Aloui jarboui “the effects of corporate governance on the stock return volatility during the financial crisis”, int j law management (2017)

The effects of corporate governance on the stock return volatility during the financial crisis International Journal of Law and Management The effects of corporate governance on the stock return volat.

International Journal of Law and Management

The effects of corporate governance on the stock return volatility: during the financial crisis

Mouna Aloui, Anis Jarboui,

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Mouna Aloui, Anis Jarboui, "The effects of corporate governance on the stock return volatility: during the financial crisis", International Journal of Law and Management, https://doi.org/10.1108/IJLMA-01-2017-0010

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The effects of corporate governance on the stock return

volatility: during the financial crisis

Keywords: Independent directors, outside directors, Stock return volatility, Simultaneous-equation models

INTRODUCTION

The board of directors is a critical element in a firm’s corporate governance system and the policy debate concerning corporate governance reform, especially regarding how the board structure contributes to reducing the stock price volatility (Steven J Jordan et al., 2012; Hathaipat Aimpichaimongkol, Ms et al 2013) One line of prior research has discovered that the supervising role of outside directors within the corporate governance system can effectivly stabilize the volatility of the stock returns (Kurt A Desender et al., 2008,)

However, other research suggests that advising and monitoring occur simultaneously, and the directors' knowledge is more critical for the volatility of the stock returns (Rhee & Lee (2008) This paper provides evidence that reconciles both views on the board’s structure by examining the impact of outside director’s tenure on advising and monitoring to reduce the stock price volatility

How the financial crisis (2006- 2009), and the souvrain crisis (2010 - 2012) affect global economies and cause the volatility of the stock return has been a topic being heatedly debated Researchers hold divergent views about the causes and origins of the financial crisis

In this context, several studies examined whether corporate governance plays a decisive role

in destabilizing the stock return volatility On the other hand, many research found that corporate governance (independent directors, foreign ownership, CEO ect…) contributes to the reduction of the stock returns volatility Moreover, the market has high adjustment ability and rapidly and efficiently responds to significant sales by foreign investors (Choe et al., 1999)

Walker’s review, UK, 2009, further investigated the weakness of corporate

governance as a principal factor of the financial crisis « it is clear that governance failures contributed materially to excessive risk taking which lead to the financial crisis Weaknesses

in risk management, the board’s quality and practice, the control of remuneration, and the exercise of ownership rights need to be addressed in the Uk and internationally to minimize the risk of a recurrence.”

However, Kirkpatrick (2009), argues that the current global financial crisis can be

“attributed to failures and weaknesses of the corporate governance arrangements” in financial service companies

Sias and Starks (2006) further investigated the relationship between corporate governance and stock return volatility They concluded that institutional shareholdings would have a positive impact on the stock price volatility.Moreover, David et al (2012) showed that companies with more independent advice and better institutional ownership have the worst stock performance during the crisis Similarly, Rhee & Lee (2008) examined the outside directors’ background which has an effect on the firm’s return volatility

Similarly, Steven J Jordan and Ji-Hwan Lee (2012) examined the possibility of a bilateral interplay between the board’s characteristics and foreign ownership, by using a variety of econometric models, including feedback, to test the robustness of (dynamic panel estimations, OLS) They showed that the proportion of outside directors with advanced foreign degrees stabilized the stock price volatility

Our study is motivated by different reasons The first motivation is from the vast literature central the question whether outside directors influence the stock return volatility (Bohl et al 2009; Chen et al 2013) In fact, the relationship between the independent directors and the stock return volatility is very weak in this area This paper contributes to the literature by examining the relationship between independent, outside directors and the stock return volatility This analysis is performed within the context of the French market because,

as we know, this problem has been researched exclusively on the Asian markets in Korea, and Taiwan Moreover, this paper has three distinct features that differentiate it from the existing studies First, it is among the first attempts to provide evidence that corporate governance (outside directors, independent directors) is an important determinant of the stock return volatility On the other hand, it is a commonly-used framework in the existing literature Empirical analysies found that the outside and independent directors seem to play a significant role in determining the stock return volatility Second, this paper provides a new perspective of choosing possible instrumental variables and resolving the endogeneity problem in the selection of the board’s structure and the stock return volatility based on outside, independent directors Finally, we use outside and independent directors of individual stocks as a direct measure of foreign presence in the local market to analyze the relation between the outside directors and stock market volatility

The results of this research have implications of potential interest to the regulators, managers, shareholder activists, and investors, as well as to academic researchers Besides, there is an extended push by numerous international institutions, regulators, and legislators toward a greater proportion of outside directors The estimation results show a strong relationship between outside directors and stock return volatility

The variables are chosen to capture the particular characteristics of the relation between corporate governance and the volatility of the stock market return Our study thus contributes to the existing literature by giving the first integrated approach to examining the linkage between corporate governance and the stock return volatility by using the

simultaneous-equation models with both panel and time series econometric techniques for 89 firms over the 2006–2012 period Specifically, this study uses three structural equation models which help to examine the impact of corporate governance (size, outside directors, and institutional investors) on the stock return volatility Therefore, more useful and reliable information can be provided to policy makers and investors to formulate effective policies for the stock return volatility Therefore, it is necessary for both investors and researchers to futher understand the stock price response to the crisis

The French stock market was chosen as the focus of this study because empirical analyses in this country on this stock market are relatively scarce Moreover, the negative impact of a financial crisis on a firm's stock price may not proceed in such a way that the firm's fundamental profitability is reduced

The French context presents an attractive setting to investigate the influence of the board’s structure (independent directors and outside directors) on the stock return volatility France has an institutional setting similar to that of most continental countries It is described

by La Porta et al (1997) as a civil law country, characterized by a high concentration of ownership, weak investor‘s rights and boards which are not independent in controlling the shareholders Futhermore, prior research on the link between stock price volatility and ownership structure during periods of crisis focused on the East-Asian stock market crisis of

1997 (Mitton, 2002; Baek et al., 2004) To our knowledge, this is the first study to investigate the importance of the board’s structure to explain the stock return volatility considering a Continental European stock market Using French data, we investigated whether the stock price fluctuation depends on the company’s ownership structure during the financial crisis Our results show that both inside ownership and its concentration are important to explain the stock price volatility during periods of crisis, after controlling the size and the sector The stock market volatility is positively related to insider ownership and the number of foreign shareholders but negatively related to ownership concentration and the number of financial shareholders

The algorithm of the article is as such: Section 2 briefly reviews the related literature, followed by section 3 that outlines the econometric modeling approach and describes the used data Section 4 depicts the empirical findings and the final section, section 5, holds the concluding annotations and offers some policy implications

LITERATURE REVIEW

Several existing studies on the nexus between corporate governance and the stock return volatility highlighted the relationship between corporate governance and the stock market Therefore, this paper reviews the literature under three subsections, e.g (a) outside directors and volatility stock return; (b) independent board and volatility stock return, (c) control variable and stock return volatility, which will be discussed below

Outside directors and stock return volatility

A few studies have focused on the role played by the relationship between outside directors

and stock return volatility.Studies in the current literature provide mixed results of the foreign ownership impacts on the stock price volatility

On the one hand, many papers argue that outside directors’ help to reduce the stock return volatility, but the consensus of these studies is that there is a negative impact running from outside directors to the stock return volatility Chen et al (2000) pointed out that the composition and characteristics of the outside directors enable them to reduce the stock return volatility

The existing literature indicates that the outside director’s sound monitoring will help raise the investors' confidence in the firm and therefore, the panic selling by investors in firms with better monitoring will be eased during the financial crisis As a consequence, their stock prices will be more stable Steven J Jordan et al (2012) indicated the role of the outside directors in reducing the stock price volatility Moreover, Steven J Jordan et al (2012) pointed out that their stock prices will be more stable, and there for support the negative impact running from the outside directors on the volatility stock return

The reforms in Korea have been the catalyst for numerous studies Choi et al (2007) studied Korea over the 1999, 2002 period and found the presence of outside directors and the level of foreign ownership positively impact on too firm’s valuation Other studies looking at firm value impacts include Black and Kim (2012), Cho and Kim (2007), Kim (2007) and Min (2013) However, none of these studies explored the effect of outside directors on foreign ownership Two studies come closest to remedying this omission Rhee and Lee (2008) found that foreign ownership increases when outside directors have advanced foreign degrees, affiliations with government organizations and experience in the relevant industry Kim et al (2010) showed that diffuse ownership and a firm's efforts to implement better corporate governance lead to higher levels of foreign ownership

In recent studies, Byung S Min et al (2015) have shown that the increase of foreign ownership associated with an improvement in the corporate governance system, occurred after controlling home bias and the firm’s size Furthermore, Byung S Min et al (2015) indicated that the positive effect of an outside director system on foreign ownership was greater for independent firms than for conglomerates (chaebols) and their affiliates The results are robust under a range of endogeneity tests

In this area, many studies argue that professional investors help reduce risks in companies, and the volatility of stock prices in which they invest (Li et al., 2011 and Umutlu

et al 2010) The increased presence of institutional investors in emerging equity markets improves risk control and reduces the risk exposure of the listed companies (and Cronqvist Fahlenbrach, 2009, Doidge et al 2004, Ferreira and Matos, 2008, Mitton, 2006 Umutlu et al.,

2010 and Wang and Xie, 2009) Foreign investors prefer to invest in well-established companies, which should further accelerate better corporate governance practices (Chari et al., 2006, Kelley and Woidtke 2006., Leuz et al., 2010, Rossi and Volpin, 2004 and Stulz, 1999) On the other hand, foreign investors could improve the quality of information on local stock markets, ensure better control of the company and the standard reports, improve a

corporate governance environment, which considerably reduces transaction costs, information costs, and risk exposure

Independent board and stock return volatility

In this vein, Mitton (2002), Lemmon and Lins (2003), and Baek et al (2004) found that corporate governance is effective regarding the stock price reduction in the event of a financial crisis However, the risk is another important factor on which investors base their investment Therefore, Huson et al., 2001; Choi et al., 2007) stated that a higher ratio of independent directors is expected to have a positive effect on corporate performance Hsu-Huei Huang and al (2011) believed that an independent board can help reduce the stock market volatility They divided the sample into two groups regarding whether the firm appoints independent directors, and investigated the effect of independent directors on the stock price volatility They showed that the price volatility and overreaction under the political crisis were lower in firms with independent directors than the ones without They measured the difference in price volatility using the standard deviation of stock returns In the same vein, the independent directors are more capable of independently and objectively monitoring managers than inside directors, which increases the investors' confidence in firms Improving the independence of the board has a subsequent effect of attracting foreign investors The home bias proposition and transaction cost theory provide further support for this view Foreign investors prefer firms that have governance systems similar to those in their countries (Dahlquist et al., 2003; Karolyi and Stulz, 2003; Bell et al., 2012)

The control variable and stock return volatility

The relationship between the control (size, COE,) variable and the stock return volatility has been the subject of considerable studies over the past few years The board’s structure has an influence on the price volatility and overreaction Burcu Nazlioglu et al (2012) showed that the interaction of ownership structure and the stock price differ from one period to another They indicated that there was a positive relationship between inside ownership structure and stock price during the period between January 2008 and March 2009 Moreover, a negative relationship was observed during the period between October 2008 and January 2009 A strong negative relationship is monitored between the largest ownership, the concentrated ownership, and the stock prices

Besides, Hsu-Huei Huang et al (2011) stated that the chairman of the board concurrently serving as the CEO will lead to increased price volatility and overreaction during

a political crisis as a result of the deterioration of the monitoring mechanism and the reduction

of the investors' confidence in firms Some studies, which examined the relationship between the control variables for firms (size, ROA) and the stock return volatility showed a significant effect on the price fluctuation, and the variable was found to be the most significant factor among those control variables

METHODOLOGY AND DATA

The following regression equation is formulated to test empirically the

VOL i= +α β CEO i+β FD i+β INDD i+β CPA i+β LEV i+β SIZE i+β PER i+β TURN i+εi (1) The  , as the dependent variable in the model, is measured by the following variables,

which include the standard deviation of annual stock returns The CEO is a dummy variable

denoting whether or not the chairman of the board holds the position of CEO The INDD, which represents the independent directors, is measured according to whether the firm

appoints independent directors, or by the ratio of independent directors The FD which

represents the outside directors is measured according to whether the firm appoints outside

directors, or by the ratio of outside directors The CPA refers to the auditor-related variables

including the audit opinion and whether the firm has previously switched accounting firms In addition to the variables related to corporate governance, the following five control variables are included to the regression model The PER represents the firm performance in terms of the

relative ROA The  is measured by the natural log of the total liabilities The SIZE is

measured by the natural log of the market value of equity and the LEV is the firm's debt ratio

measured by the ratio of total debt to total assets Our work is a panel data study, Eq (1) can be written in the form of panel data as follows:

VOL it =α+αi+∑jβ j E jit+∑nδn Y n+εit (2) Since our study is a panel data study, Eq (3) can be written in a panel data form as follows:

VOL it=α+αi+∑j−1β j E jit+∑nδn Y n+εit (3)

FD

FD INDD it =α+αi INT it+βvd VOL it+βvf +βvv INDD i t− +∑nδn Y n+εit (5)

INDD VOL

FD it =α+αi FD it+βvd it+βvf +βvv FD i t− +∑nδn Y n+εit (6) The Panel data analysis is the most efficient tool to use when the sample is a mixture of time series and cross-sectional data When the unobserved effect is correlated with independent variables, pooled OLS estimations produce their biased and inconsistent estimators The general approach for estimating models that do not satisfy strict exogeneity is to use a transformation to eliminate the unobserved effects and instruments to deal with endogeneity (Wooldridge, 2002) Thus, we decide to use the two-step system estimator (SE) with adjusted standard errors for potential heteroskedasticity proposed by Arellano and Bond (1998)

The econometric methodology for estimating the set of the presented equations is the GMM (General Method of Moment) dynamic panel A dynamic model is a model in which one or more lags of the dependent variable are included as explanatory variables Unlike the dynamic GMM, a standard econometric technique, like the MCO, does not provide efficient estimates of such a model, because of the presence of the lagged dependent variables to the right of the equation The estimate by GMM allows providing solutions to the problems of simultaneity bias, reverse causality, and omitted variables It allows treating the endogenous variable problems They were estimated simultaneously using the generalized method of moments (GMM) which is the most commonly used estimation method in models with panel data and the multiple-way linkage between some variables This method uses a set of instrumental variables to solve the endogeneity problem

The main purpose of this study is to investigate whether corporate governance has any impact

on the stock price volatility under the financial crisis Accordingly, we choose the financial crisis of 2006- 2012 as our research background Due to the crisis, the Franch stock market dramatically declined after the crisis Although the event ended one month later, the stock price following the event was significantly more volatile than the one before the elections Besides, the stock prices of some firms experienced large down and up fluctuations, while the stock prices of other firms appeared relatively stable These results show that firms overreacted differently to the financial crisis Thus, we will try to investigate which kind of firms responded to smaller price volatility and lower levels of overreaction during the financial crisis

EMPIRICAL RESULT AND DISCUSSION

Furthermore, we examined the role of corporate governance which encompasses equity structure, the board structure, the audit opinion, and whether the accounting firm was switched or not Our sample includes 89 listed firms on the French Stock Exchange The data for all the variables about the stock price, financial information and corporate governance required in this study, are obtained from the database of the SBF 120 echo investing Next, the descriptive statistics of the different variables for individuals and also for the panel are given below in Table 1:

Table 1: Summary statistics

First of all, the maximum standard deviation of the stock returns in the financial crisis in our sample is 1.67%, and there is also a much smaller standard deviation of 0.003% These figures show that the impact of the financial crisis on a firm's stock price volatility differed significantly from one firm to another The question whether the differences were related to corporate governance and the firm’s performance is the central focus of this study As shown

in the table, the proportion of firms in which the chairman of the board is concurrently serving

as the CEO is 1.% The proportion of independent directors is 33 3% Overall, the ratio of independent directors to all the directors on the board is 8.4% The percentage of firms with the size of CEO is 1.2% and smaller standard deviation of 0 All the listed firms are required

to appoint independent directors, the proportion of independent directors for the firms in the data is quite dispersed with a minimum value of 0 and a maximum value of 33,3% for the proportion of outside directors Moreover, the outside directors in these firms in the data are quite dispersed with a minimum value of 0 555 and a maximum value of 1.609 After that, the control variable, (Debt ratio, firm’s size, relative roa) is the most volatile compared to the

other variables It has the highest coefficient of variation (653.55, 8.904955, 9.285 and8.646425) as measured by the standard deviation-to-mean ratio

Table 2: Correlation matrix

Next, Table (2) provides the correlation matrix for the dependent variable, stock return volatility, and for all the independent variables It also presents the correlation coefficients among the variables in our analysis At a first glance, it can be seen that the stock return volatility is negatively correlated with the independent directors, which suggests that the independent directors variables help stabilize the stock return volatility The stock return volatility is also negatively correlated with the firm’s size and the relative ROA There is a positive correlation between the debt ratio, CEO, outside director, and audit size In fact, these have contributed to the stock return volatility The independent directors tend to avoid firms with a higher leverage ratio This is consistent with other previous studies suggesting that institutional investors tend to have preferences for firms with specific attributes to avoid informational asymmetry The correlation pairs are significant at 5% level

This table reports robustness regressions The first column (OLS-fe) controls for fixed effects, while the second (OLS-ar) controls for fixed effects and possible AR (1) structure in the residuals The next column is Arellano- Bover/Blundell-Bond linear dynamic panel-data regression (ABBB) The Arellano-Bond regression (AB) is a differencing method for producing consistent estimates This method has the advantage of allowing for dynamic effects by controlling for lagged volatility

The empirical results about (OLS-fe), (OLS-ar), the Arellano- Bover/Blundell-Bond linear dynamic panel-data regression (ABBB) and the Arellano-Bond regression (AB) showed that the independent directors have a positive and significant impact on the stock return volatility This suggests that stock return volatility is elastic on independent directors Hence, a 10% increase of the independent directors increases the stock return volatility within

a range of 18, 34 % This result indicates that the independent directors increase the volatility

of the stock prices (Jordan (2012)) Moreover, the different reports about robustss regressions (OLS-fe, OLS-ar, ABBB and AB) pointed out that the debt ratio (LEV) has a positive and significant impact on the stock market volatility This suggests that the stock return volatility

is elastic on the leverage ratio, and a 10% increase in the leverage ratio increases the stock return volatility within a range of 0.026%.This result indicates that the debt ratio increases the stock return volatility

stock returns volatility)

Table (4) reports the fixed and random effect regression effects We can see that the results of three models (models 1, 2, 3) are random effects When the model with a rondom effect is correlated, then the model is misspecified, and inferences can be faulty Moreover, the models (4), is fixed effects are correlated with one or more independent variables, an individual effect framework still gives valid inferences and thus is preferred The Hausman specification test provides information on the correlation of the individual effects and indicates the type of the

effect, random or fixed The p-value of the Hausman specification test is 0.0000 providing strong rejection of the null of no correlation Thus, we continue below with analysis within the fixed effect in our studies Table 4, we can see that foreign ownership is negatively and significantly correlated with stock return volatility in all the regressions The foreign director can help to reduce the stock return volatility According to Xuan Vinh Vo (2015) Provide, the foreign director can stabilize the stock return volatility

Table 5 presents the estimation results The results confirm that foreign ownership is negatively and significantly correlated with the stock return volatility Moreover, the firm’s size and ROA have a negative effect on the stock return volatility, which is clearly evidenced

in all the regressions On the other hand, the CEO, audit size, debt ratio and total liabilities have statically significant and positive effects on the stock return volatility These results indicate that these variables increased the stock return volatility

Besides, before running the regressions, some specific tests have been audited According to Newey (1985), Smith and Blundell (1986), the two important specification tests used for simultaneous-equation regression models are the endogeneity/exogeneity test and the over identifying restrictions test First, the Durbin-Wu-Hausman (DWH) test was used to test the endogeneity for all the three equations The null hypothesis of the DWH endogeneity test states that an ordinary least square (OLS) estimator of the same equation would give consistent estimates: this means that endogeneity between the repressors would not have deleterious effects on the OLS estimates A rejection of the null indicates that endogenous repressors effects on the estimates are meaningful and instrumental hypothesis variables techniques are required Second, we may test the over identifying restrictions to provide some evidence of the instrument validity This is tested using the Hansen test by which the null hypothesis of overidentifying restrictions cannot be rejected In other words, the null hypothesis states that the instruments are appropriate, and therefore, cannot be rejected The empirical results of the Hansen test on the identification of restrictions do not reject the null hypothesis for IND, FD in two models (p = 0.519, p = 0.741), which indicates that the model is a valid instrumentation The Hansen test evaluates all the identification / instruments It is also important to test the validity of the sub-sets of instruments (levels, differentiated and standard instruments) Regarding the DW, Wu-Durbin-Hausman test, we reject the null hypothesis Therefore, the effect of the endogenous regression estimates is significant On the other hand, the AR (1) is significant for the variables in this model; hence, the null hypothesis cannot be rejected

Table 4 presents the results of the 3SLS estimation of the three equations in which the stock return volatility is proxied by the standard deviation of the stock market The empirical results about eq presented in Table 4, show that the volatility of the stock returns has a positive andsignificant impact on the outside directors This implies that the outside directors are elastic compared to the stock return volatility In fact, a 10% increase in the stock market