Does Bad Corporate Governance Lead to too Little Competition? Corporate Governance, Capital Structure, and Industry Concentration

Abstract

We examine the relationships among corporate governance, industry concentration and financial structure that emerge endogenously in an economy. We consider entrepreneurs whose ability to raise capital is limited by the presence of agency costs in both the equity and debt markets. We argue that the quality of the corporate governance system may have a significant impact on the economy's level of competition and its degree of industry concentration. Thus, the causality between the quality of an economy's corporate governance and its degree of competition may indeed run in the opposite way to the one suggested in traditional theory: poor corporate governance and low investor protection may in fact lead to high industry concentration. We also characterize the relationships between debt-ratios, market-to-book ratios of equity, ownership concentration, industry concentration and firms' profitability in such economy, and we generate predictions on the cross sectional variations that would emerge both within an economy and in cross-country comparisons. Finally, we show that the agency costs of equity interact with the moral hazard problem in debt market in a way that (contrary to previous theory) the presence of convertible debt in a firm's capital structure may increase, rather than decrease, the insiders' incentives to take excessive risks.