corporate governance, strongfinancestrong, and the real sector.pdf

JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS Vol. 47, No. 6, Dec. 2012, pp. 1187–1214 COPYRIGHT 2012, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195 doi:10.1017/S0022109012000531 Corporate Governance, Finance, and the Real Sector Paolo Fulghieri and Matti Suominen∗ Abstract We present a theory of the linkages between corporate governance, corporate finance, and the real sector of an economy. Using a structural model of industry equilibrium with en- dogenous entry, we show that poor corporate governance leads to low levels of competition, and to firms with high insider ownership and leverage. In contrast, good corporate gover- nance promotes the adoption of more efficient technologies and development of sectors more exposed to moral hazard. We use our model to study equity market liberalization, and we show that liberalizations facilitate entry and adoption of more productive technolo- gies, especially in countries with good corporate governance. I. Introduction We study a parsimonious structural model of the codetermination of indus- try concentration, firms’ profitability, and financial structure. In our model, dif- ferences in levels of the agency costs of debt and equity across countries and industries, together with differences in production technologies, jointly determine ∗Fulghieri, paolo fulghieri@, Kenan-Flagler Business School, University of North Carolina, Campus Box 3490, Chapel Hill, NC 27599, Centre for Economic Policy Research (CEPR), and European Corporate Governance Institute (ECGI); Suominen, matti.suominen@aalto.fi, Aalto University, PL 1210, Helsinki 00101, Finland. For helpful comments, we thank Hendrik Bessembinder (the editor), Philip Bond, Jeffrey Coles (associate editor and referee), Isil Erel, Michel Habib, Philipp ¨ Hartmann, Campb