Recent empirical evidence suggests that independent outside directors play an important role in monitoring senior managers in the modern corporation. Despite this evidence, we understand little about why some boards of directors are dominated by outside directors while others consist primarily of the firm's officers. The purpose of this study is to examine how ownership structure affects the composition of the board of directors in the banking industry. The results of this study underscore the importance of ownership structure. High outsider board membership appears to be the result of monitoring activities by active outside investors, such as institutional investors and outside directors, rather than a substitute for other incentive-alignment or monitoring mechanisms. Many studies document a negative relation between outsider board membership and share ownership by insiders. One explanation for this finding is the substitution hypothesis, which argues that as share ownership by insiders increases, there is less need to monitor the CEO, so firms appoint fewer outsiders to the board. The shareholder-voting hypothesis is an alternative explanation, which suggests that the negative relation between outsider board membership and insider share ownership is the result of managers with high equity stakes who use their control over the outcome of shareholder voting to exclude outsiders from the board. The key to differentiating between the predictions of the two hypotheses is in distinguishing between the different components of insider ownership. The common measure of insider ownership includes share ownership by all officers and directors. However, according to the shareholder-voting hypothesis, share ownership by officers of the firm, especially the CEO, and share ownership by outside directors will have different influences on the composition of the board. The distinction is important because outside directors are more likely to have incentives that are consistent with the interests of shareholders. Increases in share ownership by outside directors result in better monitoring of the CEO, but increases in share ownership by the CEO and other insiders can result in manager entrenchment. In addition to share ownership by outside directors, share ownership by other active outside investors might serve to limit the extent to which a CEO can control the director-selection process. On the other hand, other incentive-alignment and monitoring mechanisms might serve to limit agency problems. Using detailed ownership structure and corporate control data for a sample of publicly traded bank holding companies, I find evidence consistent with the shareholder-voting hypothesis. Outsider beard membership tends to be lower when the CEO owns a large share of the firm, suggesting that CEOs with moderate to high share ownership use their influence to exclude outsiders from the board. Outsider beard membership is greater when outside directors and institutional investors own more of the equity of the firm, suggesting that share ownership by these investors limits the ability of CEOs to exclude outsiders from the board. Further, the results suggest that when active outside investors have significant control over the outcome of shareholder voting, they put pressure on the firm to appoint more outsiders to the board.
