How does corporate governance influence corporate bankruptcy risk?
The corporate bankruptcy risk refers to the possibility that company will not be able to cope up with the obligations of debt. It describes the anticipation that the company will become insolvent, the reason for the occurrence of inability to serve the company debts (Rachdi, Trabelsi and Trad 2013.). Due to cash flow problems resulting for sales that are inadequate and high operating expenses. The organization might take in consideration the short-term borrowings (Yu, et al. 2016). In case that the situation is not improving, the firm is at the risk of bankruptcy or insolvency (Dedu and Chitan 2013). The investors at times consider the firms bankruptcy risk before making decisions of the equity or bond investment. The discussion deals with how the company governance affects the risk of bankruptcy of the company ( García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). According to the various theories, it can be found having a large board reduces the risk of bankruptcy only for the organization that are complex in nature. The part of the internal directors is inversely related to the insolvency risk, as the firs require more specialty knowledge (Limin, Boehe, Orlitzky and Swanson 2016). The power of the variables of the corporate governance increases when the bankruptcy risk time increases, even though the variables of the corporate governance are important predictors, the corporate governance changes is unable to save the firm from the insolvency risk (Rachdi, Trabelsi and Trad 2013).
Corporate governance is the set of, policies, regulations, rules and the various regulations that controls the behavior of the corporation (Parnes 2011). The various boards of directors, shareholders, advisors and other stakeholders are the ones who are responsible for the firm’s corporate governance. The corporate governance involves in providing the organization a framework for the attainment of organizational objectives. It also controls and measures each and every performance of the company (García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). The control an mechanisms of Corporate governance are designed to decrease the inefficiencies that takes place due to adverse selections and moral hazards. There are both internal and external monitoring systems. Monitoring that is Internal is done, by one or a more large stakeholders in the case of companies that are held privately or a business group firm. Monitoring that is External takes place when an third party who is independent like the the external auditor attests the information accuracy provided by managers to investors. The debt holder or the analyst of stock also can conduct such monitoring. An ideal control and system of monitoring should regulate both ability and motivation, while providing incentive alignment toward organizational objectives and goal.
A business faces various kinds of risk every day. It is important to for the organization to tackle the risk effectively. The effective risk management includes protection of the interest of the firms stakeholders. One of the major risks of the firm is the insolvency or bankruptcy risk that is the risk whether the firm will be able to satisfy allots debt or not (Jiraporn, Chatjuthamard and Kim 2015). The risk is more when the firm has no cash flow to manage its assets. The corporate governance has direct control over the insolvency risk of the company. Insolvency risk has been the most debated issue in the global financial crisis as it has the capability to shake the total economic system (García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). The major reason for the firm’s insolvency is the shakiness in the corporate governance of the firm. Effective corporate governance by La Porta, Lopez-de-Silanes, Shleifer and Vishny( 1999) argues that the corporate governance is the source of the investors protection and stabilizes the financial markets. The corporate governance provides a shield to the various suppliers of the corporations to make sure that their investments will materialize and will get the effective returns (Rachdi, Trabelsi and Trad 2013.)
According to the journal article “how does deposit insurance affect bank risk?” by Anginer, Demirguc-Kunt and Zhu (2014), the corporate governance is more favorable to the shareholders as the risk taking behavior of the banks increases, as the shareholders who are active are not exposed to the total risk any more(García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). They cannot be termed as risk avoider. The paper clearly says that the corporate governance is positively related to the bankruptcy risk. Another journal article found by Dedu and Chitan 2013, relates the effect of the internal corporate governance on the performance of the bank (Anginer, Demirguc-Kunt and Zhu 2014). The article is based on the various empirical analyses that include the structure of ownership, internal corporate governance index and the body of the management. In this study the cumulative influence of internal governance framework on the banking performance is analyzed, which says that the internal corporate governance is a crucial component that can influence the banking regulatory requirement (Jiraporn, Chatjuthamard and Kim 2015). The requirement may induce the “agency problem” that the shareholder faces, who wants to enhance the investment value and the regulator who wants the financial stability for each of the entity and reduce the bankruptcy risk (García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). The discussion is based on the possible weakness of the corporate governance in the Romanian banking system.
However, another journal article named by Parnes (2011), assesses the between corporate governance and the risk of bankruptcy relationship as a force that can affect the bond yield. After the various examinations in the article, Parnes stated that the level of corporate governance is negatively correlated with the risk of bankruptcy. It also informs that the credit agencies prefer to take the mixed approach as the aspect of corporate governance differs. The mixed approach is the measure of the underlying forces for the result of conflicts in the corporate governance and the bond yield relation (Dedu and Chitan 2013). The analysis in the study is done through a data base risk metrics directors that provides several substitutes for the instruments of management that affect the risk of bankruptcy and the corporate governance practice of the firms.
Iqbal and Ali (2016), in their article, “Governance and the Insolvency Risk of Financial Institutions” study on detail the relationship of corporate governance with the insolvency risk of the financial institutions (Lepetit and Strobel 2015). The analysis has been made from the samples of various US financial institutions from 2005 to 2010. They have come up with the conclusion that the insolvency risk is directly proportional to the insolvency risk. The better the corporate governance in the firm, the bankruptcy risk increases along with the performance of the firm. The risk of financial crisis is stronger in case of larger firms (Iqbal and Ali 2016)
In the case study of the Tunisian conventional bank named “Banking governance and risk” by Rachdi, Trabelsi and Trad 2013, it highlights the crucial role and the responsibility of the board of directors affects the risk in banking institutions. The function of the directors boards is directly associated with insolvency risk (Anginer, Demirguc-Kunt and Zhu 2014). Although they have no impact on credit and global risk, their existance of governance has a huge impact on insolvency ratios of the firm. The case study focuses different governance mechanisms that consists the main baking risk factors. The internal mechanism of governance and the ownership structure of a firm contribute in the determination of the risk of bankruptcy of the firm (Rachdi, Trabelsi and Trad 2013.).
In the Corporate risk and corporate governance journal by Li, Jahera Jr, and Yost, (2013) description of the various measure of risk is given. In the article, standard deviation is used in making of the various decisions of investment and measure the amount of historical volatility or risks associated with the investment (García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). The study indicates the amount of return that is deviating from actual anticipated ones. The article in a similar way links the corporate governance and the corporate risk and indicated the direct relationship between the two. It has been clearly indicated that corporate governance has a important effect on the volatility or organizational risk . The increase in the corporate governance there is the rise in the risk.
The fathers of the corporate governance Tricker and Tricker( 2015), in their book consisting of the various “principles, policies and procedures of corporate governance”, on the contrary argues that there is no link between the insolvency and corporate governance in the firms. According to the book the factors that affect the corporate risk of insolvency differs (Anginer, Demirguc-Kunt and Zhu 2014). When a company hires more recourses, which crosses the budget of the financial year, may contribute in insolvency. It is clearly mentioned that overspending is important determinant that can lead to a financial crisis for the corporate firms (Dedu and Chitan 2013). Another determinant pointed out in the book is the rise in the vendor cost. When a business had paid increase prices for the various commodities and the various operational costs, it may lead to the crisis. The company should be aware of the various debts and liabilities and keep on evaluating them in order to mitigate the risk the more the company pays off the risk the lower the financial risk will be.
Vanessa Finch in the journal named “corporate insolvency laws” (2017) has talked about the laws and the rules for the financial risks of the firms. According to her financial risk, management has become importantly significant in the last few decades. Due to globalization, the market of capital has triggered and there has been a increase in the volatility in the corporate sector. The boards of directors affecting the corporate governance are the decision makers of the organization. These decision-making processes are strongly related to the risk management strategies. The investment projects that are not supported by the internal funds, has to be obtained from external debts that leads to the increase in the bankruptcy risk. The study stresses more on the debt of the firms and highlights it to the most important determinant of the corporate bankruptcy risk. There is an indirect indication about the relation between the corporate governance and corporate insolvency risk (Jiraporn, Chatjuthamard and Kim 2015). The corporate governance is responsible for increase in debt and that leads to the bankruptcy of the firms.
Therefore, in order to conclude in the topic, after the critical analysis of the literatures of different journals, it can be said that the corporate governance has a major impact on the corporate bankruptcy risk. Although according to some authors, there is a negative relationship between the two, majorities of them focuses on the direct relationship. The increase in the corporate governance, the risk of corporate governance increases. Some conclusions can be drawn and formulations can be made with regard to a short set of rules for best corporate governance practice (Anginer, Demirguc-Kunt and Zhu 2014). The various principles underlying these rules are:
Hence, with due respect to Milton Friedman who has quoted that the social responsibility of business begins and ends with increasing profit, it can be concluded that successful run of the only requires market domination and shareholder value but also a sound corporate governance is required. In addition, sound corporate governance technique is not only about a fight between disloyal, distant stakeholders of institutions and greedy board of directors but also about the ethics of the organization and fulfilling its common goals (McCahery, Sautner and Starks, 2016).
References
Anginer, D., Demirguc-Kunt, A. and Zhu, M., 2014. How does deposit insurance affect bank risk? Evidence from the recent crisis. Journal of Banking & finance, 48, pp.312-321.
Dedu, V. and Chitan, G., 2013. The influence of internal corporate governance on bank performance-an empirical analysis for Romania. Procedia-Social and Behavioral Sciences, 99, pp.1114-1123.
Baysinger, B.D. and Butler, H.N., 1985. Corporate governance and the board of directors: Performance effects of changes in board composition. Journal of Law, Economics, & Organization, 1(1), pp.101-124.
Baysinger, B.D. and Butler, H.N., 1985. Corporate governance and the board of directors: Performance effects of changes in board composition. Journal of Law, Economics, & Organization, 1(1), pp.101-124.
Du Plessis, J.J., Hargovan, A. and Harris, J., 2018. Principles of contemporary corporate governance. Cambridge University Press.
Finch, V. and Milman, D., 2017. Corporate insolvency law: perspectives and principles. Cambridge University Press.
García-Sánchez, I.M., García-Meca, E. and Cuadrado-Ballesteros, B., 2017. Do financial experts on audit committees matter for bank insolvency risk-taking? The monitoring role of bank regulation and ethical policy. Journal of Business Research, 76, pp.52-66.
García-Sánchez, I.M., García-Meca, E. and Cuadrado-Ballesteros, B., 2017. Do financial experts on audit committees matter for bank insolvency risk-taking? The monitoring role of bank regulation and ethical policy. Journal of Business Research, 76, pp.52-66.
Iqbal, J. and Ali, S., 2016. Corporate Governance and the Insolvency Risk of Financial Institutions.
Jiraporn, P., Chatjuthamard, P., Tong, S. and Kim, Y.S., 2015. Does corporate governance influence corporate risk-taking? Evidence from the Institutional Shareholders Services (ISS). Finance Research Letters, 13, pp.105-112.
Lepetit, L. and Strobel, F., 2015. Bank insolvency risk and Z-score measures: A refinement. Finance Research Letters, 13, pp.214-224. Lepetit, L. and Strobel, F., 2015. Bank insolvency risk and Z-score measures: A refinement. Finance Research Letters, 13, pp.214-224.
Li, H., Jahera Jr, J.S. and Yost, K., 2013. Corporate risk and corporate governance: another view. Managerial Finance, 39(3), pp.204-227.
Limin, F., Boehe, D., Orlitzky, M. and Swanson, D.L., 2016. Inconsistency in corporate social responsibility and corporate risk. In annual meeting of Academy of Management in the Business Policy and Strategy Division, Anaheim, CA. Google Scholar.
McCahery, J.A., Sautner, Z. and Starks, L.T., 2016. Behind the scenes: The corporate governance preferences of institutional investors. The Journal of Finance, 71(6), pp.2905-2932.
Parnes, D., 2011. Corporate Governance and Corporate Creditworthiness. Journal of Risk and Financial Management, 4(1), pp.1-42.
Rachdi, H., Trabelsi, M.A. and Trad, N., 2013. Banking governance and risk: The case of Tunisian conventional banks. Review of Economic Perspectives, 13(4), pp.195-206.
Tricker, R.B. and Tricker, R.I., 2015. Corporate governance: Principles, policies, and practices. Oxford University Press, USA.
Yu, X., Krause, R.A., Bell, G. and Bruton, G.D., 2016, January. A Configurational Exploration of Family Relationships, Corporate Governance, and Firm Performance. In Academy of Management Proceedings (Vol. 2016, No. 1, p. 10063). Academy of Management.
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