1.1.1. Definitions of corporate governance
Corporate governance in the academic literature seems to have been first used by Eells [EEL 60] to denote âthe structure and functioning of the corporate polityâ. The most quoted definition of corporate governance is the one given by Shleifer and Vishny [SHL 97]: âCorporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. Corporate governance deals with the agency problem: the separation of management and finance, the fundamental question of corporate governance is how to assure financiers that they get a return on their financial investmentâ.
In their survey, Shleifer and Vishny [SHL 97] account for different governance models, especially those of the United States, UK, Germany and Japan. They conclude that the United States and the United Kingdom have a governance system characterized by a strong legal protection of investors and a lack of large investors, except when ownership is concentrated temporarily during the takeover process. However, in continental Europe as well as in Japan, the system is characterized by a weak legal protection of minorities and the presence of large investors.
According to Braendle and Kostyuk [BRA 07], the term âcorporate governanceâ is susceptible to both narrow and broad definitions, related to the two perspectives of shareholder and stakeholder orientation. It therefore revolves around the debate on whether management should run the corporation solely in the interests of shareholders (shareholder perspective) or whether it should take account of other constituencies (stakeholder perspective).
Narrowly defined corporate governance concerns the relationships between corporate managers, the board of directors and shareholders, but it might as well encompass the relationship of the corporation to stakeholders and society. More broadly defined, corporate governance can encompass the combination of laws, regulations, listing rules and practices that enable the corporation to attract capital, perform efficiently, generate profit and meet both, legal obligations and general societal expectations.
Lipton and Lorsch [LIP 92] give a definition in favor of a shareholder perspective as follows: the approach of corporate governance that social, moral and political questions are proper concerns of corporate governance is fundamentally misconceived. If we expand corporate governance to encompass society, as a whole it benefits neither corporations nor society, because management is ill-equipped to deal with questions of general public interest.
Hess [HES 96] mentioned that âcorporate governance is the process of control and administration of the companyâs capital and human resources in the interest of the owners of a companyâ. In the same sense, Sternberg [STE 98] considered that âcorporate governance describes ways of ensuring that corporate actions, assets and agents are directed at achieving the corporate objectives established by the corporationâs shareholdersâ.
The OECD1 principles of corporate governance (2004, 20152) tried to give a very broad definition, as it should serve as a basis for all OECD countries:
âCorporate governance defines a set of relationships between a companyâs management, its board, its shareholders and other stakeholdersâ. An even broader definition is to define a governance system as âthe complex set of constraints that shape the ex post bargaining over the quasi rents generated by the firmâ [ZIN 98].
This definition focuses on the division of claims and can be somewhat expanded to define corporate governance as âthe complex set of constraints that determine the quasi-rents (profits) generated by the firm in the course of relationships and shape the ex-post bargaining over themâ. This definition refers to both the determination of value added by firms and the allocation of it among stakeholders that have relationships with the firm. It can be referred to a set of rules and principles, as well as to institutions.
Du Plessis et al. [DU 05] define corporate governance as: âThe process of controlling management and of balancing the interests of all internal stakeholders and other parties (external stakeholders, governments and local communities, etc.) who can be affected by the corporationâs conduct in order to ensure responsible behavior by corporations and to achieve the maximum level of efficiency and profitability for a corporationâ. Under a definition more specific to corporate governance, the focus would be on how outside investors protect themselves against expropriation by the insiders (large investors). This would include minoritiesâ protection and the strength of creditor rights, as reflected in collateral and bankruptcy laws, and their enforcement. It could also include such issues as requirements on the composition and the rights of the executive directors and the ability to pursue class-action suits [CLA 12].
Although there are a myriad of definitions on corporate governance and they vary between narrow and broad perspectives, governance may be defined as a set of internal and external mechanisms working together to obtain an efficient and an optimal alignment of all partiesâ interests, and getting a winâwin relationship. In a subjective conception of the term corporate governance, âbanking governance is defined as a set of internal and external mechanisms, which aims optimal harmonization between shareholders, directors and stakeholders. It is based on the safe cooperation between management and control in order to obtain a winâwin relationship in which interests are aligned and goals are achievedâ.
1.1.2. Nature of the agency problem
The problem of corporate governance is rooted in the BerleâMeans [BER 32] paradigm of the separation of shareholdersâ ownership and managementâs control in the modern corporation. The agency problem occurs when the principal (shareholders) lacks the necessary power or information to monitor and control the agent (managers) and when the compensation of the principal and the agent is not aligned. The separation of ownership and control results in information asymmetry, thus potentially leading to two types of agency problems: (1) one agency problem is between outside investors and managers (âprincipal-agentâ agency problem) and (2) the other one is between controlling shareholders and minority shareholders (âprincipalâprincipalâ agency problem) [JEN 76]. Moreover, La Porta et al.âs [LA 99] research of corporate governance patterns in 27 countries concludes that âthe principal agency problem in large corporations around the world is that of restricting expropriation of minority shareholders by the controlling shareholdersâ.
Shleifer and Veshny [SHL 97] consider that contracts between financiers and manager are the source of the first agency problem because they lead to management discretion. Then, the existence of large investors, which causes expropriation of minorities, is the second source of the agency problem. Hence, to mitigate the conflict between all the parties (managers and shareholders, large and minority shareholders), the literature offers several solutions, s...