The Role of Corporate Governance

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Chapter 3 Conceptual Framework and Hypothesis Development


The analytical model in this chapter builds on the gaps identified in the literature (chapter two) and the relevant theoretical frameworks that provide insight to answer the research questions. To answer the research questions and meet the objectives, the study is steered by the theoretical frameworks and earlier empirical studies. The analytical framework also serves as the basis to generate and empirically test the hypotheses. In addition to the literature review made in chapter two, extensive review has also been made in this chapter in the development of the hypotheses.

Conceptual Framework of Corporate Governance

Previous theoretical discussions have revealed that corporate performance is affected by three interlinked variables (see Figure 3.1), which include:

  1. The board structure that refers to board composition, director independence, and board committee. The board structure has influence on the board process i.e., the decision making activities of the board.
  2. The board process refers, among other things; to the way decisions are made involving board member commitment, critical debate (process and cognitive conflicts) in board meetings, and board room behavior/activity. The board structure and process in turn have implications for the board roles or task performances.
  3. The board role includes the service and control tasks (Forbes & Milliken, 1999; Huse, 2005; Minichilli et al., 2009).

In general, the framework adopted assumes that board performance (roles/tasks) has a direct relationship with board structure and board process. It also displays that effective corporate governance is a function of appropriate board structure and process, on which effective board performance depends. These corporate governance variables are interlinked in the sense that boards engage in right process when structural issues such as composition, independence and committee work are well addressed. The structural variables are believed to have an influence on the working of the board (process), as the decision making activity of the board benefits from boards with a mix of different backgrounds, composition, and independence (Wan & Ong, 2005). This will also have an impact on boards‟ performance, i.e., to diligently execute their roles and responsibilities. All these in turn impact on corporate performance (Forbes & Milliken, 1999).
The corporate governance theories discussed in Chapter Two are in one way or another linked with the three factors that affect the functioning of corporate governance from which the study benefits to have different lenses of examining the issue under discussion. The theories also shade light on the roles played by boards.
According to Minichilli et al. (2009), Forbes and Milliken (1999) and Johnson, Daily and Ellstrand (1996), boards are expected to provide board services in the form of advice and counselling and networking with the environment. A board‟s role in this regard has to do with the resource dependence, stewardship, and social capital theories, which argue that board of directors perform service task by bringing in different types of resources to an organization due to their diversity (co-opting outside directors) and the connections (linkage) they have with the environment. The service tasks are in the form of advice and counseling (advisory task), which is mentoring and supporting management; and strategic participation that includes initiating, formulating, evaluating, selecting, implementing strategic alternatives, and improving the quality of strategic decisions of the top management.
Boards of directors also perform control tasks (Minichilli et al., 2009; Forbes and Milliken, 1999; Johnson et al., 1996; Fama & Jensen, 1983), which is associated with the agency theory or role. Advocates of the agency theory believe that boards of directors play the control role by safeguarding the interests of shareholders from unhealthy management behavior. According to Minichilli et al. (2009), Johnson et al. (1996), Zahra and Pearce (1989), a set of related activities is performed in accomplishing the board control role that includes controlling the firm‟s performance, monitoring essential activities of the firm, and monitoring internal behavior particularly the CEO‟s behavior.
In line with the behavioral control task, boards also perform output control tasks. An output control task, according to Minichilli et al. (2009), is basically based on both agency and stakeholder theory with an external focus, which is performed through monitoring corporate financial performance. The third control task performed by boards refers to strategic control, which is based on the agency theory having a strategic focus. This is primarily concerned with evaluating and monitoring strategic decision making.

Hypothesis Development

Board Structure and Board Service and Control Task Performances

The need for corporate governance becomes evident in corporate forms of organizations where ownership and control are separate giving rise to the agency problem, which for the first time was identified by Berle and Means (1932) as resulting from the separation of ownership and control.
The agency problem occurs because of dispersal of shareholding ownership in corporate forms of organizations, in which a typical shareholder may not show interest in the day-to-day affairs of a company. Likewise the thousands of shareholders that make up the majority of owners may demonstrate the same behavior as the typical shareholder, resulting in agency cost. The agency cost results when those who are directly interested in day-to-day affairs, the management, have the ability to manage the resources of companies to their own advantage without effective shareholder control (Berle & Means, 1932). This situation is explained in terms of the key theoretical lens of the agency theory, which is a dominant theory in corporate governance studies (Jensen & Meckling, 1976; Fama, 1980; Fama & Jensen, 1983; Hermalin & Weisbach, 1991; Dalton, Daily, Ellstrand & Johnson, 1998; Dulewicz & Herbert, 2004; Grant, 2007; Anderson, Melanson & Maly, 2007; Minichilli et al., 2009; Yusoff & Alhaji, 2012). The agency problem makes both accountability and governance assume a greater significance and have emphasis in corporate organizations. It is this context that brought boards into play as one major internal governance mechanism to overcome the agency problem and thereby maintain effective organization (Fama & Jensen, 1983). These authors also view the board of directors as the top most important internal decision control system of firms. Furthermore, the resource dependence theory views outside board of directors as key board members that link the firm with the environment and help bring important resources which may not be available in the firm. They also provide services in the form of advice and counsel based on their experience and exposure. Their networking with the environment, in addition to resource generation, enhances corporate image and reputation (Daily & Danton, 1993).
As stated above, one of the internal governance mechanisms is to have an appropriate board structure that is explained in terms of composition, independence and committee functioning (Fauzi & Locke, 2012). Andres, Azofra and Lopez (2005), underline the importance of board committee as one factor that potentially affects the way boards operate by explaining their impacts on firm performance if they are omitted. The debate on corporate governance largely centers on the board characteristics, especially size and CEO duality in the context of developed economies (Hermalin & Weisbach, 1991; Daily & Dalton, 1993; Dulewicz & Herbert, 2004; Andres et al., 2005). The research focusing on developing economies is scant; particularly the study on the relationship between board composition, board independence, and board committee, the individual association of which with board performance, is not well established (Fauzi & Locke, 2012). It is clear that the system of corporate governance has to be context-specific, which should be based on a particular country‟s economic, legal, institutional framework, and cultural factors (Weimer & Papa, 1999; OECD, 2004). Garg (2007) also stated that board structure might have different relationship with firm performance in transition economies as opposed to western economies as there are differences in institutional contexts.
Therefore, in helping to overcome the agency problem, the make-up of boards and institutional contexts vary considerably from country to country, which might result in different relationships between structure and performance. For example, the recommendation by the National Bank of Ethiopia (NBE) about the composition of boards is totally in favour of a non-executive (outside) board of directors (Ethiopia Proclamation no. 592/2008, 2008) unlike the King Committee (2009), the OECD (2004) and the Cadbury Report (1992), all of which advocate for both executive and non-executive directors but with a majority of non-executive board of directors. Thus, this study limits itself to examining whether proper board structure (composition, independence, and committee) influences board performance. Emphasis is given to the above structural components as there are no CEO duality and executive (insider) directors in the Ethiopian banking context. The researcher recognizes other aspects of structural variables like CEO duality, size, and insider/outsider boards that have been examined extensively though the findings between these structural variables and firm performance have equivocal results (Minichilli et al., 2009; Dalton & Daily, 1999; Johnson et al., 1996; Zahra and Pearce, 1989). It is, therefore, hypothesized that,

  • H1a: A board with proper structure is positively and significantly related to board service task performance; and
  • H1b: A board with proper structure is positively and significantly related to control task performance.

Board Structure, Board Process and Board performances

The model in section 3.2 illustrates that the board process encompasses three constructs: board commitment, critical debate and board room behavior/activity. According to Minichilli et al. (2009:60), the board members‟ commitment implies, “… preparation before meetings and the involvement during meetings. The board members‟ preparation refers to their willingness and ability to participate in board meeting with a deep knowledge of the topic to be discussed in order to actively contribute to the decision making process … The board members‟ involvement during meetings refers to the effort they devote during discussions and in the follow up of the decisions taken during the board meetings.”
The second construct in the board process is board members‟ critical debate that relates to the task-related disagreements resulting from differences in opinions. Critical debate reflects the exchange of ideas, information and the examination of issues from different perspectives. This exercise can improve the strategic decision making process and the quality of the decision (Minichilli et al., 2009). The board room behavior, the third set of variables in the model, is expressed in terms of the board room‟s internal atmosphere at board meetings, the length of board meetings to attend to relevant issues, equal opportunity for board members to discus and ask questions and the chair‟s ability to lead meetings well with a clear focus on the major issues. Minichilli et al.‟s (2009) empirical study shows that process variables such as commitment and critical debate have positive influence on board service and control task performances. Following these results, two hypotheses are established.

  • H2a: Board process has positive and significant relationship with board service task performance;
  • H2b: Board process has positive and significant relationship with board control task performance.

The model also takes board process as an intervening/moderator variable between structure and performance following the arguments by Wan and Ong (2005), Forbes and Milliken (1999), and Johnson et al. (1996). Previous researches studying corporate governance focused on board structure more than board processes, and this could be due to the inaccessibility of board members as they are extremely busy. The strong need to study board process emanates from the fact that process is a reflection of the structure. The way boards operate, their commitment, and decision process would highly depend on structural variables such as composition, independence and committee functioning. To know what is going on in the board room, it is very important to get first hand information of the board process and this is possible only by accessing the board of directors who play a major role in directing, governing, and monitoring a company‟s affairs. Beyond board structure, to better understand board performance, about which the empirical literature has been inconclusive, governance scholars advise that the black box be uncovered to see its relationship with performance. In line with this, Buchanan and Huczynski (2010) in their organizational behavior book, argue that performance should be approached as a function of structure and process. Accordingly three hypotheses are formulated in this regard:

  • H3:  A properly structured board has positive and significant relationship with board process;
  • H4a: The board process mediates the relationship between board structure and board service task performance;
  • H4b: The board process mediates the relationship between board structure and board control task performance.

Ownership Type and Board Performance

Chapter one section 1.4 which presented the problem statement emphasized the noticeable differences observed in corporate governance practices of the private and state owned banks in terms of election and composition of board of directors. That is, privately owned banks are structured and monitored by the board of directors elected by the shareholders; whereas state owned banks are governed by a board of directors composed of senior officials that are appointed by the government (Okeahalam & Akinboade, 2003). The current practice of election versus appointment (ownership structure) is expected to bring variation in board demographics, board process and ultimately board service and control task performances. In line with this argument, the study attempts to investigate whether ownership type has a moderating effect on board service and control task performances due to the difference in structure. Thus the following hypotheses are formulated:

  • H5a: Type of ownership does not moderate board service task performances.
  • H5b: Type of ownership does not moderate board control task performances.

Ownership Structure and Firm Performance

Financial performance is one of the measures of firm performance, which in effect, is the measurement of the outcomes of a firm‟s policies and operations. To evaluate the financial performance of a firm, one should look into the income statement and balance sheet. These reports demonstrate the status of financial operations and net worth of a firm, respectively. The impact of ownership structure on firm performance has become the center of attention in the corporate governance literature (Rahman & Reja, 2015; Ongore & Kusa, 2013; Bokpin, 2013; Fauzi & Locke, 2012; Ongore, 2011; Arouri, Hossain & Muttakin, 2011; Cornett, Gou, Khaksari & Tehranian, 2010; Zeitun, 2009; Zeitun & Tian, 2007; Bhaumik & Dimova, 2004; Sun, Tong & Tong, 2002; Morck et al., 2000; Sarkar & Sarkar, 1998). However, the empirical studies on the relationship between ownership structure and firm performance have resulted in mixed and inconclusive outcomes. For example, Ongore (2011) concludes that ownership concentration and government ownership have significant negative relationships with firm performance while diffuse ownership has significant positive relationship with firm performance. Mule and Mukras (2015) and Arouri et al. (2011) findings are also consistent with Ongore‟s with regard to ownership concentration. Zeintun and Tian (2007) and Bhabra (2007) found that ownership structure has significant effects on a firm‟s financial performance. The empirical evidence of Kapopoulos and Lazaretous (2007) suggests that a more concentrated ownership structure positively relates to higher firm profitability where as Demsetz and Villalonnga (2001), and Demestz and Lehn (1985) found no significant relationship between ownership structure and firm performance. Aburime‟s (2008) study of Nigerian banks also shows that ownership structure has no significant impact on profitability.

Chapter 1 Introduction 
1.1 Corporate Governance: An Overview
1.2 Rationale of the Study
1.3 Problem Statement
1.4 Research Questions
1.5 Research Aim and Objectives of the Study
1.6 Significance of the Study
1.7 Scope of the Study
1.8 Limitations of the Study
1.9 Organization of the study
Chapter 2 Unpacking Corporate Governance: A Review of Theoretical Foundations and Literatures 
2.1 The Role of Corporate Governance
2.2 Corporate Governance Mechanisms
2.3 Requirements for Effective Corporate Governance
2.4 Need for and Roles of Board of Directors
2.5 Board Structure
2.6 The Board Process
2.7 Roles, Duties and Responsibilities of Boards
2.8 Codes of Corporate Governance Best Practices
2.9 Summary
Chapter 3 Conceptual Framework and Hypothesis Development 
3.1 Introduction
3.2 Conceptual Framework of Corporate Governance
3.3 Hypothesis Development
3.4 Summary
Chapter 4 Research Methodology 
4.1 Introduction
4.2 Research Philosophy
4.3 Research Approach/Design
4.4 Research Strategy
4.5 Time Horizon and Sampling Procedures
4.6 Summary
Chapter 5 Data Examination and Preparation
5.1 Introduction
5.2 Data Screening and Entry
5.3 Handling Missing Values
5.4 Examination of Outliers
5.5 Estimating Non-response Bias
5.6 Summary
Chapter 6 Instrument Validation, Measurement Model, Descriptive Study and Bivariate Correlation Analysis 
6.1 Introduction
6.2 Assessment of Unidimensionality of Scales (using EFA and CFA)
6.3 Reliability and Validity Assessments (CFA) through PLS Outer Model Evaluation
6.4 Descriptive Statistics of the Manifest and Latent Variables of the Conceptual Model
6.5 Bivariate Correlation Analysis of Latent Variables and Principal (Higher Order) Constructs
6.6 Summary
Chapter 7 Perception Survey of Corporate Governance Practices: Analysis, Findings and Discussions
7.1 Introduction
7.2 Survey of Governing bodies‟ (Sample-1) Perception of Corporate Governance Practices
7.3 Survey of Stakeholders‟ (Sample-2) Perception of Corporate Governance practices
7.4 Key Corporate Governance Issues/Problems
7.5 Corporate Governance Practices in the Ethiopian Banks: the way forward
7.6 Analysis of Qualitative Data
7.7 Summary
Chapter 8 Research Findings and Discussion
8.1 Introduction
8.2 PLS Structural Model Evaluation and Hypothesis Testing
8.3 Hypotheses Testing of Second Order Model Based on PLS Structural Results
8.4 Summary of Research Findings and Discussions
8.5 Summary
Chapter 9 Conclusions, Contributions and Implications of findings 
9.1 Introduction
9.2 Conclusions from Findings
9.3 Contributions of the Study
9.4 Implications for Future Research

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