12 March 2004

Commission economic paper on Issues in Corporate Governance

The objective of this economic paper is to review issues and problems arising in the area of corporate governance from a broader economic perspective at a time when a series of major corporate accounting fraud scandals has renewed interest in the subject.

The paper highlights the economic significance of corporate governance for resource allocation, investment decisions as well as financial market development. It reviews a range of matters, which have emerged in the context of recent corporate scandals, as well as efforts to address these issues.

Corporate governance has significant implications for the functioning of the financial sector. However, various factors can hamper effective disclosure, including:

incomplete and unenforceable contracts;

managerial advantages resulting from asymmetric information situations; and

opportunistic managerial behaviour.

At the heart of the corporate governance issue is the need for appropriate checks and balances between the investor and the company management. The principal-agent problem can be managed by focusing on both internal company structures and external safeguards.

A number of conclusions can be drawn:

In an age where the financial system has become simultaneously more complex and more accessible to the unsophisticated investor, it is essential that the challenge of effective corporate governance is addressed.

Harmful incentive structures, conflicts of interests, and the absence of transparency seem to be key issues in addressing shortcomings in current corporate governance arrangements.

The significance of corporate governance is likely to increase in coming years as investors in maturing economies with a declining population may be required to seek higher-yielding investment opportunities in less-developed parts of the world economy.

Full paper

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