How Corporate Governance Impacts Credit Risk

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.

How Can Lack Corporate Governance Impact Debtholders?

The lack of corporate governance can impact debt holders in many ways. A couple of famous examples have been mentioned below:

  • Debt holders tend to earn a fixed return on their investments. However, at the same time equity holders can earn a much higher return on their investment. Hence, it is common for the debt holders to try and minimize the debt being taken while the equity shareholder tries to increase the risk to some extent. This often leads to conflict. Nowhere is this conflict more evident than when a firm is about to reach bankruptcy.

    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.

  • Another common strategy used by equity holders is called asset substitution. As a part of this strategy, when a company is nearing bankruptcy, the equity shareholders often ask the company to sell off assets related to low-risk businesses and then substitute them with assets related to high risk-high return business.

    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.

  • In many companies, executive compensation has also become a reason why excessive risk-taking has become a part of the culture of the organization. In such organizations, a large chunk of executive compensation is based on the profits earned. Hence, in order to earn more profits and achieve unachievable goals, executives often end up taking huge amounts of risk. The negative impact of these risks has to be borne by the creditors. It is for this reason that in many parts of the world, creditors closely monitor executive compensation and how it affects their interests.

  • Similarly, the dividend policy of the company has also been often found to be working against the interest of its own creditors. This is because, if a company is facing financial distress, the equity shareholders are one of the first to know. In some cases, they try to extract money from the company in the form of dividend payments.

    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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Risk Management