Can shared social identity minimise corporate frictions?

A separation between owners and managers of firms gives rise to various problems known as ‘agency conflicts’. This article explores whether having a shared social identity between managers and board members can help reduce frictions and improve firm performance. Analysing data from Indian firms, it finds that homophily enhances firm value in the long run – despite the costs associated with in-group favouritism.

When it comes to firms, there is often a separation between the people who own the business and those who manage it. This separation can give rise to various problems and conflicts known as ‘agency conflicts’. These challenges include issues like managers taking excessive risks, not sharing enough information with the owners, and making decisions that may not align with the best interests of the shareholders. It is a complex issue that has been explored by researchers for decades (see, for example, Milosevic, Shleifer and Vishny (2015) and Edmans, Gabaix and Jenter (2017)).

Traditionally, corporate governance literature has proposed solutions to these agency conflicts by suggesting changes in the incentive structures for managers. The idea is that if the compensation system is designed in a certain way, the interests of managers can be aligned with those of the shareholders.¹ However, despite these efforts, the problem of agency conflicts has persisted over the years, prompting researchers to explore alternative approaches.

Inspired by a growing body of literature in fields like identity economics and social psychology, I investigate whether group identity plays a role in mitigating these agency frictions (Aswani 2022). In simpler terms, I explore whether having something in common (such as a shared social or group identity) between a manager and the board members could help reduce conflicts and improve the firm's performance.

Theoretical model

Surprisingly, the theoretical predictions suggest that there is indeed a connection between group identity and better outcomes for companies. When a manager shares a similar social identity, like cultural background or other personal characteristics, with a board member, they tend to receive higher compensation. This is because there is an inherent bias towards favouring those who are part of the same group (what is referred to as ‘in-group bias’). Nevertheless, shared social identity between a manager and a board member proves necessary to mitigate the friction between them, which, in turn, helps the firm in the long run despite the cost of in-group favouritism (that is, the portion of the compensation attributable solely to homophily). For instance, imagine a scenario where a German firm has to choose between a German and an Indian manager, both equally qualified. Given the cultural proximity and ease of communication with the board, the preference might lean towards the German manager.

While at first glance, this may seem to conflict with the push for workplace diversity, the research presents a nuanced view. It suggests that diversity and group identity need not be at odds. Rather, they can coexist effectively when a firm's board is as diverse as the identities of its managers. For example, if a German firm is led by a female CEO (chief executive officer) of German descent, introducing more women into the boardroom can foster gender diversity while still aligning with the CEO's identity.

This approach indicates that identity overlap between a manager and board members reduces the frictions between them, potentially benefitting the firm in the long run. Thus, a strategic board composition that mirrors the multifaceted identities of its management can harmonies the benefits of group identity with the advantages of diversity.

My research delves into the mechanics of how group identity affects executive compensation and firm value. It utilises the concept of ‘identity-based agent's utility function’, which essentially means that when people feel a sense of belonging to a particular group, they tend to work harder and are rewarded more within that group. This, in turn, benefits the firm's overall value.

Empirical evidence

To empirically examine these theoretical concepts, I leverage the Indian context where surnames are often indicative of one's family background, native language, place of origin, and caste – key elements of social identity. Using data from the Socio-Economic Caste Census and the Linguistic Survey of India, I compile a comprehensive dataset of Indian surnames. This dataset encompasses 3,784,001 last names, each tagged with corresponding information about language, place, and caste affiliations. It bears resemblance to the Ancestry.com database, which records approximately 4 million Indian last names but lacks detailed identity-markers. This meticulously curated identity dataset enables a nuanced identification of social group alignments among corporate managers and board members, taking into account their native language, place of origin, and caste, thus providing a robust foundation for examining social identity within the corporate framework.

I conduct an empirical analysis of data from 2,324 non-financial firms listed on major Indian stock exchanges over a 14-year period (2004-2018). I find that when a manager shares an identity with at least one board member, they receive a higher compensation compared to their counterparts. This increased compensation is observed across various identity categories, with native language and native place showing stronger effects than caste.

Importantly, the firms with these shared identities also had a significantly higher market value relative to other firms. Estimates suggest that for every 1% increase in executive pay due to group identity, the firm's value increased by 1.8%. However, as both managerial compensation and firm value are determined ‘endogenously², to know the impact of group identity on firm value conditioned on compensation, I decompose the firm value. One part of firm value is explained by managerial compensation and the second part is residual firm value. The underlying theory for using the residual firm value as a proxy of managerial reciprocation is that the determinants of residual firm value should only be correlated with firm and governance characteristics. However, the study design controls for firm findamentals and corporate governance characteristics. Therefore, if homophily explains a part of it, it is due to the manager’s extra effort put into the firm.³ I find that firms with a higher degree of group identity between a manager and board have a higher residual value, (that is, higher firm value excluding the cost of in-group favouritism).

Yet, one can argue that the residual firm value may fail to capture the simultaneity issue. To mitigate such concerns, I confirmed the results using the ‘two-stage least square’ (2SLS).⁴The results imply that the manager exerts extra effort due to the shared identity.⁵ These results (that individuals put extra effort into working with in-group members compared to out-group members) are in line with the literature on group identity in social psychology and social neuroscience (Cikara and Van Bavel 2014).

Further, as the board can select a manager having the same identity to reduce frictions in corporate decision-making, this causes ‘self-selection bias’.⁶To address this problem, I used the director’s death or non-voluntary retirement as a ‘shock’ to the homophily constructs. The results are still consistent using this exogenous (external) change.

Conclusion

In conclusion, this research suggests that shared identity between a manager and the board members reduces frictions between them. Despite the associated extra costs due to distortions such as favouritism, this system works as firm do well in the long term. By understanding the dynamics of group identity, companies can potentially improve their relationships between managers and board members and, ultimately, increase their overall value in the long run. It is a nuanced approach that acknowledges the complexities of human behaviour and how this influences corporate success.

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Notes:

Firms discussed in these studies are mainly public firms listed on main stock exchanges. For instance, in this work, I have focused on firms that are listed on Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).
There may be firm characteristics such as firm size, profitability, growth and similar others that are correlated both with managerial compensation (explanatory factor) and firm value (outcome of interest), making it difficult to establish that higher managerial compensation has a causal impact on firm value.
In simple terms, if managerial compensation and homophily explain firm value and if we notice that managerial compensation explains a part of firm value then we can conclude that remaining firm value (or residual firm value) is explained by homophily (through managerial efforts).
This is a common methodology used in econometrics to resolve simultaneity issues. For instance, if x and y can impact one another, it would be hard to estimate the impact of x on y since y can also affect x. To mitigate such concerns, we find an instrument (z) – in this case, a ‘promoter dummy’ which indicates whether the manager is also the firm’s promoter – which is correlated with x (logarithm of total managerial compensation), but not economically correlated with y (firm value concerning measures of group identity). Using this instrument, we can estimate the impact of z on y, which would be same as impact of x on y.
These results are robust to changes in firm fundamentals and corporate governance characteristics.
Here ‘self-selection bias’ means board members can hire the manager with whom they believe there would be less friction. If in hiring a manager, board members also consider identity as a characteristic, then identity created the bias while hiring. To test that my results hold, adjusting for this bias, there needs to be a shock to main explanatory factor (group identity in this case). The director’s death or voluntary retirement would change the identity composition of the board.