Most people assume that good corporate governance benefits shareholders, and that corruption in a banking system should be rooted out. But just how much benefit does a company really get when it improves its accounting and puts a few outsiders on its board of directors? And when does an anti-corruption crusade start to backfire, causing a chilling effect that denies loans to credit-worthy borrowers?

India offers a chance to study both questions, which were the subject of papers presented at a global conference on India’s Financial System held in April at Wharton. The conference was organized by Wharton’s Financial Institutions Center with the Centre for Analytical Finance at the Indian School of Business in Hyderabad and the Stockholm-based Swedish Institute for Financial Research. 

Does Good Governance Matter?

A company that issues thorough and transparent financial reports and has a few outside directors who do not take orders from management is likely to serve its shareholders better than a company that doesn’t, and that should result in better stock returns. That is a given — an argument for sound corporate-governance rules. But is it true?

Lots of academic studies have shown that governance rules can affect share prices, the size of the stock market, the makeup of shareholders as a group and the way managers behave. But most studies compare countries with strong governance rules to countries with weak ones. There is little research to show how a specific change in governance requirements can affect the companies involved.

“The big question here is, does corporate governance affect firm values? Or, more importantly, does corporate governance matter, period?” asked Vikramaditya S. Khanna, of the University of Michigan Law School, speaking at the conference.

To tease out the effect of specific rules, Khanna and Bernard S. Black of the University of Texas Law School looked at Clause 49, a set of governance reforms proposed in India in 1999 and adopted in 2000.

Their research, reported in their paper, “Can Corporate Governance Reforms Increase Firms’ Market Values? Evidence from India,” shows that stronger rules can indeed boost stock returns. Stock prices of large companies jumped 4% immediately after the reforms were announced, Khanna and Black found. “We were quite surprised with how consistent the results appeared to be,” Khanna notes.

Most governance reforms apply to all companies in a country, and so researchers in this field typically have trouble determining whether a stock-price move at the time of a reform is caused by the reform or some other factor, Khanna and Black write.

Clause 49, requiring audit committees, seating of outside directors and annual certification of financial reports by top executives, offered a unique opportunity to study the question because it applied to large companies first. If they behaved differently from mid-sized and small firms, which did not have to comply for several more years, it would suggest that the large firms’ reaction was caused by the rules, not some outside factor influencing the market as a whole.

A Natural Experiment

“This sequence offers a natural experiment,” Khanna and Black write. “Large firms can be seen as the treatment group for the reforms. Small firms provide a control group for other news affecting the Indian economy generally…If investors consider the reforms to be valuable (or more valuable for larger firms), large firms’ share prices should react positively to the key adoption announcement, relative to small firms.”

Rapid growth and dramatic change in economic policy made India ideal for exploring the issue. “Prior to the adoption of Clause 49, India was considered a laggard in corporate governance,” the researchers state. From independence in 1947 through 1991, India was essentially a socialist country. With the government controlling the economy and most key aspects of financing, there was little incentive for managers of private firms to adopt good governance practices. A fiscal crisis in 1991 led to a series of economic reforms and rapid economic growth.

With government taking a smaller role, firms sought other sources of capital to finance expansion. That led to governance reforms in 1998 that were intended to ease investors’ worries about putting money into Indian firms. But because these rules were voluntary, few firms adopted them. In 1999, India’s securities regulator, the Securities and Exchange Board of India (SEBI), formed the Kumarmangalam Birla Committee to propose further reforms, and it came up with Clause 49, named for a clause to be added to stock-listing requirements. (Editor’s note: M. Damodaran, SEBI’s chairman, regards corporate governance a key challenge that Indian firms face today, as he told Knowledge at Wharton in a podcast .)

Khanna and Black identified six “event dates” when news about Clause 49 might affect share prices. They settled on May 7, 1999, when the government announced formation of the Kumarmangalam Birla Committee. The researchers found no previous news stories to alert the markets to this move, and there were no other news stories that day big enough to explain the markets’ behavior.

The May 7 news coverage suggested the reforms would be far-reaching and would apply to big firms first. On that date, there also was a strong indication the reforms would be adopted, because they were supported by the business community.

By the end of they day following the announcement, share prices of large-company firms traded on the Bombay Stock Exchange gained 4% more than those of small firms, the researchers found. Large firms returned 7% more than small ones over five days.

The results show that investors approved of the expected reforms, Khanna and Black concluded. Investors apparently believed that improving corporate governance would strengthen investors’ sense of trust, making them more likely to buy stocks. Anticipating this extra demand, investors pushed prices upward. Small-company stocks did not benefit as much because the reforms would not affect them for several years. The researchers also found that faster-growing companies benefited more than other firms, probably because the reforms would be especially valuable to firms with a heavy need to raise capital.

Khanna and Black noted that Indian investors and business people welcomed Clause 49, while Americans were at best lukewarm about the 2002 Sarbanes-Oxley law, commonly known as SOX, which was quite similar. Indians, they concluded, saw Clause 49 as a major step forward, given the relative lack of good-governance rules previously. In the U.S., which already had strong governance regulations, investors felt SOX was not so much an improvement as an added expense, they said.

Could some other factor account for the outsized gains around the announcement? a conference attendee asked. A search of new stories on the day of the announcement revealed nothing else out of the ordinary, Khanna said. “There really seemed to be nothing else going on except monsoon announcements and heat waves.”

Corruption Probes and Their Side Effects

Somebody has to watch, and someone has to watch the watchers. But when does breathing down the workers’ necks get in the way of the work? That is a problem for policy makers who want to deter corruption but don’t want the remedy to be worse than the ailment. For insight into these tradeoffs, Shawn Cole of the Harvard Business School and two colleagues looked at Indian banks, which use aggressive monitoring and severe penalties to keep lending officers honest.

The research results are described in the paper, “Are the Monitors Over-Monitored? Evidence from Corruption and Lending in Indian Banks,” co-authored by Abhijit Banerjee and Esther Duflo, who are at the Massachusetts Institute of Technology. “We find evidence that vigilance activities result in reduced lending. The amount of credit declines sharply at the affected bank branch, as well as neighboring branches,” the researchers report. “This effect is economically and statistically significant, persisting up to two years.”

Previous studies have measured the importance of credit, both to stimulate economic growth and to produce profits for lenders. Generally, it’s in everyone’s interest to make loans available to just about all borrowers capable of paying them back. In a 2003 study, Banerjee and Duflo found that Indian banks took a highly conservative approach to lending that limited bank profits and economic benefits. In many cases, for example, they preferred to invest their deposits in government bonds rather than use them for loans to industry.

The researchers speculated that the problem was an incentive system that gave little reward to lending offers who made loans that were repaid, but which confronted them with severe penalties, including corruption charges, when their borrowers defaulted. If this is the case, the cost of corruption is higher than previously believed, because it reduces the number of good loans. “There’s sort of a presumption of guilt and corruption” whenever a lending officer makes loan that turns out badly, according to Cole. “The bankers say, ‘Any loan default can trigger an investigation of my past history. This is something they care about a lot.”

Investigations can drag on for years, he added, ruining bank officers’ chances of promotion even if they are eventually cleared.

The study looked at nearly 2,000 cases of corruption at government-owned banks, which dominate the Indian financial system. The banks face persistent corruption, ranging from small overdrafts to loans to politicians and fictitious companies. Bank employees are considered public servants and are subject to strict anti-corruption rules, enforced by the Central Vigilance Commission in a way that makes many say they are presumed guilty until they can prove their innocence, the researchers point out. The commission reported in 2000 that in 1999 it investigated 1,916 cases of possible corruption, nearly three-quarters of them involving loans, with 55% of the loan cases resulting in recommendations for major punishment. Bank officers are often reluctant to resolve cases of loans gone bad for fear of being charged with corruption, giving India one of the highest default rates in the world, Cole and his colleagues found.

The researchers used data from the Reserve Bank of India covering loans at 43,000 bank branches. They compared the volume of lending at banks subject to fraud investigations to the volume at branches that were not affected. “Following the discovery of fraud, credit drops precipitously: by1.4% relative to branches in which a fraud is not discovered…” the researches say. Afterward, the affected branch lends less than the unaffected branches do. “We find that vigilance activity leads to substantial reduction in credit,” the researchers report. “Relative to an unaffected branch, a branch in which an officer is accused of corruption experiences a 20% decline in credit over a period of two years.”

In addition, lending declines in the bank’s nearby branches even if no corruption was found in them. Unaffected branches do not step in to increase lending to offset cutbacks by the affected branch. The chilling effect of investigations thus reduces the availability of loans in the entire town where the corruption investigation occurred.

Finally, once a fraud investigation begins, loan officers tend to lend money to borrowers in industries that are perceived to be less risky — taxi companies rather than construction firms, Cole notes.

It will take more research to determine how much of the cutback in lending is a beneficial reduction in corruption, and how much is cutback on good loans due an investigation’s chilling effect. “It’s still hard to say whether this is a good thing or a bad thing,” he says. But this study’s results suggest that some portion of the cutback is due to damaging “under-lending” to creditworthy borrowers, the researchers conclude. The fact that unaffected branches reduce their lending supports this view, as does the fact that branches tend to favor safer borrowers after an investigation.

“Rather than ‘root out’ a corrupt officer and continue to lend to the optimal mix of borrowers,” they conclude, “bank branches affected by a vigilance activity shift lending towards safer industries.”