Interactions between corporate governance, bankruptcy law and firms' debt financing: the Brazilian case.
| Autor | Funchal, Bruno |
INTRODUCTION
This paper analyzes the impact of firm-level corporate governance arrangements and of an institutional shock--the new Brazilian bankruptcy law--on firms' balance sheet debt financing features. As a proxy for firm-level governance we use the newly developed Brazilian Corporate Governance Index [BCGI] (Lopes & Walker, 2007), which scores governance arrangements across four dimensions: disclosure; ownership structure; board composition; and shareholder rights(1). The BCGI's four dimensions directly affect the level of effort by managers and as such can be used as a proxy for moral hazard resolution. This effect presumably reduces agency costs and consequently firms' cost of debt. Anderson, Mansi and Reeb (2004) find an inverse relation between the cost of debt and board independence and size. Bushman, Chen, Engel and Smith (2004) show that limited transparency of firms' operations to outside investors increases demands on governance systems to alleviate moral hazard problems. More recently, Kanagaretnam, Lobo and Whalen (2007) have shown that firms with higher levels of corporate governance have lower information asymmetry around quarterly earnings announcements. Our study adds to the previous literature by relating (theoretically and empirically) firm-level corporate governance arrangements and an exogenous shock--bankruptcy law reform--to the cost of debt and to the amount (and variation) of debt.
First we develop a model that connects the governance and the bankruptcy law to such debt variables as the cost of debt and firms' amount of debt. Through a set of propositions we show that: first, corporate governance has a negative impact on the cost of debt and a positive impact on the amount of debt; second, a harsher bankruptcy law also has a negative impact on the cost of debt and a positive impact on its amount; and, last but not least, the effect of bankruptcy law changes is stronger for firms with worse corporate governance standards.
We then approach the same problem empirically by regressing the debt variables on our measure of corporate governance and the bankruptcy reform dummy. To address this issue we use both public source balance-sheet microdata from Brazilian firms and a proprietary index for corporate governance (BCGI).
Our results show that: (i) the higher the corporate governance score on the BCGI, the lower the cost of debt; and (ii) the effect on changes in the amount of firms' debt considering the new Bankruptcy Law is less significant for firms with higher BCGI scores. Hence, we can say that stronger systems of corporate governance and bankruptcy procedures contribute to reducing the cost of debt and to increasing access to the credit market as well. Moreover, we can state that the reform of Brazil's bankruptcy law has had a stronger effect on firms with lower corporate governance levels. Our findings are consistent with our theoretical model.
The remainder of the paper is organized as follows: Section The Model discusses the theoretical model relating corporate governance and the bankruptcy law to the cost of debt and credit availability; Section The Brazilian Bankruptcy Reform discusses the reform of Brazil's bankruptcy law; Section Data presents our data set; Section Conclusions presents the empirical results and concludes.
THE MODEL
In this section we develop a model that describes how corporate governance and the bankruptcy law affect debt variables. To develop our model we assume the following:
Let e be the effort exerted by the manager. We assume that the effort e is a function of the level of corporate governance of the firm and the degree of punishment imposed by the bankruptcy law:
e(L,g) = aL + bg, where [e.sub.L] > 0 and [e.sub.g] > 0.
When we take effort into account, we can assume that the probability of success of the firm increases with the firm's governance level and the punishment of the bankruptcy law. In precise terms, we assume that p(e(L,g)) is differentiable, strictly increasing, and strictly concave in the governance level, g, that p(e([bar.L],[bar.g]))
Firms Investment
We make three important assumptions: creditors are imperfect monitors of a firm's actions related to payoffs after it borrows; creditors can predict their mean payoffs in the default state; and creditors and the firm are risk-neutral. We make the first assumption because it captures the asymmetric information between the firm and its creditors. The second rests on the view that professional creditors have considerable experience with default, and the third is more accurate when applied to firms than to individual persons.
The borrowing firm has a project that requires capital, I , which it must raise externally. The firm promises to repay creditors the sum, F. The project can return a value, v , where the firm is solvent if v [greater than or equal to] F and insolvent if v
The solvency and insolvency states return to the firm [v.sub.solv] and [v.sub.ins], respectively, where ins [v.sub.solv] [greater than or equal to] [v.sub.ins]. The probability of solvency is p(e(L,g)) and the probability of insolvency is (1 - p(e(L,g))). This implies that the expected value of the project is ins [E.sub.solv] p(e(L,g)) [v.sub.solv] + (1 + p(e(L,g))) [v.sub.ins], the expected return conditional on the solvency state is [E.sub.solv](v) - [v.sub.solv], and the expected return conditional on the insolvency state is [E.sub.ins](v) = [v.sub.ins].
Assuming that the credit market is competitive, F is the largest sum that creditors can demand to fund the project. We take the risk-free interest rate equal to zero, so that a borrowing firm's interest rate is a function only of the riskiness of its project and the properties of the corporate governance level.
Creditors who lend l should expect to receive l in return. This expectation can be written as follows:
I = p(e(L,g)) F + (1 - p(e(L,g)))([v.sub.ins]);
F = I (1 + r) = 1 - (1 - p(e(L,g)))([v.sub.ins])/p(e(L,g)) (1)
The firm's interest rate is r = (F/I) - 1, which is increasing in F; this is the value that the firm is required to repay in the solvency state. Denoting by [v.sup.u.sub.ins] ([v.sup.u.sub.ins] [member of](0,1)) the per-unit-of-investment
(I = 1) counterparts of [v.sub.ins] we also have
r = 1 - p(e(L,g))/p(e(L,g)) [1 - [v.sup.u.sub.ins]], (2)
[partial derivative]r/[partial derivative]g = - p'[(e(L,g)).sup.-2] b (1 - [v.sup.u.sub.ins])
which is decreasing on the level of corporate governance.
Proposition 1: A higher level of corporate governance reduces the interest rate charged to the firm.
Also, since
[partial derivative]r/[partial derivative]L = - p'[(e(L,g)).sup.2] a (1 - [v.sup.u.sub.ins])
the interest rate is decreasing on the level of punishment of the bankruptcy law.
Proposition 2: Higher punishment of the bankruptcy law reduces the interest rate charged to the firm.
Thus, it is clear from (2) and (3) that the interest rate is decreasing on the degree of governance and bankruptcy law punishment. Both limit the agency cost associated with the external finance relationship. Moreover,
[[partial derivative].sup.2]r/[[partial derivative]g[partial derivative]L = 2p " [(e(L,g)).sup.3] ab (1 - [v.sup.u.sub.ins])
Proposition 3: The impact of the bankruptcy law's punishment on interest rate is higher for firms with worse corporate governance level.
That is, for firms with poorer governance, a harsher punishment from the bankruptcy law produces a greater reduction in the interest rate. It is possible that a good bankruptcy law works as a substitute for a good corporate governance structure to protect outside investors from agency costs.
An ex ante objective of the firm is to maximize the project option set that creditors want to finance. Society prefers firms that pursue projects with positive expected returns. A firm should therefore undertake a project that creates value. We denote social welfare as W, so that
W = p(e(L,g)) [v.sub.solv] + (1 - p (e(L,g))) ([v.sub.ins]) - I [greater than or equal to] 0 and W = p(e(L,g)) [E.sub.solv] (v) + (1 - p (e(L,g))) ([E.sub.ins]) (v) - I [greater than or equal to] 0.
As social efficiency always requires a minimum conditional expectation value of return, [E.sub.solv] ([v.bar]), we let 0 = W . Then,
[E.sub.solv] ([v.bar]) = I - (1 - p(e(L,g))) [E.sub.ins)(v)/p(e(L,g))
where F = [I - (1 -...
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