Abstract
We use variation in corruption convictions across judicial districts in the US to examine the relationship between political corruption and risk-taking of public firms. Firms headquartered in regions with high levels of political corruption have lower total risk and lower idiosyncratic risk on average. Further analysis shows that corruption tends to encourage firms to pursue risk-decreasing investments, lower the riskiness of their operations, and decrease asset liquidity. While managerial ownership is intended to align the interests of managers and shareholders, the presence of corruption appears to encourage undiversified managers to decrease risk-taking. Our evidence is consistent with agency theory and the asset-shielding argument that political corruption discourages managers from taking risks that expose firms to expropriation by politicians, resulting in suboptimal corporate policies.
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Notes
These industries are highly regulated and generally excluded in corporate finance studies. It is possible, however, that intense regulation creates even more opportunities for corruption. The results presented here are robust to the inclusion of these two industries (see Table A1 in the Online Appendix).
CEO delta measures the change in the CEO’s wealth given a 1% change in stock prices. CEO vega measures the change in the CEO’s wealth given a 0.01 change in stock return volatility. Both are estimated using the Black–Scholes option-pricing model and all holdings reported in Execucomp. Both variables are measured in dollars, so we use the natural logarithm in our analysis.
In unreported analysis, we use the risk measures calculated from the actual stock returns of both single- and multi-segment firms and find our results qualitatively unchanged.
We begin with a sample of 42,682 firm-year observations in the Compustat database during the sample period. The number of firm-year observations decreases to 36,329 after we drop firms from the utility and financial industries. After merging the sample with CEO compensation data from the Execucomp database and excluding firm-year observations with missing CEO delta and CEO vega, we obtain the final sample of 17,682 firm-year observations of 2107 multi-segment firms.
In unreported analysis, we control for firm fixed effects instead of industry fixed effects in the regressions, but the results remain qualitatively unchanged. Our results are qualitatively similar if we cluster standard errors by judicial districts.
We thank Campante and Do for making the isolation of capital city data available.
In an unreported analysis, we use the state-level shocks to newspaper reporter employment as an additional instrument for political corruption (Brown et al., 2019), but our results remain qualitatively unchanged.
We control for both GDP growth rate and GDP per capita because Barro and Lee (1993) argue that GDP can grow faster with a lower GDP per capita given an initial level of human capital.
Local corruption is likely to be more extensive if a firm primarily operates in one area, but less so if it operates across multiple states. Using data from Garcia and Norli (2012) to measure firm concentration, we find that concentrated firms are more affected by local corruption. We report these results in Table A2 in the Online Appendix.
As the HHI data are available from 1996, our corporate investment subsample consists of 14,631 firm-year observations.
Hossain and Kryzanowski (2020) define acquisitions as a method for shielding assets from rent-seeking behavior. We focus only on firms that acquired other firms, though the acquisition itself may have occurred as a result of operating in high corruption areas.
In an unreported analysis, we find that corruption reduces capital expenditures and R&D, which is consistent with the evidence reported in the literature (Ellis et al., 2020; Huang and Yuan 2021). Moreover, the relationship is stronger for R&D, implying a more pronounced effect of corruption on idiosyncratic risk because R&D tends to increase firm idiosyncratic risk more (Bhagat and Welch 1995; Bhattacharya et al., 2017; Kothari 2001). However, CEO ownership may also affect a firm’s investment level in R&D independent of corruption (e.g., Abdoh and Liu 2020).
In an unreported analysis, we also find that corruption leads to under-investment by a firm, which is a manifestation of suboptimal investment. These results are available on request.
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Acknowledgements
We thank Greg Shailer (the Section Editor) and two anonymous reviewers for helpful comments. Khieu would like to thank participants at the Prairie View A&M University College of Business research seminar for their insightful comments. All errors remain the sole responsibility of the authors.
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Appendix
Appendix
Variables definition
Variable names | Construction | Data source |
---|---|---|
Book leverage | The ratio of book value of short-term and long-term debts to book value of assets | Compustat |
Book-to-market ratio | The ratio of book value to market value of total assets | Compustat |
Political corruption | The yearly number of convictions per 100,000 residents of the judicial district in which the firm is headquartered | Hand collected |
Plant, property, and equipment (PP&E) | The net plant, property, and equipment scaled by total assets | Compustat |
Sales growth | The growth in annual sales over the prior year | Compustat |
Annual sales | The natural logarithm of the firm’s annual sales | Compustat |
Total risk | The standard deviation of 3-year rolling monthly imputed returns | CRSP |
Systematic risk | The square root of the explained variance of the regression of the imputed monthly returns on Fama–French (1993) three factors | CRSP |
Idiosyncratic risk | The square root of the unexplained variance of the regression of the imputed monthly returns on Fama–French three-factor model | CRSP |
CEO ownership | The ratio of CEO stock ownership to total common shares outstanding | Execucomp |
CEO delta | The dollar change in the CEO’s wealth for a 1% change in stock price | Execucomp |
CEO vega | The dollar change in the CEO’s wealth for a 0.01 change in standard deviation of stock returns | Execucomp |
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Khieu, H., Nguyen, N.H., Phan, H.V. et al. Political Corruption and Corporate Risk-Taking. J Bus Ethics 184, 93–113 (2023). https://doi.org/10.1007/s10551-022-05136-8
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DOI: https://doi.org/10.1007/s10551-022-05136-8
Keywords
- Political corruption
- Risk-taking
- Systematic risk
- Idiosyncratic risk
- Investment
- Capital structure
- Liquidity
- Operating leverage