Beyond diversity: Resolving corporate frictions using group identity

SCIENTIST PERSPECTIVE by Jitendra Aswani, Post-Doctoral Associate at MIT Sloan. This insight is based on his article, “Group Identity and Agency Frictions: Evidence using Big Data,” available here.

In the complex architecture of corporate governance, the dichotomy between ownership and executive management precipitates a fertile terrain for agency conflicts—a phenomenon meticulously dissected across decades of scholarly inquiry. These conflicts emerge from the discord between managerial actions and shareholder interests, manifesting in forms such as undue risk-taking, obfuscation of information, and decisions misaligned with shareholder welfare. Traditional corporate governance discourse advocates for recalibrating managerial incentive structures to synchronize managerial and shareholder interests. Despite these endeavors, the resilience of agency conflicts necessitates a reevaluation through an innovative prism.

This study embarks on a novel exploration, leveraging insights from identity economics and social psychology, to assess the potential of group identity in ameliorating agency frictions. It hypothesizes that shared social or group identities between managers and board members could serve as a harmonizing force, potentially mitigating conflicts and enhancing organizational performance.

Empirical evidence unearthed in this study underscores a positive relation between shared social identity among managers and board members, and enhanced managerial compensation. This is attributed to an ‘in-group bias,’ whereby individuals within the same social or cultural milieu receive preferential treatment. While this may appear counterintuitive, the incorporation of group identity within the corporate hierarchy is pivotal in alleviating frictions, thus serving the long-term interests of the firm despite the immediate implications of in-group favoritism.

The conventional discourse pits diversity against group identity, suggesting an inherent conflict between the two. Contrary to this perspective, this research posits that diversity and group identity are not antithetical but can coexist and synergize to mitigate agency conflicts. For instance, in scenarios where managerial candidates of equal merit differ in cultural background, the selection process might favor the candidate whose cultural identity aligns more closely with that of the board, facilitating better communication and mutual understanding. This illustrates how diversity in managerial roles can act in concert with group identity dynamics to quell conflicts.

This investigation further delves into the ‘identity-based agent’s utility function,’ positing that a strong sense of belonging to a specific group motivates individuals to exert greater effort, subsequently reaping higher rewards. This collective enhancement of performance inherently boosts the company’s market valuation.

The theoretical constructs were empirically tested against the backdrop of India’s corporate sector. Utilizing a dataset derived from the Socio-Economic Caste Census (SECC) and the Linguistic Survey of India (LSI), the study illuminated how shared social identities among managers and directors—defined by native language, place of origin, or caste—exert influence on executive compensation and company market valuation. Data spanning 2,324 non-financial firms listed on India’s major stock exchanges over a 14-year period revealed a tangible positive impact of shared social identity on both managerial compensation and company market value, with natural identities such as language and place of origin showing more significant effects than induced identities such as same educational institute or same last employer.

In conclusion, this study elucidates the multifaceted role of social identity within the corporate milieu, advocating for an integrative approach that harmonizes the role of group identity to address agency conflicts beyond traditional options or restricted stock grants-based incentive mechanisms. The findings enrich the corporate governance literature by providing a nuanced understanding of how social identity dynamics can facilitate alignment between managerial actions and shareholder interests, thereby enhancing organizational performance and market valuation.