Corporate Governance and Corporate Financing and Investment during the 2007‐2008 Financial Crisis

• DOI: http://doi.org/10.1111/fima.12071
• Author: Xiangkang Yin,Tu Nguyen,H.G. (Lily) Nguyen
• Published date: 01 March 2015
• Date: 01 March 2015

Corporate Governance and Corporate

Financing and Investment during the

2007-2008 Financial Crisis

Tu Nguyen, H.G. (Lily) Nguyen, and Xiangkang Yin∗

We examine the impact of the 2007-2008 financial crisis on nonfinancial firms’ financing and

investment activities and the roleof corporate governance in alleviating the adverse consequences

of the external capital supply shock. Employing a difference-in-differences research design, we

find that better governance mitigates the disruption caused by the bank credit supply shock to

firms’ financing and investment activities. A variety of robustness tests suggest that our findings

are unlikely to be driven by an endogeneity problem. We obtain similar results when we extend

the sample period to include the delayed spillover fromthe banking sector to other capital market

sectors.

Can corporate governance mitigate the negative impact of financial crises on firm-level fi-

nancing and investment activities? In this paper, we investigate and provide empirical evidence

concerning this issue in the context of the 2007-2008 financial crisis.

We expect that better governed firms’ financing and investment are less severely affected

by the negative shock to the credit supply in the early stages of the crisis for several reasons.

First, better governance reduces agency costs, resulting in lower costs of capital, increased

operational efficiency, and better firm performance and valuation.1These qualities make better

governed firms less reliant on bank financing to meet their demand for capital than f irms with

weaker governance(Diamond, 1991; Chemmanur and Fulghieri, 1994; Bolton and Freixas, 2000;

Fulghieri and Suominen, 2010). Second, although better governed firms rely on bank financing

to a certain extent, by virtue of their higher degree of financial transparency and information

disclosure that mitigates the information asymmetry between insiders and outside investors, it is

less costly for them to switch from bank financing to other types of financing.2In other words,

they have greater flexibility in terms of external financing. This is even more valuable in difficult

times. Furthermore, as banks tighten lending standards during the crisis period, well-governed

Weare grateful for helpful comments and suggestions from RaghuRau (Editor) and an anonymous referee. Wealso thank

Susan Elkinawy, Wei-Han Liu, Angela Lou, David Prentice, and participants at the 4th Conferenceon Financial Markets

and Corporate Governance at the VictoriaUniversity of Wellington, New Zealand and the 2013 Financial Management

Association Annual Meeting. All errors remainour own.

∗Tu Nguyen is a Lecturer (Assistant Professor)of Finance at La Trobe University in Melbourne, Australia. H.G. (Lily)

Nguyen is a Lecturer (Assistant Professor)of Finance at La Trobe University in Melbourne, Australia. Xiangkang Yinis

a Professor of Financeat La Trobe University in Melbourne, Australia.

1For empirical evidence regarding the relation between corporate governance and firm performance and valuation, see

Gompers, Ishii, and Metrick (2003), Aggarwal and Williamson(2006), Dittmar and Mahr t-Smith (2007), Harford,Mansi,

and Maxwell (2008), Aggarwal et al. (2008), and Bebchuk, Cohen, and Ferrell (2009).

2Ivashina and Scharfstein (2010) find that banks sharply curtail lending to the corporate sector during the crisis. On

the other hand, Greenlaw et al. (2008) document that the stock markets and the marketsfor high-g rade corporate bonds

remained relatively unscathed through the early stages ofthe crisis.

Financial Management •Spring 2015 •pages 115 - 146

116 Financial Management rSpring 2015

firms are more likely to meet the stricter lending standards than poorly governed firms. Other

things being equal, better governed firms should be less severely affected by the negative shock

to the supply of bank credit. In other words, the adverse effect on financing of these firms during

the early stages of the crisis period should be less dramatic; and this translates into a smaller

adverse effect on investment, all other things held constant.

We focus our main analysis on the early stages of the 2007-2008 crisis (July 1, 2007-June 30,

2008) when the confounding effect of a demand shock has not yet been at work.3Thisperiod pro-

vides a natural experiment for separating the effect of the supply channel on corporate behavior.

Weemploy a comprehensive measure of corporate governancethat encompasses those governance

mechanisms that have received the most attention in the academic literature, namely, board and

chief executiveoff icer (CEO) characteristics, compensation, insider ownership,transparency, and

antitakeovermeasures.4Following the common approach in studies examining the effect of corpo-

rate governanceduring a crisis period (Mitton, 2002; Erkens, Hung, and Matos, 2012), we measure

firm-level corporate governance as of the end of 2005 to lessen the likelihood that the governance

variable is jointly determined with the sample period’s corporate financing and investment.

FollowingDuchin, Ozbas, and Sensoy’s(2010) empirical methodology, weemploy a difference-

in-differences approach that compares a firm’s financing and investment one yearbefore and one

year after the onset of the crisis. We find that the credit crisis significantly affects the financing

and investment behavior of firms in our sample. In the first year following the onset of the crisis,

net debt issuance declines by approximately 1.6% of assets for a firm without a credit rating

as of June 2006. However, consistent with our prediction, the adverse effect on financing is

mitigated for firms with better governance. Specifically, a one-standard-deviation increase in the

governance index reduces the decline in net debt issuance by one-tenth, and a governance index

of 78.68%, approximately twostandard deviations above the sample mean, completely eliminates

the decline. The parallel decline in capital expenditures is 0.4% of assets, but a one-standard-

deviation increase in the governance index reduces the decline in capital expenditures by 10.3%,

and a governance index of 76.92% completely eliminates the decline.

Overall, while estimates from our baseline specification indicate that corporate governance

alleviates the effect of the external capital supply shock on corporate financing and investment,

there may be a concern that the governance index measured at the end of 2005 is not sufficiently

predetermined. To further address these endogeneity concerns, we measure corporate governance

further back in time; specifically, at the end of 2003 and at the end of 2004. Our results from

this robustness check are qualitatively similar. Furthermore, we do not find similar results for

placebo crises in the summers of 2004-2006, lending us some confidence that our main results are

truly associated with the crisis period. While it is empirically challenging to truly control for the

endogeneity problem and fully exclude confounding effects, the results of these robustness tests

combined suggest that our main findings are unlikely to be driven by the joint determination of

corporate governance and corporate financing and investment or merely reflect a general feature

of the data. In additional analyses, we investigate whether corporate governance alleviates or

exacerbates investment distortions while easing the effect of the external capital supply shock

on corporate investment. We do not find evidence of distortions in the firm investment process

during the early stages of the crisis.

As a further robustness check, we extend the postcrisis period and observe the impact of

a spillover from the banking sector to the securities markets. Both net debt issuance and net

3Tong and Wei (2008) show that the effects of the subprime mortgage crisis in the early stages are exerted primarily

through supply-side channels.

4For a reviewof the related literature, see Becht, Bolton, and R ¨

oell (2003).

Nguyen, Nguyen, & Yin rCorporate Governance and Corporate Financing and Investment 117

equity issuance decline, with firms with weaker governance experiencing a greater reduction.

The contraction in the availability and use of financing is accompanied by a reduction in real

outcomes that is also more severe for poorly governed firms. Overall, the evidence supports the

view that governance mechanisms in place mitigate the disruption caused by the external capital

supply shock to firms’ financing and investment activities.

Our study contributes to the literature that examines how variations in the supply of external

capital influence corporate behavior. Sufi (2009) analyzes the effects of the introduction of

syndicated bank loan ratings in 1995 on the financial and real outcomes of fir ms that obtain

a rating. Lemmon and Roberts (2010) study the implications of changes in regulation and the

collapse of the junk bond markets in 1989 for the financing and investment behavior of below-

investment-grade firms. In contrast, our study does not merely investigate the consequences of

the 2007 credit supply shock for firms’ financial and investment policies, but focuses on the role

of corporate governance in mitigating the adverse consequences. To our knowledge, our paper is

the first to investigate and document the mitigating effect of governance mechanisms in place on

corporate financing and investment subsequent to the credit supply shock.

In studying the consequences of the financial crisis for the corporate sector, our work is an

extension of Duchin et al. (2010). Duchin et al. (2010) examine the effect of the financial crisis on

corporate investment and provide evidenceregarding the precautionary benef its of cash holdings,

that is, internal resources in the form of cash reserves lessen the decline in corporate investment.

Following Duchin et al.’s (2010) methodology and controlling for firms’ beginning level of cash

reserves, we show that the decline in corporate investment is associated with a decline in firms’

net debt issuance in the first year following the onset of the bank credit supply shock, and an

additional decline in firms’ net equity issuance in later periods that witness the spillover from

the banking sector to other capital market sectors. More importantly, we find that good gover-

nance mechanisms act as a buffer against the capital supply shock, lessening its impact on both

corporate financing and investment. Thus, our work also contributes to the growing body of

research that examines the real effects of the 2007-2008 financial crisis on the corporate sector

(Tong and Wei, 2008; Campello, Graham, and Harvey, 2010; Ivashina and Scharfstein, 2010,

among others).

Our paper also adds to a strand of literature that examines the linkage between corporate

governanceand cor porate policies. Regarding corporate financing, a prevalent view in the existing

literature is that managers prefer to issue less debt than shareholders wish for because of a desire

to reduce bankruptcy risk to protect their underdiversified human capital (Fama, 1980) or their

dislike of performance pressures associated with the commitments to service the debt (Jensen,

1986). Consistent with this view, Berger, Ofek, and Yermack (1997) show that managers who do

not face pressure from either ownership and compensation incentives or activemonitoring tend to

avoid debt, and Garvey and Hanka (1999) find that firms that are shielded from takeovers reduce

their use of debt. Contrary to the traditional view,Wald and Long (2007) show that manufacturing

firms incorporated in states that have passed antitakeover laws increase their leverage after the

passage of these laws. John and Litov (2010) also find that firms with entrenched managers, as

measured by the Gompers, Ishii, and Metrick (2003) governance index, use more debt financing

and have higher leverage ratios. These latter studies support the view that entrenched managers

may pursue more conservative investment policies and debtholders, in turn, may view a firm

with weak shareholder governance as being less risky and therefore provide better terms for debt

financing.

In a similar vein, empirical evidence concerning the relation between corporate governance

and investment is also mixed. Richardson (2006) finds that firms with more activist shareholders

experience lowerlevels of overinvestmentof free cash flows. Harford, Mansi, and Maxwell (2008)