Three essays on corporate default prediction : special reference to corporate governance, default correlation and capital structure dynamics
Fernando, R. (2019). Three essays on corporate default prediction : special reference to corporate governance, default correlation and capital structure dynamics (Thesis, Doctor of Philosophy (PhD)). The University of Waikato, Hamilton, New Zealand. Retrieved from https://hdl.handle.net/10289/12893
Permanent Research Commons link: https://hdl.handle.net/10289/12893
This thesis consists of three essays that investigate corporate defaults connected to corporate governance, default correlations and capital structure adjustment. Granting a loan requires mutual trust between lenders and borrower and depends on the flow of information. The relevance and the accuracy of the information are necessary to ensure the best judgement about the creditworthiness of borrowers. However, information asymmetry between the borrower and the lender is the main hurdle for any judgement about the borrower. Although default prediction has commanded the attention of researchers over many years, there is still an important gap in the literature on the selection of the suitable default predictor information for improved borrower evaluation. To broaden the understanding of the information content of default predictor variables, the first essay addresses and tests the impact of corporate governance on default prediction. It examines several testable hypotheses regarding the relations between corporate governance and default prediction, building on the Standard and Poor (2002) corporate governance framework proposed by Ashbaugh-Skaife et al. (2006). The research employs the conventional logistic regression to provide empirical evidence from U.S. default data over the period of 2000 to 2015. Empirical results are consistent with the following notions: First, default firms are associated with high ownership concentration, low shareholder rights, low financial transparency and disclosures, and less board effectiveness. Second, in-sample and out-of-sample tests support the incremental contribution of corporate governance information on default prediction, when compared with the models involving just financial information. In addition to the analyses on the U.S. data, this thesis conducts a comparative study using the data of Sri Lanka, which serves as a representative emerging market. This study argues that emerging markets are important because they present several institutional differences that cannot be examined in the developed markets. The rapid evolvement of these markets provides excellent experimental grounds for studying many financial issues. The empirical results show that whilst an integrated model provides overall stronger predictive value; financial information is more relevant for USA firms. Corporate governance appears more relevant in emerging markets than in mature markets, but the effectiveness of the individual corporate governance practices differs between countries. The second essay discusses the impact of corporate governance on the correlation in corporate defaults. This essay investigates for the first time the effect of firm-specific corporate governance on default correlation as an extension to the contagion and cyclical effect proposed by Das et al. (2007) as the sources of default correlation. It hypothesizes that the degree of default correlations could increase disproportionally for firms with weak corporate governance in terms of high ownership concentration, low board effectiveness, low financial transparency, and higher shareholder rights. This study employs Lucas’s (1995) method to provide empirical evidence based on the historical default data from the United States from 2000 to 2015. The empirical results imply that corporate governance is essential for credit risk management because poor corporate governance may increase not only individual default risk but also the domino effect of credit defaults. Moreover, the impact of corporate governance on the correlation in corporate defaults is more pronounced in the financial crisis. The third essay examines the heterogeneity of the speed of capital structure adjustment in firms. In contrast to previously documented contemporaneous results, it tests the issue through distinguishing two types of the firms (default and non-default firms), and two measures of the speed of adjustment (cumulative versus marginal). The empirical results show that the speed of adjustment is non-uniform across firms and over time. In particular, default firms are associated with a higher speed of adjustment than non-default firms. The completion of leverage adjustment takes multiple periods. The marginal speed of adjustment accelerates from the beginning period to the end period, which is consistent with the anchoring and adjustment bias heuristic. The empirical results are robust using a book/market leverage and a two/one-step estimation approach. In addition to the tests on the speed of capital structure adjustment, this essay also examines the effect of leverage deviation on measuring firms’ default risk. The in-sample and out-of-sample tests suggest that taking into account leverage deviation enhances the capacity of measuring corporate borrowers’ default risk. Additionally, such benefit is persistent over various time horizons. Overall, the empirical findings provide important policy implications for banks before granting loans to corporate customers. This work fills crucial gaps in the credit risk literature.
The University of Waikato
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