ANALYSE THE DEVELOPMENT OF CORPORATE GOVERNANCE IN TRANSITION COUNTRIES

1 Introduction

1.1 Background

Corporate governance comprises many dimensions. Based on the research from the United States, it can be divided broadly into the role of directors, ownership concentration, the role of shareholders, and accountability and audit. According to Jensen and Meckling (1976) argues that corporate governance structure plays the role of mitigating the conflict among bondholders and stockholders. Stockholders have the incentives of transferring wealth from bondholders. Corporate governance also mitigates conflicts between stakeholders (including bondholders) and management. Separating ownership and control may create informational asymmetries. This may create channels for self-interested insiders to act in their own interest at the peril of other stakeholders. Additionally, large shareholders may act in self-interest by influencing management at the expense of minority shareholders. Different studies utilise different measures of corporate governance such as director independence, block holding, and institutional holding to predict credit risk (Gompers et al., 2003). Corporate governance is aimed at enhancing transparency and market efficiency, thereby boosting investor confidence. Corporate governance tools that safeguard shareholders may not necessarily be beneficial to creditors. In the period of the financial distress, banks may not be in a position to take on lucrative projects, thereby reducing their future cash flows. Aguilera and Jackson (2003) argue that corporate governance stipulates the organisational structures, responsibilities, obligations and rights among the insiders. As a result, corporate governance directs a firms operations.

Corporate governance includes a countrys private and public institutions, which collectively govern the connection between manages and other stakeholders in the country. Stakeholders include shareholders, countrys regulatory entities, security entities, accounting bodies, and environmental bodies among others. The transition economies in Central and Eastern Europe have been undergoing privatisation since the 1990s. Their governments anticipated that privatised entities would be more efficient and speed up economic growth. While the vision was very strategic, the fruits are yet to be realised due to lack of effective corporate governance. Having a strong corporate governance is a pre-requisite for market growth. Corporate governance encompasses the integrity and transparency of corporations and financial operations. The idea is to have strong checks and balances that comply with instituted laws, solid financial and accounting practices. Laws are enacted in order to ensure that firms operate in a more transparent and accountable manner to stakeholders. However, having goods laws is not enough. The laws must be enacted in a timely manner, updated consistently and enforced judiciously. Developing effective corporate governance is of critical essence for transition economies given that it is not only a key ingredient for growth but also for sustaining a healthy market economy. In their paper, Bekaert et al. (2001) note that financial market liberalisation in transition economies in transition economies boosts growth by about 2 percent per annum. In some countries like Ukraine and Romania, corporate governance is so poor. This is attributed to rampant corruption and racketeering in the political and economic divides. In other economies like Hungary and Poland, corporate governance is strong and sound, effectively promoting the success of these economies.

1.2 The Scope of Corporate Governance Authors have attempted to define corporate governance in order to further the understanding of this concept. Berle and Means (1932) are the pioneers of the concept of corporate governance. The authors explain that corporate governance is the "equitable control" that managers need to exercise in order to meet the shareholders interests. One of the widely used definition is that of Cadbury Committee (Mallin, 2007). The author defines corporate governance as a system by which corporations are controlled and supervised. In a more recent study, Lamm (2010) defines corporate governance is the system of rules and norms within which various categories of stakeholders operate. This definition attempts to capture the multifaceted nature of corporate governance concepts. Dobroeanu et al. (2011) content that corporate governance encompasses a myriad of codes, procedures and processes designed to ensure optimal allocation of resources and development of corporate strategies that safeguard stakeholders objectives.Corporate governance comprises of the internal and external measures that are instituted to maintain accountability of firms. Different countries tend to have different implementation of corporate governance measures. For example, in the advanced markets such as the UK, clear corporate governance codes have been created in order to ensure independent monitoring and supervision of management. The aim of developing corporate governance codes is to enhance transparency and market efficiency, as a result, improving investor confidence. In many of the studies, measures of corporate governance include key factors such as director independence, ownership structure, CEO duality, and institutional holding (Gompers et al., 2003). In essence, good corporate governance ought to impact positively on firm performance. In literature, there is no paper that fully covers all governance mechanisms. This is because corporate governance measures differ from country to country and there is not universally accepted measure of corporate governance. The differences are also attributed to different data sets, study periods and research method the differences in research methodologies.The development of corporate governance is linked to various theories. Jensen and Meckling (1976) developed the agency theory, arguing that the separation of ownership from management enhances performance if proper accountability measures are put in place. Recent studies show that corporate governance has significant implications on transaction costs regarding efficient allocation of resources and organisational structure (Iacobu and Frunz, 2006). This idea is captured by the transaction cost theory, transaction is the key unit of analysis in economics. In this regard, economic governance is basic for optimizing allocation of resources and increasing economic efficiency. Other studies have looked at the stewardship theory, where managers are inclined to act in the best interests of shareholders. Based on this theory, managers should not further their own interests but be good stewards of shareholders interests.

Donaldson and Preston (1995) proposed the stakeholder theory, indicating that managerial decision making process should take into consideration the interests of other stakeholders. According to Crane and Ruebottom (2011), the main objective of management is to create value for the firm that will benefit all stakeholders. In this context, numerous studies have examined the relevance of shareholder value versus stakeholder alignment in advanced markets, particularly, the U.S. and UK (Stadler et al., 2006). There are other corporate governance models examined in literature, these include shareholder value model and stakeholders model (De Jong (1997) and insider and outsider system model (Bostan & Bostan, 2010).1.3 Corporate Governance in the Context of Transition Economies The issue of corporate governance in the context of transition economies is largely that of ownership concentrationmajority verses minority shareholders. In early studies, privatization of the state-owned enterprises (SOEs) led to concentrated ownership, with majority shares in the hands of block shareholders or employee buyouts. In this regard, the controlling shareholders had significant control over corporate assets than warranted by their stock ownership. The issue here is that the concentrated ownership can impede proper decision making due to the multifaceted ownership structures through multiple-class shareholdings, cross-shareholdings and pyramidal corporate shareholdings. In a definitive study by Bebchuk et al (1999), the author notes that expropriation costs are significantly high in such complex shareholdings. The role of corporate governance in promoting competition and transparency in the former command-based economies. The principal- agent connection that guides most of the capitalistic economies provides incentives and the requisite environment where investors (principals) can maximise their returns from their corporations under managers (agents). Transition countries are characterised by an implementation gap between enactment and enforcement of laws. Disparate from developed countries such as the United States which have widely dispersed shareholders, transition economies suffer principal-agent conflicts because the agent may misuse their power to further own interests. The underlying objective of corporate governance in advanced markets is to protect shareholders from expropriation costs by management. On the contrary, in European transition economies, advanced, corporate governance emphasize stakeholder protection (the state, employees and block holders). A relationship based system and investor expropriation tends to prevail in emerging economies. In transition economies, corporate governance is still in its developmental stage and faces challenges from the ruling class and politically connected oligarchs. The absence of effective corporate governance, in transition economies spawns an antagonistic business environment, one that is riddled with corruption, judicial bias, organized crime, and undue government interference. In the transition countries, the set of corporate governance codes implemented vary depending on historical legal heritage. For example, the cohort of Central and Eastern Europe and Baltic (CEEB) countries (Czech Republic, Estonia, Croatia, Latvia, Lithuania, Poland, Hungary, the Slovak Republic and Slovenia) has a German legal heritage. The cohort of South East European (SEE) economies (Bulgaria, Yugoslavia, Romania, Bosnia and Albania) are characterised by a French legal heritage. The third cohort is that of Commonwealth of Independent States (CIS). According to Pistor (2000), past legal heritage may not be a significant factor in explaining the mostly likely predominant system of legal structure that a transition country can adopt. Nonetheless, legal heritage explains can affect a countrys adoption of corporate governance codes in the initial transformation period. At the moment, countries are attempting to converge with the with the EU legal system, aiming to attain accession or adoption of the US system. Pistor (2000) further notes that the underlying differences in legal reforms among transition economies are attributed to differing ways in which policy makers respond to economic changes. Increased privatisation implies better protection of shareholder and stakeholders rights. In a similar study, Mahoney (2001) posits that a countrys overtly or covertly adopts a set of legal structures in line with changes in circumstance as opposed to its past legal heritage. For example, Poland and the Czech Republic have the same legal heritage but Poland is far much ahead in terms of privatisation intensity, development of corporate governance codes and economic growth. Interestingly, Coffee (1999) compares the differences between Poland and the Czech Republic and notes that while both adopted corporate law system based on the Germans heritage, Poland largely applies common laws of the Anglo-American in the regulation of its securities and financial markets. In essence, the country is characterised by stronger protection of ownership rights, stringent disclosure requirements and enforcing of securities commission agency. In this regard, the country has better securities regulation in place to safeguard minority shareholders from expropriation. Clearly, the Anglo-American common laws regime of corporate governance outdoes those of German and France that are based on civil law structure. Consequently, Poland has a healthy and growing stock market. 1.4 Research Question

The main objective is to identify key tends in transition economies and its impact on firm performance. The research questions include related to objectives of the study as:

a) Have transition economies improved their corporate governance after the recent global financial crisis?

b) Does ownership concentration significantly affect the performance of firms in transition economies?

1.5 Research Objective

This research aims at analysing how ownership concentration affects the performance of firms in transition economies. The study will also look at the development of corporate governance in the light of the recent global economic downturn. The study models the manner in which corporate governance affects firm performance. The empirical model involves controlling for accounting measures including leverage, profitability, size, cash reserves, working capital to total assets, and tax over total assets, sales of total assets and Stock market performance. The inclusion of other factors is aimed at controlling for firm-specific variables that may impact on firm performance. The study aims to contribute to existing literature on corporate governance in transition economies. The findings on the linkage between corporate governance and firm performance are not consistent, some find a significant impact while others do not establish any evidence. For this reason, this project will attempt to fill in the gap by deepening knowledge on corporate governance codes in transition economies. In particular, the study will examine the impact on ownership concentration on the performance of firms in these economies during and after the recent global financial crisis. It is vital to analyse how corporate governance has developed, with the knowledge that many countries are increasingly updating their corporate governance codes, following the financial crisis, in order to enhance corporate transparency and accountability. 2 Literature Review

2.1 Introduction

The process of identifying and understanding the corporate governance in transition economies necessitate the need to understand the concept of corporate governance based on the existing body of literature. Coffee (1999) attempted to explain the concept of corporate governance by stating that corporate governance refers to the equitable control which managers must demonstrate at the best interest of their shareholders. Chew and Gillan (2005) study on corporate governance presented the now widely applied definition stating that corporate governance is the system through which firms are controlled and directed. According to Shleifer and Vishny (1997), corporate governance is the process in which financial investors safeguards the profitability of their investment by ensuring sustainable organizational functions. Mahoney 2001 have offered a more objective definition stating that corporate governance is the systems of rules and procedures in which shareholders, stakeholders, managers, and other involved parties develop. Most recently, Martynova & Renneboog, 2009) defined corporate governance as the concept that encompasses rules, process, procedures and activities meant to guarantee optimal use of resources for sustainable development.

There are a number of theories upon which the concept of corporate governance is developed. The stewardship theory states that administrators and managers of a business must always act in such a way as to meet the interests of the shareholders. This theory aligns perfectly with the concept of corporate governance in transition economies as it eliminates the concepts of personal interests (Donaldson, 1990). The stakeholder theory states that shareholders must be involved in the managerial decision-making process as Black et al (1999) suggest. Conventionally, managers must endeavour to create value and satisfaction for their shareholders and stakeholders respectively. There are a number of corporate governance models that have been developed as the existing scholarly literature attests. These corporate governance models include: Shareholder value model and the stockholder model, American, continental and Latin, the insider system and the outsider system models Estrin et al (2009).

In 1999, the Wold Bank stated that corporate governance encompasses two mechanisms. These mechanisms are the external and the internal corporate governance. The internal corporate governance gives priority to interests of the shareholders while monitoring the top management External corporate governance, on the other hand, monitors the behaviours of the managers through force and external regulations. Here many parties including stakeholders, credit rating agencies and professional institutions and suppliers are involved. A body of the literature investigating the effect of corporate governance on firm performance presents a number of characteristics that every corporate governance system must exhibit. First is the board size, the duality of the CEO, the existence of female board members, board working experience, education level of board members, block-holders, board ownership, board compensation and independent directors (Miwa, Y. and Ramseyer 2000). However, for the purposes of the current thesis, only the literature on block-holders, investor protection, enforcement and ownership concentration will be examined.

2.2 Common Law Model in Corporate Governance

The Asian economic and financial crises resuscitated the issue of corporate governance to the limelight of research. The focus of the research studies focused on the agency problem and weak dispersed investors in the emerging and developing countries. Later in the years, researchers focused their attention on corporate governance among developed countries after the U.S. corporate fraud scandals. The study examined the topics ranging from internal to external governance incorporating important components such as the role of Board of Directors, transparency and ethics, and compensations and incentives. Most of the studies were based on the common law models as Chew and Gillan (2005) observed. The common law model which relates to the dispersed shareholders whereby no shareholders own a majority state formed the basis of a majority of the corporate governance studies. Majority of the researchers asserted that investors interest protection could be safeguarded through a meaningful corporate governance system (Shleifer & Vishny, 1997; Glaeser et al, 2001; Hanousek & Kocenda, 2003). The common law corporate governance system districts shareholders from stakeholders with fully-developed and sustainable external equity market system to monitor the managers role. The voice and protection that was accorded to the dispersed shareholders in the common law model is that they were at liberty to leave in the event of poorly monitored and weakening internal corporate governance. The dispersed shareholders were further provided with timely information arising from the rating agencies and related market scrutiny forming a distinct layer of protection. Another set of studies focused on the extent of common law adoption relative to the civil laws in investor protection (Coffee 1999; Pistor, 2000; Mahoney 2001). Mahoney (2001) found that economies that adopted the common law system of corporate governance afforded the investors better protection and significant financial market development as opposed to civil law systems. He concluded that common law economies sustained significant economic growth than civil law countries since common law supports private economic enterprises and protects property while the civil law is based on government restrictions and undue interventions.

2.3 Corporate Governance in Transition Countries

The other body of studies on corporate governance focused on the transition countries. This set of studies was based on the unprecedented mass privatization of state-owned enterprises and the structural systems in which they operate to transform to success market economies. The studies that focused on the corporate governance in transition countries were based on a number of contentious issues. These issues included the type of ownerships [dispersed versus concentrated], sufficiency of the shareholder protection, mode of privatization and whether or not ownership structural systems should precede privatization. Indeed, ownership structural systems are yet to full evolve in transition countries. There are no widely held firms because of the small and illiquid underdeveloped capital markets. As such, studies performed on the corporate governance in developed countries may not be adequately applicable to transition countries with such differential conditions. In other words, the problem of corporate governance in transition countries are significantly different from those experienced in developed countries and it is the responsibility of any ethical researcher to take this difference into account.A set of studies focuses on whether the past legal heritage of a transition country affects the adoption of corporate governance and current legal structures or the common law system is more eminent (Pistor, 2000; Martynova & Renneboog, 2009). The heavy privatization and dispersed ownership and presence of intermediaries in institutions help to bolster capital and security markets development (Gray and Hanson, 1993).Gray and Hanson (1993) further argued that German-Japanese model that involves active shareholding monitoring through institutional intermediaries can foster better relationships among managers, timely and better access to information and deeper understanding of business compare to Anglo-American model involving dispersed shareholders. As such, the German-Japanese model that involves concentrated ownership with corporate governance designated to intermediaries may be suitable for transition countries. This assertion is advocated for by other studies (Shleife & Vishny 1997). These studies assert that concentrated corporate ownership structures are the product of poor investors ownership protection and agency problems. La Porta et al. 1999 studies further support this assertion citing that the degree of rights ownership and protection impacts corporate behaviour and, in effect, economic development. However, Miwa and Ramseyer (2000) discredited the concept of concentrated shareholders and intermediary institutional but rather accredited the concept of dispersed shareholders as being more effective in management control in transition countries. The foregoing body of literature focuses on the varying degree of legal protection with a variety of corporate governance structures based on present ownership [dispersed or concentrated].

2.4 The Effects of Privatization on Corporate Governance

State-owned privatization in transition countries goes beyond the typical transfer of assets to private owners. As such, the concept of privatizations has to be examined based on three basic areas: One, the system creation of corporate governance to bolster healthy economic environments for businesses; two, self-sustaining economic growth; and three, enforcement and legal infrastructural advancement. There is a whole body of research studies that highlight the positive and the negative impact of privatization in transition countries. Estrin et al (2009); Frydman, Hessel & Rapaczynski 1999; and Coffee 1999 conducted studies to assess the effects of privatization on corporate governance in transition countries. The results from the three studies provided positive findings. In particular, Estrin et al (2009) found that privatization had positive effects on corporate governance in CEEB countries. Frydman, Hessel & Rapaczynski (1999) observed that privatization to outsider owners as opposed to corporate insiders has a positive effect on performance due to the greater entrepreneurial skills of the outsider owners. Coffee (1999) found that state-created monitors and slower privatization through investment funds surpass inefficient legal structures and rapid privatization. On the other hand, Hanousek and Kocenda (2003) and Black et al (1999) found negative effects of privatization on corporate governance in their respective study countries [that is, Czech Rep. and Russia respectively]. Hanousek and Kocenda (2003) found that lack of regulations and disperse ownership regulations brought about a weak management environment. However, the authors found that the improvement of corporate governance since 1995 improved firm profitability. Black et al (1999) found that effective institutional structures are important and should precede privatization. This is because the authors found that after privatization of firms in Russia, insider managers stripped assets, engaged in fraudulent theft through self-dealing and corruption. State-owned privatization is perceived as the force that transforms transition countries to market economy. As such, private ownership helps profit-oriented managers to focus on market restructuring which consequently leads to economic growth under the concept of principal-agent model. However, this phenomenon is yet to be achieved in transition countries, partly because of lack of adequate self-sustaining corporate governance and partly due to unfriendly business environments (Meye, 2003). In fact, the issue with corporate governance progress is worsened by the self-interest of the highly concentrated owners who are tied to the most powerful political fibre. Consequently, corruption set in, plaguing the early transformational efforts of the transition countries. This phenomenon is prevalent in transition countries such as China, Russia and Bulgaria. China, for example, privatized a number of her state-owned enterprises. In effect, agency problems and poor moral relationships undermined the emerging corporate governance practices. According to Lin (2001), managers gained greater autonomy from the privatization of the Chinese state-owned enterprises, resorting to misuse of company funds through self-dealings, embezzlements and corruption. As such, the transfer of state-owned assets to private ownership in transition countries does not guarantee that agents will always act at the best interest of their principals, especially if no institutional structures exist to monitor the private ownership. The presence of the institutional structures and legal framework is adequate to enforce the roles of the various stakeholders with distinct interests.

The experience of the Russian government further raises the question on whether privatization is the most important ingredient in transforming to a market economy. This is because the privatization of the Russian state-owned enterprises to concentrate manager ownership was the genesis of issues such as insider dealings, incompetent management, corruption, asset stripping and the destruction of the value of minority shareholders. As such, activity of transferring state-owned assets to concentrated corporate owners should be preceded with legal and enforcement structures to preclude incidences of corruption and self-dealing. In effect, corporate governance and the emergence of a favourable business environment will be achieved. According to Glaeser et al. (2001), the Czech security market greater than the Polish market prior to the 1990s reforms. The establishment of strong and independent security commission in Poland to oversee corporate governance bolstered rapid capital market development. As such, the Polish market is the largest among the transition countries. On the other hand, Czech Republic created a small ineffective commission that paved way for corruption, corporate asset stripping and destruction of minority shareholders value. Oman et al. (2003) study found that adequate centralized regulatory enforcement of security law through security commission is more efficient than the protection of principles rights through judicial enforcement in Poland and Hungary. The foregoing literature disputes the benefit of privatization of state-owned assets without effective corporate governance and legal structures that must precede privatization. Nonetheless, Miwa, Y. and Ramseyer,) study found that firms with satisfactory future investment prospects can practice adequate corporate governance despite the presence of weak institutional frameworks. In fact, the researchers found that if a firms corporate governance improved by 10%, the firms market share improved by 9%.

The difference in corporate governance among transition countries is based on the problem of minority versus controlling shareholders. Privatization in recent history resulted in concentrated ownership by block-shareholders which afforded these dominant shareholders superior control over corporate assets exceeding their stock ownership. The prevalence of complex ownership structures in terms of pyramidal, multiple-class and cross-shareholdings exacerbated the situation. Bebchuk et al (1999) study shows that the costs associated to these complex arrangements exceeds the cash flow right of the shareholders. The duty of the corporate governance to undersize weak competitive market mechanism is the single most important ingredient necessary to set a long-term modernization of transition countries. This phenomenon can only be achieved if the transition countries are able to set and enforce a set of corporate governance standards. Contrary to developed countries with widely dispersed shareholders, the principal-agent corporate governance model is ineffective in transition countries due to rising incidents of fraud and embezzlement. The corporate governance of the US-UK emphasizes the protection of shareholders from potential exploitation by the management. On the other hand, the German-French regime emphasizes the protection of stakeholders from potential deprivation of private property rights. In European Nations adopt a varied set of corporate governance standards which often depends on the historical legal heritage. Nevertheless, Pistor (2000) study found that historical legal heritage does not significantly explain the predominant legal structure the transition countries might adopt. Pistor (2000) further observed that legal varying legal reforms among the transition countries are often in response to greater privatization stimulations, adequate creditor protection and the rights of stakeholders or whether the external advisors are from EU or US. According to Mahoney (2001) study, countries adopt a set of legal structures not because of its past legal heritage but as a response to change.

Czech Republic and Poland provide excellent cases of the differences in privatization, economic growth and corporate governance development. Coffee (1999), found that Poland and Czech Republic adopted the German heritage based corporate law system. The difference was that Polands securities practices adopted the common law system of the Anglo-American model that encompassed protection of private ownership protection, strong and independent security commissions and strict disclosure standards. Coffee (1999) concluded that better securities are effective in protecting minority shareholders than ineffective corporate laws. This explains the ever growing stock market in Poland relative to Czech Republic.

2.5 Indices of Corporate Governance

Martynova and Renneboog (2009) conducted a study to investigate the corporate governance indices with the aim of capturing the major factors of corporate governance in relation to capital market laws of the sampled countries. The indices were constructed based on the heritage of common laws or civil laws of the sampled countries. The database that was utilized was based on various corporate governance regulations as results from direct interviews and detailed questionnaires sent to 150 legal experts provided. The study concluded that German legal heritage countries gave the shareholders more decision rights; English legal heritage countries put more emphasizes on representatives and trustees of the stockholders with greater control. The authors further established that former communist countries have stronger creditor protection. The transition countries are more characterized by stakeholder-based regime as opposed to the US-UK stockholder-based regime. In fact, the transition countries afforded least protection to investors.

Majority of the studies on corporate governance in transition economies emphasizes the problem present in managerial entrenchment and scarcity of the external finance for investment as Shleifer and Vishny (1997) suggested. Shleifer and Vishny view corporate governance as the problem that emanates from the supply of external finance to firms. Form of ownership in different systems is represented by varying dominant principal-agent problems. This system typically involves dispersed ownership whereby the owner-agent relationship presents the problem in the central corporate governance. On the other hand, concentrated ownership systems present the problem of the large shareholder versus the minority investors. In both the systems, minority or outside investors provide the external finance whenever the manager or the majority shareholders commit not to exploit their control powers unreasonably. The private benefits that arise from excessive use of the control powers range from fraudulent theft to incompetence. Shleifer and Vishny (1997) asserted that corporate governance with functional systems is one comprising of ownership concentration to impose profit-seeking behaviour. This is a common experience for systems with large shareholders: In systems with no controlling shareholders, profit seeking behaviours occur through the mechanism of hostile takeovers. Shleifer and Vishny (1997) further pointed the protection of legal rights of suppliers of external finance as another requirement for efficiency. The study suggested that in the case of concentrated ownership incorporating large share-holders, the demand for legal systems tends to be less as compared to the demand on legal systems which are heavy in dispersed ownership models.

Shleifer and Vishny (1997) study presents a bolder hypothesis by suggesting that a key success to external finance is based on a countrys legal code. The legal codes are classified into either the common law (US, UK and commonwealth countries) and civil laws (German, French and a number of Asian countries). In their study of 49 countries based on legal code, Shleifer and Vishny (1997) summarized important information detailing the aspects of investor protection, enforcement and ownership concentration. The results revealed that the greater degree of investor protection was due to low ownership concentration in common law countries thereby increasing the respective countries chance to external finance. On the other hand, the authors found that the French civil law countries had the weakest investor protection with excessive ownership concentration. Nonetheless, no correlation between the legal system of investor right protection and per capita income was noted.

2.6 Indicators of Firms performance

2.6.1 Performance Indicator

The existing body of literature in the field of corporate governance offers a variety of measurements that can be used to reflect a firms performance. Majority of the studies examines the performance of a firm using financial indicators such as return on assets, return on equity, return on investment and net profit margin (Ittner & Larcker, 2003). These measures can be categorised into accounting-based measures which reveals the current financial performance of the company. According to Haniffa and Hudaib (2006), there is no consensus in the literature on the most suitable or appropriate indicator of financial performance citing that each measure of a firms performance has associated strengths and weaknesses. As such, there is no suitable proxy to denote financial performance.

Nonetheless, the current study will use return on Asset (ROA), commonly referred to as return on investment (ROI) which provides an accurate representation of the underlying business parameters as far as annual fluctuations are concerned. ROA is one of the accounting-based measures of firms performances that provide the most comprehensive indicators of the current status of a firm. Market based measures such as Tobins Q are not problematic and inappropriate in the context of the transition and emerging economies where most firms are focused more on debt financing than equity financing. Overall, the use of ROA is particularly important as it reflects an effective use of firm assets in increasing the value of the shareholders wealth (Haniffa and Hudaib 2006). In addition, ROA eliminates the problem of the company size while providing an effective comparative framework among firms. Therefore, ROA is an indicator of how profitable and efficient a firm is. Conventionally, the lower the value of the return on asset reflects firms inefficiency.

Return on Assets (ROA) = Net Income/ Total Assets.

2.6.2 Control Variables

2.6.2.1 Ownership Concentration:

There exists an extensive body of literature that provides information on how ownership concentration relates to a firms overall performance. Shleifer and Vishny (1997) asserted that whenever the ownership structure of a firm is dispersed, it becomes highly unlikely for shareholders to monitor management decisions closely. In addition, shareholders in a dispersed ownership structure often have no motivation to monitor management decision partly because the potential benefits of monitoring is downplayed by the agency costs associated with the activity. On the other hand, Shleifer and Vishny (1986) cited that shareholders within the concentrated ownership structure contribute objectively to the mitigation of any arising agency problems. This is because they often have the motivation, incentives and capacity to monitor management decisions since they also have a shared benefit of control irrespective of their shareholdings. As such, it can be concluded that an increase in ownership concentration increases the degree to which costs and benefits are borne by the same investor. As such, concentrated ownership fosters a companys performance since shareholders remain active in corporate governance to prevent information asymmetry between themselves and the agents. Overall concentrate ownership has in large part a positive relationship with a firms overall performance.

2.6.2.2 Firm size

Existing literature review provides ambiguous association between the firm performance and the firm size Durnev & Kim, 2005. Martynova and Renneboog (2009) argues that larger firms have higher prospects of generating funds internally and accessing credit from external sources than smaller firms. At the same time, larger firms benefits from large economies of scale than smaller firms. These benefits have a positive relationship on firm performance. Although Boone et al (2007) argues that larger firms are often inefficient due to the complexity of the operations, Black et al. (2006) cited that larger firm sizes positively affects their respective performances due to the ability to raise funds and execute diversified strategies.

2.6.2.3 Leverage

It has been argued that leverage affect performance of a firm either positively or negatively. According to Jensen 1986, leverage mitigates agency problems as an important mechanism of internal corporate governance especially with regard to free cash problems. As a result, leverage may have a positive effect on a firms performance as the high level of debt disciplines the managers to utilize funds efficiently and objectively. Although Andrade and Kaplan (1998) posits that firms with higher financial leverages tend to perform poorly relative to those with lower leverages, Jensen 1986 cited that higher financial leverage in a firm reflects its ability to service large amounts of debt, an indicator of high performance. Myers (1977) further noted that higher levels of financial leverage affect the stocks market value which results in higher financial risk. The expectation is that the firms with higher amount of financial leverage will reflect poor firm performance in the long-run.

Leverage = Long-Term Debt/Total Assets

2.6.2.4 Other variables

The other variables include of cash reserves, working capital over total assets, retailed earnings over total assets, earnings before interest and tax over total assets and sales of total assets. From the existing body of literature, cash reserve-the highly liquid investment with low rate of return-has either a negative or a positive relationship with a firms performance (Hirschey, john & Makhija, 2009). On one hand, a firm with a high level of cash reserves often has good performance since it shows profitability, efficient administration and lower financial leverages. On the other hand, firms with high amount of cash reserve might face severe agency problems which might be reflected in the firms performance. Existing literature further shows that firms with higher earnings before interest and tax tend to perform well. This is because the firm has enough funds to cover its daily operations and service short-term borrowings (Hirschey, john & Makhija, 2009). Hirschey, John and Makhija (2009) further cite that firms with high working capita over total assets also means that a firm is able to cover its short term financial obligations. Chew and Gillan (2005) asserted that higher retained earnings to total assets indicate that a firm is profitable. This is the portion of earnings that is left after all the shareholders receive their dividends. As such, the ratio the ratio of retained earning relative to total assets reflects better firm performance. Finally, sales to total assets ratio is the measure of the ability of a companys assets to generate sales or revenue. Hirschey, john and Makhija (2009) asserted that a firm with high sales to total asset ratio reflects efficiency in its operation. The efficiency is highly characterized with improved firm performance.

2.7 Summary of Literature

The chapter focuses on the concept of corporate governance in transition countries incorporating the major ingredients of corporate governance. The internal mechanism of corporate governance has been identified majorly on ownership structure in terms of concentrated ownership and accounting measures. Furthermore, the body of literature identifies the need to enact legal and institutional reforms to enforce effective corporate governance in the transition economies. In the current paper, the research questions are focused on investigating whether or not transition economies improved their corporate governance after the recent global financial crisis and whether the ownership concentration significantly affects the performance of firms in these economies. Furnished with the body of literature available, we seek to model the manner in which corporate governance affects firm performance, whereby the empirical model would control for accounting measures such as leverage, profitability, size, cash reserves, working capital to total assets, and tax over total assets, sales of total assets and Stock market performance.

3 Research Methodology

3.1 Introduction

The chapter summarizes the research design, variable descriptions, sources of the data, method of data collection, and the operationalization of the data to formulate a model that could be used to estimate the corporate governance in transition countries. The resulting model will be used to establish whether ownership concentration significantly affects firms performance in transition economies.

3.2 Research Methodology

There are two major research methods namely the quantitative and qualitative research methods. Although the methods are said to differ fundamentally, their operationalization and objectives often overlap. Nonetheless, researchers should make an informed decision on which method to adopt based on the needs of their studies. Quantitative research is used with numerical data or data that can be transformed into statistics. The sample results are thereafter generalized into the larger population. On the other hand, qualitative research is exploratory in nature and it is utilized to gain an in depth understanding of a particular problem. Quantitative research method would be used in the current study since the numerical data that can be transformed into statistics is used. In essence, the quantitative research methods would be used in an attempt to gain the true understanding of the effect of corporate governance on firms performances in transition countries and to estimate a model that can be used to assess the effect of ownership concentration on firms performance. As such, quantitative research methods will be used to collect numerical data [secondary data] that will thereafter be analysed using mathematical-based methods.

3.3 Data Collection and Description

The study utilizes data sampled from non-financial firms in the transition economies. In particular, the data is retrieved from AMADEUS database via WRDS. The firms sampled from the selected transition countries will comprise of yearly observation for the selected variables which include: market to book value of equity, leverage, firm size, cash reserves, and working capital over total assets, retailed earnings over total assets, earnings before interest and tax over total assets and sales of total assets. The yearly observations for the selected variables cover the period between 2000 and 2014. The data on ownership structures will be collected manually. This is because annual reports of companies are more accurate than other secondary data sources as jijo asserted. At the same time, data based on reports have a higher level of quality and reliability. The data from the annual reports will be double checked by the researcher to avoid errors during copying. The chosen firms had to pass the suitability test. In other words, the companies that were liquidated either voluntary or by obligation and those that were merge with or acquired by other companies were excluded. On the same note, financial firms were also excluded from the study since firms in this sector are often administered by a set of rules and regulations. As such, these firms are incomparable to firms in other sectors of the transition countries economy (Abed et al. 2012). For the purposes of the research objectives, the study will utilize sub-samples encompassing the long-run period [2000-2014], crisis period [2007-2010] and post-crisis period [2011-2014]. The criteria used in the data collection will assist the researcher to meet the needs for the analysis of panel data. The sub-samples will enable the researcher to assess the impact of corporate governance prior and after the 208-2010 financial crisis.

3.4 Description of the Variables

3.4.1 Performance Variable

The existing body of literature in the field of corporate governance offers a variety of measurements that can be used to reflect a firms performance. Majority of the studies examines the performance of a firm using financial indicators such as return on assets, return on equity, return on investment and net profit margin (Ittner & Larcker, 2003). These measures can be categorised into accounting-based measures which reveals the current financial performance of the company. According to Haniffa and Hudaib (2006), there is no consensus in the literature on the most suitable or appropriate indicator of financial performance citing that each measure of a firms performance has associated strengths and weaknesses. As such, there is no suitable proxy to denote financial performance.

Nonetheless, the current study will use return on Asset (ROA), commonly referred to as return on investment (ROI) which provides an accurate representation of the underlying business parameters as far as annual fluctuations are concerned. ROA is one of the accounting-based measures of firms performances that provide the most comprehensive indicators of the current status of a firm. Market based measures such as Tobins Q are not problematic and inappropriate in the context of the transition and emerging economies where most firms are focused more on debt financing than equity financing (Haniffa and Hudaib 2006). Overall, the use of ROA is particularly important as it reflects an effective use of firm assets in increasing the value of the shareholders wealth (Haniffa and Hudaib 2006). In addition, ROA eliminates the problem of the company size while providing an effective comparative framework among firms. Therefore, ROA is an indicator of how profitable and efficient a firm is. Conventionally, the lower the value of the return on asset reflects firms inefficiency.

Return on Assets (ROA) = Net Income/ Total Assets.

3.4.2 Control Variables

3.4.2.1 Ownership Concentration

Ownership concentration is the main exogenous variable for the study. For this study, ownership concentration measure is retrieved from Bureau Van DijksAMADEUS database. The BvD Independence Indicator categorises banks with respect to the degree of independence of the bank regarding shareholders. In the database: A+ is awarded to companies that have shareholders with less than 25% ownership; A is awarded to entities with 4 to 5 shareholder(s) holding less than 25% of the total stake; ownership (direct or collective); and A- is awarded to entities with 1 to 3 shareholders with less than 25% ownership. B+, B, and B- are awarded to entities with identified 6 or more shareholders, 4 or 5 shareholders and 1 to 3 shareholders with no shareholder exceeding 50% ownership, but at least one with more shareholder than 25% ownership, respectively. C+ is awarded to entities with a single shareholder owning more than 50% and C is awarded to entities with a direct shareholder with more than 50.01%. D is awarded to an entity with an identified shareholder with a direct ownership exceeding 50%. In order to implement a comprehensive empirical analysis this study generates two dummy variables. The first variable is Ownership level 1this takes the value of 1 if the BvD Independence Indicator is A+, A- or A and zero if otherwise. The second variable is Ownership level 2 takes the value 1 if the BvD Independence Indicator is C or D and zero if otherwise.

3.4.2.2 Firm size

Existing literature review provides ambiguous association between the firm performance and the firm size Durnev & Kim, 2005. Jijo argues that larger firms have higher prospects of generating funds internally and accessing credit from external sources than smaller firms. At the same time, larger firms benefits from large economies of scale than smaller firms. These benefits have a positive relationship on firm performance. Although Boone et al (2007) argues that larger firms are often inefficient due to the complexity of the operations, Black et al. (2006) cited that larger firm sizes positively affects their respective performances due to the ability to raise funds and execute diversified strategies.

3.4.2.3 Leverage

It has been argued that leverage affect performance of a firm either positively or negatively. According to Jensen 1986, leverage mitigates agency problems as an important mechanism of internal corporate governance especially with regard to free cash problems. As a result, leverage may have a positive effect on a firms performance as the high level of debt disciplines the managers to utilize funds efficiently and objectively. Although Andrade and Kaplan (1998) posits that firms with higher financial leverages tend to perform poorly relative to those with lower leverages. On the other hand, Jensen 1986 cited that higher financial leverage in a firm reflects its ability to service large amounts of debt, an indicator of high performance. Myers (1977) further noted that higher levels of financial leverage affect the stocks market value which results in higher financial risk. The expectation is that the firms with higher amount of financial leverage will reflect poor firm performance in the long-run.

Leverage = Long-Term Debt/Total Assets

3.4.2.4 Other variables

The other variables include of cash reserves, working capital over total assets, retailed earnings over total assets, earnings before interest and tax over total assets and sales of total assets. From the existing body of literature, cash reserve-the highly liquid investment with low rate of return-has either a negative or a positive relationship with a firms performance (Hirschey, john & Makhija, 2009). On one hand, a firm with a high level of cash reserves often has good performance since it shows profitability, efficient administration and lower financial leverages. On the other hand, firms with high amount of cash reserve might face severe agency problems which might be reflected in the firms performance. Existing literature further shows that firms with higher earnings before interest and tax tend to perform well. This is because the firm has enough funds to cover its daily operations and service short-term borrowings (Hirschey, john & Makhija, 2009). Hirschey, John and Makhija (2009) further cite that firms with high working capita over total assets also means that a firm is able to cover its short term financial obligations. Jijo asserted that higher retained earnings to total assets indicate that a firm is profitable. This is the portion of earnings that is left after all the shareholders receive their dividends. As such, the ratio the ratio of retained earning relative to total assets reflects better firm performance. Finally, sales to total assets ratio is the measure of the ability of a companys assets to generate sales or revenue. Hirschey, john and Makhija (2009) asserted that a firm with high sales to total asset ratio reflects efficiency in its operation. The efficiency is highly characterized with improved firm performance.3.5 Data Analysis

3.5.1 Descriptive Statistics and Correlation Analysis

The current study presents descriptive statistics for each of the main variables. The main descriptive statistics used for this study include mean and standard deviation. Pearsons correlation will be analysed for the main variables in order to determine the strength and direction of the existing relationship.

3.5.2 Panel Data Regression Analysis

In order to analyse the factors affecting banks credit risk during and beyond the financial crisis, this study first applies panel data regression. The use of panel data techniques is aimed at minimising heterogeneity issues when evaluating the determinants of credit risk for the sampled firms. The model is estimated in STATA and the significance of the results is based on 5% level of statistical significance. This study aims at establishing the impact of corporate governance on firm performance in transition countries. The study utilises panel data regression methods to examine the impact of different variables on firm performance (ROAreturn on assets). Explanatory variables include corporate governance ownership concentration and accounting measures including Leveragetotal liabilities over total assets, MBmarket to book value of equity, Sizefirm size measured as the log of total assets, Cash reservescash reserves as a percentage of total assets, WCAP_TAworking capital over total assets, RE_TAretailed earnings over total assets, EBIT_TAearnings before interest and tax over total assets, and SALES_TAsales of total assets. The research Model is formulated as follows:

Where: PERF denotes the average performance of a firm.

Random Effects Method

The Random effects approach performs estimation based on the assumption that intercepts of each variable vary randomly. Based on this assumption, each of the intercepts of the cross-sectional data is presumed to originate from a common intercept with an error term that cross-sectionally varies over time. This approach is mathematically expressed as follows:

(2)

In the random effects model the error term decomposes as follows:

(3)

In the equation above, the permanent component of the error term (i) represents the random effect and is normally distributed while vit are serially uncorrelated among cross-sections. Random effects model parameters are estimated based on the Generalized Least Square method (GLS).

Fixed Effects

This estimation assumes no differences in the cross-sectional data matrices. In other words, the fixed effects model assumes that each firm differs in their intercept. Fixed effects approach may appear to be simpler to use due to no requirement of testing for the null hypothesis of serial correlation, the random selection of firms from a large population and large sample size is an indication that it is also important to use the random effects model.

3.6 Summary of the Research Methodology

The study will use model both fixed effects and the random effects (one-way through variation of cross-sectional). Given that the panel data is unbalanced; two-way random effects will not be performed in this study. The use of the two approaches will be tested using Hausman test in order to come up with conclusions on which approach is most appropriate.

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