Three Essays on Bankruptcy Risk and Corporate Governance

This study investigates the association between bankruptcy risk and corporate governance in the United States and is presented in the form of three separate but related papers. The first paper is presented in Chapter 2. In this paper, we begin by evaluating five key bankruptcy models from the literature using an up-to-date data set and econometric methods. Early models of bankruptcy prediction employed financial ratios drawn from pre-bankruptcy financial statements and performed well both in-sample and out-of-sample. Since then there has been an ongoing effort in the literature to develop models with even greater predictive performance. A significant innovation in the literature was the introduction into bankruptcy prediction models of capital market data such as excess stock returns and stock return volatility, along with the application of the Black-Scholes-Merton option pricing model. We find that each of the models we examine contains unique information regarding the probability of bankruptcy but that their performance varies over time. We build a new model comprising key variables from each of the five models and add a new variable that proxies for the degree of diversification within the firm. The degree of diversification is shown to be negatively associated with the risk of bankruptcy. This more general model outperforms the existing models in a variety of in-sample and out-of-sample tests. The second paper is presented in Chapter 3. In that paper, we explore the effect of board composition on bankruptcy risk and find that having larger boards reduces the risk of bankruptcy for complex firms, but not for simpler firms. We also find that having a greater proportion of inside directors reduces the risk of bankruptcy in firms that require more specialist knowledge, and that the reverse is true in technically unsophisticated firms. We find that bankruptcy is more likely when the board is less diversified, where the CEO has more power, and where poorly-performing management teams are left in place. Our results indicate that the additional explanatory power from corporate governance variables becomes more pronounced as the time to bankruptcy is increased, suggesting that while corporate governance variables are important, they have a longer-term effect and cannot by themselves save a firm on the verge of bankruptcy. The third paper is presented in Chapter 4. In that paper, we further investigate the relationship between board composition and the probability of bankruptcy, conditional on the firm being in distress. The results suggest that complex firms with larger boards are more likely to avoid bankruptcy after entering distress because of greater availability of advice and potential networks, which are mainly provided by the outside directors. Further analysis reveals that complex (simple) firms with larger (smaller) boards or more outsiders tend to perform better (worse); however, the positive (negative) impact of these board variables on complex (simple) firm performance is reduced (increased) when the firm’s distress level is high.