Corporate Governance and Risk-Taking

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THE JOURNAL OF FINANCE • VOL. LXIII, NO. 4 • AUGUST 2008

Corporate Governance and Risk-Taking
KOSE JOHN, LUBOMIR LITOV, and BERNARD YEUNG∗

ABSTRACT
Better investor protection could lead corporations to undertake riskier but valueenhancing investments. For example, better investor protection mitigates the taking of private benefits leading to excess risk-avoidance. Further, in better investor protection environments, stakeholders like creditors, labor groups, and the government are less effective in reducing corporate risk-taking for their self-interest. However, arguments can also be made for a negative relationship between investor protection and risktaking. Using a cross-country panel and a U.S.-only sample, we find that corporate risk-taking and firm growth rates are positively related to the quality of investor protection.

A CENTRAL THEME OF CORPORATE governance studies is how constraints on corporate decision makers’ pursuit of self-interest lead to firm value-maximizing behavior. In this paper we focus on how these mechanisms affect managerial risk choices in corporate investment decisions and their consequent implications for growth. Building on the seminal work of La Porta et al. (1997, 1998), recent finance research examines the importance of investor protection. One strand of the literature focuses on the effect of investor protection on the cost of capital (e.g., Shleifer and Wolfenzon (2002), Lombardo and Pagano (2002), and Castro, Clementi, and MacDonald (2004)). Poor investor protection creates the need for dominant owners (Burkart, Panunzi, and Shleifer (2003)). But, since the owners cannot be trusted to protect minority shareholders’ rights, the equilibrium outcome is a high cost of capital, and in turn under-utilization of external capital and generally suboptimal investment. For example, Wurgler (2000) shows that ∗ John is with Stern School of Business, NYU; Litov is with Olin Business School, Washington University in St. Louis; and Yeung is with National University of Singapore Business School and Stern School of Business, NYU. We thank the editor, Robert Stambaugh, and an anonymous referee for their helpful comments. We are also grateful for comments and discussions from Heitor Almeida, Yakov Amihud, David Backus, Matt Clayton, Art Durnev, Phil Dybvig, Bill Greene, Jianping Mei, Todd Milbourn, Randall Morck, Holger Mueller, Stew Myers, Darius Palia, Thomas Philippon, Enrico Perotti, Annette Poulson, S. Abraham Ravid, Joshua Ronen, Anjan Thakor, Peter Tufano, Ren´ Stulz, S. Viswanathan, Daniel Wolfenzon, Jeffrey Wurgler, David Yermack, Luigi Zingales, e and the participants of the seminars at Brown University, Peking University, New York University, Rutgers University, Rensselaer Polytechnic Institute, EISAM (European Institute for Advanced Studies in Management) in Brussels, FIRN (Financial Integrity Research Network) in Melbourne, the second corporate governance conference at Washington University in St. Louis, the 2005 AEA meetings in Philadelphia, the Spring 2005 corporate governance NBER meetings, the 2005 EFA meeting in Moscow, and the 2007 AFA meeting in Chicago.

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in locations with poorer investor protection, investment is less responsive to changes in value added.1 In another strand of related literature, Morck, Yeung, and Yu (2000) show that poor investor protection is associated with a low level of informed risk arbitrage, and Durnev et al. (2004) suggest that a low level of informed risk arbitrage could lead to poor corporate governance, poor resource allocation, and ultimately low productivity growth. While this literature focuses on the implications of investor protection on financing, few studies examine the relationship between investor protection and corporate investment behavior. An exception is Durnev, Morck, and Yeung (2004), who show that more informed risk arbitrage, which is associated with better investor protection, is likely...
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