Corporate Governance and Managerial RiskTaking: Theory and Evidence

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Corporate Governance and Managerial Risk-Taking
Theory and Evidence

• Kose John, Lubomir Litov, Bernard Yeung
• Stern School of Business
• New York University
• July 2005

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What is this paper about?

• Large existing literature
• Better investor protection ? lower cost of
  capital, more informed and developed capital
  markets, better capital allocations ? faster
  growth
• Offer an additional angle
• Better investor protection ? investors undertake
  more value enhancing risky investment ? faster
  growth
• An expanded stakeholder perspective, an
  illustrative model, empirical evidence

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Literature

• King and Levine (1993a, b), Beck and Levine
  (2002, JFE), Rajan and Zingales (1998, AER)
• Financial market development boosts growth
• LaPorta, Lopez-de-Silanes, Shleifer and Vishny
  (1997) many others
• Importance of legal origins and investor
  protection as determinants of capital market
  development, higher firm valuation and growth.
• Morck, Yeung, Yu (2000), Durnev, Morck, Yeung
  (2004), Durnev, Li, Morck, Yeung (2004)
• Capital markets can carry out resource allocation
  role better when investors are more informed and
  informativeness stems from secured investor
  property rights.
• Wurlger (2000, JFE)
• Financial markets development accelerates
  re-allocation of capital and thus enhances
  growth.
• Allen and Gale (1997), Acemoglu and Zilibooti
  (1997)
• Capital market development allows diversification
  and thus promote more risk taking in investment
  and growth

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Better investor protection ? more risk taking

• Insider dominance problem
• Poor corporate governance locations ? dominant
  controlling owners (Burkart, Panunzi, and
  Shleifer (2003)
• Dominant controlling owners control a lot of
  corporations via pyramids, cross holding, super
  voting share, appointing trusted allies (family
  members) as executive in pyramidal units (Morck
  Stangeland Yeung (2000)
• Control rights gt Cashflow rights, get personal
  benefits
• Insiders wealth from the groups Cashflow
  rights B (available corporate resources for
  private benefits)
• Insider has a lot invested (cashflow rights),
  this by itself makes insider risk averse in
  directing corporate investment
• B cashflow rights ? even more risk averse
• The problem is worse the worse the investor
  protection (Morck, Wolfenzon, Yeung (JEL)

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• Rely on insider being risk averse because her
  portfolio is not very diversified.
• Insiders can make corporation group very
  diversified
• So, one more argument

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Better investor protection ? more risk taking

• Intuition
• Insiders claim P (to finance their B) before
  allowing investors access to cashflows
• Low investment payoffs in poor state cut into P
• Thus, insiders act like a senior debt claimant
• excessively conservative in investment choices
• Forego even value enhancing risky projects
• Better investor protection lowers P
• Induce insiders to undertake more value enhancing
  risky investment projects, which lead to higher
  firm value and faster growth

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A simple illustrative model to establish the
intuition

• Beginning
• The insider has a claim of a firm
• Without loss of generality, no fixed salaries nor
  debts
• Two investment projects
• t 1
• The insider learns q (only she observes) and
  chooses between the risky and the risk-free
  projects.
• t2
• Project payoff is realized
• The insider appropriates P as perks
• The residual is reported available for
  shareholders
• With probability f, the insider is caught
  stealing

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• The insiders expected utility is
• where
• a cash flow rights of the manager.
• probability of detecting diversion.
• P diversion.
• Y project cash flow.
• g propensity to consume perks.
• Note that makes the insiders utility
  concave

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• Solution procedure
• First solve for the insiders diversion
• Obviously, the higher the f, the lower the
  diversion
• Backward induction, solve for the insiders
  investment choice

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Due to diversion, insider may by-pass risky
investment projects

• P has to be lt investment payoffs
• If P is reduced in the low payoff state, the
  insider wants a high probability for the high
  payoff state to compensate.
• Hence,
• there is a minimally acceptable (prob. for
  the high payoff state), given the managers
  tendency to consume P
• If the manager observes a q lt , the manger
  chooses the riskfree project
• ? The higher the tendency to consume perks, the
  higher is , the more likely the riskfree
  project is chosen.

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By-passed risky projects could be value enhancing

• The concavified insiders utility
• ? gt where the expected value of the risky
  project the value of the risk free payoff
• Given that the NPV of the risky project increases
  with q, some value enhancing investment is
  by-passed
• ? But, the higher the f, the lower the P and thus
  the lower the
• ? the lower the , the higher the expected
  intrinsic value of the firm

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Other reasons better investor protection ? more
risk taking

• Poor investor protection countries rely on bank
  financing, have interventionist government,
  strong labor union (Roe 2003)
• They constrain corporate risk taking (Morck,
  Nakamura (2003), Roe (2003)
• Generally, poor corporate governance, managers
  avoid risk taking for a quiet life

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Better investor protection ? less corporate risk
taking

• Insider control a pyramid
• A dollar inside a unit max(1-t), a
• where c tunneling cost, a cashflow rights
• If t declines sharply as cashflow goes up,
  encourages risk taking (like a regressive tax
  system does)

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Hypotheses

• H1 Better investor protection,less presence of
  interest groups (e.g., bank, government, labor
  union)
• ? higher (or lower) risk-taking at the firm- and
  country- level.
• H2 Higher risk-taking is associated with higher
  firm level growth rate, higher real
  GDP-per-capita TFP growth.

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Empirical Design

• Regressions

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Data

• Compustat Global Vantage Database
• Data spans 1992-2002.
• Use data for 38 countries included.
• Use manufacturing firms (5,452 companies).
• Penn World Tables, 6.1
• Data on total factor productivity growth.
• International Financial Statistics, IMF
• Data on real GDP-per-capita growth.

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Firm level risk-taking variables

• Measuring firm level risk-taking
• define EBITDA as operating income depreciation
  scaled by total assets
• Firm level risk-taking proxy (RISK1)

the standard deviation for each firm the
deviation of its EBITDA/Asset from country
average and net out time invariant firm-specific
factor.
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Governance Variables

• Measures that mitigate stealing
• La Porta et al. (1997)
• Anti-director index.
• Disclosure.
• Rule of Law.

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Interest group variable

• Bank Market Development
• Claims on private sector by deposit banks (Levine
  et al. (2001))
• Interventionist Government
• Country average of the government
  expenditures/GDP 1980-1995.
• Labor force unionization
• Union membership as a percentage of the
  non-agricultural labor force in the International
  Labor Organizations World Labor Report,
  1997-1998

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Control Variables

• Equity Market Development
• Stock Market Capitalization as share in GDP
  (Levine et al. (2001))
• Competition
• Herfindahl index
• Firm Size
• Ln of initial firm size in US constant dollars.
• Earnings Management

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Company Risk-taking Determinants
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Company Risk-taking Growth
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Why switch to country level risk-taking variables

• Regressions based on the firm level Risk1 gives
  more weights to countries with lots of firms
• Average out for each country ? Country
  risk-taking proxy (RISK2)

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Why switch to country level risk-taking variables

• High protection countries have less income
  smoothing.
• The volatility measures can reflect merely a low
  level of income smoothing
• Mechanically, less stealing lower volatility

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Imputed country level risk-taking variables

• Imputed risk-taking score (RISK3)
• for each industry, using US data, to compute
  industry volatility
• value-weighted average of sector volatilities.

The construct is equivalent to computing for
industry j the standard variation based on its
firms EBITDA/Asset in year t minus the US
average in the same year and minus industry
specific time invariant factor.
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Note Slope is the estimate from a quintile
regression.
27
Note Slope is the estimate from a quintile
regression.
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Note Slope is the estimate from a quintile
regression.
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Note Slope is the estimate from a quintile
regression.
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Note Slope is the estimate from a quintile
regression.
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Note Slope is the estimate from a quintile
regression.
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Pairwise Correlations
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Country Risk-taking Determinants
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Growth Variables

• Measuring real GDP-per-capita growth
• Real GDP-per-capita growth
• ?log GDP /(Deflator Population)

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Growth Variables (cont)

• Measuring Total Factor Productivity (TFP)
• Follow King and Levine (1993a,b)
• K19500, roll forward.
• Ic,t is aggregate real investment for country c
  in year t.
• Taken from Penn World Tables, version 6.1,
  1950-2000.
• Depreciation, delta7.
• KK/population.
• Factor Accumulation
• Productivity growth

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Note Slope is the estimate from a quintile
regression.
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Note Slope is the estimate from a quintile
regression.
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Note Slope is the estimate from a quintile
regression.
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Note Slope is the estimate from a quintile
regression.
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Additional controls for growth regressions

• Human Capital
• Average schooling years in population, 1990
  (Barro and Lee (1993))
• Economic Development
• 1991 GDP-per-capita in US constant dollars.

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Country Risk-taking Growth
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Robustness checks

• Clustered regressions instead of random effects
• Results are better
• Global Vantage covers attractive firms
• Biased against finding our results
• Exclude cross-listed firms (firms with ADRs)?
• Results are even better
• Excluding financials and utilities same results

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Robustness checks

• Robustness to use total risk
• Should we use total risks?
• Is macro volatility within insiders control?
• Would they mitigate these volatility at the
  expense of return?
• Use total, same results, albeit slightly less
  significant
• Poor institutions raise macro risks (Acemoglu et
  al. 2003).
• Poor institutions also reduce firm specific risk
  taking
• In the net, there is still a negative
  relationship between the institutional variable
  and total risks

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Conclusion

• Show that poor investor protection (thus dominant
  controlling insiders)
• constrain corporate risk taking
• The low risk-taking is associated with lower
  growth, including productivity growth
• The data do not show any consistent influence of
  non-equity based stakeholders (e.g., bank
  dominance, interventionist government, and
  powerful organized labor) on corporate risk
  taking.