Behavior and Rationality in Corporate Governance

Article excerpt

The governance debate identifies the central problem of the separation of ownership and control in the large corporation and centers on the alignment of the agent's interests with those of the principal. Key factors in monitoring senior managements' performance include the composition and independence of outside board members, issues of transparency, outside reporting, accounting standards, and shareholder composition. Empirical research on corporate governance (e.g., Klein 2000; Peasnell et al. 2002) typically investigates quantifiable relationships between measures of corporate performance and specific remedies to agency problems, including the number and independence of directors on a company board or board committees and the independence of external auditors. This large body of research identifies important aspects of the problem of minimizing the conflicts between principal and agent.

Until fairly recently, however, issues of bias in human cognition and perception, decision making under uncertainty, risk assessment, and the impact of emotion and affect on behavior received somewhat less attention in this literature. Monitors are frequently assumed to be rational actors (Fama 1980; Shleifer and Vishny 1997; Prentice 2000). (1) Findings from cognitive psychology and behavioral studies, however, indicate that judgment, decision making, and behavior are not exclusively based on logical reasoning but are also subject to numerous heuristics and cognitive biases (Tversky and Kahneman 1974; Kahneman and Tversky 1979; Fischhoff 2002), affect (Slovic et al. 2002), visceral factors (Schelling 1984; Loewenstein et al. 2001), and pressures toward conformity with the group or authority (Asch 1956; Janis 1982). Divergence from utility maximization over time adds a temporal dimension to this literature (Strotz 1955; Thaler 1981). These influences tend to steer human judgment, inference, and behavior away from the predicted outcome of expected utility theory and lead to systematic violations of the normative assumptions central to the economist's rational model.

Members of the board of directors and external auditors are, for example, expected to care about their reputation and their prospects in the job market, which is theorized to discipline their actions. There are, however, limits to reputation as a determinant to behavior. Auditors and board directors are, no less than other individuals, subject to the common human preference for immediate gratification, typically with insufficient regard for potential negative future consequences. The gratification from a bonus, re-election to a board of directors, renewal of an auditing contract, or the prospects of employment in a client's firm is certain and experienced in the present or the immediate future. In contrast, expected damage from questionable activities, including reputational damage, legal or financial sanctions, and loss of career is merely potential and in the more distant future. The magnitude of negative outcomes may be further discounted and reduced in perceived severity and probability by self-serving justifications and overoptimism. (2)

This paper examines corporate governance from an agency perspective and asks why some of the standard means of monitoring the activities of senior decision makers in large corporations are prone to failure. The focus of the paper is on issues of agent behavior, questioning some of the assumptions of the familiar neoclassical maximizing model. The issue of corporate governance touches on core assumptions in economics concerning the behavior of individual agents, the tendency toward equilibrium in financial markets, the role of the corporate firm, and the subject of regulation. Institutional economics has a long tradition of fundamental criticisms of some of the core assumptions of mainstream economics, in particular with regard to the strict assumptions about rationality and utility maximization. The unease of this school with the neoclassical assumption of perfectly optimizing behavior of agents predates the discussion of human cognition and decision making under uncertainty. …