Do gender quotas make sense?

In the UK, the regulator has announced a mandatory gender quota for companies listed on the main market of the London Stock Exchange. Starting next year, companies must have at least 40% women on the board, at least one woman in a senior board position (Chair, CEO, CFO or Senior Independent Director) and at least one ethnic minority on the board. Companies that do not comply with these quotas must explain why not and how they intend to rectify this situation. But does this make sense?

My initial reaction to this new regulation was: “I hope companies don’t go out and hire a female director just to tick boxes. That would make governance worse not better.” Speaking to a number of fund managers and corporations after the regulation was announced that I noted I wasn’t alone. Everybody has the same concern. By mandating a fixed quote there is a temptation to just meet the requirements by hiring lesser qualified people.

Don’t get me wrong. I am all in favour of increasing diversity on the board. I have written many times about the evidence that companies run by a more diverse leadership team take fewer extreme risks and are more profitable in the long run. But diversity comes not from hiring people with a different genome, but by hiring people with a different perspective, different experiences and abilities and by breaking up old boys’ clubs of (mostly) middle-aged white men sitting in no longer smoke-filled rooms but closed rooms nevertheless.

Interestingly, though, the empirical evidence tends to be in favour of mandatory diversity quotas. In theory, companies may be tempted to hire directors that are less qualified, but in practice they don’t because directors have to be approved by shareholders.

Martina Gertsberg and her colleagues looked at the implications of a 2018 mandate for female board representation in California. CA Senate Bill 826 mandated all publicly held companies headquartered in California to have what amounted to somewhere between 25% and 40% female representation on the board by the end of 2019. When the bill was announced the stock market reacted negatively because investors feared that companies would appoint lesser qualified individuals.

But the opposite happened. The chart below showed the approval new and existing directors got at shareholder meetings. Incumbent female directors got more votes than incumbent male directors and new female directors got substantially more votes than new male directors. After the gender quota was introduced, the approval for new female directors declined somewhat but it always stayed above the approval for male directors. California companies had no problems finding qualified female directors and the share prices of these companies got a boost from hiring female directors if these new directors replaced incumbents with low approval from shareholders.

Approval of new and existing directors by shareholders

Source: Gertsberg et al. (2021)

And herein lies the trick. When companies replaced male directors with a high approval from shareholders with a new female director, share prices dropped because the market didn’t like to see a qualified director leave. But if the companies replaced the director with the lowest shareholder approval with a woman, share prices rallied as investors recognised the improved governance from bringing on a more diverse set of directors.

So, I and my fellow investors probably need not worry too much about the new regulation in the UK. Speaking with a number of UK companies they all are intent to hire female directors, but only if they are qualified. None of the corporate leaders I spoke to will hire a woman just to tick boxes. And that is a good thing.