Interplay between regulatory changes and firm behavior

Abstract

This thesis consists of three empirical studies on the interplay between regulatory changes and firm behavior from the viewpoint of business ethics. While the first study investigates one of the most stringent anti-bribery laws in the U.K., the next two studies examine a new regulation in Korea affecting the ownership structure of large-sized business groups. The first study uses the U.K. Bribery Act 2010 to examine the impact of anti-bribery regulation on firm risk. I find that U.K. firms with high bribery exposure experience a significant reduction in the cost of equity as a proxy for risk to shareholders, which is estimated by using the residual income valuation model. I further find that the Bribery Act affects the cost of equity by improving the internal control system and increasing the stock liquidity of firms with high bribery exposure. This study highlights the risk reduction benefit of stringent anti-bribery laws. The second study examines the relation between cross-shareholdings and firm value in the context of changing regulatory regimes. Exploiting a new regulation in Korea that prohibits new and existing cross-ownership of business groups over 5 trillion KRW in combined assets, I estimate the market valuation changes of group-affiliated firms. I find the overall positive market response to the affiliates of regulated business groups, but significant costs of removing pre-existent cross-shareholdings. The costs are positively moderated by a greater disparity in cash-flow and voting rights, a distance from controlling shareholders’ direct ownership, and a dependency on the internal capital market. The findings suggest that the removal of cross-shareholdings reduces agency costs but simultaneously imposes potential costs. The third study explores how ownership structure affects the financing choices and efficiency of capital allocation of firms in a business group. Using a difference-in-differences design with the same regulatory change on cross-shareholdings of the second study, I provide evidence that a controlling shareholder’s direct ownership from the removal of cross-shares substitutes intra-group loans with external debts and external equity with internal equity financing. The substitution is due to the enhancing motive of controlling shareholders to maintain control over group firms from reduced wedges between control and cash-flow rights. I further find that the financing substitution improves the firms’ debt-financing sensitivity to growth potential and investment efficiency. The findings on financing and investment efficiency are valid against robustness checks with a placebo test using an artificial event year and parallel-trends test. I also show that capital allocative efficiency comes from exposing the management to financial market discipline rather than being over-leveraged. Overall, these findings suggest that the controlling shareholder’s direct equity ownership limiting access to internal capital markets improves the capital allocative efficiency of group-affiliated firms.