Piergiuseppe Fortunato and Ana Hidalgo-Cabrillana
The Determinants of Governance

Abstract: Recent empirical evidence shows that corporate governance (CG for short) at the firm level differs across as well as within countries. Moreover the quality of governance is positively correlated with firm performance. However, although CG practices appear to benefit the firm, not all firms adopt good codes. This paper tries to tackle this corporate governance puzzle by endogenizing the choice of governance practices at the firm level as well as the portfolio decisions of investors. In our model managers raise money on financial markets that are subject to imperfections: output is not perfectly observable for the financiers and effective CG at the firm level can be adopted to amend these frictions. In particular, investors only observe a signal correlated with the returns. Managers optimally decide about the quality of the signal (i.e. the "quality of governance") trading off the possibility of expropriating a bigger share of the profits against the opportunity of raising more capital on the market. The model delivers important and novel predictions. First, when CG is low shareholders pay an additional premium due to agency problems. Therefore, CG practices at the firm level turn out to be an important determinant of the portfolio choice of shareholders. And second, in equilibrium the quality of CG at the firm level depends on three variables: the market structure (measured by the level of competition in the capital market), firms’ idiosyncratic characteristics (measured by the level of cash flow of the firm), and the country level dimension of CG. We test these predictions with data provided by CLSA and OSIRIS and found that, consistently with our model, firms operating in competitive capital markets tend to display a higher level of CG.

JEL: D82, D86, E44.
Keywords: Corporate Governance; Disclosure; Hidden information; Portfolio Choice.



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