Nexus between boardroom independence and firm financial performance: evidence from South Asian emerging market

This research examines the correlation between boardroom independence and the financial success of businesses in Pakistan, a developing nation with unique institutional features, concentrated ownership, and a prevalence of family-controlled enterprises. Effective corporate governance is crucial for a firm's success, and the board of directors is a central component of this mechanism. Boardroom independence, specifically the proportion of independent directors (those without direct ties to the firm), is a key element of good corporate governance. The agency theory suggests independent directors offer objective oversight, reducing agency costs and aligning management decisions with shareholder interests. Conversely, stewardship theory posits that managers are inherently motivated to act in the best interests of the firm, potentially diminishing the need for independent director oversight. The existing literature presents mixed findings on the link between board independence and financial performance, with some studies showing a positive correlation and others a negative or insignificant one. This variation highlights the importance of considering the unique contextual factors of the market being studied. Pakistan, operating under the Anglo-Saxon corporate governance model, presents a case with concentrated ownership and family-controlled businesses. The roles of outside directors in such a context might be influenced, therefore, requiring deeper investigation. The study uses data from 152 non-financial firms listed on the Pakistan Stock Exchange (PSX) between 2003 and 2018 to analyze this complex relationship and contribute to the existing body of knowledge on corporate governance.

The study delves into the existing literature on boardroom independence and firm financial performance, drawing upon agency theory, stewardship theory, and resource dependency theory. Agency theory argues that independent directors mitigate agency costs by monitoring management and aligning their actions with shareholder interests. Stewardship theory, in contrast, suggests that managers are inherently motivated to maximize firm value, reducing the impact of independent directors. Resource dependency theory emphasizes the role of directors in establishing external linkages for resource acquisition. Prior research on this relationship offers conflicting evidence; some studies report a positive association, others a negative one, or no association at all. The inconsistent findings underscore the influence of contextual factors, prompting the study's focus on the unique environment of Pakistan. Studies such as Agrawal and Knoeber (1996), Franks et al. (2001), and De Jong et al. (2005) reveal negative associations between boardroom independence and firm performance. Conversely, Bhagat and Black (2001), Aggarwal et al. (2007), and others show positive relationships. These contrasting findings highlight the context-dependent nature of this relationship, with institutional environments and ownership structures playing key roles.

This study employs a panel data set comprising 152 non-financial firms listed on the Pakistan Stock Exchange (PSX) over the period 2003-2018, representing roughly 41.41% of the total listed non-financial firms at the end of 2018. Financial performance is measured using four proxies: return on assets (ROA), return on equity (ROE), market-to-book ratio (MBR), and Tobin's Q (TQ). Board independence is measured as the proportion of non-executive outside directors on the board. Control variables include board size, CEO duality, firm size, leverage, growth, profit margin, payout ratio, and liquidity ratio. The study addresses the potential endogeneity issue using the dynamic generalized method of moments (GMM) estimator, following the methodology of Adams and Ferreira (2009), Wintoki et al. (2012), and Udin et al. (2017). This approach incorporates a one-year lag of the dependent variable to account for dynamic adjustment and mitigate endogeneity concerns. Descriptive statistics and a variance inflation factor (VIF) test are used to assess data characteristics and multicollinearity, respectively. Arellano-Bond tests for serial correlation and a J-statistic test for over-identifying restrictions are used to evaluate the validity of the GMM estimations. The model considers various factors affecting firm financial performance to control for variables unrelated to board independence. The dataset is created through a combination of publicly available financial statements and manual collection from annual reports, ensuring data quality and accuracy.

The GMM regression results reveal a significant negative relationship between boardroom independence and firm financial performance across all four performance proxies (ROA, ROE, MBR, and Tobin's Q). This finding contradicts the agency theory prediction of a positive association and suggests a passive role for independent directors in Pakistan. The negative relationship is consistent with findings in other emerging markets like Bangladesh and India. The average board independence in the sample (58%) is higher than in neighboring countries but still suggests that the independent directors might not be truly independent due to existing close ties with the management and dominant shareholders. The study also shows a significant negative association between firm performance and both board size and CEO duality. Larger boards might impede communication and decision-making, while CEO duality could weaken board control and negatively impact performance. Firm size, growth, and payout ratio were found to have a significant positive relationship with firm performance, while leverage and liquidity had a significant negative relationship. Profit margin showed a positive relationship with ROA but a negative one with ROE, MBR, and TQ. The results highlight the importance of considering the specific institutional context when evaluating the impact of board characteristics on financial performance. These findings are consistent with prior research in this area, indicating a need for reform in corporate governance practices to improve the effectiveness of monitoring and reduce agency conflicts.

The study's findings challenge the conventional wisdom that board independence consistently enhances firm performance. The negative relationship observed in Pakistan's context underscores the limitations of applying universal corporate governance models without acknowledging the influence of unique institutional and ownership structures. The close ties between independent directors and dominant shareholders/management could explain the counterintuitive results. This points to a need for stronger regulations and oversight to ensure true independence and effectiveness of outside directors. The negative effect of board size and CEO duality further emphasizes the limitations of the current governance structure. The results highlight the complexity of corporate governance in emerging markets, where institutional voids and concentrated ownership structures may hinder the effectiveness of traditional mechanisms. These findings contribute to the ongoing debate on the optimal design of corporate boards in developing economies, offering important implications for policymakers and regulators.

This study demonstrates a significant negative relationship between boardroom independence and firm financial performance in Pakistan. This contradicts the agency theory prediction and highlights the importance of considering contextual factors in evaluating the effectiveness of corporate governance mechanisms. The findings emphasize the need for regulatory reforms to ensure the true independence and effectiveness of independent directors. The study also indicates that large board size and CEO duality negatively impact firm performance. Future research should examine specific characteristics of independent directors to determine if experience, expertise or other factors influence their performance and effectiveness. Further research could expand this study to other emerging markets and explore how effective various corporate governance mechanisms are in different contexts.

The study's focus on non-financial firms in Pakistan limits the generalizability of the findings to other sectors or countries. The use of self-reported data on corporate governance practices may introduce potential biases. The time period of the study (2003-2018) could reflect historical conditions that may not apply to future periods. While the dynamic GMM addresses endogeneity concerns, unobserved heterogeneity may still affect the results. Future research should address these limitations for a more comprehensive understanding of the relationship between board independence and firm performance in emerging markets.