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 Abstract

Every organization having different corporate governance practices according to their

nature of businesses and country or area wise. In today’s competitive and inflationary world the

corporate governance and financial risk are becoming the vital issues for the survival of

corporations in Pakistan. Corporate governance is all about the guidelines to run our business in

a smooth way. Financial risk is somewhat related to the financial structure of the corporation,

financial risk arises when a corporation is becoming unable to pay its debt. Corporate

governance is linked with the financial risk or uncertainty of a business. It is related to the

corporate hierarchy, top management and strategic decisions of the corporation. So, this study

will be an attempt to explore the corporate governance practices in Pakistan and its impact on the

financial risk of the corporations.

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 Introduction/background to the study

Corporate governance is the way a corporation governed it. In short, it is a method of

governing the company like a sovereign state, instating its own customs, policies and laws to its

employees from the highest to the lowest levels. Failed energy giant Enron, and its bankrupt

employees and shareholders, is a prime argument for the importance of solid corporate

governance. Corporate governance is of paramount importance to a company and is almost as

important as its primary business plan. When executed effectively, it can prevent corporate

scandals, fraud and the civil and criminal liability of the company. It also enhances a company’s

image in the public eye as a self-policing company that is responsible and worthy of shareholder

and debt holder capital. It dictates the shared philosophy, practices and culture of an organization

and its employees.

Well-executed corporate governance should be similar to a police department’s internal

affairs unit, weeding out and eliminating problems with extreme prejudice. A corporation

without a system of corporate governance is often regarded as a body without a soul or

conscience. Corporate governance keeps a company honest and out of trouble. If this shared

philosophy breaks down, then corners will be cut, products will be defective and management

will grow complacent and corrupt. The end result is a fall that will occur when gravity – in the

form of audited financial reports, criminal investigations and federal probes – finally catches up,

bankrupting the company overnight. Dishonest and unethical dealings can cause shareholders to

flee out of fear, distrust and disgust. So, the corporation could be travelled towards the downfall

and will become a victim of different risks, among these risks one can be the financial risk,

which will ultimately effect the corporation’s performance.

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In Pakistan, the publication of the “Code of Corporate Governance” in 2002 by SECP for

publicly listed companies has made it an important area of research for the corporate sector. The

primary objective of corporate governance is to protect the rights of the shareholders in best

possible ways. Effective check and balance or governing system ensure the investors about their

rights protection. When the Company will achieve its objective, it will move on the track of good

performance, which will reduce the risks of the company.

The study is organized as follows. In first introduction section, first two paragraphs are

consists of the importance of the research topic, next two are related to the objective of the study,

which we are going to study, after these the problem of our research is discussed that actually

what we are going to surf with the support of theory, in the end the significance of our topic in

the academic and practical scenario. Second section lists the work already carried out by other

researchers in the form of a literature review. Third section is related to the methodology of

work.

 Problem Statement

In today’s competitive and inflationary world the corporate governance and financial risk

are becoming the vital issues for the survival of corporations in Pakistan. Corporate governance

is all about the guidelines to run our business in a smooth way. Financial risk is somewhat

related to the financial structure of the corporation, financial risk arises when a corporation is

becoming unable to pay its debt. Early studies mainly focused on ownership structure and how

this structure can minimize the agency cost and other areas and this time a struggle to study the

relationship between corporate governance and financial risk in Pakistan and how the corporate

governance affect the financial risk of business.

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The literature on corporate governance suggests that there is a gap present regarding the

financial risk and corporate governance in Pakistan economy. Different organizations having

different corporate governance practices according to their nature of businesses and country or

area wise. Corporate governance is linked with the financial risk or uncertainty of a business. It

is related to the corporate hierarchy, top management and strategic decisions of the corporation.

So, this study will be an attempt to explore the corporate governance practices in Pakistan and its

impact on the financial risk of the corporations.

 Research Objectives

1. The relationship between the firm’s corporate governance and financial risk as an

empirical study in Pakistan

2. That How the corporate governance and financial risk affect each other

3. That What are the techniques to measure the financial risk

4. That Either corporate governance practices exists in Pakistani corporations in good

manner or not

5. To know that how much work has done on this topic in literature, and in which direction I

can move forward

 Purpose and Scope of Study

Purpose of this study is to explore the impact of governance system of the corporations

on its financial risk, that how these are linked with each other and how we can control financial

risk with proper governance system.

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 Significance of Research

This study is significant in the scenario of Pakistan because in literature little research is

done regarding this topic of research. So, it will be beneficial for the public, especially for the

corporations, through this study they can understand the concept of the corporate governance and

financial risk that how they can control their financial risk through the corporate governance. It

will help out the policy makers for taking up the appropriate measures for governance and risk

management. It will also find out the weak areas for improvements and recommendations

regarding better governance system. If the corporation is properly controlled then it will effect

positively on the performance of the business. Secondly it will contribute the existing literature.

 Literature Review

1. Operational definitions

A narrow definition of Corporate governance by Cadbury (1992) “the system by which

companies are directed and controlled”. It means that through the proper corporate governance

the firm will be able to work efficiently. Another concise definition by La Porta et al. (2000)

“Corporate governance is to a certain extent a set of mechanisms through which outside investors

protect themselves against expropriation by the insiders”.

A general saying about financial risk by Van Horne (p. 252) “financial risk encompasses the risk

of cash insolvency. However this notion will be expanded to include the risk of being unable to

meet prior claims with the cash generated by the firm, which is determined by the dispersion of

net cash flows and the level of fixed obligations, as well as the firm’s pool of liquidity

resources”. (Van Horne & Wachowicz JR). The possibility that shareholders will lose money
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when they invest in a company that has debt, if the company's cash flow proves inadequate to

meet its financial obligations.

2. Existing models and theories with focus on identifying gap in literature

At the beginning of 21st century all the regulatory authorities from all over the world

introduced the codes of the corporate governance to be followed by corporate firms registered in

countries, it will change the overall environment of the corporations in the economies of world.

The practitioners, policy makers and legal experts, are striving to appraise corporate activity in

better ways and in helping to design rules and regulations to improve the way out companies are

managed. In developing countries, corporate governance practices are under way.

Corporate governance, in the finance literature, is described as the set of rules, structures

and procedures by which investors assure themselves of getting a return on their investment

and ensure that managers do not misuse the investor’s funds (e.g., Shleifer and Vishny,

1997).

Financial Risk is the possibility that shareholders will lose money when they invest in a

company that has debt, if the company's cash flow proves inadequate to meet its financial

obligations. When a company uses debt financing, its creditors will be repaid before its

shareholders if the company becomes insolvent.

Corporate governance is related with the protection of the rights of the shareholders, which is

directly related to the Agency theory, while Agency theory is aligning the interest of internal

agents (executives/managers) who display strong self-interest with those of the shareholders

(owner). So, if we resolve the agency conflict then it will protect the shareholder’s rights.

Stewardship theory is related to general human motives of achievement, altruism and

meaningfulness should be managed and guided in the most opportune manner. It is related to the
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performance of the organization that how much we are motivated to enhance our firm’s

performance that will reduces the overall risk of the corporation. One other theory which relates

to our topic is transactional cost theory it says that we can reduce the cost of our transactional

hazards through our internal corporate governance, means it will effect on cost reduction that

will ultimately effect on our firm’s performance.

Meanwhile, risk management is one of the key aspects of corporate governance. There is

a growing realization that corporate governance has an impact on enterprise risk management.

Without the corporate governance there is no check and balance in the firm that leads to the

financial risk. La Porta et al. (1998) said that good corporate governance leads to the protection of the

rights of the investors, which will urge in investors for further investment of his funds. It will also affect

positively on firm’s solvency, which will enhance its market value and create attraction for foreign

investments (as citsd in Anwar, 2012). According to OECD’s most recent report by Richard

Anderson, Corporate Governance alone is not the cause of the current Financial Crisis. However,

Corporate Governance could have prevented some of the worst aspects of the crisis. (How Can

Corporate Governance Control Enterprise’s Financial Risk?, 2009)

Mr. Anwar’s view about corporate governance is that the firms with poor corporate

governance system will results in a increase in asset price and misallocation of the financial

resources, these firms are less attractive in the view of investors because they feel themselves as

insecure. (as citsd in Anwar, 2012). Corporate Governance country assessment (2005) Good

corporate governance reduces emerging market vulnerability to financial crises. La Porta, et al

(1999) argues that an investor’s protection tends to be greater when the legal environment is

stronger, and therefore his willingness to invest tends to increase. They find strong positive

association between corporate governance and firm’s performance. (as cited in Khatab, Masood,
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Zaman, Saleem, & Saeed, 2011). As a famous economist, Dr Shahid Javaid Burki- a long

observer of Pakistan’s economy has recently stated “Pakistan can generate a greater bounce in its

economy than India by creating better governance. It has occurred before in the country’s

difficult economic history and could happen again.” Improved Governance: Dawn, 12th, October

2010). Vishny and Shleifer (1997) say that “Corporate governance concerns with the framework

wherein finance providers are reasonably assured to get the return on their investments made in

the companies”. (as cited in AZAM, USMANI, & ABASSI, 2011).

Catherine M. Daily and Dan R.Dalton (1994) examine the relationships among corporate

governance structures and corporate bankruptcy using data from 1972 to 1982. Logistic

regression statistical technique was used to measure the relationship between dependent and

independent variables. Profitability, Liquidity and, leverage are dependent variables and CEO

duality and proportion of affiliated directors are independent variables. The results show that

there is a significant relationship between corporate governance structures and corporate

bankruptcy. (as cited in AZAM, USMANI, & ABASSI, 2011)

Sung Wook Joh (2003) examines the effect of corporate governance on firm’s

profitability using data from 1993 to 1997.Regression statistical technique was used to measure

the relationship between independent and dependent variables. Profitability is dependent variable

and ownership concentration is independent variable. The firms with low ownership

concentration show low profitability. (as cited in AZAM, USMANI, & ABASSI, 2011). The

findings show that corporate governance has significant and positive impact on firm’s

performance and it is concluded that firm’s performance can be increased by improving the

corporate governance structure. (AZAM, USMANI, & ABASSI, 2011)

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A way of enhancing the board’s focus on risk management is to invite the

company’s chief risk officer to participate in board meetings. The same survey indicated

that, although is consider a sound corporate governance practice, only 8% of the boards

represented in the study regularly have the chief risk officer attend board meetings, and only

13% of directors say they believe the chief risk officer (CRO) should regularly attend.

Similarly, in the 2009 survey of the PWC (PWC, 2009) 15% of represented boards have a risk

management committee. In reverse to the above findings only 25% of the participants

believe they should institute a risk management committee for their board. Finally, in the

2010 survey (PWC, 2010) 83% of responding directors believe that audit committees are

effective or very effective in their ability to accurate financial reporting.

(Vassileios, 2011) The Financial Stability Forum (2009) stated that compensation

practices at large financial institutions are one factor among many that contributed to the

financial crisis that began in 2007. High short-term profits led to generous bonus

payments to employees without adequate regard to the longer-term risks they imposed on

their firms. These perverse incentives amplified the excessive risk taking that severely threatened

the global financial system and left firms with fewer resources to absorb losses as risks

materialized. The lack of attention to risk also contributed to the large, in some cases extreme

absolute level of compensation in the financial industry. (Vassileios, 2011)

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Conceptual Framework

Variables

The variables for interest under study are measures of firm performance and proxies used

for the characteristics of corporate governance.

Independent variables for firm Performance

For measuring the firm performance, most of the authors preferred to use following

variables. Current study also focused on profitability, reason being availability of data and ease

in statistical analysis. The study employed following four variables;

1. Return on Asset

“Return on assets, measured as the percentage of net income to total assets”.

2. Return on Equity

“Return on equity, measured as a percentage of net income to common equity”.

3. Tobin’s Q

“Tobin’s Q, measured as the market value of equity capital and the book value of firm’s

debt divided by the book value of total assets”

4. Earnings per share

“Net income divided by number of shares outstanding”

Paul Gompers, Joy and, Andrew (2003) examine the relationships between EPS and

corporate governance using data from 1990 to 1999. Regression statistical technique was used to

measure the relationship between independent and dependent variables. The results show that

corporate governance structures have strong association with EPS.

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Reference of use

Most of the researchers have tried to analyze the link between any aspect of the corporate

governance characteristic or corporate governance index by using these performance measures

(Ehikioya, 2009), Fosberg (1989), Hermalin and Weisbach (1991), Bhagat and Black (2002),

Yermack (1996) and Brown and Calyor (2004).

Independent variables for Corporate Governance

1. Outsider director

Presence of outsider director in the board is used as the tool for minimizing

agency problem. Different point of view exists on the relationship of Outsider director

and with performance measures. Fosberg (1989), Hermalin and Weisbach (1991), You et

al. (1986) and Bhagat and Black (2002) has identified that outsider director

representation have no significance positive effect on sales and ROE. Baysinger and

Butler (1985), Rosenstein and Wyatt (1990), Denis and Sarin (1997) and Brickley, Coles

and Terry (1994) reported positive relationship of outside director with firm performance.

2. Ownership structure

Corporate structure can be Concentrated and Dispersed. Some studies suggest no

relationship between type of ownership structure and firm performance Demsetz and

Lehn (1985). But McConnell and Serveas (1990) and Sarkar and Sarkar (2000) and

Palepu (2000) identified no relationship between them.

3. CEO Duality

CEO duality means one person is holding two positions of CEO and chairperson.

Yermack (1996) and Brown and Caylor (2004) have linked absence of CEO duality

positively with firm performance.

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4. Board-Size

Different point of view exists on the linkage between the board size and firm

performance as studied in literature review.

5. Audit committee

“Non-executive directors divided by total members of audit committee”

Firm Specific Variables

1) Debt Financing

Use of Institutional debt has been studied in the past as the mechanism for getting

control on management and for increasing firm performance. Ahuja and Majumdar

(1998) and Nishat (2004) have identified positive relationship between debt financing

and firm performance.

2) Firm Age

“Firm’s age is defined as the number of years since its incorporation, Calculated

as observation year less incorporation year”. Ehikioya (2007) have used firm age as

important firm specific determinant in firm performance and corporate governance.

3) Firm Size

“Firm size, the total assets owned by the firm. Measured as the natural logarithm

of total assets”
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Theoretical Frame work

Corporate
Governance

Outside Director

Firm Performance

(ROA, ROE, EPS,

Ownership Tobin’s Q)
Structure

CEO-Duality

Audit Committee

Board-size

Debt-Financing

Firm age

Firm Size
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The above model depicts the relationship of variables with one another and this model

takes an assumption that corporate governance is affected by CEO duality, ownership

concentration, Audit committee, outside director, board size, firm age, firm size and debt

financing having impact on firm’s performance. Moreover, the firm’s performance has been

determined by return on equity, return on assets, Earnings per share and Tobin’s Q in this model.

The literature provides differing view on their relationship with each other.

 Research Design

1. Study type

Comparative Analysis

(An empirical study on the impact of corporate governance on financial risk in corporate

sector of Pakistan)

2. The Population

Population of the study comprises on the all 650 KSE listed firms in Pakistan.

3. Sample and sampling strategy

Sample consist on the 30 selected firms with 5 years data of each firm from 2008

to 2012, random sampling technique is used for sample selection. KSE listed firms are

selected so that we can get easy access to their data plus they have to match with the

basic criteria of corporate governance to be listed with stock exchange.

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4. The measurement Method

 First we have selected the firms listed in the Karachi stock exchange

 Analyze the financial statements and annual reports of these firms

 Then we have analyzed the corporate governance determinants

 ROA,ROE,EPS Tobin’s Q ratio is calculated for all firms

 Run the regression analysis between variables of interest

 analysis and interpretation of the results

 conclusion and findings based on the results

5. Data Processing and Analysis

 Statistical tools

Regression( & t-test for significance) with in sector

Correlation

 Statistical software

SPSS

6. Limitation of Study

Sample size is short, further research is recommended by selecting large sample

size.

 Budget

10,000 Pak Rupee

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 Tentative Time Frame For Research

Time Period Task

2 Months Development of theoretical base for

the study

1 Month Data collection

1 Months Data Analysis

2 Months Data interpretation & Conclusion

Total 6 Months

 Tentative Structure of Dissertation

1. Copyright waiver

2. Declaration

3. Title page

4. Abstract

5. Acknowledgments

6. Table of contents

7. Introduction

8. Literature review

9. Middle chapters

 Materials and Methods

 Theory

 Results and discussion

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10. Final chapter, references and appendices

 Conclusions and suggestions for further work

 References

 Appendices
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Bibliography

Anwar, Y. (2012). Ethics, corporate governance and financial inclusion.

AZAM, M., USMANI, S., & ABASSI, Z. (2011). The Impact of Corporate Governance on Firm’s

Performance: Evidence from Oil and Gas Sector of Pakistan. Australian Journal of Basic and Applied

Sciences , 5 (12), 2978-2983.

(2005). Corporate Governance country assessment.

How Can Corporate Governance Control Enterprise’s Financial Risk? (2009).

Khatab, H., Masood, M., Zaman, K., Saleem, S., & Saeed, B. (2011). Corporate Governance and Firm

Performance. International Journal of Trade, Economics and Finance , 12 (1).

Van Horne, J. C., & Wachowicz JR., J. M. Fundamentals of Financial management.

Vassileios, K. (2011). The Relation Between Corporate Governance And Risk Management During The

Credit Crisis. The Case Of Financial Institutions. 145-156.