The peer effect of corporate financial decisions around split share structure reform in China

• DOI: http://doi.org/10.1002/rfe.1088
• Author: Qian Wang,Wei He
• Date: 01 July 2020
• Published date: 01 July 2020

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wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2020;38:474–493.

© 2019 University of New Orleans

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INTRODUCTION

Peer effect recently has received growing attention from researchers with evidence ranging from corporate investment, trading

strategies, to CEO compensation adjustment. It is the application of social learning in decision‐making, where investors con-

verge in behavior (herding) and ignore the private information signals (cascading) in their trading decisions. In the corporate

context, firms observe prior actions and outcome of industry peers in making corporate decisions. Managers learn by observing

the consequences of their peer firms’ actions and engage in herding and informational cascades in making decisions as they are

concerned about their reputation and consequences if they are away from the industry norm. If revising the financial policies to-

ward those of peers is consistent with shareholder interests, managers would have more incentives to engage in peer mimicking.

Herding cascade models by Banerjee (1992) and Bikhchandani, Hirshlerifer, and Welch (1992) indicate that managers may

mimic industry peers’ decisions to claim that the firm belongs to a desired group. Cascade applies to the situation where private

signals might be too costly to obtain so managers decide to use the peer group information as a benchmark to make corporate

decisions. Kaustia and Rantala (2015) show that firms are more likely to execute stock splits after their peers recently have

done so, especially with a favorable impact on stock prices. Grennan (2019) provides additional evidence that firms’ dividend

policies are responsive to peer influence and investors partially anticipate the consequences of peer effects. Managers may

prefer to mimic peers' decision to minimize their professional risk as well. Scharfstein and Stein (1990) show that herding

Received: 1 July 2019

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Revised: 21 September 2019

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Accepted: 26 September 2019

DOI: 10.1002/rfe.1088

ORIGINAL ARTICLE

The peer effect of corporate financial decisions around split share

structure reform in China

WeiHe1

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QianWang2

1LaPenta School of Business,Iona College,

New Rochelle, NY, USA

2College of Business and

Computing,Georgia Southwestern State

University, Americus, GA, USA

Correspondence

Qian Wang, College of Business and

Computing, Georgia Southwestern State

University, Americus, GA 31709, USA.

Email: qian.wang@gsw.edu

Abstract

We examine the peer effects in financial decisions of Chinese listed companies for

the period of 1998–2016 as well as around Split Share Structure Reform (SSSR).

Consistent with the information‐based theory of learning, Chinese firms do adjust

their capital structure in response to the changes in their peers’ market leverage

ratios. The industries that are more competitive, with more young firms, and high

leverage volatility tend to exhibit stronger peer effects. Within industries, the firms

with lower market share and profits, paying no dividends, and being financially

constrained mimic their peers more strongly than their counterparts. The evidence

around the SSSR reveals that firms tend to follow their industry peers and leaders

more closely in making financial decisions after the reform. Finally, the mimicking

behavior in financial decisions enhances firm value in the long run and this finding

is more evident after the reform.

KEYWORDS

Capital Structure, Financial Policy, International Financial Markets, Peer Effects

JEL CLASSIFICATION

G15; G32

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HE and WanG

may be motivated by career concerns as it is potentially costly for managers to deviate from “the herd”. Low‐ability managers

under the threat of being replaced are better off mimicking the decisions of high‐ability managers. Morck, Shleifer, and Vishny

(1989), Farrell and Whidbee (2003), and Mergenthaler, Rajgopal, and Srinivasan (2011) also find that executive compensa-

tion and CEO dismissal largely depend on the firms’ financial performance relative to that of their industry peers. Therefore,

CEOs and executives have strong tendency to follow the peers in corporate decision‐making to secure their jobs and boost their

compensation.

Signaling appears to be another motivation for mimicking. The firm's financial policy signals to the market its financial

health and quality. Low‐quality firms tend to mimic the financial structure of high‐quality firms if signaling is not too costly.

Zeckhauser, Patel, and Hendricks (1991) suggest that free riding in information acquisition or relative performance evaluation

for managers may lead to herd behavior in capital structure policies. Free riding in capital structure decisions can help firms

avoid the cost to derive firm‐specific information and especially the information of those industry leaders (Bikhchandani,

Hirshleifer, & Welch, 1998). The existence of peer effect also proves that the information transfers among firms within the

same industry are valuable for the followers. There is evidence that highly levered firm mimic less levered competitors due to

predator price competition or lost market shares (Brander and Lewis (1986), Bolton and Scharfstein (1990), and Chevalier and

Scharfstein (1996)). Leary and Roberts (2014) find evidence of peer effects in capital structure decisions for U.S. firms.

In this paper, we investigate peer effect in the context of capital structure decisions. Consistent with the information‐based

theory of learning, our evidence shows that Chinese firms’ corporate structure decisions are influenced by their industry peer's

prior leverage revisions. The industries that are more competitive, with more young firms and high leverage volatility tend to

have stronger peer effects than the counterparts. Within the industry, the firms with lower market share and profits, paying no

dividends, and financially constrained are more likely to mimic their peers. Another objective of our study is to fill a research

gap by examining whether the Split Share Structure Reform (SSSR) has an impact on the mimicking behaviors of Chinese firms

in revising their capital structure toward their peers’. We predict that the peer effects of Chinese firms are more pronounced in

the postreform period than in the prereform period due to mitigated agency problems between tradable and non‐tradable share-

holders after the reform. The empirical evidence supports such prediction. Finally, the firms tend to follow industry leaders in

adjusting their leverage ratios and the Chinese stock market rewards the mimicking firms in the long run, especially after the

reform.

The peer effects of Chinese listed companies are particularly interesting due to the unique institutional settings in China.

The Chinese stock markets were established in early 1990s and experienced significant growth in parallel with the country’s

economy. Two classes of shareholders co‐existed under the split share structure—restricted non‐tradable shares for state and

legal persons and freely tradable shares for anyone else. The split share structure adopted by Chinese firms created conflicts of

interests between tradable and non‐tradable shareholders since both shares have the same voting and dividend rights but differ-

ent trading rights. The non‐tradable shares cannot be freely traded and can be transferred only with the authorities’ approval at a

value close to the book value or auctioned usually at a substantial discount due to its illiquidity. The restrictions on free trading

prevent state shareholders from capitalizing from share price fluctuations, therefore state shareholders have limited incentives

to exert sufficient monitoring on corporate decisions to ensure value maximization like private shareholders do. The China

Securities Regulatory Commissions (CSRC) realized the agency problem between the tradable and non‐tradable shareholders

and started the Split Share Structure Reform in 2005 to gradually abolish the trading restrictions on state shareholders’ non‐

tradable shares and convert them to be tradable over 3 years. The reform started with negotiations between non‐tradable and

tradable shareholders on a payout plan to compensate the tradable shareholders and completed all restricted share conversion

by the end of 2011. The Chinese stock markets then functioned the same in terms of pricing and valuation as the stock markets

in the western economy after the reform.

Several researchers empirically examine the impact of SSSR on corporate decisions as increased incentive alignment be-

tween state and private shareholders and improved corporate governance are expected after the reform. Liao, Liu, and Wang

(2014) report increases in output, profit, and employment after the reform and conclude that the reform played an important role

in aligning the interests of government and public investors. Bin, Chen, and Chan (2015) also find that SSSR improves the prof-

itability performance but does not necessarily benefit the corporate governance of Chinese listed companies. He, Mukherjee,

and Baker (2017) investigate the impact of SSSR on Chinese firms’ investment in working capital and find that increased work-

ing capital efficiency is associated with improved firm performance after the reform. Zhang, Gao, and Yang (2016) examine

the impact of SSSR on capital structures and find improved corporate governance and increased interest‐bearing debt ratios

due to market expansion after the SSSR. In contrast, Guo, Lien, and Dai (2016) studied whether the pecking order theory of

capital structure exists in China and found that Chinese firms use more equity than debt, especially after the SSSR. They also

note that the share reform has prompted Chinese firms to address the divergence of actual leverage ratios more quickly from

long‐term target levels, but not for short‐term target leverage divergence. He and Kyaw (2018) recently provide additional