A cross-country comparison of corporate governance and firm performance: Do financial structure and the legal system matter?

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Abstract

We blend the corporate governance and the financial structure/legal system literature streams to study whether firm performance is enhanced when its governance structure embodies the demands of the host country’s financial structure and legal system. Using a sample of 1736 unique firms representing 22 countries, we find that the joint effect of a country’s financial structure and legal system does matter when explaining the relationship between performance and the overall level of corporate governance in a given country. The results also suggest that firms operating in the market/common combination countries tend to command higher market valuations than firms with a comparable level of corporate governance that operate in the bank/civil combination countries.

Introduction

This study examines whether and how a country’s financial structure and its legal system impact a firm’s corporate governance structure and consequently its market performance. We do not derive any hypotheses in this paper, instead we explore three research questions: (1) Does firm-level corporate governance vary across different combinations of financial structure and legal system? (2) Do a host country’s financial structure and legal systems, individually and jointly, impact firm-level corporate governance and consequently its performance? and (3) Do different corporate governance mechanisms impact firm performance differently in distinctive combinations of financial structure and legal systems. Our findings indicate that firm-level corporate governance varies across different combinations of financial structure and legal systems which in turn exerts differential influence on the market performance of firms in host countries.

Prompted by the financial scandals of Enron and WorldCom, a steady stream of research has emerged that primarily focuses on untangling the relationship between a firm’s governance practices and it’s operating, financial and market performance. Concurrently, other research scholars have focused on how differences in the financial structure—process of allocating capital to entrepreneurs—and legal systems—the way laws are formulated and quality of their enforcement—across countries impact: (i) the firm-level corporate governance practices (Klapper and Love, 2004), and (ii) the overall flow of capital in a country (Levine, 2002).

On the surface, the goals of these two research streams may appear to differ—enhancing firm performance via good governance practices versus country-wide economic development through enhanced capital flows resulting from “financial deepening and legal sophistication”—but they both converge on the role of corporate governance. Both perspectives embrace the notion of investor protection (i.e., what mechanisms a firm has put in place to protect its shareholders and how effective are the laws in a country to enforce contracts with a firm) and market for corporate control (i.e., how “investor-friendly” are a firm’s “decision and control” rights and how effective are the capital markets in a country to drive out poor managers). The former research stream analyzes the impact of governance practices at the firm-level while the same phenomena are investigated at the country-level in the latter research stream.2 In this paper, we triangulate these two research streams to explore the joint mitigating effect, if any, of a host country’s financial structure and legal system on the firm-level governance-performance link.

The remainder of the study is organized as follows. Section 2 summarizes the literature and develops the research questions. Section 3 describes the data used to explore the research questions. Section 4 presents the empirical model and discusses the findings. Section 5 presents the conclusions and areas for future research.

Section snippets

Corporate governance and firm performance

Shleifer and Vishny (1997, p. 737) observe that “most advanced market economies have solved the problem of corporate governance at least reasonably well, in that they have assured the flows of enormous amounts of capital to firms, and actual repatriation of profits to providers of finance.” Thus market economies have achieved adequate “investor protection” through some combination of firms’ voluntary disclosures and requiring a “legal minimum” set of good governance practices. However, there is

Sample data

Firms in our sample are drawn from the corporate governance database maintained by the Institutional Shareholder Service (ISS)7 and Thomson Worldscope®

Empirical model, findings, and discussion

To answer our first research question, whether firm-level corporate governance varies across firms in countries with different types of financial structure and legal systems, we conduct two separate tests. First, we test for this variation individually at the financial structure and legal system level by comparing the mean CGQ score of: (i) firms operating in market-based financial system with that of the firms operating within the bank-based financial system, and (ii) firms operating in the

Conclusions and future research

In summary, our results provide evidence that the joint effect of a country’s financial structure and legal system does matter when explaining the relationship between firm-specific performance and the firm’s overall level of corporate governance. The results also suggest that firms operating in the market/common combination countries tend to exhibit better corporate governance as measured by the ISS CGQ score. Such firms tend to command higher market valuations than firms with a comparable

Acknowledgements

This paper has benefited from comments made by James Largay, Nandu Nayar, Marlene Plumlee, Geraldo Vasconcellos, and participants of the 27th McMaster University World Congress on Corporate Governance (Hamilton, Ontario), the European Institute of Advanced Studies in Management 2nd Workshop on Corporate Governance (Brussels, Belgium), the 20th Asian-Pacific Conference (Paris, France), the CAR/JCAE Joint Symposium on Asia-related issues (Hong Kong), and accounting research seminars at George

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