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

Abstract

Internal monitoring is a cardinal responsibility of the board of directors, many of which have been subject to relentless criticism of conceding too much power to the managers and allowing them too much latitude. We analyze the role of internal monitoring in a dynamic 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. Monitoring has two effects: an ex-post disciplining effect, whereby more intense monitoring limits the information advantage and the rents for managers with higher ability; and an ex-ante screening effect, whereby weaker monitoring allows firms to attract better managers. We show an optimal level of monitoring intensity that balances the disciplining effect and the screening effect exists, even when monitoring is intrinsically costless and can be made arbitrarily strong. We empirically test these predictions and find that less monitoring by the board is indeed associated with on average more capable managers, and the relationship between monitoring intensity and firm value is hump-shaped in the data. Although the lack of monitoring is often viewed as a failure of internal governance, our analysis suggests it is a plausible tactic for attracting and retaining talented managers.

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

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