Working Paper: CEPR ID: DP6627
Authors: Viral V. Acharya; Paolo Volpin
Abstract: We argue that the choice of corporate governance by a firm affects and is affected by the choice of governance by other firms. Firms with weaker governance give higher payoffs to their management to incentivize them. This forces firms with good governance to also pay their management more than they would otherwise, due to competition in the managerial labour market. This externality reduces the value to firms of investing in corporate governance and produces weaker overall governance in the economy. The effect is stronger the greater the competition for managers and the stronger the managerial bargaining power. While standards can help raise governance towards efficient levels, market-based mechanisms such as (i) the acquisition of large equity stakes by raiders and (ii) the need to raise external capital by firms can help too, and we characterize conditions under which this happens.
Keywords: corporate governance; executive compensation; externality; governance standards; ownership structure; regulation
JEL Codes: G34; J63; K22; K42; L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Corporate governance choice by a firm (G34) | Governance choices of other firms (G38) |
| Governance choices of other firms (G38) | Corporate governance choice by a firm (G34) |
| Competition for managerial talent (M51) | Corporate governance levels (G38) |
| Corporate governance levels (G38) | Investment in governance (G38) |
| Weak governance in competing firms (L10) | Governance externality (D62) |
| Competition in managerial labor market (J29) | Downward pressure on governance standards (G38) |
| Market mechanisms (large equity stakes by raiders) (G34) | Governance standards (G38) |