Social Diversity in Corporate Boards and Firm Outcomes

Journal: Journal of Corporate Finance

Abstract: In recent years, the lack of diversity in corporate boards has garnered considerable attention. Several measures have been proposed to diversify corporate boards, with a key principle being that diversity of identities and backgrounds brings diversity of perspectives and attitudes. This paper measures social diversity using a relatively unexplored instrument which relates deeply to people’s sense of identity. In particular, the authors focus on diversity of religion and caste – an informal social institution that divides India’s Hindu society into hundreds of communities. 

The findings of the paper reveal that India’s corporate boards are strikingly homogeneous (i.e. lack diversity) in their religious and caste composition. The paper then asks how this lack of diversity is associated with firm outcomes and shows that firm performance is negatively related to social homogeneity of boards. In addition, the research delves into plausible mechanisms underlying this effect. The evidence is consistent with the notion that socially homogeneous boards are less likely to offer novel perspectives (thus impairing their advisory role) or challenge management (thus impairing their monitoring role) thereby adversely affecting firm performance outcomes. 

The paper develops a novel computational methodology to come up with a data driven mapping of last names to social identity at three levels of granularity – religion, coarse- and fine-grained caste. This method helps in  mapping 16,637 unique last names into eight religions, five coarse-grained castes, and 471 distinct fine-grained castes. 

The relationship between diversity of boards and firm performance ex ante is unclear. On one hand, homogeneous board members may not bring a wide range of perspectives to bear upon the decisions they make for the firm, worsening their advisory roles. They may also be more prone to cronyism (which refers to their inability to challenge the firm’s management and have tough conversations needed to improve firm performance), hurting their monitoring role and, hence, the firms they serve. On the other hand, socially homogeneous directors may have greater trust, which reduces conflicts during strategy execution, thus improving firm performance. Regression analysis, therefore, provides with estimates of the net effect of these mechanisms. The authors find using several instrumental variable analysis that social homophily on boards adversely impacts firm performance. 

Finally, the  moderation tests (implemented using interaction terms in a regression framework) provide suggestive evidence for mechanisms through which high caste homogeneity on boards adversely affects firm performance. It is shown that firms with homogeneous boards fare even worse than others during slow GDP growth years. This finding is consistent with the possibility that caste homogeneous boards’ overlapping external networks and viewpoints inhibits them from providing novel and useful advisory input to the firm precisely when such advice is needed for improving firm performance. Next, it is shown that firms with homogeneous boards perform even more badly when key board committees that impact the board’s monitoring role have an over-representation of the dominant caste.

Taken together, these findings are consistent with the possibility that caste homogeneity makes it less likely that boards effectively discharge their monitoring role of challenging management’s actions, thereby leading to poor firm performance. Overall, the authors interpret these patterns of findings as consistent with the notion that caste homogeneity on the board causes poor firm performance in part because homogeneity inhibits the efficacy of boards’ monitoring and advisory roles.