Modern theories of capital structure have traveled a long way since the publication of the pioneering article by Modigliani and Miller in 1958. All the theories that have subsequently emerged tried to answer the moot question as ‘what are the factors that affect capital structure decisions’. In the process of their enquiry scholars have identified several dimensions of imperfections which can affect capital structure decisions of firms. Such imperfections may arise due to nature of contract, transaction cost, conflict of interest, asymmetry of information, institutional structure etc. Among these factors, institution is unique in the sense that institutions play a dual role on one hand, the presence of institution itself creates imperfection, and on the other hand, presence of institution is necessary to correct the imperfection if it is arising out of asymmetry of information.
For example, presence of government institution, such as tax authority, may create imperfection through the imposition of tax on individual as well as on corporations and the presence of capital market regulator may reduce the asymmetry in information through the regulation. Since the institution has the ability to create as well as resolve the imperfections and corporations operate in proximity with various institutions, such as tax authority, banking system, capital market and regulatory authority, it implies that institution may explain the behavior of corporations, particularly its financial behavior. To be specific, “capital structure decision is not only the product of the firm’s own characteristics, but also the result of the corporate governance, legal framework and institutional environment of the countries in which the firm operates” (Deesomsak et al. 2004: 404).
Rajan and Zingales (1995) while comparing the capital structure difference of G-7 countries have pointed out that institution explains large part of variation of capital structure decision in different countries. Relative importance of institutions varies across countries, depending on the level of development of banking system, corporate bond market, and development of stock market. In this context it is worth mentioning that countries like Japan, Germany, France and Italy are bank-oriented countries where as US, UK and Canada are market-oriented countries. The “difference between bank-oriented and market-oriented countries is reflected in the choice of private and public financing” (De-Miguel and Pindado 2001: 83). De-Miguel and Pindado (2001) have further argued that whether a country is bank oriented or market oriented depends on the ownership structure of the corporate firms.
Those countries in which the corporate ownership is concentrated, particularly dominated by family ownership, their dependence on banking system is much more as compared to market, probably because dilution of ownership is a great concern to them – Germany, France are glaring examples of this. Nature of business corporations in India resembles the pattern of Germany and France where three-fourth of the largest companies are family business (Chakraborty 2010). Therefore, dilution of ownership is critical to the determination of capital structure. Another feature of Indian economy is that it is dominated by banks (nationalized bank) and development financial institutions since its independence. The combined effect of family ownership and dominance of banks and financial institutions result in dominance of private lending over public debt.
