Financial Transparency and External Managerial Labor Market Activity

Abstract

This paper presents a model explaining the positive relationship between the availability of financial information to outsiders and external managerial labor market activity. An adverse selection problem appears when firms don't know the financial condition of other firms and thus the ability of outside managers. Firms could offer a performance-based contract screening out low-ability managers. Managers require a risk premium to take such a contract, however, since they do not know the financial condition of the firm offering the contract. Thus, an ex ante mutually beneficial contract may not exist. The theory suggests that the inferior monitoring by inside corporate directors of firms relative to outside directors may be due not to their career concerns, but to the fact that they have less information about outside managerial candidates.