Paolo F. Volpin

Governance with Poor Investor Protection: Evidence from Top Executive Turnover in Italy

This Paper studies the determinants of executive turnover and firm valuation as a function of ownership and control structure in Italy, a country that features low legal protection for investors, firms with controlling shareholders, and pyramidal groups. The results suggest that there is poor governance, as measured by a low sensitivity of turnover to performance and a low Q ratio, when (i) the controlling shareholders are also top executives, (ii) the control is fully in the hands of one shareholder and is not shared by a set of core shareholders, and (iii) the controlling shareholders own less than 50% of the firm’s cash-flow rights.

Credit Ratings Failures and Policy Options

This paper examines the role of credit rating agencies in the subprime crisis that triggered the 2007-08 financial turmoil. The focus of the paper is on two aspects of ratings that contributed to the boom and bust of the market for asset-backed securities: rating inflation and coarse information disclosure. The paper discusses how regulation can be designed to mitigate these problems in the future. The suggestion is that regulators should require rating agencies to be paid by investors rather than by issuers (or at least constrain the way they are paid by issuers) and force greater disclosure of information about the underlying pool of securities.

Shareholder Protection, Stock Market Development, and Politics

This paper presents a political economy model where there is mutual feedback between investor protection and stock market development. Better investor protection induces companies to issue more equity and thereby leads to a broader stock market. In turn, equity issuance expands the shareholder base and increases support for shareholder protection. This feedback loop can generate multiple equilibria, with investor protection and stock market size being positively correlated across equilibria. The models predictions are tested on panel data for 47 countries over 1993-2002, controlling for country and year effects and endogeneity issues. We also document international convergence in shareholder protection to best-practice standards, and show that it is correlated with cross-border M&A activity, consistent with the model.

Lobbying on entry

We develop a model of endogenous lobby formation in which wealth inequality and political accountability undermine entry and financial development. Incumbents seek a low level of effective investor protection to prevent potential entrants from raising capital. They succeed because they can promise larger political contributions than the entrants due to the higher rents earned with less competition. Entry and investor protection improve when wealth distribution becomes less unequal, and the political system becomes more accountable. Consistent with these predictions, in a cross-section of 38 countries we find that greater accountability is associated with higher entry in sectors that are more dependent on external capital and have greater growth opportunities. Also, higher accountability and lower income inequality are associated with more effective legal enforcement, even after controlling for legal origin and per-capita income.

Politics, Investor Protection and Competition

External finance is critical for less established entrepreneurs, so poor investor protection can hinder competition. We model how lobbying by incumbents may reduce access to finance in countries where politicians are less accountable to voters. In a broad cross-section of countries and industries, we find that (i) the number of producers and entry rates are positively correlated with investor protection in financially dependent sectors, and (ii) countries with more accountable political institutions have better investor protection.

Corporate Governance of Pension Plans: The U.K. Evidence

For this study of the governance of defined-benefit pension plans in the United Kingdom, the governance measure was equal to the proportion of trustees of the pension plan in 2002 who were also executive directors of the sponsoring company. The findings indicate that pension plans of indebted companies with a higher proportion of insider than independent trustees invest a higher proportion of pension plan assets in equities and that the sponsors contribute less to the plan and have a larger dividend payout ratio. This evidence supports the agency view that insider trustees act in the interests of shareholders of the sponsor, not necessarily in the interests of pension plan members. Many companies have promised their employees defined-benefit (DB) pensions. The large increases in life expectancy that have occurred since the 1970s and the decline in interest rates that are used to calculate the present value of pension liabilities have led to significant increases in corporate pension liabilities. As a result, many DB corporate pension plans now show substantial deficits. In the United Kingdom, which is the focus of this article, DB pension plans are set up in trusts with trustees responsible for the trust assets and management. More precisely, the trustees must decide how to invest the assets of the pension plan and must put in place a schedule of contributions for the sponsoring companies. These powers, combined with the size and deficit of the pension plans, mean that the actions of pension plan trustees have important implications not only for pension plan members (or beneficiaries) but also for the value and behavior of sponsors. The law specifies that the trustees of the pension plan may be directors of sponsoring companies, which may lead to conflicts of interest between the executive and trustee roles. In this article, we study such conflicts of interest. We focus on two alternative hypotheses. The first is that the presence of insiders is a source of agency problems because it allows insider trustees to favor shareholders of the company over members of the pension plan. A company with a DB pension plan can be considered to own a put option: If the assets (the company and DB assets) fall short of the pension fund liabilities, the company has the option of giving those assets to the DB beneficiaries as payment. Because the value of a put option increases with the risk of the underlying assets, insider trustees may have an incentive to increase the riskiness of the assets (the company and the DB plan assets) beyond what is optimal for the members of the pension plan by, for example, investing the pension plan assets in equities. Agency problems may also be reflected in the contributions paid into the pension plan. Pension plan liabilities are similar to long-term debt, and pension plan members are debtholders of the company. Insider trustees who favor shareholders of the company over debtholders (i.e., pension plan members), however, may have an incentive to reduce company contributions to the plan. The second hypothesis is that insider trustees facilitate an efficient management of tax liabilities, which may be positive for both shareholdersand pension plan members. More precisely, companies may be able to generate tax savings if they integrate their financial and pension investment policies: If a company increases leverage, uses the proceeds to fund the pension plan, and invests those funds in bonds, it may generate tax savings without affecting financial risk. The reason is that the increase in leverage generates a debt tax shield while the return on bonds held in the pension plan is tax exempt. To test these hypotheses, we collected information for 2002 and 2003 on U.K. companies that had DB pension plans. We found evidence that supports the agency hypothesis that insider trustees act in the interests of shareholders of the sponsoring company, not necessarily in the interests of pension plan members. More precisely, we found that pension plans of the more-leveraged companies with a higher proportion of insider trustees invest a higher proportion of the pension plan assets in equities than do other plans and, in this way, make riskier investments. Also, we provide evidence, consistent with the risk-shifting effect, that the presence of insider trustees allows companies to reduce contributions to the plan.

Governance with Poor Investor Protection: Evidence from Top Executive Turnover

This paper analyzes executive turnover and firm valuation in Italy, a country that features all the characteristics of the most common governance structure around the world, as described by La Porta, et al. (1999): low legal protection for investors, firms with large controlling shareholders and pyramidal groups. The main findings are that turnover is significantly lower and unaffected by performance when the controlling shareholder of the firm is also a top executive in the firm, while it is more sensitive to performance when control is, to some extent, contestable and when the controlling shareholder owns a larger fraction of the firms cash-flow rights. The results on valuation are the mirror image of those on turnover: the firms Q is lower for companies with the controlling shareholder as a top executive, larger when a voting syndicate controls the firm, and increases with the fraction of cash-flow rights owned by the controlling shareholder.

Corporate Pension Plans as Takeover Deterrents

We use UK data to show that firms that sponsor a defined-benefit pension plan are less likely to be targeted in an acquisition and, conditional on an attempted takeover, they are less likely to be acquired. Our explanation is that the uncertainty in the value of pension liabilities is a source of risk for acquirers of the firms shares, which works as a takeover deterrent. In support of this explanation we find that these same firms are more likely to use cash when acquiring other firms, and that the announcement of a cash acquisition is associated with positive announcement effects.

Credit ratings failures : causes and policy options

This paper examines the role of credit rating agencies in the subprime crisis, which was at the outset of the ongoing financial turmoil. The focus of the paper is on two aspects that contributed to the boom and bust of the market for assetbacked securities: rating inflation and coarse information disclosure. The paper discusses how regulation can be designed to mitigate these problems in the future. The suggestion is that regulators should require rating agencies to be paid by investors rather than by issuers (or at least constrain the way they are paid by issuers) and force greater disclosure of information about the underlying pool of securities.

The Political Economy of Entry: Lobbying and Financial Development

We present a model of endogenous lobby formation in which wealth inequality and political accountability undermine both entry and financial development. The elite will seek a lower level of effective minority protection than the middle class to prevent potential entrants from raising financing. The elite wins because its lobby can promise larger political contributions due to the higher rents earned by restricting entry. Entry and investor protection improve when wealth distribution becomes less unequal, and the political system becomes more accountable. Evidence across 48 countries indicates that greater accountability and lower income inequality are associated with stronger legal enforcement, even after controlling for legal origin and per-capita income. Moreover, greater political accountability increases entry in external capital-dependent industries; its inclusion makes financial development insignificant. These results suggest that lobbying protects established interests by creating entry barriers and undermining legal enforcement.