How Badly Run is Your Firm? The Impact of Key Governance Issues.

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Financial Risk
Risk Management
Corporate Governance

A new corporate governance index enables the impact of some potentially problematic corporate behavior to be better assessed – allowing policymakers and executives to devise more effective governance measures.

Regular reports of corporate wrongdoing in the media make it clear that, with regard to corporate governance, there is considerable room for improvement. Designing effective governance provisions is a tough challenge for policymakers, though. Difficulties measuring the impact of problematic corporate behavior make it hard to assess which governance provisions are most effective.

Academics Erwan Morellec, Boris Nikolov, and Norman Schürhoff offer some help to policymakers with this challenge. They outline a new approach to establishing the impact of two governance issues prevalent in many mainland European firms.  Issues that involve competing stakeholder interests and that can lead to loss of value for the firm overall and for certain stakeholders.

 

One issue is where controlling shareholders (often an owner-manager) influence the decision making of the firm at the expense of minority shareholders – diluting minority shareholdings, for example, or buying a company jet. The other is where controlling shareholders act at the expense of bondholders. If a company defaults, the absolute priority rule governs the payout order; creditors first, shareholders divide what remains. However a controlling shareholder may, after the event, try to renegotiate the order of payments, expropriating some of the money due to creditors.

Morellec and his colleagues use managerial decision making relating to financing the corporation and the leverage ratio in the capital structure to assess the impact of these potentially problematic behaviors. A controlling shareholder maximizing value decision making exhibits certain behaviors – tends to opt for greater leverage, changes the level of leverage more frequently as economic conditions evolve, and defaults later in the event of trouble. Deviation from such optimal behavior signals the presence and extent of any agency conflict.

For anyone with an interest in corporate governance, this new corporate governance index provides a unique insight into the impact of two potentially problematic areas of corporate behaviors.

The academics have developed model to detect such deviation from the optimal and express that as a corporate governance index score. Testing the model on data from 12,652 firms from 14 OECD countries showed the impact of these two types of conflict led to a 5.3% loss in firm value (market capitalization plus debt). Thus regulating these behaviors more effectively would add considerable value to firms, benefitting minority shareholders and bondholders.

For anyone with an interest in corporate governance, this new corporate governance index provides a unique insight into the impact of two potentially problematic areas of corporate behaviors. More generally, it allows managers to benchmark firms on corporate responsibility performance, and policymakers to gauge the effectiveness of specific governance provisions.

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Research | 42 articles