Is leverage a substitute or outcome for governance? Evidence from financial crises

Abstract

PurposeThe authors investigate the impact of governance on the leverage of East Asian firms in the financial crisis context, in order to understand the puzzle whether debt acts as a substitute for governance or an outcome of the governance mechanism.Design/methodology/approachThe authors use 86,030 firm-years and the country-level governance data from eight East Asian countries over the period 1996–2017. The authors employ the fixed effects (FE) model, in the main analysis and the weighted least squares model, as a robustness check in order to compare the two competing hypotheses of agency theory, substitute and outcome models.FindingsThe authors’ results show that debt acts as a substitute for governance before the GFC, but during and after the GFC the picture changes. Namely, debt acts as an outcome of the governance mechanism during the GFC and its aftermath. Since during financial downturns both agency costs increase, and information asymmetry widens, firms in poor-governed countries may be reluctant to increase their leverage in order not to face financial distress and additional restrictions. Thus, the results imply that the use of debt as a tool to mitigate agency conflicts and a substitute for governance strongly depends on the environment that the firms operate and the general macroeconomic conditions, such as facing a financial crisis or not.Research limitations/implicationsThis study provides an interesting case of the firms' capacity to raise money during a crisis and that governance plays an important role in borrowing activities of firms. This will undoubtedly help motivating owners and policymakers for improving governance. The authors’ findings may be useful for policymakers to develop policies considering the adverse effects caused by exogenous shocks. This is crucial because the severity of GFC as a shock seems to change the macro and institutional environment that firms operate. While the authors properly address the research hypotheses using country governance data, future research may employ corporate governance data to attain firm-level results by testing two competing hypotheses.Originality/valueThere are several important areas where this study makes original contributions. First, while Tsoy and Heshmati (2019) focus on the dynamics of capital structure for only Korean firms, the authors extend the sample including eight East Asian countries considering the impact of country governance on capital structure policy. Specifically, this study is the first in using the robust country governance data, which differs by country and year, in the crisis context. Next, the authors investigate both the AFC and GFC to compare whether these two crises have different effects on capital structure policy of East Asian firms. Finally, the authors aim to understand whether leverage is used as a substitute for governance or an outcome of governance mechanism considering recessions.

Islamic governance and leverage: the interacting role of corporate social responsibility disclosure

“…This study supports the concept of stakeholder theory related to the existence of the ISB, as explained Al-Nasser Mohammed and Muhammed (2017) that the role of the ISB is to advise and supervise the company's operations and ensure that all operations are following Sharia principles. The results of this study are also in line with the findings by Handley-Schachler et al (2007) and Tekin and Polat (2021), who state that corporate governance has a significant positive effect on leverage in the banking sector. However, it seems that the pecking order theory cannot be aligned with the results of this study because of the presence of high leverage in the Islamic banking sector, which is proof of people's trust in the Islamic banking sector by depositing their funds in the form of current accounts and savings.…”

Financial Distress Prediction: The Role of Financial Ratio and Firm Size

“…Based on agency theory, leverage can be a tool of responsibility that reduces agency problems (Ugur et al, 2022). Accordingly, the company seeks to minimize agency costs by optimizing external funds to obtain large profits (Tekin & Polat, 2021); then the possibility of the company going bankrupt is slighter (Lucky & Michael, 2019). Meanwhile, companies that are able to manage liabilities effectively will have a good impact on the company's sustainability in the future (Waqas & Md-Rus, 2018).…”

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