Y. S. Lee et al. International Review of Economics and Finance 8 1999 421–431 423
Several studies examine the characteristics of outside directors other than their specific occupations. For example, Kosnik 1990 found that a firm is more likely to
pay greenmail when the outside directors come from diverse backgrounds, perhaps indicating that a fragmented board is less able to ensure that management and share-
holder interests are closely aligned. Shivdasani and Yermack 1997 assert that the number of other outside directorships held by independent directors is important in
determining their value to the firm. Although several other outside directorships will be looked on as an indication of high quality, independent directors with more than
three additional directorships may be viewed as being too thinly spread to be effective. Shivdasani and Yermack show qualitative evidence to support this claim. Brickley et
al. 1994 found that on the adoption of a “poison pill,” the proportion of the board that are “professional directors” i.e., retired business executives and those who list
their occupation as being a director has a large positive influence on abnormal returns.
With respect to financial outside directors, Rosenstein and Wyatt 1990 find that appointments of financial outside directors are associated with significantly positive
abnormal returns. However, they cannot reject the hypothesis that outside directors from financial corporations, nonfinancial firms, or other occupational backgrounds
have a differential effect on firm value.
Booth and Deli 1997 studied the characteristics of firms that have financial direc- tors, finding that firms with a financial outside director have more debt than those
without a financial outsider. They then provided evidence consistent with the theory that financial outside directors provide expertise to the firms on whose boards they
sit, and not as a means of monitoring a business relationship.
In summary, the literature suggests that the financial markets discriminate among outside directors by their occupations and experience. In addition, there is some
evidence that financial outside directors have a specific value to corporations, setting the stage for an examination of valuation effects as a function of the type of financial
firm from which financial outside directors are drawn.
3. Testable implications
Financial directors are expected to provide specific types of knowledge to corporate boards. All three of the categories we examine—commercial bankers, insurance com-
pany executives, and investment bankers—have intimate and timely knowledge of conditions in the financial markets, and they should be able to provide management
with general information regarding the least costly and most prudent method of acquiring long-term or working capital.
Berger and Udell 1995 found that small firms have longer banking relationships, pay lower interest rates, and are less likely to pledge collateral. Petersen and Rajan
1994 found that, for small firms, the primary benefit of building close ties with institutional creditors is the availability of financing. One motive for the appointment
of a financial outside director is to use the board of directors’ relationship as a substitute or complement for a banking relationship. In addition, as pointed out by Easterbrook
1984, financial directors should have expertise in monitoring financial performance
424 Y. S. Lee et al. International Review of Economics and Finance 8 1999 421–431
in their roles as appraisers of credit worthiness. The appointment of a commercial banker or insurance company executive may serve to reduce agency costs between
creditors and shareholders, increasing firm value. Our first hypothesis, then, is that there is a significantly positive wealth effect associated with the appointment of a
financial outside director to the board of a public corporation.
This article builds on previous research by examining the relative valuation effects of the three different types of financial directors. This examination is exploratory in
nature because there is little in the way of past empirical or theoretical work to guide hypotheses with respect to relative valuation effects. Brickley et al. 1988 characterize
all three groups as “pressure-sensitive,” meaning that the potential for business rela- tionships with the firms on whose boards they sit may cause these directors to be less
than arm’s length monitors of management performance. This pressure, along with the more complete understanding of the companies gained as a result of their serving
on the board, may result in lower financing costs.
As experts in credit analysis, commercial bankers and insurance company executives on the board might also be expected to mitigate agency problems between shareholders
and creditors. Investment bankers, on the other hand, are associated with both debt and equity issues, and also with acquisition activity. While their expertise might be
valuable, there is little reason to expect that they would mitigate agency costs more or less than any other outside director. In the absence of a more complete theory,
we make no predictions with respect to the relative valuation effects of appointments of these three types of financial director.
Directors are rarely recruited from pressure-resistant organizations public pension funds, mutual funds, endowments, and foundations owning at least 1 of the firm’s
stock; see Brickley et al., 1988, either because of legal restrictions, tradition, or because corporate managements do not want them on their boards. Therefore, we
cannot test the relative wealth effects of appointments of pressure-sensitive versus pressure-insensitive financial outside directors.
Our second testable hypothesis is that wealth effects associated with the appointment of a financial outside director are inversely related to firm size. It is generally recognized
that small firms have less access to financial markets than do large firms and are less likely to be covered by securities analysts. In addition, small firms are less likely to
be able to support the necessary staff personnel to maintain expertise in all forms of financial dealing. Thus, the appointment of a financial director to the board may be
more valuable for small firms than for large firms. Again, we make no predictions with respect to relative valuation effects across the types of financial directors.
4. Data and methodology
