The Complementarity Between Signal Informativeness and Monitoring

Abstract

A firm that must decide whether to retain or terminate a manager can rely on several sources of information to assess managerial ability. When it relies on a performance signal and monitoring, we show that a more informative signal can surprisingly increase the value of monitoring. Then, signal precision and monitoring are complements. This happens if a more precise information system makes some signals more negative indicators of managerial ability that still do not trigger termination. When the turnover cost is high enough and the manager is more entrenched after a positive performance, an increase in signal precision increases expected monitoring. In firms with a high turnover cost, a less informative signal is compounded by worse monitoring after a disappointing performance. This “bad corporate governance trap” makes it hard for these firms to eventually improve performance.