The Impact of Corporate Governance on Bankruptcy Risk in Finance

This finance report delves into the critical relationship between corporate governance and corporate bankruptcy risk. It begins with an abstract summarizing the core argument: firms with strong corporate governance exhibit less risk. The report then reviews literature, defining corporate bankruptcy risk and exploring various theories, including the impact of board size, internal directors, and ownership structures. It examines internal and external monitoring systems, risk management strategies, and the influence of corporate governance on financial stability. The report analyzes multiple journal articles and case studies, highlighting the varying perspectives on the relationship between corporate governance and bankruptcy risk, with some studies suggesting a direct correlation and others an indirect or even negative one. The conclusion synthesizes these findings, emphasizing the significant impact of corporate governance on bankruptcy risk and suggesting the importance of ethical practices and balanced organizational objectives for effective risk management. The report stresses the importance of a well-structured corporate governance framework for mitigating financial risks and ensuring the long-term stability of financial institutions.

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Author’s Note

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Abstract
The discussion provides an evidence of corporate governance impact of the on the corporate risk
taking. The discussion shows how the firms with most affective corporate governance exhibit the
strategies that consist of less risk. The various theories on the analysis of the financially
distressed firms have been assessed. The study helps in understanding the firs ability to avoid
bankruptcy and the power of sound corporate governance to predict bankruptcy. According to
the examination, it has been found that small and the independent boards with a high ratio of
internal directors and with larger share of ownerships of internal directors is more likely to avoid
the insolvency situation. These types of the corporate governance structures have monitoring that
is more effective. There is also a consistency with the view that this kind of corporate
governance increases the ability to predict the bankruptcy possibility.

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“How does corporate governance influence corporate bankruptcy risk?”
Literature review
The corporate bankruptcy risk refers to the possibility that company will not be able to
cope up with the obligations of debt. It describes the anticipation that the company will become
insolvent, the reason for the occurrence of inability to serve the company debts (Rachdi, Trabelsi
and Trad 2013.). Due to cash flow problems resulting for sales that are inadequate and high
operating expenses. The organization might take in consideration the short-term borrowings (Yu,
et al. 2016). In case that the situation is not improving, the firm is at the risk of bankruptcy or
insolvency (Dedu and Chitan 2013). The investors at times consider the firms bankruptcy risk
before making decisions of the equity or bond investment. The discussion deals with how the
company governance affects the risk of bankruptcy of the company ( García-Sánchez, García-
Meca and Cuadrado-Ballesteros, 2017). According to the various theories, it can be found having
a large board reduces the risk of bankruptcy only for the organization that are complex in nature.
The part of the internal directors is inversely related to the insolvency risk, as the firs require
more specialty knowledge (Limin, Boehe, Orlitzky and Swanson 2016). The power of the
variables of the corporate governance increases when the bankruptcy risk time increases, even
though the variables of the corporate governance are important predictors, the corporate
governance changes is unable to save the firm from the insolvency risk (Rachdi, Trabelsi and
Trad 2013).
Corporate governance is the set of, policies, regulations, rules and the various regulations
that controls the behavior of the corporation (Parnes 2011). The various boards of directors,
shareholders, advisors and other stakeholders are the ones who are responsible for the firm’s

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corporate governance. The corporate governance involves in providing the organization a
framework for the attainment of organizational objectives. It also controls and measures each and
every performance of the company (García-Sánchez, García-Meca and Cuadrado-Ballesteros,
2017). The control an mechanisms of Corporate governance are designed to decrease the
inefficiencies that takes place due to adverse selections and moral hazards. There are both
internal and external monitoring systems. Monitoring that is Internal is done, by one or a more
large stakeholders in the case of companies that are held privately or a business group firm.
Monitoring that is External takes place when an third party who is independent like the
the external auditor attests the information accuracy provided by managers to investors. The debt
holder or the analyst of stock also can conduct such monitoring. An ideal control and system of
monitoring should regulate both ability and motivation, while providing incentive
alignment toward organizational objectives and goal.
A business faces various kinds of risk every day. It is important to for the organization to
tackle the risk effectively. The effective risk management includes protection of the interest of
the firms stakeholders. One of the major risks of the firm is the insolvency or bankruptcy risk
that is the risk whether the firm will be able to satisfy allots debt or not (Jiraporn, Chatjuthamard
and Kim 2015). The risk is more when the firm has no cash flow to manage its assets. The
corporate governance has direct control over the insolvency risk of the company. Insolvency risk
has been the most debated issue in the global financial crisis as it has the capability to shake the
total economic system (García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). The
major reason for the firm’s insolvency is the shakiness in the corporate governance of the firm.
Effective corporate governance by La Porta, Lopez-de-Silanes, Shleifer and Vishny( 1999)
argues that the corporate governance is the source of the investors protection and stabilizes the

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financial markets. The corporate governance provides a shield to the various suppliers of the
corporations to make sure that their investments will materialize and will get the effective returns
(Rachdi, Trabelsi and Trad 2013.)
According to the journal article “how does deposit insurance affect bank risk?” by
Anginer, Demirguc-Kunt and Zhu (2014), the corporate governance is more favorable to the
shareholders as the risk taking behavior of the banks increases, as the shareholders who are
active are not exposed to the total risk any more(García-Sánchez, García-Meca and Cuadrado-
Ballesteros, 2017). They cannot be termed as risk avoider. The paper clearly says that the
corporate governance is positively related to the bankruptcy risk. Another journal article found
by Dedu and Chitan 2013, relates the effect of the internal corporate governance on the
performance of the bank (Anginer, Demirguc-Kunt and Zhu 2014). The article is based on the
various empirical analyses that include the structure of ownership, internal corporate governance
index and the body of the management. In this study the cumulative influence of internal
governance framework on the banking performance is analyzed, which says that the internal
corporate governance is a crucial component that can influence the banking regulatory
requirement (Jiraporn, Chatjuthamard and Kim 2015). The requirement may induce the “agency
problem” that the shareholder faces, who wants to enhance the investment value and the
regulator who wants the financial stability for each of the entity and reduce the bankruptcy risk
(García-Sánchez, García-Meca and Cuadrado-Ballesteros, 2017). The discussion is based on the
possible weakness of the corporate governance in the Romanian banking system.
However, another journal article named by Parnes (2011), assesses the between corporate
governance and the risk of bankruptcy relationship as a force that can affect the bond yield. After
the various examinations in the article, Parnes stated that the level of corporate governance is

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negatively correlated with the risk of bankruptcy. It also informs that the credit agencies prefer
to take the mixed approach as the aspect of corporate governance differs. The mixed approach is
the measure of the underlying forces for the result of conflicts in the corporate governance and
the bond yield relation (Dedu and Chitan 2013). The analysis in the study is done through a data
base risk metrics directors that provides several substitutes for the instruments of management
that affect the risk of bankruptcy and the corporate governance practice of the firms.
Iqbal and Ali (2016), in their article, “Governance and the Insolvency Risk of Financial
Institutions” study on detail the relationship of corporate governance with the insolvency risk of
the financial institutions (Lepetit and Strobel 2015). The analysis has been made from the
samples of various US financial institutions from 2005 to 2010. They have come up with the
conclusion that the insolvency risk is directly proportional to the insolvency risk. The better the
corporate governance in the firm, the bankruptcy risk increases along with the performance of
the firm. The risk of financial crisis is stronger in case of larger firms (Iqbal and Ali 2016)
In the case study of the Tunisian conventional bank named “Banking governance and
risk” by Rachdi, Trabelsi and Trad 2013, it highlights the crucial role and the responsibility of
the board of directors affects the risk in banking institutions. The function of the directors
boards is directly associated with insolvency risk (Anginer, Demirguc-Kunt and Zhu 2014).
Although they have no impact on credit and global risk, their existance of governance has a huge
impact on insolvency ratios of the firm. The case study focuses different governance mechanisms
that consists the main baking risk factors. The internal mechanism of governance and the
ownership structure of a firm contribute in the determination of the risk of bankruptcy of the firm
(Rachdi, Trabelsi and Trad 2013.).

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In the Corporate risk and corporate governance journal by Li, Jahera Jr, and Yost, (2013)
description of the various measure of risk is given. In the article, standard deviation is used in
making of the various decisions of investment and measure the amount of historical volatility or
risks associated with the investment (García-Sánchez, García-Meca and Cuadrado-Ballesteros,
2017). The study indicates the amount of return that is deviating from actual anticipated ones.
The article in a similar way links the corporate governance and the corporate risk and indicated
the direct relationship between the two. It has been clearly indicated that corporate governance
has a important effect on the volatility or organizational risk . The increase in the corporate
governance there is the rise in the risk.
The fathers of the corporate governance Tricker and Tricker( 2015), in their book
consisting of the various “principles, policies and procedures of corporate governance”, on the
contrary argues that there is no link between the insolvency and corporate governance in the
firms. According to the book the factors that affect the corporate risk of insolvency differs
(Anginer, Demirguc-Kunt and Zhu 2014). When a company hires more recourses, which crosses
the budget of the financial year, may contribute in insolvency. It is clearly mentioned that
overspending is important determinant that can lead to a financial crisis for the corporate firms
(Dedu and Chitan 2013). Another determinant pointed out in the book is the rise in the vendor
cost. When a business had paid increase prices for the various commodities and the various
operational costs, it may lead to the crisis. The company should be aware of the various debts
and liabilities and keep on evaluating them in order to mitigate the risk the more the company
pays off the risk the lower the financial risk will be.
Vanessa Finch in the journal named “corporate insolvency laws” (2017) has talked about the
laws and the rules for the financial risks of the firms. According to her financial risk,

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management has become importantly significant in the last few decades. Due to globalization,
the market of capital has triggered and there has been a increase in the volatility in the corporate
sector. The boards of directors affecting the corporate governance are the decision makers of the
organization. These decision-making processes are strongly related to the risk management
strategies. The investment projects that are not supported by the internal funds, has to be
obtained from external debts that leads to the increase in the bankruptcy risk. The study stresses
more on the debt of the firms and highlights it to the most important determinant of the corporate
bankruptcy risk. There is an indirect indication about the relation between the corporate
governance and corporate insolvency risk (Jiraporn, Chatjuthamard and Kim 2015). The
corporate governance is responsible for increase in debt and that leads to the bankruptcy of the
firms.
Therefore, in order to conclude in the topic, after the critical analysis of the literatures of
different journals, it can be said that the corporate governance has a major impact on the
corporate bankruptcy risk. Although according to some authors, there is a negative relationship
between the two, majorities of them focuses on the direct relationship. The increase in the
corporate governance, the risk of corporate governance increases. Some conclusions can be
drawn and formulations can be made with regard to a short set of rules for best corporate
governance practice (Anginer, Demirguc-Kunt and Zhu 2014). The various principles
underlying these rules are:
1. ethical approach - culture, society; organizational paradigm
2. balanced objectives - congruence of goals of all interested parties
3. each party plays his part - roles of key players: owners/directors/staff

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4. process of decision-making - following he company policies and giving equql
wiightage the stakeholders
5. all shareholders must be treated equally – some stakeholders must not be given
greater weight than others
6. Transparency and accountability – there must be accountability and transparency for
all stakeholders.
Hence, with due respect to Milton Friedman who has quoted that the social responsibility of
business begins and ends with increasing profit, it can be concluded that successful run of the
only requires market domination and shareholder value but also a sound corporate governance is
required. In addition, sound corporate governance technique is not only about a fight between
disloyal, distant stakeholders of institutions and greedy board of directors but also about the
ethics of the organization and fulfilling its common goals (McCahery, Sautner and Starks, 2016).

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References
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