The Role of Corporate Governance in Coping with Risks and Unknowns

Abstract

The concern of this conference is with Financial Risk Management: The Known, The Unknown and The Unknowable. There may not be complete agreement on what that encompasses. For my purpose, I would define risk as the possible occurrence of a future event (state of nature) that has a significant financial consequence for a decision-maker. Depending on your particular position, your primary focus might be on the management of risk by financial institutions, or on the oversight of that management by government agencies regulating financial institutions, or on businesses in their operations or dealings with financial institutions and transacting partners. My perspective will mostly be centered on the latter.

Further, the conference theme is the utility of classifying risks as known (K), unknown (u) and unknowable (U). The organizers at one point circulated a table of the use of those terms by various presenters. In the absence of full consensus, one can only make clear his own usage. I view those risks in terms of a probability distribution, with the KuU classes lying along a continuum of knowledge about the density function and how it is generated. The polar K example might be an honest roulette wheel, while the polar U example would be an event that no one is even thinking about. There is no sharp definitional line to be drawn, but we can have varying degrees of confidence in our understanding of the mean and variance (and other parameters) of the distribution in question.

Most of the conference papers deal with aspects of addressing risks directly - classifying them, examining their origins and generating processes, calculating their probabilities of occurrence and density functions and tails, estimating the losses associated with different magnitudes and circumstances, considering individual perceptions and responses to those risks (cognitive biases and tendencies).

Corporate governance per se does not address those matters as its focus. (Corporate governance, it should be noted, is not limited to corporations, but is concerned with the decision-making structure of any form of firm or organization.) In most of the legal and economic literature, it centers on agency costs: conflicts among shareholders (controlling and minority), directors and management, or more broadly between principals (who hold some type of ownership or residual stake) and agents (through whom they must act) in administering the affairs of the firm or organization. Principals can utilize assistants to aid in the internal monitoring of management: directors, accountants, counsel, consultants. But they too are agents, imposing costs. The extent of residual agency costs is one of the risks investors bear.

There are some who define corporate governance so broadly as to include every force or factor that bears on the decision-making of the firm, which can be so all-encompassing as to thwart productive analysis. In this paper, I will consider how the firm can try to manage the postulated three categories of risk, in the context of the various agency costs which shape their responses.