Name: Rishit Rawat

Course Code: C30DX

ID: H00333479
Course: MA in Accountancy and Business Finance
Year: 4

Literature Review:

Introduction
In recent times, the mismanagement of various multinational corporations has led to an
increase in the attention towards the issue of corporate governance. Corporate scandals such
as Enron and WorldCom have further reinforced the need to implement an appropriate
governance structure. In order to understand the importance of corporate governance and its
potential impact on a firm’s performance, it is important to gather a perspective on the
meaning of corporate governance, its relevance and significance in the performance of a firm
and in the UAE.

1) Corporate Governance and the Agency Problem: An Introduction

1.1) Corporate Governance: Concepts

Corporate Governance can be defined as a systematic process of directing and controlling
through the establishment of various board committees (Cadbury, 1992). It aims to allocate
resources in a manner that maximizes value for all stakeholders. Values such as transparency,
accountability and ethics are fundamental to an effective corporate governance structure
(Gebba and Aboelmaged, 2016). An effective governance structure ensures the efficient
utilisation of resources both internal as well as external to the firm. It will also assure the
utilisation of debt and equity capital by corporations capable of investing it efficiently
(Mohamad, 2004).
Corporate governance plays a key role in improving confidence among investors. This leads
to a reduction in the cost of capital and an increase in the value of the firm. Moreover, the
presence of an effective governance structure provides assurance to lenders, thus making it
easier to acquire loans. Transparency in operations and finances further contributes to
investor confidence. It also prevents any irregularity in the information presented.
The need for Corporate Governance may differ globally. Continental Europeans may utilise
the structure to satisfy the interests of stakeholders such as suppliers, creditors and local
communities whereas the same structure may focus on satisfying shareholders in Anglo-
Saxon countries (Millstein, 1998). Various corporate governance guidelines such as Cadbury,
Greenbury and Hampel in the 1990’s ensure uniformity in approach.

1.2) Corporate Governance: theories

Much of the research into corporate governance revolves around the agency theory. A
principal-agent relationship is formed when the shareholder hires the management to act as
an agent and cover for his own lack of experience and skill (Ross, 1973). The need for
corporate governance arises when there are conflicts of interests between the shareholders
and management.
According to the agency theory (Jensen and Meckling, 1976), separation of ownership and
control is likely to create conflicts between the shareholders and management. This
separation from control forms the core of the agency problem (Berle and Means, 1932).
Managers may perceive this separation as an opportunity to take actions that will benefit
themselves and not the owners. For example, managers can utilize the funds obtained from
investors on ventures that are beneficial to themselves and not the investors. The uncertainty
faced by investors in assuring that their funds are not utilized in unattractive ventures is
referred to as the agency problem. Companies basing their corporate governance structure on
the Anglo-Saxon model, where the emphasis is placed on maximisation of shareholder
wealth, would require a greater need for corporate governance. Such companies are manager
controlled and can give rise to agency problems. Management can be induced to act in the
best interests of the company and shareholders by the implementation of an incentive scheme.
However, managers can misuse this system of providing incentives. Benefits in the form of
accounting profits can be further increased by managers through the selection of a specific
accounting method (Yusoff and Alhaji, 2012). A better approach would be through the use of
agency costs. Agency costs can be defined as the sum of monitoring expenditure and binding
expenditure by the agent which will guarantee that the agent shall not act beyond the scope of
his powers and shall otherwise be liable to compensate the principal (Jensen and Meckling,
1976).
The Stakeholder theory provides an alternative framework for corporate governance. Taking
birth in the countries of Japan and Germany, this theory states that the stakeholders of a
company include anyone affected by the company. Safeguarding the interests of these
stakeholders can ensure long term prosperity of the business. However, it is argued that the
shareholders face greater risk whereas suppliers, customers and employees receive benefits
and protection (Pande and Ansari, 2014). Moreover, a distinction exists between a company’s
responsibilities towards various interest groups and its objectives (Ansoff, 1987). Despite
these arguments, the stakeholder theory is better at explaining corporate governance and has
relevance as it affects the direction of the company.

Another theory, which is a stark contrast of the agency theory, is the stewardship theory. This
theory presents a model where the managers are considered to act in the best interests of the
owners (Donaldson and Davis, 1991). This model assumes managers to benefit from
shareholder’s wealth maximisation. By working for the shareholders, the managers are
working towards a successful organization which in turn reaps benefits for the managers.

2) Significance in the performance of a firm:

Jensen and Meckling (1976) made the initial assumption that an effective corporate
governance could lead to an increase in the firm’s performance. Over time several factors
have been used as a basis to establish a link between corporate governance and a firm’s
performance.
Existing literature dictates the various corporate governance mechanisms used for measuring
the firm’s performance.

Board Independence:
Board Independence refers to the inclusion of directors who do not have a relationship with
the company. Studies of a relationship between board independence and firm performance
has shown mixed results. Researchers such as Arslan et al. (2010) and O’ Connell found a
positive relationship between board independence and firm’s performance. In other words, a
higher proportion of independent directors would lead to better performance. Whereas,
researchers such as Farhan et al. (2017) and Chugh et al (2011) found a negative relationship
between independent directors and firm performance. The presence of independent members
can provide credibility to any information obtained. This is not the case for insiders, who may
choose to hide key information due to personal benefits or as a lack of independence from the
executives (Raheja, 2005). The rationale behind board independence having a positive effect
on a firm’s performance is the use of agency theory. Theoretically the presence of
independent directors can lead to effective monitoring thereby, solving the agency problem
and improving firm performance. However, the lack of evidence to back this up may suggest
that additional factors such as experience of independent directors as well as financial
expertise need to be considered. Based on the above discussion our hypothesis can be as
follows:
Hypothesis 1: Board independence impacts firm performance

Board Size:
Board size refers to the number of executives and non-executives in the board. Having a large
board size allows the possession of greater collective information which can assist in the
monitoring function of the board (Lehn et al., 2004; Sun et al., 2014). However, the
subsequent difficulties and delays in coordination and communication are a major downside
(Guest, 2009). Moreover, the possibility of directors avoiding accountability may increase
with a larger board size. Alternatively, a reasonable board size may reduce costs and provide
better monitoring (Haniffa and Hudaib, 2006). The term ‘reasonable’ is subjective and may
vary from case to case. Different researchers have recommended different number of
directors to form an ideal board size. Lipton and Lorsh (1992) recommended seven or eight
directors whereas Bennedsen et al (2008) recommended not more than 6. However, the ideal
number will vary from small to large organizations and must therefore, be at the discretion of
the organization. We can thus, form our next hypothesis:
Hypothesis 2: Board Size impacts firm performance

Audit Committee Independence:

Global corporate governance guidelines mandate the existence of an audit committee. The
transparency function of this committee helps prevent fraud and inaccurate financial
reporting. A committee consisting of a majority of external members is likelier to carry out
this function effectively. The corporate governance code of UAE requires that the members
remain independent of the firm. This independence plays a vital role in exercising effective
internal control as well as improving the quality of financial reporting (Zhang et al., 2007). It
also allows auditors to be autonomous and make unbiased judgements when detecting errors.
Significant research points towards a positive relationship between the existence of an audit
committee and reduction in earnings management and fraud (Weir et al., 2002). Nevertheless,
the results on the impact of AC independence are still inconclusive. The independence can
either have a positive or negative impact on the firm’s performance. This gives rise to the
next hypothesis.
Hypothesis 3: Independence of an audit committee impacts firm performance

Audit Committee Meetings:

An audit committee that meets frequently is able to prepare financial statements of higher
quality within a short period of time (Ionescu, 2004). Frequent meetings can help compensate
for any time lag by providing accurate and timely information. Xie et al (2003) found that a
committee which met at least twice a year significantly reduced the probability of earnings
management. It is fair to assume that if increased frequency of audit committee meetings can
improve financial reporting, then it can also improve a firm’s performance. Thus, a new
hypothesis can be formed.
Hypothesis 4: Frequency of audit committee meetings impacts firm performance

Audit Committee Financial Experts:

The process of financial reporting requires the presence of persons specializing in accounting
and finance. Their expertise is vital in understanding and interpreting the financial statements.
Xie et al. (2003) found that the presence of financial experts in an audit committee can result
in better decision making thereby, increasing the return on assets. Another consideration in
this research line is the influence exercised by such experts. Carrera et al. (2017) found that a
large number of experts resulted in poor quality financial reporting. Similar to the agency
problem, it was found that the experts exercised greater financial control to meet their own
needs. In the same vein, Krishan (2005) found that audit committees having financial experts
are highly susceptible to internal control problems. These findings are challenged by Chan et
al. (2011) and Carcello et al. (2011), who support the need of a financial expertise in the
committee. It is difficult to come to a definitive conclusion due to subjective nature of
financial experts. This gives rise to our next hypothesis.
Hypothesis 5: Existence of Financial Experts in the audit committee impacts firm
performance

3) Significance in UAE:
Recent financial crises in the form of Enron and WorldCom have reinforced the need to
implement an effective governance structure. UAE had its own share of corporate governance
failures through the Abraaj group and Arabtec. The low tax rates offered in UAE has aided its
rapid economic growth and raised its potential to become an attractive avenue for foreign
investment (Farhan et al, 2017). The implementation of sound governance practices is
imperative for UAE if it is to maintain its attractiveness as an investment hub.
Research on the impact of corporate governance in the UAE has been done by Aljifri and
Moustafa (2007) and Farhan et al. (2017). However, their research fails to incorporate the
newly introduced corporate governance regulations for banks (2019). Therefore, the current
study is aimed at bridging that gap and adding to the existing literature by taking the case of
Emirates NBD.

Corporate Governance Regulations for Banks (2019):

The CG regulations for banks were introduced by the central bank to ensure that the
governance practices were in line with the international standards. These regulations lay
down the foundation for effective management. Additionally, these regulations are relevant to
the current study as they provide a basis for testing and measuring the aforementioned
hypothesis.
The corporate governance regulations (2019) mandate the need to diversify the board of
members. A balance between skills, diversity and expertise must complement the size and
complexity of the bank. The board must also consist of 7-11 members. The regulations
dictate the need to ensure that at least one third of the members are independent.
Additionally, the regulations specify a minimum of meetings to be held by the board.
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