Liberty Street Economics

« | Main | »

October 12, 2016

Let the Light In: How Financial Reporting and Transparency Improve Corporate Governance

Let the Light In: How Financial Reporting and Transparency Improve Corporate Governance

Financial reporting is valuable because corporate governance—which we view as the set of contracts that help align managers’ interests with those of shareholders—can be more efficient when the parties commit themselves to a more transparent information environment. This is a key theme in our recent article “The Role of Financial Reporting and Transparency in Corporate Governance,” which reviews the literature on the part played by financial reporting in resolving agency conflicts among managers, directors, and shareholders. In this post, we highlight some of the governance issues and recommendations discussed in the article.

Better Reporting Shrinks Asymmetry, Boosts Efficiency

We first survey the papers that argue that high-quality financial reporting can alleviate information asymmetries that would otherwise impair the efficiency of important governance mechanisms. For example, accurate and timely financial information about firm profitability and risks can provide directors, investors, and regulators with early warning signals that allow for timely and appropriate intervention and discipline. Empirical studies have found that information transparency is positively associated with the proportion of outside directors on the board, the proportion of outside directors on the audit committee, and the proportion of outside directors with financial expertise. These findings show that transparent financial reporting reduces information asymmetry between insiders and outsiders, which facilitates the appointment of outside directors because they are better able to perform their monitoring and advising duties.

Formal and Informal Contracts

Our survey also highlights the distinction between formal and informal contracting relationships, and discusses how both can shape a firm’s governance structure. Formal contracts, such as written employment agreements, are often quite narrow in scope and tend to be relatively straightforward to analyze. Informal contracts are used to govern longer-term, complex relationships and allow the parties to engage in a broad set of activities for which a formal contract is either impractical or infeasible. For example, the responsibilities of the chief executive officer (CEO) are so complex that it is difficult for firms to draft a contract that covers all possible contingenies. Consequently, although some CEOs do have formal employment contracts, these contracts are necessarily incomplete and relatively narrow in scope. As a result, the board and the CEO develop informal rules and understandings that guide their behavior over time.

One Size Fits All?

Another key theme of our survey is that a firm’s governance structure and its information environment evolve together to resolve the firm’s particular set of agency conflicts. Consequently, one should not necessarily expect every firm to converge to a single “best” type of governance structure and financial reporting system. Instead, one should expect to observe heterogeneity in these mechanisms that reflects differences in firms’ economic and financial characteristics. We argue that the corporate governance literature seems unduly burdened by the notion that certain governance structures can be categorically identified as “good” or “bad.”

What’s Different about Banks?

We pay special attention to the literature on the governance of banks and other financial intermediaries. Bank governance tends to differ in important ways from the governance of other firms owing to the existence of public governance, such as regulatory oversight and capital requirements, which may either substitute for or complement internal mechanisms, such as the board. In particular, public governance is supposed to serve the interests of various public constituencies who expect safe and sound financial institutions. These objectives do not necessarily coincide with those of investors who demand performance, which necessarily entails taking risks. The incentives for information production are also different in banks. Policies such as living wills, the explicit prohibition against bailouts, and stress testing can encourage voluntary disclosure by banks. At the same time, however, regulations such as the annual stress testing may reduce other parties’ incentives for information production (credit analysts, for example). We argue that closer examination of how managers, analysts, and regulators interact to produce information about banks and financial institutions is an area ripe for future research.

Rules to Live By

Finally, we discuss five governance practices that can facilitate the production of information and enhance the transparency of banks and possibly other firms. First, separating the positions of CEO and board chair can improve the accuracy and timeliness of financial reporting, since board chairs have incentives to provide information to stakeholders that the CEO might prefer be kept private. Second, identifying successors to replace key members of the executive management team, should the need arise, is likely to facilitate a smoother, more effective transition and a steadier flow of credible information. Third, an incentive structure that rewards managers who share information—both good and bad—with regulators could be established. Fourth, if boards were to engage in regular self-assessments and they agreed to share this information with regulators, such evaluations might facilitate the replacement of ineffective directors. And fifth, bank creditors could take a more prominent role in demanding timely and accurate information, which could improve the efficacy and efficiency of their own monitoring as well as that of other stakeholders.

Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.



Christopher S. Armstrong is an associate professor of accounting at the Wharton School of the University of Pennsylvania.

Wayne R. Guay is the Yageo Professor of Accounting at the Wharton School of the University of Pennsylvania.

Hamid MehranHamid Mehran is an assistant vice president at the Federal Reserve Bank of New York.

Joseph P. Weber is the George Maverick Bunker Professor of Management and a professor of accounting at the MIT Sloan School of Management.

How to cite this blog post:

Christopher S. Armstrong, Wayne R. Guay, Hamid Mehran, and Joseph P. Weber, “Let the Light In: How Financial Reporting and Transparency Improve Corporate Governance,” Federal Reserve Bank of New York Liberty Street Economics (blog), October 12, 2016, http://libertystreeteconomics.newyorkfed.org/2016/10/let-the-light-in-how-financial-reporting-and-transparency-improve-corporate-governance.html.

About the Blog

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

Liberty Street Economics does not publish new posts during the blackout periods surrounding Federal Open Market Committee meetings.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Image of NYFED Economic Research Tracker Icon Liberty Street Economics is available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Economic Inequality

image of inequality icons for the Economic Inequality: A Research Series

This ongoing Liberty Street Economics series analyzes disparities in economic and policy outcomes by race, gender, age, region, income, and other factors.

Most Read this Year

Comment Guidelines

 

We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1,500 characters.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be relevant: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post.

Please be respectful: We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will
not be posted.‎

Comments with links: Please do not include any links in your comment, even if you feel the links will contribute to the discussion. Comments with links will not be posted.

Send Us Feedback

Disclosure Policy

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.

Archives