Academic journal article IUP Journal of Corporate Governance

The Relationship between Board Diversity and Firm Performance: Evidence from the Banking Sector in Pakistan

Academic journal article IUP Journal of Corporate Governance

The Relationship between Board Diversity and Firm Performance: Evidence from the Banking Sector in Pakistan

Article excerpt

Introduction

The Board of Directors are responsible for the protection of shareholders' rights by ensuring that the interests of managers and shareholders are aligned in the same direction, and they also have to monitor the managers in order to avoid agency conflicts (Kang et al., 2007). A large number of boards follow the corporate governance principles and practices to improve their effectiveness even in the absence of external corporate governance instruments like government regulations and blockholders monitoring. The directors are viewed as assets because they have skills, experience, knowledge, judgment, and expertise that are important to meet the needs of the firm (Scarborough et al., 2010). Diversity is one of the current problems faced by the firms and is related to the age, gender and independence of directors (Rhode and Packel, 2010). In corporate governance, board diversity is defined as the board composition of the qualities, characteristics, properties, skills, and expertise of individual members that help to make decisions in the board. Demographic diversity in the board affects the nomination process of directors, compensation system and also the incentives for directors for replacing the CEO. Furthermore, diversity affects the firm performance, but it depends on the firm's characteristics. Finally, board diversity results in costs and benefits for the firm (Ferreira, 2010). There are wide and different views about the relationship between board diversity and firm performance.

Literature pertinent to the positive role of director's diversity argues that social or observable diversity (gender, ethnicity, and age) of the board adds value to the firm (Kang et al., 2007). This is because of several advantages of diversity like creativity, innovation, better ideas, mutual problem solving, better understanding of the market globally and board independence (Carter et al., 2003; and Kang et al., 2007). Supporters of this view suggest that diverse boards are better and more effective (Adams and Ferreira, 2004). Diversity provides signals to shareholders about the future planning of the firm and indicates that the firm values diversity which is essential for the long-term survival in the market (Terjesen et al., 2009). Demographic diversity of boards protects the firms from value-destroying strategies, thus helping the firms to improve shareholder's value. Turgut and Hafsi (2008) used the data of S&P 500 companies and found that the demographic diversity and dissimilarities among the board members affect the social performance of the firms to a great extent.

However, opponents of boardroom diversity argue that more diversity does not always raise firm value. Therefore, firms need to balance diversity among the board members to maximize their performance (Tibben, 2010). Diversity in the board brings natural complexity within the board (Ruigrok et al., 2007). Board diversity results in an increase in the resources and time required to learn how to work cooperatively in a diverse environment (Heidrick and Struggles, 2011). The reason for low diversity is that people are more likely to interact with others who show similarities with them. Furthermore, there are more emotional conflicts attached with the people of a group that is heterogeneous in many aspects (Gregoric et al., 2010).

The literature presents inconsistent results related to boardroom diversity and firm performance relationship. This inconsistency is due to the differences in the time period of the studies, countries, types and forms of companies, economic environment, and difference in the measurement of diversity and financial performance indicators, regulatory and governance structures, culture, and size of capital markets, as well as sample size and methodologies used previously (Rhode and Packel, 2010). These characteristics of board have been examined mostly in the context of developed financial markets. Understanding their role and effectiveness in the developing financial markets is important due to organizational structural differences across these financial markets (Sarkar et al. …

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