From Financial Markets to Corporate Governance: Steering the Capital Allocation Process and Its Implications for Firm Performance and Society at Large

Abstract

Ten years ago, much of the Western world was shocked by the financial crises affecting not only the corporate ecosystem, but society at large. This brought a - classical - question to the forefront: How can we ensure that capital is allocated to its most efficient uses? Not only economists consider a well-functioning capital allocation process to be of first order importance for a modern (capitalist) economy and differentiate two levels of capital allocation: First, on the macro-level investors decide about their investments (i.e. which firms receive capital). Second, on a micro-level managers determine the capital allocation among the multitude of firms. Following this hierarchy, this research proceeds in two steps. First, it examines the role and economic impact of financial structures (i.e., the size and composition of financial markets) for economic development (broadly defined). Analyzing 98 countries over the years 1975-2016, it provides novel evidence for the importance of equity markets for growth, investment, capital formation, and productivity, as well as for reducing unemployment and inequality. Moreover, it documents that stock markets are particularly important in countries with well-functioning institutions, as for instance measured by the Rule of Law. Second, it examines the role and economic impact of corporate governance on individual firm behavior. Analyzing about 450 European firms over the years 2004-2016, it provides novel evidence for the importance of long-term oriented institutional investors and board independence for a firm’s long-term development. Specifically, it documents that these two factors are able to reduce the firm’s cost of capital and to encourage more unique strategies. The project contributes to the ongoing debate about the optimal design of financial markets and the role of corporate governance in the capital allocation process among the firms. It provides strong arguments for initiatives fostering equity capital markets and establishing country- and firm-level governance mechanisms ensuring an efficient capital allocation process.