Sarbanes-Oxley Act (2002) in the U.S., the Cadbury ... ASX Corporate Governance Council (2003) defines ... of ASX on âriskâ while defining CG is one of the.
Theoretical Framework Research Background The role of corporate governance quality (CGQ) came under intense scrutiny following major corporate collapses in the U.S. (e.g., Enron, Tyco, WorldCom and Adelphia Communications), Europe (e.g., Parmalat), and Australia (e.g., HIH, OneTel and Ansett Australia) in the early 2000s. As a response to the collapses, policymakers in these countries and beyond have become more vigilant about the risk prevailing in a firm’s balance sheet (i.e., assets and liabilities) and, over time, have developed new legislation and governance frameworks to restore the confidence of investors (Clarke and Dean, 2007). Examples are the Sarbanes-Oxley Act (2002) in the U.S., the Cadbury Report (1992) in the U.K., and the ASX’s ‘Principles of Good Corporate Governance and Best Practice Recommendations’ (2003) in Australia.
achieved, how risk is monitored and assessed, and how performance is optimised. Good corporate governance structures encourage companies to create value (through entrepreneurism, innovation, development and exploration) and provide accountability and control systems commensurate with the risk involved” (pp. 03). The emphasis of ASX on “risk” while defining CG is one of the important factors which motivate us to investigate the relation of corporate governance with various risk factors such as financial distress, liquidity and downside risk.
ASX Corporate Governance Council (2003) defines corporate governance as “a system by which companies are directed and managed. It influences how the objectives of the company are set and
• First, agency theory suggests that effective governance reduces the level of financial distress by controlling the agency cost that arises from conflicts of interest between managers and external stakeholders and between bondholders and shareholders (Jensen and Meckling, 1976).
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• Better CGQ reduces financial distress of firms.
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• Second, we assume that better governance reduces liquidity risk because better CGQ improves financial transparency (Leuz et al., 2003), which mitigates information asymmetry between managers and investors, as well as among investors. • Better CGQ reduces liquidity risk of firms. • Third, most of the prior literature argues that the better governance should encourage riskaverse managers to undertake risky but value enhancing and growth oriented investments (John et al., 2008). However, the literature does not differentiate the effects of governance on upside potential and downside risk. We hypothesize that better governance should improve the upside potential but decrease the downside risk. • Better CGQ reduces downside risk of firms.
Research Design and Methods
RQ1: Does CGQ reduce financial distress of firms in Australia?
Dependent variable 1. Merton (1974) distance to default model Key independent variables 1. Horwath CGQ index 2. Self-constructed CGQ index 3. Sub CGQ indices (board qaulity, subcommittees’ quality)
RQ3: Does CGQ reduce downside risk but increase upside potential of firms in Australia?
RQ2: Does CGQ reduce liquidity risk of firms in Australia? Dependent variables 1. Time-weighted quoted spread 2. Amihud illiquidity estimate 3. Liquidity ratio 4. Stock turnover 5. Proportion of zero return days 6. Turnover-adjusted number of zero daily volumes
Dependent variables 1. Downside risk 1.1. Historical and parametric VaR (95%, 99%) 1.2. Expected short fall (95%, 99%) 1.3. Negative semi standard deviation 2. Upside potential 2.1 Upside historical VaR (95%, 99%) 2.2 Positive semi standard deviation
Data 1. Sample period: 2001 to 2013 2. Data sources: Horwath report, SIRCA, Morningstar and DATASTREM. Estimation methods 1. Pooled OLS 2. Random effect vs fixed effect 3. Lagged independent variables 4. 2SLS and GMM
An empirical investigation of corporate governance quality with financial distress, liquidity and downside risk in Australia Research Contributions
Searat Ali (s2863914) Co-principal Supervisors: Dr Benjamin Liu, Dr Jen Je Su Department of Accounting Finance & Economics
Key Findings
We contribute to existing literature in several ways including context, data and methodology. First study
• As far as it could be ascertained, this is the first study to show that composite CGQ score is relevant to various risk factors such as financial distress, liquidity risk and downside risk in Australian context.
Australian Context
• Australia provides an interesting context to examine such relationship for several reasons, including relatively less stringent governance environment, weak market for control, low litigation risk, and high ownership concentration that we assume has a considerable bearing on CGQ and risk factors.
Horwath Report
• To gauge CGQ, we follow Horwath report which is comprehensive and well-recognized in the Australian research community. • Prior studies that use the Horwath report as a measure of CGQ either are cross-sectional or have linked CGQ to corporate activities other than financial distress, liquidity and downside risk.
First, we find that better governed firms have lower level of financial distress and such relation is stronger in post-CG reforms period and in firms with low growth opportunities. Second, we find that better governed firms have narrower spread, smaller price impact of trade, higher turnover and lower zero proportion return days, suggesting that strong governance alleviates liquidity risk. Overall, these findings are robust to alternative proxies of CGQ, estimation methods, sample specifications and endogeneity bias.
• Market based proxy of financial distress i.e., Merton (1974) distance to default.
Methodology
• Both high frequency and low frequency proxies of liqudity risk that captures all the key dimentions of liquidity suhc as trading cost, depth, resiliency and immidiacy. • Examining the differential effect of CGQ on downside risk and upside potential.
Data and Sample Period
Practical Implications
• This is the first study which covers all the available governance data in SIRCA during the period from 2001 to 2013. • In addition, the study period is important because of the two significant events, the first is the CG reforms (2003) and the second is the global financial crisis (2008). • The findings of the study have practical implications for various stakeholders of the firm. For instance, fund managers can develop their understanding about the role of governance quality in the level of financial distress, liquidity risk and downside risk, and then develop their investment strategies and equity portfolios accordingly in order to protect themselves from huge losses.
Griffith Business School
References Clarke, F., Dean, G. W., 2007. Indecent disclosure: Gilding the corporate lily: Cambridge University Press. Jensen, M. C., Meckling, W. H., 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics. 3(4), 305-360. John, K., Litov, L., Yeung, B., 2008. Corporate Governance and Risk‐Taking. The Journal of Finance. 63(4), 1679-1728. Leuz, C., Nanda, D., Wysocki, P. D., 2003. Earnings management and investor protection: an international comparison. Journal of financial economics. 69(3), 505-527.
griffith.edu.au/gbs
