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

• DOI: http://doi.org/10.1111/irfi.12085
• Published date: 01 September 2016
• Author: Xiaofei Pan,Can An,Gary Tian
• Date: 01 September 2016

How Does Corporate Governance

Affect Loan Collateral? Evidence

from Chinese SOEs and Non-SOEs

CAN AN

†

,XIAOFEI PAN

‡

AND GARY TIAN

§

†

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

ABSTRACT

We examine the effect of corporate governance on the collateral requirements

for firms’bank 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 firm’s 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

I. INTRODUCTION

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. 325–356

DOI: 10.1111/irfi.12085

financial distress. As a firm’s 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 China’s

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 China’s 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”.

1

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.

China’s environment is an excellent laboratory in which to conduct this

research for the following reasons. Firstly, China’s 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

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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 pyramid’s 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

government’s tight control over interest rates during our sample period, which

severely limited creditors’use of loan pricing to differentiate across borrowers

with different levels of risk (Podpiera 2006; Koivu 2009).

2

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 China’s 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 banks’interests 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

327