Can I Trust You with My Money? The Role of Social Trust in Corporate Cash Policy

Abstract

We examine how corporate cash policy is related to the level of social trust in a country, with trust defined as the subjective probability that an individual assigns to the event of a potential counter-party performing an action that is beneficial or at least not harmful to that individual. We explore two competing hypotheses. On the one hand, in a high-trust country, shareholders are less concerned about managers abusing corporate cash resource for personal gains and therefore allow firms to maintain larger cash holdings. On the other hand, the reduced concern about managerial moral hazard in high-trust countries increases investors’ willingness to provide capital to firms. The resultant greater accessibility of external finance weakens firms’ precautionary saving motive and leads to lower corporate cash reserve. Our analysis of a large sample of firm-year observations from 41 countries supports the first hypothesis. Specifically, corporate cash holding is significantly and positively related to a country’s level of social trust. In addition, consistent with a substitutive relation between subjective belief and formal rules and regulations, the impact of trust is more pronounced in countries with poorer investor protection and weaker legal enforcement. We also observe an elevated effect of trust following negative shocks to investors’ confidence in formal institutions created by high-profile corporate scandals. Finally, we find that the market value of corporate cash holding is significantly higher in high-trust countries. Overall, our results highlight the importance of social trust as an informal institution in influencing corporate cash policy.