Corporate governance risk and the agency problem

AuthorWalaa Wahid ElKelish
Publication Date03 Apr 2018
Corporate governance risk and the
agency problem
Walaa Wahid ElKelish
Purpose This study aims to investigate the relationship between corporate governance risk and
agencycosts across different countries.
Design/methodology/approach Corporate governance risk indicators were obtained from the
Institutional Shareholder Services Europe (S.A.) for 4,135 firms across 27 countries. Agency costs and
other control variables were derived from companies’ annual financial reports using the DataStream
database. Ordinary least squares multiple regression analysis model was used to test the study
Findings Agency costs have a significant negative impact on corporate governance risk across
countries. The extent of corporate governance mechanisms used, however, varies across geographic
regions and industry types. The relationship between corporate governance risk and agency costs is
more obvious in the non-financialthan financial sector. These results were robustafter several statistical
Practical implications The findings will help stakeholders, including corporate management,
regulators and investorsto improve corporate governance mechanisms and capital allocationdecisions
Originality/value Evidence is provided on the role of agency costs in corporate governance risk
across geographic regions for financial and non-financial companies. The paper also overcomes
common problems in corporate governance research such as construct validity, limited data and
Keywords Agency costs, Corporate governance, Financial and non-financial companies,
International variations
Paper type Research paper
1. Introduction
Previous empirical studies have often used the agencytheory (Jensen and Meckling, 1976)
to explain corporate governance practices (Aguilera and Jackson, 2010). This entails that a
conflict of interest between managers and shareholders creates agency problems, which
can be resolved using contractual agreements. Some scholars have argued, however, that
the basic principal–agent model provides limited solutions to agency problems arising with
other stakeholders, and undervalues international variations (Young et al., 2008). Some
empirical studies have, therefore, highlighted the importance of firm-specific characteristics
and/or national institutional factors such as legal, political, economic and cultural factors on
corporate governance mechanisms (Aggarwal et al., 2009;Ammann et al.,2013). The
results of these studies arevaried across countries (Doidge et al.,2007).
The main purpose of this paper is, therefore, to investigate the relationship between
corporate governance risk and agency costs across countries during 2014. The aim is to
highlight the heterogeneous nature of corporate governance models because of the
different agency problems in different geographic areas. This may provide useful
explanations for the mixed results in previous empirical studies. Corporate governance risk
Walaa Wahid ElKelish is
Assistant Professor at
Accounting Department,
College of Business
Administration (AACSB),
University of Sharjah,
Sharjah, United Arab
JEL classication M40, M41
Received 28 August 2017
Revised 25 September 2017
Accepted 2 October 2017
PAGE 254 jCORPORATE GOVERNANCE jVOL. 18 NO. 2, 2018, PP. 254-269, © EMERALD PUBLISHING LIMITED, ISSN 1472-0701 DOI 10.1108/CG-08-2017-0195
is defined as the “strength of governance mechanisms”, with strong governance
mechanisms indicating low risk of wealth expropriation and vice versa. The corporate
governance index is measured at the firm level and includes four dimensions: board
structure, compensation/remuneration, shareholders’ rights and audit practices. This
study’s findings suggest that corporate governance risk is related to agency costs and
other control variables. More specifically, the strength of these relationships is dependent
upon the geographic region and industry type. This implies that different corporate
governance models are applied to suit localagency conditions across countries.
This paper contributes to the literatureby investigating the impact of a comprehensive list of
internal and external factors on corporate governance risk across countries. It uses a
composite index of corporate governance practices, rather than single mechanisms, to
reflect a comprehensive range of internal and external control systems. The paper includes
a detailed analysis of several corporate governance risk sub-dimensions to highlight
possible improvements. The empirical analysis used a large sample of firms across several
developed and developing countries, unlike previous studies, which focused mainly on
particular western countries, such as the USA. More importantly, the study addresses
several standard problems of statistical models, including construct validity, limited data
and endogeneity. In this paper, Section 2 deals with the background and hypothesis
development, Section 3 presents the data collection and methodology and Sections 4 and
5, respectively, contain the empiricalresults and conclusions.
2. Background
The agency theory (Jensen and Meckling, 1976) predicts a conflict of interests between
corporate management and shareholders because managers can pursue their own
objectives in defiance of the interests of other shareholders. This basic principal–agent
model can also create information asymmetry, which allows managers to withhold important
information to maximize personal interests (Godfrey et al.,2003). Companies with a high
ownership concentration may sufferfrom principal–principal agency problems, where major
shareholders expropriate company resources from minority shareholders,using techniques
like tunneling. Contractual arrangements between management and shareholders can be
used to address these agency problems by providing incentives or constraints for
managers. It is further argued that the original principal–agent model may provide only a
limited solution to the agency problem, and undervalue different formal and informal
institutions across countries. This implies that different corporate governance models may
be used to deal with agency costs across countries to suit local conditions.
Previous studies on corporate governance determinants show heterogeneous results
across countries because of the existence of different firm-specific and country
characteristics. Firm-specific factors include level growth opportunities, external financing
needs, firm size, ownership structure, firm risk and industry characteristics (Aggarwal et al.,
2009;Ammann et al., 2013;Barucci and Falini, 2005;Brick and Chidambaran, 2008;
Doidge et al.,2007;Durnev and Kim, 2005;Giroud and Mueller, 2011). For example,
Durnev and Kim (2005) found a positive relationship between the quality of governance,
disclosure and growth opportunities, need for external financing and concentrated cash
flow rights using data from 859 firms across 25 countries. Some studies have found a
different evidence for developed and developing countries. Doidge et al. (2007) showed
that firm characteristics explain corporate governance in developed countries more than
that in developing countries. Other studies focused on country-level characteristics,
including legal (La Porta et al.,1998), political and economic (Kim et al., 2017;Roe and
Siegel, 2011). National cultural values have also been shown to affect corporate
governance practices (Sarahand Catherine, 2017).
This led to the emergence of two main research themes. The first debates whether firm-
specific or national factors are more important in determining the level of corporate

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