Bridge over ocean
1 March 2016 CFA Institute Journal Review

Culture, Agency Cost, and Governance: International Evidence on Capital Structure (Digest Summary)

  1. Marc L. Ross, CFA

Looking at the G–20 nations over a 15-year time span, the authors investigate how social characteristics of individualism and risk aversion affect corporate governance and capital structure.

What’s Inside?

Based on their examination of the effects of social characteristics on firm governance and capital structure selection, the authors conclude that high levels of individualism correlate positively with greater use of debt and lower cost of capital. Firms displaying greater risk aversion achieve the opposite result. These phenomena become less pronounced as the firms get larger and the governance gets better, and they hold true principally in developed markets.

How Is This Research Useful to Practitioners?

Culture influences firm capital structure meaningfully, particularly in the developed world. But the stronger the governance process becomes, the less pronounced this cultural influence becomes. Furthermore, this outcome appears to be less prevalent in emerging markets.

In cultures that are more individualistic, companies’ use of leverage—in general and relative to equity—is greater. By contrast, where risk aversion prevails, the likelihood of debt use decreases. The relationship does not hold for emerging markets, which may have limited access to capital. Similarly, levels of individualism and risk aversion explain firms’ debt interest cost. Increased individualism translates into lower capital cost, whereas higher risk aversion results in the opposite. This relationship, too, is valid in developed markets; in emerging markets, debt markets are often less flexible and open because of greater government control and the outsized presence of sovereign wealth funds. In all instances, stronger firm-level governance significantly mitigates these cultural effects.

Students of corporate governance and corporate finance will find the authors’ work useful in deepening their understanding of the drivers of capital markets, as will those interested in the interplay of firm-level governance and national culture. Such findings would also be of interest to portfolio managers, market strategists, and policymakers.

How Did the Authors Conduct This Research?

The relevant literature on the impact of national culture on firm governance is surveyed. National culture affects economic well-being, and cultural identity may well determine a society’s degree of risk aversion as well as how its companies use debt or equity in corporate financing decisions. Differences in national culture may affect investment decision making and market behavior.

The authors put forward three hypotheses. The first is that greater levels of individualism are associated with an increased likelihood of using debt and greater risk aversion will achieve the opposite result. The second is that a higher level of individualism is associated with a greater debt-to-equity ratio and increased risk aversion is associated with the opposite outcome. The third is that higher levels of individualism are correlated with lower debt interest cost and higher levels of risk aversion result in greater firm-level financing costs. In all cases, a stronger governance process cancels out these effects.

The data examined are all stocks in the G–20 nations from 1 January 1995 to 31 December 2009 taken from DataStream and WorldScope. The G–20 members include a cross section of developed and developing countries, diversified and concentrated economies, and varying political systems. The Thomson Reuters ASSET4 Corporate Governance Performance measure gauges firm-level governance that considers board structure, compensation policies, shareholder rights, and strategy. The authors control for company size, profitability, growth, and tax considerations.

Multivariate analysis tests the authors’ hypotheses by regressing debt use, debt-to-equity ratios, and debt interest cost on a host of variables. Presented in tabular form, their findings support the aforementioned propositions. Individualism is associated with greater borrowing and lower debt interest cost, perhaps because of managerial overconfidence. Conversely, risk aversion is associated with less debt use and higher financing costs. All else being equal, strong governance tends to dampen these effects substantially in developed markets and larger corporations, where well-defined processes control the corporate financing decisions. Perhaps because of excessive government involvement, local legal systems, and constrained borrowing options, emerging markets tend to exhibit results that are inconsistent with what the authors posit.

Abstractor’s Viewpoint

National culture is a function of history. Such traits as individualism and risk aversion can affect corporate finance decisions and debt interest cost. To the extent that a firm’s governance process is strong, it can largely eliminate these influences. This phenomenon is valid in developed markets, where there are few, if any, constraints on debt and equity financing. In contrast, the outsized presence of government control, different legal structures, and the influence of sovereign wealth funds often limit access to debt capital markets in the developing world.

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