DP6627 Corporate Governance Externalities

Author(s): Viral V Acharya, Paolo Volpin
Publication Date: January 2008
Keyword(s): corporate governance, executive compensation, externality, governance standards, ownership structure, regulation
JEL(s): G34, J63, K22, K42, L14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6627

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.