How do Independent Directors Influence Corporate Risk-Taking. Evidence from a Quasi-Natural Experiment

Motivated by agency theory, we explore the effect of independent directors on corporate risk taking. To minimize endogeneity, we exploit the passage of the Sarbanes-Oxley Act as an exogenous shock that raises board independence. Our difference-in-difference estimates show that board independence diminishes risk-taking significantly, as evidenced by the substantially lower volatility in the stock returns. In particular, board independence reduces total risk and idiosyncratic risk by 24.87% and 12.60%, respectively. The evidence is consistent with the notion that board independence represents an effective governance mechanism that prevents managers from taking excessive risk. Additional analysis based on propensity score matching also confirms our results. Our research design is based on a natural experiment and is far more likely to show causality, rather than merely an association.