Corporate governance effects on market volatility: Empirical evidence from Portuguese listed firms.
| Autor | Teodosio, Joao |
1 Introduction
How firms' internal corporate governance mechanisms influence market volatility and how investors react to those mechanisms are relevant questions for managers and shareholders.
The literature focused on the effects of board independence and board size on firms' market risk allows us to identify some tendencies. Within the U.S. context, larger and more independent boards are beneficial in terms of decreasing market volatility (Pathan, 2009), while non-U.S. research presents mixed evidence (Huang & Wang, 2015; Nakano & Nguyen, 2012; Zhang, Cheong, & Rasiah, 2018). For these results, the literature presents conflicting theoretical premises.
Concerning board independence, Jiraporn and Lee (2018) developed two alternative hypotheses: i) the "risk-avoiding hypothesis," which is based on the assumption that board independence lowers the firm's risk levels by protecting shareholders from unnecessary risk-taking and forcing managers to define policies aligned with shareholders' interests; and ii) the "risk-seeking hypothesis," which assumes that board independence is a strong mechanism of corporate governance to prevent managers from adopting policies that reflect their risk aversion, thus increasing firms' risk-taking.
Concerning board size effects on firm risk-taking, there are two competing arguments: i) increasing the size of the decision-making group tends to reduce risk-taking behaviors (Moscovici & Zavalloni, 1969) and risky firms should work with larger boards because they need more guidance and monitoring actions (Coles, Daniel, & Naveen, 2008; Guest, 2008; Linck, Netter, & Yang, 2008); and, at the opposite pole, (ii) by adapting Jensen's (1993) argument, it is possible to say that ineffectiveness in the monitoring role of the board may not be related with its size, but with an excess of CEO power, directors' self-interest, lack of board expertise, and communication disruptions.
Our study is framed under these theoretical controversies and analyzes the effect of board independence and board size on firm risk-taking in the Portuguese context of Euronext Lisbon (EL). Portugal is a small economy in Southern Europe, with a small stock market characterized by high levels of ownership concentration and low levels of shareholder protection. Despite the size of the country, Portugal is relevant to research since it has privileged international relations with the South American, African, and Asian regions. Consequently, it is seen by many companies from those regions as an entry platform into the European market. Also, over the last years, Portugal has drawn attention from international companies belonging to the most developed stock markets as an attractive market for considerable investments in the areas of energy, banking, and technology.
The Portuguese stock market has been in operation for about two decades and, since it launched, corporate governance codes and firm governance practices have evolved. Vieira and Neiva (2019) and Lisboa, Guilherme, and Teixeira (2020) present the evolution of the corporate governance practices adopted by Portuguese firms and a compelling vision of the major changes that have occurred in the context of listed firms. According to Vieira and Neiva (2019), the prevailing governance model is the Latin model, where the governance structure is composed of a board of directors (BoD), or a sole director, and an audit committee or a statutory auditor. Additionally, the authors indicate that, over the past few years, there has been an increase in the proportion of independent directors and an increase in the proportion of women directors on BoDs. Lisboa et al. (2020) report that almost half of Portuguese listed firms are family firms, that the firms' remuneration plans for board members have increased their fixed component to around 75%, and that a small percentage of firms use stock options in their remuneration systems. Moreover, there has been a consistent increase of merger and acquisitions (M&A) operations and a growing presence of international institutional investors in shareholder structures.
According to our literature review, there are few studies published in indexed journals (1) that analyze the interactions between corporate governance mechanisms and market volatility in the Portuguese context. The research documents a negative effect of board independence on market risks for non-family firms (Vieira, 2014) and non-financial listed firms (Sa, Neves, & Gois, 2017). Madaleno and Vieira (2018) conclude that there is similarity between family firms and non-family firms with regard to the liquidity-volatility relationship.
Using a sample of 38 non-financial Portuguese listed companies comprising 418 firm-year observations, our results show that larger and more independent boards increase firm systematic risk.
Concerning the effects of board independence on corporate risk, our results confirm the "risk-seeking hypothesis," proposed by Jiraporn and Lee (2018), for the effects of board size on firm systematic risk. This hypothesis states that board independence is a strong mechanism of corporate governance to prevent managers from adopting policies that reflect their risk aversion, thus increasing firm risk.
In terms of board size effects on corporate risk, our results are, to the best of our knowledge, new to the literature by documenting a robust finding that increasing board size promotes an increase of firm systematic risk. This result may support some of the theoretical arguments presented by Jensen's (1993) theory of constraints for a well-functioning board. Since the Portuguese stock market is very small, it is customary for executive managers and members of boards of directors to move from firm to firm. This scenario promotes an increase in social ties, which in turn affect executive and board decisions. Decisions that may collide with "friends' interests" can result in the exclusion of people from the restricted circle of executives and directors. As such, and in line with Jensen's (1993, p. 863) assumption, Portuguese firms' "emphasis on politeness and courtesy at the expense of truth and frankness in boardrooms is both a symptom and cause of failure in the control system."
This investigation contributes to the literature in various ways. First, to the best of our knowledge, we are the first to document that a larger board size increases corporate systematic risk. Second, this is the first investigation that simultaneously analyzes the effects of both board size and independent directors as the main explanatory variables for market volatility in continental Europe, namely in Portugal. Within the South European context, none of the studies (Aloui & Jarboui, 2018; Sa et al., 2017; Vieira, 2014) on this subject contemplate board size as a variable in their econometric models. Additionally, the literature devoted to the Portuguese context analyzes isolated market risk measures. Sa et al. (2017) studied total and idiosyncratic risks and Vieira (2014) examined systematic risk, while this study aggregates all those risk measures. Moreover, within the Portuguese context, the previous literature ends the analysis period in 2010, while we use data up to 2017. As such, this study incorporates a unique and hand-collected database with a sample period (2007-2017) not covered by the extant research, within the EL context. Third, it contributes to the increasing body of research that provides valuable information outside the U.S. context. Portugal is an example of a country where corporate governance codes are optional, which may indicate that the governance structure of public firms is more heterogeneous when compared to other countries. Finally, we add to the growing body of literature on financial risk effects (Lameira et al., 2013; Righi et al., 2019), this time analyzing the effect of board independence and board size on firm risk-taking.
The remainder of the paper is organized as follows. Section 2 presents the literature review and formulates the hypotheses. Section 3 presents the methodology. Section 4 presents and discusses the empirical results. Finally, Section 5 presents the conclusions.
2 Literature Review and Hypotheses
The impact of internal corporate governance mechanisms on firm performance accounts for a major stream of research in the finance field. Several corporate board attributes have been studied over the last decades (Cunha & Rodrigues, 2018), such as: i) board independence (Black, Carvalho, & Gorga, 2012; Coles, Daniel, & Naveen, 2014; Falato, Kadyrzhanova, & Lel, 2014); ii) board diversity (Farag & Mallin, 2017; Owen & Temesvary, 2018; Pathan & Faff, 2013); and iii) the effects of CEO attributes on market and accounting performance (Brodmann, Unsal, & Hassan, 2019; Fang, Francis, & Hasan, 2018; Nguyen, Hagendorff, & Eshraghi, 2018).
The literature that studies the effects of corporate governance mechanisms on firm performance includes a segment that focuses on specific measures related to firm risk-taking. Corporate risk-taking is generally gauged by three different measures of volatility associated with stock returns: total risk, idiosyncratic risk, and systematic risk (Jiraporn & Lee, 2018). The research on market volatility has studied a wide range of corporate governance mechanisms as its drivers, which can be grouped into four major antecedents of volatility: i) CEO characteristics (Cain & McKeon, 2016; Coles, Daniel, & Naveen, 2006; Ferris, Javakhadze, & Rajkovic, 2017); ii) board independence (Aloui & Jarboui, 2018; Bird, Huang, & Lu, 2018; Jiraporn & Lee, 2018; Sa et al., 2017; Vieira, 2014); iii) board diversity (Faccio, Marchica, & Mura, 2016; Poletti-Hughes & Briano-Turrent, 2019; Sila, Gonzalez, & Hagendorff, 2016); and iv) board size (Cheng, 2008; Huang & Wang, 2015; Nakano & Nguyen, 2012).
From our viewpoint, some lines from previous studies can be highlighted. First, CEO age is the only individual characteristic, from...
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