Understanding Corporate Governance Through Learning Models of Managerial Competence

• Author: Michael S. Weisbach,Benjamin E. Hermalin
• Date: 01 February 2019
• Published date: 01 February 2019
• DOI: http://doi.org/10.1111/ajfs.12243

Understanding Corporate Governance

Through Learning Models of Managerial

Competence*

Benjamin E. Hermalin**

University of California, Berkeley, United States and ECGI, Brussels, Belgium

Michael S. Weisbach

Ohio State University and NBER, United States and ECGI, Brussels, Belgium

Received 29 November 2018; Accepted 28 December 2018

Abstract

Shareholders, the board of directors, and potential future employers are continually assessing

any CEO’s quality. As documented by an extensive literature, such assessment plays a critical

role in corporate governance because it generates incentives (good and bad), introduces

assorted risks, and affects the various battles that rage among the relevant actors for corpo-

rate control. Consequently, assessment (or learning) is a key perspective from which to study,

understand, and possibly even regulate corporate governance. Moreover, because learning is a

behavior notoriously subject to systematic biases, assessment is a natural avenue through

which to introduce behavioral and psychological insights into the study of corporate

governance.

Keywords Corporate governance; Career concerns; Learning and assessment; Cognitive biases

JEL Classification: G34, M12, D83, D81

1. Introduction

Within economics, corporate governance has long been viewed through the lens of

agency: the fear that a firm’s managers are inclined to behave at odds with the

*This paper is a shorter and less technical discussion of the issues addressed in Chapter 3 of The

Handbook of the Economics of Corporate Governance (Hermalin and Weisbach, 2017a) and

draws heavily from it. The authors thank Jongha Lim, Yihui Pan, Miriam Schwartz-Ziv, Berk

Sensoy, Luke Taylor, Ralph Walkling, and Tracy Wang for helpful comments on an earlier

draft, and Shan Ge for excellent research assistance. Hermalin gratefully acknowledges the

financial support of the Thomas & Alison Schneider Distinguished Professorship in Finance.

**Corresponding author: University of California, Berkeley, CA, United States. Tel: +1-510-

642-6474, email: hermalin@berkeley.edu.

Asia-Pacific Journal of Financial Studies (2019) 48, 7–29 doi:10.1111/ajfs.12243

©2019 Korean Securities Association 7

desires of its principals (typically, the firm’s shareholders).

1

Yet, without minimizing

the importance of agency, there is another key aspect to governance that has

received much less attention, namely the way in which managers are assessed with

respect to their intrinsic ability, competency, and match with their employer, and

the effects such assessments have on the behavior of the relevant actors.

A long recognized scientific principle is that observation or measurement can

directly affect the phenomenon being observed or measured. In a governance context,

this principle manifests in the following way: because they know that others seek to

make inferences about them, managers know there are personal consequences of being

observed, an insight attributable to Fama (1980) and Holmstrom (1982).

2

Further-

more, this insight has important implications for incentive provision and corporate

governance. In particular, because the outcome of an assessment, which can affect a

manager’s employment, pay, or both, is unknown in advance, the act of observation

necessarily exposes the manager to risk. Consequently, in their contracts, managers

will demand compensation for this risk, so management compensation will be a func-

tion of the way in which the assessment is carried out. Furthermore, since managers

are strategic players, they can, therefore, be expected to influence how they will be

observed and by whom. Assessment should, therefore, affect corporate governance by

generating incentives (some good, some bad); by creating tradeoffs between how accu-

rately managers are assessed and the risk thereby imposed on them; and by motivating

managers to seek to influence by whom they are observed (i.e., governed).

The way in which the relevant parties learn about managerial ability can explain a

number of factors related to firms’ governance. First, the managerial labor market’s

assessment of a manager’s ability can provide him incentives to perform well, because

such assessment affects his future wages. However, such incentives are unlikely to be

optimal, often being weaker than ideal, but, in other instances, being too strong. Worse,

they can potentially have perverse effects, such as distorting managers’ decisions about

investment or project choice. Second, assessment is a critical part of the process by which

managers are chosen and fired. Consequently, management turnover is naturally studied

through a learning framework. Third, what will be learned is unknown ex ante;hence,

1

Smith (1776, p. 700): “The directors of [joint stock] companies, however, being the man-

agers rather of other people’s money than of their own, it cannot well be expected, that they

should watch over it with the same anxious vigilance [as owners] ... Negligence and profu-

sion, therefore, must always prevail, more of less, in the management of the affairs of such a

company.” In the modern era, there was a revived interest in agency problems and their rela-

tion to governance led by Berle and Means (1932), Williamson (1963), and Jensen and Meck-

ling (1976), among others. (See Becht et al. (2003) and Hermalin (2013) for recent surveys

of the relevant literature as well as Hermalin and Weisbach (2017b).)

2

Holmstrom’s paper was originally published in 1982, in a hard to find festschrift for Lars

Wahlbeck. In the pre-PDF 1980s, a photocopy of the working-paper version of the paper was

a treasured belonging of students and scholars interested in contract theory and governance.

In 1999, the Review of Economic Studies wisely reprinted the paper (Holmstrom, 1999).

B. E. Hermalin and M. S. Weisbach

8©2019 Korean Securities Association