Corporate Governance and Internal Capital Markets

by Zacharias Sautner & Belén Villalonga

Overview — What is the impact of corporate ownership on corporate diversification and on the efficiency of firms' internal capital markets? Corporate governance and internal capital markets are two topics closely intertwined in theoretical research; for example, agency problems—which corporate governance mechanisms seek to mitigate in a variety of ways—are at the heart of every theory of inefficient internal capital markets. Yet surprisingly few empirical studies have looked into the actual link between corporate governance and internal capital markets. This paper by University of Amsterdam professor Zacharias Sautner and HBS professor Belén Villalonga seeks to fill the gap by taking advantage of a natural experiment provided by a tax change in Germany in 2002. The researchers provide direct evidence of the effect of governance structures on how markets work, as well as new evidence about the benefits and costs of ownership concentration. Key concepts include:

  • In 2002, Germany repealed the prevailing 52 percent corporate tax on capital gains from investments in other corporations, thus eliminating a significant barrier to changes in ownership structures.
  • Corporate governance has a significant impact on internal capital markets. Specifically, ownership concentration reduces the extent of corporate diversification, but increases the probability that internal capital markets are efficient.
  • Both ownership concentration and corporate diversification have potential benefits and costs, as documented in prior studies. Given prior findings that there is no diversification discount in Germany, our results imply that the benefits and costs of ownership concentration just offset each other when it comes to diversification strategies. However, our own finding that more concentrated ownership leads to more efficient allocation of internal resources suggests that the net benefits of ownership concentration may in fact be positive.
  • There is no "one size fits all" solution to governance problems. The recent tax reform in Germany may have been partially counterproductive. The broader policy implication is that caution should be exercised when implementing tax or other legal reforms that seek convergence in international corporate governance systems.

Author Abstract

We exploit an exogenous shock to corporate ownership structures created by a recent tax reform in Germany to explore the link between corporate governance and internal capital markets. We find that firms with more concentrated ownership are less diversified and have more efficient internal capital markets. Our findings provide direct evidence in support of Scharfstein and Stein's (2000) model, which suggests that internal capital misallocations are partly a result of poor corporate governance. We also provide evidence of a channel through which the benefits of ownership concentration outweigh its costs. 48 pages

Paper Information