Last Updated 10 Aug 2020

System of corporate governance

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A governance structure is the system which governs the relationships among a firm's managers, shareholders, employees, customers and suppliers, playing an important role in providing both incentives and controls of managerial behavior (Tran, 1998). It can be defined as 'an institutional framework in which the integrity of a transaction, or related set of transactions, is decided' (Williamson, 1996). The efficiency of a governance structure, that is, its ability to reduce transaction costs, is judged by its ability to economize on bounded rationality and to safeguard against the hazards of opportunism.

Corporate governance is a term used when the focus of attention is on the governance structure of modern corporations that is on the system by which companies are directed and controlled. It refers to the set of activities which constitute the internal regulation of a corporation, including the relationship between owners and managers. (M. Moschandreas, Business Economics, 2000) The essential element of the agency problem is the separation of management and finance, and of control and ownership.

In many modern corporations, managers act as the agents of owners who have their right of internal monitoring and control to top management. The managerial corporations are controlled mainly by professional managers and most of their shareholders are too small and numerous to have a say. In these firms control was effectively separated from ownership. However, the conflict of interest clearly arises whenever an outside investor wishes to exercise control differently from the manager in charge of the firm.

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A small outside shareholder would like management to maximize the value of the firm. For example, by making acquisitions, that are unprofitable on average, top managers can increase both the size of the firm and their own compensation. Given the very unpredictable nature of merger outcomes, it is difficult for outsiders to be sure that managers are not simple looking for economies of scale or distribution or some other expected but elusive synergy. (F.R. Fitzroy, Z. J. Acs ; D. A. Gerlowski, Management and Economics of Organisation, 1998)

Corporate governance has been thought of as 'a question of performance accountability' (Mayer, 1996), a question of how to induce managers to run the firm so as to maximize shareholder wealth. In the UK's Cadbury report (1992), it suggests that managers must be free to drive their companies forward but exercise freedom within a framework of effective accountability.

Therefore, the fundamental issue concerning governance by shareholders today seems to be how to regulate large shareholders so as to obtain the right balance between managerial discretion and small shareholder protection. Corporations need a system that can provide effective protection for shareholders and creditors, so that they can assure themselves of getting a proper return on investment. It should also help to create an environment conductive to the efficient and sustainable growth of the corporate sector. (M. Becht, P. Bolton & A. Roell, Corporate Governance and Control, 2002) 2. Comparative systems

Around the world, one of the most debated topics is the relative merit of two different systems of corporate governance, the Anglo-American market-based system and the bank-based model of Continental Europe and Japan (Allen and Gale, 2000). In the 1980s, the Japanese and German long-term large investor corporate governance perspectives were seen as strengths relative to the Anglo-American market based short-term perspective; and the 1990s, when both minority shareholder protections and the reliance on equity financing are greater, the Anglo-American systems were seen as major advantages.

A Bank-based system can also be called an 'insider system', in which a main bank provides a significant share of finance and governance to each firm. In most other OECD countries and nearly all non-Members, ownership and control are relatively closely held by identifiable and cohesive groups of 'insiders' who have longer-term stable relationships with the company. These relationships may be purely financial or based on past or current commercial relationships.

The interests of large shareholders are often supported by board representation, either directly or through alliances with other shareholders. Thus there is less reliance on elaborate legal protections, and more reliance on large investors and banks. (A. Shleifer & R. Vishny, A Survey of Corporate Governance, 1996) Insider groups usually are relatively small, their members are known to each other and they have some connection to the company other than their financial investment, such as banks or suppliers. Read about Corporate Governance at Wipro

Patterns of equity ownership differ significantly from 'outsider' countries. One characteristic of countries with insider systems is that they have generally experienced less institutionalization of wealth than other countries. In addition, patterns of corporate finance often show a high dependence upon banks and high debt/equity ratios. Instead of arm's length lenders, banks tend to have more complex and longer term relationships with corporate clients. (OECD, 1997)

The investment risks of the inside model include potentially limited accountability to shareholders outside the core insider group and the costs of self dealing if inside shareholder groups make private gains at the expense of other shareholders. These gains may be taken in the form of advantageous commercial relationships, capital or asset transfers, or the pursuit of broader political, economic or corporate agendas than would normally be required by companies in the course of business relationships and their the pursuit of long-term shareholder value.

(OECD, Corporate Governance in the UK, 1997) There is no evidence that the cost of capital is lower in the US or the UK than in Germany or Japan. It is commonly argued that the market-based setting provides a better environment for startups, new technologies and the redeployment of resources into new, more profitable lines of business, while bank-based system are perhaps more suitable for effective management of existing technologies. (M. Becht, P. Bolton ; A. Roell, Corporate Governance and Control, 2002)

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