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the board to become an effective control mechanism. First, board cultures must be changed to emphasize frankness and truth instead of politeness and courtesy so that
CEOs do not have the influence to control the board and escape scrutiny. Second, board members must have free access to all relevant information and not just the
information selected by the CEO. Then the board members must have the expertise to evaluate this information. Third, legal liabilities must be altered so that directors
have the appropriate incentives to take actions that create value for the company, not reduce the risks of litigation. Fourth, management and board members should
have significant equity holdings in the company to promote value maximization for shareholders. Fifth, boards should be kept small seven or eight members so they
can function more efficiently and not be controlled by the CEO. Similarly, the CEO should be the only insider because other insiders are too easily influenced by the
CEO. Sixth, the board should not be modeled after the democratic political model that represents other constituencies in addition to shareholders. Seventh, the CEO
and the chairman of the board should not be the same person. Finally, the role of investors that hold large debt or equity positions in the company and actively seek
to participate in the strategic direction of the company should be expanded.
Jensen 1993 suggested that LBO associations and venture capital funds provide a model governance structure that has effectively resolved some of the problems
associated with current corporate control systems. The problems addressed are not firm failure but slow growthdeclining firms and high growth entrepreneurial firms.
The concepts apply to faulty internal control systems in banking firms that result in financial distress.
The characteristics of LBO associations and venture capital funds that provide a model for efficient internal corporate controls are:
1. limited partnership agreements at the top level that prohibit headquarters from cross-subsidizing divisions,
2. large equity ownership by both managers and directors, 3. directors that represent a large fraction of the owners,
4. a small number of directors on the board eight or less, 5. no management insiders on the board other than the CEO, and
6. the CEO is not the chairman of the board.
The framework offered by Jensen 1993 provides a conceptual framework drawn from observation that was intuitively appealing and provided the basis for a set of
empirically testable hypotheses.
3. Hypotheses
3.1. Hypothesis I: Management and board member equity ownership Jensen 1993 suggests that many problems occur because neither managers nor
directors normally own a substantial proportion of the firm’s equity, which decreases the incentives of directors and officers to pursue the shareholders’ interests. Saunders,
284 W.G. Simpson, A.E. Gleason International Review of Economics and Finance 8 1999 281–292
Strock, and Travlos 1990 provide evidence that banks controlled by stockholders have incentives to take higher risk than banks controlled by managers. If stockholders
prefer more risk than non-owner managers and stock ownership aligns managers and directors with owners, then the probability of financial distress in a bank would be
higher when managers and directors own a higher proportion of the equity.
H
A
: Banks with higher proportions of equity ownership by directors and managers have higher probabilities of experiencing financial distress, ceteris paribus.
3.2. Hypothesis II: Board size Jensen 1993 proposed that a smaller number of board members produces a more
effective control mechanism. Changanti, Mahajan, and Sharma 1985 also suggested that smaller boards play a more important control function whereas larger boards
have difficulty coordinating their efforts which leaves managers free to pursue their own goals. However, a smaller board might be easier for the CEO to influence and
a larger board would offer a greater breadth of experience. The impact of board size on the corporate control mechanism is not obvious, but the strongest arguments
suggest that a smaller board would result in closer alignment with shareholder interests, which would increase risk taking.
H
A
: Banks with smaller boards have higher probabilities of financial distress than banks with larger boards, ceteris paribus.
3.3. Hypothesis III: Insiders on the board Jensen 1993 argued that corporate officers who report to the CEO cannot be
effective monitors because the possibility of retribution is high. Therefore, the officers of the corporation should not serve on the board. Kesner, Victor, and Lamont 1986
referred to this point as the “outsider dominance perspective”. To the contrary, outsiders sometimes do not understand the complexities of the company and are
technically ineffective monitors. When outsiders represent a large number of diverse interests, they may restrict the economic flexibility of the firm and produce conflicts
between the board and management. It is often suggested that the participation of outsiders on the board influences the effectiveness of the control function. Weisbach
1988 and Brickley, Coles, and Terry 1994 present empirical evidence which suggests that outside directors represent shareholder interests better than inside directors.
H
A
: Banks with higher percentages of inside directors on the board have lower probabilities of financial distress, ceteris paribus.
3.4. Hypothesis IV: CEO duality Jensen 1993 argued that the CEO should not have a dual position as chairman
of the board because the CEO may not separate personal interests from shareholder interests. The function of the chairman of the board is to conduct board meetings
and supervise the evaluation and compensation of the CEO Jensen, 1993. The dual CEOchairman of the board probably has significantly increased power over the
W.G. Simpson, A.E. Gleason International Review of Economics and Finance 8 1999 281–292 285
board and corporation. This would probably reduce the effectiveness of the control mechanisms of the governance structure. The issue of CEO duality has received
considerable attention because the practice is commonly observed in many large corporations Kesner, Victor, Lamont, 1986. Supporters argue that CEO duality
provides better strategic vision and leadership than an independent chairman.
H
A
: The probability of financial distress is lower for a banking firm with a dual chairman of the board and CEO, ceteris paribus.
3.5. Hypothesis V: CEO equity ownership A major premise of Jensen 1993 is that the CEO should pursue the interests of
the shareholders. The argument against a combination of the chairman of the board and the CEO is that the manager will be too powerful and not have interests aligned
with shareholders. The fact that a CEO would be able to control other officers who were on the board follows the same line of reasoning. A parallel consideration is the
equity ownership position of the CEO. The amount of equity a CEO holds should increase the alignment of the interests of the CEO with the interests of shareholders.
H
A
: A banking firm where the CEO has a lower equity ownership position has a lower probability of financial distress, ceteris paribus.
4. Statistical methodology
