What is the Relation (if any) Between a Firm's Corporate Governance Arrangements and its Financial Performance?

We present a model to test the null hypothesis that firms organize their corporate governancearrangements optimally given the constraints they face. Following the literature, the modelrejects the null if the conditional correlation between governance and performance issignificantly different from zero. Our model provides a clean test of this hypothesis bycontrolling for measurement errors in all observed variables and avoiding simultaneousequation biases by casting our model as a reduced-form bivariate equation. We modelgovernance, performance and the constraints on the firm’s investment decisions as latentvariables. Our estimate of the conditional correlation between our measures of governanceand performance is statistically speaking equal to zero, which therefore provides empiricalsupport for the in-equilibrium view proposed by Demsetz (1983), of corporate governanceArrangements.