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Kiel Institute of World Economics Duesternbrooker Weg 120 24105 Kiel (Germany) Kiel Working Paper No. 968 Complementarities in Corporate Governance: Ownership Concentration, Capital Structure, Monitoring and Pecuniary Incentives by Ralph P. Heinrich February 2000 The responsibility for the contents of the working papers rests with the author, not the Institute. Since working papers are of a preliminary nature, it may be useful to contact the author of a parti
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  Kiel Institute of World Economics Duesternbrooker Weg 12024105 Kiel (Germany) Kiel Working Paper No. 968 Complementarities in Corporate Governance:Ownership Concentration, Capital Structure,Monitoring and Pecuniary Incentives byRalph P. Heinrich February 2000 The responsibility for the contents of the working papers rests with theauthor, not the Institute. Since working papers are of a preliminarynature, it may be useful to contact the author of a particular working paper about results or caveats before referring to, or quoting, a paper. Any comments on working papers should be sent directly to the author.  2 Complementarities in Corporate Governance:Ownership Concentration, Capital Structure, Monitoringand Pecuniary Incentives * Abstract:The paper shows that, as owners accumulate larger stakes and hence become lessrisk-tolerant, their incentives to monitor management are attenuated becausemonitoring shifts some of the firm’s risk from management to owners. Thiscounterbalances the positive effect which more concentrated ownership has onmonitoring via reduced free rider problems. Moreover, the paper shows how theopportunity cost of concentrated ownership, which is the loss of risk-sharingbenefits, creates scope to use leverage as an additional complementarygovernance instrument. The paper offers new explanations for several empiricalregularities found in the literature.Keywords: Corporate governance, Complementarity, Agency problemJEL-classification: G 300, D 230Ralph P. HeinrichInstitut für Weltwirtschaft24100 KielTelefon: +49 431 8814-263Telefax: +49 431 8814-500E-mail: Heinrich@ifw.uni-kiel.de  * I thank Claudia Buch and seminar participants at the Kiel Institute of World Economics forhelpful comments. All remaining errors are my own.  Contents 1 INTRODUCTION*....................................................................................................................................................12 OPTIMAL CONTRACT WITHOUT MONITORING.........................................................................................43 VARYING INFORMATION ASYMMETRIES: THE IMPACT OF MONITORING ON THEDISTRIBUTION OF RISK........................................................................................................................................74 VARYING DIFFERENCES IN RISK TOLERANCE: THE IMPACT OF THE OWNERSHIP ....................STRUCTURE...........................................................................................................................................................125 THE CAPITAL STRUCTURE AS A COMPLEMENTARY GOVERNANCE INSTRUMENT.................186 DISCUSSION OF THE RELATED LITERATURE...........................................................................................237 CONCLUSIONS......................................................................................................................................................258 REFERENCES........................................................................................................................................................27  1 Introduction The literature on corporate governance is largely based on variants of theprincipal agent model of the firm. The problem of corporate governance isviewed as how to minimize the costs arising from agency conflicts at the firmlevel. In the standard model, asymmetric information is combined withdifferential tolerance towards risk to create a situation where principal and agenthave to strike an imperfect balance between the optimal provision of incentivesand the optimal allocation of risk. It has been customary in the literature toemploy this model to study the use of a single incentive or governanceinstrument at a time. For instance, the model has been used to explain howmanagerial pay can be structured to reduce agency costs, or how the capitalstructure can be harnessed to this purpose, or how the firm’s ownership structureinfluences agency costs.What is lacking however is a systematic explanation of why firms typically usemore than one governance instrument simultaneously, and what drives thechoice among alternative combinations of governance instruments.Understanding these issues is of considerable importance for empirical researchon corporate governance, as most research to date has been based on modelswhich focus on a single governance instrument to the neglect of all others. Thesemodels and the empirical findings based on them start from the maintainedassumption that all governance instruments that a given firm may be using areindependent of eachother at the margin. Moreover, understanding the interplaybetween governance instruments is important for informing the policy debateabout reforming corporate governance systems in the US, the European Union,and in emerging markets.The present paper submits that governance instruments not only have benefitsin terms of reducing agency costs, but also carry opportunity costs in terms of aggravating agency problems. Jensen and Meckling (1976) have argued thatleverage can be used as an instrument to govern the agency conflict betweenmanagement and a dispersed group of owners, but that the use of leverage islimited by the fact that it creates costly agency conflicts between owners andcreditors. We follow up on this idea by showing how an additional governanceinstrument can be used to counterbalance the adverse effects of a firstinstrument. In particular, we argue that certain groups of governance instrumentsare Edgeworth complements: the more you use one of them, the more useful it
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