Political institutions and corporate risk‐taking: International evidence

• Published date: 01 December 2023
• Author: Helen X. H. Bao,Rohan Cardoza
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/irfi.12423

ORIGINAL ARTICLE

Political institutions and corporate risk-taking:

International evidence

Helen X. H. Bao | Rohan Cardoza

Department of Land Economy, University of

Cambridge, Cambridge, UK

Correspondence

Helen X. H. Bao, Department of Land

Economy, University of Cambridge, CB39EP

Cambridge, UK.

Email: hxb20@cam.ac.uk

Funding information

Cambridge University Land Society; Economic

and Social Research Council, Grant/Award

Number: ES/P004296/1; National Natural

Science Foundation of China, Grant/Award

Number: 71661137009

Abstract

Tapping into firm-level accounting data across 90 countries

over a 26-year period, we find that sound political institu-

tions are positively associated with corporate risk-taking.

This result is economically significant, robust to alternative

proxies for corporate risk-taking and political institutions,

and continues to hold after mitigating endogeneity con-

cerns of political institutions. We also collect evidence that

sound political institutions may compensate for weak legal

institutions in inducing corporate risk-taking. We argue that

sound political institutions improve the investment environ-

ment for firms and can induce higher levels of corporate

risk-taking, which is ultimately associated with economic

growth.

KEYWORDS

behavioral theory of the firm, firm size, legal institution,

managerial risk-taking, profitability

JEL CLASSIFICATION

G31, G32, G34

1|INTRODUCTION

Corporate risk-taking is critical to the study of management (Wright et al., 1996). It has implications for firms' perfor-

mance, growth, and their ability to compete and hence firms' survival (Bromiley, 1991). Moreover, at the national

level, John et al. (2008) show that corporate risk-taking is positively associated with both economic growth and total

Received: 10 August 2021 Revised: 28 March 2023 Accepted: 25 June 2023

DOI: 10.1111/irfi.12423

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2023 The Authors. International Review of Finance published by John Wiley & Sons Australia, Ltd on behalf of International Review

of Finance Ltd.

International Review of Finance. 2023;23:777–793. wileyonlinelibrary.com/journal/irfi 777

factor productivity growth; and Acemoglu and Zilibotti (1997) show that corporate risk-aversion slows down the

capital accumulation process, thus impeding economic development. The study of corporate risk-taking is therefore

both of interest at the firm-level and country-level.

Whereas an extensive theoretical literature exists on how factors internal to the firmimpact corporate risk-taking

(Bromiley et al., 2005),there is also a growing literature on the impact of environmental factors, which areexternal to

the firm and outsidethe control of managers (Boubakriet al., 2013;Tran,2019; Vural-Yavas, 2021). Amongthese envi-

ronmental factors are political institutions, which define the political environment and constrain managerial decision-

making. In an international setting, where managers face starkly different politicalenvironments, it is of both academic

interest and practical significanceto understand how corporateinvestment behavior may be shapedby the quality of a

country's political institutions. Within the context of a growing consensus that formal institutions matter in shaping

incentives and hence economic outcomes (Glaeser et al., 2004), this study asks whetherthe quality of political institu-

tions (i.e., the effectiveness of checks and balances on political action) influences corporaterisk-taking. In doing so, we

add to the growingliterature on the determinants of corporaterisk-taking.

This paper draws upon a panel dataset for 47,613 firms in 90 countries over 26 years by match-merging multiple

databases. We conduct a panel regression to determine the extent to which variation in corporate risk-taking may

be explained by the quality of prevailing political institutions. We make several contributions to the existing litera-

ture. First, our study is the largest investigation of corporate risk-taking to date, with a sample period spanning from

1993 to 2019. This long sample period enables us to analyze a period of significant political change across the world.

Second, whereas most of the empirical work in the corporate risk-taking literature uses data from a single country,

our study is one of only a few to expand the scope of empirical analysis internationally. Finally, we extend the litera-

ture by finding that sound political institutions may compensate for weak legal institutions in inducing corporate

risk-taking; and smaller firms' risk-taking is more sensitive to changes in political constraints than larger (possibly

politically connected) firms.

The remainder of this paper is organized as follows. Section 1provides a review of the theoretical and empirical

risk-taking literature. Section 2discusses the theoretical mechanisms which underpin our hypothesis. Section 3pre-

sents the data used and justifies our measures of corporate risk-taking and political institutions. We then present the

empirical estimation framework and comment on the obtained results in Section 4. Finally, we draw concluding

remarks in Section 5.

2|RELATED LITERATURE

Our research sits at the intersection of various interesting bodies of research within management and corporate

finance. This section provides background context on the different strands of research we have drawn from.

2.1 |Definition and measurements of corporate risk-taking

Scholars refer to “risk-taking”by conceptualizing strategic decision-making as choosing between different risky

choices (March & Shapira, 1987). Managerial risk-taking, defined as management's strategic choices between uncer-

tain outcomes, is distinguished from organizational risk, which refers to the subsequent uncertainty of a firm's future

earnings stream. Put simply, however, managerial risk-taking ultimately determines organizational risk (Hoskisson

et al., 2017). Baird and Thomas (1985) and March and Shapira (1987) find that managers' understanding of risk gen-

erally conflicts with Knight's (1921) definition. Knight distinguishes risk from uncertainty. Whereas risk exists when

the probability distribution of outcomes is known, uncertainty exists when the probability distribution of outcomes

is unknown. Most strategic decisions involve uncertainty since few strategic business decisions have clear alterna-

tives with known payoff probabilities.

778 BAO and CARDOZA