Question

How does corruption affect development? What is corporate governance? How does its definition relate to the shareholder value argument?

Answer 1

Corporate governance is a relatively recent concept (Cadbury 1992; OECD 1999, 2004). Over the past decade, the concept has evolved to address the rise of corporate social responsibility (CSR) and the more active participation of both shareholders and stakeholders in corporate decision making. As a result, definitions of corporate governance vary widely. Two categories prevail. The first focuses on behavioral patterns — the actual behavior of corporations, as measured by performance, efficiency, growth, financial structure, and treatment of shareholders and other stakeholders. The second concerns itself with the normative framework — the rules under which firms operate, with the rules coming from such sources as the legal system, financial markets, and factor (labor) markets. Both definitions include CSR and sustainability concepts. For studies of single countries or firms within a country, the first type of definition is the more logical choice. It considers such matters as how boards of directors operate, the role of executive compensation in determining firm performance, the relationship between labor policies and firm performance, and the roles of multiple shareholders and stakeholders. For comparative studies, the second type is more relevant. It investigates how differences in the normative framework affect the behavioral patterns of firms, investors, and others. In a comparative review, the question arises: how broadly should we define the framework for corporate governance? Under a narrow definition, the focus would be only on those capital markets rules governing equity investments in publicly listed firms. This would include listing requirements, insider dealing arrangements, disclosure and accounting rules, CSR practices, and protections of minority shareholder rights. Under a definition more specific to the provision of finance, the focus would be on how outside investors protect themselves against expropriation by the insiders. This would include minority rights protections and the strength of creditor rights, as reflected in collateral and bankruptcy laws and their enforcement. It could also include such issues as requirements on the composition and rights of executive directors and the ability to pursue class-action suits. This definition is close to the one advanced by economists Shleifer and Vishny (1997): “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.” This definition can be expanded to define corporate governance as being concerned with the resolution of collective action problems among dispersed investors and the reconciliation of conflicts of interest between various corporate claimholders. A somewhat broader definition would characterize corporate governance as a set of mechanisms through which firms operate when ownership is separated from management. This is close to the definition used by Sir Adrian Cadbury, head of the Committee on the Financial Aspects of Corporate Governance in the United Kingdom: “Corporate governance is the system by which companies are directed and controlled” (Cadbury Committee 1992, introduction). An even broader definition of a governance system is “the complex set of constraints that shape the ex post bargaining over the quasi rents generated by the firm” (Zingales 1998). This definition focuses on the division of claims and can be somewhat expanded to define corporate governance as the complex set of constraints that determine the quasi-rents (profits) generated by the firm in the course of relationships with stakeholders and shape the ex post bargaining over them. This definition refers to both the determination of the value added by firms and the allocation of it among stakeholders that have relationships with the firm. It can be read to refer to a set of rules and institutions. Corresponding to this broad definition, the objective of a good corporate governance framework would be to maximize firms’ contributions to the overall economy — including all stakeholders. Under this definition, corporate governance would include the relationship between shareholders, creditors, and corporations; between financial markets, institutions, and corporations; and between employees and corporations. Corporate governance would also encompass the issue of corporate social responsibility, including such aspects as the firm’s dealings affecting culture and the environment and the sustainability of firms’ operations. Looking over the past decade, we see increased emphasis on CSR, as reflected in investor codes, companies’ best practices, company laws, and securities regulatory frameworks. In an analysis of corporate governance from a cross-country perspective, the question arises whether a common, global framework is optimal for all. With the emergence of China, India, and Brazil, among others, as global economic powers, the traditional model for corporate governance — monitoring and supervision through active investors, free and informed financial media, and so on — is not necessarily the framework that works best in the increasingly significant emerging market economies. Concepts such as accountability and safeguarding shareholders’ interests have cultural moorings in addition to legal and economic foundations. Western concepts and approaches may not be translatable, easily understood, or relevant to non-Western cultures. Because corporate governance is essentially about decision making, it is inevitable that social norms and structures play a role. These vary from country to country. In Islamic countries, for example, Sharia law has a large role in many aspects of life, ethical and social, in addition to its role in criminal and civil jurisprudence (Lewis 2005). Corporate governance must operate differently in these environments. These differences underscore the necessity for some level of adaptation of corporate governance principles, an area of increasing activity in recent reform efforts, and of much research interest. Another question arises over whether the framework extends to rules or institutions. Here, two views have been advanced. One — considered as prevailing in or applying to Anglo-Saxon countries — views the framework as determined by rules and, related to that, by markets and outsiders. The second, prevalent in other areas, views institutions — specifically, banks and insiders — as the determinants of the corporate governance framework. In reality, both institutions and rules matter, and the distinction, although often used, can be misleading. Moreover, institutions and rules evolve. Institutions do not arise in a vacuum; theyare affected by national or global rules. Similarly, laws and rules are affected by the country’s institutional setup. In the end, institutions and rules are endogenous to a country’s other factors and conditions. Among these, ownership structures and the state’s role are important in the evolution of institutions and rules through the political economy process. Shleifer and Vishny (1997) offer a dynamic perspective: “Corporate governance mechanisms are economic and legal institutions that can be altered through political process.” This dynamic aspect is especially relevant in a cross-country review, but only lately has it received attention from researchers (see Roe and Siegel 2009; Licht 2011). It is easy to become bewildered by the scope of institutions and rules that can be thought to matter. An easier way to ask the question of what corporate governance means is to take the functional approach. This approach recognizes that financial services come in many forms, but that if the services are unbundled, most, if not all, key elements are similar (Bodie and Merton 1995). This approach — rather than the specific products provided by financial institutions and markets — has distinguished six types of functions: pooling resources and subdividing shares; transferring resources across time and space; managing risk; generating and providing information; dealing with incentive problems; and resolving competing claims on corporationgenerated wealth. We can operationalize the definition of corporate governance as the range of institutions and policies that are involved in these functions as they relate to corporations. Both markets and institutions will, for example, affect the way the corporate governance function of generating and providing high-quality and transparent information is performed.

Why has corporate governance received more attention lately?

One reason is the proliferation of crises over the past few decades, with the recent, ongoing financial crisis being another impetus to the realization that corporate governance affects overall economic well-being. The recent financial crisis has been a particularly severe wake-up call, because it has adversely affected employment, consumer spending, pensions, the finances of national and local governments worldwide, and the global economy. Weaknesses in corporate governance structures within companies and banks were cited as reasons for excessive risk taking, skewed incentive compensation for senior managers, and the predominance of a board culture that values short-term gains over sustained, long-term performance. However, these crises are manifestations of several structural reasons why corporate governance has become more important for economic development and a more significant policy issue in many countries.First, the private, market-based investment process — underpinned by good corporate governance — is now much more important for most economies than before. Privatization over the past few decades in most countries has raised corporate governance issues in sectors that were previously in the state’s hands. Firms have gone to public markets worldwide to raise capital, and mutual societies and partnerships have converted themselves into listed corporations. In the aftermath of the financial crisis, though, these precrisis patterns have slowed amid projections that the cost of capital will rise as its availability becomes more scarce. This change, too, will have consequences for corporate governance. Second, because of technological progress, the opening up of financial markets, trade liberalization, and other structural reforms (notably, deregulation and the removal of restrictions on products and ownership), the allocation of capital among competing purposes within and across countries has become more complex (when financial derivative products are involved, for example), as has the monitoring of how capital is being used. These changes make good governance, particularly transparency, more important but also more difficult — particularly from an accounting perspective, to provide investors with clear, comprehensive financial statements. Third, the mobilization of capital is increasingly one step removed from the principal-owner, given the increasing size of firms, the growing role of financial intermediaries, and the proliferation of complex financial derivatives in investment strategies. The role of institutional investors has grown in many countries, the consequence of many economies moving away from defined benefit retirement systems (upon retirement, the employee receives a set amount regularly) toward defined contribution plans (the employee contributes to a fund with a possible match from the employer, and retirement income is determined by the amount the employee has accumulated in his or her retirement savings account). This increased delegation of investment has raised the need for good corporate governance arrangements. More agents — asset management companies, hedge funds, institutional investors, proxy advisors, among others — are involved in the investment process, which means multiple steps between the investor and the final user of that investor’s capital. This increases the degree of asymmetric information and agency problems and makes corporate governance at each step between the firm and its final investor even more important. Fourth, programs of financial deregulation and reform have reshaped the local and global financial landscape. Longstanding institutional corporate governance arrangements are being replaced with new institutional arrangements, but in the meantime, inconsistencies and gaps have emerged, particularly those related to CSR and stakeholder engagement. Fifth, international financial integration has increased over the last two decades, and trade and investment flows have greatly increased, doubling in the period from 2000 to 2008, when the global financial upheaval reversed this trend (see McKinsey 2011; Lane and Milesi-Ferretti 2007). Figure 1 illustrates the trend through 2006. This financial integration has led to many cross-border issues in corporate governance, arising from differences in regulatory and legal frameworks embodied in company laws and securities regulators’ rules. What remains to be seen is how global and national responses to reduce the risks of another financial crisis will influence the direction of financial integration and, as a consequence, economic development.

The link between finance and growth

First, over the past two decades, the importance of the financial system for growth and poverty reduction has been clearly established (Levine 1997; World Bank 2001, 2007). The recent financial crisis has demonstrated how the lack of a sound, stable financial system can lead to severe risks with adverse economic consequences that are contagious and global in scope. There is extensive cross-country evidence establishing a positive impact of financial development on economic growth. Almost regardless of how financial development is measured, there is a strong cross-country association between it and the level of growth in GDP per capita. Although early cross-country evidence does not necessarily imply a causal link, many empirical studies (for example, Rioja and Valev 2004) using a variety of econometric techniques suggest that the relation is a causal one: that is, it is not only the result of better countries having both larger financial systems and growing faster. The relationship has been established at the level of countries, industrial sectors, and firms (as reviewed in Levine 2005, and documented recently in Ang 2008). This literature has been adding more evidence to that presented in the 2003 edition of Focus. Figure 2 illustrates this link, using data on economic growth for the last 20 years. It shows the relationship between the development of the banking system (private credit as a share of GDP) and GDP growth. In countries with more limited development of the banking system (private credit to GDP ratio below 30 percent), the average growth rate has been about 2.7 percent from 1990 to 2010, whereas countries with a more developed banking system have experienced growth rates exceeding 3.2 percent. However, questions on financial sector development remain. It is well known that there are significant differences among countries’ circumstances and various structural features; institutional aspects may have a direct bearing on the impact of financial development in the process of economic growth. Lin and coauthors (2010) suggest, for example, that certain types of financial structures — mix of large versus small banks — are more conducive to growth at a lower level of development. In light of the recent financial crisis, it is also argued that financial systems sometimes can grow too large and actually become a drag on economic growth and financial stability (Arcand et al. 2010). This is, in part, reflected in Figure 2, which shows that countries in the upper quartile of financial sector development actually did not grow faster than those in the third quartile in the last 20 years (whereas evidence covering earlier periods had shown that there was a monotonic relation, with greater financial sector development always associated with faster growth). Therefore, there remains a debate on the financial sector’s role in general development. Some argue that much of what the financial sector is engaged in — derivatives — is not productive to the economy, creating costly systemic risks that offer few benefits for development (Stiglitz 2010; Turner 2010). Others counter that financial innovation has reduced systemic and specific (for example, those of a company or an investor) risks, lowering the cost of capital, making financing more widely available worldwide, and enhancing liquidity to give investors more flexibility and choice for their portfolio strategies (see Philippon 2010).

The link between the development of financial systems and growth

Second, and importantly for the analysis of corporate governance, the development of banking systems and of market finance helps economic growth. In many studies, the impact on growth of the development of both the banking system and capital markets is economically large.Banks and securities markets are generally complementary in their functions, although markets will naturally play a greater role for listed firms. Empirical research documents that those countries with liquid stock markets grew faster than those with less-liquid markets.3 For both types of economies, growth per capita is higher where the banking system is more developed. This shows the complementarity between the two. More generally, the findings and supporting formal research provide support for the functional view of finance. That is, it is not financial institutions or financial markets themselves that matter, but rather the functions that they perform. In particular, for any regression model of growth that is selected and adapted by adding various measures of stock market development relative to banking system development, the results are consistent. At least until recently, it was found that none of these measures of financial sector structure has any statistically significant impact on growth (see Demirgüç-Kunt and Levine 2001; Beck and Levine 2004).4 To function well, financial institutions and financial markets, in turn, require certain foundations, including good governance, but not necessarily a certain mix of banks and capital markets. The role of the financial structure is being questioned, however, in part in light of the financial crisis. Although more research is needed, there is some evidence that structure can matter for economic growth (Demirgüç-Kunt and Feijen 2011; Levine and Demirgüç-Kunt 2001).5 The stability of those financial systems that are more market-based has also been questioned, but bank-based systems have not necessarily been stable either (IMF 2009). Questions have also been raised about the performance of financial conglomerates that provide many forms of financial services, and some work has considered that performance (see Laeven and Levine 2009). This issue has become an active policy debate, with (renewed) interest, for example, on whether there should be activity restrictions on commercial banks to assure greater financial stability (so-called Volcker rules, which restrict U.S. banks engaging in certain kinds of investment activities). More generally, there is a debate on the scope of financial activities and the perimeter of financial regulation (for example, whether hedge funds should be regulated). To date, however, research on this is limited.

Corruption and its Impact on Economic Growth

corruption and its impact on economic growth. In the most part, the available research on the issue of corruption has generally adopted a macroeconomic approach, examining corruption in terms of GDP, its impact on foreign direct investment, and its affect on the allocation of resources on a national level. In addition, the literature can be broadly grouped into quantitative and qualitative analysis of the impact of corruption. The primary issue involved with the quantitative research approaches has been the means used to operationalize the somewhat subjective variable of corruption. The qualitative studies focused on identifying and raising the issues. Thus, based on the review of related literature, theoretical frameworks and models are proposed. Extensive literature examined corruption from the perspective of rent-seeking behavior, which is the opportunity for an individual or a group to obtain income that exceeds the income normally available in a perfectly competitive market. Kahn and Jomo (2000) examined the impact of government-created rents on the development of Asian 14 economies; this differs from rents due to corruption because the government officially or unofficially sanctions the rent. The impact of official government rent and the unofficial rents due to corruption on economic growth is variable, as some types of rents are not invariably harmful to the economy. Hutchcroft (1997) supports this argument; the study found no simple or direct correlation between corruption and the economic growth of a developing country. The way that privileges and rents are distributed in the economy form four independent variables that determine the corruptive impact on the dependent variable of economic growth. In situations where corruption does not prevent development, the economy could grow despite the corrupt environment. Antwi and Adams (2003) found that when a governmental agency diverts resources from outside sources intended for urban renewal projects through high salaries and privileges for administrators, very few funds reach their intended use. This model corresponds with that of Hutchcroft’s model by establishing conditions where corruption impedes economic development. Mbaku (1999) concluded that political and institutional structures in African nations foster rent-seeking behavior by placing a large number of restrictions on ordinary economic activities. A complex regulatory system creates a strong tendency for bureaucrats to take advantage of their positions by seeking gratuities for performing routine services; this leads to endemic and institutionalized corruption. Colombatto (2004) examined corruption as a breach of contract between a principal and an agent; the ethics of the corruption is contingent on the underlying terms of the contract. In the context of government, the bureaucrat is bound by the implied 15 contract associated with the position and breaches the contract through the sale of administrative functions that should be freely granted. Corruption in the private sphere is self-limiting, because competitive forces eventually force the corrupt practices to end. Corruption in the public sphere, however, is subject only to the structural limitations placed on governmental activities. Easterly’s assessment indicated corruption’s effect on economic growth varies both in different countries and within a nation over time, as variable factors determine the impact (Easterly, 2001). The two decentralized and centralized models of corruption suggest that the way in which corrupt institutions operate in a society is a strong factor for determining corruption’s economic impact. In the decentralized model, the impact of corruption on economic growth appears to be more focused and reduces the overall level of incentives for individuals to engage in economic activity. This accounts for some of the differences in the impact of corruption among various nations. Research of Fisman and Gatti (2004) appears to support Easterly’s position. Their research suggests that decentralized governments are more corrupt because spending decisions are made at the local level, with less oversight of local officials by the central government. De Soto contends that when a government imposes excessive regulations, it reduces the rate of economic growth by raising the costs associated with business (De Soto, 2002). This creates a widespread disincentive for firms to engage in business, and economic growth reduces.