No. 222: Board Composition and Implicit Team Incentives

Boards of directors function as teams. We study how board composition – diverse or homogeneous – affects shareholder value. In our model, two directors jointly design the CEO’s compensation contract and monitor performance, while the CEO chooses productive effort and earnings manipulation. Repeated interactions between the two directors shape monitoring incentives, CEO compensation, manipulation, and ultimately, shareholder value. Directors with longer team tenure and/or stronger incentive alignment with shareholders exert greater monitoring effort and offer higher-powered CEO bonuses. While these higher bonuses increase productive effort, they also incentivize manipulation. Nonetheless, shareholders always prefer stronger board monitoring. Although these results hold for both board types, board composition alters their relative strength. Diverse boards exert greater monitoring effort and offer higher-powered CEO bonuses when incentive alignment is strong and team tenure is moderate, whereas homogeneous boards do so when director tenure is long. Our model also predicts that governance measures aimed at strengthening board monitoring may either succeed or backfire, depending on board composition.