitions.
• Regulators: It is not clear whether regulators
strategically time the release of bad news about
banks. Moreover, the size of potential losses
may be uncertain at the time that regulators
disclose this information to stakeholders. With
later disclosure, the eect on security prices
might be large.
e foregoing description of each party’s incentives may
evolve in light of recent banking reforms, such as living
wills. If the reforms improve the value of information and
consequently enhance the incentive for its production, banks’
security prices may become more informative about growth
and risk under a wider range of circumstances. Further
research on this topic would be helpful for the eective regu-
lation of banks.
4.3 Bank Governance during
Financial Distress
An important challenge for bank stakeholders is preventing
nancial distress and, if it should arise, localizing and
containing any adverse consequences. Potential defaults and
subsequent runs by creditors and re sales of assets witnessed
during the recent nancial crisis are a reminder of the
potential social costs associated with the distress and failure
of systemically important nancial institutions.
26
e risk of
such negative outcomes is largely due to the nature of banks’
assets and the relatively rapid speed at which the value of their
assets can deteriorate. ese features of the banking system
can make workouts and bankruptcy more challenging.
27
Similarly, governance changes in the face of nancial
distress, including replacing management and the board,
can be more dicult in the banking sector, notwithstanding
the view oen expressed that banks should be held to a
higher level of accountability.
28
It will be interesting to see
whether the Dodd-Frank resolution model that allows
banks to fail will impose new discipline on banks’ choice of
governance structures.
A related issue is management’s control of information
in bad times and the potential for information asymmetry
with respect to the board and regulators. As we indicated
26
Firms with substantial intangible assets, including nancial institutions, are
likely to be especially vulnerable to negative news about their nancial health
and viability.
27
See Skeel (2015) for further discussion.
28
A potential exception might be government-assisted acquisitions, which
occurred in a few cases during the recent nancial crisis.
FRBNY Economic Policy Review / August 2016 123
earlier, in dicult times, CEOs are more likely to withhold
bad news about their poor performance or news that could
otherwise be detrimental to their interests. is incentive may
be particularly pronounced for bank managers if they perceive
that the information could result in a loss of control rights to
regulators and other stakeholders. In addition, if managers
privately know that their bank is in distress, their expectation
of a bailout—whether justied or not—may provide them
with strong risk-taking incentives: they would benet from
the upside, but would be at least somewhat protected on the
downside (although their assessment could be complicated by
marketwide shocks and correlated risks). Alternatively, manag-
ers’ personal costs of taking action are particularly high during
times of nancial distress, this could dampen their incentives,
especially if the benets accrue largely to other stakeholders.
e foregoing discussion highlights the fact that management
typically has more information than the board, and that the
information disparity is expected to be more pronounced during
bad times—particularly when the information is firm-specific
rather than related to market and industry conditions. us, the
board and regulators are likely to be at their greatest informa-
tional disadvantage relative to management when shareholders
and the public are most in need of well-informed directors. is
issue is of vital importance in the nancial services industry,
where timely decision making is crucial during crises because of
the potentially systemic eects of these decisions.
4.4 Considerations for Improving
Information Flow
As highlighted above, information ow between insiders and
outside stakeholders is an important component of ecient
governance for all institutions. We now discuss several
mechanisms with which nancial institutions could increase
the ow of timely information to outsiders. Modifying
governance structures to achieve a desired result entails
both costs and benets that warrant careful evaluation. e
following measures seem well worth considering.
Separating the Positions of CEO and Board Chair
A number of studies highlight the benets and costs of splitting
the roles of CEO and board chair. A potential benet of an
independent board chair is an incentive to accurately disclose
timely information to regulators, especially information that
may help avert large losses to stakeholders. An alternative to
separating the CEO and chair positions is providing a strong
lead director who can act as a check on the information ow
from management. If the change is initiated from the regulatory
side, the authorities could provide exibility by requiring that
the board either separate the roles of CEO and board chair or
publicly explain why it chose not to do so.
Succession Planning
Identifying successors to replace key individuals in the executive
management team (including the CEO and CFO), should the
need arise, is likely to contribute to an eective transition and a
smoother ow of information. Although succession planning
can generate tension between the incumbent executives and their
designated replacements, the incumbents should recognize that
they may be replaced under some eventuality, and thus their
objective might be to avoid the realization of those situations.
Moreover, some executives may not be able to execute their duties
or may be forced to step down quickly because of unanticipated
events. Naming and training potential replacements before a
crisis strikes ensures continuity in the ow of information to
stakeholders. Furthermore, a credible replacement could assist
regulators and the board in the event that they need to quickly
replace the CEO of a distressed institution. (e question of
who knows the bank’s assets and could manage the bank if the
management of a large institution were to be terminated was a
widely discussed issue during the nancial crisis.)
Identifying a credible replacement may also incentivize
incumbent CEOs to work harder and smarter, and may also
reduce their appetite for risk. In addition, potential successors
(assuming they are internal candidates) are likely to commu-
nicate serious problems to the board because it increases the
likelihood of their becoming CEO; delaying the disclosure
of current problems may adversely aect their personal rep-
utation and remuneration if the information is subsequently
released during their tenure. Again, regulators may consider
requiring nancial institutions to either publicly disclose, or
privately disclose to regulators, a viable and ongoing succes-
sion plan for certain executive offices.
Information Sharing with Supervisors
Regulators and managers can be encouraged to work together
as a team to identify and address nascent issues.
29
As noted
earlier, bank insiders generally know about problems before
regulators do and have a much better understanding of
29
See Harris and Raviv (2014) for an alternative approach to providing
incentives for sharing bad news with regulators.
124 Financial Reporting and Transparency in Corporate Governance
firm-specific deciencies and vulnerabilities. A regulatory
system could be developed that rewards bank managers
who inform regulators in a timely manner about bad news
concerning their rm or industry. For example, information
that is shared sooner could command a larger reward
(or entail a lesser punishment).
30
Rewarding the prompt
disclosure of bad information can be justied on the grounds
that it promotes cooperation with regulators.
31
Further, it
could reduce the likelihood of incurring even larger social
costs from bank failures and possibly widespread market
failure. Regulators could induce competition for early
disclosure by rewarding banks that share information both
with regulators and each other.
Sharing the Results of Director Peer Assessments
and Board Self-Evaluations with Regulators
Peer assessments can arguably provide valuable information
about the performance of specic directors and, ultimately,
about the ecacy of the board as a whole. Directors are likely
to dier in their reputation risk, which can lead to negative
selection, whereby less reputable or less competent directors
remain on the board while superior directors do not seek
additional terms. Peer assessment, board self-evaluation, and
sharing those results with regulators can facilitate the removal
of ineective directors, which benets the remaining directors
and other stakeholders.
Encouraging Activists in the Credit Market
Adams and Mehran (2003) argue that equity blockholders
are relatively more passive in the banking industry because
of the constraining eects of regulation on blockholders’
actions. Consequently, the potential benets of activist investor
30
For some evidence, see “Financial Crime: Unsettling Settlements,”
eEconomist, May 23, 2015.
31
Alternatively, rewarding the disclosure of bad news can be more formally
justied by appeal to the mechanism design literature and the requirement
that truth-telling be incentive compatible.
involvement that have been documented in nonnancial rms
that are either in nancial distress or troubled by ineciencies
associated with large agency problems are less likely to be
available to nancial institutions. However, bank creditors
remain a potential source of greater activism. Mehran and
Mollineaux (2012) nd that bank creditors tend to be highly
concentrated among large institutions. In a regulatory regime
without bailouts, prices of debt securities at issuance are more
likely to reect default probability. Anticipating relatively
large losses in the event of nancial distress, creditors could
become more proactive monitors, as argued by Shleifer
and Vishny (1997).
5. C
We review the recent corporate governance literature
that examines the role of financial reporting in resolving
agency conflicts among a firm’s managers, directors, and
shareholders. Although most of the research we review is
large-sample and not specific to a particular industry, we
transpose several arguments in this literature to consider
the firm-specific governance structures and financial
reporting systems of financial institutions.
Financial reporting plays an important role in reducing
the information asymmetries that exist between managers
and both outside directors and shareholders. Our discussion
highlights the distinction between formal and informal con-
tracting relationships and shows how both help shape a rm’s
overall governance structure and information environment.
We stress that a rm’s governance structure and its informa-
tion environment evolve together over time to resolve agency
conicts. Consequently, we expect to observe dierent gover-
nance structures and nancial reporting choices in dierent
economic environments.
In the nancial sector, the observed bank governance
structures are likely the result of not only endogenous design,
but also the existence of certain external monitoring mecha-
nisms, including regulators. ese may partly substitute for
internal monitoring mechanisms, and they may evolve to
serve the interests of shareholders and other stakeholders.
FRBNY Economic Policy Review / August 2016 125
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