The Hidden Hand of Trust

Firms that operate in countries with weak shareholder protection and low societal trust have more depleted cash holdings
Piggy Bank in Prison

The essentials

  • Firms located in countries with less trusting societies accumulate less cash than firms in more trusting societies. That’s because spooked shareholders put pressure on management to pay out dividends or repurchase shares on a regular basis.
  • Societal trust matters a lot more when companies have not established private trust between managers and investors.
  • The effect of societal trust on corporate cash holdings is lower in firms that have raised a significant amount of capital from equity or debt markets in the past, as well as in firms that are followed by one or more analysts.

For all that is written about corporate financial management, a key element that shapes finance decisions is hidden in plain view: trust.

Evan Dudley brings it down to the personal. “If your family member comes and asks you for a personal loan, there’s a huge element of trust. It’s the same thing for corporations. They’re asking for money from banks and capital markets.”

Dudley, assistant professor of finance at Smith School of Business, says that when firms operate in countries where institutions that protect shareholders are weak, such as Peru or the Philippines, “that’s going to matter a lot more” with respect to corporate cash holdings than in a country such as Switzerland where investor confidence is high.

Surprisingly, the relationship between trust and corporate cash holdings has been underexplored. “Other studies hadn’t focused on trust,” says Dudley. “The idea of trust has been overlooked and it seems to us a much more important one.”

Cash Accumulation

Dudley and Smith colleague Ning Zhang set out to fill in the blanks. They designed a study that looked at governance and corporate finance decisions in 54 countries. Data relating to levels of trust came from the World Values Survey, which uses individuals’ survey responses to measure the level of trustworthiness in a country.

The researchers discovered that firms located in countries with more trusting societies accumulate more cash than firms in less trusting societies. The reason why, Dudley says, is that shareholders in less trusting societies are concerned that cash flows may be used for projects that benefit insiders at the expense of outside shareholders. Shareholders respond by putting pressure on management to pay out dividends or repurchase shares on a regular basis.

Societal trust is an economically significant determinant of corporate financial policy

The researchers also looked at the impact of private trust versus societal trust. They found that societal trust matters a lot more when companies have not established private trust between managers and investors. “Firms with managers that are viewed as less trustworthy, or whose potential investors are distrustful, may have difficulty raising external capital and may also find it costlier to access capital markets,” they point out in a paper to be published in the Journal of Corporate Finance.

Conversely, if a firm had recently raised capital from the markets, “then maybe they’ve established some kind of private trust with their investors,” says Dudley.  “In those cases, we’d expect the societal trust to not matter at all.”

Dudley and Zhang also found that the effect of societal trust on corporate cash holdings is lower in firms that have raised a significant amount of capital from equity or debt markets in the past, as well as in firms that are followed by one or more analysts.

Trust Assessment

The message here is that firms with offices in countries with low levels of societal trust must take steps to protect themselves. “If I’m in a low-trust society, I have to go out there and communicate with my shareholders and be honest and establish private trust,” Dudley says.

He also suggests firms in these countries who want to access more capital may want to look for capital outside the low-trust country.

As for who is most at risk, smaller, lesser-known firms are more vulnerable than firms with an established track record. Those are firms with fewer interactions with players in capital markets, so they need to work on establishing high levels of private trust, says Dudley.

The payoff can certainly be significant. “When a company has a long history of positive interactions with investors,” he says, “societal trust is much less important.”

Dudley suggests that firms seeking to relocate abroad should conduct a “trust” risk assessment to determine the type of financial climate that exists and to explore how their operations will mesh with that culture.

“Societal trust is an economically significant determinant of corporate financial policy,” the researchers point out in their paper. “This finding is important because the firm’s managers (or insiders in a closely held family firm) do not exist in a vacuum. Both their decisions and their ability to analyze their firm’s prospects are the product of the society and cultural norms managers belong to.”

Anna Sharratt

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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