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«Maran MARIMUTHU• Abstract This paper makes an attempt to understand the extent to which ethnic diversity in top level management affects firm ...»

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Ethnic Diversity on Boards of Directors and Its Implications on Firm Financial

Performance

Maran MARIMUTHU•

Abstract

This paper makes an attempt to understand the extent to which ethnic

diversity in top level management affects firm financial performance. Thus, the

purpose of this paper is to empirically examine the relationship between ethnic

diversity on boards of directors with firm financial performance. This paper uses

secondary data from the top 100 non-financial companies listed on the Main Board over a period of 2000 to 2005 (six years). It involves a non-probability sampling as there is a need to meet some specific criteria and requirements. Top 100 companies are determined by ranking them based on their market capitalization. Relevant concepts, propositions and a hypothesis are developed to suit the parametric statistical procedures. Ethnic diversity is measured by the percentage of Non-Malay directors and performance is viewed in terms of Return on Asset (ROA) and control variables are also considered. Statistical techniques such as correlation and regression analyses are considered and the details of the findings explain the impact of ethnic diversity on firm financial performance. This paper is expected to make a significant contribution to the workforce diversity literature particularly at top level management by proving that ethnic diversity on boards of directors is more likely to lead to superior financial performance.

Key Words: diversity, financial performance, board of directors, non- financial companies, top management • Universiti Tunku Abdul Rahman (UTAR), Faculty of Accounting and Management Department of Finance E-mail: maran@mail.utar.edu.my 432 Maran MARIMUTHU

INTRODUCTION

The board of directors plays a very significant role in view of maximizing shareholders’ wealth via exercising control over top management (Kose and Senbet, 1998). As a corporate governance mechanism, the board of directors will have direct impact in assuring adequate returns for shareholders (Vafeas, 1999; Weir and McKnight, 2001). The board has the obligation to optimize shareholder value (Coles et al., 2001). The general principles outlined by the Malaysian Code of Corporate Governance in 2000 includes board structure, board size and independent board of directors and subsequently, Bursa Malaysia decided to impose restriction on the number of directorship of a person in 2002.

Obviously, there is no clear emphasis made on the need of instituting workforce diversity on board of directors. This research however, does not investigate the characteristics or discrimination within the boards of directors rather this work is specially designed to investigate the impact of diversity within boards of directors on firm financial performance. Hence, the purpose of this study is to empirically examine the relationship between ethnic diversity on boards of directors with firm financial performance. In relation to this, the conceptual understanding is essentially important as illustrated below.

Definition Diversity is the variation of social and cultural identities among people existing together in a defined employment or market setting, social and cultural identity refers to the personal affiliation with groups that research has shown to have significant influence on peoples’ major life experiences. These affiliations include gender, race, national origin, religion, age cohort and work specialization, among others (Cox, 2001).

Primary categories of diversity include age, race, ethnicity, gender …, secondary categories of diversity include education, experience, income, marital status, …(Slocum and Hellriegel, 2007).

As the terms multi-ethnic and multi-culturalism are inter-changeably used, Kabilan and Hassan (2005) … prefer the use of the term ‘multi-ethnic’ to ‘multiculturalism’…multi-culturism is a misled concept or a misnomer, when applied to Malaysia. Hasan, Samian and Silong (2005) …managing diversity is very much based

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on tolerance and respect …to preserve inter-ethnic harmony. Hence, ethnic would be the right term to address racial composition in Malaysia.

Studies on diversity can be viewed in two perspectives; demographic and coginitive. Demographic diversity includes gender, age, race and ethnicity and cognitive diversity includes knowledge, education, values, perception, affection and personality characteristics (Maznevski, 1994; Milliken and Martins, 1996; Pelled, 1996; Boeker, 1997; Watson et al., 1998; Peterson, 2000; Timmerman, 2000).

There have been many contemporary studies on demographic diversity and its effect on performance (Lee and Far, 2004; Evans and Carson, 2005; Bergen and Massey, 2005). Some researchers even studied specifically on the impact of demographic diversity on top management team or boards of directors and its implications on firm performance (Roberson and Park, 2007; Erchardt, et al., 2003;

Certo et al., 2006; Carson, et al., 2004;). However, very few studies found on racial/ethnic diversity at top management ( e.g. Roberson and Park, 2007) and meanwhile, increased racial diversity on boards of directors is being experienced in the U.S. (burke, 1995). For this study, diversity is defined as the representation of ethnic difference (Malay, Chinese, Indian and others) on boards of directors.





Diversity and Organizational Performance The current literature reveals the fact that the relationship between diversity and organizational or group performance can be either positively correlated or negatively correlated or even some studies show that there is no relationship (somewhat mixed findings) between diversity and performance.

Some empirical findings indicate that diversity results in greater knowledge, creativity and innovation and thus, organizations tend to become more competitive (Watson et al., 1993). In addition, improvement in decision making at strategic level can also be seen in the presence of diversity (Bantel, 1993).

Meantime, both educational and cognitive diversity are positively correlated with organizational performance (Simons and Pelled, 1999). Siciliano (1996) found that board diversity paves a way for positive results in performance. Cultural heterogeneity results in issue-based conflict which in turn enhances greater organizational performance. Heterogeneity is positively linked to better problem solving and offering creating solutions (Michael & Hambrick, 1992). Hence, diversity is positively related to performance. However, there could be no relationship between diversity (cultural heterogeneity and member diversity) and group cohesion. Murray

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(1989) suggested that the infusion of homogeneous groups would result in better performance.

On the other hand, diversity can be disadvantageous to organizational performance (Hambrick et al., 1996), In which, homogeneous top management tends to produce better results as compared to heterogeneous top management. Similarly, Knight et al. (1999) also argues that team performance tends to deteriorate as diversity level increases.

Diversity, Board Diversity and Firm Performance A very important theory dealing with diversity within top management and its impact on firm performance that should be considered here is the Upper Echelon Theory by Hambrick and Mason (1984). In view of this, top management members could with greater demographic diversity, influence decision making process in the top management and positively contribute to firm performance. The basic foundation of this theory could be linked to the earlier concepts on the characteristics at the top management and competitive behaviours (Cyert and March, 1963). Thus, firm performance could be positively impacted by the competitive behaviours at top level of an organization.

Admittedly, to a large extent (as discussed above), diversity enhances greater creativity, innovativeness and quality decision making, thus this study expects the similar outcome at strategic level particularly involving the boards of directors (Zahra and Pearce, 1989) and boards are the most influential actors, boards are also to carry out the monitoring role representing shareholders (Hambrick 1996). Significantly, some research shows that increasing diversity on boards of directors would be beneficial to organization in terms of gaining critical resources (Pfeffer and Salancik,

1978) and where corporate governance is concerned, benefits at strategic level are positively related to diverse top management (Eisendardt and Bougeois, 1988).

Occupational diversity among board members is also positively related to performance in the context of social obligation (Siciliano, 1996). Zander (1993), stresses that efforts must also be taken to make fullest use of the talents of board members.

Obviously, the presence of the demographic heterogeneity at top management level tends to increase firm performance, hence, heterogeneity is suitable for complex, ambiguous business operations and the decision making processes are structured in nature whereas, homogeneity in top management is more effective especially when faced with unstructured decision making processes (Hambrick and Mason, 1984).

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However, advantages associated with homogeneous top management can not be ignored. In fact some argue having homogeneous management team would be more beneficial with regard to firm performance (Wiliams and O’Reilly, 1998). Evidence shows that heterogeneity tends to lead to conflicts and negatively affects the effectiveness of communication in top management (Pelled at al., 1999; Amason, 1996; Carpenter, 2002).

Hypothesis Formulation The Upper Echelon Theory by Hambrick and Mason (1984) becomes a very important platform in connecting heterogeneity in top management team (TMT) with firm performance. In view of this, a closer look at the model and its components would be of great help to expand our knowledge on diversity in TMT, thus board of directors could be viewed in the same context as TMT (Hofman, Lheureux and Lamond, 1997) and it should be noted that it is not organizational performance rather financial performance is being investigated here and ethnic diversity represents diversity (Roberson and Park, 2007).

Therefore, these concepts allow us to form a reliable proposition that explains the relationship between demographic diversity on boards of directors and financial performance, thus the following hypothesis is proposed: Firm financial performance is positively impacted by ethnic diversity among board members.

Methods Data for the study were gathered from top 100 non- financial companies listed on the Main Board of the Bursa Malaysia over a period of 2000 to 2005. It involved a non-probability sampling (judgemental sampling) as there was a need to meet some specific criteria in selecting the 100 companies.

First, as there were over 600 companies listed on the Main Board, the companies were split into two; financial and non-financial companies. It seemed top 100 companies accounted for about 60 per cent of the total market capitalization as compared to about 80 per cent contributed by both groups in the top 100 list. Thus, non-financial companies were still making substantial contribution on the main board and as for this study, this is important to maintain the homogeneous characteristics of the companies selected. Then, the average market capitalization for each non-financial company was calculated over a period of 2000 to 2005. Then finally top 100 companies (refer to Supplement 1) are determined by ranking them based on their market capitalization.

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Measures As the main focus was to detect the effect of board diversity (by using ethnic diversity as a proxy) on firm financial performance and this was measured at two different points; 2000 and 2005 and these periods reflected the beginning of the postcrisis and the enhancement of the corporate governance in Malaysia (evidenced by the release of the Malaysian Code on Corporate governance by the committee in March 2000). The dependent variable was financial performance, independent variable was ethnic diversity and the control variables were board size, firm size and financial performance for year 2000 (used for the second period year 2005).

The dependent variable, ROA; Return on Asset (Net Income divided by Total Asset) was a measure used to measure firm financial performance (Certo et al.,2006;

Erhardt et al., 2003), the independent variable, ethnic diversity (board diversity) was measures on a ratio scale (Non- Malay directors divided by the total directors), the control variables; board size was determined by the taking the number of directors sitting on the board, firm total asset was a measure for firm size (Roberson and Park, 2007; Jehn and Bezrukova, 2004).

Analyses and Findings Two statistical techniques were adopted; correlation and regression analyses.

The correlation result (Table 1) shows the relationships among the variables considered in the study and the regression analysis explains the effect of ethnic diversity (board diversity) on firm financial performance in the presence of the control variables.

The regression model first based based on the OLS (ordinary least squares) estimators was however further corrected; first diagnostic testing done on the multicollinearity effect, and it was verified that the VIFs (Variance-inflating factor) for both control and independent variables were less than 5. Then the method of Weighted Least Squares (WLS) was adopted as a remedial measure of correcting heteroscedasticity and the findings were reported accordingly.

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a In billions * p 0.05 * p 0.01 The mean, standard deviations and correlation are coefficients shown in Table

1. As for correlation analysis, ethnic diversity was significantly and positively related to performance’05 (r = 0.239, p 0.05). However, there was a significant negative correlation between ethnic diversity and firmsize’05 (r = -0.233, p 0.05). This indicates that the larger the company, the lower the ethnic diversity will be. Meantime, firmsize’05 and firmsize’00 were strongly correlated (r = 0.815, p 0.01) and this reflects positive growth of the companies.

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