governanace_pp04

Short-Term FinancingInternational Corporate Governance
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Lecture Aims
This lecture reviews the main taxonomies of corporate governance systems.
Before proceeding with this review, the lecture discusses the economic and political context in which global capitalism has risen.
This lecture reviews both the classifications based on the law and finance literature (La Porta et al. on the quality of law and investor protection; Pagano and Volpin on electoral systems; and Roe on political orientation of governments in power) and the varieties of capitalism (VOC) literature.
An important distinction between the two is that the former prescribes a hierarchy of systems whereas the latter argues that very different institutional arrangements may generate similar economic performance.
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Learning Outcomes
By the end of this lecture, you should be able to:
Understand the economic and political context which has enabled global capitalism to rise
Critically review the assumptions underlying the taxonomies from the law and finance literature and those from the VOC literature
Assess the possible limitations of the various taxonomies as well as the validity of their predictions
Explain path dependence and distinguish between the two types of path dependence.
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Introduction
This lecture reviews the various taxonomies of corporate governance systems.
It is important to realise that the various taxonomies have very different premises.
The taxonomies from the law and finance assume that
individuals maximise their utilities in the presence of institutions which constrain their behaviour, and
there is a zero-sum game between improving the rights of investors and those of workers.
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Introduction (Continued)
In contrast, the varieties of capitalism literature
focus on the concept of complementarities, and
do not assume that there is a zero-sum game between worker and investor rights.
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The Rise of Global Capitalism
We will briefly discuss the political and economic context of the rise of capitalism first.
In their 1932 book, Adolf Berle and Gardiner Means identified a new social phenomenon and major step in the development of capitalism.
This was the emergence of a class of professional managers running firms on behalf of their owners.
The first challenge faced by this new class was the stock market crash of 1929 and the Great Depression of the 1930s.
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The Rise of Global Capitalism (Continued)
The Great Depression gave start to large-scale government programmes globally to revive the economy.
The most famous one was US President Franklin Delano Roosevelt’s New Deal.
As a response to the recent failures of its commercial banks, the USA introduced the Glass-Steagall Act in 1933.
The Act introduced a segmentation between commercial banks and investment banks.
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In summer 1944, the Bretton Woods agreement created new global economic institutions for the post-WWII period
the International Monetary Fund (IMF), and
the International Bank for Reconstruction and Development (IBRD) or World Bank.
It also set up a system of fixed currency exchange rates.
At the end of WWII, the USA and the USSR emerged as the two pillars of political power.
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The post-WWII period saw substantial improvements in workers’ rights and the emergence of the welfare state.
The class of professional managers now faced a class of blue- and white-collar workers represented by powerful unions.
In Germany, the Co-determination system was put in place consisting of workers councils and workers board representation.
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During the 1960s, Western economies experienced unprecedented economic growth.
However, at the beginning of the 1970s the Bretton woods system was in crisis
The USA had a massive trade deficit due to the Vietnam war
The deficit was financed by printing more dollars which fuelled inflation
In 1971, President Nixon put an end to the convertibility of the dollar into gold.
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The 1973/4 oil crisis further fuelled inflation.
By 1976, the Bretton Woods agreement had broken down and all major currencies were now floating.
Developed countries were now experiencing stagflation, i.e. stagnation combined with high inflation and unemployment, caused by high oil prices as well as a spiral of wage and price adjustments.
Few believed that Keynesian economic policies would be a way out of the crisis.
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The crisis gave rise to neoliberalism as a new political ideology.
Neoliberalism is the doctrine that
markets are better at allocating economic resources, and
individuals are better at making economic decisions
than governments.
The next few decades were to be dominated by this new doctrine, also called financialisation or globalisation.
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Financialisation refers to different, but related phenomena
the increasingly important role of capital markets and the financial services industry compared to the manufacturing industry, and
the process of turning any asset generating cash flows into a financial security or a derivative.
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In 1979, the Conservatives won the elections in the UK and Margaret Thatcher became Prime Minister.
In 1980, Ronald Reagan, A Republican, became the President of the USA.
Both engaged in programmes of market liberalisation and deregulation.
Thatcher curbed trade union power with a succession of laws during the 1980s.
Trade union membership fell from roughly 50% to 34% in 1990.
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The UK was the first country in Europe to start an ambitious programme of privatisation.
Two of the major aims of the privatisation programme were
to widen share ownership, and
to encourage employee share ownership.
Other European countries were to follow with their own privatisation programmes.
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In the USA, Ronald Reagan was a fervent follower of supply-side economics.
According to supply-side economics, a necessary and sufficient condition to achieve economic growth is to reduce barriers to the supply side of the economy.
Reagonomics consisted of keeping inflation low by controlling the supply of money, reducing tax and government spending.
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The 1970s and 1980s also saw a wave of deregulation of the major financial markets.
On 1 May 1975 (May Day), the US stock exchanges moved from a system of fixed commissions to negotiated commissions.
As a result of this decrease in trading costs
a lot of foreign companies applied for a cross-listing in the USA, and
a major chunk of the trading in their shares moved to the USA.
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In response to the loss of business to the USA, the London Stock Exchange underwent major changes in 1986 (Big Bang).
The most important change was to remove minimum commissions on stock trades.
The 1980s and 1990s also saw the demutualisation of British building societies, i.e., converted to joint stock companies.
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In 1985, Mikhail Gorbachev succeeded Leonid Brezhnev as head of state of the USSR.
He is famous for
perestroika (economic and political reform) policies.
During the late 1980s, revolutions swept across the Communist Bloc resulting in
the reunification of West and East Germany, and
the breakdown of the USSR.
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In 1992, the Single European Act came into effect in the European Union
It removed barriers to capital flows and the movement of EU citizens within the EU
It brought about a liberalisation of financial and labour markets.
In the USA, the Gramm-Leach-Bliley Act of 1999 practically repealed the 1933 Glass-Steagall Act.
Banks were now allowed to conduct both commercial and investment banking.
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First Attempts to Classify
Corporate Governance Systems
The British economist John Hicks and the American business historian Alfred Chandler Jr. were the first to attempt to categorise the different systems of capitalism.
Hicks distinguishes between
market-based economies, and
bank-based economies.
The former rely on well developed capital markets and the issue of publicly traded securities to finance corporate investments.
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Corporate Governance Systems (Continued)
Chandler studied the differences between American, British, German and Japanese capitalism from a historical perspective.
Mark Roe highlights the importance of past regulation to understand differences in corporate governance across countries.
In particular, banking regulation has had a major impact on whether a national economy develops into a market-based or bank-based system.
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Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Julian Franks and Colin Mayer have developed a more nuanced classification which does not just focus on the sources of financing for corporations.
They distinguish between insider systems and outsider systems.
Insider systems are characterised by
concentrated control and complex ownership structures,
managers being monitored and disciplined by the large shareholder, and
underdeveloped takeover and stock markets.
Continental Europe is a representative of this system.
Outsider systems are characterised by
dispersed ownership and control,
well developed takeover and stock markets,
managers being disciplined by hostile raiders.
The UK and the USA are representatives of the outsider system.
Lucian Bebchuk and Mark Roe formalise how the past shapes a country’s corporate governance system.
They distinguish between two forms of path dependence
Structure-driven path dependence is about how current corporate governance arrangements and corporate control structures depend on the structures that were initially in place
Rule-driven path dependence is about how current regulation is influenced by the corporate structures that were initially in place.
The characteristics of national systems will tend to persist over time given the structure-driven and rule-driven path dependences.
Legal Families
Rafel La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny have started the law and finance literature.
Their theory is based on the importance of property rights, in particular investor protection.
They argue that in countries where investor protection is high capital markets are highly developed.
Ultimately, the degree of investor protection drives economic growth.
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Legal Families (Continued)
La Porta et al. distinguish between two broad legal families, i.e. common law and civil law.
Common law is case-based law.
Judges pronounce judgements on the cases presented to them in a court of law.
These judgements then create precedents for other similar future cases.
Civil law originates from Roman law.
It relies on extensive codes of law.
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The role of judges is limited to interpreting the law texts in court.
La Porta et al. argue that the reliance on codes of law makes civil law less flexible and more reactive than common law which can easily adjust to new ways of managerial abuses.
Common law is the law of the UK, the USA and most of the former colonies of the UK.
Within the broader family of civil law, La Porta et al. distinguish between
French (or Latin) law prevailing in French speaking and Southern European countries,
German law prevailing in Germanic countries as well as China and Japan, and
Scandinavian law.
Their antidirector rights index measures how well shareholders are protected against the management or the large shareholder.
Their creditor rights index measures how creditor rights are protected.
La Porta et al. find that shareholder protection and creditor protection are
highest in common law countries,
lowest in French law countries, and
somewhere in between in countries of German and Scandinavian law.
They also study the link between
investor and creditor protection on one side, and
the size of capital markets on the other side.
They find that the size of stock markets, as measured by the number of domestic listed firms, is
largest in common law countries,
smallest in French law countries, and
somewhere in between in countries of German and Scandinavian law.
However, when stock market size is measured by the value of IPO firms, the relationship with investor protection is less clear.
The relationship between creditor protection and the size of the debt market is also somewhat ambiguous as German law countries have much larger debt markets than common law countries.
Finally, La Porta et al. find a negative link between investor protection and the concentration of control.
They conclude that control remains concentrated in countries with weak investor protection to avoid expropriation by the managers.
Political Determinants of
Corporate Governance
Mark Roe proposed politics and political ideology as the main driver of corporate governance.
Political ideology determines how countries achieve social peace.
The Continental European social democracies have achieved social peace by favouring employees over investors.
Layoffs will be relatively hard, unemployment benefits and unemployment will be high.
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Corporate Governance (Continued)
Managers will less likely focus exclusively on the maximisation of shareholder value.
High incentive packages for managers will also be less common to avoid the envy of other social classes.
There will be less takeover activity as takeovers may generate layoffs.
In summary, social democracies seek social equality at the cost of economic efficiency.
Control will stay concentrated as this is the only way to keep managers and employees at bay.
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In countries with more conservative governments, the focus will be on improving investor rights.
Given the strong investor rights, ownership and control will separate.
Roe tests his prediction on OECD countries and finds support for it
Ownership and control are more concentrated in countries with left-wing governments.
Marco Pagano and Paolo Volpin propose an alternative theory based on electoral systems.
Their theoretical model is based on three different types of economic actors
managers,
Managers run the firms on behalf of the rentiers, but do not themselves own shares.
Rentiers live off the revenues of their investments.
Both managers and employees prefer weaker investor rights.
Weaker investor rights give more power to managers and facilitate the extraction of private benefits of control.
They also provide better job security for employees, in particular less productive employees.
While managers and employees have similar preferences, rentiers are assumed to be a less homogenous group.
Pagano and Volpin distinguish between majoritarian electoral systems and proportional electoral systems.
Under a majoritarian system, the political party with a majority of districts wins the elections.
Pagano and Volpin assume that the pivotal district is the district of the rentiers.
Hence, under a majoritarian system political parties will cater for the rentiers and focus on improving investor rights.
Under a proportional system, the political party that obtains a majority of votes wins the elections.
Under the latter, political parties will focus on the homogenous group of the managers and workers.
The focus will be on employee rights at the expense of investor rights.
Pagano and Volpin test their theory on 21 OECD countries.
In line with their predictions, they find that countries with more proportional voting systems have stronger employment protection and weaker investor rights.
However, they only find that the La Porta et al. legal families only explain the levels of employee rights, but not those of investor rights.
They conclude that the proportionality of the electoral system is better at explaining the level of investor rights than the legal family.
The Varieties of Capitalism Literature
So far, the focus has been on the law and finance literature which argues that the main role of institutions is to constrain the behaviour of managers and employees.
Contrary to La Porta et al. and Pagano and Volpin, Roe does not advocate the superiority of one particular system.
Nevertheless, he also assumes that strong investor rights cannot coexist with strong employee protection.
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(Continued)
In contrast, the varieties of capitalism (VOC) literature does not favour a particular system.
Peter Hall and David Soskice study a wide range of questions relating to the distribution of wealth and the resolution of economic coordination problems.
They argue that economic systems are not just about investments in assets and technologies.
They are also about investments in human capital.
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The way economic coordination problems are solved depends on whether an economy is
a liberal market economy (LME) or
a coordinated market economy (CME).
In LMEs, the coordination mechanism is the markets.
Labour markets and markets for assets are highly flexible and developed.
Firms tend to invest in highly marketable and liquid assets.
(Continued)
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There is an emphasis on assets with relatively short payback periods.
In-house training of employees is kept to a minimum to avoid competitors from free-riding on the firm’s efforts.
Innovation is mainly of the blue skies nature.
LMEs tend to excel in highly competitive, innovative industries as well as low value-added services industries.
The UK, the USA and Australia are LMEs.
(Continued)
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CMEs are based on complex networks to coordinate economic decision making.
Markets, including labour and capital markets, are fairly illiquid and inflexible.
Hence, there is less focus on highly liquid and generic assets.
The emphasis tends to be on more specific, less marketable assets.
Firms provide more in-house training and powerful employers associations avoid free-riding.
(Continued)
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High employee protection and inflexible labour markets provide incentives for workers to invest in firm-specific skills.
CMEs tend to do well in industries associated with incremental innovation such as high value-added manufacturing.
France, Germany and Italy are examples of CMEs.
(Continued)
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The concept of complementarities is key to the VOC literature.
Two institutions have complementarities if their joint existence increases the efficiency of one or both of them.
This concept implies that substantially different sets of institutions may still have very similar levels of economic output and wealth creation.
(Continued)
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How Do the Various Taxonomies Perform?
The first attempts to arrive at taxonomies consisted of finding commonalities as well as differences across countries in terms of corporate governance.
More recent attempts have been based on theoretical foundations, generating predictions as to
how institutional arrangements come about, and
how existing institutional arrangements explain differences in corporate governance and corporate or economic performance.
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(Continued)
A basic criticism of La Porta et al. is its static nature.
Taken to an extreme, today’s characteristics of the Italian corporate governance system are mainly due to what happened in the distant past, starting with the 12 Tables that laid down the foundation of Roman law in the 5th century BC.
La Porta et al. justify the static nature of their theory by the fact that law only changes slowly over time.
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There also exist four more specific critiques of La Porta et al.
The first critique has been formulated by Michael Graff.
He argues that the La Porta et al. antidirector rights index includes criteria that are irrelevant whereas other, relevant criteria have been excluded.
When the index is adjusted as proposed by Graff, there is no longer a link between investor protection and legal origin.
(Continued)
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Holger Spamann’s critique is based on errors of encoding.
He finds errors for 33 out of the 49 countries covered by La Porta et al. due to their use of secondary sources.
After these errors have been corrected, the link between legal families and investor protection no longer exists.
(Continued)
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Amir Licht, Chanan Goldschmidt and Shalom Schwartz argue that culture is the true driver behind differences in corporate governance.
Using survey evidence, they find that countries that were under British rule are much more willing to deal with conflicts of interests in a court of law.
They find a strong relationship between cultural attitudes and investor and creditor protection.
(Continued)
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They argue that the persistence of cultural attitudes may explain why the countries of the former Communist Bloc have failed to improve investor protection despite wide-ranging legal reforms.
Finally, Julian Franks, Colin Mayer and Stefano Rossi find that the separation of ownership and control in the UK can be traced back to the period before 1930 when investor protection was still low.
(Continued)
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Franks et al. argue that the proximity of shareholders to their investee companies via local stock exchanges acted as a substitute for strong investor rights.
There has also been criticism of the simple version of the VOC literature.
The dichotomous version has been criticised to fail to account for the distinct character of Rhineland economies, the Nordic social democracies and Southern Europe.
(Continued)
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While the last few decades have seen major political, economic and technological upheavals on a global level, giving rise to global capitalism, national systems of corporate governance and capitalism nevertheless are still characterized by a series of idiosyncrasies. This chapter has reviewed the various taxonomies of national systems that have been proposed by business historians, as well as financial, legal and management scholars.
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Conclusions
In insider system, stock markets are relatively underdeveloped, corporate control is highly concentrated and badly performing managers are disciplined by the large shareholder. In outsider systems, organised capital markets are highly developed, most companies are listed on the stock market and have dispersed ownership and control and managerial disciplining is done via the market for corporate control.
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Conclusions
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Conclusions
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Conclusions
First attempts at categorising corporate governance systems.
Path dependence.
The law and finance literature and the hierarchy of corporate governance systems.
The VOC literature and the concept of complementarities.
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governanace_pp04

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