Looking the Other Way: The Screening Role of (Weak) Internal Governance
Posted: 8 Feb 2021 Last revised: 20 Jun 2022
Date Written: February 25, 2022
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
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