Ruling Family Political Connections and Risk Reporting: Evidence from the GCC
Introduction
This study examines whether the presence of ruling family members1 on boards of directors influence the extent and the quality of risk reporting by Gulf Cooperation Council (GCC)-listed financial firms from 2007 to 2011. The GCC2 provides an ideal setting in which to examine the relationship between the political connections of board members and the reporting transparency of firms. Many of the GCC-listed firms have at least one ruling family member on the board of directors (Halawi & Davidson, 2008). For instance, in the United Arab Emirates (UAE) in 2008, 56 directors from 101 listed firms were ruling family members (Halawi & Davidson, 2008). Furthermore, in Qatar, 78 (24%) of all listed companies had ruling family members on their boards. Similarly in Kuwait and Oman, there were 45 (21%) and 31 (26%) listed firms that had ruling family members on their boards, respectively. Leuz and Oberholzer-Gee (2006) and Chaney, Faccio, and Parsley (2011) call for further research into the effects that these political connections that GCC firms have on reporting transparency.
This study is motivated by the growing interest in the relationship between political connections and corporate transparency (Chaney et al., 2011, Leuz and Oberholzer-Gee, 2006). Polsiri and Jiraporn (2012) provide evidence that firms with ruling family connections may obtain economic benefits from their family ties. These researchers cite a case where firms belonging to the King of Thailand were less likely to fail during the 1997 Asian Financial Crisis due to their ruling family connections. Few studies, however, have investigated the relationship between political connections and corporate risk transparency in emerging economies such as the GCC. Survey results (see, e.g., IFC & Hawkamah, 2008) suggest that adequate disclosures are of paramount importance in the GCC as a means to protect shareholders' rights, particularly because monarchial control is strongly entrenched. Effective disclosure of firms' risks can minimize rent-seeking activities by ruling family members and other controlling interests (Jaggi, Leung, & Gul, 2009). Risk disclosures are considered to be an integral component of good corporate governance structure, and such disclosures are particularly important to market and bank regulators, international organizations, and development institutions in the GCC, as these enterprises seek to consolidate firms' risk management frameworks and practices or to strengthen internal controls (Hertog, 2012, IFC and Hawkamah, 2008). The provision of adequate risk disclosures is an important factor in the regulation of publicly listed GCC firms.
Appointment of ruling family members on boards arise through their seniority among a monarchical group, being a founding member of a firm, their large equity and controlling interest in a firm, and appointment by a nomination committee (Hertog, 2012, IFC and Hawkamah, 2008). Generally, the board structures and legal provisions regarding the appointment of directors and their responsibilities follow those that are required under company law in a Western-based system, but there can be some significant local variations. The financial reporting frameworks of GCC countries are based on both company laws and royal decrees (Al-Shammari, Brown, & Tarca, 2008). Some firms are established through presidential decrees or other special statutes that give them particular benefits, including appointments of politically connected directors such as ruling family members. Thus, ruling family appointments to the boards are likely to be driven by a mixture of Western-based legal principles and political or family connections (Hertog, 2012).
The power of ruling family members over the GCC's economic and political regimes may undermine recent efforts by the region's regulators to enforce and improve corporate governance and to enable financial reporting transparency. First, to the extent that board memberships for ruling family members serve to protect these members' personal interests and the interests of related companies, the management of firms characterized by ruling family directorships may fail to disclose risk-related information, including disclosures mandated by accounting standards or regulatory bodies. Second, the rent-seeking behavior and the business interests of politically connected firms are protected by the monarchy (Mazaheri, 2013), which makes it less likely that management will resist the wishes of powerful ruling family directors (Jaggi et al., 2009). A setting in which there is no real separation between the monitoring and controlling functions is likely to have a negative effect on firm reporting and transparency. Third, ruling family board directors may not wish to attract negative market attention by disclosing information relating to their firms' risk exposures (Certo, 2003). Furthermore, politically connected firms could have lower disclosure levels, even in the face of higher risk levels or in times of distress, due to the protection that ruling family connections may offer these firms. Ruling family directors may consider that their connections with key stakeholders, such as other groups in the royal family or important government officials, will protect their firms in difficult times. Such ruling family directors are able to transfer wealth to themselves at the expense of other contracting parties and to make their risk-related disclosures in an opportunistic manner (Emanuel, Wong, & Wong, 2003).
However, several recent developments in the GCC region are likely to stimulate an increased demand for transparency and disclosure, particularly with respect to risk reporting (Al-Hadi et al., 2016, IFC and Hawkamah, 2008). Corporate governance codes3 and regulations are now well established in all GCC countries, with some of these countries holding their firms accountable for non-compliance with business regulations (Al-Shammari et al., 2008). Some GCC countries have established corporate governance task forces to monitor the adherence of firms to codes of conduct and good governance (Al-Hadi et al., 2016, IFC and Hawkamah, 2008). Recently, regulation of GCC firms has made significant progress toward establishing more independent boards of directors. In all of the GCC countries, the corporate governance codes require that an audit committee must review a firm's risk management systems and policies, including their disclosure practices. Adoption of the International Accounting Standards (IAS) or the International Financial Reporting Standards (IFRS) is mandatory for all listed financial companies throughout the GCC (Al-Shammari et al., 2008, IFC and Hawkamah, 2008).4 All GCC central banks have adopted Basel II, including Pillar III: Disclosures. Finally, although board risk management is voluntary in practice, about 39% of all the GCC financial firms have adopted risk management policies that require board oversight and disclosure of risk (Al-Hadi, Taylor, & Hossain, 2015).
The GCC region has also seen a marked increase in foreign direct investment (Mina, 2007). As a whole, the GCC has experienced unprecedented growth rates, and many of its companies trade with offshore partners or have subsidiaries incorporated in countries outside the GCC (Lagoarde-Segot & Lucey, 2007). This internationalization of GCC-listed firms makes them subject to greater scrutiny from stakeholders, regulators, and international institutional investors, who have recently been demanding greater transparency and accountability from those firms (Abu-Nassar & Rutherford, 1996).
Although ruling family membership on boards is relatively high in the GCC region, the ruling family ownership of financial firms is relatively low compared to such ownership of non-financial firms (Al-Hassan, Oulidi, & Khamis, 2010). Market risk exposures are considered to be particularly important for GCC financial firms (Al-Hadi et al., 2016, Beattie et al., 2004), given the recent emphasis of regulatory bodies on strengthening risk management and risk reporting systems (Al-Shammari et al., 2008). Firms belonging to the financial sector are generally more prone to issues related to risk disclosure, as these firms are subject to greater regulatory constraints (e.g., Central Bank regulations, Basel, and IFRS). Prior research on the financial industry and on market risk reporting shows that financial firms disclose more risk-related information than other industries (e.g., Hirtle, 2007, Nier and Baumann, 2006, Perignon and Smith, 2010a). Financial firms represent a significant part of total stock market value in the GCC (Hammoudeh & Choi, 2006).5 Additionally, the shareholdings of GCC financial firms are often dominated by influential royal families or government leaders (Al-Hadi et al., 2016, Al-Shammari et al., 2008). Halawi & Davidson (2008) finds that royal family members are strongly represented on the boards of directors of GCC financial firms.
Given this dominance of royal family ownership and the strong representation of royal family members on the boards of financial firms, it is important to focus on these firms in our investigation. Especially in the case of financial firms, there is a real need to determine whether the presence of ruling family members on boards of directors influences the extent and quality of risk reporting. Overall, the risk disclosure patterns of GCC financial firms are affected by both the existence of ruling family board members and by the increasing requirements for greater transparency, such as the recent developments in governance codes, the adoption of IAS/IFRS, the growing importance of regulatory bodies, and the internationalization of GCC-based firms.
Using 667 firm-year observations from between 2007 and 2011, we provide evidence that being a politically connected GCC financial firm (as identified by the presence of ruling family members on their boards of directors) is negatively and significantly associated with the extent and the quality of market risk disclosure. We further find that firms with ruling family board members disclose significantly less risk reporting during periods of financial distress and when they are subject to higher levels of risk. Moreover, firms chaired by a ruling family member and boards with members who have a direct family connection to the ruling family are significantly and negatively associated with the extent and quality of market risk disclosures.
The empirical models used in this study control for firm-specific factors, including the reporting quality and the corporate governance structures of firms (e.g., Chaney et al., 2011, Guedhami et al., 2014). Furthermore, we include firm-specific governance regimes and country-specific investor protection levels in our empirical tests (e.g., Boubakri, Guedhami, Mishra, & Saffar, 2012b). We also include family (other than ruling family) and government ownership variables in certain models to control for the effects of ownership structures (e.g., Boubakri et al., 2012b, Ding et al., 2014, Jaggi et al., 2009, Wan-Hussin, 2009). Consistent results are obtained after using alternative specifications of firm reporting. We also use instrumental variable (IV) techniques and ordinary least squares (OLS) estimations to mitigate endogeneity concerns. The results from the IV estimations are very similar to those of the baseline OLS estimations, indicating that endogeneity is not likely to account for the observed associations.
We contribute to the literature on political connection and risk disclosure in several important ways. First, to the best of our knowledge, the literature has not thus far examined the association between political connections and the market risk disclosures of financial firms in the context of the GCC. We extend earlier studies (e.g., Polsiri & Jiraporn, 2012) by providing evidence that the presence of ruling family members on a board of directors reduces the extent and quality of market risk disclosures. Anecdotal evidence has suggested that the presence of ruling family members on boards is important or even critical to achieving business outcomes. Parallel studies (e.g., Ali et al., 2007, Jaggi et al., 2009, Wan-Hussin, 2009) on the family and government connections of board members also suggest that political links are likely to be important determinants of business decisions by firms in the GCC, including decisions related to the nature and degree of risk reporting (e.g., Polsiri & Jiraporn, 2012).6 This study explicitly contributes to the literature by quantifying the association between the existence of ruling family board members and the quality of market risk reporting by financial firms. The literature to date (e.g., Chaney et al., 2011, Guedhami et al., 2014, Leuz and Oberholzer-Gee, 2006) provides mixed evidence regarding the direction of association between politically connected firms and corporate transparency. We use multiple measures of political connection in this study7 and provide consistent evidence of a negative and significant association between the presence and the number of ruling family members in boards (or serving as board chairs) and the extent or quality of market risk disclosures.
Second, despite the pivotal role of disclosure in enhancing a firm's value and its relations with shareholders (Healy & Palepu, 2001), comparatively little research has addressed the issue of risk disclosure from the perspective of less democratic, family relations-based economies. Hence, in this study, we draw our sample from the six monarchical GCC countries, which are characterized by low levels of democracy, the dominance of ruling family members in businesses, high levels of state ownership, a lack of transparency, and weaker disclosure levels (Al-Hadi et al., 2016, Al-Yahyaee et al., 2011, Mazaheri, 2013). The political and economic setting of the GCC region provides us with an important opportunity to investigate the role of political connections in corporate transparency. The findings of this study can be extrapolated to other relations-based developing countries.
This study proceeds as follows. Section 2 provides the theory and develops the hypothesis. Section 3 explains the research design, data sources, and sample selection. Section 4 presents the empirical results. Section 5 contains the results of our robustness checks and additional tests, and Section 6 offers the study's conclusions.
Section snippets
Market risk disclosures
Market risk is defined as the risk of fluctuations in fair value, cash flows, or earnings due to changes in market prices (Jorion, 2002). Such risk may be initiated by changes in interest rates, exchange rates, equity prices, or commodity prices (Al-Hadi et al., 2016). Various U.S.-based studies (e.g., Jorion, 2002, Rajgopal, 1999) and professional surveys (e.g., Chartered Financial Analyst (CFA) Institute, 2013) argue that market risk disclosure allows investors to make informed decisions
Sample and data
We drew our sample from the population of financial firms listed in Bahrain, the Kingdom of Saudi Arabia (KSA), Kuwait, Oman, Qatar, and the UAE between 2007 and 2011. We hand-collected data related to market risk disclosures, the ruling family members on the boards, and other governance characteristics from annual reports. All other data were obtained from Capital IQ. Definitions of the variables used in the study are provided in Table 1.
The sample initially consisted of 1375 firm-year
Descriptive statistics
Table 3, Panel B reports the descriptive statistics for the variables included in the regression models. The mean (standard deviation) values for the MRDFACTOR, EMRD, and QMRD indices are 0.760 (0.270), 0.566 (0.282), and 7.736 (3.768), respectively. Our results are similar to those of Miihkinen (2012). On average, 31.2% of the listed financial firms have at least one ruling family member on their board of directors. This result is similar to the lower bound of ruling family membership on
Robustness test: two-stage least squares (2SLS)
It is possible that the statistically significant and negative association between risk disclosure proxies and the presence of ruling family members on the boards is a consequence of endogenous factors. In other words, a certain level or quality of risk disclosure may be determined by board-related factors other than the presence of ruling family members. To consider this possibility, we re-ran each regression model to test for endogeneity, using a 2SLS estimator. We also report the results of
Conclusions
Using a sample comprising 667 firm-year observations, we document that the extent and quality of market risk disclosures provided in the annual reports of publicly listed GCC financial firms are significantly lower for firms that are politically connected. These results are consistent when using several alternative proxy measures of political connection, including the presence of ruling family members on the board of directors, firms chaired by a ruling family member, the presence of a board
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