by David H. Erkens, Assistant Professor of Accounting at the University of Southern California, Mingyi Hung, Assistant Professor of Accounting at the University of Southern California, and Pedro Matos, Assistant Professor of Accounting at the University of Southern California.


The worldwide 2007-08 economic crisis has made regulators across the globe question the soundness of existing corporate governance practices. Similar to how the debacles at Enron and WorldCom led to the passage of the 2002 Sarbanes-Oxley Act, the recent financial crisis has sparked a call for new regulation. For example, one of the objectives of the new Dodd–Frank Wall Street Reform and Consumer Protection Act is to strengthen corporate governance by empowering shareholders. In addition, the SEC recently passed rule 14a-11, making it significantly easier for large investors to nominate their own board candidates.
Conventional wisdom holds that because independent directors are appointed by shareholders, they necessarily act in shareholders’ interests. This belief has led to calls for greater shareholder control over the appointment of directors, the separation of the CEO and chairman roles, and so on, to potentially make the board a more effective counterweight to powerful chief executives.
However, our study of the world’s largest financial institutions during the 2007-2008 crisis suggests that these “good” governance practices don’t necessarily do what conventional wisdom suggests. We investigate 296 of the world’s largest financial firms from 30 different countries with assets of more than $10 billion. Contrary to the commonly held belief that increased oversight of management is beneficial to shareholders, we find that firms with more independent boards actually had lower shareholder returns during the financial crisis than firms with less independent boards.
For example, when the fraction of independent directors in a firm increased by 10 percent (that is, the percentage of the firms’ directorships that were independent were 80 percent versus 70 percent), the returns were 4 percent lower. Citigroup and other financial firms that employed powerful outside directors experienced some of the more severe share value losses. Some analysts will attribute this finding to independent directors having insufficient financial experience and will give Lehman Brother’s board as an example, as it included among its directors a theatre producer with no financial background (even though it also included a former chief economist of Solomon Brothers who in the 1980s was known as “Dr. Doom” for his bearish views at that time). On average, however, we find that board members’ financial expertise had little or nothing to do with firm performance during the crisis. Neither did it matter whether or not the CEO also served as board chairman or whether the board had a risk committee.
Why did firms with more independent boards perform worse during the crisis? Did firms with more independent boards take more risk on behalf of higher shareholder returns? Our empirical study shows that this, in fact, was not the case. What we did find is that firms with more independent boards raised more equity capital during the crisis. Raising equity capital during the crisis compounded the negative effects on the shareholders because financial markets were severely distressed.
Why did independent directors pressure firms into raising more equity capital when share prices were plummeting? One possible explanation is that raising equity capital, while very costly during the crisis period, helped reduce bankruptcy risks and protect independent directors’ reputation in the market for directorship.
So where does this leave us? Can we expect corporate governance reforms to be effective in preventing a future financial crisis? The answer is no. Although our findings are specific to the crisis setting and may not extend to normal times, they do suggest that practices that are commonly touted as being “good” corporate governance will not prevent companies from taking excessive risks.
In fact, regulation that is designed to increase shareholder control over firm policies may have the negative unintended consequence of increasing risk-taking by financial institutions. For example, Royal Bank of Scotland undertook its very risky acquisition of part of ABN AMRO based on enthusiasm of its institutional shareholders. Our study finds evidence that institutional investors, who are generally viewed as being sophisticated and independent from management, encouraged managers to take greater risk before the crisis, which exacerbated the losses during the crisis. We believe that this occurred because shareholders do not bear the full cost of a firm’s bankruptcy. A large part of these costs are born by other parties such as the Federal Deposit Insurance Corporation. Consequently, shareholders prefer a level of risk that may be excessive from the perspective of regulators.
Overall, our study suggests that good (shareholder-centric) corporate governance is not the panacea for preventing future financial crises. What should regulators do? We believe that regulators should address the more fundamental question of what level of risk is appropriate for financial institutions. G-20 leaders recently adopted a proposal that significantly increases the level of capital that banks must hold, in particular for banks that are “too big to fail.” We believe that this reform is a step in the right direction, and will be much more effective in preventing a future financial crisis than corporate governance reforms that are geared towards increasing the influence of shareholders and independent directors over firm policies. Developing a good system of checks and balances is a process that requires continuous learning.


This article is based on the findings of the paper “Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide” (available at