Internal Capital Market and Bankruptcy Risk of Korean Chaebol Firms: A Recursive Model*

Jooha Nam** & Taehong Jinn***

2001. 6. 8

1st draft

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* We would like to thank Seung-Rok Park(Korea Economic Research Institute) and Jung-hwn Ahn for providing computer code and data, respectively.  Of course all remaining errors are ours.

**  Sogang University

*** Hongik University

Correspondence Address: Jookong Apt 505-1403, Buylyang dong,                                         Kwacheon, Kyngkido, Korea, 427-040

e-mail : thj2274@wow.hongik.ac.kr       Fax: 041-864-7533

Abstract

Most of empirical studies on internal capital market have investigated the relationship between investments and cash flow.  Focusing on the cross debt guarantee instead of cash flow as an internal capital market we empirically investigate whether internal capital market have positive effect on the bankruptcy risk of korean chaebol firms. Since a cross debt guarantee can have a direct effect on the bankruptcy risk as well as an indirect effect through an increase of debt equity ratio there may have been a simutaneous problem between explanatory variables. In order to resolve this problem we employed a recursive model.  Empirical findings show that a firm receiving more debt guarantee from other firms in the same chaebol are more likely to go bankrupt.  However, this finding is supported from the indirect channel rather than the direct channel.  This paper also finds that the likelihood of bankruptcy of a chaebol firm is affected by aggregate financial status of other firms in the chaebol it belongs to.  Findings in this paper imply another demerit of internal capital market of chaebols other than inefficiency.

I. Introduction

Aggressive behaviour of chaebols with respect to financing and investment is now regarded as one of factors that gave rise to korean economic crisis of 1997.  Corporate finance of chaebols before the crisis is characterized by excessive borrowing, excessive investment and low profitablity. The average return on invested capital of firms which belongs to 30 biggest chaebols was 5.9 % in 1996 and  their average debt-equity ratio was 387%.

Even though financial excesses led to the lack of competitiveness under the changed economic environment and business failures of some chaebols eventually, internal market coupled with a weak corporate governance is also responsible for the faltering of chaebols  after the economic crisis. The latter is more fundamental in that it has enabled excessive financial behaviour of chaebols.

Chaebol is not a single entity but a gathering of loosely coupled firms. Despite legal independence firms in a chaebol are under a single common administrative and financial control as if they are divisions of a conglomerate corporation. Interaction among firms are done in either internal capital market or intermediate goods market.  Speaking of internal capital market group a chaebol firm can provide funds to other firms in the same chaebol in the form of either debt guarantee or equity participation. Especially, the practice of debt guarantee has been singled out as a mechanism inducing the aggressiveness of chaebols in financing and investment in that it has enabled chaebol firms to raise capital irrespective of their financial conditions. As for intermediate goods market chaebol firms conduct extensive internal sales and purchase of goods. Internal goods market can be also used for subsidizing a firm in a chaebol. A certain firm in a chaebol can be subsidized by either buying goods from other firms  in the same chaebol at cheap prices or selling goods to them at expensive prices. This kind of subsidy is possible since legally independent firms in a chaebol are under control of a single administrative entity run by families of a chaebol.

While there have been a lot of studies which explore internal business transaction and cross-subsidization, most of them have relied on anecdotal episodes to support their arguments. More rigorous studies on the working of internal market have yet to be done. In particular the literature lacks studies exploring internal capital market of chaebols. A few exceptions are Park and Shin(1998)and Jinn(1999) who found that internal capital market is very active in chaebols in that the investment of a chabol firm is positively correlated with the cash flow of other firms in the same chaebol. As for the efficiency of internal capital market Park and Shin(1998) did not found the evidence that cash flow of other firms in a chaebol is used to finance the investment of a good firm in the same chaebol.

Although most of empirical studies on internal capital market have investigated the relationship between investment and cash flow, this paper analyzes how the bankruptcy risk of a chaebol firm is affected by internal capital market. Failures of a lot of chaebol firms since the economic crisis of 1997 give us an excellent data set for the analysis. We would like to confirm whether chaebol firms are more likely to go bankrupt as they rely more on internal capital market. As it turns out, the evidence that firms with more reliance on internal capital market are more likely to go bankrupt implies another demerit of internal capital market other than inefficiency itself. A variable, the amount of debt guarantee given to a firm by other firms in a chabol, is employed as a measure of the degree of exposure to internal capital market. A set of bankruptcy equations which take into account the endogeneity of variables are estimated to explore the relation bankruptcy and internal capital maket.

See Gertner and Scharfstein(1994), Stein(1997), Lamont(1997), Sharfstein(1998), Shin and Stultz(1998), and Shin and Park(1999).

In addition to exploring the effect of internal capital market on likelihood of bankruptcy of a chaebol firm we also check the validity of the claim that financial status of a chabol as a group do affect the likelihood of bankruptcy of a chaebol firm since chaebol firms behave as if they were divisions of a company. Remaining contents of this paper are as follows. Section 2 explains the role of cross debt guarantee in internal capital market, and a survey literature on internal capital market, section 3 describes the data and empirical results.  Section 4 concludes the text.

Ⅱ. Internal capital market and Cross debt guarantee

2.1. Cross debt guarantee and Korean chaebols.

The practice of cross debt guarantee among affiliated firms in a chaebol has been one of building blocks for the growth of chaebols. Irrespective of credit ratings chaebol firms which received debt guarantee from affiliated firms could borrow funds from banks for investments. One of remarkable features about the practice of cross debt guarantee is that guarantor firm guarantee the payment of debts of affiliated firms free of charge. The feature is thought to have induced reckless use of debt guarantee by chaebol firms and resulted in high leverage and aggressive investment. The practice of cross debt guarantee was legally abolished after the economic crisis of 1997 since it was regarded as one of factors responsible for the crisis.

Even though there is a consensus that cross debt guarantee is a component of the internal capital market, different perspectives can be put forth on the role of debt guarantee in the internal capital market.

One of theoretical explanations on the role of cross debt guarantee is that cross debt guarantee can enhance the efficiency of the internal capital market since it can ameliorate asymmetry of information between debtor and creditor. One of firms in a chabol who knows the value of affiliated firms better than outsiders can signal the value of guaranteed firms and lower borrowing cost. The point of the view is that cross debt guarantee is a type of signalling behaviour under the circumstance of asymmetry of information. Given that asymmetry of information problem has been plagued in korean financial market for a long time due to the underdevelopment of infrastructure underlying financial market such as disclosure, the view has some merits.

The other perspective on the role of debt guarantee is that the practice of cross debt guarantee lowers the efficiency of internal capital market due to the agency problem between the controlling shareholder and minority shareholders. The controlling shareholder who control all firm in a chaebol by a unique ownership structure has incentive to make a firm in which he has a smaller stake to guarantee other firms in which he has a  larger stake even if the guaranteed firm has a poor investment opportunity set. As a matter of fact resources of a good firm in a chaebol can be transferred to a bad firm via cross debt guarantee.

Two opposing theories above imply that cross debt guarantee has the aspects of increasing as well as decreasing the efficiency of internal capital market. It follows that further empirical analyses will shed light on the actual role of cross debt guarantee in the internal capital market.

2.2. Literature on internal capital market

Gertner et al(1994) showed that if either a large shareholder or an owner-manager has the authority to allocate funds in internal capital market, he can allocate  funds more efficiently than financial institutions since he has a stronger incentive to monitor as a residual claim holder. Stein(1997) noted that efficiency of allocation is enhanced in internal capital market since funds are allocated through the process of winner picking in internal capital market. Sharfstein and Stein(1997) showed that funds can be allocated inefficiently in a diversified firm where a kind of social allocation by subsidy leads to either overinvestment or underinvestment in some divisions. Shin and Stultz(1998) explored how internal capital market works in muti-divisional firms using a sample that report segment information. While they found results that show that intenal capital market is active, they did not find any evidence implying that internal capital market is efficient. In particular, they found that the sensitivity of a segment's investment to the cash flow of other segments does not depend on whether its investment opportunities are better than those of the firm's other segments.

Ⅲ. Methodology, Data and Empirical results

3.1. Methodology

Since the main objective of this study is to analyze how the degree of exposure to internal capital market affect the likelihood of bankruptcy of chaebol firms, not to build the prediction model itself, we do not follow the conventional approach of finding statistically significant variables that can classify bankrupt firms from non-bankrupt ones, using either discriminant analysis or logit model. Instead we estimate two bankruptcy models.  Both models consist of  a bankruptcy equation incorporating probit analysis and another equation in which debt equity ratio, one of expalnatory variables in the bankruptcy equation, is regressed as a dependent variable in debt equity ratio equation. In fact we construct a kind of simultaneous equation models. Note that estimated debt equity ratio from debt equity equation is put in the bankruptcy equation as one of explanatory variables. The only difference between model one and model two is that while the bankruptcy equation in  model one includes only variables at the firm level,  the bankruptcy equation in  model two includes variables at group level. In each model the focus of the analysis is how a variable denoting the degree of exposure to internal capital market, i.e. the amount of debt guarantee a chaebol firm received from other firms in a chabol.(debt guarantee, hereafter) affects the bankruptcy of chaebol firms. It should be noted that debt guarantee is supposed to affect the bankruptcy risk of a chaebol firm via two channels in the structure of models. As seen in figure 1 debt guarantee is supposed to affect the bankruptcy of a chaebol firm indirectly via its effect on debt equity ratio as well as directly in bankruptcy equations. Note that variables other than debt guarantee and debt equity ratio play the role of control variables explaining the likelihood of bankruptcy of a chaebol firm.

In order to resolve a simultaneous problem between explanatory variables, for examples, debt guarantee and debt equity ratio, this paper employed a recursive model.

< Figure 1> routes in which bankruptcy is affected by debt guarantee

Profitability

Growth factor

direct effect

indirect effect

Debt equity Ratio

Bankruptcy Risk

indirect effect

direct effect

Internal Capital Market(cross debt guarantee)

Five explanatory variables in the bankruptcy equation as control variables are return on invested capital, debt equity ratio, fixed asset turnover ratio, firm size, and market share. Return on invested capital and debt equity ratio reflect profitability, leverage, respectively. Fixed asset turnover ratio measure capital intensity of a firm. Three group variables that are added in the bankruptcy equation in model two are group return on invested capital, group debt equity ratio and group fixed asset turnover ratio. Note that these variables are added to control for the effect of group wide financial status on bankruptcy.

Altman(1983), Hambrick and D'Aveni(1988), and Nam and Jinn(2000) find that debt equity ratio has positive effect on the bankruptcy risk.

We estimate the following models:

Model 1:

Y=f(a, ROIC, DE, CI, SIZE, MS, DG)                            (1)

DE=g(a, ROIC, GS, FCR, SIZE, DG)                             (2)

Model 2:

Y=f(a, ROIC, DE, CI, SIZE, MS, GROIC, GDE, GCI. DG)          (3)

DE=g(a, ROIC, GS, FCR, SIZE, DG)                              (4)

where

Y= dummy variable denoting whether sample firm is bankrupt or not

ROIC = return on invested capital

GROIC = average return on invested capital of other firms in a chaebol

DE  = debt equity ratio

GDE = average debt equity ratio of other firms in a chaebol

CI = fixed asset turnover ratio

GCI = average fixed asset turnover ratio of other firms in a chaebol

SIZE= logarithm of total assets

MS= market share

GS = growth of sales

FCR = Fixed asset divided by total assets

DG = the amount of debt guarantee a sample firm received from other firms in a chabol.

Note that equation 1) and 3) are bankruptcy equations and that same debt equity ratio equation is used as equation 2) and 4) in both models. Note also that while bankruptcy equations are estimated  from cross section data, debt equity ratio equation is estimated from panel data spanning three years before bankruptcy.

We use a random effect panel model to estimate debt equity ratio equation.

In both models sign and statistical significance of coefficient of DG provide a direct effect of internal capital market on the bankruptcy risk of a chaebol firm.

In addition to analyzing the effect of internal capital market on the likelihood of bankruptcy of a chaebol firm, we  check whether  group wide financial status of a chabol does affect the likelihood of financial distress and eventual bankruptcy of a chaebol firm by comparing explanatory power of mode1 2 which includes three more variables on group wide financial status with that of model 1.

3.2. Data

To construct our sample we identified 64 business groups(chaebols) of which bank borrowings are greater than 250 billion won. The Korean Fair Trade Commission(KFTC) legally defines a business group as a group of companies, more than 30% of whose shares are owned by some individuals or by companies controlled by those individuals. From 64 business groups we obtained 120 manufacturing firms that went bankrupt in 1997, 1998 and 1999. We also obtained 466 non-bankrupt firms from those business groups. After getting rid of outliers our final sample consists of 40 bankrupt firms and 208 non-bankrupt firms. Note that the sample of 208 non-bankrupt firms is not matched with that of bankrupt firms. Matching a sample of non-bankrupt firms with that of  the original sample is crucial to building a reliable bankruptcy prediction model since matching enhance the accuracy of prediction. Since the main concern here is not to build a bankruptcy prediction model itself, we do not match a sample of non-bankrupt firms.

3.3. Empirical results

Table 1 shows summary statistics of variables based on all firms in the sample.  Table 2 and table 3  show descriptive statistics based on bankrupt firms and non-bankrupt firms, respectively.

Note that average ROIC of non-bankrupt firms is greater than zero while that of bankrupt firms is less than zero and that average debt equity ratio of bankrupt firms is much higher than that of non-bankrupt firms.

<table 1> Summary statistics of all firms

Variables*	mean	std dev	minimum	maximum
ROIC DE CI SIZE MS GROIC GDE GCI DG	1.94 480.21 8.43 19.44 29.65 1.39 381.11 3.49 18.0	4.30 460.35 31.03 1.56 33.36 1.85 204.36 9.95 1.90	-10.61 56.48 0.32 16.05 0.09 -5.85 110.99 0.42 9.10	24.67 4169.29 192.14 23.0 100.0 10.15 1817.46 157.10 22.62

* ROIC = return on invested capital(%)

DE  = debt equity ratio(%)

CI = fixed asset turnover ratio(%)

SIZE= logarithm of total assets

MS= market share(%)

DG= logarithm of the amount of debt guarantee received

<table 2> Summary statistics of bankrupt firms

Variables*	mean	std dev	minimum	maximum
ROIC DE LIQ CI SIZE MS GROIC GLIQ GDE GCI DG	2.36 436.20 102.72 8.84 19.41 32.88 1.52 94.68 355.89 3.58 17.94	4.22 428.56 41.43 22.13 1.61 34.78 1.75 21.10 163.55 10.80 1.92	-9.96 56.48 16.22 0.32 16.05 0.09 -4.54 39.98 114.52 0.42 9.10	24.67 4169.29 309.75 192.14 23.0 100.00 10.15 161.83 1209.07 157.10 22.62

<table 3> Summary statistics of non-bankrupt firms

Variables*	mean	std dev	minimum	maximum
ROIC DE LIQ CI SIZE MS GROIC GLIQ GDE GCI DG	-0.21 709.05 104.02 6.33 19.60 12.89 0.71 101.24 512.28 3.02 18.36	4.12 550.75 50.31 14.01 1.28 16.86 2.18 31.07 318.57 2.90 1.75	-10.61 113.50 33.21 0.55 16.55 0.15 -5.85 40.26 110.99 0.84 12.49	10.15 2878.67 273.65 88.85 22.66 69.34 5.38 172.21 1817.46 16.05 20.89

* ROIC = return on invested capital(%)

DE  = debt equity ratio(%)

CI = fixed asset turnover ratio(%)

SIZE= logarithm of total assets

MS= market share(%)

DG= logarithm of the amount of debt guarantee received

Results on the estimation of debt equity ratio equation are shown in table 4. Coefficients of ROIC and SIZE are found to be negative and statistically significant, while those of GS and FCR are found to be positive and statistically significant. These results are roughly in line with the existing literature on factors affecting debt equity ratio of korean firms. Coefficient of DG turns out to be positive and statistically significant, confirming the belief that cross debt guarantee enabled chaebol firms to maintain high debt equity ratio. This result also reassure that debt guarantee is working as a key mechanism for the internal capital market in chaebols. Note that variables other than DG in debt equity ratio equation should be regarded as control variables for isolating the effect of DG on debt equity ratio.

<table 4> Estimation of debt equity ratio equation

variables*	coefficients(t-statistics)
ROIC GS FCR SIZE DG	-7.205(-3.63) 1.321(4.38) 1.41(35.55) -20.83(-3.22) 3.83(1.64)
sample size** 744 adj. R-square 0.667

* ROIC = return on invested capital(%)

GS = growth of sales(%)

FCR = Fixed asset divided by total assets*100(%)

SIZE= logarithm of total assets

DG= logarithm of the amount of debt guarantee received

** three year panel data of 248 firms

Table 5 shows results on the estimation of bankruptcy equation in model 1 in which only variables at firm level are included as explanatory variables. Note that DEFIT denotes debt equity ratio estimated from debt equity ratio equation. Signs and statistical significance of coefficients of control variables do not much conflict with our intuition about which type of firms are more likely to go bankrupt. For example, coefficients of ROIC and MS are negative and statistically significant, confirming the intuition that the more profitable and the greater market share, the less likely to bankrupt a firm will be. Sign of coefficient of DG, a variable denoting the degree of expose or relation to internal capital market, turn out to be positive. Although statistical significance of the coefficient is not that high, this result implies that firms receiving more debt guarantee from other firms in the same group are more likely to go bankrupt. Note that coefficient of DG in the bankruptcy equation  reflects only  direct effect of debt guarantee on the bankruptcy. Since debt equity ratio is found to be positively correlated to debt guarantee we should check coefficient of DEFIT in bankruptcy equation in order to see the indirect effect of debt guarantee on the probability of bankruptcy. As it turns out, coefficient of DEFIT is positive and statistically significant. It implies that the probability of bankruptcy of firms with more debt guarantee will increase since debt guarantee play the role of increasing debt equity ratio which is positively related to the likelihood of bankruptcy.

Table 5 also shows results on the estimation of bankruptcy equation in model 2 in which explanatory variables at group level are added to variables in bankruptcy equation in model 1. Signs and statistical significance of coefficients of  control variables at firm level are not much different from those in model 1. Signs of coefficients of control variables at group level such as GROIC, GDE and GCI seem to be in line with the intuition. In particular, group debt equity ratio is found to be positively related to the likelihood of bankruptcy. Signs and statistical significances of coefficients of DG and DEFIT are almost same as those in model 1.  As in model 1, debt guarantee is found to be related to the likelihood of bankruptcy through the indirect channel rather than the direct channel in model 2. This result implies that a chaebol firm with more debt guarantee  may have a higher probability of bankruptcy when it suffers from financial distress.

<table 5> Estimation of bankruptcy equations

variables*	model 1	model 2
ROIC DEFIT CI SIZE MS GROIC GDE GCI DG	-0.08(-2.65) 0.0005(1.70) -0.0058(-0.97) 0.0235(0.26) -0.017(-3.43) 0.07(0.96)	-0.079(-2.54) 0.0005(1.49) -0.0072(-1.16) -0.02(-0.277) -0.017(-3.26) -0.079(-1.18) 0.0016(2.87) -0.014(-0.75) 0.79(1.02)
No. of obs R-square F-statistic(GROIC=GDE=GCI=0)=5.16	248 0.15	248 0.19

* ROIC = return on invested capital(%)

DEFIT  = debt equity ratio estimated from debt equity ratio equation(%)

CI = fixed asset turnover ratio(%)

SIZE= logarithm of total assets

MS= market share(%)

DG= logarithm of the amount of debt guarantee received

GDE = average debt equity ratio of other firms in a chaebol

CI = fixed asset turnover ratio

GCI = average fixed asset turnover ratio of other firms in a chaebol

Aside from the effect of debt guarantee on the probability of bankruptcy, a question that remains to be answered is whether  group wide financial status of a chabol affects the probability of bankruptcy of a chaebol firm. We try to answer the question by comparing explanatory power of mode1 2 which include three more group-level variables with that of model 1. Null hypothesis that addition of three group-level variables do not increase explanatory power of the model is found to be rejected at 1% significance level.  F statistics is calculated at 5.16, which is greater than 3.98, 1% significance level value when the distribution is F(3, 245). This result implies that the probability of bankruptcy of a chaebol firm is affected by the financial status of the group it belongs to.

Ⅳ. Conclusion

In this paper we explore how the bankruptcy of a chaebol firm is related to internal capital market. We analyze whether a chaebol firm is more likely to go bankrupt as it relies more on internal capital market. Debt guarantee is used as a measure of the degree of reliance on internal capital market. We find results that show that a firm receiving more debt guarantee from other firms in the same chaebol are more likely to go bankrupt. Since statistical significance of debt guarantee however, is not that high, it should be noted that debt guarantee affects the likelihood of bankruptcy via indirect channel. That is to say, debt guarantee is found to be indirectly related to the likelihood of bankruptcy via its effect on leverage which turn out to be positively related to the bankruptcy.

In addition to the effect of debt guarantee on the likelihood of bankruptcy, we analyze whether aggregated financial status of a chaebol affect the likelihood of bankruptcy of a chaebol firm. Results show that the likelihood of bankruptcy of a chaebol firm is affected by aggregated financial status of  other firms in the chaebol it belongs to.

The contribution of this paper are two fold. First, it further enriches the literature on chaebol by providing evidence related to debt guarantee which is thought to be a critical leverage for the aggressive behaviour of chaebols. Second, it identifies a different demerit of internal capital market other than inefficiency identified in Shin and stultz(1998) and Park and Shin(1999).

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