Looking the Other Way: The Screening Role of (Weak) Internal Governance

Abstract

We analyze the role of internal governance in a dynamic adverse selection model in which managers have unobservable ability and must be given rents through a compensation contract in exchange for revealing their private information. Governance has an ex-post disciplining effect, whereby stronger governance limits the information advantage and the rents managers with higher ability can extract. Meanwhile, governance has an ex-ante screening effect, whereby weaker governance allows firms to attract on-average better managers. An optimal level of governance balancing the disciplining and the screening effects can exist, even when governance is intrinsically costless and can be made arbitrarily strong.

Keywords: internal governance, board of directors, dynamic adverse selection, persistent private information, screening

JEL Classification: G32, G34, D82, D86, M12