Asian Review of Financial Research

pISSN: 1229-0351
eISSN: 2713-6531

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Asian Review of Financial Research / May 2009 Vol. 22 No. 2

The Effect of Corporate Governance on the Level of a Firm's Cash Holdings

Soon Hong Park;Kang Heum Yon

Asian Review of Financial Research :: Vol.22 No.2 pp.1-36

Abstract
The Effect of Corporate Governance on the Level of a Firm's Cash Holdings ×

Two dominant theories explaining firms' different level of cash holdings are the static trade-off model and the pecking order theory. According to the former, a firm holds cash and cash equivalent assets when the subject firms' managers can easily enjoy the incentives from the transactions of such assets and the precautionary motive outweigh the cost and benefit of cash holdings. In contrast to the static trade-off model, the pecking order theory asserts that the level of firm's cash holdings is determined passively and that the optimal level of cash holdings does not exist since a firm first expends on the profitable investment opportunities and then pays off the debt and accumulates cash holdings with what is left (Myers and Majluf (1984)). Most empirical studies have also placed emphasis on the static trade-off model and the pecking order theory. Both models exhibit exceedingly similar results that smaller-sized firms tend to increase the level of cash holdings, implying a greater degree of information asymmetry existing in a subject firm especially when its investment and R&D expenditures are projected to be high. Higher expenditures subsequently lead to higher future capital requirement and higher possibility of liquidity shortage owing to more volatility in past cash flows (Opler et al. (1999), Gong (2006)). On the other hand, as Myers and Rajan (1998) have mentioned, managers in a firm with a higher possibility of an agency problem due to the separation of ownership and management are likely to have an incentive to hold more cash assets. This is because cash and its equivalents are the easiest types of assets with which managers can exercise their discretional power.. Conversely, at a firm with more transparent corporate governance, on the other hand, its management has less incentive to hold more cash assets as a way to expand his/her discretional power since, then, such firm closely monitors management's transactions, which reduces the possibility of the agency problem. As such, based on the previous studies, we examine whether the agency theory, as well as the static trade-off model and pecking order theory, is also a significantly influential factor in deciding the level of cash holdings for Korean companies. Most studies consider only partial elements of corporate governance such as ownership structure including shareholding ratios of management, or institutional investors and foreign investors as proxy variables for the possibility of agency problem. Unlike those preceding studies, we use a unique data set of the firm-level corporate governance scores on an annual basis as a proxy variable for the degree of agency problem. The data are being provided by the Korea Corporate Governance Service (KCGS) every year, following the evaluation of listed firms' ownership structures and governance structures. In addition, we provide an empirical evidence on how the agency problem affects a firm's level of cash holdings based on our analysis of 2,541 sample firms listed in the Korea Stock Market between 2002 and 2006. We collect an individual firm's annual financial statement data, stock price data, and composite data with respect to Korean business groups (aka. chaebols) from KisValue II and FnDataGuide. The annual ratio of average cash holdings to total assets ranges from 9.34% to 10.42%. We also consider the standardized score of shareholder protection, board of directors, corporate disclosure (transparency), auditing organization, and earnings distribution which altogether constitute the total corporate governance score. By controlling various factors of the static trade-off model and the pecking order theory, we find that firms with sound corporate governance, especially those that enforce strong shareholder protection rules, tend to reduce the level of cash holdings. Moreover, we also undertake various robustness tests to control for the effects of endogeneity problems of corporate governance and the characteristic of panel data. Furthermore, we provide additional evidence reinforcing our results and the agency theory. We conclude that chaebols show lower levels of cash holding ratios than non-chaebols do, if all else equal. The tendency of the lower the level of cash holdings the better corporate governance the firm has is found more apparent in chaebol firms than in non-chaebol firms. Further, as the level of cash holdings of the other group-affiliated firms increases, the firm's cash holding ratio becomes lower, implying that the static trade-off model and the pecking order theory have less influence on the cash holdings due to the existence of internal capital markets within Korean chaebol groups. In other words, internal capital markets within chaebols indeed have a substantial impact on the group-affiliated firms and allow them to maintain lower level of cash holdings than those of non-chaebols, all else equal. Overall, this paper provides the evidence strongly supportive of the agency theory and shows that differences in the intensity of agency problem across firms play an important role in explaining the different levels of firms' cash holdings.

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The Effect of Firm Characteristics on Firm-Bank Relationships

Sang Wook Lee

Asian Review of Financial Research :: Vol.22 No.2 pp.37-70

Abstract
The Effect of Firm Characteristics on Firm-Bank Relationships ×

This paper analyzes the firm-bank relationship from a borrower (firm)'s perspective using the data of Korea' s listed firms and banks in transaction relationships (say related banks). For the analysis, I use a number of related banks or the of dependence of a firm on the main bank as measurements of firm-bank relationship. Further, the more related bank means that the firm has many ties with banks, which implies the firm can make new relationship with new bank easily. However, each tie is weak in the strength. In the other hands, the more dependence on the main bank means that the firm has the deeper relationship with the main bank. The firm characteristics for the analysis are classified into four categories. The first includes the information asymmetries on the borrower. Firm size, firm history and proportion of tangible assets among total assets are used to capture the information asymmetries. In particular, the firm with bigger size or longer history might have lower information asymmetries in the loan market. The more tangible asset of a firm, often hold as a mortgage in the loan contract, also could decrease the information asymmetries in loan market. The second category includes the performance and the risk of the borrower. ROA and the interest expenses-sales ratio capture the performance and the risk of the firm respectively. The firm showing better performance or with lower risks has less trouble to make a new relationship with new banks. However, these variables does not indicate the depth of relationship between a firm and banks. The third includes the characteristics regarding the growth and investment of a firm. Growth rate in sales and average growth rate in sales for recent five years are used to capture the growth characteristic of a firm. Further, investment activity of a firm is measured by the increase in tangible asset divided by total asset of a firm. Since the firm with fast growth and intensive investment is more likely to have the higher information asymmetries in the loan market, the firm might have trouble to raise funds from banks except the main bank. Therefore, we expect that the growth and investment of a firm are loosely related to the depth of relationship with banks. The fourth is the financial soundness, which is important factor to determine the firm-bank relationship. The financially sounder firm can raise funds easily from only limited numbers of banks. Thus, the sounder financial status of a firm implies the deeper relationship with banks. Since the paper analyzes the firm-bank relationship in the firm's perspective, I control the characteristics of banks for the analysis using variables like ROA and size of main bank. To control the effects of firm's dependency on the bank loan, size of bank loans of a firm divided by total liabilities is used. Furthermore, year and industry dummies are included to control the effects of macro economic condition or industry characteristics. The result of empirical analysis shows that borrower with lower information asymmetries is easier to find new relationships with banks and has lower dependency on the main bank. Tuning to the performance and risk of a firm, the firm showing better performance or with lower risks is easier to find new relationship with banks and has lower dependency of the main banks. However, a firm with fast growth and intensive investment is more likely dependent on the main bank to raise funds. Also the result suggest that a firm with the sounder financial status has the smaller number of related banks and the higher dependence on the main bank. In summary, borrower with lower information asymmetries, better performance, and lower risks is more likely to have multiple ties with banks than growth-oriented (or investment-oriented) firms. However, the dependency on the main bank is stronger in growth-oriented (or investment-oriented) firms. In addition, the financial soundness make strengthen the relationship between the borrower and the main bank. It is a common belief that the alleviation of information asymmetry in the loan market can improve the intermediary role of banks. Also the strengthening of main bank stimulates the growth or investment of small-medium enterprise. Moreover, financial soundness of firms is crucial to strengthen the firm-bank relationship and enhance the intermediary role of banks. The analysis in this paper using Korean data empirically supports these common beliefs. However, this paper has several limitations to be improved in future researches. The empirical results are obtained from the recent Korean data, and the time-span of data is not sufficient. Therefore, more rigorous studies are required to generalize the result of this paper. Further, although simple test of correlation among variables shows that endogenous problem is negligible, still the endogenous problem could exist.

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The Role of Market Depth in Determining Appropriate Tick Size in the Korea Exchange

Hyung Cheol Kang;Jong-Ho Park;Kyong Shik Eom

Asian Review of Financial Research :: Vol.22 No.2 pp.71-102

Abstract
The Role of Market Depth in Determining Appropriate Tick Size in the Korea Exchange ×

To determine the appropriate tick size for the Korean Exchange (KRX), we analyze the effect of changing the minimum tick size (hereafter “tick size”) on, first, the liquidity, measured by relative spread, market depth, and volume and secondly, on the overall market quality. The results from these analyses shed light on the optimal tick size for the KRX. Our finding shows an ambiguous effect of changing the tick size on market quality: reducing the tick size increases relative spread and volume but decreases market depth. Also, compared to the U.S. exchanges whose tick size is one cent regardless of the stock price, the tick size of the KRX is a step function of the stock price. This characteristic allows us to study the effect of changing the tick size by comparing stocks with prices just above and just below the level at which the tick size changes. Unlike previous studies, our analyses focus on the effect of changing the tick size on market depth among liquidity variables, by, among others, addressing the endogeneity problem among the variables. Other specific methods used in our analyses are as follows. First, as a preliminary study, we examine whether our results regarding the effects of changing tick size on three variables of liquidity--relative spread, market depth, and volume--in the KRX are the same as those from previous studies on domestic and overseas exchanges. Second, we investigate the effects of changing tick size on investors' order submission patterns to find the reasons and implications of the adverse effects of reducing tick size on market depth. For both analyses, we conduct panel-data analyses, which are robust even with the endogeneity problem. Rogers' (1993) standard errors are incorporated in order to adjust for the clustering effect. Third, we test dynamic relations between tick size and market depth in order to obtain detailed results indicating the effects of reducing tick size on market depth. This test is designed to measure the extent to which the KRX tick size could be reduced. For this test, we use the sample stocks whose tick sizes change during the sample period. We, first, sort them into 9 categories based on their upper and lower price limits and, then, conduct “endogeneous” event studies. Using all 689 common stocks listed on the KRX during our sample period of 122 trading days from January 3 to June 30 in 2005, we apply both TAQ (Trades and Quotes) and daily data to each stock. The data are provided by the KRX. The test results for our seven null hypotheses are as follows. •Results from Analyses for the Effects of Changing Tick Size on Liquidity: Reducing tick size has a favorable effect on relative spread and volume, but an unfavorable effect on market depth. This finding of trade-off among the liquidity variables confirms similar results from previous studies; however our finding is more robust, since the endogeneity problem among the variables is taken into account in the regression analyses. Our study also has the practical implication that policy makers must heed unfavorable effect on market depth when considering reducing the tick size as a way to reduce transaction costs. •Results from Analyses Using Investors' Order Submission Patterns: As tick size is reduced, order size decreases and the ratio of cancellation and correction orders increases. Market depth, in turn, is decreased and market quality deteriorates. As tick size is reduced, the ratio of “order-more-improved to best-order” also increases. This increase leads market depth and relative spread to decrease; as a result, it can either improve or deteriorate market quality due to the trade-off between them. As tick size is reduced, the market-order ratio slightly increases, decreasing liquidity and, in turn, resulting in a slight deterioration of market quality. All together, a decrease in order size and an increase in the ratio of cancellation and correction orders are, at least, principal causes for decreasing market depth as tick size reduces. •Results from Dynamic Relation between Tick Size and Market Depth: Reducing tick size does not decrease the market depths of the stocks whose prices are around the points at which the tick size jumps, except at 10,000 won. This implies that the tick size can be reduced at most price levels without deterioration of market depth. The price range jumping around 10,000 won is the only exception at which market depth decreases with statistical significance as the tick size decreases. This phenomenon is closely related to the large change in the relative tick size (from 0.1% to 0.5%) at this price range, which is a very abrupt change compared to that at other price ranges (from 0.1% to 0.2%, in particular for 5,000 won and 50,000 won price ranges). Therefore, if we set our argument to stocks under 100,000 won, the KRX can reduce the relative tick size 0.2 percent without having significant adverse effects on market depth.

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