In the wake of the Enron and WorldCom financial scandals, the importance of corporate governance has become a top priority in today's business and financial world. There is now a large body of literature on this subject and arguments are increasingly being put forward that the legal protection of investors is key to effective corporate governance.

Adding to this growing body of literature on the importance of effective corporate governance are the findings of a research project led by Professor Kuo-Ching John Wei, Chair Professor of Finance at the Centre for Asian Financial Markets at the Hong Kong University of Science and Technology. Titled, Corporate Governance and Conditional Skewness in Stock Returns, the research investigates why stock returns in emerging markets tend to be more positively skewed than those in developed markets. Based on the project's findings, Professor Wei argues that the quality of corporate governance in a market affects the skewness of its stock returns.

In his findings, published in the Journal of Business (2006, vol 79, no 6, University of Chicago) Professor Wei points out that there are at least two reasons for the positive skewness in emerging markets and how corporate governance can affect returns.

Firstly, there is the risk-sharing factor where, due to cross-subsidies among group-affiliated businesses, earnings or returns of these organizations are more positively skewed. If an organization chooses to use its resources to support a distressed firm, the negative impact of the firm's failure may not be fully reflected in the stock's returns, particularly if there is an expectation in the market for the firm's bailout. In more regulated markets however, the protection of investor's property rights does not facilitate this shifting of income between different business groups or sections. Since business groups are a more prevalent organizational form in emerging markets, positive skewness in these markets is more pronounced.

Secondly, stock markets with poor corporate governance also tend to have poor information disclosure. In more developed markets, the United States for example, managers are bound by regulatory and governance mechanisms that ensure they act in the best interests of shareholders. In emerging markets, corporate governance is

often not practiced while regulatory mechanisms and guidelines can be non-existent. This lack of regulation allows businesses greater discretion in the disclosure of information, the hiding of bad news as well as the rapid disclosure of good news for example, to create positive skewness in the market.

In arriving at these conclusions, the study evaluated data from more than 14,000 stocks in 38 countries over an eight-year period, from 1995 to 2003. Using earnings management scores as a measure of corporate governance the results showed that the poorer the corporate governance the greater the positive skewness of stocks in the market. The results are highly robust, proving their consistency irregardless of whether returns were measured in US dollars or the local currency, whether gross domestic product (GDP) per capita was included in the specifications, or how the levels of returns were measured. They remained consistent despite the use of different corporate governance indexes and analogous results were also obtained from aggregate stock market returns.

However, bad news will eventually be revealed – it is therefore likely that extremely negative rates of return will occur more frequently in businesses or countries with poor corporate governance. The research corroborated this hypothesis. Extremely negative rates of return were found to occur significantly more often in markets with poor corporate governance than in countries with good corporate governance. Protecting the rights of investors in such a situation, the need for effective corporate governance and the importance of accurate and transparent disclosure policies is highlighted.

Prof. Kuo-Ching John Wei
School of Business,
The Hong Kong University of Science and Technology
johnwei@ust.hk