The Impact of Corporate Governance on Insolvency Risk: Evidence from Licensed Finance Companies in Sri Lanka.

Abstract

Corporate governance is involved in addressing agency problems within organizations by aligning the interests of management and shareholders. This study is grounded in the evidence that corporate governance is vital for mitigating the excessive risk-taking behaviors that often lead to insolvency. The increasing financial instability among Finance Companies (FCs) highlights the critical need for a comprehensive analysis of corporate governance (CG) mechanisms and their impact on insolvency risk (IR). This study aims to identify the specific CG factors that significantly influence the probability of insolvency of the Licensed Finance Companies (LFCs) listed on the Colombo Stock Exchange (CSE) in Sri Lanka. It provides insights into how governance practices can enhance financial stability and reduce vulnerability to insolvency. The sample comprised 25 LFCs listed on the CSE from 2019 to 2023. In this study, the independent variables include board independence, gender diversity on boards, audit committee independence, and the frequency of board and audit committee meetings. The dependent variable is the insolvency risk (IR). Insolvency risk was measured using Altman's emerging-market Z-score (EMZ score). The panel regression analysis was employed to analyze the data. Additionally, multinomial logistic regression analysis was used to explore the impact of corporate governance on the likelihood of insolvency risk. The findings indicate that the presence of women on boards and the frequency of board meetings exert a significant and inverse influence on insolvency risk. Furthermore, the inclusion of women on boards has a significant negative impact on low insolvency risk, while the active audit committee engagement exhibits a substantial negative impact on insolvency risk. These findings highlight the significance of corporate governance practices, gender diversity, and the effectiveness of board and committee meetings in mitigating the risk of insolvency. Companies that prioritize gender diversity, ensure regular board meetings, and foster active audit committee engagement are more likely to enhance their organizational stability and reduce excessive risk-taking behaviors. These implications suggest that adopting robust corporate governance mechanisms and promoting diversity and inclusivity within leadership structures can contribute to companies' long-term sustainability and success, particularly in managing and minimizing the risk of insolvency.