The COSO Framework for Internal Control
February 12, 2025
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Corporate governance can have a huge impact on credit risk. This is because corporate governance is the set of rules which is used to manage the interests of various stakeholders in the company. However, many times these interests can be incompatible with one another. For instance, when a company is approaching bankruptcy, the interests of the shareholders and the debtholders are usually opposed to each other.
However, in most parts of the world, the objective of any company is said to be the maximization of shareholder value. This can lead to the interest of other stakeholders such as employees, creditors, and even the government being held subservient to the shareholders. The basic idea behind corporate governance is to ensure that when a group of investors invests their money in an organization, they should be given fair treatment.
In this article, we will have a closer look at some of the common ways in which the lack of corporate governance negatively impacts the debtholders.
The lack of corporate governance can impact debt holders in many ways. A couple of famous examples have been mentioned below:
When the firm is about to reach bankruptcy, equity shareholders are likely to lose some or all of their investment. As a result, they are desperate and hence prone to accept high-risk projects. This is because of these high-risk projects work out, they may be able to save the company from bankruptcy and hence may be able to save their own investments. However, if it doesn’t work out, they have nothing more to lose! However, the debt holders have a lot to lose from such speculative ventures. This is because they have the first claim on the assets of the firm and hence would like to ensure that these assets are not decreased.
In the absence of a proper corporate governance system, the interests of the shareholders will be considered to be superior to the interests of the debtholders. This is why investors prefer companies where corporate governance mechanisms are in place.
Once again, the intent is to speculate at the expense of the debtholder. Hence, this can be considered to be another reason why good corporate governance is an absolute imperative. Unless debtholders believe that they will be treated fairly, they are unlikely to invest their hard-earned money.
Often these dividend payments are financed by taking more loans. Hence, when the company goes bankrupt, there is a larger amount of debt outstanding whereas the shareholders were able to extract more value using dividends. This is where a corporate governance framework is required to ensure that all stakeholders are on the same page and that there is less information asymmetry amongst them.
The job of the corporate governance team is to ensure that an environment of constructive criticism is created between the shareholders and the debtholders. Both groups should be able to reasonably criticize each other within the framework of the risk policy of the government. The end result would be that a balanced approach to credit risk would be followed. The creditors will prevent too much risk-taking while the shareholders will prevent playing to too safe.
In the absence of proper corporate governance, the interests of any group will be sacrificed which will lead to problems that will persist for several years in the future. The corporate governance team has to create a framework wherein opposing parties can find common ground and can steer the company in the right direction.
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