VoxEU Column Industrial organisation

Outside directors, firm behaviour, and performance: Evidence from a quasi-natural experiment in Japan

Japanese listed companies are recruiting many more outside directors to their boards in response to changes in corporate law and governance codes. The column uses data on firm performance to show that these changes have had no impact yet on the risk-taking behaviour or performance of firms. One-size-fits-all regulation may not be in the best interests of all firms.

Following an amendment to the Companies Act, and the introduction of the Corporate Governance Code, the number of independent outside directors in Japan's listed firms has increased rapidly. We can view this change in board composition as a quasi-natural experiment, similar to the enactment of the Sarbanes-Oxley Act (SOX) in the US, and use it to study the causal impact of an increase in outside directors on the risk-taking behaviour and performance of firms. 

Corporate governance reform in Japan

In recent years, the Japanese government has implemented policies to promote corporate governance reforms – in particular to increase the number of independent outside directors on the boards of listed firms. According to the government’s economic growth strategy, the purpose of the corporate governance reform is to encourage Japanese firms “[t]o proactively use their earnings for new capital investment, instead of accumulating internal reserves" (Japan Revitalization Strategy 2014).

The government's guidance on the role of corporate boards suggest that it expects outside directors to use their rights and responsibilities as advisors to discover new investment opportunities, rather than focusing on their monitoring responsibilities.

The government amended the Companies Act in 2014 and introduced the Corporate Governance Code in 2015. If firms do not have independent outside directors on their board, a rule now forces them to explain, at both annual shareholder meetings and in annual reports, why not. 

Since this is a ‘comply or explain’ style of rule, appointing independent outside directors is not strictly a statutory obligation. However, it is not easy to provide convincing reasons for not appointing independent outside directors, and so the rules put strong pressure on listed firms. In 2018, the government amended the Corporate Governance Code to increase the number of independent outside directors and to ensure gender diversity on corporate boards.

Following the adoption of these policies, the number of outside directors in listed firms has been increasing rapidly, in sharp contrast to the unlisted firms that these policies do not affect (Figure 1). 

Figure 1 The trend in outside directors in Japanese listed and unlisted firms, 2011-2017

Source: Calculated from the Basic Survey of Japanese Business Structure and Activities.

According to the Basic Survey of Japanese Business Structure and Activities (BSJBSA) conducted by the Ministry of Economy, Trade and Industry, the percentage of listed firms with at least one outside director has been increasing, particularly since 2014, and reached 87% in 2017. In contrast, the percentage of unlisted firms with outside directors has remained constant at around 46%. The mean share of outside directors on the boards of listed firms also increased from 13% in 2011 to 25% in 2017, but the figure has remained steady at around 18% for unlisted firms. These trends clearly indicate that only listed firms responded to the pressure from corporate governance reform.

Past studies on the impact of outside directors

Many studies have examined the relationship between outside directors and firm performance. Since board composition is an endogenous decision of the firm, we cannot interpret simple correlations between the introduction and expansion of outside directors and firm performance as a causal relationship (Hermalin and Weisbach 2003, Adams et al. 2010, Wintoki et al. 2012, Roberts and Whited 2013).

The enactment of the SOX Act and related reforms in the US, which forced listed firms to strengthen the roles of outside directors, constituted an exogenous change in board composition. Several studies have exploited this natural experiment to analyse the causal impacts of outside directors on firm performance. The results do not necessarily support a popular belief that outside directors contribute to the benefit of shareholders (for evidence, see Linck et al. 2009, Ahmed et al. 2010, Duchin et al. 2010). Many studies pointed out that one-size-fits-all regulation is not desirable (e.g. Coles et al. 2008, Linck et al. 2008, Duchin et al. 2010, Schmidt 2015).

In Japan, there have been some empirical studies on the impact of outside directors (e.g. Miyajima and Ogawa 2012, Kim and Kwon 2015, Tanaka 2019, Sako and Kubo 2019), but they have not analysed the impacts of the recent amendment of the Companies Act and the introduction of the Corporate Governance Code. 

I used a panel of both listed and unlisted Japanese firms to address the effects of outside directors on investments, profitability, and productivity by exploiting the quasi-natural experiment of recent corporate governance reforms (Morikawa 2019). As the impact of board composition in non-Anglo-American firms is understudied (Adams et al. 2010), this study also contributes to the literature by presenting causal evidence for Japanese firms.

Data and methodology

I mainly use firm-level panel data for the years 2014-2017 constructed from the BSJBSA. The BSJBSA collects information on the number of inside and outside directors, and those from related firms (parent and subsidiary), as a subset of outside directors. Importantly, the data cover both listed and unlisted firms, and so we can make comparisons between these firms.

I focus on the increase in the number of outside directors between 2014 and 2016 and analyse its impact on firm behaviour and performance in the next year and the following year. The data prior to 2014 are used to control for trends in the dependent variables before the increase in the number of outside directors, and also to construct an instrumental variable (the ratio of outside directors in the previous year).

I wanted to discover whether the reform promoted active risk-taking and improved firm performance, as the Corporate Governance Code and other government documents – such as the Japan Revitalization Strategy – suggest, using tangible investments and R&D expenditure (both divided by sales) as the dependent variables representing firm behaviour. 

The rate of return on assets (ROA) and total factor productivity (TFP) measure firm performance. A difference-in-difference (DID) strategy compares listed and unlisted firms, and fixed-effects instrumental variable (FEIV) estimations for listed firms detect causality.

Results and policy implications

Table 1 summarises the estimation results on the relationship between increasing outside directors and investments, R&D expenditure, ROA, and TFP. In both the DID and FEIV specifications, the estimated coefficients are small and rarely significant. Where the coefficients are significant (expressed in bold in the table), the figures are negative. 

Table 1 Effects of increasing outside directors on investments/firm performance in Japan

Source: Morikawa (2019).
Notes: The figures indicate the coefficients for a dummy variable of listed firms that increase the number of outside directors. The figures in bold are statistically significant at the 10% level. 

In short, this provides no evidence that the increase in the number of outside directors among listed firms has promoted active investments or risk-taking behaviour. In addition, it has had no positive impact on the profitability or productivity of the affected firms.

So the Corporate Governance Code has successfully increased the number of independent outside directors in Japanese listed firms, but without observable positive impacts on firm behaviour and performance – at least up to two years after the implementation of board reforms. These results support the view repeatedly expressed in other research that the optimal board composition differs depending on a firm’s characteristics, and that one-size-fits-all regulation can harm some firms. From a management perspective, the results suggest that it is desirable for firms to search for appropriate talent that suits their business strategy, and that firms should avoid rushing to appoint token outside directors simply to address governance reform. 

Editors’ note: The research on which this column is based first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.


Adams, R B, B E Hermalin, and M S Weisbach (2010), “The Role of Boards of Directors in Corporate Governance: A Conceptual Framework and Survey”, Journal of Economic Literature 48(1): 58–107.

Ahmed, A S, M L McAnally, S Rasmussen, and C D Weaver (2010), “How Costly Is the Sarbanes Oxley Act? Evidence on the Effects of the Act on Corporate Profitability”, Journal of Corporate Finance 16(3): 352–369.

Coles, J C, N D Daniel, and L Naveen (2008), “Boards: Does One Size Fit All?”, Journal of Financial Economics 87(2): 329–356.

Duchin, R, J G Matsusaka, and O Ozbas (2010), “When Are Outside Directors Effective?”, Journal of Financial Economics 96(2): 195–214.

Hermalin, B E and M S Weisbach (2003), “Boards of Directors as an Endogenously Determined Institution: A Survey of the Economic Literature”, FRB New York Economic Policy Review 9(1): 7–26.

Kim, Y G and H U Kwon (2015). “The Effects of Reforming Board Meetings on Firm Productivity in Japan”, RIETI Discussion Paper 15-J-060 (in Japanese).

Linck, J S, J M Netter, and T Yang (2008), “The Determinants of Board Structure”, Journal of Financial Economics 87(2): 308–328.

Linck, J S, J M Netter, and T Yang (2009), “The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors”, Review of Financial Studies 22(8): 3287–3328.

Miyajima, H and R Nakajima (2012), “Understanding Change in Board Composition: Determinants of Board Composition and Effects of Outside Directors”, RIETI Policy Discussion Paper 12-P-013 (in Japanese).

Morikawa, M (2019), “Effects of Outside Directors on Firms’ Investments and Performance: Evidence from a Quasi-Natural Experiment in Japan”, RIETI Discussion Paper 19-E-072.

Roberts, M R and T M Whited (2013), “Endogeneity in Empirical Corporate Finance”, in G M Constantinides, M Harris and R M Stulz (eds.), Handbook of the Economics of Finance 2A, Elsevier: 493–572.

Sako, M and K Katsuyuki (2019), “Professionals on Corporate Boards: How do they affect the bottom line?”, RIETI Discussion Paper 19-E-010.

Schmidt, B (2015), “Costs and Benefits of Friendly Boards during Mergers and Acquisitions”, Journal of Financial Economics 117(2): 424–447.

Tanaka, T (2019), “Gender Diversity on Japanese Corporate Boards”, Journal of the Japanese and International Economies 51: 19–31.

Wintoki, M B, J S Linck, and J M Netter (2012), “Endogeneity and the Dynamics of Internal Corporate Governance”, Journal of Financial Economics 105(3): 581–606.

420 Reads