An introduction to corporate governance

By Priya Chetty on January 7, 2012

The topic of corporate governance came to the forefront of global business limelight from the shadows after a series of collapses of high profile companies. Enron, energy giant based in Houston Texas, and the telecom behemoth, WorldCom, shocked the business world with their large scale of unscrupulous and illegal operations. When the corporate practices in the US companies came under attack, it was apparent that the problem was more widespread. From Parmalat in Italy to Hollinger Inc., the multinational newspaper group, revealed deep-rooted problems in their corporate governance. Even the prestigious New York Stock Exchange had to replace its director, Dick Grasso, due to public outcry over excessive compensation. It was obvious that something was missing and not quite right in the area of corporate governance all over the world.

Corporate governance has been an important field of query within the finance order for years. Finance researchers have intensively investigated this field for more than a quarter century (Jensen & Mecking, 1976) and the father of modern economics, Adam Smith recognized the problem over two centuries before they happened. Several arguments about whether the Anglo-Saxon market- model of corporate governance is better than the bank-based models of Germany and Japan have taken place. However, the differences in the quality of corporate governance in these developed countries are no comparison to the gap that exists between corporate governance standards and practices in these countries as a group and those in the developing world (Shleifer and Vishny, 1997).

Corporate governance has been a central issue in developing countries even before the recent corporate scandals in advanced economies made news. Corporate governance and economic development are inherently linked. Effective corporate governance systems help to promote the development of strong and stable financial systems irrespective of whether they are largely bank-based or market-based. This in turn, has a positive effect on economic growth and poverty reduction.

There are several ways through which this causality works. Effective corporate governance increases access to external financing by firms, leading to greater investment and higher growth and employment. The proportion of private credit to GDP in countries in the highest quartile of creditor right enactment and enforcement is more than twice than that in the countries in the lowest quartile. With respect to equity financing, the ratio of stock market capitalization to GDP in the countries in the highest quartile of shareholder right enactment and enforcement is about four times as large as that for countries in the lowest quartile. Poor corporate governance is detrimental to the creation and development of new firms.

The basic definition of corporate governance is:  “The system by which organizations are directed and controlled.” It is concerned with mainly systems, processes, controls, accountabilities and decision-making at the heart of and at the highest level of an organization. Corporate governance is about the manner in which top managers execute their responsibilities and authority and how they account for that authority with respect to those that have entrusted them with assets and resources. It is particularly concerned with the abuse of the power and the need for openness, integrity and accountability in the decision-making processes of the organization. This is equally relevant to any organization, regardless of whether it is public or private. Effective corporate governance accompanied by clinical governance, is necessary for the Primary Care Trust (PCT) to achieve clinical, quality, and financial objectives. Fundamental to effective corporate governance is having the means to verify the effectiveness of this direction and control. This is achieved through what is called by the NHS as “controls assurance”. Risk management is the common thread that links corporate and clinical governance. Risk management is defined as “the culture, processes and structures that are directed towards the effective management of potential opportunities and adverse effects”.

References

  • Jensen, M.C., and W.H. Meckling (1976) “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” Journal of Financial Economics, October, V.3, 4, pp. 305-360.
  • Shleifer, Andrei & Vishny, Robert W, 1997. ”  A Survey of Corporate Governance,” Journal of Finance, American Finance Association, vol. 52(2), pages 737-83, June.
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