Corporate governance is normally associated with scandals such as Enron, Worldcom, Parmalat and Maxwell. It is not, in general, linked with capital markets, but I will argue that these are fundamentally related and that corporate governance is critical to the future development of capital markets.
The starting point for this is the impact of corporate governance on corporate performance. Does corporate governance improve performance? It is not easy to answer this question in that it is hard to measure corporate governance, difficult to isolate its effect from all the other influences on corporate performance and complicated to determine the direction of causation—whether good governance results in good performance, or vice versa. However, there is mounting evidence that corporate governance does matter in terms of corporate performance.
One recent study attempts to overcome the first of these problems by using investors’ own assessment of corporate governance of firms, and highlights companies where corporate governance standards are thought to be inadequate. It finds a significant effect of corporate governance on both accounting measures of performance—return on assets and share price returns.
The relation is particularly significant with regard to corporate failures. A recent study of institutional activism reveals very significant returns to it. The particular case is the Hermes UK Focus Fund in the UK. The fund is active in replacing management, stopping investments, forcing asset sales and changing financial policy in poorly performing firms through direct engagement with management. The outcomes of these interventions are associated with significant share price gains in the target firms and, overall, Hermes’ UK Focus Fund earned significantly higher returns than the market average. Further, more than 90% of that superior performance may be attributed directly to the interventions.
Corporate governance, therefore, matters in terms of corporate performance—but what about in relation to capital markets? One of the best-known pieces of research on this is in the field of law and finance. There is a relation between the degree of investor protection across countries and the development of financial markets. Investor protection that emanates from common law legal systems—such as India’s, the UK’s and the US’—is associated with better developed financial markets than that of civil law countries—such as France, Germany and Scandinavia.
The reason is that common law systems provide investors, in particular minority investors, with better and more appropriate protection than civil law systems. Investors are, therefore, willing to invest to a greater extent, and capital markets are deeper and more liquid. However, the assertion that law and regulation are the main driving forces behind capital market development has been challenged by looking at the early emergence of capital markets in developed economies.
Studies of the evolution of equity markets in Germany, Japan and the UK record flourishing markets at the beginning of the 20th century, even in countries such as Germany that are now associated with banking rather than stock market systems. This occurred in the absence of strong investor protection in any of these countries.
The most striking case is that of Japan. At the beginning of the 20th century, it had active stock markets raising significant amounts of finance. There was little investor protection until after World War II, when US-style regulation was adopted. Far from strengthening Japanese stock markets, this externally imposed tightening of regulation was associated with a shift from a stock market to the insider system of bank and inter-corporate ownership with which we associate Japan today.
So, how did capital markets evolve in the developed world in the absence of strong investor protection?
The answer appears to be that institutions played an important role in upholding relations of trust between investors and firms—institutions such as the many local stock markets that used to exist in towns around the UK; the banks in Germany that played as important a role in supporting the country’s stock markets as in providing loans to companies; and the business coordinators and family firms, the zaibatsu, in Japan.
Good corporate governance is associated with upholding conditions of trust and, while formal systems of regulation may be required when those conditions of trust break down, they are critical in the early development of capital markets.
Understanding the institutional conditions that promote relations of trust is critical to the successful promotion of capital markets. These institutional arrangements allow firms to provide the commitments to investors that give them access to capital markets. They correspondingly grant companies the freedoms to realize their full capabilities.
When institutional arrangements for upholding trust fail, then regulation is the response to crises, as was seen in the US in the 1930s, the UK at the end of the 1940s, in Japan at the beginning of the 1950s, and in the US again at the beginning of this decade.
In future, the commitments that will be required of good corporate governance will be much greater. Corporate governance that promotes the interests of corporations and investors alone will no longer be adequate. It will not be acceptable to have economic development that creates serious degrees ofinequality, benefits this generation at the expense of degradation of the environment in the future, or misleads or damages the health of consumers.
What will be meant by good governance everywhere in the future will be embracing the interests of society more generally and future generations as well as the current. But, this is not a threat to the viability of business. On the contrary, it is as potentially profitable for the corporate sector as it is intellectually challenging for academics.
Colin Mayer is the Peter Moores dean of the Saïd Business School, University of Oxford. This is the text of the keynote address Mayer delivered at the Oxford India Business Forum on 14 March in Mumbai.
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