Board diversity and independence: crucial
factors for increasing firm performance?
Name: Maik Bootsma
Student number: S4128524
Date: 21-05-2012
Supervisor: A. Bellisario
Course: Research Paper for Pre-MSc BA MAC (EBS009B10.2019-2020.2) Wordcount: 5.304
Abstract
Board diversity is a hot topic in research papers and especially gender diversity. Gender diversity is an important topic in society these days. For a few years, different countries have regulated board diversity by law and standards. Well, board diversity is a hot topic in
1. Introduction
Sometimes people question the corporate board of directors' matter because, in day-to-day life, the impact of boards is not always visible. However, when things go wrong, they are accountable (Adams, Hermalin & Weisbach, 2010). To illustrate, on March 23, 2020,
Bloomberg reported that five former board members of Deutsche Bank AG are under investigation for tax evasion (Matussek & Comfort, 2020). Examples like this can have an enormous (financial) effect on a firm. To prevent events like this one, the board of directors is a hot topic for academic research.
The board of directors has to ensure that managers make decisions that are in the best interest of stakeholders, and therefore they play an essential role in the decision-making process and can influence organizational actions. According to Hooghiemstraa, Hermes, Oxelheimc, Randøy (2019); “the board of directors has three main roles. First, they monitor management by hiring, promoting, assessing, and dismissing managers. Second, they provide resources enabling organizational access to important resources and relevant information channels, as well as to resources that contribute to ensuring legitimacy. Finally, they provide advice to management in setting the strategy of the firm.” The role of the board has led to two theoretical frameworks that are mainly used in prior literature. First, the agency theory, and secondly, the resource independence theory. Agency theory states that an agent is
contractually bound with another party, and acts on behalf of another party (Shapiro, 2005). During the period, the agent could behave sub-optimally, caused by differences in goals and/or preferences, or information asymmetry. Resource dependence theory states that board members bring human capital (e.g., director’s experience, expertise, knowledge, and skills), and relational capital (e.g., a director’s personal network) (Hooghiemstraa, Hermes,
Following the agency theory, more diverse and independent boards should be able to monitor the board better. More diverse boards should have higher quality resources, and therefore better advise the management (Aggarwale, Jidalb & Seth, 2019). In other words, boards should be diverse and independent to perform their tasks optimally. Firm performance should increase when a board performs optimally.
Based on theoretical considerations indicating that more diverse and independent boards increase firm performance, empirical research gives contradictory results. Some studies report significant positive effects, well other researchers find results that could affect firm performance negatively (Aggarwale, Jidalb & Seth, 2019; Erhardt, Werbel & Shrader, 2003; Hooghiemstra, Hermes, Oxelheim, & Randoy, 2019). The difference in empirical outcomes and the theoretical expectations are contradictory and need further research. Prior research using different factors or events to investigate the relationship between board
characteristics and firm performance, such as: sudden dead of independent directors, earnings management, and business groups (Nguyen & Nielsen, 2010; Hooghiemstraa, Hermes, Oxelheimc, Randøy, 2019; Aggarwale, Jidalb & Seth, 2019). However, the primary dominant performance measurement is a stock-based measurement (Tobin's Q), and accounting-based measure (return on assets, ROA). In this study, use a different accounting-based measure, return on investments (ROI). By using a different performance measure, this research complements prior research and show another way of measuring firm performance.
creativity and innovation (Carter, Simkins, & Simpson, 2003). According to Adams, de Haan, Terjesen, and van Ees (2015), board members diversity brings unique perspectives to the board. Therefore, the board should come with better solutions and would react more adequately when a problem arises. According to Adams and Ferreira (2009), independent board members monitor more effectively due to their unique skills and do not belong to the "old boys network.” According to Carter, Simkins, & Simpson (2003), the more diverse board will solve problems more effectively, because they are less exposed to group thinking.
“diverse board will evaluate potential solutions and consequences more carefully than a homogenous board.” The expectations are that a more diverse board will improve firm performance.
Due to the separation between ownership and control, the agency problem can occur. Efficient board monitoring should help to reduce the self-serving behavior of managers (Hooghiemstraa, Hermes, Oxelheimc, Randøy, 2019). “independent directors, are not, or are less, subject to potential conflicts of interest that reduce their monitoring capacity” (Nguyen & Nielsen, 2009). Therefore, they should monitor the management more effectively.
Independent directors also care about their reputation because they serve as experienced professionals in other firms or organizations (Nguyen & Nielsen, 2009). Because they care about their reputation and do not want to damage their reputation, they would monitor more effectively to decrease corporate scandal change. According to Weisbach (1978), independent directors are more likely to fire the CEO for poor performance. Therefore, a CEO has to ensure the firm is performing well. In line with the theoretical reasons, the expectations are that a more independent board will improve firm performance.
To explore the potential effects of board diversity and board independency on firm performance, the following research question is proposed: does a more diverse and
by return on investment (ROI after). To test the stated hypotheses, a sample of 2349 US-listed firms is used based on the fiscal year of 2017. We removed observations for which there was no data available for the corresponding variables. We obtained a sample of 2303 firms after (N = 2303) cleaning the data set. This resulted in a balanced penal design, with firms
operating in diverse markets, such as the airline industry, energy industry, and finical market. Due to laws and enforcement, the US is viewed as a world leader in corporate governance and transparency. Furthermore, the US has the largest economy in the world (McCarthy & Puffer, 2002). This resulted in a wide range of companies with different board structures, which gives a more reliable outcome when testing the hypotheses. Also, the firms are comparable to firms from West-European countries, and therefore the results of this study can also be used for West-European firms. The first independent variable is board diversity, to be more specific: demographic diversity. Board diversity is measured as a percentage of female or foreign culture representation on the board (Rusanescu, 2020). A higher percentage stands for a more diverse board. The second independent variable is independent board members. This variable is measured as a percentage of independent board members, as reported by the company (Rusanescu, 2020). A higher percentage stands for a more independent board. In this study, the return of investment (ROI) is for both hypotheses, the dependent variable. ROI directly measure the amount of return on a particular investment, relative to the investment's cost (Chen, 2019).
2. Theoretical background
In the following sections, this study explains two hypotheses about the relationship between board diversity and ROI, and board independence and ROI.
Board diversity and return on investment
The board of directors is the highest decision-making and functions as a supervisory body, and therefore are the members accountable for firm strategy and firm performance. The effect of board diversity and firm performance is one of the prolific topics in the last decade. In 2019, 26% off all S&P 500 board members where female. This is an increase of 63% compared with 2009. In 2019, 99% of all the S&P 500 boards had as least one female on the board. Also, board members with a minority background increased. In 2019, 23% of all the S&P 500 board members had a minority background. An increase of 92% compared with 2009 (Spencer Stuart, 2019). These numbers have increased in the past decade, indicating that board diversity is gaining more attention.
Prior research on the topic of board diversity differentiates between demographic and structural diversity. Demographic diversity is associated with its directors' gender, culture, nationality, and experience (Aggarwale, Jidalb & Seth, 2019). Structural diversity is associated with board independence (Ararat, Aksu, & Cetin, 2015). The differentiation is based on two different theories; resource dependency theory and the agency theory.
Demographic diversity is linked to the resource dependency theory, and structural diversity is linked to the agency theory (Ararat, Aksu, & Cetin, 2015). In this study, we will focus on demographic diversity when researching board diversity. The structural diversity will be research as board independence.
(Aggarwale, Jidalb & Seth, 2019). According to Dalziel & Hilleman (2003) these other resources can be “human capital (experience, expertise, reputation) and relational capital (a network of ties to other firms and external contingencies)."
Board diversity has benefits, but also comes with costs. First, a more diverse board of directors will increase creativity and innovation (Carter, Simkins, & Simpson, 2003).
According to Adams, de Haan, Terjesen, and van Ees (2015), board members diversity brings unique perspectives to the board. “A more diverse board will collectively possess more information and will have the potential to make better decisions.” Secondly, according to Adams and Ferreira (2009), a broader and more diverse board of directors will also improve the monitoring activities due to their unique skills and do not belong to the "old boys
network" and, therefore, can monitor more independent. Third, a more diverse board will solve problems more effectively. A diverse board will evaluate potential solutions and consequences more carefully than a homogenous board (Carter, Simkins, & Simpson, 2003). Fourth, diversity results in a better understanding of the marketplace in which the corporation operates. Inlining the diversity of the firm with the diversity of its (potential) clients and stakeholders, a firm can penetrate markets more effectively (Carter, Simkins, & Simpson 2003). A more heterogeneity board will have a less narrow perspective and a broader view. Resulting in a better understanding of the market complexity (Carter, Simkins, & Simpson, 2003). Fifth, diversity improves relationships and cultural awareness. (Carter, Simkins, & Simpson, 2003). Resulting in better employee and global relationships (Aggarwale, Jidalb & Seth, 2019). Finally, female directors are shown as “tough” monitors. As a result, firms have lower agency costs (Vafaei, Ahmed & Mather, 2015).
board can lead to more lack of knowledge of local accounting rules as well as due to language issues. This can lead to a higher chance of earning management and can harm the company (Hooghiemstra, Hermes, Oxelheim, & Randoy, 2019).
Prior research offers a better understanding of both broad spectrums of the advantages and disadvantages of a diverse board. I believed that the advantages outweigh the
disadvantages, so a more diverse board will increase firm performance. The following hypothesis is drawn:
Hypothesis 1: Higher percentage of board diversity will increase firm performance.
Board independence and return on investment
in the interest of stakeholders." Due to the separation between ownership and control, the agency problem can occur. According to Hooghiemstra et all; "Information asymmetry between managers and shareholders provides self-interested managers with the opportunity to behave opportunistically and to increase their personal wealth at the expense of shareholders. Efficient board monitoring should help to reduce the self-serving behavior of managers” (Hooghiemstraa, Hermes, Oxelheimc, Randøy, 2019).
In conclusion, independent board members monitory and disciplinary capacity is more effective than non-independent board members. They are resulting in lower agency costs, which is beneficial for the shareholders. However, why are independent board members better in monitoring the CEO? Firs, “independent directors, are not, or are less, subject to potential conflicts of interest that reduce their monitoring capacity” (Nguyen & Nielsen, 2009). Second, independent directors care about their reputation because they serve as experienced professionals in other firms or organizations (Nguyen & Nielsen, 2009). Third, independent directors are effective monitors due to their experience in management and decision making (Nguyen & Nielsen, 2009). Fourth, according to Weisbach (1978), independent directors are more likely to fire the CEO for poor performance. Last, demographic more diverse boards are expected to have higher quality resources at their disposal. Therefore, in line with the resource dependence view, they should be better able to counsel and give advice to the management (Aggarwale, Jidalb & Seth, 2019).
In conclusion, prior research has shown that independent board members will increase firm performance. Therefore, the following hypothesis is drawn:
3. Methods
Research design and sample
To test the stated hypotheses, a sample of 2349 US-listed firms is used. The data is taken from the SPSS dataset Asset4. The data is collected by the Tilburg University, and the data provides objective, relevant, and systematic governance information. All the data is based on the fiscal year 2017.
We removed observations for which there was no data available for the corresponding variables. We obtained a sample of 2303 firms after (N = 2303) cleaning the data set. This resulted in a balanced penal design, with firms operating in diverse markets, such as airline industry (American Airlines Group Inc, Southwest Airlines Co, Spirit Airlines Incorporated), energy industry (SM Energy Co, Southwestern Energy Company, Spark Energy Inc), and finical market (Visa Inc, Bancorpsouth Bank, Bank of New York Mellon Corp).
Due to laws and enforcement, the US has been viewed as a world leader in corporate governance and transparency. Furthermore, the US has the largest economy in the world (McCarthy & Puffer, 2002). This resulted in a wide range of companies with different board structures, which gives a more reliable outcome when testing the hypotheses. Also, the firms are comparable to firms from West-European countries, and therefore the results of this study can also be used for West-European firms. Moreover, the concept of board independence has originated in the United States (McCarthy & Puffer, 2002), and therefore, US-listed firms are an ideal sample to research the relationship between board independence and firm
Description of the variables
Dependent variable
In this study, the return on investment (ROI) is for both hypotheses, the dependent variable. The ROI is a financial ratio, and a well-known performance measured method is used to evaluate the efficiency of an investment or compare the efficiency of several different investments. ROI directly measure the amount of return on a particular investment, relative to the investment's cost (Chen, 2019). I use the return on investments as a performance measure because the return on assets (ROA) and return on equity (ROE) are well-known and
Independent variable
The first independent variable is board diversity, to be more specific: demographic diversity. Board diversity is measured as a percentage of female or foreign culture
representation on the board (Rusanescu, 2020). A higher percentage stands for a more diverse board.
The second independent variable is independent board members. This variable is measured as a percentage of independent board members, as reported by the company (Rusanescu, 2020). A higher percentage stands for a more independent board.
Data analysis
A correlation and univariate, linear regression analysis are conduct to test both stated hypotheses. In other words, the strength of the correlation between board diversity and ROI, and board diversity and ROI is attempted to be found. If there is a strong correlation between one of the independent and dependent variables, I can assume a possible relationship between these variables.
Last, multiple regression with two independent variables is executed. Multiple
regression is an extension of a simple regression in which more than one independent variable is used to predict a single dependent variable (Psychstat3).
Estimation models
The estimation model is given in figure 2 for studying the effect of both board diversity and board independence on the general measure of firm performance. In statistical terms this will look as follows for the single linear regression:
For the multiple regression, the estimation model is expressed as follows: 𝑅𝑂𝐼 = a + b1 B𝑜𝑎𝑟𝑑 diversity 𝑋𝑖 + b2 B𝑜𝑎𝑟𝑑 independency 𝑋𝑖+ 𝜀𝑖
4. Results
In the results section, the quantitative data and outputs of this study will be discussed. Table 1, the correlations, the mean and standard deviation for the variables board diversity, board independence, and return on investment are shown. In table 2 shows the results of the regression analysis shown. In the end, I will discuss the results.
Mean SD 1 2 3
1. ROI -2,40 % 84.66 1 .093*** .074***
2. Board diversity 15,82 % 11.11 .093*** 1
3. Board independency 76,27 % 15.61 .074*** 1
Figure 3: Descriptive statistics and correlation
Note: ***, **, and * denote significance at the 0.01, 0.05, and 0.10 levels (two-tailed). N = 2303
The table shows that the average ROI is - 2.4 percent. Suggesting that, on average, the firms making a loss on investments. The average board diversity of the firm’s 15.82 percent. The average board independency is 76.27%.
A positive correlation (r = .093, r < .01) is found between board diversity and return on investment. When board diversity increases, the return on investment will increase. This supports our first hypothesis that a more diverse board will lead to a higher return on investment.
Board independence is also positively correlated with return on investment. However, the correlation is weaker (r = .074, r < .01). When board independency increases, the return on investment will increase slightly. This support our second hypothesis that a more
Figure 4: Regression analyze
Note: ***, **, and * denote significance at the 0.01, 0.05, and 0.10 levels (two-tailed). N = 2303
The regression analysis shows a positive and significant relationship between board diversity and return on investment. The results of the regression analysis correspondents with the results of the correlation analysis. The regression analysis shows a positive and significant relationship (b = .710, r <.01) between the percent of board diversity and return on
investment. The variance of return on investment that can be directly linked to board diversity is 0.9% (R2 = .009, r < .01). In other words, board diversity has a slight effect on the variance of return on investment. This result does support the first hypothesis, which stated that board diversity would have a positive effect on the return on investment. However, the linear relationship is weak.
The regression analysis also shows a positive relationship between board
independence and return on investment. The results of the regression analysis correspondents with the results of the correlation analysis. The regression analysis shows a positive and significant relationship (b = .403, r <.01) between the percent of independent board members and return on investment. The variance of return on investment that can be directly linked to board independence is 0.6% (R2 = .006, r < .01). This result does support the second
hypothesis, which stated that board independence would have a positive effect on the return on investment. However, the linear relationship is again weak.
(1) ROI (2) ROI (3) ROI
Board diversity .710*** (.158) .605*** (.163)
Board Independence .403*** (.113) .294** (.116)
Constant -13.652*** (3.057) - 33.127** (8.776) -34.397*** (8.758)
In the third row of figure four, we can find the results of the multiple regression
analysis. The regression analysis, with independent variables, shows a positive and significant relationship (b = - 34.397, r <.01). The variance of return on investment that can be directly linked to board diversity and independence is 1.1% (R2 = .011, r < .01).
5. Discussion
First, the research findings will be explained, and after that, theoretical implications and practical implications will be discussed. As last, weak points and limitations will be addressed to improve further research regarding this subject.
Findings
In this study, the relationship between board independence and board diversity on firm performance is analyzed. By analyzing the relationship between board diversity and board independence on firm performance, this research aimed to find an answer to the question: "Does a more diverse and independent board lead to better firm performance?".
board diversity and ROI. This implies that a higher percentage of board diversity enhances firm performance. The results are in line with the prior literature that found a positive relation (Aggarwal et al. (2019); Carter et al. (2003)). Also, the positive relationship indicates that board diversity is linked to both resource dependency theory and agency theory.
The second hypothesis in this paper is that board independence is positively related to ROI, which means that a higher percentage of independent board members will increase firm performance. According to the agency theory, independent board members monitory and disciplinary capacity is more effective than non-independent board members. The reason for this is that independent directors are not, or are less, subject to potential conflicts of interest that reduce their monitoring capacity. Independent board members are more likely to care about their reputation and do not want to be related to corporate scandals. Therefore, they monitor the CEO and management more effective. Resulting in lower agency costs and better advice. The results of the empirical analysis show that there is a significant positive
relationship between board independence and ROI. This implies that a higher percentage of board independency enhances firm performance. The results are in line with the prior literature of Nguyen and Nielsen (2009) and Weisbach (1978).
In conclusion, this study documents that firms perform better when their board members are more diverse and independent, which is in line with both hypotheses.
Theoretical implications
into one model. By combining both theories, a broader view is obtained. Therefore, this study complements the study of Hillman and Dalziel, (2003) who argued that board diversity is both linked to the agency theory and the resource dependency theory.
Secondly, there are two dominant measurements for firm performance in the field of board diversity and firm performance. The measurements are: Tobin's Q (stock-based measurements) and return on assets (accounting-based measurements) (Adams & Ferreira, (2009); Aggarwale, Jidalb & Seth. (2019); and Carter et al. (2003)). In this study, return on investment (another accounting-based measure) is used as a measurement for firm
performance. Tobin’s Q is, as mentioned, a stock-based measurement. Stock-based
measurements do not only use data from the past, but mainly look at the future. Therefore, the data is more subjective due to making estimates for the future. Accounting-based
measurements look at the past, and are therefore less subjective. Comparing the return on assets of different firms in different industries, cross-industry comparisons, is not a fair measurement due to the difference in assets required by the different industries. Some industries are more capital-intensive than others; for example, automobile manufacturing, oil production, and refining, steel production, telecommunications, and transportation are high capital-intensive industries (Frankenfield, 2020).
of linear regression. Meaning that there is a maximum or tipping point for board diversity that will improve firm performance significant.
Practical implications
This study may have two practical implications for shareholders and policymakers. First, shareholders may use the results of this study when deciding on board composition. The results show that a more diverse and independent board has a positive effect on firm
performance. In practical terms, boards should possess a variety of gender, foreign board members and independent board members.
Secondly, the results of this study can be used by policymakers as an argument against discrimination and gender inequities. The results show that board diversity is positive for firm performance, and therefore can be used as an argument to improve board diversity and reform corporate governance laws. Improving board diversity and corporate governance laws can have a positive influence on firm performance and society. Improved corporate governance laws can decrease the gap between majorities, and ethical and gender minorities in
organizations and society.
Limitations
This study has limitations that should be considered when interpreting the results. First, the data that is used is from 2303 companies based in the United States. The United States is a leader in corporate governance, and firms in other countries may have more or less significant results due to different corporate governance laws and standards. Also, there are cultural differences between countries. Each culture has different norms and values that can influence corporate governance at multiple levels. Therefore, the results may not be
Secondly, the data is from a single year, namely 2017. Therefore, it was not possible to compare years with each other. This might lead to inaccurate results for some firms if they performed less in that year. For example, firms could perform financially less due to changes in markets or made big investments.
Perspectives for future research
As discussed, the results of this research are significant but have their limitations due to time spam of the data and limited environment of only using data of companies listed in The United States. Therefore, the results may not be generalizable by research using data of companies listed in other countries. Using a larger dataset in time spam and companies from multiple countries could result in better and more reliable data to overcome this problem.
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