Politically connected boards, family and business group affiliations, and cost of capital: Evidence from Indonesia
Introduction
Government policies have profound effects on corporate performance, and in Indonesia it has become quite common for corporations to develop some forms of connection with top level government bureaucrats and military officers (past and present) to influence policies and extract benefits. Such connections involve, among others, appointing politically connected individuals to serve on corporate boards (Houston, Jiang, Lin, & Ma, 2014). Consequently, the possible effects of corporate political connections on performance and financing costs have attracted much attention from academics, researchers and policy-makers in accounting and finance disciplines (e.g. Bliss & Gul; 2012; Boubakri, Guedhami, Mishra, & Saffar, 2012; Chaney, Faccio, & Parsley, 2011; Faccio, 2006; Fisman, 2001; Fan, Wong, & Zhang, 2007; Goldman, Rocholl, & So, 2009; Houston et al., 2014; Wong & Hooy, 2018). However, such studies are mostly undertaken in the context of a single-tier corporate board system and therefore can't be generalized to countries where a two-tier corporate board system exists to govern and monitor a corporation. There have been some studies on the role of two-tier corporate board systems in China, Germany, Japan1 and Netherlands (e.g. Firth, Fung, & Rui, 2007; Ran, Fang, Luo, & Chan, 2015; Xiao, Dahya, & Lin, 2004; Schilling, 2001; Tran, 2014; Van Ees, Postma, & Sterken, 2003; among others). However, there is either no or limited information currently available from any countries where a two-tier board system is prescribed on the nature of board composition and its effect on corporate cost of finance.
In this study, we redress this lack of knowledge of the role of politically connected corporate boards in relation to cost of financing in Indonesia which has not been considered in any prior research.2 In particular, we focus on the role of politically connected Supervisory Boards (SB) and Boards of Directors (BOD) in cost of equity and cost of debt financing. The Indonesian two-tier corporate board system is modelled on Dutch and European civil law. Indonesian Company Law No. 1 (1995) requires all listed firms to form a Board of Directors (BOD) (also known as a management board) which is entrusted with daily operations, and a Supervisory Board (SB) (also called a Board of Commissioners) to supervise and monitor the BOD.3 SBs in Indonesia, like in Germany and the Netherlands, have the authority to decide on the development strategies and business plan for the company, investment projects, re-organisation or dissolution of the company, the purchase of shares from other enterprises, and even to negotiate and approve contracts for purchase, sale, borrowing and lending. Commissioners are allowed to own company shares but are not required to by law (International Finance Corporation (IFC), 2014).
The BOD is responsible for the daily operations of the corporation, and the SB has both supervision and monitoring functions. The BOD is responsible for executing decisions made by the SB and reports to it on a regular basis for effective monitoring by the SBs on behalf of the shareholders (IFC, 2014). The Financial Services Authority (FSA) has given SBs the authority to appoint audit committee members to increase the companies' accountability and transparency to their stakeholders by providing more relevant and reliable financial information. In the corporate structure hierarchy in Indonesia, SBs are higher than BODs, and SB members can't sit on the BOD and vice versa, to ensure accountability of the two boards (Hermawan, 2011).
In Indonesia, unlike in Germany and Netherlands, the Company Law (1995) has adopted a shareholder rather than stakeholder orientation of executive and supervisory company boards. As a result of shareholder orientation, employee representatives do not have the right to sit on the SBs in Indonesian companies. Schilling (2001) argues that the involvement of employee representatives in German SBs weaken their monitoring role, because SB members cannot discuss critical and confidential issues in the presence of employee representatives. In the context of China, Dahya, Karbhari and Xiao (2002) argue that Chinese SBs are not entirely independent of BODs and lack legal power and responsibility, because they do not have authority to employ and dismiss directors and executives and are thus less effective than BODs.
Another institutional feature of corporate governance in Indonesia is that corporate board members (both SBs and BODs) are highly connected with politicians, military and senior government officials (Fisman, 2001; Habib, Abdul Haris Muhammadi, & Jiang, 2017; Leuz & Oberholzer-Gee, 2006). Fisman (2001) and Leuz and Oberholzer-Gee (2006), using Indonesia as their sample, examined political connections during the period of Suharto's presidency, finding that 35% of the sample had direct political connections with the president and his family. Chaney et al. (2011), in their international study of earnings quality and political connections, document that 23% of companies have connections with the government in Indonesia. Habib et al. (2017) report that 36% of companies in their sample had political connections.4
Prior research also finds that Indonesian corporate ownership is dominated by family and business groups and government ownership (Sato, 1993; Fisman, 2001; Daniel, 2003; Leuz & Oberholzer-Gee, 2006). Claessens, Fan, and Lang (2006) report that 73% firms in Indonesia belong to a business group.5 The Indonesian setting provides an opportunity to investigate the interplay between the importance of SBs, their high level of political connection, and the dominance of business groups and government ownership in the cost of equity and debt.
The existing evidence on the effect of politically connected boards on cost of debt and equity capital is unclear and conflicting. Bliss and Gul (2012) argue that politically connected firms in the context of Malaysia are more risky than non-politically connected firms, and therefore face higher cost of debt compared to their peers. Boubakri et al. (2012), on the other hand, using an international sample, suggest that politically connected firms are less risky based on investors’ perceptions, and find that politically connected firms are associated with lower cost of equity capital (they include only 8 firm year observations from Indonesia). Houston et al. (2014) find that lenders charge lower interest rates to the politically connected S&P 500 firms. Chaney et al. (2011), using cross-country data, find that non-politically connected firms face a significantly higher cost of debt compared with politically connected firms. Thus, the extent and direction of the association between political connection and cost of finance depends on the institutional context of the study.
In this paper, we examine the role of the two-tier board system and investigate how politically connected corporate board members affect the cost of financing in Indonesia. In particular, we focus on whether politically connected SB members have a more significant association with cost of equity and cost of debt than BOD members in Indonesian listed corporations. Furthermore, we assess whether family firms and business groups extract more economic benefits, compared with non-family and stand-alone firms, when they appoint politically connected members on the SBs/BODs, as reflected in lower cost of equity and debt capital.
We hand-collect data for 250 firms (1037 firm-year observations) for publicly listed firms on the Indonesian Stock Exchange (IDX) for the period 2010–2013. We document that firms with politically connected boards extract more benefits than their non-politically connected counterparts through obtaining lower costs of debt and equity capital. Specifically, our results show that politically connected SBs are negatively related with the costs of debt and equity capital, whereas the association between politically connected BODs and cost of capital is not statistically or economically significant. These results are consistent with prior studies which posit that political connections may reduce cost of finance (Boubakri et al., 2012; Chaney et al., 2011; Houston et al., 2014). We also find that politically connected boards are negatively associated with the cost of debt and equity capital for family firms and firms belonging to business groups.
Overall, the findings lead us to conclude that family firms and firms belonging to business groups extract more economic benefits, in the form of lower cost of debt and equity capital, than do their non-business group counterparts, by appointing politically connected boards, especially politically connected SBs. Our study extends a growing body of literature concerning the relationship between politically connected boards and financing costs (Bliss & Gul, 2012; Boubakri et al., 2012; Chaney et al., 2011; Houston et al., 2014).
The remainder of the paper is structured as follows. In Section 2, we describe the institutional background of the paper. Section 3 reviews the literature and develops the hypotheses; followed by the research design in Section 4. Section 5 presents our empirical results; and Section 6 reports additional tests. In Section 7, we provide concluding comments.
Section snippets
Indonesian two-tier board system
As stated earlier, the two-tier board system corporate governance system in Indonesia is based on the Dutch and European civil law model. The first Indonesian Code of Good Corporate Governance was developed in 1999 by The National Committee on Corporate Governance (NCCG) and has been revised several times with the latest being the 2006 Code (IFC, 2014). The General Meeting of Shareholders (GMS) holds the highest authority in the structure. The BOD is responsible for the daily operations of the
Literature review and hypotheses development
Political connections are external dimensions of corporate governance mechanisms that affect the behaviour of an organisation. These governance mechanisms can influence organisational behaviour in many ways, such as in how an organisation determines profit, how it raises capital, who has the controlling ownership, and how financial statements are prepared (Roe, 2003). Through the lens of the agency theory, there are two competing arguments on the consequences of political connections. One
Sample selection
The initial sample consists of all publicly listed companies on the Indonesian Stock Exchange (IDX) during the period 2010–2013.14 The time frame of the paper coincides with the second term of Susilo Bambang Yudhoyono (SBY). The first period of SBY was 2004–2009 and the second was 2009–2014.15
Descriptive statistics
Table 3 presents descriptive statistics of the variables based on the full sample of 1037 firm-years in the cost of equity analysis and 945 firm-years in the cost of debt analysis. Except for the dummy variables, continuous variables are winsorised at the 1st and 99th percentiles. Among the key variables, COE (COD) has a mean value of 0.134 (0.037) with a maximum value of 0.350 (0.121) and a minimum value of 0.020 (0.000). Consistent with other studies, the magnitude of the cost of equity and
Endogeneity
One potential concern regarding our test specifications is endogeneity. Firms with lower cost of capital are more likely to have political connections. It is possible that political connections could be endogenously determined. We address the potential endogeneity problem of political connections by using a selection model that corrects for self-selection bias. In the first stage, we estimate a multivariate probit model in which the dependent variable is the probability that firms appoint
Conclusions
In this paper, we examined the effect of politically connected SBs/BODs on the cost of debt and equity capital in the context of Indonesia. In addition, we extended the research question by identifying whether firms belonging to family and business groups extract more benefits by enjoying a lower cost of debt and equity capital when firms appoint politically connected SBs/BODs. We chose Indonesia as our research setting because both politically connected SBs and family and business groups
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