Corporate Governance As An Institution To Overcome Social Dilemmas Introduction - Corporate Governance and Business Ethics

While many governments and companies struggle with the aftermaths of the current financial crisis, commentators in the media and in the academic community are trying to understand how the distortions in the financial system could have gone so far. Based on allocated housing loans, financial experts designed complicated financial instruments that were sold to investors. These financial instruments were often repackaged several times, which made it difficult for investors to estimate the actual value of their investments. A considerable information asymmetry developed between the designers of financial instruments and the ultimate investors. The dangers of this information asymmetry were hardly noticeable as long as the market for these financial instruments was very liquid due to a long period of rising housing prices. This changed dramatically in summer 2007. A combination of rising interest rates and falling housing prices made the market for these financial instruments collapse. A number of banks saw themselves forced to keep large amounts of these assets in their books although they had intended to resell them. Moreover, a vast number of investors noticed that they had invested in “toxic” assets with very uncertain value. It became clear that part of these financial instruments were based on mortgage loans that had been offered to people with very low or no income. Once the housing prices began falling, many of these mortgage loans became stressed.

A number of observers are wondering why banks with solid reputations allocated hazardous housing loans to people with very low credit worthiness. It is widely believed that some bankers abused their informational advantage in order to make short-term gains. In more general terms, the current financial crisis is partly attributed to opportunistic behavior, a culture of “greed”, and failures in corporate governance. These attributions are quite surprising since the major focus of recent corporate governance regulations was actually the containment of greed and opportunistic behavior. In the wake of the Enron scandal, legislators all over the world debated on measures to reduce managerial opportunism and to align the interests of managers and shareholders.

Why did the widespread adoption of the dominant corporate governance paradigm fail to reach its primary objective, namely the containment of opportunism? We argue that the dominant paradigm has an important shortcoming: it assumes managerial self-interest and potential opportunism as an axiom. However, the new and fast-growing field of psychological economics has offered much evidence that self-interest and opportunistic behavior are not given characteristics of people. Individuals vary systematically in their inclination toward self-interested behavior. To a great degree, self-interested behavior can be influenced by institutions.

In this chapter, we apply insights from psychological economics to corporate governance. In our analysis, we present different perspectives on corporate governance and their shortcomings. Then we suggest our view that corporate governance can be seen as an institution to overcome the possibilities of free riding or, in other words, social dilemmas. In today’s companies, which are characterized by more and more knowledge work, the traditional mechanisms of behavior and outcome control (Ouchi 1978) become less and less effective (Osterloh 2006). Therefore, social dilemmas need to be overcome by means of voluntary self-control. Taking account of psychological economic insights, we suggest that voluntary self-control is not just wishful thinking but indeed possible. The key to voluntary self-control are institutions fostering protocol preferences. When viewing corporate governance as an institution that fosters protocol preferences, our analysis leads to suggestions that clash with conventional wisdom. We suggest that the following measures help to overcome social dilemmas: board representation of knowledge workers who invest in firm-specific human capital, attenuation of variable pay-for performance, selection of directors and managers with protocol preferences, and employee participation in decision-making and control.

This article proceeds as follows. In the section “Corporate Governance Based on Self-Interest as an Axiom”, we present the dominant agency paradigm in the corporate governance literature and the theory of incomplete contracts, which are both based on self-interest as an axiom. While both theories have their shortcomings, the theory of incomplete contracts serves as a basis for newer corporate governance approaches based on psychological economics. In the section “The Financial Crisis and Corporate Governance”, a brief analysis of the current financial crisis is provided, followed by important implications concerning the theory of corporate governance. In the section “Corporate Governance Based on Psychological Economics”, we first explain the team production theory of corporate governance as an alternative to the dominant paradigm. Then, we contrast this team production perspective with our own approach of corporate governance as an institution to overcome social dilemmas. Both approaches are partly based on the same psychological foundations, however, there are important differences as well. Based on empirical findings in the field of psychological economics, we explain our recommendations concerning the design of corporate governance institutions. In the last section, we conclude.

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