Why do Countries Matter so Much for Corporate Governance?

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Abstract
This paper develops and tests a model of how country characteristics, such as legal protections for minority investors and the level of economic and financial development, influence firms' costs and benefits in implementing measures to improve their own governance and transparency. We show that the incentives to adopt better governance mechanisms at the firm level increase with a country's financial and economic development. Further, these incentives increase or decrease with a country's investor protection depending on whether firm-level governance mechanisms and country-level investor protection are substitutes or complements. When economic and financial development is poor, the incentives to improve firm-level governance are low because outside finance is expensive and the adoption of better governance mechanisms is expensive. Using international corporate governance and transparency ratings for a large sample of firms from around the world, we find evidence consistent with this prediction. Our main empirical result is that country characteristics explain much more of the variance in governance ratings ranging from 39% to 73%) than observable firm characteristics (ranging from 4% to 22%). Further, we show that firm characteristics explain almost none of the variation in governance ratings in less-developed countries and that access to global capital markets sharpens firms'incentives for better governance.