We refer again to the financial crisis, this time with a specific focus on the implications for corporate governance. Hertig (2009) provides a recent analysis of corporate governance deficiencies preceding the current financial crisis, with a particular emphasis on the failures in risk management. Many firms were not prepared to handle the shocks arising from the financial crisis, in part due to overly simplistic or optimistic scenarios in their “stress testing”. This negligence has become particularly visible in the financial sector. However, numerous firms in non-financial sectors were concerned as well. Several factors had caused this negligence in risk management. First, the board of directors was under pressure to adopt ill-fated strategies that were favored by investors or executives with short-term preferences. These pressures were enhanced by top management compensation that was often oriented toward short-term performance and, hence, led to excessive risk-taking. Second, it was often difficult for sensitive information to reach the board of directors. In many firms, the directors were neither aware of the increase in credit risks nor did they understand the consequences of these risks for the management of the firm’s liquidity. Third, as Hertig (2009) posits, the focus of corporate governance reforms was not on improving the board’s effectiveness, but rather on reducing the board’s discretion by means of disclosure and other requirements.1 Fourth, whistle-blowing was not effective. On the one hand, employees had few incentives to blow the whistle because they were often fired, quit under pressure or shifted their duties (Dyck et al. 2007). On the other hand, it was easier to blow the whistle on obvious offences, such as corporate fraud, than on deficiencies in risk management. However, sustainable monitoring by a controlling constituency, such as a strong shareholder, depends on a loyal relationship with managers and employees (Hirschman 1970), which also entails whistle-blowing.
These deficiencies, which preceded the financial crisis, lead to several important conclusions for our subsequent analysis. First, series of corporate governance reforms that were inspired by the economic model of self-interested individuals were not able to constrain opportunism. They may even have fostered opportunistic tendencies as a self-fulfilling prophecy. Second, incentives do not suffice to align the interests of shareholders, directors, managers, and employees. Rather, corporate governance needs to create the preconditions for a loyal relationship between these constituencies. Third, it is important that employees who have informational advantages over directors are willing to contribute to collective goods, such as the firm’s reputation and survival. Therefore, a new theory of corporate governance need not be confined to the board of directors as a benevolent ruling body, but rather address cooperative behavior at all levels of the hierarchy.
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