Information externalities in corporate governance

Abstract

The paper studies the interaction between corporate governance standards in different firms and uncovers an information externality. Investors engage in costly monitoring to evaluate CEO performance and take informed firing decisions. When firms are exposed to a common shock an externality arises: firing decisions in well-governed firms transmit valuable information about the common shock to poorly governed rivals. In equilibrium, firms free-ride and there is underprovision of monitoring. Imposing a limit on CEO compensation can mitigate the free-rider problem and increase investor welfare. I derive novel empirical predictions on patterns of CEO turnover and ownership concentration across firms.