CEO-director connectedness and firm’s operational risk

ABSTRACT

While internal controls are often carefully set by firm owners to manage risks, operational losses caused by errors in people and procedures could occur if board directors’ monitoring functions are weakened by having private connections with senior managers. This paper provides empirical evidence that the presence of social tie between a firm’s CEO and its board member is associated with a higher likelihood of operational risk events after other key determinants are controlled for. Our sample consists of 168 event and non-event firms that are publicly listed in the U.S. and spans over a historical period over 2000–2008 when the Basel II Accord is in full operation. Our results imply that existing provisions against operational risk should take CEO-director social ties as an additional factor that can undermine corporate governance and expose firms to a higher level of operational risk.

KEYWORDS:

• Operational risk
• corporate governance
• CEO
• board of directors
• social ties

JEL CLASSIFICATION:

• G32
• G34

Acknowldgement

We would like to express our sincere appreciation to the editor and the anonymous referee for their valuable comments and suggestions. We also want to thank Jingqing Liu for his valuable research support. All authors contributed equally to this manuscript. Part of this research was done while Zong-Han Lin was the Postdoctoral Research Fellow at National Taiwan University. Errors are our own.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Specifically, we merge Compustat and BoardEx by CIK, CUSIP, and TICKER, and we then manually search for unmatched BoardEx company names in Compustat.

² We merge the CRSP database and Compustat database via the CRSP-Compustat link file to obtain the CRSP-Compustat combined dataset.

³ We have also tried the total number of connected SDs and the total number of different types of connections as the dependent variable, with the overall number of SDs controlled for. The results are virtually unchanged, thus not shown in the results table here.

⁴ Board heterogeneity in this paper is proxied by the percentage of female directors on board, executive compensation structure is captured by calculating the incentive compensation over total compensation, averaged over top 5 earners in the firm; business complexity is proxied by the number of segments and branches owned by the firm.