Research Article

Corporate Governance &

Firm Profitability:
evidence from Korea before
the economic crisis
SOURCE & AUTHOR
Elsevier (Journal of Financial
Economics)

Sung Wook Joh
INTRODUCTION
Many countries that suffered during the recent economic crises
in Asia and other emerging markets had weak legal
environments and poor governance systems.

This observation has triggered much discussion on the
importance of Corporate Governance.

Johnson et al. (2000) shows that countries with weak
legal protections suffered greater exchange rate
depreciation and severer stock market declines during the
crisis.

Contd
Using firm level data, Mitton (2002) shows that
corporate governance measures, such as high disclosure
quality and concentrated ownership, affected stock market
valuation during the crisis.

Lemmon and Lins (2002) show that, during the crisis,
firms showed low performance when their controlling
managers had more control rights than ownership rights.

Aghion et al. (2000) and Krugman (1999) argue that the
financial distress of firms helped cause the crisis. If poor
corporate governance helped lower firm value and financial
survivability before the crisis, it arguably increased the
economys aggregate vulnerability.




CRISIS & CORPORATE SECTOR PROBLEMS
High debt-equity ratios and low profitability in
Korean firms persisted for many years, open by a
weak corporate governance system.

Together, these factors helped increase the
vulnerability of the corporate sector before the 1997
economic crisis.





OWNERSHIP STRUCTURE OF THE FIRMS
The largest shareholder, usually the founder, typically
controls a Korean firm.

In over 80% of large firms, the largest and controlling
shareholder or family members are among the top
executives.

The other 20% are likely to be state-controlled enterprises
and financial institutions.

Even when a hired professional CEO manages the firm, his
decision-making power and scope are often quite limited .





DETERMINANTS OF FIRM PROFITABILITY
In firms with high disparities between control and
ownership rights, conflicts of interest among
shareholders can affect performance.

A firms organizational structure can aggravate these
conflicts.

Other factors that affect firm profitability include firm
attributes such as financial structure, size, market
share and business strategy.






CONTROL-OWNERSHIP DISPARITY
In a firm with a high control-ownership disparity, a
controlling shareholder exercises control but owns only a small
fraction of the firms cash flow.

Bebchuck et al. (1999) call it a controlling minority structure.

Lemmon and Lins (2002) show that firms with greater
separation of control and ownership rights had severer firm
devaluation during the crisis.

Mitton (2002) shows that firms with high disclosure quality and
ownership concentration showed better stock market
performance during the Asian economic crisis.






FINANCIAL STRUCTURE
Past literature has shown mixed effects of debt on
firm profitability.

Debt affects profitability positively in Hurdle
(1974), but negatively in Hall and Weiss (1967)
and in Gale (1972).






VARIABLES
This study measures Firm Performance through Profitability.
Accounting Profitability is likely a better performance measure
than stock market-based measures for the following reasons:

1. Stock prices are less likely to reflect all available information
when the stock market shows inefficiency.
2. A firms accounting profitability is more directly related to its
financial survivability than is its stock market value.
3. Accounting measures allow us to evaluate the
performance of privately held firms as well as that of
publicly traded firms.







DATA
This study uses financial and ownership data from the
National Information and Credit Evaluations (NICE)
database.

As all firms in the same country are subject to the same
accounting standards, the potential problems associated with
poor accounting practices will likely be smaller than those in
cross-country studies.

The data includes 5,829 firms in the standard four-digit
Korean industrial classifications between 1993 and 1997.

Financial institutions and state-controlled firms are not
included.








SUMMARY OF RESULTS
The empirical analysis shows that the poor corporate governance system in
Korea had contributed to poor profitability even before the crisis.

Firms with lower controlling family ownership or higher differences
between control rights and ownership rights showed lower performance.

In addition, Korean firms affiliated with business groups in the mid-1990s
showed lower profitability than independent firms did.

Moreover, the negative effects of control-ownership disparity and
internal capital market inefficiency were stronger in publicly traded firms
than in privately held ones.








CONCLUSION
These results suggest that Koreas weak corporate
governance system offered few obstacles against
controlling shareholders impounding of minority
shareholders. Firm performance had been
deteriorating over time even before the crisis
occurred. Weak corporate governance systems
allowed poorly managed firms to stay in the market
and resulted in inefficiency of resource allocation
despite low firm profitability for many years.






Questions?