Global Corporate Governance Forum Corporate Governance and Development Stijn Claessens

Foreword by Sir Adrian Cadbury
1 Focus
ABOUT THE AUTHOR
Stijn Claessens is Professor of International Finance at the University of Amsterdam.
He is the Co-Convenor of the Global Corporate Governance Forum's Corporate
Governance Research Network, which promotes research on corporate governance
issues in developing and transition economies. A Dutch national, he holds a Ph.D. in
business economics from the Wharton School of the University of Pennsylvania.
From 1987 to 2001, Stijn Claessens worked in the World Bank, most recently as
Lead Economist, Financial Sector Strategy and Policy Group. His policy and research
interests are in external finance and domestic financial sector issues. He has published
extensively in these areas and is the editor of several books, including International
Financial Contagion (Kluwer 2001) and Resolution of Financial Distress (World Bank
Institute 2001).
Corporate Governance
and Development
Stijn Claessens
Global Corporate Governance Forum
Focus 1
ii Corporate Governance and Development
Copyright 2003.
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CONTENTS
Foreword, by Sir Adrian Cadbury .........................................................................v
Corporate Governance and Development............................................................1
What Is Corporate Governance and Why Is It Receiving More Attention?............4
The Link between Corporate Governance and
Other Foundations of Development ....................................................................8
How Does Corporate Governance Matter for Growth and Development? .........14
Corporate Governance Reform..........................................................................25
Conclusions and Areas for Future Research ......................................................30
Bibliography.......................................................................................................33
Notes ................................................................................................................43
FIGURES
Figure 1. The relationship between the development
of a country’s banking system and per capita growth.........................8
Figure 2. The complementary role of banks and stock
markets with respect to growth ..........................................................9
Figure 3. The relationship between creditor rights and
rule of law and the depth of the financial system ..............................15
Figure 4. The relationship between shareholder rights
and the size of stock markets...........................................................15
Figure 5. The relationship between weak corporate
governance and the cost of capital...................................................16
Figure 6. The relationship between governance and
firm operational performance............................................................17
Figure 7. The relationship between the strength of equity rights and the firms'
rate of return on investment..............................................................18
Figure 8. The relationship between the degree of currency depreciation and
the efficiency of the judicial system.................................................. 20
Figure 9. The relationship between merger and acquisition
activity and the strength of corporate governance............................21
Figure 10. Ownership concentration and institutional development ...................28
Corporate Governance and Development
iv Corporate Governance and Development
Corporate Governance and Development v
FOREWORD
by Sir Adrian Cadbury
It is a privilege to be asked to write a foreword to this study, given the international
importance of the issues with which it deals and the pointers it provides for the
direction which corporate governance policy should take. The key question the
study addresses is the degree of influence which standards of corporate governance
have in promoting the efficient use of scarce resources to the benefit of society as a
whole. Stijn Claessens has carried out a thorough and rigorous review of the available
evidence on the relationship between corporate governance and development.
His review confirms the generally accepted view that there is a positive link at the
level of the firm between good governance and good performance. How widely the
benefits of the value which good governance can add are distributed depends on
the institutional and structural context within which firms carry out their activities.
Corporations work within a governance framework. That framework is set by law,
by regulations, by the corporation’s own constitution, by those who own and fund
them, and by the expectations of those they serve. The framework will differ country
by country, since it owes much to history and culture and it involves both rules
and institutions. Its effectiveness depends on its coherence and on the degree of
reliance which can be placed on its constituent parts. The governance framework
also changes shape and develops through time. Stijn Claessens rightly draws
attention to how little we know about the nature of these changes and how their
direction might be influenced.
Standards of corporate governance are determined by the measures which
companies take for themselves, whether voluntarily or otherwise, to improve the
way they are directed and controlled, and by the legal, financial, and ethical
environment in which they work. However, the actions which corporations take to
improve their internal governance cannot make up for deficiencies in the external
framework, notably if an appropriate and enforceable legal system is lacking. This
provides useful guidance for where the priorities for reform lie, especially as the
study makes the point that poor corporate governance is a particular handicap for
small firms. It is the growth potential of such firms which is crucial to improving the
economic prospects of countries in the course of development.
The review clearly sets out the reasons why corporate governance has moved
higher up the agenda of corporations and countries. Private capital has become
the prime source of funds for investment. Investment is to an increasing extent in
the hands of institutions who act as intermediaries. In that role—a role, incidentally,
which raises issues about their governance and accountability—they place the funds
for which they are responsible wherever in the world they see them earning acceptable
returns. They are looking for a spread of risk and reward and in coming to their judgements
on this, standards of corporate governance have a measurable part to play.
A further reason why corporate governance has become increasingly relevant is that,
with advances in communications technology, detailed information about individual
corporations and about their national governance frameworks is now readily available
on screen and the public scrutiny of business is correspondingly more intense.
The importance of international institutional investors is that they apply the same tests
of security and rate of return wherever in the world they place the funds of those for
whom they are acting. They are, therefore, a force for governance convergence, a
process which has its pluses and minuses. Convergence of this kind raises corporate
governance standards generally, since these investors look for the same levels of board
effectiveness, transparency, accountability, and financial probity wherever in the world
they invest. The downside is that they may thereby overlook opportunities in countries
where their investment could earn both an acceptable return and make a considerable
contribution to that country’s development; in effect, where their investment could be
socially and economically most productive.
As the review points out, only a limited number of countries provide investment funds
of this kind, important though they are in economic terms. Businesses throughout the
world rely more on banks and on internally generated finance than they do on capital
markets. Family businesses are after all the dominant corporate form. Nevertheless,
the same issues arise for banks and for those who have the responsibility for allocating
funds on behalf of others as they do for institutional investors. They have an equal
responsibility for the effectiveness and integrity with which the enterprises they are
financing are being directed and controlled. The upshot is that, whatever their source,
funds will flow to businesses around the world which are seen to meet internationally
accepted standards of corporate governance.
What practical policy lessons can be drawn from this review? First, they suggest
caution over importing governance structures or systems from foreign jurisdictions.
Countries and corporations are best advised to start from where they are and to
build on their existing structures and systems. Convergence is taking place, but it is
convergence on standards of corporate governance, not necessarily on their form.
The OECD identified four principles against which governance practice can be
assessed; they were those of fairness, transparency, accountability, and responsibility.
vi Corporate Governance and Development
These principles are equally relevant whether businesses are privately, publicly, or
state-owned, or are subject to a controlling shareholder.
The objective, therefore, of the agencies with responsibility for the way in which
corporations are governed—whether businesses themselves, the states who
regulate them, or those who provide them with funds—should be to encourage the
firm application of these principles. The more widely the four principles are applied,
the more equitably and effectively will resources be allocated. Transparency and
disclosure are in many ways the key. Provided companies are open about their purposes
and the way in which they go about achieving them, they will earn the trust
of those on whom they depend for their success. Resources will flow to companies
which inspire trust, through their approach to governance and through the integrity
of those who manage them. Responsible governance is the basis on which trust is
established and enterprise encouraged.
Corporate governance is a process, not a state. The field is continually evolving, as
the review explains. Its initial focus was on the way in which individual corporations
are directed and controlled. This led to the introduction of national codes of best
practice. As the wider economic and social significance of corporate governance
became apparent, international guidelines were published to advance its cause
more broadly. These guidelines reflected the part which good governance can play in
promoting economic growth and business integrity. The way ahead lies in ensuring
that the fruits of good governance, its ability to add value, are widely and wisely
shared, thus playing a positive part in the goal of the developed and developing
world to alleviate poverty.
In its broadest sense, corporate governance is concerned with holding the balance
between economic and social goals and between individual and communal goals.
The governance framework is there to encourage the efficient use of resources and
equally to require accountability for the stewardship of those resources. The aim is
to align as nearly as possible the interests of individuals, of corporations, and of
society. The incentive to corporations and to those who own and manage them to
adopt internationally accepted governance standards is that these standards will
assist them to achieve their aims and to attract investment. The incentive for their
adoption by states is that these standards will strengthen their economies and
encourage business probity.
Sir Adrian Cadbury
Corporate Governance and Development vii
viii Corporate Governance and Development
CORPORATE GOVERNANCE AND DEVELOPMENT
Abstract
This paper investigates the relationship between corporate
governance and economic development and well-being. It finds
that better corporate frameworks benefit firms through greater
access to financing, lower cost of capital, better firm performance,
and more favorable treatment of all stakeholders. Numerous
studies agree that these channels operate not only at the level of
the firms, but in sectors and countries as well—although causality
is not always clear. There is also evidence that when a country’s
overall corporate governance and property rights system are
weak, voluntary and market corporate governance mechanisms
have limited effectiveness. Less evidence is available on the direct
links between corporate governance and poverty. There are also
some specific corporate governance issues in various regions and
countries that have not yet been analyzed in detail. In particular,
the special corporate governance issues of banks, family-owned
firms, and state-owned firms are not well understood, nor are the
nature and of determinants of enforcement. Importantly, the
dynamic aspects of corporate governance—that is, how
corporate governance regimes change over time—have only
recently received attention. This paper concludes by identifying some
main policy and research issues that require further study.
Corporate governance, a phrase that not long ago meant little to all but a handful
of scholars and shareholders, has now become a mainstream concern—a staple
of discussion in corporate boardrooms, academic meetings, and policy circles
around the globe. Two events are responsible for the heightened interest in
corporate governance. During the wave of financial crises in 1998 in Russia, Asia,
and Brazil, the behavior of the corporate sector affected entire economies, and
Corporate Governance and Development 1
Presented at the Global Corporate Governance Forum Donors Meeting, held in the
Hague, The Netherlands, March 13, 2003. I would like to thank the participants for
their useful comments. I would also like to thank Florencio Lopez de Silanes for useful
suggestions.
deficiencies in corporate governance endangered the stability of the global financial
system. Just three years later confidence in the corporate sector was sapped by
corporate governance scandals in the United States and Europe that triggered
some of the largest insolvencies in history. In the aftermath, not only has the
phrase corporate governance become nearly a household term, but economists,
the corporate world, and policymakers everywhere began to recognize the
potential macroeconomic consequences of weak corporate governance systems.
The scandals and crises, however, are just manifestations of a number of structural
reasons why corporate governance has become more important for economic
development and well-being (Becht, Bolton, and Röell 2003). The private, marketbased
investment process is now much more important for most economies than
it used to be, and that process is underpinned by better corporate governance.
With the size of firms increasing and the role of financial intermediaries and institutional
investors growing, the mobilization of capital has increasingly become one
step removed from the principal-owner. At the same time, the allocation of capital
has become more complex as investment choices have widened with the opening
up and liberalization of financial and real markets, and as structural reforms,
including price deregulation and increased competition, have increased companies’
exposure to market forces risks. These developments have made the monitoring
of the use of capital more complex in certain ways, enhancing the need for good
corporate governance.
This paper aims to trace the many dimensions through which corporate governance
works in firms and countries. To do so, it reviews the extensive literature on the
subject—and identifies areas where more study is needed. A well-established
body of research has for some time acknowledged the increased importance of
legal foundations, including the quality of the corporate governance framework, for
economic development and well-being. Research has started to address the links
between law and economics, highlighting the role of legal foundations and welldefined
property rights for the functioning of market economies. This literature has
also started to address the importance and impact of corporate governance.1
Some of this material is not easily accessible to the nonacademic. Importantly,
much of it refers to situations in developed countries, in particular the United
States, and less so to developing countries. Furthermore, this literature does not
always have a focus of the relationship between corporate governance and economic
development and well–being. The purpose of this paper is to fill these gaps.
2 Corporate Governance and Development
The paper is structured as follows. It starts with a definition of corporate governance,
as that determines the scope of the issues. It reviews how corporate
governance can and has been defined. It describes why more attention is being
paid to corporate governance in particular, and to protection of private property
rights, more generally. The paper next explores why corporate governance may
matter. It does so by reviewing the general evidence of the effects of property rights
on financial development and growth. It also provides some background on the
ownership patterns around the world that determine and affect the scope and
nature of corporate governance problems. After analyzing what the literature has to
say about the various channels through which corporate governance affects economic
development and well–being, the paper reviews the empirical facts about
some of these relationships. It explores recent research documenting how legal
aspects can affect firm valuation, influence the degree of corporate governance
problems, and more broadly affect firm performance and financial structure. The
paper concludes by identifying some main policy and research issues that require
further study.
Corporate Governance and Development 3
WHAT IS CORPORATE GOVERNANCE AND WHY IS
IT RECEIVING MORE ATTENTION?
What is corporate governance?
Definitions of corporate governance vary widely. They tend to fall into two categories.
The first set of definitions concerns itself with a set of behavioral patterns: that is, the
actual behavior of corporations, in terms of such measures as performance, efficiency,
growth, financial structure, and treatment of shareholders and other stakeholders.
The second set concerns itself with the normative framework: that is, the rules under
which firms are operating—with the rules coming from such sources as the legal
system, the judicial system, financial markets, and factor (labor) markets.
For studies of single countries or firms within a country, the first type of definition is
the most logical choice. It considers such matters as how boards of directors
operate, the role of executive compensation in determining firm performance, the
relationship between labor policies and firm performance, and the role of multiple
shareholders. For comparative studies, the second type of definition is the more
logical one. It investigates how differences in the normative framework affect the
behavioral patterns of firms, investors, and others.
In a comparative review, the question arises how broadly to define the framework
for corporate governance. Under a narrow definition, the focus would be only on
the rules in capital markets governing equity investments in publicly listed firms.
This would include listing requirements, insider dealing arrangements, disclosure
and accounting rules, and protections of minority shareholder rights.
Under a definition more specific to the provision of finance, the focus would be on
how outside investors protect themselves against expropriation by the insiders.
This would include minority right protections and the strength of creditor rights, as
reflected in collateral and bankruptcy laws. It could also include such issues as the
composition and the rights of the executive directors and the ability to pursue
class-action suits. This definition is close to the one advanced by economists
Andrei Shleifer and Robert Vishny in their seminal 1997 review: “Corporate governance
deals with the ways in which suppliers of finance to corporations assure
themselves of getting a return on their investment” (1997, p. 737). This definition
can be expanded to define corporate governance as being concerned with the
4 Corporate Governance and Development
resolution of collective action problems among dispersed investors and the
reconciliation of conflicts of interest between various corporate claimholders.
A somewhat broader definition would be to define corporate governance as a set
of mechanisms through which firms operate when ownership is separated from
management. This is close to the definition used by Sir Adrian Cadbury, head of
the Committee on the Financial Aspects of Corporate Governance in the United
Kingdom: “Corporate governance is the system by which companies are directed
and controlled” (Cadbury Committee, 1992, introduction).
An even broader definition is to define a governance system as “the complex set
of constraints that shape the ex post bargaining over the quasi rents generated by
the firm” (Zingales, 1998, p. 499). This definition focuses on the division of claims
and can be somewhat expanded to define corporate governance as the complex
set of constraints that determine the quasi-rents (profits) generated by the firm in
the course of relationships and shape the ex post bargaining over them. This definition
refers to both the determination of value-added by firms and the allocation
of it among stakeholders that have relationships with the firm. It can be read to
refer to a set of rules, as well as to institutions.
Corresponding to this broad definition, the objective of a good corporate governance
framework would be to maximize the contribution of firms to the overall
economy—that is, including all stakeholders. Under this definition, corporate
governance would include the relationship between shareholders, creditors, and
corporations; between financial markets, institutions, and corporations; and
between employees and corporations. Corporate governance would also encompass
the issue of corporate social responsibility, including such aspects as the dealings
of the firm with respect to culture and the environment.
When analyzing corporate governance in a cross-country perspective, the question
arises whether the framework extends to rules or institutions. Here, two views
have been advanced. One is the view that the framework is determined by rules,
and related to that, to markets and outsiders. This has been considered a view
prevailing in or applying to Anglo-Saxon countries. In much of the rest of the
world, institutions—specifically banks and insiders—are thought to determine the
actual corporate governance framework.
Corporate Governance and Development 5
In reality, both institutions and rules matter, and the distinction, while often used,
can be misleading. Moreover, both institutions and rules evolve over time.
Institutions do not arise in a vacuum and are affected by the rules in the country or
the world. Similarly, laws and rules are affected by the country’s institutional setup.
In the end, both institutions and rules are endogenous to other factors and conditions
in the country. Among these, ownership structures and the role of the state
matter for the evolution of institutions and rules through the political economy
process. Shleifer and Vishny (1997, p. 738) take a dynamic perspective by stating:
“Corporate governance mechanisms are economic and legal institutions that can
be altered through political process.” This dynamic aspect is very relevant in a
cross-country review, but has received much less attention from researchers to date.
When considering both institutions and rules, it is easy to become bewildered by
the scope of institutions and rules that can be thought to matter. An easier way to
ask the question of what corporate governance means is to take the functional
approach. This approach recognizes that financial services come in many forms,
but that if the services are unbundled, most, if not all, key elements are similar
(Bodie and Merton 1995). This line of analysis of the functions—rather than the
specific products provided by financial institutions, and markets—has distinguished
six types of functions: pooling resources and subdividing shares;
transferring resources across time and space; managing risk; generating and
providing information; dealing with incentive problems; and resolving competing
claims on the wealth generated by the corporation. One can define corporate
governance as the range of institutions and policies that are involved in these
functions as they relate to corporations. Both markets and institutions will, for
example, affect the way the corporate governance function of generating and
providing high-quality and transparent information is performed.
Why has corporate governance received more attention lately?
One reason, mentioned earlier, is the proliferation of scandals and crises. As also
mentioned, the scandals and crises are just manifestations of a number of structural
reasons why corporate governance has become more important for economic
development and a more important policy issue in many countries.
First, the private, market-based investment process—underpinned by good
corporate governance—is now much more important for most economies than it
used to be. Privatization has raised corporate governance issues in sectors that
6 Corporate Governance and Development
were previously in the hands of the state. Firms have gone to public markets to
seek capital, and mutual societies and partnerships have converted themselves
into listed corporations.
Second, due to technological progress, liberalization and opening up of financial
markets, trade liberalization, and other structural reforms—notably, price deregulation
and the removal of restrictions on products and ownership—the allocation within
and across countries of capital among competing purposes has become more
complex, as has monitoring of the use of capital. This makes good governance
more important, but also more difficult.
Third, the mobilization of capital is increasingly one step removed from the
principal- owner, given the increasing size of firms and the growing role of financial
intermediaries. The role of institutional investors is growing in many countries, with
many economies moving away from “pay as you go” retirement systems. This
increased delegation of investment has raised the need for good corporate
governance arrangements.
Fourth, programs of deregulation and reform have reshaped the local and global
financial landscape. Long-standing institutional corporate governance arrangements
are being replaced with new institutional arrangements, but in the meantime,
inconsistencies and gaps have emerged.
Fifth, international financial integration has increased, and trade and investment
flows are increasing. This has led to many cross-border issues in corporate
governance. Cross-border investment has been increasing, for example, resulting
in meetings of corporate governance cultures that are at times uneasy.
Corporate Governance and Development 7
THE LINK BETWEEN CORPORATE GOVERNANCE
AND OTHER FOUNDATIONS OF DEVELOPMENT
The research on the role of corporate governance for economic development and
well-being is best understood from the broader perspective of other foundations
for development, notably the importance of finance, the elements of a financial
system, property rights, and competition. Four elements of this broad literature are
worth highlighting.
The link between finance and growth
First, over the past decade, the importance of the financial system for growth and
poverty reduction has been clearly established (Levine 1997; World Bank 2001).
One demonstration is the link between finance and growth. Almost regardless of
how financial development is measured, there is a cross-country association
between it and the level of GDP per capita growth. Numerous pieces of evidence
have been assembled over the past few years to indicate the relation is a causal
one: that is, it is not only the result of better countries having both larger financial
systems and growing faster (although that plays an important role). The relationship
has been established at the level of countries, industrial sectors, and firms and has
consistently survived a rigorous series of econometric probes (as documented in
World Bank 2001).
Figure 1 illustrates this link. It
shows the relationship between
the development of the banking
system (private credit as a
share of GDP) and per capita
growth. A simple relationship is
plotted, as well as one that
controls for some other variables
affecting growth. The size of the
estimated effect is substantial
(and actually larger than would
be predicted by a naïve simple
regression of growth rates on
financial development). A
doubling of the ratio of private
8 Corporate Governance and Development
The development of a country’s private credit
system has a substantial impact on growth.
Figure 1. The relationship between the development of
a country’s banking system and per capita growth
Source: World Bank (2001).
1 2 3 4 5 6
-4
-2
0
2
4
6
8
Model
Naive
Private credit as a percentage of GDP
Average GDP growth, 1960-95
credit (for example, from 19 percent of GDP to the sample average of 38 percent)
is associated with an increase in the average long-term growth rate of almost 2
percentage points.
The link between the development of banking systems and market
finance and growth
Second, and importantly for the analysis of corporate governance, the development
both of banking systems and of market finance helps economic growth. Banks
and securities markets are complementary in their functions, although markets will
naturally play a greater role for listed firms.
Figure 2 makes clear the importance of stock markets. It shows that countries that
had more liquid stock markets in 1960 have grown faster than those that had less
liquid markets from 1976 to 1993.2 For both types of economies, growth per capita
is higher if the banking system is more developed. This shows the complementarity
between the two.
More generally, the findings provide support for the functional view of finance. That
is, it is not financial institutions or financial markets that matter; it is the functions
that they perform that matter. In
particular, for any regression
model of growth that is selected
and adapted by adding various
measures of stock market
development relative to banking
system development, the
results are consistent. None of
these measures of financial
sector structure has any
statistically significant impact on
growth (see Demirgüç-Kunt and
Levine 2001).3 To function well,
financial institutions and financial
markets, in turn, require certain
foundations, including good
governance.
Corporate Governance and Development 9
Countries with more liquid stock markets have
grown faster than those with less liquid
markets.
Figure 2. The complementary role of banks and stock
markets with respect to growth
Source: Demirgüç-Kunt and Levine (1996)
1
2
3
4
Illiquid Liquid
High banking
development
Low banking
development
Initial stock market liquidity
Per capita growth, 1976-93
High banking
development
Low banking
development
The link between legal foundations and growth
Third, the role of legal foundations is now better understood and documented.
Legal foundations matter crucially for a variety of factors that lead to higher
growth, including financial market development, external financing, and the quality
of investment. Legal foundations include property rights that are clearly defined
and enforced and other key regulations (disclosure, accounting, and financial
sector regulation and supervision).
Comparative corporate governance research took off following the works of
economists Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and
Robert Vishny (La Porta and others 1997, 1998). These two pivotal papers
emphasized the importance of law and legal enforcement on the governance of
firms, the development of markets, and economic growth. Following these papers,
numerous studies have documented institutional differences relevant for financial
markets and other aspects.4 These papers have established that the development
of a country’s financial markets relates to these institutional characteristics and
furthermore that institutional characteristics can have direct effects on growth.
Thorsten Beck and colleagues (Beck, Levine, and Loayza 2000), for example,
document how the quality of a country’s legal system not only influences its
financial sector development but also has a separate, additional effect on economic
growth. In a cross-country study at a sectoral level, Stijn Claessens and Luc
Laeven (2003) report that in weaker legal environments, firms not only obtain less
financing but also invest less in intangible assets. Both the less-than-optimal
financing and investment patterns in turn affect the economic growth of a sector.
The role of competition and of output and input markets in
disciplining firms
Fourth, besides financial and capital markets, other factor markets need to function
well to prevent corporate governance problems. These real factor markets include
all output and input markets, including labor, raw materials, intermediate products,
energy, and distribution services. Firms subject to more discipline in the real factor
markets are more likely to adjust their operations and management to maximize
value added. Corporate governance problems are therefore less severe when
competition is already high in real factor markets.
10 Corporate Governance and Development
The importance of competition for good corporate governance is true in financial
markets, as well. The ability of insiders, for example, to mistreat minority shareholders
consistently can depend on the degree of competition and protection. If
small shareholders have little alternative but to invest in low-earning assets, for
example, controlling shareholders may be more able to provide a below-market
return on minority equity. Surprisingly, while well accepted and generally acknowledged
(see Khemani and Leechor 2001), there is little empirical evidence that such a
complementary relationship exists between corporate governance and competition.5
The role of ownership structures and group affiliation
The nature of the corporate governance problems that countries face varies over
time and between countries. One factor of importance is ownership structure, as it
defines the nature of principal-agent issues. Another factor is group-affiliation,
which is especially important in emerging markets. Of course, ownership and
group-affiliation structures can vary over time and can be endogenous to country
circumstances, including legal and other foundations (see Shleifer and Vishny
1997). As such, ownership and group-affiliation structures both affect the legal and
regulatory infrastructure necessary for good corporate governance and are affected
by the existing legal and regulatory infrastructure.
Much of the corporate governance literature has focused on conflicts between
managers and owners. But around the world, except for the United States and to
some degree the United Kingdom, insider-controlled or closely held firms are the
norm (La Porta and others 1998). These can be family-owned firms or firms
controlled by financial institutions. Families like the Peugeots in France, the
Quandts in Germany, and the Agnellis in Italy hold large blocks of shares in even
the largest firms and effectively control them (Barca and Becht 2001; Faccio and
Lang 2002). Wealthy, powerful families dominate the ownership of most corporations
in emerging markets (Claessens, Djankov, and Lang 2000; Lins 2003). In
other countries, such as Japan and to some extent Germany, financial institutions
control large parts of the corporate sector (La Porta and others 1998; Claessens,
Djankov, and Lang 2000; Faccio and Lang 2002). This control is frequently
reinforced through pyramids and webs of shareholdings that allow families or
financial institutions to use ownership of one firm to control many more. Even in
the United States, family-owned firms are not uncommon (Gadhoun, Lang, and
Young 2003; Anderson and Reeb 2003).
Corporate Governance and Development 11
A corporation’s ownership structure affects the nature of the agency problems
between managers and outside shareholders, and among shareholders. When
ownership is diffuse, as is typical for U.S. and UK corporations, agency problems
stem from the conflicts of interests between outside shareholders and managers
who own an insignificant amount of equity in the firm (Jensen and Meckling 1976).
On the other hand, when ownership is concentrated to a degree that one owner
(or a few owners acting in concert) has effective control of the firm, the nature of
the agency problem shifts away from manager-shareholder conflicts. The controlling
owner is often also the manager or can otherwise be assumed to be able and
willing to closely monitor and discipline management. Information asymmetries
can also be assumed to be less, as a controlling owner can invest the resources
necessary to acquire necessary information.
Correspondingly, the principal-agent problems will be less management-versusowner
and more minority-versus-controlling shareholder. In these countries, the
protection of minority rights is more often key. Countries in which insider-held
firms dominate will have different requirements in terms of corporate governance
framework than those where widely held firms dominate.
A related aspect is that many countries have large financial and industrial
conglomerates and groups. In some groups, a bank or another financial institution
lies at the apex of the group, as insurance companies do in Japan (Prowse 1990)
and banks do in Germany (Gorton and Schmidt 2000b). In others, and often in
emerging markets, a financial institution lies within the group.
Such groups can have many benefits for the firm and its investors, such as the
use of internal factor markets, which can be valuable in case of missing or
incomplete external (financial) markets. Particularly in emerging markets, groupaffiliation
can be valuable for firms. Groups or conglomerates can also have costs,
however. They often come with worse transparency and less clear management
structures. This opens up the possibility of worse corporate governance, including
expropriation of minority rights.
The existence of such problems and related corporate governance issues also
depends on the overall competitive structure of the economy and the role of the
state. In more developed, more market-based economies that are also more
12 Corporate Governance and Development
competitive, group affiliation is less common. Again, as with ownership structures,
the line of causality is unclear. The prevalence of groups can undermine the drive
to develop external (financial) markets. Alternatively, poorly developed external
markets increase the benefits of internal markets.
Corporate Governance and Development 13
HOW DOES CORPORATE GOVERNANCE MATTER
FOR GROWTH AND DEVELOPMENT?
The literature has identified several channels through which corporate governance
affects growth and development:
• The first is the increased access to external financing by firms. This in turn can
lead to larger investment, higher growth, and greater employment creation.
• The second channel is a lowering of the cost of capital and associated higher
firm valuation. This makes more investments attractive to investors, also leading
to growth and more employment.
• The third channel is better operational performance through better allocation of
resources and better management. This creates wealth more generally.
• Fourth, good corporate governance can be associated with a reduced risk of
financial crises. This is particularly important, as financial crises can have large
economic and social costs.
• Fifth, good corporate governance can mean generally better relationships with
all stakeholders. This helps improve social and labor relationships and aspects
such as environmental protection.
All these channels matter for growth, employment, poverty, and well-being more
generally. Empirical evidence using various techniques has documented these
relationships at the level of the country, the sector, and the individual firm and from
the investor perspectives.6 A review follows.
Increased access to financing
As mentioned, financial and capital markets are better developed in countries
with strong protection of property rights, as demonstrated by the law and finance
literature. In particular, better creditor rights and shareholder rights have been
shown to be associated with deeper and more developed banking and capital
markets. Figure 3 depicts the relationship between an index of creditor rights
(adjusted for the extent to which the rule of law is being enforced in the country)
and the depth of the financial system (as measured by the ratio of private credit to
GDP).7 The figure shows that the better creditor rights are defined and enforced,
the more willing lenders are to extend financing.
14 Corporate Governance and Development
A similar relationship exists
between the quality of shareholder
protection and the
development of countries’ capital
markets. Figure 4 depicts
the relationship between an
index of shareholder rights (the
index of La Porta and others
1997, again adjusted for the
efficiency of the judicial system)
and the size of the stock
markets (as a ratio of GDP).8
The figure shows a strong
relationship, with the market
capitalization almost
quadrupling between the
lowest quartile country and
the highest quartile country. As for the comparison between creditor rights and
the development of private credit, this comparison does not correct for other
factors that affect financial sector development, such as inflation and macroeconomic
performance. Yet almost all studies find that these results are robust to
including a wide variety of control variables in the analysis (see Levine 2004).
In countries with better property
rights, firms thus have greater
access to financing. As a
consequence, firms can be
expected to invest more and
grow faster. The effects of
better property rights leading
to greater access to financing
on growth can be large. For
example, countries in the third
quartile of financial development
enjoy between 1 and 1.5 extra
percentage points of GDP
growth per year, compared with
countries in the first quartile.
Corporate Governance and Development 15
The better the quality of shareholder
protection, the larger the country's stock
markets.
Figure 4. The relationship between shareholder rights
and the size of stock markets
Source: La Porta and others (1997).
The stronger the creditor rights, the greater the
depth of the financial system.
Figure 3. The relationship between creditor rights and
rule of law and the depth of the financial system
Source: La Porta and others (1997).
0.2
0.4
0.6
0.8
1.0
1 2 3 4
Lowest to highest quartile
Ratio of private credit to GDP
0.1
0.2
0.3
0.4
0.5
0.6
0.7
1 2 3 4
Lowest to highest quartile
Ratio of stock market
capitalization to GDP
Figure
There is also evidence that under conditions of poor corporate governance (and
underdeveloped financial and legal systems and higher corruption), the growth rate
of the smallest firms is the most adversely affected, and fewer new firms start
up—particularly small firms (Beck, Demirgüç-Kunt, and Maksimovic 2002; Rajan
and Zingales 1998).
Higher firm valuation
The quality of the corporate governance framework affects not only the access to and
amount of external financing, but also the cost of capital and firm valuation. Outsiders
are less willing to provide financing and are more likely to charge higher rates if they
are less assured that they will get an adequate rate of return. Conflicts between
small and large controlling shareholders are greater in weaker corporate governance
settings, implying that smaller investors are receiving lower rates of return.
There is clear empirical evidence for these effects. The cost of capital has been
shown to be higher and valuation lower in weaker property rights countries (La
Porta and others 2000). Investors also seem to apply a discount in their valuation
for firms and countries with relatively worse corporate governance (McKinsey and
Company 2002). Furthermore, in countries with weaker property rights, controlling
shareholders also obtain a fraction of the value of the firm that exceeds their direct
ownership stake, at the expense of minority shareholders.
Figure 5 depicts this using the
prices paid in a number of
actual transactions for a
block of shares that implies
transferring control over the
firm relative to the price of
normal shares, plotted against
the equity rights index. The
higher cost of capital, and the
corresponding lower firm
valuation, translates into
economic costs for lower
corporate governance countries,
as less attractive investments
are bypassed.9
16 Corporate Governance and Development
Weak corporate governance translates into
higher costs of capital.
0.05
0.10
0.15
0.20
0.25
0.30
0.35
1 2 3 4 5 6
Excess of control price
over non-control price
Equity rights index
Figure 5. The relationship between weak corporate
governance and the cost of capital
Source: Dyck and Zingales (forthcoming).
Better operational performance
In the end, the way better corporate governance can add value is by improving
the performance of firms, whether through more efficient management, better
asset allocation, better labor policies, and similar efficiency improvements.
Evidence for the United States (Gompers, Ishii, and Metrick 2003), Korea (Joh
2003), and elsewhere strongly suggests that at the firm level, better corporate
governance leads not only to improved rates of return on equity and higher valuation,
but also to higher profits and sales growth. This evidence is maintained when
controlling for the fact that “better” firms may adopt better corporate governance
and perform better due to other reasons. These and other firm-specific tests can
nevertheless be criticized as suffering from homogeneity (see further, Himmelberg
2002). Across countries, there is also evidence that operational performance is
higher in better corporate governance countries, although the evidence is less strong.
Figure 6 depicts the accounting rates of assets for a sample of publicly listed firms
using data from Worldscope, plotted against the equity rights index. It shows a
much less strong relationship between a measure of the quality of the governance
framework and firm performance than for the relationship between the quality of
the governance framework and access to financing and valuation. Other factors
evidently affect operational performance to mute this relationship. As noted, many
institutions and factors influence
a firm’s management and
performance. Firms in developing
countries may face better
growth opportunities, thus
reporting higher profits,
although they may have worse
corporate governance. There
may also be a reporting bias.
Firms in worse corporate
governance environments
may more likely overstate their
accounting profits.
The limited relationship between
operational performance and
corporate governance measures
at the country level may also
Corporate Governance and Development 17
Better corporate governance translates into
somewhat higher returns on assets.
Figure 6. The relationship between governance and firm
operational performance
Note: Data on returns are from Claessens and others 2000 and cover
the 1996–99 period. The index on equity rights is from La Porta and
others 1998. The figure excludes Mexico and Venezuela, where rates of
return were heavily influenced by inflation and/or currency movements.
Source: Claessens and others (2000); La Porta and others (1998).
1
2
3
4
5
6
7
8
1 2 3 4 5 6
Rates of
return on assets
Equity rights index
reflect the fact that corporate governance in most countries does not concern
a conflict between management and owners, leading to inefficient firm operation
and low rates on assets. Rather, as most firms are closely held or controlled
by insiders, corporate governance concerns conflicts between controlling
shareholders and minority shareholders, leading to lower valuation and
reduced access to external financing.
This interpretation is supported by a comparison of the rate of return on investment
relative to the cost of capital for different strengths of corporate governance
framework. Figure 7 depicts firms’ rate of return on investment for a sample of
some 19,000 publicly listed firms from a variety of countries, plotted against a
strength-of-equity-rights index. It shows that firms in many countries do not earn
the cost of capital required by shareholders; only in the best corporate governance
countries does the rate of return on investment exceed the cost of capital. The
relationship derives, however, largely from the higher cost of capital—that is, the
lower valuation of firms in weak corporate governance countries.
Reduced risk of financial crises
The quality of corporate governance can also affect firms’ behavior in times of
economic shocks and actually contribute to the occurrence of financial distress,
with economywide impacts.
During the East Asian financial
crisis, cumulative stock returns
of firms in which managers had
high levels of control rights, but
little direct ownership, were 10
to 20 percentage points lower
than those of other firms
(Lemmon and Lins 2003).
This shows that corporate
governance can play an
important role in determining
individual firms’ behavior, in
particular the incentives of
insiders to expropriate minority
shareholders during times of
distress. Similarly, a study of the
18 Corporate Governance and Development
Greater equity rights translate into higher
returns on investment relative to the cost of
capital.
Figure 7. The relationship between the strength of
equity rights and the firm’s rate of return on investment
Note: The data on returns come from Gugler, Mueller, and Yurtoglu
(2003), who in turn use data from Worldscope. The figure depicts
the marginal rates of return on new investment adjusted for the
cost of capital calculated using the Tobin's Q model. The index on
equity rights is again from La Porta and others (1998).
Source: Gugler, Mueller, and Yurtoglu (2003); La Porta and others
(1998).
0.2
0.4
0.6
0.8
1.0
1.2
1 2 3 4 5 6
Rates of return on assets
relative to cost of capital
Equity rights index
stock performance of listed companies from Indonesia, Korea, Malaysia, the
Philippines, and Thailand found that performance is better in firms with higher
accounting disclosure quality (proxied by the use of Big Six auditors) and higher
outside ownership concentration (Mitton 2002). This provides firm-level evidence
consistent with the view that corporate governance helps explain firm performance
during a financial crisis.
Related work shows that hedging by firms is less common in countries with weak
corporate governance frameworks (Lel 2003), and to the extent that it happens, it
adds very little value (Alayannis, Lel, and Miller 2003). The latter evidence suggests
that in these environments, hedging is not necessarily for the benefit of outsiders,
but more for the insiders. There is also evidence that stock returns in emerging
markets tend to be more positively skewed than in industrial countries (Bae, Lim,
and Wei 2003). This can be attributed to managers having more discretion in
emerging markets to withhold bad information, or that firms share risks in these
markets among each other, rather than through financial markets.
There is also country-level evidence that weak legal institutions for corporate
governance were key factors in exacerbating the stock market declines during
the 1997 East Asian financial crisis (Johnson and others 2000). In countries with
weaker investor protection, net capital inflows were more sensitive to negative
events that adversely affect investors’ confidence. In such countries, the risk of
expropriation increases during bad times, as the expected return of investment is
lower, and the country is therefore more likely to witness collapses in currency and
stock prices.
Figure 8 depicts a relationship between the efficiency of the judicial system
and currency depreciation between the end of 1996 and the beginning of 1999.
It shows that countries with less efficient judicial systems, which often also have
weaker corporate governance systems, experienced much higher currency
depreciation during the East Asian and global financial crises.10 More generally,
a well-functioning financial and legal system can help reduce financial volatility.
The view that poor corporate governance of individual firms can have economywide
effects is not limited to developing countries. Recently, the argument has
been made that in industrial countries corporate collapses (like Enron), undue
profit boosting (by Worldcom), managerial corporate looting (by Tyco), audit fraud
(by Arthur Andersen), and inflated reports of stock performance (by supposedly
independent investment analysts) have led to crises of confidence among
Corporate Governance and Development 19
investors, leading to the
declines in stock market valuation
and other economywide
effects, including some slowdowns
in economic growth.
While this is anecdotal evidence,
and weaker corporate
governance has not triggered
financial crises in these countries,
it is clear that corporate
governance deficiencies have
started to carry a discount,
either specific to particular firms
or for markets as whole, even in
developed countries. As such,
poor corporate governance
practices can pose a negative
externality on the economy as a
whole for any country.
More generally, poor corporate governance can affect the functioning of a
country’s financial markets. One channel is that poor corporate governance can
increase financial volatility. When information is poorly protected—due to a lack of
transparency and insiders having an edge on firms’ doing and prospects—
investors and analysts may have neither the ability to analyze firms (because it is
very costly to collect information) nor the incentive (because insiders benefit
regardless). In such a weak property rights environment, inside investors with private
information, including analysts, may, for example, trade on information before
it is disclosed to the public. There is evidence that the worse transparency associated
with weaker corporate governance leads to more synchronous stock price
movements, limiting the price discovery role of the stock markets (Morck, Young,
and Yu 2000). A study of stock prices within a common trading mechanism and
currency (the Hong Kong stock exchange) found that stocks from environments
with less investor protection (China-based) trade at higher bid-ask spreads and
exhibit thinner depths than more protected stocks (Hong Kong-based) (Brockman
and Chung 2003). Evidence for Canada suggests that ownership structures indicating
potential corporate governance problems also affect the size of the bid-ask
spreads (Attig, Gadhoum, and Lang 2003).
20 Corporate Governance and Development
Currency depreciation can be much higher in
weak corporate governance countries.
Figure 8. The relationship between the degree of
currency depreciation and the efficiency of the judicial
system
Note: The degree of currency depreciation is relative to the U.S.
dollar and refers to the percentage depreciation between
December 3, 1996, and January 31, 1999. It is depicted against an
index of the efficiency of the judicial systems as reported by La
Porta and others (1998).
Source: Johnson and others (2000).
2 4 6 8 10 12
0.2
0.4
0.6
0.8
1.0
1.2
Efficiency of the judicial system
Currency depreciation
much
governance
Figure 9. The Relationsh
and Acquisition
Strength
Another area where corporate governance affects firms and their valuation is
mergers and acquisitions (M&A). During the 1990s, the volume of M&A activity and
the premium paid were significantly larger in countries with better investor protection
(Rossi and Volpin 2003). This indicates that an active market for mergers and
acquisitions—an important component of a corporate governance regime—arises
only in countries with better investor protection (figure 9). The analysis also shows
that in cross-border deals, the acquirers are typically from countries with better
investor protection than the targets. This suggests that cross-border transactions
play a governance role by improving the degree of investor protection within target
firms. It further suggests that cross-border transactions aid in the convergence of
corporate governance systems.
Better relations with other
stakeholders
Besides the principal owner
and management, public and
private corporations must deal
with many other stakeholders,
including banks, bondholders,
labor, and local and national
governments. Each of these
monitor, discipline, motivate,
and affect the management
and the firm in various ways.
They do so in exchange for
some control and cash flow
rights, which relate to each
stakeholders’ own comparative
advantage, legal forms of
influence, and form of contracts.
Commercial banks, for example,
have a greater amount of inside
knowledge, as they typically
have a continued relationship
with the firm.
Corporate Governance and Development 21
The M&A market is more active in stronger
corporate governance countries, but crossborder
M&A can help improve governance.
Figure 9. The relationship between merger and
acquisition activity and the strength of corporate
governance
Note: The chart depicts data on international mergers and acquisitions
used in the paper by Rossi and Volpin (2003), sorted by the
level of equity rights protection of La Porta and others (1998). M&A
activity is the percentage of traded companies targeted in a completed
deal. Hostile takeovers are the number of attempted hostile
takeovers as a percentage of domestic traded firms. Cross-border
ratio is the number of cross-border deals as a percentage of all
completed deals. Source is SDC Platinum, provided by Thompson
Financial Securities Data, and the World Development Indicators.
The measure of the effective rights of minority shareholders is computed
as the product of Rule of Law and Antidirector Rights divided
by 10.
Source: Rossi and Volpin (2003); La Porta and others (1998).
10
20
30
40
50
60
1 2 3 4
Percentage
Lowest to highest quartile
M&A activity (%)
Hostile takeovers (%)
Cross-border ratio (%)
Relationship between Merger
Acquisition Activity and the
Strength of Corporate Governance
Formal influence of commercial banks may derive from the covenants banks
impose on the firm: for example, in terms of dividend policies, or requirements for
approval of large investments, mergers and acquisitions, and other large undertakings.
Bondholders may also have such covenants or even specific collateral.
Furthermore, lenders have legal rights of a state-contingent nature. In case of
financial distress, they acquire control rights and even ownership rights in case of
bankruptcy, as defined by the country’s laws.11 Debt and debt structure can be
important disciplining factors, as they can limit free cash flow and thereby reduce
private benefits. Trade finance can have a special role, as it will be a short-maturity
claim, with perhaps some specific collateral. Suppliers can have particular insights
into the operation of the firm, as they are more aware of the economic and financial
prospects of the industry.
Labor has a number of rights and claims. As with other input factors, there is an
outside market for employees, thus putting pressure on firms to provide not only
financially attractive opportunities, but also socially attractive ones. Labor laws
define many of the relationships between corporations and labor, which may have
some corporate governance aspects. Rights of employees in firm affairs can be
formally defined, as is the case in Germany, France, and the Netherlands where in
larger companies it is mandatory for labor to have some seats on the board (the
co-determination model).12 Employees of course voice their opinion on firm
management more generally. And then there is a market for senior management,
where poorly performing CEOs and other senior managers get fired, that exerts
some discipline on poor performance.
Stakeholder management. Two forms of behavior can be distinguished in corporate
governance issues related to other stakeholders: stakeholder management and
social issue participation. For the first category, the firm has no choice but to
behave “responsibly” to stakeholders: they are input factors without which the firm
cannot operate; and these stakeholders face alternative opportunities if the firm
does not treat them well (typically, for example, labor can work elsewhere). Acting
responsibly toward each of these stakeholders is thus necessary. Acting responsibly
is also most likely to be beneficial to the firm, financially and otherwise.
Acting responsibly might in turn also be beneficial for the firm’s shareholders and
other stakeholders. A firm with a good relationship with its workers, for example,
will probably find it easier to attract external financing. Collectively, a high degree of
corporate responsibility can ensure good relationships with all the firm’s stakeholders
22 Corporate Governance and Development
and thereby improve the firm’s overall financial performance. Of course, the effects
depend importantly on information and reputation because knowing which firms
are more responsible to stakeholders will not always be easy.
Social issue participation. Whether participation in social issues is also related to
good firm performance is less clear. Involvement in some social issues carries
costs. These can be direct, as when expenditures for charitable donations or
environmental protection increase, and so lower profits. Costs can also be indirect,
as when the firm becomes less flexible and operates at lower efficiency.
As such, socially responsible behavior could be considered “bad” corporate
governance, as it negatively affects performance. (Of course, it can also be the
case that government regulations require certain behavior, such as safeguarding
the environment, such that the firm has no choice—although the country does.)
The general argument has been that these forms of social corporate responsibility
can still pay: that is, they can be good business for all and go hand in hand with
good corporate governance. So while there may be less direct business reasons
to respect the environment or donate to social charity, for example, such actions
can still create positive externalities in the form of better relationships with other
stakeholders.
So far, there have been few empirical studies to document these effects. The
general findings are of mixed evidence or no relationship between corporate social
responsibility and financial performance. The willingness, for example, of many
firms to adopt high international standards, such as ISO 9000, that clearly go
beyond the narrow interest of production and sales, suggests that there is
empirical support for positive effects at the firm level.
At the country level, clearly, more developed countries tend to have both better
corporate governance and rules requiring more socially responsible behavior of
corporations. There is also some evidence, however, that government-forced
forms of stakeholdership may be less advantageous financially. In the case of
Germany, one study found that workers’ co-determination reduced market-to-book
values and return on equity (Gordon and Schmidt 2000a).
Corporate Governance and Development 23
As with many other corporate governance studies, the problem is in part the
endogeneity of the relationships. At the firm level, does good corporate performance
beget better social corporate responsibility, as the firm can afford it? Or does
better social corporate responsibility lead to better performance? The firms that
adopt ISO standards, for example, might well be the better performing firms even
if they had not adopted such standards. At the country level, a higher level of
development may well allow and create pressures for better social responsibility,
while at the same time improving corporate governance.
24 Corporate Governance and Development
CORPORATE GOVERNANCE REFORM
The analysis so far suggests that better corporate governance generally pays for
firms, markets, and countries. The question then arises why firms, markets, and
countries do not adjust and adopt voluntarily better corporate governance measures.
The answer is that firms, markets, and countries do adjust to some extent, but
that these steps fail to provide the full impact, work only imperfectly, and involve
considerable costs. The main reasons for lack of sufficient reform are entrenched
owners and managers at the level of firms and political economy factors at the
level of markets and countries. Both issues are considered below.
The role of entrenched owners and managers
Evidence shows that firms adapt to weaker environments by adopting voluntary
corporate governance measures. A firm may adjust its ownership structure, for
example, by having more secondary, large blockholders, which can serve as effective
monitors of the primary controlling shareholders. This may convince minority
shareholders of the firm’s willingness to respect their rights. Or a firm may adjust
its dividend behavior if it has difficulty convincing shareholders that it will reinvest
properly and for their benefit. These voluntary mechanisms can include hiring more
reputable auditors. Since auditors have some reputation at stake as well, they may
agree to conduct an audit only if the firm itself is making sufficient efforts to
enhance its own corporate governance. The more reputable the auditor, the more
the firm needs to adjust its own corporate governance. A firm can also issue
capital abroad or list abroad, thereby subjecting itself to higher level of corporate
governance and disclosure.
Empirical evidence shows that these mechanisms can add value and are appreciated
by investors in a variety of countries. A study of a sample of U.S. firms found
that the more firms adopt voluntary corporate governance mechanisms, the higher
their valuation and the lower their cost of capital (Gompers, Ishii, and Metrick
2003). Similar evidence exists for Korea (Black, Jang, and Kim 2002), Russia
(Black 2001), and the top 300 European firms (Bauer and Guenster 2003).13
Gompers, Ishii, and Metrick (2003) also report that these firms have higher
profitability and sales growth, and lower their capital expenditures and acquisitions
to levels that are presumably more efficient.
Corporate Governance and Development 25
There is also evidence that the voluntary corporate governance adopted by firms
matter more in weak corporate governance environments. Two studies compared
indexes of firm-specific corporate governance measures with countries’ corporate
governance indexes to analyze the effects on firm valuation and firm performance
(Klapper and Love 2002; Durnev and Kim 2002). They found that firm-level corporate
governance matters more to firm value in countries with weaker investor
protection. Markets can adapt as well, partly in response to competition, as listing
and trading migrate to competing exchanges, for example. While there can be
races to the bottom, with firms and markets seeking lower standards, markets can
and will set their own, higher corporate governance standards. One example is the
Novo Mercado in Brazil, which has different levels of corporate governance standards,
all higher than the main stock exchange. Firms can choose the level they
want, and the system is backed by private arbitration measures to settle corporate
governance disputes. Efforts like these can help corporations improve corporate
governance at low(er) costs as they can list locally.
There is evidence, however, that these alternative corporate governance mechanisms,
apart from being costly, have their limits. In a context of weak institutions and poor
property rights, firm measures cannot and do not fully compensate for deficiencies.
The work of Klapper and Love (2002) and Durnev and Kim (2002) shows that
voluntary corporate governance adopted by firms only partially compensates for
weak corporate governance environments.
There are also elements of self-selection, with worse firms choosing to list in worse
environments. Competition between stock exchanges takes many forms, including
not only listing standards, but also the direct cost of trading. This suggests that
firms consider several dimensions in selecting where to list. One study, for example,
has argued that family-owned firms prefer to choose to list in weak corporate
governance environments (with perhaps higher trading costs). These markets
would have little incentives to improve their corporate governance standards.
By contrast, (large) firms with diversified ownership structures prefer to list in
international markets (Coffee 1999 and 2001). Nevertheless, there are many other
reasons why firms do not adjust their corporate governance or list in the environment
optimal from a cost of capital point of view, including entrenched owners.
26 Corporate Governance and Development
The role of political economy factors
Importantly, countries do not always reform their corporate governance frameworks
to achieve the best possible outcomes. In some sense, this is shown by the
pervasive importance of the origin of the legal system in a particular country in
many analyses and dimensions. Whether a country started with or acquired as a
result of colonization a certain legal system some century or more ago still has
systematic impact on the features of its legal system today, the performance of its
judicial system, the regulation of labor markets, entry by new firms, the development
of its financial sector, state ownership, and other important characteristics
(Djankov and others 2003). Evidently, countries do not adjust that easily and move
to some better standards to fit their own circumstances and meet their own needs.
Partly this is because reforms are multifaceted and require a mixture of legal,
regulatory, and market measures, making for difficult and slow progress. Efforts
may have to be coordinated among many constituents, including foreign parties.
Legal and regulatory changes must take into account enforcement capacity, often
a binding constraint. While markets face competition and can adapt themselves,
they must operate within the limits given by a country’s legal framework. The Nova
Mercado in Brazil is a notable exception where the local market has attempted to
improve corporate governance standards using voluntary mechanisms. But it
needs to rely on mechanisms such as arbitration to settle corporate governance
disputes as an alternative to the poorly functioning judicial system in Brazil.
Experiments with self-regulation in corporate governance, as in the Netherlands,
have often not been successful.14 The ability of corporations to borrow the
framework from other jurisdictions by listing or raising capital abroad, or even
incorporating, is limited to the extent that some local enforcement of rules is
needed, particularly concerning minority rights protection (see Seigel 2002 for the
case of Mexico).
Corporate governance reforms involve changes in control and power structures.
As such, corporate governance reforms can depend on ownership structures. In
parts of East Asia, for instance, where considerable corporate sector wealth is
held by a small number of families, the degree to which corporate governance
standards have been enhanced has been negatively correlated with the share of
corporate sector wealth held by those families (Claessens, Djankov, and Lang 1999).
Corporate Governance and Development 27
Figure 10 compares ownership concentration and institutional development across
a sample of East Asian countries. Causality is unclear, as weak corporate governance
standards could have led to more concentrated corporate sector wealth.
Conversely, a higher concentration of wealth could have impeded improvements in
corporate governance. For example, in Indonesia, there are direct relationships
between the government and the corporate sector. The sample is too small to
make any statistical inference. Nevertheless, it does suggest that wealth structures
may need to change in order to bring about significant corporate governance
reform. This can happen through legal changes (over time), and also as a result of
direct interventions (such as privatizations and nationalizations, as during financial
crises). Reforms can also be impeded by a lack of understanding. Partly this will
be linked to political economy factors, perhaps directly related to ownership
structures, as when the media is tightly controlled.
To date, the relationships between institutional features and countries’ more
permanent characteristics, including culture, history, and physical endowments,
have not been widely researched. Institutional characteristics (such as the risk of
expropriation of private property) can be long-lasting and relate to a country’s
physical endowments (Acemoglu and others 2003 show this for a cross-section of
countries). Both the origin of its legal systems and a country’s initial endowments
are important determinants of the degree of private property rights protection (Beck,
Demirgüç-Kunt, and Levine 2003). The role of culture and openness in finance,
including in corporate governance, is also important (Stulz and Williamson 2003).
More generally, the dynamic
aspects of corporate governance
reform are not yet well understood.
The underlying political
economy factors that may drive
changes in the legal frameworks
over time is the subject of a study
by Raghuram Rajan and Luigi
Zingales (2003a). They highlight
the fact that many European
countries had more developed
capital markets in the early
twentieth century (in 1913)
than for a long period after
the Second World War.
28 Corporate Governance and Development
Countries with higher concentrations of wealth
show less progress in institutional reform.
Figure 10. Ownership concentration and institutional
development
Source: Claessens, Djankov, and Lang (1999).
10 20 30 40 50 60 70 80
2
4
6
8
10
Judicial efficiency
Rule of law
Absence of corruption
Rating
(10 is the best 0 is the worst)
Japan
Taiwan
Malaysia
Singapore
Hong Kong
Korea
Philippines
Thailand
Indonesia
Ownership by top 15 families (%)
Importantly, many of these countries’ capital markets in 1913 were more developed
than the U.S. market at that time. A review of ownership structures at the
end of the nineteenth century in the United Kingdom (Franks, Mayer, and Rosi
2003) shows that most UK firms had widely dispersed ownership before they were
floated on the stock exchanges. And in 1940 in Italy, the ownership structures
were more diffused than in the 1980s (Aganin and Volpin 2003). These three
studies cast doubt on the view that stock market development and ownership
concentration are monotonically related (positively and negatively, respectively) to
investor protection.
These papers identify the issue but do not clarify the channels through which institutional
features alter financial markets and corporate governance over time, and
how institutional features change. As such, these papers represent the beginning
of a research agenda (see also Rajan and Zingales 2003b). A more general review
of the “new comparative economics” literature can be found in Djankov and others
(2003), which also highlights the many unknown areas.
Corporate Governance and Development 29
CONCLUSIONS AND AREAS FOR FUTURE
RESEARCH
At the level of the firm, the importance of corporate governance for access to
financing, cost of capital, valuation, and performance has been documented in a
number of countries. Better corporate governance leads to higher returns on equity
and greater efficiency. Across countries, the important role of institutions aimed at
contractual and legal enforcement, including corporate governance, has been
underscored by the law and finance literature. At the country level, various papers
have documented a number of differences in institutional features. Across countries,
the relationships between institutional features and development of financial
markets, relative corporate sector valuations, efficiency of investment allocation,
and economic growth have been shown. Using firm-level data, relationships have
been documented between countries’ corporate governance frameworks, on the
one hand, and performance, valuation, cost of capital, and access to external
financing, on the other.
While the general importance of corporate governance has been established,
knowledge on specific issues or channels is still weak in a number of areas. These
include the following:
• The corporate governance of banks. This has been identified to be different than
that of corporations, but in which ways is not yet clear—besides the important
role of prudential regulations, given the special nature of banks. Clarifying this
topic will be key, as banks are important providers of external financing,
especially for small and medium-size firms. Separately, in many countries banks
have important corporate governance roles, as they are direct investors themselves
or act as agents for other investors. And creditors, including banks, can
see their credit claim change into an ownership stake, as when a firm runs into
bankruptcy or financial distress.
• The role of institutional investors. Institutional investors are increasing throughout
the world, and their role in corporate governance of firms is consequently
becoming more important. But the role of institutional investors in corporate
governance is not obvious. In many countries, institutional investors have
purposely been assigned little role in corporate governance, as more activism
was considered to risk the company’s fiduciary obligations. Furthermore, the
governance of the institutional investors themselves is an issue, as they will not
30 Corporate Governance and Development
exercise good corporate governance without being governed properly themselves.
Moreover, the form through which more activism of institutional investors can be
achieved is not clear. For example, institutional investors typically hold small
stakes in any individual firm. Some form of coordination is thus necessary, on the
one hand. On the other hand, too much coordination can be harmful, as the financial
institutions start to collude and political economy factors start playing a role.
• Enforcement. How can enforcement be improved in weak environments? How
can a better enforcement environment be engineered? More generally, what
factors determine the degree to which the private sector can solve enforcement
problems on it own, and what determines the need for public sector involvement
in enforcement?
• State-owned firms. What is the role of commercialization in state-owned
enterprises? Are there special corporate governance issues in cooperatively
owned firms? How do privatization and corporate governance frameworks
interact? Are there specific forms of privatization that are more attractive in weak
corporate governance settings? What are the dynamic relationships between
corporate governance changes and changes in degree of state-ownership of
commercial enterprises?
• Family-owned firms. Such firms predominate in many sectors and economies.
They raise a separate set of issues, related to liquidity, growth, and transition to
a more widely held corporation, but also related to internal management, such
as intrafamilial disagreements, disputes about succession, and exploitation of
family members. Where family-owned firms dominate, as in many emerging
markets, they raise systemwide corporate governance issues.
• Best practice in relation to other stakeholders. Little empirical research has
been conducted on the relationships between corporate governance and social
corporate responsibility. To the extent there is research, it refers to firms in
developed countries.
• The impact on poverty alleviation. There are few studies on the direct relationship
between better corporate governance and greater poverty alleviation. While the
general importance of property rights for poverty alleviation has been established
(De Soto 1989; North 1990), the specific channels through which improved
Corporate Governance and Development 31
corporate governance can help the poor have so far not been documented.
This is in part because much of the corporate governance research has been
directed to the listed firms. However, much of the job creation in developing
countries and emerging markets comes from small and medium-size enterprises.
Different corporate governance issues arise for these firms. These require different
approaches, which so far have not been researched very much.
• The dynamic aspects of institutional change. Finally, little is known about the
dynamic aspects of institutional change, whether change occurs in a more
evolutionary way during normal times or more abruptly during times of financial
or political crises.
In this context, it is important to realize that enhancing corporate governance will
remain very much a local effort. Country-specific circumstances and institutional
features mean that global findings do not necessarily apply directly to each and
every country and situation. Local data need to be used to make a convincing
case for change. Local capacity is needed to identify the relevant issues and make
use of political opportunities for legal, and regulatory reform. As such, the progress
with corporate governance reform depends upon local capacity, in terms of data,
people, and other resources.
32 Corporate Governance and Development
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NOTES
1 The first broad survey of corporate governance was Shleifer and Vishny (1997).
Several surveys have since followed, including Becht, Bolton, and Röell (2003),
Claessens and Fan (2003), Denis and McConnell (2003), and Holmstrom and
Kaplan (2001).
2 Liquid stock markets have turnover ratios (turnover in value terms divided by market
capitalization) greater than the median turnover.
3 As reported in World Bank (2001). The report also states that there appears to be
no effect either on the sectoral composition of growth or on the proportion of firms
growing more rapidly than could be financed from internal resources; even bank
profitability does not appear to be affected. This is the case regardless of whether
the ratio employed relates to the volume of assets (bank deposits, stock market
capitalization) or efficiency (net interest margin, stock turnover).
4 All these applications are important, although not novel. Coase (1937, 1960),
Alchian (1965), Demsetz (1964), Cheung (1970, 1983), North (1981, 1990), and
subsequent institutional economic literature have long stressed the interaction
between property rights and institutional arrangements shaping economic behavior.
The work of La Porta and others (1997, 1998), however, provided the tools to
compare institutional frameworks across countries and study the effects in a number
of dimensions, including how a country’s legal framework affects firms’
external financing and investment.
5 In a paper on Poland, Grosfeld and Tressel (2001) find that competition has a
positive effect on firms with good corporate governance, but no significant effects
on firms with bad corporate governance.
6 Some of these studies suffer from endogeneity issues: that is, firms, markets, or
countries may adopt better corporate governance and perform better. However,
the relationship is not from better corporate governance to improved performance;
rather it is either the other way around or because some other factors drive both
better corporate governance and better performance. For discussions of the
econometric problems raised by endogeneity, see Himmelberg (2002) and Coles,
Lemmons, and Meschke (2003).
7 The figure is based on the analysis of La Porta and others (1998). The creditor
rights index is developed by La Porta and others (1998). It is the summation of
four dummy variables, with four being the highest possible score. The rule of law is
a measure of the (lack of) judicial efficiency. Countries are sorted into four quartiles,
depending upon where they rank on a scale that is the product of their creditor
rights and the efficiency of the judicial system, a measure of the index of the efficiency
and integrity of the legal environment. The measure is reported for most
countries by La Porta and others (1998) and for transition economies by Pistor
(2000).
8 The equity rights index is developed by La Porta and others (1998) and is the
summation of five dummy variables, with five being the highest possible score. It
includes the following dummy variables: the country allows shareholders to mail
their proxy vote; shareholders are not required to deposit their shares prior to the
General Shareholders’ Meeting; cumulative voting is allowed; an oppressed minorities
mechanism is in place; the minimum percentage of share capital that entitles a
shareholder to call an Extraordinary Shareholders’ Meeting is less than or equal to
10 percent.
9 The cross-country evidence on the costs of poor corporate governance is corroborated
in a number of country studies. Johnson and others (2000), Bae, Kang,
and Kim (2002), and Bertrand, Mehta, and Mullainathan (2002), for example, analyze
the siphoning off of funds by controlling shareholders in the Czech Republic,
Korea, and India, respectively. In turn, the misuse by controlling shareholders
translates into higher cost of capital.
10 This may have been a specific phenomenon experienced only in this time period,
when many emerging markets were faced with financial stress. In other periods,
this relationship is not observed. As such, the perverse effects of weak corporate
governance may depend on the state of the economy.
11 Note the large differences between countries in this respect. In the United
States, for example, banks are limited in intervening in corporations operations, as
they can be deemed to be acting in the role of a shareholder, and therefore
assume the position of a junior claimholder in case of a bankruptcy (the doctrine of
equitable subordination). This greatly limits the incentives of banks in the United
States to get involved in corporate governance issues as it may lead to their claim
being lowered in credit standing. Other countries allow banks a greater role in corporate
governance.
12 Employee ownership is of course the most direct form in which labor can have a
stake in a firm. The empirical evidence on the effects of employee ownership for
U.S. firms is summarized by Kruse and Blasi (1995). They find that “while few
studies individually find clear links between employee ownership and firm performance,
meta-analyses favor an overall positive association with performance for
ESOPs and for several cooperative features” (abstract).
13 For the top 300 European firms, it was found that a strategy of over-weighting
companies with good corporate governance and under-weighting those with bad
corporate governance would have yielded an annual excess return of 2.97 percent
(Bauer and Guenster 2003).
14 In the Netherlands, the corporate governance reform committee suggestions in
1997 stressed self-enforcement through market forces to implement and enforce
its recommendations. A review of progress in 2003 (Corporate Governance
Committee 2003), however, showed that this model did not work and that more
legal changes would be needed to improve corporate governance. Earlier empirical
works had anticipated this effect (de Jong and others 2001) as they
documented little market response when the recommendations were announced.
44 Corporate Governance and Development
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