Abstract

Exploiting the global financial crisis of 2007–۰۸ as an exogenous shock that resulted in a significant decline in the ownership of foreign institutional investors (FIIs) in the Indian equity market, we find evidence of a causal link between FIIs’ ownership and different dimensions of board monitoring. Specifically, the empirical results suggest that higher FIIs ownership leads to lower board size, busyness, network size, CEO power, CEO pay, and improved board diligence. However, we also document a negative link between FIIs’ ownership and board independence, indicating that FIIs do not view independent directors as effective monitors. In terms of implications, our results suggest that improved board monitoring, induced by higher FIIs’ ownership, leads to higher firm valuation and innovation activities.

Introduction

Although boards are recognized as a powerful internal corporate governance mechanism, their effectiveness can vary significantly (Adams et al., 2010, Tung, 2011).1 This has spurred research into the underlying causes and strategies for enhancing board effectiveness. Implementing effective internal corporate governance mechanisms that enhance board effectiveness is associated with reducing information asymmetry and agency risks (Jensen and Meckling, 1976, Renders et al., 2010). Existing literature provides support to this conjecture (e.g., Brick and Chidambaran (2010) and Conheady et al. (2015)) by showing a positive association between board monitoring, its effectiveness, and firm value.2

Our study adds to this growing area of literature by examining the influence of foreign institutional investors (FIIs) as a source of external corporate governance mechanism on the internal corporate governance mechanism, namely board effectiveness. Gillan and Starks (2003) offer a theoretical argument that growth in FIIs’ ownership should result in improved board monitoring and overall governance of the host firm.3 The literature highlights the role of FIIs in shaping corporate governance due to their substantial ownership in firms. FIIs are able to monitor board and management activities through voting rights and incentives via cash-flow rights. For instance, Bena et al., 2017, Ferreira and Matos, 2008, and Aggarwal et al. (2011) show that FIIs’ monitoring efforts are primarily directed toward enhancing long-term firm performance, demonstrating that FIIs can curb managers’ incentives to overinvest and improve governance, particularly in countries with weak shareholder protection. FIIs act as independent monitors, being non-domestic investors with limited ties to the host firms, thereby reducing agency costs and improving board monitoring quality (Gillan and Starks, 2003, Tsang et al., 2019). They are also more likely to exit investments in firms with subpar governance (Leuz et al., 2009). FIIs’ independence from local political pressure allows them to perform arms-length monitoring and resist decisions that do not maximize shareholder value. Moreover, their deep understanding of global corporate governance practices, experience, demand for information disclosure, and superior monitoring technologies empower them to foster better governance practices and board monitoring (Grinblatt & Keloharju, 2000). Unsurprisingly, anecdotal evidence suggests that FIIs influence board monitoring by removing directors whose decisions do not maximize their wealth and expropriate minority shareholders.4

Conclusion

One of the key trends in the global financial market during the financial crisis of 2007–۰۸ was the “flight of capital” from emerging markets to developed economies. India, one of the largest emerging economies, also witnessed a substantial outflow of foreign capital in the aftermath of the crisis. From an empirical identification point of view, this crisis represents an unexpected negative shock to FIIs’ ownership in India, making it an ideal set-up to investigate the role of FIIs in influencing the monitoring role of boards. In this study, we focus on the four years pre-crisis and post-crisis beginning in 2008 and use different proxies of board monitoring to evaluate the impact of FIIs on the board monitoring of the firms in which they invest.

The literature on corporate governance notes that FIIs, being informed and sophisticated investors, have the incentive and ability to improve board monitoring. Our study adds to this literature by providing causal evidence of FIIs’ influential role in enhancing the effectiveness of board monitoring. Consistent with economic arguments, the results show that firms with higher FIIs’ ownership are associated with lower board size, busyness, network size, CEO power, CEO pay, and higher board diligence. Interestingly, we also find that FIIs prefer lower board independence in India. However, our result on board independence is counter-intuitive but not surprising, given the empirical evidence that managers in emerging markets may appoint directors independent from the regulators’ point of view. However, they are still connected and sympathetic to the existing management. We also find that FIIs improve the performance of the firms through their improved board monitoring role. Specifically, we find that the enhanced board monitoring by FIIs improves both firm value and corporate innovation measures.