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CORPORATE GOVERNANCE: EFFECTS ON FIRM PERFORMANCE AND ECONOMIC GROWTH

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This document addresses corporate governance and its effect on corporate performance and economic performance. It first recapitulates and builds on previous work undertaken by DSTI, for example, it gives a more explicit exposition of the shareholder and stakeholder models of corporate governance. It then goes on to address some of the underlying factors that promote efficient corporate governance, and examines some of the strengths, weaknesses, and economic implications associated with various corporate governance systems. In addition to providing data not presented in the previous work, it also provides newly available information on ownership concentration and voting rights in a number of OECD countries. The document also provides a survey of empirical evidence on the link between corporate governance, firm performance and economic growth. Finally, several policy implications are identified.
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CORPORATE GOVERNANCE:
EFFECTS ON FIRM PERFORMANCE AND
ECONOMIC GROWTH
by
Maria Maher and Thomas Andersson
ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT
© OECD 1999

CORPORATE GOVERNANCE:
EFFECTS ON FIRM PERFORMANCE AND ECONOMIC GROWTH
TABLE OF CONTENTS
SUMMARY.................................................................................................................................................... 3
I.
Introduction.......................................................................................................................................... 4
II. Analytical Framework: The Shareholder and Stakeholders Models of Governance ........................... 5
II.1
The Shareholder Model ................................................................................................................ 6
II.2
The Stakeholder Model ................................................................................................................ 8
II.3
The Interaction of Corporate Governance with the Institutional and Economic Framework..... 10
III.
Corporate Governance in OECD Countries: Strengths, Weaknesses, and Economic Implications12
III.1
Outsider Systems of Corporate Governance .............................................................................. 17
III.2
Insider Systems of Corporate Governance ................................................................................. 24
III.3
A Convergence in Systems? ....................................................................................................... 30
IV.
Corporate Governance and Performance: The Empirical Evidence............................................... 31
IV.1
Ownership concentration and firm performance ........................................................................ 31
IV.2
Dominant shareholders and the expropriation of minority shareholders.................................... 34
IV.3
The market for corporate control and firm performance ............................................................ 37
IV.4
Managerial compensation and firm performance ....................................................................... 41
V. Conclusions........................................................................................................................................ 44
BIBLIOGRAPHY......................................................................................................................................... 46
2

CORPORATE GOVERNANCE:
EFFECTS ON FIRM PERFORMANCE AND ECONOMIC GROWTH1
SUMMARY
1.
This document addresses corporate governance and its effect on corporate performance and
economic performance. It first recapitulates and builds on previous work undertaken by DSTI, for
example, it gives a more explicit exposition of the shareholder and stakeholder models of corporate
governance. It then goes on to address some of the underlying factors that promote efficient corporate
governance, and examines some of the strengths, weaknesses, and economic implications associated with
various corporate governance systems. In addition to providing data not presented in the previous work, it
also provides newly available information on ownership concentration and voting rights in a number of
OECD countries. The document also provides a survey of empirical evidence on the link between
corporate governance, firm performance and economic growth. Finally, several policy implications are
identified.
2.
One of the most striking differences between countries’ corporate governance systems is the
difference in the ownership and control of firms that exist across countries. Systems of corporate
governance can be distinguished according to the degree of ownership and control and the identity of
controlling shareholders. While some systems are characterised by wide dispersed ownership (outsider
systems)
, others tend to be characterised by concentrated ownership or control (insider systems). In
outsider systems of corporate governance (notably the US and UK) the basic conflict of interest is between
strong managers and widely-dispersed weak shareholders. In insider systems (notably Germany and
Japan), on the other hand, the basic conflict is between controlling shareholders (or blockholders) and
weak minority shareholders.
3.
This document shows how the corporate governance framework can impinge upon the
development of equity markets, R&D and innovative activity, entreprenuership, and the development of an
active SME sector, and thus impinge upon economic growth. However, there is no single model of
corporate governance and each country has through time developed a wide variety of mechanisms to
overcome the agency problems arising from the separation of ownership and control. The document looks
at the various mechanisms employed in different systems (e.g. concentrated ownership, executive
remuneration schemes, the market for takeovers, cross-shareholdings amongst firms, etc.) and examines
the evidence on whether or not they are achieving what they were intended to do. For example, one of the
benefits of concentrated ownership is that it brings more effective monitoring of management and helps
overcome the agency problems arising from the separation of ownership and control. Some of the costs,
however, are low liquidity and reduced possibilities for risk diversification. While dispersed ownership
brings higher liquidity it may not provide the right incentives to encourage long-term relationships that are
required for certain types of investment. Therefore, one of the challenges facing policy makers is how to
develop a good corporate governance framework which can secure the benefits associated with controlling
shareholders acting as direct monitors, while at the same time ensuring that they do not impinge upon the
development of equity markets by expropriating excessive rents.

1.
This paper was written by Maria Maher and Thomas Andersson of the OECD Secretariat. A modified
version was presented at the Tilburg University Law and Economics Conference on “Convergence and
Diversity in Corporate Governance Regimes and Capital Markets”, Eindhoven, the Netherlands,
4-5 November 1999. The opinions expressed in the paper are the responsibility of the author(s) and do not
necessarily reflect those of the OECD or of the governments of its Member countries.
3

I.
Introduction
4.
At the 1998 Industry Ministerial, a new direction for industrial policy was stressed and Ministers
agreed on a number of priority areas for future work, including corporate governance. The OECD Council,
meeting at Ministerial level in April 1998, also stressed the importance of corporate governance and called
upon the OECD to develop a set of corporate governance standards and guidelines. In order to fulfil this
Ministerial mandate, the OECD established an Ad Hoc Task Force on Corporate Governance, consisting of
representatives from national governments, other relevant international organisations and the private
sector. DSTI also participated in the Secretariat team serving the Task Force and contributed substantive
input into the development of the OECD Principles on Corporate Governance, see OECD (1999a). OECD
Ministers, meeting in May 1999, endorsed the Principles developed by the Task Force and also agreed that
the Principles be assessed in due course, possibly in two years time. The OECD Council, therefore, also
requested continuing analytical work in this area, see OECD (1999b).
5.
The May 1999 Council Ministerial also called upon the OECD to study the causes of growth
disparities (e.g. technological innovation, framework conditions for firm creation and growth, SMEs, etc.),
and identify the factors and policies which could strengthen long-term growth performance. While
macroeconomic factors certainly play a major part in the economic performances of OECD countries,
governments have increasingly come to recognise that there are strong complementarities between sound
macroeconomic policies and sound microeconomic foundations. As the last decade has seen a
convergence on what constitutes good macroeconomic policy the OECD countries have increasingly come
to recognise that weakness in microstructures can have profound impacts on a macro level. For example,
the 1997 financial crisis in Asia was thought to be due, in part, to weaknesses in the banking sector and in
corporate governance. Countries are therefore looking towards microeconomic foundations and structures
in order to enhance their economic performance. The OECD reports on Regulatory Reform, the Jobs
Study and the Principles for Corporate Governance are good examples of this new approach. This
approach is also in line with the new direction of work for the Industry Committee as set out by Industry
Ministers at their 1998 OECD Ministerial meeting.
6.
One key element of improving microeconomic efficiency is corporate governance. Corporate
governance affects the development and functioning of capital markets and exerts a strong influence on
resource allocation. It impacts upon the behaviour and performance of firms, innovative activity,
entrepreneurship, and the development of an active SME sector. In an era of increasing capital mobility
and globalisation, corporate governance has become an important framework condition affecting the
industrial competitiveness of OECD countries. Meanwhile, in transition economies, privatisation has
raised questions about the way in which private enterprises should be governed. It is thought that poor
corporate governance mechanisms in these countries have proved, in part, to be a major impediment to
improving the competitiveness of firms. Better corporate governance, therefore, both within OECD and
non-OECD countries should manifest itself in enhanced corporate performance and can lead to higher
economic growth.
7.
However, there is no single model of corporate governance. Governance practices vary not only
across countries but also across firms and industry sectors. However, one of the most striking differences
between countries’ corporate governance systems is in the ownership and control of firms that exist across
countries. Systems of corporate governance can be distinguished according to the degree of ownership and
control and the identity of controlling shareholders. While some systems are characterised by wide
dispersed ownership (outsider systems), others tend to be characterised by concentrated ownership or
control (insider systems). In outsider systems of corporate governance (notably the US and UK) the basic
conflict of interest is between strong managers and widely-dispersed weak shareholders. In insider
systems (notably Continental Europe and Japan), on the other hand, the basic conflict is between
controlling shareholders (or blockholders) and weak minority shareholders. However, these differences
are also rooted in variations in countries’ legal, regulatory, and institutional environments, as well as
4

historical and cultural factors. Therefore, policies that promote the adoption of specific forms of
governance should attempt to account for the product and factor market contexts, and other institutional
factors, within which they are being contemplated.
8.
The OECD Principles for Corporate Governance represent a common basis that OECD Member
countries consider essential for the development of good governance practice. This work, on the other
hand, provides an economic rationale for why corporate governance matters and explores the relationship
between corporate governance, corporate performance, economic growth, and, where relevant, industry
structure. The search for good corporate governance practices in this context, therefore, is based on an
identification of what works in different countries and circumstances, to discern what lessons can be
derived from these experiences, and to examine the conditions for transferability of these practices to other
countries. Continued work in this area, therefore, will aim to ascertain what are the key factors that shape
the effectiveness of different corporate governance mechanisms, and to determine what are the key policy
adjustments that are most needed in individual systems of corporate governance. This analytical work will
also provide valuable input to the work of other Committees and Directorates, especially DAFFE, and into
OECD horizontal projects. In particular, it will provide input into the assessment of the OECD Principles
in due course and to the OECD mandate in determining the underlying factors contributing to economic
growth.
9.
This paper recapitulates and builds on previous work undertaken by DSTI, see OECD (1998a).
It also builds on lessons gleaned in the development of the OECD Principles for Corporate Governance. It
structures the previous DSTI work better (e.g. it gives a more explicit exposition of the shareholder and
stakeholders models of corporate governance) and goes on to provide a qualitative assessment of the
strengths, weaknesses and economic implications of different systems of corporate governance. In
addition to new data on ownership concentration and voting rights in a number of OECD countries, it also
provides data not presented in the previous work. It also provides a survey of empirical evidence on the
link between corporate governance, firm performance and economic growth, identifying areas in which a
consensus view appears to have emerged in the literature. This work also examines areas not covered
previously e.g. the markets for corporate control, the effects of executive remuneration, etc.
10.
Section II of this paper provides an analytical framework for understanding how corporate
governance can affect corporate performance and economic growth. Section III looks at the critical
differences in corporate governance systems in OECD countries. It then goes on to provide a qualitative
assessment of the strengths, weaknesses, and economic implications associated with the different systems.
Section IV provides a review of the empirical evidence of the effect of corporate governance on corporate
performance and economic performance, and section V concludes. Wherever possible, we also identify
those areas where policy implications emerge.
II.
Analytical Framework: The Shareholder and Stakeholders Models of Governance
11.
Corporate governance has traditionally been associated with the “principal-agent” or “agency”
problem. A “principal-agent” relationship arises when the person who owns a firm is not the same as the
person who manages or controls it. For example, investors or financiers (principals) hire managers
(agents) to run the firm on their behalf. Investors need managers’ specialised human capital to generate
returns on their investments, and managers may need the investors’ funds since they may not have enough
capital of their own to invest. In this case there is a separation between the financing and the management
of the firm, i.e. there is a separation between ownership and control, see Berle and Means (1932).
12.
Before looking at the relationship between corporate governance, firm performance, and
economic growth, it is useful to have a framework with which to understand how corporate governance can
affect firm behaviour and economic performance. One of the problems with the current debate on
corporate governance is that there are many different, and often conflicting, views on the nature and
5

purpose of the firm. This debate ranges from positive issues concerning how institutions actually work, to
normative issues concerning what should be the firm’s purpose. Therefore, in order to make sense of this
debate, it is useful to consider the different analytical backgrounds or approaches that are often employed.
13.
The term corporate governance has been used in many different ways and the boundaries of the
subject vary widely. In the economics debate concerning the impact of corporate governance on
performance, there are basically two different models of the corporation, the shareholder model and the
stakeholder model. In its narrowest sense (shareholder model), corporate governance often describes the
formal system of accountability of senior management to shareholders. In its widest sense (stakeholder
model), corporate governance can be used to describe the network of formal and informal relations
involving the corporation. More recently, the stakeholder approach emphasises contributions by
stakeholders that can contribute to the long term performance of the firm and shareholder value, and the
shareholder approach also recognises that business ethics and stakeholder relations can also have an impact
on the reputation and long term success of the corporation. Therefore, the difference between these two
models is not as stark as it first seems, and it is instead a question of emphasis.
14.
The lack of any consensus regarding the definition of corporate governance is also reflected in
the debate on governance reform. This lack of consensus leads to entirely different analyses of the
problem and to the strikingly different solutions offered by participants in the reform process. Therefore,
having a clear understanding of the different models can provide insights and help us to appreciate the
different sides of this debate. An understanding of the issues involved can also provide the basis from
which to identify good corporate governance practices and to provide policy recommendations.
II.1
The Shareholder Model
15.
According to the shareholder model the objective of the firm is to maximise shareholder wealth
through allocative, productive and dynamic efficiency i.e. the objective of the firm is to maximise profits.
The criteria by which performance is judged in this model can simply be taken as the market value (i.e.
shareholder value) of the firm. Therefore, managers and directors have an implicit obligation to ensure
that firms are run in the interests of shareholders. The underlying problem of corporate governance in this
model stems from the principal-agent relationship arising from the separation of beneficial ownership and
executive decision-making. It is this separation that causes the firm’s behaviour to diverge from the profit-
maximising ideal. This happens because the interests and objectives of the principal (the investors) and the
agent (the managers) differ when there is a separation of ownership and control. Since the managers are
not the owners of the firm they do not bear the full costs, or reap the full benefits, of their actions.
Therefore, although investors are interested in maximising shareholder value, managers may have other
objectives such as maximising their salaries, growth in market share, or an attachment to particular
investment projects, etc.
16.
The principal-agent problem is also an essential element of the “incomplete contracts” view of
the firm developed by Coase (1937), Jensen and Meckling (1976), Fama and Jensen (1983a,b), Williamson
(1975, 1985), Aghion and Bolton (1992), and Hart (1995). This is because the principal-agent problem
would not arise if it were possible to write a “complete contract”. In this case, the investor and the
manager would just sign a contract that specifies ex-ante what the manager does with the funds, how the
returns are divided up, etc. In other words, investors could use a contract to perfectly align the interests
and objectives of managers with their own. However, complete contracts are unfeasible, since it is
impossible to foresee or describe all future contingencies. This incompleteness of contracts means that
investors and managers will have to allocate “residual control rights” in some way, where residual control
rights are the rights to make decisions in unforeseen circumstances or in circumstances not covered by the
contract. Therefore, as Hart (1995) states: “Governance structures can be seen as a mechanism for making
decisions that have not been specified in the initial contract.”
6

17.
So why don’t investors just write a contract that gives them all the residual control rights in the
firm, i.e. owners get to decide what to do in circumstances not covered by the contract? In principle this is
not possible, since the reason why owners hire managers in the first place is because they needed
managers’ specialised human capital to run the firm and to generate returns on their investments. The
“agency” problem, therefore, is also an asymmetric information problem i.e. managers are better informed
regarding what are the best alternative uses for the investors’ funds. As a result, the manager ends up with
substantial residual control rights and discretion to allocate funds as he chooses. There may be limits on
this discretion specified in the contract, but the fact is that managers do have most of the residual control
rights.2 The fact that managers have most of the control rights can lead to problems of management
entrenchment and rent extraction by managers. Much of corporate governance, therefore, deals with the
limits on managers’ discretion and accountability i.e. as Demb and Neubauer (1992) state “corporate
governance is a question of performance accountability”.
18.
One of the economic consequences of the possibility of ex-post expropriation of rents (or
opportunistic behaviour) by managers is that it reduces the amount of resources that investors are willing to
put up ex-ante to finance the firm, see Grossman and Hart (1986). This problem, more generally known as
the hold-up problem has been widely discussed in the literature, see Williamson (1975, 1985) and Klein,
Crawford and Alchian (1978). A major consequence of opportunistic behaviour is that it leads to socially
inefficient levels of investment that, in turn, can have direct implications for economic growth. According
to the shareholder model, therefore, corporate governance is primarily concerned with finding ways to
align the interests of managers with those of investors, with ensuring the flow of external funds to firms
and that financiers get a return on their investment.
19.
An effective corporate governance framework can minimise the agency costs and hold-up
problems associated with the separation of ownership and control. There are broadly three types of
mechanisms that can be used to align the interests and objectives of managers with those of shareholders
and overcome problems of management entrenchment and monitoring:
? One method attempts to induce managers to carry out efficient management by directly
aligning managers interests with those of shareholders e.g. executive compensation plans,
stock options, direct monitoring by boards, etc.
? Another method involves the strengthening of shareholder’s rights so shareholders have both
a greater incentive and ability to monitor management. This approach enhances the rights of
investors through legal protection from expropriation by managers e.g. protection and
enforcement of shareholder rights, prohibitions against insider-dealing, etc.
? Another method is to use indirect means of corporate control such as that provided by capital
markets, managerial labour markets, and markets for corporate control e.g. take-overs.
20.
One of the critiques of the shareholder model of the corporation is the implicit presumption that
the conflicts are between strong, entrenched managers and weak, dispersed shareholders. This has led to
an almost exclusive focus, in both the analytical work and in reform efforts, of resolving the monitoring
and management entrenchment problems which are the main corporate governance problems in the
principal-agent context with dispersed ownership. For example, most of this work has addressed concerns
related to the role of the board of directors, stock options and executive remuneration, shareholder
protection, the role of institutional investors, management entrenchment and the effectiveness of the
market for take-overs, etc.

2 .
See Shleifer and Vishny (1997), p. 741.
7

21.
The fact is that the widely held firm, presumed in Berle and Means (1932) seminal work, is not
the rule but is rather the exception.3 Instead, the dominant organisational form for the firm is one
characterised by concentrated ownership. One of the reasons why we observe ownership concentration
may be due, in part, to the lack of investor protection. However, unlike the widely-held corporation where
managers have most of the residual control rights with shareholders having very little power, the closely-
held corporation is usually controlled by a majority shareholder or by a group of controlling blockholders.
This could be an individual or family, or blockholders such as financial institutions, or other corporations
acting through a holding company or cross shareholdings.
22.
Another reason why ownership concentration is so prevalent as the dominant organisational form
is because it is one way of resolving the monitoring problem. According to the principle-agent model, due
to the divergence of interests and objectives of managers and shareholders, one would expect the
separation of ownership and control to have damaging effects on the performance of firms. Therefore, one
way of overcoming this problem is through direct shareholder monitoring via concentrated ownership. The
difficulty with dispersed ownership is that the incentives to monitor management are weak. Shareholders
have an incentive to “free-ride” in the hope that other shareholders will do the monitoring. This is because
the benefits from monitoring are shared with all shareholders, whereas, the full costs of monitoring are
incurred by those who monitor. These free-rider problems do not arise with concentrated ownership, since
the majority shareholder captures most of the benefits associated with his monitoring efforts.
23.
Therefore, for the closely held corporation the problem of corporate governance is not primarily
about general shareholder protection or monitoring issues. The problem instead is more one of cross-
shareholdings, holding companies and pyramids, or other mechanisms that dominant shareholders use to
exercise control, often at the expense of minority investors. It is the protection of minority shareholders
that becomes critical in this case. One of the issues that arises in this context is how do policy makers
develop reforms that do not disenfranchise majority shareholders while at the same time protect the
interests of minority shareholders. In other words, how do we develop reforms that retain the benefits of
monitoring provided by concentrated ownership yet at the same time encourage the flow of external funds
to corporations, and which, in turn, should lead to dilution of ownership concentration.
24.
Another critique of the shareholder approach is that the analytical focus on how to solve the
corporate governance problem is too narrow. The shareholder approach to corporate governance is
primarily concerned with aligning the interests of managers and shareholders and with ensuring the flow of
external capital to firms. However, shareholders are not the only ones who make investments in the
corporation. The competitiveness and ultimate success of a corporation is the result of teamwork that
embodies contributions from a range of different resource providers including investors, employees,
creditors, suppliers, distributors, and customers. Corporate governance and economic performance will be
affected by the relationships among these various stakeholders in the firm. According to this line of
argument, any assessment of the strengths, weaknesses, and economic implications of different corporate
governance frameworks needs a broader analytical framework which includes the incentives and
disincentives faced by all stakeholders.
II.2
The Stakeholder Model
25.
The stakeholder model takes a broader view of the firm. According to the traditional stakeholder
model, the corporation is responsible to a wider constituency of stakeholders other than shareholders.
Other stakeholders may include contractual partners such as employees, suppliers, customers, creditors,
and social constituents such as members of the community in which the firm is located, environmental
interests, local and national governments, and society at large. This view holds that corporations should be

3 .
See, for example, Shleifer and Vishny (1997) and Berglof (1997).
8

“socially responsible” institutions, managed in the public interest. According to this model performance is
judged by a wider constituency interested in employment, market share, and growth in trading relations
with suppliers and purchasers, as well as financial performance.4
26.
The problem with the traditional stakeholder model of the firm is that it is difficult, if not
impossible, to ensure that corporations fulfil these wider objectives. Blair (1995) states the arguments
against this point of view: “The idea [...] failed to give clear guidance to help managers and directors set
priorities and decide among competing socially beneficial uses of corporate resources, and provided no
obvious enforcement mechanisms to ensure that corporations live up to their social obligations. As a result
of these deficiencies, few academics, policymakers, or other proponents of corporate governance reforms
still espouse this model.”5
27.
However, given the potential consequences of corporate governance for economic performance,
the notion that corporations have responsibilities to parties other than shareholders merits consideration.
What matters is the impact that various stakeholders can have on the behaviour and performance of the
firm and on economic growth. Any assessment of the implications of corporate governance on economic
performance must consider the incentives and disincentives faced by all participants who potentially
contribute to firm performance. With this in mind, the stakeholder model has recently been redefined,
where the emphasis has been to more narrowly define what constitutes a stakeholder. Therefore, the
“new” stakeholder model specifically defines stakeholders to be those actors who have contributed firm-
specific assets, see Blair (1995). This redefinition of the stakeholder model is also consistent with both the
transaction costs and incomplete contract theories of the firm in which the firm can be viewed as a “nexus
of contracts”, see Coase (1937), Williamson (1975, 1985), Jensen and Meckling (1976), and Aoki,
Gustafsson and Williamson (1990).
28.
The “best” firms according to the “new” stakeholder model are ones with committed suppliers,
customers, and employees. This new stakeholder approach is, therefore, a natural extension of the
shareholder model. For example, whenever firm-specific investments need to be made, the performance of
the firm will depend upon contributions from various resource providers of human and physical capital. It
is often the case that the competitiveness and ultimate success of the firm will be the result of teamwork
that embodies contributions from a range of different resource providers including investors, employees,
creditors, and suppliers. Therefore, it is in the interest of the shareholders to take account of other
stakeholders, and to promote the development of long term relations, trust, and commitment amongst
various stakeholders (see Mayer, 1996). Corporate governance in this context becomes a problem of
finding mechanisms that elicit firm specific investments on the part of various stakeholders, and that
encourage active co-operation amongst stakeholders in creating wealth, jobs, and the sustainability of
financially sound enterprises, see the OECD Principles of Corporate Governance (OECD 1999a).
29.
However, opportunistic behaviour and hold-up problems arise whenever contracts are incomplete
and firm specific investments need to be made. As discussed previously, one consequence of opportunistic
behaviour is that in general it leads to underinvestment. The principal-agent relationship discussed in the
shareholder model is only one of the many areas in which this occurs. Underinvestment in the stakeholder
model would include investments by employees, suppliers, etc. For example, employees may be unwilling
to invest in firm specific human capital if they are unable to share in the returns from their investment, but
have to bear the opportunity costs associated with making those investments. Alternatively firms may be
unwilling to expend resources in training employees if once they have incurred the costs they are unable to
reap the benefits if employees, once endowed with increased human capital, choose to leave the firm.
Suppliers and distributors can also underinvest in firm-specific investments such as customised
components, distribution networks, etc. In this broader context, corporate governance becomes a problem

4 .
Mayer (1996), p. 11.
5.
Blair (1995), p. 203.
9

of finding mechanisms that reduce the scope for expropriation and opportunism, and lead to more efficient
levels of investment and resource allocation.
30.
According to the stakeholder model, corporate governance is primarily concerned with how
effective different governance systems are in promoting long term investment and commitment amongst
the various stakeholders, see Williamson (1985).6 Kester (1992), for example, states that “the central
problem of governance is to devise specialised systems of incentives, safeguards, and dispute resolution
processes that will promote the continuity of business relationships that are efficient in the presence of self-
interested opportunism”. Blair (1995) also defines corporate governance in this broader context and argues
that corporate governance should be regarded as the set of institutional arrangements for governing the
relationships among all of the stakeholders that contribute firm specific assets.
31.
One of the critiques of the stakeholder model, or fears of participants in the reform process, is
that managers or directors may use “stakeholder” reasons to justify poor company performance. The
benefit of the shareholder model is that it provides clear guidance in helping managers set priorities and
establishes a mechanism for measuring the efficiency of the firms’ management team i.e. firm profitability.
On the other hand, the benefit of the stakeholder model is its emphasis on overcoming problems of
underinvestment associated with opportunistic behaviour and in encouraging active co-operation amongst
stakeholders to ensure the long-term profitability of the corporation.
32.
One of the most challenging tasks on the reform agenda is how to develop corporate governance
frameworks and mechanisms that elicit the socially efficient levels of investment by all stakeholders. The
difficulty, however, is to identify those frameworks and mechanisms which promote efficient levels of
investment, while at the same time maintaining the performance accountability aspects provided by the
shareholder model. At a minimum, this implies that mechanisms that promote stakeholder investment and
co-operation should be adopted in conjunction with mechanisms aimed at preventing management
entrenchment. Stakeholder objectives should not be used to prevent clear guidance on how the firms’
objectives and priorities are set. How the firm will attain those objectives and how performance
monitoring will be determined also need to be clearly defined.
II.3
The Interaction of Corporate Governance with the Institutional and Economic Framework
33.
There is another argument, not addressed above, that asks why should we worry about corporate
governance in the first place, since product market competition should provide incentives for firms to
adopt the most efficient corporate governance mechanisms. Firms that do not adopt cost-minimising
governance mechanisms would presumably be less efficient and in the long run would be replaced, i.e.
competition should take care of governance. This line of argument would oppose any external policy
interventions on the grounds that at best they are unhelpful and at worst distortionary. Rather than
justifying public intervention, it says that the resolution of governance problems should be left to market
participants. Thus recent development in the managerial labour market, such as executive stock options
and the market for corporate control, e.g. leveraged and management buy-outs, are seen as market
responses to institutional deficiencies.7
34.
While there are likely to be important interactions between product markets and corporate
governance systems, market competition alone cannot solve the market failures arising from asymmetric
information, hold-up, and principal-agent problems that are at the heart of the corporate governance

6 .
Zingales (1997) also defines a corporate governance system in the spirit of Williamson (1985) as a
“complex set of constraints that shape the ex-post bargaining over the quasi rents generated in the course of
the relationship”.
7.
See Keasey, Thompson, and Wright (1997), p. 3.
10

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