Board monitoring and advising trade‐offs amidst economic policy uncertainty

• Published date: 01 February 2022
• Author: Melissa B. Frye,Duong T. Pham,Rongrong Zhang
• Date: 01 February 2022
• DOI: http://doi.org/10.1111/fire.12286

DOI: 10.1111/fire.12286

ORIGINAL ARTICLE

Board monitoring and advising trade-offs amidst

economic policy uncertainty

Melissa B. Frye1Duong T. Pham2Rongrong Zhang2

1University of CentralFlorida, Orlando,

Florida, USA

2Georgia Southern University, Statesboro,

Georgia, USA

Correspondence

MelissaB. Frye, College of Business Adminis-

tration,University of Central Florida, Orlando,

FL32816, USA.

Email:melissa.frye@ucf.edu.

Abstract

We examine the changes in the board’s dual roles of moni-

toring and advising in times of fluctuating economic policy

uncertainty (EPU). We find that a rise in EPU leads boards

to reduce the size and increase independence and the pro-

portion of female directors. They also decrease the involve-

ment of insiders and outside executives. There is also a drop

in the busyness of the directors. Overall, we find that boards

enhance their monitoring power to deal with greater EPU.

KEYWORDS

board structure, corporate governance, economic policy uncer-

tainty

JEL CLASSIFICATION

G30, G34, G18, E60

1INTRODUCTION

Concerns about economicpolicy uncertainty (EPU) have explodedin the wake of the global pandemic and the ensuing

economic downturn, coupled with unprecedented partisan politics. Uncertainty may put pressure on firms to ensure

that their monitoring structures are adequate to deal with the changing environment. Institutional Shareholder Ser-

vices (ISS) and Glass Lewis, providers of corporate governance and proxyadvisory services, highlight that uncertain

times magnify the importance of effective governance while increasing the demands on directors’ time. Glass Lewis

contends that “the ability of boards and management to successfully navigatethe crisis and outperform their competi-

tors will highlight the stark differences in the effectiveness of boards, directors, and their governancestructures.”1

While it maybe too early to evaluate board responses to the pandemic, it raises the question as to how boards react

to exogenouschanges in uncertainty. Specifically, we examine how companies change the structure of their boards in

response to fluctuating EPU. Baker et al. (2016) define EPU as uncertainty about who will make economic decisions,

what economic policy actions will be undertaken, and when the economic effects of the actions or inactions will be

1https://www.jdsupra.com/legalnews/blog-glass-lewis-considers-impact-on-96400/

Financial Review. 2022;57:5–26. wileyonlinelibrary.com/journal/fire ©2021 The Eastern Finance Association 5

6FRYE ET AL.

realized. Broadly, EPUcaptures the uncertainty introduced by government policymakers regarding fiscal, regulatory,

or monetary policy.EPU is intended to be a more comprehensive measure of uncertainty, capturing uncertainty about

a firm’s operating environmentrather than simply proxying for an imminent recession or weak economy. The measure

developed by Bakeret al. shows that EPU spikes around close presidential elections, wars, the September 11 attacks,

the collapse of Lehman Brothers, and the COVID-19pandemic.

Prior literature links EPU to firm decision making. Gulen and Ion (2016) find that EPU steers firms to a reduction in

investmentexpenditures. Bonaime et al. (2018) show that policy and regulatory uncertainty reduce merger activity at

the firm level. Hankins et al. (2019) ascertain that firms use cash and reduce capital spending to increase research and

development spending following a shock to EPU. Ion and Yin (2021) establish that EPU affects CEO decision making.

CEOs sell their own shares of company stock and exercisefewer options when uncertainty is high. They also find that

firms increase hedging activities and diversifying mergers when EPU is high. Fryeand Pham ( 2020) extendthis strand

of the literature and show EPU also influences board decision making. They show that boards are more apprehensive

about forcing out a poor performing CEO when EPU is high, consistent with the notion that performance assessment

and monitoring may be more difficult for boards when the economic environment is highly uncertain.

However,previous studies largely overlook whether and how firms alter their board structures in response to EPU.

Attig et al. (2021) contend that firms will be more vulnerable to agency problems when EPU is high. EPU has nega-

tive implications for macroeconomic activities (Baker et al., 2016) and capital investments(Gulen & Ion, 2016), which

Attig et al. argue leads to higher cash reserves and greater agency problems. Empirically, Attig et al. show that firms

increase corporate payouts when EPU is high, consistent with EPU being associated with increased agency costs of

free cash flows. Thus, we posit that boards may alter their decision making regarding their own structure to enhance

their effectiveness in dealing with EPU and the accompanying agency costs.

Linck et al. (2008) show that firms alter their board structures to mitigate agency conflicts specific to their contract-

ing environment. Boone et al. (2007) show that economic considerations, particularly the firm’s competitive environ-

ment and managerial team, affect board structure evolution. Cicero et al. (2013) show that board structures change

frequently in waysthat are consistent with firms pursuing an economically efficient board. Chung et al. (2019)findthat

boards restructure themselves to respond to changes in their contracting environment. Graham et al. (2020) empha-

size that firms alter their board structures for more or less monitoring over time.

Even though board structures need to focus on providing sufficient monitoring capabilities, directors are also

charged with providing strategicadvice. Linck et al. (2008) define the monitoring role for directors as focusing on scru-

tinizing managers to protect against harmful behaviors, spanning from shirking to fraud. In contrast, they define the

advising function as assisting management in making good decisions regarding strategy and actions. Linck et al. find

that directors structure their boards in ways that are consistent with the costs and benefits of board monitoring and

advising.

Exploring the idea that there may be a trade-off between board monitoring and advising is particularly interesting

in the context ofE PU.Exogenous risk changes provide a setting where the demand for board advising and board mon-

itoring may shift, implying advising and monitoring trade-offs maychange in response to EPU. Faleye et al. (2011)find

evidence supporting a trade-off between directors’ duty to monitor management and their responsibility to provide

strategicadvice. However, Kim et al. (2014) suggest that monitoring and advising are more likely to be complementary

than competing.

Prior literature shows that uncertainty is generally associated with fewer strategic corporate decisions in terms

of investments, mergers, and strategic alliances (Baxamusa et al., 2020; Gulen & Ion, 2016; Nguyen & Phan, 2017). If

the board perceives that strategic decisions will be limited in times of uncertainty,they may shift their structures to

provide less advising capacity.Alternatively, the importance of monitoring may be magnified with uncertainty (Frye &

Pham, 2020; Miller et al. 2002) and with the increase in agency costs associated with EPU (Attig et al., 2021). Rising

agency costs calls for greater monitoring. Likewise, uncertainty makes it difficult for boards to assess and evaluate

CEO performance and thus increases their need for monitoring capabilities. Thus, we expect boards to prioritize their

monitoring role over their advising role in times of increasing uncertainty.