Board Diversity, Firm Risk, and Corporate Policies

In the last decade, at least six countries have mandated gender diversity on corporate boards and several other are considering legislation. As a result, there are many studies that investigate the impact of gender diversity of the board of directors on corporate performance. While gender diversity is important from a social equity perspective, is it the most important aspect of diversity when it comes group outcomes? Recently, Harvard University defended its admissions process against allegations of racial discrimination based, in part, on the idea that diverse student bodies produce better educational outcomes. Rakesh Khurana, the dean of Harvard College, stated, “That when we talk about diversity of backgrounds and experiences, it includes different academic interests. It includes different occupations of parents. It includes socioeconomic differences. It includes different viewpoints on issues.” Khurana, an economist by training, understands that while diversity in gender and race may be important from a social equality perspective, it is diversity in ideas, beliefs, and expertise that should also be important for group outcomes and performance. In our recent article, Board Diversity, Firm Risk, and Corporate Policies, published in the Journal of Financial Economics, we ask whether diversity in the board of directors affects corporate risk-taking, performance, and other policies, but we take a much broader approach than previous researchers, defining diversity along numerous demographic and cognitive dimensions.

To estimate the effects of board diversity we must first construct a measure. To do so, we use data on S&P 1,500 firms and their boards from 1996 to 2014. We collect data on numerous characteristics of board members that proxy for differences in ideas, beliefs, and expertise. We then construct measures of diversity for each characteristic among directors of each firm during each year, and then aggregate these diversity measures into a firm-level board diversity index each year. Included in the index are six measures of diversity. Three are demographic measures and three measure cognitive diversity. Specifically, our index includes diversity in gender, age, ethnicity, educational background, financial expertise, and breadth of board experience.

When it comes to diversity and risk-taking, two competing theories emerge. Work by Ken Arrow suggests that diversity will lead to greater conflict and more erratic decision-making, ultimately resulting in more volatile outcomes. Alternatively, work by Raaj Sah and Joseph Stiglitz suggests that diversity moderates group decisions. Differing views between board members act as a governance mechanism, preventing radical decisions from being made.

Our evidence is consistent with Sah and Stiglitz. Firms with more diverse corporate boards have lower realized risk, as measured by idiosyncratic stock market volatility and their corporate policies (leverage, investment, R&D) are much more stable. Moreover, firms with greater board diversity adopt less risky financial policies. They have lower debt and greater dividend payouts, for example. In answering, “What type of diversity matters?” we find that both demographic and cognitive measures are important, but no particular aspect of diversity seems to drive our results. Diversity can come from different dimensions for different boards. We conclude that it is the combined effect of board diversity along all these dimensions that affects board decisions.

One difficulty with our study, and studies of board dynamics in general, is the classic “chicken or the egg” problem or what economists call “endogeneity.” Is it that diverse boards cause firms to implement policies that result in lower risk? Or is it that low-risk firms choose to have diverse boards? In attempt to make this distinction, we rely on an econometric technique called instrumental variables. To implement this technique we must find an “instrument” that is correlated with board diversity, but that is only correlated with corporate risk-taking through its effect on board diversity. In our case, our instrument is the diversity of the pool of directors who reside a nonstop flight away from the firm headquarters. The idea is that travel times to the firm’s headquarters restricts the pool of outside directors. Therefore, if the pool of directors within a nonstop flight from headquarters is diverse, then it is more likely that the firm’s board is diverse. Importantly, however, choices about airline routes and director residences are not likely to directly affect corporate risk-taking. Using this technique we verify that all of our results are causal, meaning that greater board diversity moderates corporate risk-taking.

While board diversity leads to lower risk taking on most dimensions, there is one notable exception—research and development expenditure (R&D, hereafter). This is particularly interesting because R&D is inherently risky. However, studies in psychology and organizational behavior suggest that diverse teams are better at solving problems and can also be more innovative. We therefore test whether R&D expenditure is more efficient for firms with diverse boards and find that it is: the number of patents granted per dollar of R&D expenditure is higher for firms with more diverse boards. Additionally, firms with more diverse boards are more innovative, when defining innovation by patenting activities.

We also explore the potential costs of diversity. Using crude proxies (board turnover rates, board attendance rates), we test whether there exists more board conflicts among firms with diverse boards. We find no evidence of this. However, we do find that benefits of diversity vary based on the economic environment. During times of high market volatility, the moderating effect on firm risk of board diversity is muted. One can liken this result to the old adage that “democracy is messy.” A dictator is very good at making quick decisions and so is a homogenous board. So when it is important to be nimble and reactive, the benefits of diverse boards are reduced.

We conclude our empirical analysis by testing whether the benefits of board diversity outweigh the costs. We do so by testing whether firms with greater board diversity perform better and are valued higher. We find that they are.

So what should we take away from this study? At least in the context of corporate boards of large U.S. firms, diversity seems to be good not only from a social equality perspective, but also in terms of economic efficiency. Firms with more diverse boards, measured on multiple dimensions, outperform similar firms with less diverse boards, are more innovative, are more efficient in their innovation, and do so with less risky policies. So it seems that diversity of boards should be promoted, but should not be imposed. Diversity can come from many different dimensions and it is unlikely that policy-makers would choose the economically efficient dimensions in all cases.

The complete article is available for download here.