Two-stage least squares regressions are employed to examine the interaction of different governance devices and their impact on firm performance. Agrawal and Knoeber (1996) set up a good model for us to study the interlocked variables together. They simultaneously examine the use of seven mechanisms to control agency problems. Variables included in their study are: shareholdings of insiders, institutions, and large blockholders, use of outside directors, debt policy, the managerial labor market, and the market for corporate control.
Our research setup differs from Agrawal and Knoeber’s (1996) in a number of respects: First, we include the comprehensive governance scorecard measure. Second, we control for fixed effects in the simultaneous analysis. On one hand, we double control for the endogenous problem. On the other hand, as argued previously, we believe that the changes of governance have more impact on performance than the level of governance itself. Third, since use of outsiders in the board has already been captured in our governance scorecard, we exclude it from the equations. The managerial labor market is also excluded because it is less related with governance ratings. Our focus is on the internal control. Therefore, the market for corporate control falls outside this study and is excluded.
Altogether, there are five equations relating to governance mechanisms in our investigation. The governance mechanisms are corporate governance scorecard, shareholdings of insiders, institutions, and blockholders, and debt policy. All of them are treated as endogenously determined. In estimating the system of equations, we use the following variables as instruments: FSIZE, ADR, OUTDIRE, TENURE, NOD, RISK_D, RISK, RDAI_D, RDAI, NINSTI, and CR. In order to satisfy the order condition to ensure that the equations in the system are identified, each equation must exclude at least four of the exogenous variables since each equation includes four endogenous variables as regressors. The specification of Equations (10) to (14) below is partially driven by the need to satisfy this order condition. Nevertheless, as far as possible, we rely on theory or prior research to determine the exogenous variables to be included or excluded in each of the equations.
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