Looking the Other Way: The Screening Role of (Weak) Internal Governance

Abstract

We analyze the role of internal governance in an adverse selection model in which managers have unobservable ability and must be given rents through a compensation contract in exchange for revealing their private information. Governance has an ex-post disciplining effect, whereby stronger governance limits the information advantage and the rents managers with higher ability can extract. Meanwhile, governance has an ex-ante screening effect, whereby weaker governance allows firms to attract on-average better managers. An optimal level of governance balancing the disciplining and the screening effects can exist, even when governance is intrinsically costless and can be made arbitrarily strong.

Keywords: internal governance, board of directors, dynamic adverse selection, persistent private information, screening

JEL Classification: G32, G34, D82, D86, M12