How Does Corporate Governance Affect Loan Collateral? Evidence from Chinese SOEs and Non‐SOEs

Published date01 September 2016
AuthorXiaofei Pan,Can An,Gary Tian
Date01 September 2016
How Does Corporate Governance
Affect Loan Collateral? Evidence
from Chinese SOEs and Non-SOEs
Baoshang Bank Institute, Baotou, Nei Mongol, China,
School of Accounting, Economics and Finance, University of Wollongong,
Wollongong, New South Wales, Australia and
Department of Applied Finance and Actuarial Studies, Macquarie University, Sydney,
New South Wales, Australia
We examine the effect of corporate governance on the collateral requirements
for firmsbank loans in China. We find that firms with lower excess control
rights and other large shareholders face lower collateral requirements, which
is more pronounced in non-state-owned enterprises (SOEs) than in SOEs.
Regarding board characteristics, we find that smaller board size, more
independent directors, separation of the positions of CEO and chairman,
and larger supervisory board size can reduce a firms use of collateral; the effect
of all the preceding characteristics is more pronounced in SOEs. Overall, our
research suggests that, in China, corporate governance structures are able to
affect bank-lending decisions in respect of collateral requirements and that
the influence depends on the controlling shareholder type and associated
agency problems.
JEL Codes: G21; G34
An evolving literature is beginning to focus on the agency conflicts faced by
creditors in modern corporations (Anderson et al. 2004; Ashbaugh-Skaife et al.
2006; Boubakri and Ghouma 2010; Lin et al. 2011). In principle, creditors face
two types of agency conflict. The first is the conflict between creditors and firm
managers. The separation between ownership and control leads to moral hazard
problems and managerial self-serving behaviors, at the expense of shareholders
and creditors. The second is the conflict between creditors and controlling
shareholders. In firms with concentrated ownership, controlling shareholders
have incentives to expropriate other investors, which incentives might be more
significant when other investors are creditors (Shleifer and Vishny 1997; Lin
et al. 2011). These agency conflicts will reduce the expected value of cash flows
to the firms and creditors and increase the probability that the firms will face
© 2016 Commonwealthof Australia. InternationalReview of Finance © 2016John Wiley & Sons Australia, Ltd
International Review of Finance, 16:3, 2016: pp. 325356
DOI: 10.1111/ir.12085
financial distress. As a firms financial distress will increase the credit risks faced
by creditors, creditors will require higher collateral to protect their interests in
case of default (Menkhoff et al. 2006; Chen et al. 2013).
Meanwhile, another strand of literature has documented that effective
governance mechanisms can mitigate the agency conflicts between creditors and
manager/controlling shareholders and thereby decrease the probability of
financial distress and the associated credit risks faced by creditors (Anderson et al.
2004; Ashbaugh-Skaife et al. 2006). Consistent with this view, existing studies
with cross-country evidence indicate that borrowers with better governance
are rewarded with lower collateral requirements (e.g., Francis et al. 2012;
Ge et al. 2012). However, Larcker et al. (2007) argue that existing studies do not
show a consensus on the appropriate measurement of corporate governance
indicators or of the number of corporate governance dimensions. This prompts a
question: how do various governance mechanisms affect collateral requirements
by creditors? In particular, the present study investigates the governance
mechanisms through which the financial distress faced by firms and credit risks
faced by creditors can be mitigated.
To answer this question, the relationship between corporate governance and
the use of collateral in loan contracts is examined, using a sample of Chinas
listed firms. This examination is motivated by the contrasting views on this
subject, which currently exist. On the one hand, it has been argued that the
corporate governance of Chinas listed firms is designed simply to meet the
regulatory requirements of the Chinese Securities Regulatory Commission
(CSRC), and Liu (2006) argues that the corporate governance model adopted in
China has demonstrated many built-in weaknesses, which makes it less effective
in disciplining management/controlling shareholders.
On the other hand, a
growing number of studies are beginning to document that corporate
governance has become more effective, especially since 2005 when listed firms
were required to complete the split-share structure reform (Huyghebaert and
Wang 2012; Liu et al. 2015). Thus, it is worthwhile to examine whether corporate
governance is an effective monitoring mechanism to benefit creditors. In
addition, rather than relying on the corporate governance index or country-
specific governance (e.g., Francis et al. 2012; Ge et al. 2012), this paper explores
the role of actual corporate governance practices within the two-tier board
structure. Moreover, we are interested in examining the effect of governance, as
measured by the excess control rights of controlling shareholders and other large
shareholder ownership, on the use of collateral. We then further investigate how
corporate governance interactively works with the ownership structure in
affecting the use of collateral.
Chinas environment is an excellent laboratory in which to conduct this
research for the following reasons. Firstly, Chinas listed firms exhibit concen-
trated ownership, and in many cases, the controlling shareholder is the govern-
ment, an individual, or a family. This indicates that the controlling shareholder
1 We thank the reviewer for pointing out this issue.
International Review of Finance
© 2016 Commonwealth of Australia. International Review of Finance
© 2016 John Wiley & Sons Australia, Ltd
has substantial control over the firm and potentially exposes creditors to severe
expropriation and credit risks. However, the dominant agency conflicts vary
across different types of owners. In state-owned enterprises (SOEs), the excess
control rights held by the government are mainly driven by the incentive of
the central government needing to separate SOEs from political interference
and to decentralize decision rights to SOE managers (Fan et al. 2013). Neverthe-
less, insulated from the pyramids top owners, SOE managers may be induced
into severe managerial agency problems, so that creditors mainly face agency
conflicts with firm management. In non-SOEs, controlling shareholders have a
strong incentive to enhance their ultimate control through excess control rights
and to extract private benefits, while managerial agency problems are mitigated
because controlling shareholders usually have an incentive to monitor managers
(Boubakri and Ghouma 2010; Cao et al. 2011); thus, creditors usually face agency
conflicts with controlling shareholders in non-SOEs. Therefore, we are able to
assess how better governance mechanisms interact with the type of ownership
control to prevent financial distress and how the collateral requirements of
creditors are determined.
Secondly, we intend to shed light on the impact that the supervisory board
has on the use of collateral, which is an important but unexplored aspect of
corporate governance, although the supervisory board in China still lacks the
power to appoint and dismiss executive directors, in contrast to the corporate
governance approach in Germany and Japan. Lastly, China also provides a
unique opportunity for examining collateral requirements because of the
governments tight control over interest rates during our sample period, which
severely limited creditorsuse of loan pricing to differentiate across borrowers
with different levels of risk (Podpiera 2006; Koivu 2009).
In developed markets,
lenders are able to price loans through both interest rates and pledging collateral,
so that they face a potential endogeneity issue where ownership structure,
corporate governance, and collateral requirements might have a joint impact
on interest rates. This joint setting of interest rates and collateral requirements,
in most other countries, may contaminate any observed causal relationship
between ownership structure, corporate governance, and collateral requirements.
From this perspective, because our study is based on China, there will be less
concern over endogeneity.
Briefly, the results reveal that governance mechanisms influence the use of
collateral in Chinas listed firms but that their effects differ according to
ownership structure. Firstly, we find that the use of collateral is lower for firms
in which controlling shareholders have lower excess control rights or in which
other large shareholders have larger ownership and that this relationship is
stronger in non-SOEs than in SOEs. In terms of a two-tier board structure, the
2 This situation confirms the view that collateral is used to protect banksinterests from
defaulting by borrowers. This also addresses the alternative view that high-quality borrowers
are likely to pledge more collateral to enjoy a lower interest rate (Besanko and Thakor 1987), be-
cause regulation of interest rates in China prevents them from doing this.
Corporate governance and loan collateral
© 2016 Commonwealth of Australia. International Review of Finance
© 2016 John Wiley & Sons Australia, Ltd

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