Board Independence and Compensation Policies in Large Bank Holding Companies

Financial Management (Financial Management Association), Autumn, 2000 by Chandra S. Mishra, James F. Nielsen

Our study defines an outside director as an independent outside director. Gray directors are excluded. Because outside directors are usually independent of the CEO, it follows that the greater the percentage of outside directors, the more likely it is that significant checks and balances will be maintained in board deliberations (Vance, 1983), and the greater the degree of overall board independence.

However, a board's ability to carry out its legal role of representing shareholder interests over the interests of management can also be greatly influenced by the power the CEO has over the board (Pearce and Zahra, 1991). Since the CEO has the ability to shape board membership over time (Alderfer, 1986), the CEO can gain power the longer he/she holds the position. By measuring the average tenure of outside directors relative to the CEO, we attempt to measure the quality of board independence or the degree of influence the outside directors have in corporate governance (Singh and Harianto, 1989).

The longer the outside directors have served on the board, the greater their organization influence (Singh and Harianto, 1989), and the less likely they are to succumb to management pressures for conformity (Kosnik, 1990). However, the longer the members of a board of directors have worked together, the more likely they are to be committed to the status quo (Katz, 1982), to resist change (Goodstein and Boeker, 1991), and to tolerate poor performance on the part of senior management (Vance, 1983). As a result, as far as tenure is concerned, heterogeneous boards are more likely to do a more effective job of monitoring senior management and interceding on the part of shareholders (Kosnik, 1990). Finally, one of the strongest ways in which outside directors can influence senior management is through membership on the compensation committee.

We use two variables to measure bank performance, return on average total assets (ROA) and return on average common equity (ROE). Both of these variables represent accounting measures of financial performance and have been widely used in performance-based studies. We calculate these variables based on year-end 1990 data.

We also gather data on three additional variables: ownership structure, as measured by the percentage of stock held by directors (inside, affiliated outside, independent outside), institutions, and blockholders (Brickley, Lease, and Smith, 1988); leadership structure, as measured by CEO tenure and CEO/chairman duality (Brickley, Coles, and Jarrell, 1997); and market takeover activity, as measured by the restrictiveness of interstate branching laws (Brickley and James, 1987). Information for these measures comes from Disclosure, legal statutes that took effect in 1990 in the states in which the bank holding companies are operating, and 1990 annual reports and proxy statements.

III. Empirical Tests

In principle, the two monitoring variables, board independence and pay-related incentives, could be either substitutes or complements. If independent boards provide the necessary monitoring of senior management, the need for compensation contracts to align the interests of managers and shareholders can be reduced. On the other hand, if independent boards and compensation contracts complement each other, both would play a role in the monitoring function. Since the substitution-monitoring hypothesis is more solidly grounded in theory (Beatty and Zajac, 1994; Mehran, 1992), we examine the association between the two corporate control mechanisms on the basis of this hypothesis. As part of this analysis, we control for firm size, growth opportunities, ownership structure, leadership structure, and market takeover activity.