Ebook Risk Shifting, Debt Governance and Managerial Incentives
The economics of risk shifting (or asset substitution) has long been established in the finance literature. With limited liability, equityholders of a levered firm have incentives to increase the firmss risk once the debt is in place. Debtholders use covenants as the governance mechanism to protect their investments from various types of shareholder(debtholder agency conflicts.
For example, Smith & Warner (1979) discuss covenants as addressing four categories of conflicts dividend payment, claim dilution, asset substitution and underinvestment. This study investigates the impact of debt governance on the firmss risk taking behavior. We ask three questions: What is the relationship between debt governance and the firmss risk shifting behavior? What is the role of debt governance in mitigating the impact of managerial risk(taking incentives on the firm risk? What implication does our study have for the design of corporate governance?
The literature has been inconclusive about the importance of the risk shifting problem. For example, although Black & Scholes (1973) and Jensen & Meckling (1976) theoretically illustrate the potential conflicts between equityholders and debtholders, Leland (1998) derives a contingent claim framework to find that the importance of the risk shifting problem is small. Although the relevance of risk shifting behavior in the financial industry is well recognized both theoretically and empirically, Parrino & Weisbach (1999) conduct a numerical study and conclude that the empirical evidence of risk shifting behavior among industrial firms is limited. Recently, Fang & Zhong (2004) and Larsen (2006) have used a market(based methodology to estimate firmsstotal asset risk and report strong evidence of risk shifting behavior among industrial firms.
With respect to our first question, the literature has remained largely silent. This paper presents the first systematic evidence on the impact of debt governance on firmss risk taking behavior. First, we document a significant negative relation between risk shifting and debt governance. Our empirical model estimates that increasing the debt governance proxies from minimum to maximum level is associated with a reduction in the firmss industry adjusted asset risk of up to 25% of the level in previous periods. To conduct the analysis, we construct two firm level debt governance proxies, based on the corporate bond issue level covenant indices developed in Wei (2006). To measure risk shifting relative to industry peers, we follow the market(based approach adopted in Fang & Zhong (2004) and Larsen (2006).
We further investigate the impact of debt governance on risk shifting when firms are close to financial distress. Theories predict that risk shifting is more likely when default likelihood is high, and therefore debt governance should play a more important role under such situations. We use two proxies for high default probabilities (a direct estimate of default probability as inferred from the Merton (1974) model using Moodyss KMV algorithm and an indicator of whether the firm is rated speculative. Analysis using either proxy finds strong evidence that debt governance plays a more significant role in controlling the firmss risk shifting behavior among firms close to financial distress. For example, we find that debt governance plays virtually no role in restricting risk shifting when firms have relatively low default risk or are rated investment(grade. Among firms with high default probabilities (or a speculative(grade rating), however, strong debt governance is associated with 25% (or 27%) reduction in industry adjusted asset risk ratio.
Download
PDF Ebook Risk Shifting, Debt Governance and Managerial Incentives
Posted in :
