The effect of board foreign and gender diversity on firm performance

The effect of board foreign and gender diversity on firm performance

Manuscript Type: Empirical

Research Question/Issue: I examine the business case for the presence of female and foreign directors on the board. Specifically, I investigate the relationship between (1) female and foreign directors on the board and (2) a policy regarding female and foreign directors on the board and financial performance measured as return on assets (ROA).

Research Findings/Insights: I find a positive and significant relationship between the gender or ethnic diversity of the board and financial performance for a sample of major US corporations over the year 2017. Secondly, I find no significant relationship between female and foreign directors on the board and firm performance.

Theoretical/Academic Implications: A theoretical framework is built from resource dependence theory, human capital theory and agency theory, which suggests that gender and ethnic diversity may have a positive. My analysis supports this theoretical position. Secondly, my findings are consistent with a contingency explanation, because it suggests no relationship of a board diversity policy and firm performance, which might differ per policy form.

Practitioner/Policy Implications: The results support the business case for the presence of women and foreign directors on boards. My findings suggest that a more (gender and ethnic) diverse board result in better firm performance. But, there is no relationship between a (gender and foreign) diverse board policy and firm performance.

2 Introduction

Recent public discussions highlight the importance of female and foreign directorships, which are still the underrepresented members of the board McKinsey and Company, 2016; Terjesen et al., 2016). Some management suggest stimulating female and foreign directors, while others do not. Yet, prior research has not provided us with a clear answer on whether board diversity impacts the firm’s performance (e.g. Hooghiemstra et al., 2019; Terjesen et al., 2009; Hillman et al., 2002; Oxelheim, and Randøy, 2003). Based on prior literature (Calderón et al., 2000), the board is responsible for roughly three main tasks, based on the agency theory, the human capital theory and resource dependency theory. The agency theory suggests that the board is responsible for monitoring management (Fama & Jensen, 1983; Jensen & Meckling, 1976). The human capital theory proposes that, due to unique skills, expertise and (educational) background, directors are required to provide proper advise and counseling to management. In addition, the resource dependency theory states that directors provide the firm with (external) resources to better advice management. Consequently, effectiveness is the board’s ability to perform its functions and add value to the company (Martinez-Jimenez, Hernandez-Ortiz, and Fernandez, 2020). By that, a board has a direct effect on firm performance (Hillman & Dalziel, 2003). Consequently, the composition of the board is of importance when discussing the board’s effectiveness (Carter et al., 2010).

expertise and skills, which strengthens the advisement qualities, although more inexperienced female directors might weaken this impact (Adams et al., 2010). Lastly, from a resource dependence theory perspective, female and foreign directors have the ability to provide information from different perspectives, which provides the board with a more broad knowledge for better decision making (Carter et al., 2010).

Due to the unique skills and expertise of female and foreign directors and their active membership, I expect a positive relationship between board diversity and firm performance. These characteristics of female and foreign diverse boards will possibly strengthen the advice and monitor capabilities, which will lead to an increase in firm performance.

(e.g. experience and education) of the directors (Kirsch and Wrohlich, 2020). It is possible that the negative impact of ‘hard’ policies cancel out the positive impact of ‘soft’ policies.

This study considers two effects of board diversity on firm performance: first, it studies the effect of female and foreign directors on firm performance, and secondly, it investigates the impact of board diversity policies on firm performance.

Prior research offers mixed results on these impacts. First of all, shareholders need to address this issue when selecting (new) board members, which makes it relevant to provide an answer on the relationship between both female and foreign directors and firm performance. When this relationship is known, shareholders can choose the composition of the board wisely and effectively.

The dependent variable is firm performance, measured as the return on assets (ROA). The two independent variables are gender and ethnic diversity on the one hand and board diversity policy on the other hand. The sample consists of 2,012 firms from the United States during the year 2017.

In line with the expectations, the results suggests a positive impact of female and foreign directors on firm performance. Nevertheless, the effect of board diversity policies is, in contrast with the expectations, positive but insignificant. Policies regarding female and foreign directors do not impact the firm performance significantly.

positively, which is in line with e.g. Hillman et al (2002),Carter et al (2010) and Oxelheim, and Randøy (2003). In addition to these studies, I used an integrated framework of three theories: the agency theory, the human capital theory and resource dependency theory. It therefore encourages firms to stimulate female and foreign directorships. Furthermore, this study could not find significant evidence that a policy regarding gender and foreign cultural diversity impacts the performance. This is in line with the study from e.g. Kirsch and Wrohlich (2020). It is likely that the ‘soft’ policies impact the firm performance positively, but that the ‘hard’ policies negatively impact this, resulting in an insignificant relationship overall. I therefore encourage future study to research the impact of both ‘soft’ and ‘hard’ policies regarding female and foreign directors.

Because of the information from this study, shareholders can make decisions on the board composition regarding female and foreign directors. By that, firms’ board can grow more in being effective, which impacts firm performance positively.

The paper is organized as the following: in section 2, I review prior literature, that altogether forms a framework, from which the hypotheses are developed. In section 3, I describe the methodology of the study as well as the empirical context, data and variables. Next, in section 4, the findings are reported. Section 5 discusses the findings in relation with the theoretical contributions and limitations of the study.

3 Theoretical background

1983; Jensen & Meckling, 1976), (2) linking the firm to external organizations to address environmental dependencies, following the resource dependence theory (Pfeffer & Salancik, 1978) and (3) providing skills, education and experience to advise the firm’s management, based on the human capital theory (Terjesen, et al., 2009). Consequently, effectiveness is the board’s ability to perform its functions and add value to the company, which depends on certain attributes of the board and its directors (Martinez-Jimenez; Hernandez-Ortiz, and Fernandez, 2020). By that, a board has a direct effect on firm performance (Hillman & Dalziel, 2003), as independent directors are better monitors and a more diverse board is expected to provide better and broader advice to the management. Consequently, the composition of characteristics of the board impacts the extent to which a board is effective.

One very important board characteristic is board diversity. Board diversity can be distinguished in (1) task-related diversity, such as functional or educational background, (2) non-task-related diversity, like age, gender, race, or nationality, and (3) structural diversity, in other words board independence and CEO non-duality (Adams et al., 2015). Each of these characteristics can possibly have a positive or negative impact on the boards effectiveness. Following the upper-echelon theory which indicates that higher education level results in a higher level of knowledge base, prior research suggests a positive relationship between the task-related diversity and board effectiveness, (Darmadi, 2013). Nevertheless, the non-task-related characteristics are yet under researched and research, therefore, provide mixed results.

form of such a policy is the gender quota, which obliges a firm to reach a predetermined percentage of female directors on the board. For instance Italy declared a law imposing nationality quotas on boards in order to balance the foreign presence of boards (Schwizer et al. 2012). Besides this strict form of policy, lots of the policies are more about the principle of promoting a diverse board: ‘soft’ policies. Such a policy could regard a certain minimum (e.g. 50%) of female and foreign directors on job interviews.

3.1 Gender and foreign diversity

The effect that the presence of female directors on the board have on firm performance is an important topic which received a lot of attention recently (McKinsey and Company, 2016; Terjesen et al., 2016). Based on agency theory, human capital theory and resource dependence theory, several prior studies discuss a positive, negative or insignificant relationship between female and foreign directors on the board and firm performance. This inconclusive evidence shows that having a diverse board does not enhance firm performance in some settings, which leaves an unresolved debate on the benefits of having a board diversity policy.

through attendance and committee assignments may lead to a decrease in shareholder value, as it could cause communication problems. This interference may lead to negative effects on the performance. Indeed, when de members are more dissimilar, they would possibly argue more, which complicates the decision making process. In contrast with these positive and negative effects, Carter et al (2010) document, following a contingency framework, no relationship at all, since the impact of gender diversity might be different under different circumstances and times. Therefore, these results may cancel out, leaving no significant relationship.

Secondly, according to the agency theory, foreign directors may bring both costs and benefits. Basically, there are two contrary perspectives that might explain the impact of foreign directors on firm performance (Hooghiemstra et al., 2019). Both focus on the ability of the board members to monitor management. In essence, both the views together clarify that a foreign diverse board comes both with costs and benefits. First, the presence of foreign directors may increase the independency of the board, which leads to better monitoring and thus better firm performance. As foreign directors do not take part of the “old boy’s network”, it is likely that they stimulate openness and frankness in the monitoring role of the board (Oxelheim, and Randøy, 2003) which benefits the discussions within the boardroom (Hooghiemstra et al., 2019). But, the cohesiveness of a board, the degree to which board members are attracted to each other and are motivated to stay on the board (Forbes and Milliken, 1999), might decrease.

lower firm performance. Secondly, language can be a barrier for foreign directors to monitor management effectively (Kassis-Henderson, 2005). Differences in native languages among directors may change the dynamics of discussions in the boardroom. Even when the board decides to change the language from the national language to English, the lingua franca of boards that include a foreign director, discussions may become elementary and less nuanced (Hooghiemstra et al., 2019). Differences in language may cause trust problems due to communication problems (Kassis-Henderson, 2005) and have consequences for how individuals deal with future-oriented actions (Chen, 2013). Altogether, differences in language and a lack of local accounting knowledge can affect the monitoring skills of a board and thus firm performance.

Following the human capital theory, gender diversity broadens the available unique human capital in terms of skills, education and experience on the board. On the one hand, Hillman et al (2002) found that female directors are not less qualified, but do have different roles on the board than men, which is presumably because of their unique human capital. Therefore, gender diverse boards differ from non-diverse boards, and may affect firm performance positively as a result of different, unique human capital on the board. On the other hand, Terjesen et al (2009) found evidence that women are indeed as well qualified for directorships as men in terms of education and personal skills, but lack the experience required for the directorship. Since experience improves the director’s ability to contribute to the effectiveness of the board, a lack of this would weaken the board. By that, gender diverse boards may, following Terjesen et al (2009), lead to a decrease in firm performance. This view implies that women are not better directors than men.

and operations, and even more when the firm is considering expanding into foreign markets (Adams et al., 2010). By that, foreign directors can provide knowledge and expertise that home country directors lack. Altogether, the human capital theory suggests that gender and ethnic diverse board affect the firm performance positively, although inexperienced female directors might weaken this impact.

A convincing argument for a gender and ethnic diverse board is based on the resource dependency theory (Pfeffer & Salancik, 1978). From a resource dependence theory perspective, research states that diverse directors bring unique information to the board (Carter et al., 2010). Because of the different background and human capital, female and foreign directors have the ability to provide information from different perspectives. Therefore, they are able to address certain problems from a different environmental view, which provides the board with a more broad knowledge for better decision making (Adams et al., 2015; Tasheva & Hillman, 2018; Aggerwal et al, 2019).

Following the agency theory, some contrasting view are presented. On the one hand, with the presence of foreign directors, a lack of knowledge on local accounting rules and language would possibly lead to less effective monitoring by a diverse board. But on the other hand, female directors are more active members and bring in different views. Altogether, the results from agency theory cancels out, which leaves no result. Therefore, I expect no impact on the monitoring role of the board.

Based on the human capital theory, female and foreign directors bring different and unique skills and expertise, which makes the board a better advisor for management. On the other hand, since female directors sometimes lack experience, a diverse board might result in a decrease of firm performance. Altogether, I expect that diverse boards will impact firm performance positively.

Following the resource dependence theory, a gender and ethnic diverse board is, because of a more diverse set of experience and expertise, better able to provide the firm with external resources. These external resources makes it possible to provide better advice. I, therefore, expect a gender diverse board to be a more effective advisor, which, consequently, could promote an increase in firm performance.

Hypothesis 1: The gender and ethnic diversity of the board has a positive association with firm performance.

3.2 Gender and foreign diversity policy

diversity policy might impact a firm positively, due to the positive image it accomplished. Stakeholders might be attracted to a firm that deliberately tries to stimulate equal chances for female and foreign directors, which impacts firm performance positively.

Furthermore, by implementing soft policies, firms encourage equal opportunities for female and foreign directors. By that the total number of potential directors increases significantly, as both female and foreign directors can also be appointed. Since soft policies stimulates equal opportunities, but does not necessarily result in a raise of women and foreign directors on the board, it just broadens the potential ‘fishing pool’ of directors. Therefore, following the human capital theory (Hillman, et al., 2002), a firm can potentially attract better directors and establish a board with a broad, unique set of skills, expertise and background. Such a board might be better able to advise management, which potentially lead to better firm performance.

(2012) documents that, due to age and inexperience of the new, female directors, the Norwegian hard quota negatively impacts the overall firm performance in the long-run.

Altogether, ‘soft’ policies might impact a firm, but it is unknown whether this is negatively or positively. Nevertheless, ‘hard’ policies can harm firm performance, since it mandates a firm to focus on non-task related characteristics of directors, rather than task-related qualities. So, the negative impact of ‘hard’ policies may overshadow the possible positive impact of ‘soft’ policies.

Altogether, on the one hand, the implementation of diversity policies may lead to an increase in the pool of potential directors. Firms have therefore a wider choice, which can lead to a more balanced and more unique board composition (e.g. education, experience and expertise) which results in more effective monitoring and advisement.

On the other hand, more strict policies (e.g. ‘hard’ quotas) have an undesired effect on firm performance. By mandating a certain percentage of female or foreign directors, the composition of the board may be more about gender and nationality than qualities of the board members. Therefore, the board’s effectiveness could decrease and thus the firm performance as well. As a result, the negative impact of ‘hard’ policies may rule out the possible positive impact of ‘soft’ policies. Therefore, I expect that a policy regarding a gender diverse board would negatively impact firm performance.

Hypothesis 2: A policy regarding gender diversity in a board has a negative association with firm performance.

3.3 Framework

Figure 1 – The Conceptual Model

4 Methodology

In this section the sample selection and the description of variables is presented.

4.1 Empirical context

To test the hypotheses, I make use of data from the United States. First, the United States is a big country with a large number of big firms. This makes it possible to select a big sample to test the hypotheses. Second, the economy of the United States is one of the largest worldwide. Therefore, the effect that gender and ethnic diversity, and even more the less researched policy regarding gender diversity on boards has on firm performance is a big example for many other countries besides the United States, given the United States’ institutional characteristics.

4.2 Sample selection (data)

Drawn from the dataset Asset4, I took a sample of 2,349 listed US firms. The data provides information on the year 2017. I removed observations that did not provide information about the dependent, independent and control variables. The final sample consists of 2,012 different firms from the United States.

4.3 Measures

4.3.1 Dependent variable

Following Carter et al. (2010), the dependent variable used in this study is the Return On Assets (ROA), which measures the ability of the firm to generate revenues from the available assets. For each firm, the ROA is calculated as a ratio by dividing the net income by the book value of the total assets.

4.3.2 Independent variables

The two independent variables are gender and ethnic diversity of the board (BOD_DIV) and a policy regarding gender and ethnic diversity of the board (POL_BOD_DIV). The gender diversity is presented as the percentage of female directors on the boards of directors. The board diversity policy is a binary variable, where the presence of a policy equals a 1 and a lack of a policy is noted as 0. Multiple sorts of policies regarding board diversity are possible, and all are noted as 1, so that there is no hierarchy in different forms of policies.

4.3.3 Control variables

and firm performance (e.g. Baysinger, and Butler, 1985; Bhagat, and Bolton, 2008). Independent directors are better monitors, but may lack human capital to provide advice to management. To exclude these effects, I control for board independency (BOD_IND).

The fourth variable I control for is the number of board meetings (BOD_NUM_MET), since prior research (Sahu and Manna, 2013) document that the number of board meetings impacts the firm performance positively.

The last board specific control variable is average attendance to board meetings (BOD_ATT_MET). Following Sahu and manna (2013), the number and intensity of board meetings increases the monitoring skills of a board, due to good observation. The larger the attendance to board meetings, the larger the effect on firm performance.

In line with prior research (Li and Chen, 2016), I control for one firm-level characteristics, namely the CEO compensation link to total shareholder return (CEO_COM_TSR), as this is related to the firm performance.

4.4 Estimation models

To test the two hypotheses, I use the univariate and regression analysis. Eq. (1) calculates the impact that board gender diversity and a policy regarding gender diversity on the board has on firm performance after controlling for the factors as given in the previous section.

ROAi,t = α + β1 BOD_DIVi,t + β2 POL_BOD_DIVi,t + β3 BOD_TENi,t + β4 BOD_NUM_METi,t + β5 BOD_ATT_METi,t + β6 BOD_SIZEi,t + β7 CEO_DUAi,t + β8 BOD_IND + β9

CEO_SHA_RETi,t + ε it (1)

The definitions of the variables are stated in table 1, see below.

Variable Definition ROA BOD_DIV POL_BOD_DIV BOD_TEN BOD_NUM_MET BOD_ATT_MET BOD_SIZE CEO_DUA BOD_IND CEO_COM_TSR

The return on assets, computed as the ratio between the net income and the book value of the total assets.

The gender and foreign diversity of the board of directors, measured as the percentage of female and foreign directors on the board

The (in)existence of a policy regarding gender and foreign diversity on the board of directors. Equal to 1 when existing, and 0 if not

Average number of years each board member has been on the board at the end of the fiscal year.

The number of board meetings per year Average board meeting attendance

The total number of board members at the end of the fiscal year

CEO Chairman Separation, equals 1 if CEO is a chair on the board, and 0 if not.

Percentage of independent board members as reported by the company. CEO compensation link to total shareholder return, Binary variable equal to 1 if CEO compensation is linked to total shareholder return, 0 if otherwise

5 Empirical results

5.1 Descriptive statistics and correlations

Table 2 – Descriptive Statistics N Mean Std. Dev. ROA BOD_DIV POL_BOD_DIV BOD_TEN BOD_NUM_MET BOD_ATT_MET BOD_SIZE CEO_DUA BOD_IND CEO_COM_TSR 2012 2012 2012 2012 2012 2012 2012 2012 2012 2012 .60 16.15 .87 8.77 8.10 78.45 9.17 .56 77.57 .50 29.00 11.04 .34 4.31 4.34 7.99 2.34 .50 13.81 .50

Notes: this table reports the descriptive statistics of the sample. The variable definitions are given in Table 1.

Table 3 – Correlations of All Variables

1 2 3 4 5 6 7 8 9 ROA BOD_DIV POL_BOD_DIV BOD_TEN BOD_NUM_MET BOD_ATT_MET BOD_SIZE CEO_DUA BOD_IND CEO_COM_TSR 1 .10** .01 .17** -.00 .06** .10** .07** .09** .12** 1 .07** -.04 -.03 .00 .22** .02 .23** .20** 1 -.04 .07** -.02 .02 -.02 .09** .08** 1 -.10** .07** .08** .23** .03 .01 1 -.05* .02 -.05* .06** .03 1 .01 .08** .01 .05* 1 .07** .16** .24** 1 -.02 .04 1 .24** Notes: this table reports the correlations of the sample. The variable definitions are given in Table 1. N = 2,012. *p < 0.05, **p < .01

assets, excluding the board diversity policy and the number of meetings of the board. By that, we can conclude that this study controlled for lots of important control variables, which would otherwise have skewed the results.

5.2 Regression analysis

Table 4 reports the results of the regression analyses of hypothesis 1 and 2. In model 1, the effect of the control variables on firm performance is measured. In model 2, the two main independent variables are added. Comparing both the models, the coefficients of the controls remain fairly similar.

Table 4 – Regression Estimates of the effect of (1) Foreign Cultural and Female Directors and (2) a Policy Regarding Foreign Cultural and Female Directors on Firm Performance

Model 1 Model 2 Variables Intercept Control variables BOD_TEN BOD_NUM_MET BOD_ATT_MET BOD_SIZE CEO_DUA BOD_IND CEO_COM_TSR Independent variables BOD_DIV POL_BOD_DIV Adjusted R2 DR2 -39.60 (7.61) ** 1.01 (.15) ** .02 (.15) .16 (.08) .68 (.28)* 1.67 (1.31) .12 (.05)* 5.08 (1.33) ** .05 ** -39.43 (7.72) ** 1.04 (.15) ** .05 (.15) .16 (.08) * .53 (.29) 1.57 (1.31) .09 (.05) 4.60 (1.34) ** .19 (.06) ** .35 (1.88) .05 ** .01

Notes: the first number in each cell is the regression coefficient and the value in parentheses is the associated p-value. The variable definitions are given in Table 1.

Based on the results presented in table 4, I conclude that there is a positive, and significant relationship (p < .01) between board diversity and firm performance and no relationship (p > 0.05) between board diversity policy and firm performance. This means that firm performance is positively affected by the presence of female and foreing directors on the board, but not affected by a diversity policy. By that, these results support hypothesis 1, but hypothesis 2 is not supported. Furthermore, table 4 shows that firm performance increases when board tenures increases (b = 1.04, P < .01), when the average board meetings attance increases (b = .16, P < 0.05) and when the CEOs’ compensation is linked with total shareholder return (b = 4.60, P < 0.01). In contrast, the other control variables are not significantly related to firm performance (P > 0.05)

6 Discussion

6.1 Theoretical and practical contributions

Furthermore, board diversity policies have been regulated in the past years (Schwizer et al. 2012), but yet, no research provided an answer on the relationship between board diversity policies and firm performance. By that, implementing a gender or ethnic diversity policy makes a firm vulnerable because of the unknown consequences. I expected that policies lead to a focus on non-task related characteristics of directors (gender and ethnicity), rather than task related qualities. In that sense, the possible unique qualities of female directors might not bring along different resources. This would consequently lead to a less effective board. Therefore, I expect an increase in the number of female and foreign directors on the board, but a decrease in the quality of board and thus in firm performance.

In line with hypothesis 1, this study finds that the presence of female and foreign directors has a positive and significant impact on firm performance (ROA). By that, we can conclude that female and foreign directors add unique skills and expertise to the board, which leads to a more effective fulfilment of the advisory role of the board, in line with the human capital theory and resource dependence theory. It is also possible that the presence of female and foreign directors result in an increase of independency and activity, which effects the monitoring role of the board, following the agency theory.

This study contributes to the literature in two ways. First, it contributes to the literature on board gender and cultural diversity and firm performance (e.g. Hillman, et al., 2002; Hillman & Dalziel, 2003; Hooghiemstra et al., 2019; Terjesen et al., 2009) in providing compelling evidence on this relationship with a different perspective from an integrated framework of three theories: the agency theory, the resource dependence theory and the human capital theory. My findings claim the importance of board diversity for firms as this significantly impacts the performance. Furthermore, this study could not find significant evidence that a policy regarding gender and foreign cultural diversity impacts the performance. This is in line with the study from e.g. Kirsch and Wrohlich (2020). It is likely that the ‘soft’ policies impact the firm performance positively, but that the ‘hard’ policies negatively impact this, resulting in an insignificant relationship overall. I therefore encourage future study to research the impact of both ‘soft’ and ‘hard’ policies regarding female and foreign directors.

Because of the information from this study, shareholders can make decisions on the board composition regarding female and foreign directors. By that, firms’ board can grow more in being effective, which impacts firm performance positively.

6.2 Limitations and directions for future research

data on board diversity policy was limited, due to its binarity. Therefore, this study could not make a distinction between different sort of policies (‘soft’ and ‘hard’ policies), which possibly results in different impacts on firm performance. To study the impact of both ‘hard’ and ‘soft’ policies, further study is required.

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