Corporate governance mechanisms are ways employed by organizations to deal with problems of corporate governance. Now and then, firms are faced with internal problems which they can control and external problems which cannot be controlled. To eliminate these problems good governance is needed to balance the roles of shareholders, the board of directors, managers and other employees who have governance roles. Corporate governance mechanisms are market-based or institutional-based mechanisms that influence the decision-making process by controllers of firms to maximize the company’s value to its owners.
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These governance mechanisms are either internal or external governance mechanisms. Internal corporate governance mechanisms employed by most firms include ownership concentration, executive compensation, multi-divisional organization structure and board of directors. While external corporate governance mechanisms include corporate takeover market and product market competition (Cremers and Nair 2859). Below are some of the internal corporate governance mechanisms.
The Board of directors is one of the main internal corporate governance mechanisms (Aljifri and Moustafa 79). Board of directors in many organizations comprises of insiders, outsiders, and related outsiders. These people represent the interests of shareholders and due to that they are well versed with their company’s operations. Insiders are responsible for monitoring the performance of chief executive officers and top-level managers in any organization.
These internal members of the board of directors are responsible for firing and replacing CEOs as well as determining their salaries and rewards. Related outsiders refer to people who have a relationship with a company but are not involved in the day-to-day operations of the company. On the other hand, outsiders refer to people who do not have any relationship with the firm and are not involved with everyday operations of the firm but they have a say in the firm’s decision-making process. External directors who include related outsiders and outsiders are chosen according to the interests of the shareholders.
The Board of directors is an independent entity when it comes to management. Board of directors is a very important internal corporate governance mechanism because it monitors managers, shareholders, directors and other stakeholders in any company and has a direct influence on the decisions made by the top people in any organization. Board sizes differ from firm to firm but it should be of reasonable size and its roles should be clear to every member of the board.
Board of directors is the main decision-maker of any company and due to that, the board of directors will decide on how to finance various more investments or on how to carry out various operations for the benefit of the company. Most companies do not recommend strong boards because most of them will demand high salaries and are normally associated with the fraud.
Generally, board quality is associated with high levels of internal control (Babatunde and Olaniran 334).
Another internal corporate governance mechanism is ownership concentration. Ownership concentration refers to the percentage of shares held by financial institutions or institutional owners such as stock mutual funds and pension funds. Ownership concentration simply refers to the percentage of shares held by block shareholders.
Under normal circumstances block holders will hold more than 5% of the company’s shares. When institutional block holding is high, then the block holders are permitted to monitor their shares in the company. Hence, these shareholders have a voting right and they may influence the decision-making process of a given company where they own shares (Babatunde and Olaniran 336).
They have the right to question various moves proposed by the company and may demand their refund anytime. This may result in a conflict of interests because of close monitoring by the block holders who may have may have different views about different operations of a given company. However, most financial institutions are forbidden by the law to take board seats of various firms where they own a considerable number of shares as argued by Shleifer and Vishny (754). All in all, a firm with a high level of block shareholders is likely to get high returns hence most firms encourage institutional block holding.
Another internal corporate governance mechanism that is essential to most companies is executive compensation. Executive compensation refers to the provision of salaries, wages, bonuses, stock rewards, stock grants, stock options or establishment of other long-term incentives by firms to match the firms interests with the interests of its shareholders, managers, and directors.
Shareholders are the main stakeholders of any organization and their interests should be taken into account first. Putting their interests into consideration motivates them and makes them deliver their best services for the benefit of the company. In most cases, these incentives or compensations are often criticized as being controlled by the top-level people in most organizations. However, executive compensation as a mechanism of internal corporate governance will increase the likelihood of firms getting various anticipated outcomes (Shleifer and Vishny 760)
Incentives are inefficient moves or actions taken by managers or controllers of a firm to promote various sectors of the firm. Incentives may even be offered to investors to encourage them to invest more in the firm. Executive compensation informs of incentives is a risky operation and companies may encounter losses due to offering incentives. However, incentives may generate high returns with time, they may also lead to increased investments and increased share block holding which is associated with high profits.
Most managers are concerned with increasing profits but at times they let go of their profits and offer incentives to their firm’s stakeholders hoping to gain more profits in return. Executive compensation involves careful decision-making and tolerance because various compensations or incentives may not bring about expected outcomes soon. Normally, companies will offer incentives that are likely to improve the company’s performance (Shleifer and Vishny 743).
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Effective corporate governance is very essential to many firms because it results in increased profits, the company’s expansion, and other long term returns. Internal corporate governance mechanisms differ from one firm to another and the benefits accruing from them depend on how a certain company employs them. Internal corporate governance mechanisms, however, do not run alone. For better performance, a company should use both external and internal corporate governance mechanisms as the two are dependent on each other. External corporate governance mechanisms such as corporate takeover market and product market competition are therefore important to any firm (Aljifri and Moustafa 86).
Both external and external mechanisms have various benefits and drawbacks and employing them together in governance is vital as they in one way or the other complement each other. With proper corporate governance, various strategies will be formulated and implementations will be put in place to help companies to compete in equal terms with other companies in the same line of business. This helps them to reap above-average returns or abnormal returns in the long run. Indeed a firm with good governance will perform better than other competitor companies and will enjoy larger investments and create employment opportunities for many.
Alfieri, Khaled and Moustafa Mohamed. The Impact of Corporate Governance Mechanisms on the Performance of UAE Firms: An Empirical Analysis. Journal of Economic & Administrative Sciences 23, 2 (2007):71-93. Web.
Babatunde, Adetunji M and Olaniran Olawoye.The Effects of Internal and External Mechanism on Governance and Performance of Corporate Firms in Nigeria. Corporate ownership & control 7, 2(2009):330-344. Web.
Cremers, Martijn K and Nair Vinay B.Governance Mechanisms and Equity Prices The Journal of Finance 6 (2005): 2859-2893. Print.
Shleifer, Andrei and Vishny Robert W. A Survey of Corporate Governance. The Journal of Finance 52, 2(1997):737-783. Web.