Foreign institutional ownership and corporate risk‐taking: International evidence

• Published date: 01 March 2023
• Author: Garland Huang,Zhe An,Donghui Li
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/corg.12456

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Foreign institutional ownership and corporate risk-taking:

International evidence

Garland Huang

1

| Zhe An

2

| Donghui Li

1

1

College of Economics, Shenzhen University,

Shenzhen, China

2

Monash Business School, Monash University,

Melbourne, Australia

Correspondence

Donghui Li, College of Economics, Shenzhen

University, Shenzhen 518060, China.

Email: lidonghui2019@hotmail.com

Funding information

National Natural Science Foundation of China,

Grant/Award Number: 71873058

Abstract

Research Question/Issue: This study aims to investigate the role of foreign

institutional investors (FIIs) on corporate risk-taking in an international context.

We conjecture that FIIs play a role in encouraging firms to take risks and can

substitute country-level corporate governance in determining corporate

risk-taking.

Research Findings/Insights: Employing a large sample of 17,698 firms across

42 economies, we show that foreign institutional ownership positively influences

corporate risk-taking. This positive relation is achieved through the monitoring channel

and the insurance channel. Furthermore, we show that FIIs substitute country-level

corporate governance in determining corporate risk-taking, indicating that FIIs play a

significant role in promoting risk-taking in economies with weaker governance. In

addition, debtholders view FIIs' risk-promoting role negatively and use more restric-

tive covenants to protect themselves.

Theoretical/Academic Implications: This study provides empirical support for the

role of FIIs on corporate investment decisions, thus complementing the existing liter-

ature. In addition, our paper documents that country-level corporate governance and

FIIs are substitutes in determining corporate risk-taking, thus shedding additional

light not only on the role of country-level corporate governance but also on its con-

troversial joint role with FIIs.

Practitioner/Policy Implications: FIIs from economies with stronger corporate gover-

nance are particularly effective at promoting corporate risk-taking in economies with

weaker corporate governance, providing a new channel through which foreign

investments can influence economic growth in developing economies. Therefore,

policymakers should carefully consider and trade off the costs and benefits of foreign

investment when proposing relevant policies.

KEYWORDS

corporate governance, foreign institutional ownership, corporate risk-taking

1|INTRODUCTION

Corporate risk-taking is fundamental to firms' performance and

growth (John et al., 2008). Shareholders incline firms to take risks as

they can alleviate their exposures to firm-specific risk through

diversified portfolio allocation. However, managers are reluctant to

take risks due to career concerns (Amihud & Lev, 1981;

Hirshleifer & Thakor, 1992; Holmstrom & Ricart I Costa, 1986),

creating conflicts of interest between shareholders and managers

regarding corporate risk-taking. In addition, debtholders are likely

Received: 3 March 2021 Revised: 21 March 2022 Accepted: 25 April 2022

DOI: 10.1111/corg.12456

260 © 2022 John Wiley & Sons Ltd. Corp Govern Int Rev. 2023;31:260–284.wileyonlinelibrary.com/journal/corg

against risk-taking as they are entitled only to fixed claims. There-

fore, motivating firms to take risks and alleviating risk-related

agency issues is inherently important from shareholders' perspective.

The prior literature focuses on motivating managers through

managerial ownership and compensation (Coles et al., 2006; Denis

et al., 1997; Low, 2009). Recent studies study how shareholders

promote corporate risk-taking through increased ownership and

portfolio diversification (Faccio et al., 2011; Paligorova, 2010).

However, there is little evidence on whether shareholders' identity

influences firms' risk-taking decisions. This paper attempts to fill this

gap by examining the role of foreign institutional investors (FIIs),

who typically have internationally diversified portfolios and thus

stronger incentives to promote corporate risk-taking.

An ever-growing flow of foreign capital provides evidence that

FIIs play an increasingly important role in the world economy. As

illustrated in Graph A of Figure 1, foreign investment (ownership) by

institutions extracted from the FactSet database has grown from

1.89 trillion (2.58%) in 2000 to 7.55 trillion USD (5.19%) in 2007.

Although a dip occurred during the Global Financial Crisis (GFC) in

2008, it had almost entirely rebounded to pre-GFC levels by 2011.

Graph B of Figure 1shows that the Top 8 countries with the highest

foreign institutional investment exhibit the same pattern. Moreover,

this trend is set to continue as governments worldwide continually

relax policies to attract foreign investment as an avenue to fuel

economic growth, which makes understanding the role of FIIs

increasingly important.

1

How can FIIs promote corporate risk-taking? First, managers

can divert corporate resources into private benefits and thus tend

to avoid risky investments, which lessen the firms' available

resources for them to divert and increase the probability of being

detected (John et al., 2008). To maximize the private benefits that

managers can draw from the firm and minimize penalization, they

become increasingly conservative regarding risk-taking. Unlike

domestic institutional investors (DIIs), FIIs are more likely to

intervene in firms since there are fewer potential conflicts of

interest due to existing business relationships that interfere with

their roles as effective monitors (Ferreira & Matos, 2008; Gillan &

Starks, 2003). This fact allows FIIs to be less tolerant of managerial

behavior that hurts shareholders' interests, making FIIs effective

monitors using their “voice”and “threat of exit”as disciplinary

mechanisms (Ahmadjian & Robbins, 2005). In the same vein,

Aggarwal et al. (2011) show that FIIs take a more independent and

active stance in corporate governance than DIIs and play a crucial

role in exporting good corporate governance practices to investee

firms worldwide.

2

Improved corporate governance constrains the

amount of corporate resources managers can divert, while enhanced

monitoring restrains managers' incentives to avoid risky projects

(Shleifer & Wolfenzon, 2002). Therefore, we expect that monitoring

by FIIs can reduce managers' incentives to avoid riskier projects.

That is, FIIs promote corporate risk-taking through the monitoring

channel.

Second, FIIs can also promote corporate risk-taking by providing

insurance to managers from failures associated with taking risks.

Specifically, risk-averse managers are dissuaded from risky invest-

ments, leading to short-term underperformance (Kaplan &

Mitton, 2012; Porter, 1992). It has been shown that standard pay-

for-performance schemes are ineffective in motivating corporate

risk-taking because the threat of failure outweighs the potential

financial gains for managers (Ederer & Manso, 2013; Manso, 2011).

Thus, incentive schemes that support risk-taking should exhibit a

certain level of tolerance for failure, implying that compensation

should be less sensitive to performance (Holmstrom, 1989). When

standard incentive schemes cannot mitigate the risk-related agency

issue, institutional investors could step in to encourage firms to take

risks by providing managers with insurance against the downsides

FIGURE 1 The growth of foreign institutional investment. Graph

A: Foreigninstitutional investmentand foreign institutionalownership;

Graph B: Top 8 countries with the highest foreign institutional investment.

Graph A illustrates the growth of aggregate foreign institutional

investment (in trillion USD) and the average foreign institutional ownership

(FIO in percentage) for all sampled firms across 42 economies from 2000

to 2011. Graph B illustrates the growth of aggregate foreign institutional

investment (in trillion USD) for firms in the Top 8 countries with the

highest foreign institutional investment [Colour figure can be viewed at

wileyonlinelibrary.com]

HUANG ET AL.261