The heterogeneous effect of governance mechanisms on zero-leverage phenomenon across financial systems

• DOI: https://doi.org/10.1108/CG-10-2020-0443
• Published date: 16 August 2021
• Date: 16 August 2021
• Pages: 67-88
• Subject Matter: Strategy,Corporate governance
• Author: Flávio Morais,Zélia Serrasqueiro,Joaquim J.S. Ramalho

The heterogeneous effect of governance

mechanisms on zero-leverage

phenomenon across financial systems

Fl

avio Morais, Zélia Serrasqueiro and Joaquim J.S. Ramalho

Abstract

Purpose –The purpose of this paper is to investigate whether the effect of country and corporate

governance mechanisms onzero leverage is heterogeneous across market- and bank-based financial

systems.

Design/methodology/approach –Using logit regressionmethods and a sample of listed firms from 14

WesternEuropean countries for the 2002–2016period, this study examines the propensity of firms having

zero leveragein different financial systems.

Findings –Country governancemechanisms have a heterogeneouseffect on zero leverage, with higher

quality mechanisms increasing zero-leverage propensity in bank-based countries and decreasing it in

market-basedcountries. Board dimension and independencyhave no impact on zero leverage. A higher

ownershipconcentration decreases the propensityfor zero-leverage policies in bank-basedcountries.

Research limitations/implications –This study’s findings show the importance of considering both

country- and firm-levelgovernance mechanisms when studying the zero-leveragephenomenon and that

the effectof those mechanisms vary across financialand legal systems.

Practical implications –For managers, this study suggests that stronger nationalgovernance makes

difficult (favours) zero-leverage policies in market (bank)-based countries. In bank-based countries, it

also suggests that the presence of shareholders that own a large stake makes the adoption of zero-

leverage policiesdifficult. This last implication is also importantfor small shareholders by suggestingthat

investing in firmswith a concentrated ownership reduces the riskthat zero-leverage policies are adopted

by entrenchedreasons.

Originality/value –To the best of the authors’ knowledge, this is the first study to consider

simultaneouslythe effects of both country- and firm-levelgovernance mechanisms on zero leverageand

to allow sucheffects to vary across financial systems.

Keywords Corporate governance, Financial system, Zero leverage, Country governance

Paper type Research paper

1. Introduction

Recent literature has considered the role played by corporate governance mechanisms on

several firm’s decisions and outcomes, such as the effect on dividend policy (Tahir et al.,

2020), on corporate social responsibility (Jouber, 2020) and on firm performance and value

(Aluchna et al.,2020;Daryaei and Fattahi, 2020;Vairavan and Zhang, 2020). There is also a

long debate about the effect of governance structures on firm’s financing decisions (Briozzo

et al., 2019;Elmagrhi et al.,2018;Sheikh and Wang, 2012), but little is known about their

influence on the adoption of financial conservative policies.

Financial conservatism is a topic that has acquired particular attention from corporate

finance researchers and practitioners in the past two decades, driven by the stylized fact

that a growing number of firms carry out substantially less debt than the optimal level

Fl

avio Morais is based at

the Department of

Management and

Economics, Center for

Advanced Studies in

Management and

Economics of the UBI

(CEFAGE-UBI) and

Research Center in

Business Sciences (NECE-

UBI), Universidade da

Beira Interior, Covilha,

Portugal. Ze

´lia

Serrasqueiro is based at

the Department of

Management and

Economics, Center for

Advanced Studies in

Management and

Economics of the UBI

(CEFAGE-UBI),

Universidade da Beira

Interior, Covilha, Portugal.

Joaquim J.S. Ramalho is

based at the Department of

Economics, Business

Research Unit (BRU-IUL),

ISCTE-Instituto

Universitario de Lisboa,

Lisboa, Portugal.

Received 2 October 2020

Revised 23 April 2021

Accepted 26 July 2021

The authors thank the two

anonymous referees for their

valuable comments and

suggestions on previous versions

of this paper. The authors would

like to thank financial support from

Fundac¸a

˜oparaaCie

ˆncia e a

Tecnologia (FCT) (grant: SFRH/

BD/119851/2016).

DOI 10.1108/CG-10-2020-0443 VOL. 22 NO. 1 2022, pp. 67-88, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 67

predicted by dominant capital structure theories(Strebulaev and Yang, 2013). In particular,

the trade-off theory claims that there is an optimal level of debt that maximizes firms’ value

and may be reached by balancing the benefits and the costs of debt (Kraus and

Litzenberger, 1973). Therefore, firms below their target level are leaving a substantial

amount of money on the table by not levering up to obtain debt tax shields. While this reality

is already a challenge for the capital structure literature, the findingsthat a growing number

of firms do not have any amount of debt (Bessler et al., 2013) is even more puzzling.

Particularly, Strebulaev and Yang (2013) show that, between 1962 and 2009, an average of

10.2% of large listed US firms followed a zero-leverage policy, with a growing trend that

rose from 4.3% in 1980 to 19.5% in 2009. See also Devos et al. (2012),Bigelli et al. (2014),

Dang (2013),Haddad and Lotfaliei (2019),Huang et al. (2017),Morais et al. (2020) and

Ramalho et al. (2018) for more evidence on the existence and persistence of zero-leverage

policies.

To explain firm’s motivation to adopt zero-leverage policies, which is one of the most

enigmatic managerial decisions about firm’s capital structure, most empirical studies

consider the existence of credit constraints, i.e. creditors are not willing to grant debt to

firms without reputation, and the desire to build up financial flexibility, i.e. firms opts to

remain without debt to preservefinancial flexibility. An alternative, less explored approachis

to explain the zero-leverage rationale by managerial entrenchment and governance

structures, under the arguments that weaker governance mechanisms give more power

and control to managers, smoothing managerial entrenchment and, consequently,

increasing their propensity to adopt debt conservative policies and stockpiling cash to

protect their own private benefits (Jensen, 1986). Byoun and Xu (2013),Devos et al. (2012)

and Strebulaev and Yang (2013) are the most recognized studies that use the corporate

governance approach to explain zero leverage. However, in spite of all of them using

samples of US listed firms, their results are not consensual. In particular, Strebulaev and

Yang (2013) find evidence that poorer corporate governance mechanisms, such as small

and less independent boards, increase zero leverage, while Devos et al. (2012) and Byoun

and Xu (2013), using the same and other indicators, did not find any significant effect of

corporate governance mechanisms on zero debt, rejecting the hypothesis that zero-

leverage policies are driven by entrenched managers and concluding that debt-free firms

do not have weaker governance mechanisms. This lack of consensus may be explained, at

least partially, by the fact that Strebulaev and Yang (2013) classify a firm as debt-free if in a

given year it does not have any amount of debt, while Devos et al. (2012) require that the

firm does not have any amount of debt for three consecutive years, which illustrates the

importance of using a suitabledefinition of what is a zero-leverage firm.

One important limitation of the studies that explain zero leverage by using corporate

governance arguments isthat governance mechanisms are considered only at the firmlevel

(i.e. mechanisms directly developed by the firm board and related structures or by the

firm’s controlling shareholdersas an attempt to align principal–agent interests), ignoring the

country-level governance quality. However, both firm- and country-specific governance

mechanisms influence monitoring forces, allowing a better or worse protection of external

shareholders against managers’ opportunistic decisions (Martins et al.,2017). The

importance of studying the role played by country-specific governance mechanisms on the

zero-leverage phenomenon is enhanced considering that such structures are a good

indicator of the country’s legal and regulatory system, shaping the strength of firms’

monitoring forces (Saona et al.,2020). Therefore, the validation of the arguments that zero-

leverage policies are driven by entrenched managers, which are potentiated by weaker

governance mechanisms, should consider both corporate and country governance

mechanisms.

Furthermore, supported by the findings of Bessler et al. (2013),Ghoul et al. (2018) and

Morais et al. (2020) that the zero-leverage phenomenon strongly depends on the financial

PAGE 68 jCORPORATE GOVERNANCE jVOL. 22 NO. 1 2022