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Governance and Performance: The Direction of the Causation Arrow

Here is a provocative paper that argues the causation arrow runs in the opposite direction of what one might assume:

A common view, seemingly supported by empirical findings, is that better corporate governance leads to better corporate performance. But, if true, why do firms then leave money on the table by having poor governance? This paper builds a model that explains the empirical findings, but which doesn’t suffer from this money-on-the-table critique. The paper argues that the common view essentially gets causality backward. Firms that have the best potential to perform well are the ones that have the most to lose from poor governance, so they are the ones that have strong governance. Strong governance and performance are positively correlated, but the former does not drive the latter. This perspective can explain a number of real-world phenomena, such as the correlation between firm size and executive compensation, the growth in executive compensation, and why measured incentives for executives often seem too low, among others.

The policy implication seems to be that governance reform isn’t worth the price and that firms with poor governance ought to be allowed to stew in their own juices as they slide slowly into senescence.