Power Trip: CEOs and Firm Performance
Professor Han Kim says CEO power can enhance firm performance and enrich shareholders---as long as it's applied properly.
ANN ARBOR, Mich.---Despite the public outcry over CEO pay and abuses of authority, powerful chief executives can be good for the bottom line, says a Ross School professor.
E. Han Kim, professor of finance at U-M's Ross School of Business, says that CEO power can enhance firm performance and enrich shareholders---as long as CEOs employ power properly.
"Recent evidence on CEO power suggests that, in general, powerful CEOs are bad news for shareholders," Kim says. "But in most corporations, the CEO position is designed to be a center of power for coordination, efficiency and organizational discipline to enhance performance.
Power, Kim says, grants CEOs the ability to enhance shareholder value or further their own private benefits at the expense of shareholders. CEO power can be good, bad or benign, depending on the type of power and how they make use of it.
Kim and U-M doctoral student Yao Lu studied how CEO power affects firm performance and the impact of firm performance on CEO pay for more than 2,000 U.S publicly listed firms from 1993 to 2006.
They examined three separate dimensions of CEO power: structural power, ownership-related power and ability-based power. Structural power is based on formal organizational structure and hierarchical authority; ownership power stems from voting rights associated with share ownership; and ability-based power rises from the expertise and prestige of a CEO to effectively make decisions.
Kim and Lu find that structural power can harm firm performance, but only when external corporate governance curbing CEO power is weak.
"Structural power helps CEOs exert their will to achieve personal objectives by making their pay, for example, less sensitive to performance or by shielding themselves from challenges by external shareholders," Kim says. "Structurally powerful CEOs often get their way by having board members and other executives---many of whom they appoint---agree with their plans."
Ownership power, on the other hand, can be a double-edged sword, depending on the level of ownership and the strength of external governance, the researchers say. At low levels of ownership, CEOs are more closely aligned with shareholders and may welcome monitoring by the market for corporate control in order to enjoy higher share returns and valuation associated with lower levels of entrenchment.
However, when CEOs' ownership is sufficiently large to allow them to pursue private benefits of control without fear of reprisal from within their firms, they may use ownership power to shield themselves from monitoring by the market for corporate control, Kim and Lu say.
Ability-based power, however, can be good for performance---but only when firms are operating under strong corporate governance, they say.
"Well-functioning external governance facilitates better utilization of a CEO's ability," Kim says. "Moreover, more-able CEOs do not reduce their pay sensitivity to performance nor monitoring by the corporate control market through entrenchment."
What determines the strength of external governance? Kim and Lu identify two sources of external governance: monitoring by highly concentrated institutional investor ownership and highly competitive product markets leaving no room for managerial slack. They help restrain CEO power and improve firm governance, they say, illustrating that other types of properly structured external pressure to check CEO power may also be good for the U.S. economy.
"In any case, the power-performance relation depends on how well external governance mechanisms work to curb CEO power," Kim says. "Firm performance is significantly related to structural power and to CEO share ownership when governance is weak. In contrast, the positive link between performance and ability power is significant when governance is strong."
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