The Importance of Corporate Governance and Creditor Protection for Total Risk – Evidence from the United States and the European Union

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MSc in International Financial Management

Master Thesis

The Importance of Corporate Governance

and Creditor Protection for Total Risk –

Evidence from the United States and the

European Union

Borislava Petrova s3070549

Email:

b.p.petrova@student.rug.nl

Supervisor: Mr. M. Reijenga

Second assessor: Dr. Wim Westerman

Abstract:

Good corporate governance deals with the communication between shareholders and managers, attracts new investors and supports the overall development of a firm, and therefore has become an important topic in recent years. In this study, its effect on total risk is examined. The results show evidence for a negative relationship between corporate governance and total risk of a firm. The moderating effect of creditor protection on this relationship is also included in the regression analysis, but the results were not significant. The data that is used consists of 1740 companies, 426 from EU and 1314 from the USA.

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1. Introduction

Globalization is a crucial factor for the business world and prompts researchers to examine its effects. As an important part of the business, corporate governance is also broadly discussed in the literature. Companies face conflicts of interests between manager boards and shareholders, which are caused by differences in their risk perception and aversion. In this context, Agency theory is used to explain the relationship between corporate governance and firm risk-taking behavior (Gadhoum & Ayadi 2003; Jensen & Meckling 1976). Creditor rights differ across countries and they also take part in the business processes such as risk taking and debt adoption. Following the academic literature, this study aims to explain the relationship between corporate governance, creditor protection, and total risk of a firm.

Corporate governance is an important topic as a result of corporate scandals in the past and because it is another method to attract investors. Many countries issued Codes of Good Governance, followed by transnational organizations such as the Organization for Economic Cooperation and Development (OECD), the International Monetary Fund and the World Bank. Countries have also adopted either new legislation for corporate governance or codes that served as guidance for good governance (Aguilera & Cuervo-Cazurra, 2009). Those events demonstrate the importance of corporate governance and strengthen the need for further investigation of the topic.

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3 question is: How creditor protection is related to the total risk of a firm? Those questions are interesting and novel for the business literature. Many studies examined creditor rights, corporate governance, and total risk, yet any of them have not put them together in one study with a focus on their interaction. These questions are important and useful for both insiders and government. Firstly, managers may benefit from this research results since they may reconsider and improve their corporate behavior in general. Corporate governance and creditor protection are prior in decision-making processes such as expanding abroad and attracting investments from both outside and inside their country of origin. Moreover, governments and politicians, in particular, can introduce more effective regulations in order to help certain businesses and therefore to boost the economy. Finally, the results of this thesis will show whether low or strong creditor protection is more beneficial for firms, which will be also addressed to decision makers at firm- and country-level.

The study will observe the overall effect across countries; in addition, it will look for differences in these effects between USA- and Europe-based companies. The rationale for selecting countries is based on countries that issued for the first time and at the same time the biggest amount of codes of good governance were the USA (issued their first Code in 1978, and the Sarbanes – Oxley Act in 2002) and United Kingdom (issued the Cadbury Report in 1992), followed by other members of the European Union like Belgium, France, Spain, Denmark, the Netherlands etc.

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2. Literature review

In this section, a general discussion of the existing literature is provided. First, corporate governance, total risk and the relationship between them are explained. Next, creditor protection is examined. After each section, relevant hypotheses are introduced on the base of the reported literature.

2.1 Corporate governance and total risk

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5 governance and equity returns, operating performance, and firm value separately, but within the European borders, and agreed about the existence of such positive relationship (Bauer et al., 2004).

Recently, “good governance” is taking advantage in the academic literature. It prompts more and more authors to discuss what exactly it is and whether hard laws like the Sarbanes-Oxley Act in the USA or the so-called soft laws like codes for good governance are more efficient in enhancing the corporate governance manner around the world (Aguilera & Cuervo-Cazurra, 2009). The increasing need for good corporate governance can be also explained because of corporate globalization, which includes the internationalization of different economies and the integration of capital markets, and since the transformation of ownership, structures prompted by the increased shareholder activities (Aguilera & Cuervo-Cazurra, 2004). Therefore, locations (meaning not only countries, but companies as well) following certain corporate governance standards, legislation, or codes for best practices attract more investors (La Porta, Rafael, Lopez‐ de‐Silanes et al. 1998) and also economic growth (Levine, 1999).

There is plenty of studies that investigate the importance of corporate governance and specific firm aspects and the overall conclusion follows the logic. Well-governed companies perform better than poor-governed firms. Wang et al. (2015) made their research based on such studies and emphasized the downside risk as their dependent variable. They differentiated corporate governance in three types in building hypotheses and found consistency with previous researches and concluded that good corporate governance leads to lower downside risk by explaining different ways by which it is done so (Wang et al. 2015).

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6 That gives a ground for taking the level of internationalization into account when examining the influence of a certain factor of total risk.

Many studies investigate the interaction between different stakeholders like, for example, managers and shareholders. According to their personal benefits, they may act in a different way regarding the risk-taking activities. Researchers suggest a positive relationship between the ownership structure and risk taking (Gadhoum & Ayadi 2003). Since the quality of corporate governance in a company determines the dealings between management and outside stakeholders, a relationship between corporate governance and total risk should be found. Therefore, the first hypothesis of this thesis is:

H1a: There is a negative relationship between corporate governance and total risk of EU firms.

H1b: There is a negative relationship between corporate governance and total risk of USA firms.

2.2 Creditor protection

Companies’ financing is represented by the liabilities on the balance sheet and represent a composition of both equity and debt. Since equity is raised by shareholders, debt is provided by creditors such as banks, for example. Previous academic literature focuses on the importance of investor protection on firm’s performance either considering investors in general, or in specific investor types (creditors or shareholders). The aim of this study is to examine the influence of creditor protection on the relationship between corporate governance and total risk of a firm.

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7 means poor creditor protection and 4 means strong creditor protection. The index was constructed as a score for the existence of certain conditions (Djankov et al., 2007). However, other studies that focus on the effect of creditor rights on cash flow risk suggest a negative relationship between them (Acharya et al. 2011). Following the previous academic work, this study assumes that the level of creditor protection will affect negatively total risk and corporate governance.The authors’ hypothesis was supported by the data analysis. On the other hand, when examining the relationship between insiders and shareholders in the sense of corporate governance and its influence on the total risk this thesis suggests the same negative impact on creditor protection. So as to fully satisfy this paper aims, both a more general and specified relationship will be examined. The hypotheses are constructed to be in line with the previous studies, therefore, the second and the third hypotheses can be defined as:

H2a: There is a negative relationship between creditor protection and total risk of EU firms.

H2b: There is a negative relationship between creditor protection and total risk of USA firms.

H3a: A higher degree of creditor protection weakens the relationship between corporate

governance and total risk of EU firms.

H3b: A higher degree of creditor protection weakens the relationship between corporate

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3. Methodology and data collection.

In this section, the represented variables will be grouped and described. An appropriate measurement will be provided for each variable and at the end, a summary table will be presented.

3.1 Total risk

In this thesis, the total risk of a firm is the dependent variable. As discussed earlier, risk can be considered as a different risk type. Some researchers measure downside risk using value-at-risk (VaR) and expected shortfall (Wang et al. 2015), or z-score describing risk-taking (Ashraf et al. 2016). This study will be consistent with Kwok et al. (2000) and will measure the total risk of a firm with a standard deviation of stock returns. The data is collected on a weekly basis and then calculated separately for each year.

3.2 Corporate governance

The independent variable in the research topic is corporate governance. It will be measured by Corporate Governance Score (“CGS”), provided by Datastream. In previous studies, theorists measured one or few of corporate governance’ components, however, in this research CGS will be used to comprise its overall power of influence.

3.3 Creditor protection

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3.4 Control variables

In order to provide better clarity of the results, other influences outside the main relationship should be included. A variety of firm-specific factors affects the total risk of a company. First, the liquidity of assets that the firm owns determines its ability to face short-term difficulties in relation to obligations. The more liquid assets are, the faster transformation in cash can be realized, thus the risk level decreases (Hiller et al. 2016). Tangible assets are the most liquid one; therefore in this thesis liquidity will be measured by dividing intangible and total assets. Second, firm’s size and growth opportunities are crucial factors for companies’ risk exposure, since bigger companies with the higher ability for expanding seem to be less risky (Harris & Raviv 1991; Kwok & Reeb 2000). Firm’s size is presented as the natural logarithm of total assets and growth opportunities are represented by the market value of equity divided by book value of equity (i.e. market-to-book ratio). As many studies have noted, the level of internationalization affects firm’s risk. Therefore internationalization is included as a control variable and is calculated by dividing foreign and total assets. Finally, controlling for leverage proceeds since the amount of debt has an impact on the total risk of a firm.

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Table 1. Summary of the variables and their measurements.

Variable Abbreviation Measurement

Dependent variable Total risk TOTRISK Standard deviation of

stock returns

Independent variable Corporate governance CG Corporate Governance

Score

Moderating variable Creditor protection CP Creditor Rights Index

C

ontrol Va

ria

bles Firm-level

Tangibility of Assets TAN Intangible assets/Total

assets

Firm's size SIZE Natural logarithm of total

assets

Growth opportunities MTB Market-to-Book ratio

Internationalization FAR Foreign assets/Total

Assets

Leverage LEV Long-term Debt/Total

Assets

Country-level

GDP per capita GDPPC

GDP GDP

Inflation INFL

Taxes on income TAX

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11 from 2009 to 2016. The country-level data was collected from the Worldbank Online Database, where GDP, GDP per capita, inflation and tax rates were downloaded for each country. The date for the main moderator in this study, i.e. creditor protection was manually added from Djankov, McLiesh and Shleifer’s study (2007). The final lists consist of 426 and 1,314 for EU and USA, respectively. The countries included in the dataset are the following: USA, Austria, Czech Republic, Germany, Denmark, Spain, Finland, France, Great Britain, Croatia, Ireland, Lithuania, Luxembourg, Latvia, Netherlands, Poland, Portugal, and Sweden. After the automatic adjustment of the statistical software due to the unbalanced panels, the final number of observations is 770 for EU and 3,387 for the USA. Each of the variables is collected on a yearly basis. The total return index was collected on a weekly basis since the precision of the calculation of the annual standard deviation of stock returns. The data is analyzed by EViews statistical software, where the unbalanced panel is taken into consideration. Three specific regressions are used for analyzing the main hypotheses of this study.

Hypothesis 1: There is a negative relationship between corporate governance and total risk.

,

and

Hypothesis 2: There is a negative relationship between creditor protection and total risk.

,

and

Hypothesis 3: A higher degree of creditor protection weakens the relationship between corporate governance and total risk.

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12 where i, j, and t denote each company, country, and year, respectively. The variables TAN, SIZE, MTB, FAR and LEV are also included in the models since as controlling ones they have an impact on the total risk as mentioned earlier and based on previous researches. Moreover, some country-level variables are included to control for external influences over a firm. εit represents

the error term. After some primary results tested the most appropriate econometric model for the regression will be applied.

Table 2 and Table 3 provide descriptive statistics for the EU and the USA, separately. The data will be divided into two different working files in the econometric software because of the need to test for each sub-hypothesis. From now on Panel A will be referred to EU data and Panel B for USA data.

Table 2. Summary statistics for Panel A.

Sample: 2009 - 2016

Variable Mean Maximum

(Minimum) Std. Dev. Observations

Total Risk 2473.04296 99645.61 (0.38) 10307.871 765 Corporate Governance 66.394 97.04 (4.1) 22.269 765 Tangibility 0.232 0.823 (0) 0.192 765 Size 6.705 8.626 (4.893) 0.746 765 Market-to-book ratio 2.657 265.4 (-228.35) 13.1 765 Internationalization 34.049 192.45 (0) 30.287 765 Leverage 0.205 2.515 (0) 0.229 765 GDP per capita 45900.87 61330.913 (18002.231) 6581.299 765 GDP 1.9419E+12 3879276587198.9 (194851319174.891) 1.27E+12 765 Inflation 1.565 4.484 (-4.48) 1.395 765 Tax rate 28.91 48.151 (12.696) 9.647 765 Creditor Protection 2.57 4 (0) 1.49 765

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13 Table 3. Summary statistics for Panel B.

Sample: 2009 - 2016

Variable Mean Maximum

(Minimum) Std. Dev. Observations

Total Risk 1024.448 228548.961 (0.278) 6790.337 3387 Corporate Governance 74.841 97.61 (4.85) 16.775 3387 Tangibility 0.222 0.872 (0) 0.202 3387 Size 6.811 8.893 (4.913) 0.569 3387 Market-to-book ratio 3.804 1326.2 (-682.27) 37.224 3387 Internationalization 12.834 107.66 (0) 19.505 3387 Leverage 0.25 1.372 (0) 0.17 3387 GDP per capita 51826.328 56115.718 (47001.555) 3131.463 3387 GDP 1.63267E+13 18036648000000 (14418739000000) 1.241E+12 3387 Inflation 1.333 3.157 (-0.356) 1.09 3387 Tax rate 51.506 54.53 (45.5) 3.049 3387 Creditor Protection 1 1 (1) 0 3387

The table shows descriptive statistics for the USA. The minimum values are provided in parentheses.

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14 one of the possible explanations for the higher score of CGS in the USA. All variables have similar values for both panel A and panel B. However the tax rates differ since that panel A consists of 19 countries while panel B includes just one (USA) where taxes are between 45.5 and 54.53 percent. Although members of the EU follow the same rules and directives, their current state is not the same for each country, so distinct methods are needed to accomplish Union’s purposes. Therefore, different tax rates are applied which can be seen in Table 2 on page 12. The level of internationalization is also highly different in EU and USA and it can be concluded that companies in EU are expanding abroad more than those in the USA. This can be simply explained by the fact that the USA is a developed country and following Kwock and Reeb (2000), firms going international from more developed to less developed country face a higher level of systematic risk. Not all of the EU members are developed markets, moreover, some of them need to apply different regulations in order to attract more investments from outside. This results in a higher mean value of the level of internationalization in EU – 34.049 as opposed to the USA where it is 12.834.

4. Results.

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15 which does not permit fixed effects model to be performed. The regression related to the second hypothesis is run by a Random effects model since it appears to be the most appropriate one (p-value of the Hausman test is 0.1904). For the third hypothesis where the moderating effect of creditor protection is included, only the EU regression can be estimated since creditor rights index in USA dataset is static over time and over entities and the statistical software indicates a correlation matrix error, because of the correlation between creditor protection and corporate governance. Similarly, to the first hypothesis, the equation for EU was performed and tested via both Redundant and Hausman tests. In this case cross-section fixed effects cannot be applied, so the only period fixed effects were carried out where the p-value of the Redundant fixed effects was highly insignificant, thus this model is also not the most appropriate one. As a next step, a Random effects model was joined and the corresponding Hausman test gave a p-value of 0.0087 which is less than any significance level (1%, 5%, and 10%). Therefore the part of the error, which is a constant with a random disturbance around it, is uncorrelated with the independent variables and this model is also not appropriate. As a final option, the Pooled Ordinary Least Squares (OLS) model is performed, although it is not the best one for analyzing panel data.

4.1 Corporate governance and total risk.

The first hypothesis, named as:

H1a: There is a negative relationship between corporate governance and total risk of EU firms.

H1b: There is a negative relationship between corporate governance and total risk of USA firms.,

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16 and downside risk but this does not stand for the EU (Wang et al. 2015). However only in the USA, the results are significant at 5 percent level, thus we can conclude that the null hypothesis of the model that the coefficient is equal to zero, i.e. there is no relationship, can be rejected and hypothesis 1b of this paper is supported by the data. It is possible to explain the insignificant results of the EU regression with the fewer data and observations. When the quality of corporate governance increases in the USA the level of company’s total risk decreases. Giving a more precise explanation of the results requires the explanatory variables to be also taken into account in the analysis. For example, when looking at tangibility of assets which in turn is highly significant and negative for EU it can be found that the ability of companies to deal with short-term liabilities decreases firm’s total risk. The same statement stands for the USA, too but since it is not significant it will not be reasonable. Firm’s size is highly significant (at 1 percent level) and positive thus it can be stated that it increases the total risk that firm faces. The level of internationalization which, as mentioned earlier, is calculated as foreign to total assets ratio and its coefficient for both datasets different as well as corporate governance’ coefficient. Assuming that firms from the EU tend to go internationally more than these in the USA those results acquire more logical view especially with regards to other researchers who found that going downstream increases the systematic risk (Kwok & Reeb 2000), which in turn will be the case of USA firms going international. Furthermore, the total risk of companies in EU tends to be positive meaning that going international may lead to a rise in the risk that firm faces and to be more precise this increase will be with 23.64 units. Such results should not be taken into final conclusion that internationalization harms companies since there are other factors that have an impact on firm’s performance. According to Pantzalis et al. (2001), foreign exchange risk, as a part of the total risk, is lower in multinationals than in domestic companies. They explain this with the operational flexibility to shift resources through countries and therefore be less exposed to such type of risk.

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17 of risk that companies in EU face. They become more sensitive to fluctuations in tax rates which however cannot be found in the USA where variations in taxes are lower (see table 2 and table 3 in the previous section).

Table 4. Regression on the relationship between corporate governance and total risk of a firm.

Variable: EU USA

Intercept -47300.996*** -20950.26

Corporate Governance Score 3.893 -18.432**

Tangibility of Assets -16293.211*** -1473.732 Firm's size 7771.687*** 1989.893*** Market-to-book ratio 5.676 0.135 Internationalization 23.644** 0.948 Leverage -1622.208 -408.619 GDP per capita -0.057 0.7 GDP -2.044 -1.624 Inflation -66.432 -23.701

Corporate Tax Rate 254.239** 9.354

The table provides the results of the regression equation for the first hypothesis for both EU and USA. The coefficients are next to the corresponding variable. The probability value is represented via ***, **, and * for 1%, 5%, and 10% significance level, respectively. The dependent variable is Total Risk and the independent variable is Corporate Governance Score. The number of observations is 770 for EU and 3387 for the USA.

4.2 Creditor protection and total risk.

The second hypothesis named as:

H2a: There is a negative relationship between creditor protection and total risk in EU firms.

H2b: There is a negative relationship between creditor protection and total risk in USA firms,

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18 found a negative relationship between creditor rights and cash flow risk (Acharya et al. 2011). In the case of this paper, the difference between cash flow risk and total risk should be defined. A cash flow risk is the risk of the inability to meet firm’s obligations. This risk type is just a part of the total risk, which assumes that the same relationship will stand for the second hypothesis. Since total risk consists of a huge variety of risks, these results might be expected.

Similarly to the previous hypothesis, the only other variable that is significant is firm’s size. It is highly significant (at 1 percent level) and positive, meaning that expanding companies face a higher total risk. The other firm-level and country level explanatory variables are insignificant, therefore a statement cannot be made. The reason for those results of not supporting the hypothesis might be explained by the type of data that is collected. As mentioned in the previous section the mean value of CRI is 2.57 in the EU shows a variety of this variable across countries. Although this variety, the relationship is not in line with the theory, suggesting that a deeper examination is needed in further research.

Table 5. Regression on the relationship between creditor protection and total risk of a firm.

Variable: EU USA Intercept -5788.341** - Creditor Protection 675.128* - Tangibility of Assets -1369.999 - Firm's size 1028.952*** - Market-to-book ratio 1.13 - Internationalization 5.332 - Leverage -391.056 - GDP per capita -0.044 - GDP 3.16E-10 - Inflation -101.454 -

Corporate Tax Rate 39.207 -

The table provides the results of the regression equation for the second hypothesis for both EU and USA. The coefficients are next to the corresponding variable. The probability value is represented via ***, **, and * for 1%, 5%, and 10% significance level, respectively. The dependent variable is Total Risk and the independent variable is Creditor Protection. The number of observations is 1770 for EU.

4.3 Creditor protection effect on the relationship between corporate governance and total risk.

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H3a: A higher degree of creditor protection weakens the relationship between corporate

governance and total risk of EU firms.

H3b: A higher degree of creditor protection weakens the relationship between corporate

governance and total risk of USA firms.,

is tested using the pooled OLS model which however assumes that there is no heterogeneity, meaning that for the whole data holds the same relationship which is not in line with the panel data type. However, this is the only way to regress the data including the moderating effect of creditor protection. In this case, as mentioned in the beginning of this section, only hypothesis 3a can be tested. The creditor rights index for this country is equal to 1 for all the entities and years, thus when multiplying it with the corporate governance score the result is the same as the latter. This simply results in analyzing the moderating effect of corporate governance on the relationship between corporate governance and total risk which would be not sufficient.

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Table 6. Regression on the effect of creditor protection on the relationship between corporate governance and total risk of a firm.

Variable: EU USA

Intercept 11718.024 ** -

Corporate Governance Score -13.849 -

Tangibility of Assets 2527.16 - Firm's size -1322.292 ** - Market-to-book ratio 4.49 - Internationalization 18.969 - Leverage -4857.413 *** - GDP per capita -0.103 - GDP 2.10E-10 - Inflation -195.006 -

Corporate Tax Rate 124.185 ** -

Creditor Protection -164.834 -

CP*CG 10.104 -

The table provides the results of the regression equation for the third hypothesis for both EU and USA. The coefficients are next to the corresponding variable. The probability value is represented via ***, **, and * for 1%, 5%, and 10% significance level, respectively. The dependent variable is Total Risk and the independent variable is Corporate Governance Score. The effect of creditor protection on the relationship between corporate governance and total risk is presented as CP*CG. The number of observations is 765 for EU.

5. Conclusion.

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21 The data was focused on companies that operate in both the United States and the European Union since those continents are under a specific legislation and rules about the business behavior and more specifically, about corporate governance (Rockness & Rockness 2005). Only one of the four hypotheses was accepted. The results were significant for Hypothesis 1b, which confirms prior findings in the literature, however for Hypotheses 1a, 2a, and 3a were rejected. It was not possible to test for hypotheses 2b and 3b due to high correlation. Possible explanations for those results might be the lack of data especially for EU, so collecting data for more countries and respectively more companies can be seen as a suggestion for next studies. Therefore the supported hypothesis was in line with the theory which gives evidence that USA-based companies’ risk is liable to changes in the corporate governance practices.

Overall, this thesis succeeded in answering its research question although in the case of USA it was not fully possible. When creditor protection in a certain country increases, the level of total risk of a firm also increases, which is not in line with previous researches. This can serve as a basis for future research taking into account a different sample of countries. Creditor protection does not affect the relationship between corporate governance and total risk, while this relationship is negative. Moreover, the main limitation of this research is the sample selection. It appears to be limited and insufficient to satisfy this thesis’ necessities.

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The Importance of Corporate Governance and Creditor Protection for Total Risk – Evidence from the United States and the European Union

MSc in International Financial Management

Master Thesis