The effect of board composition on firm performance in Indonesia

The study investigates the effect of the compositions of board of directors on firm performance in Indonesia. This country offers a specific institutional environment, which provides a natural setting to further examine the effectiveness of the board in mitigating agency conflicts. The conceptual framework is derived from agency theory, assuming that the governance mechanisms affect the behaviour of contracting parties. The theory predicts that a board’s independence determines the effectiveness of its monitoring role and organizational outcome. The study presents a cross-sectional analysis of 190 non-financial companies listed on the Jakarta Stock Exchange during 2002-2004.Indonesian firms exhibit ownership concentrated in the hands of a few wealthy families and this provides them with sufficient voting rights to influence management and control decisions. Accordingly, the agency problems stem from the conflicts between controlling owners and minority shareholders as such ownership enables controlling owners to commit expropriation. The agency problem is further exacerbated by the presence of family members of controlling owners serving in management and on the boards. This study argues that the involvement in management and on the boards creates the absence of separation between management and control decisions that potentially negates the link between governance mechanisms and firm performance. This dissertation is the first to study the impact of such involvement on the association between board composition and firm performance. This provides sufficient justification that the study offers significant contribution to the governance literature as it applies to Indonesia.The Jakarta Stock Exchange officially requires that listed firms’ boards consist of at least 30% independent directors, or that the number of independent directors be proportional to the shareholding by minority investors, whichever is higher. The results show that most of the domestic-listed firms demonstrate a compliance with such regulation. However, the study fails to document a significant relationship between the fraction of outside directors and firm performance. Further testing reveals that the proportion of independent directors is insignificantly related to prior firm performance. This indicates that the inclusion of independent directors is irrespective of the agency problem specific to the firm and is merely driven by the listing requirement.The prevalence of ownership concentration by controlling families has been claimed as providing the rationale to construct a particular framework where the family serves as the unit of analysis. Although Indonesia adopts a two-tier system, such a framework implies that the substance of combined leadership might occur in Indonesia whenever a family member of the controlling owners is assigned as board chairperson. The study shows that most of the Indonesian listed firms have affiliated leadership, where in some instances the family member of controlling owners serves as board chairperson. Using the family as the unit of analysis, this finding provides undeniable evidence that combined leadership exists in the two-tier system. Independent leadership is found to have a positive relationship with firm performance, and such a relationship is robust after controlling for interdependence, measurement, linearity, and endogeneity issues. Governance reform, therefore, should address the board leadership structure that promotes board independence and, accordingly, board monitoring effectiveness.The analysis reveals that the identity of large shareholders needs to be analyzed separately. Shareholding by controlling owners is found to have a negative association with firm performance. This finding suggests that the presence of dominant large shareholdings in the hands of families is more likely to be the source of the agency problem rather than to serve as a governance device that alleviates agency conflicts. The finding implies that governance reform that seeks to reduce dominant control by the family needs to be addressed. Foreign investors demonstrate a positive relationship with firm performance. Further analysis reveals that ownership by foreign investors is the antecedent of independent board leadership. This finding suggests that this type of large shareholder induces better governance as the leadership board independent is positively related to firm performance. This suggests that Indonesia would be better off whenever a friendly foreign investor regulation is in place.This study finds that the controlling owners of Indonesian listed firms typically appoint their family members to serve in management and on the boards. The analysis reveals that such appointments create a different impact on the corporate control and firm performance. This study finds that the entrenchment effect of family involvement on the board is higher than that of such involvement in management. This finding suggests the necessity to disaggregate the family control devices. Nevertheless, such involvements provide supportive evidence that controlling owners engage in excessive control enhancing mechanisms that facilitate the extraction of private benefit with relatively ease. Accordingly, this finding implies that Indonesia needs to establish a corporate system that prevents the dominant owners from engaging in excessive control-enhancing mechanisms