Who Monitors the Monitor? The Effect of Board Independence on Executive Compensation and Firm Value

Recent corporate governance reforms focus on board independence and encourage equity ownership by directors. We analyze the efficacy of these reforms in a model where both adverse selection and moral hazard exist at the level of the firm's management. Delegating governance to the board improves monitoring but creates another agency problem because directors themselves avoid effort and are dependent on the CEO. We show that as directors become less dependent on the CEO, their monitoring efficiency may decrease even as they improve the incentive-efficiency of executive compensation contracts. Therefore, a board composed of directors that are more independent may actually perform worse. Moreover, higher equity incentives for the board may increase equity-based compensation awards to management