| LLSV and other scholars established the school of "Law and Finance",introducing theories of law and institutions into the financial / economic fields,discussing the influence of legal sources and institutions on financial and economic consequences,and emphasizing the importance of improving laws and regulations and increasing law enforcement efficiency for economic and financial development.Emerging markets are more institutionally specific than mature capital markets in developed Western countries.Economic development is still in transition,the market economy isn’t fully developed,the legal system isn’t perfect,and the government plays a significant role in financial activities.Therefore,emerging market economies have very different institutions than developed economies.Several scholars compare the governance performance of emerging markets based on contract conclusion and governance mechanisms under the Western system,arguing that as a result of the lack of legal and regulatory systems in emerging markets,parties to transactions are only able to conclude and execute contracts through informal governance mechanisms(such as reputation,social relations,etc.).Therefore,strengthening the legal system and increasing the cost of default are considered the solutions for the agency problem and improving performance efficiency in emerging markets.History,culture,religion,and so on,however,are among the differences.As a result,emerging market countries need to replicate the legal systems of developed countries in their entirety,and they may not be fully applicable,and the legal system needs to be matched with customs,rituals,culture,politics,and other aspects.According to the theory of property rights economics,the transaction cost of a contract depends on the mechanism of its conclusion and execution.The parties to a transaction will invest in private performance mechanisms when the public mechanisms(custom,etiquette,law,politics,etc.)cannot adequately protect their property rights.Custom,etiquette,law,politics,and other public mechanisms embed private performance mechanisms.Due to this,private performance mechanisms are highly correlated with the role they play in reducing transaction costs.In other words,in order to minimize transaction costs,the choice of performance mechanism is embedded in the various transaction models constrained by public mechanisms in a country.Consequently,in order to explore the governance mechanisms of listed companies in emerging markets represented by China,which are very different from those of Western companies,in order to further sort out the relationship and applicability of law and financial development in emerging markets,which are products of the legal,political,and cultural institutions of the country.This paper chooses to take credit defaults of Chinese listed companies as the entry point to further demonstrate that,in a relationship-based economy,private performance mechanisms can still be the governance method that minimizes transaction costs and achieves good governance results.By comparing different performance mechanisms that banks use to manage defaulted debts within the same rule of law environment,even when relevant legal and regulatory protections exist.Scholars have explored a large number of useful studies related to the governance of debt contracts.In countries and regions with better creditor rights protection mechanisms,creditors can play an active role in corporate governance(Jensen and Meckling,1976;Aghion and Bolton,1992;Myers,1977;Watts and Zimmerman,1986).Despite this,since Chinese laws do not adequately protect creditors’ rights,debt covenants cannot perform the regulatory and binding role that they should in Chinese market transactions(Bailey et al.,2011;Lina Wu and Zhengfei Lu,2005).In some studies,creditor control of defaulting firms begins to shift to creditors when the firm is in financial distress.Some argued that creditors play a passive role until the firm defaults.Gilson and Vetsuypens(1993)argue that creditors play a crucial role in corporate governance once the firm is in financial distress.This section,however,has mainly focused on the economic consequences of financial distress on corporate control,financing decisions,and corporate governance,along with the costs of debt default imposed on various aspects of the firm’s operations and finances.Debt default has rarely been studied in terms of the institutional environment and the method of compliance.When a firm defaults on its debts,there is a certain uncertainty about the profitability and operation of the firm at this time,and the bank’s most concerned interest is to secure its own funds in a timely manner.At this time,the lending bank has two options: first,the bank can directly take litigation to preserve the safety of property.China has laws and regulations to protect the interests of creditors(Company Law,Contract Law,Security Law,Bankruptcy Law and Property Law),and timely legal preservation of assets can be protected from further deterioration of business conditions,or avoid opportunistic behavior of firms to transfer assets to escape from debts.However,in order to prevent the adverse selection of firms,banks will conduct detailed information investigation on firms before lending,if the bank can maintain long-term trading relationship between firms,the initial investment will yield higher value,once suing to laws,also means that the relationship between banks and firms is broken,the prior investment will be reduced to sunk costs.Secondly,banks choose to share the risk with firms by giving them extensions or debt relief through private negotiations to help them tide over their difficulties(Chen and Wei,1993;Gopalakrishnan and Parkash,1995;Nini et al.,2012;Roberts and Sufi,2009).This performance approach can maintain the relationship of cooperation and ensure continued transactions in the future.However,when a firm defaults on its debt,there is some uncertainty about the profitability and operating conditions of the firm,and the bank may be "hold-up" by the firms due to information asymmetry,and the firm takes advantage of the opportunity to transfer its assets,and the bank has to help the "zombie firm" in order to avoid nonperforming assets.Social relationships as a private performance mechanism can effectively balance the cost-benefit of banks.It has been found in the literature that in relationship-based economies,by being integrated into the same social network,social ties help decipher and verify firms’ transaction patterns,address information asymmetries between the two sides of the transaction,and act as collateral to inhibit opportunistic behavior in compliance(Li et al.,2020;Tang,Song et al.,2017).Therefore,our analysis suggests that in the same legal system context,since social relationships can alleviate the information asymmetry between banks and firms,and act as collateral to inhibit the opportunistic behavior of defaulting firms,thus avoiding the breakage of bank-firm relationship due to the sues,firms with relationships are more likely to resolve the default with banks than those without relationships The defaulted debt is more likely to be resolved through private communication with the bank than with the unrelated firms.We examine the relationship between law,social relationships,and compliance mechanisms from three perspectives: the choice of governance of credit contracts,influencing factors,and governance effects in this paper based on a sample of credit defaults of A-share listed companies between 2001 and 2019.The empirical results show that when the registered place of the defaulting firm has a geographical relationship with the lending bank institution(belonging to the same prefecture-level city),or when the bank president has social relationships with the directors or executives of the firm,such as hometown or alumni,the bank is less likely to use legal action to recover the amount owed to the defaulting firm and more likely to use negotiation to communicate and solve the problem.The effect of geographic or social ties is stronger when the law is more efficiently enforced in the region to which the firm belongs.This is because the level of community trust is lower.When a firm adopts a relationship-based transaction model or faces a higher degree of policy uncertainty in its operation,banks with geographical or social ties are more likely to share the risk with the firm and thus less likely to use litigation to recover the outstanding amount.When banks face stronger financial competition,or when monetary policy is relatively accommodative,they are more inclined to use litigation to collect debts.As a further test,we verify whether the geographic or social ties between banks and firms act as a governance effect of debt contracts and inhibit the opportunistic behavior of debtors,or whether there is complicity between bank and firm executives that undermines the property value of banks.The results show that the repayment rate of overdue loans is higher when firms with geographic or social ties between banks and firms and are not sued by banks.The governance effect of geographic or social ties is stronger when the firm has more social capital in the region,i.e.,when the firm’s chairman or CEO originates from the firm’s place of incorporation,or when the firm has more subsidiaries in the place of incorporation.The main contributions of this paper include the following: First,it has been argued that sound laws and regulations and more efficient law enforcement can help financial and economic development,especially in emerging markets where market economies are not yet well established(LLSV,1998).Therefore,strengthening the legal system and increasing the cost of violating the law are considered to be the solutions for agency problems in emerging markets.This paper takes the governance mechanism of credit default of Chinese listed firms as an entry point.It compares the different compliance mechanisms adopted by banks with geographical or social ties to debtors in the same credit default environment.This is because there are clear laws and regulations to protect creditors,and ultimately produce different governance effects.The findings of this paper confirm that the choice of compliance mechanism is embedded in the various transaction patterns of a country’s public institutions,and extend the theory of the "Law and Finance" school of thought on the relationship between sound regulatory institutions and financial development.The paper demonstrates that law is endogenous to the institutional environment,not exogenous to the institutional conditions,and that in a business model where relationships are prevalent,social relationships still have a dominant governance effect even when there is a well-developed legal system to protect them.Second,the findings of this paper contribute new insights into the debt governance model of Chinese banks.Due to financial regulations and invisible government guarantees,China’s banking sector has been perceived as struggling to function as a corporate governance system.As a result of a relationship-based economy(Wong,2016;Li Zengquan,2017;Hung et al.,2015),firms rely on social networks of relationships to enforce contracts rather than arm’s length transactions.When creditors are discussed by including them in the social relationship network,this paper finds that the localized management of Chinese banks and the social relationships between banking executives help to alleviate information asymmetry between banks and firms and inhibit the opportunistic behavior of debtors,effectively playing the role of creditor governance.Finally,the findings of this paper have some policy implications for the legal establishment of capital markets in China.Part of the literature explores agency problems in emerging markets,using the institutional context and governance mechanisms of developed markets as a benchmark for comparison.When firms in emerging markets do not exhibit governance mechanisms or governance effects consistent with those of Western economies,the reason is inadequate investor protection systems and low costs of violation.In fact,the choice of compliance mechanisms is embedded in a country’s public institutional constraints.In addition,the governance mechanisms of emerging market firms are a product of legal,political and cultural institutions that are very different from those of Western firms.The "rule of law" is an increasingly critical strategic issue,and the judiciary and financial sector at all levels are considering how to improve laws and regulations to promote the healthy development of capital markets,support the development of financial markets,and protect the rights and interests of stakeholders.Our research also shows that policy making should start from the system,take into account the legal,political and cultural systems in China.It should also fully explore the adaptation mechanism of corporate governance,and take into account the local business model and contractual characteristics in order to truly develop a targeted regulatory system,fill the gaps in the system,and improve the efficiency of resource allocation. |
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