Saturday, 19 April 2014

COUNTRY TRUST, FIRM TRUST AND THEIR IMPACT ON FIRM FINANCIAL PERFORMANCE

There is a well established literature in economics (see e.g. the study by Stephen Knack and Philip Keefer) which shows that country level trust increases economic performance, as measured by GDP growth. These studies measure country trust by the percentage of respondents from the World Values Survey who agree that "most people can be trusted"; the alternative being that one "need[s] to be very careful when dealing with people". 

When it comes to what drives country trust, the literature is somewhat less consistent. Broadly speaking however, country trust is negatively affected by income inequality, ethno-linguistic diversity and the importance of hierarchical religions. Contradicting the "trickle-down" wealth effect, this literature finds that income inequality is bad for economic wealth, via the decrease in country trust which in turn hurts economic growth. Ethno-linguistic diversity is normally measured by the probability that two randomly selected persons from a country have different mother tongues. The idea here is that, if people within a country speak (lots of) different languages, they will find it difficult or impossible to communicate with each. The result would be mutual distrust. Hierarchical religions also seem to cause distrust. This goes back to a thesis developed by Robert Putnam, a Harvard University professor of political science. He argues that vertical associations, that is associations with hierarchical structures, engender distrust whereas horizontal associations, that is those whose members are all on a par, create trust. Some religions such as Catholicism are clearcut examples of hierarchical institutions.

However, existing studies on trust and economic performance have neglected the firm level. I conducted a study (click here for the pre-publication version) with colleagues where, in addition to country level trust, we look at the impact of firm level trust on firm financial performance. In order to measure firm level trust, we use survey data from the Cranfield Network (Cranet). We look at five different aspects of firm level trust, based on a total of 73 questions from the Cranet survey. These aspects include (i) staff communication, (ii) profit sharing, (iii) internal promotion, (iv) staff turnover, and (v) training. 

We study a total of 2,999 firm-level observations from 19 OECD countries. Apart from country trust and firm trust, we also look at the impact of a country's institutional setting on firm performance. In terms of the institutional setting, we focus on the degree of investor protection and the level of worker rights. 

Source: Goergen, M., Chahine, S., Brewster, C. and Wood, G. (2013), Trust, Owner Rights, Employee Rights and Firm Performance. Journal of Business Finance & Accounting, 40: 589–619. doi: 10.1111/jbfa.12033
What do we find? We confirm the positive effect of country trust on performance. However, firm level trust also matters and has a strong and consistently positive effect on firm performance. This suggests that firms operating in countries characterised by weak trust can overcome this institutional weakness by creating their own high-trust environment. In turn, this would improve their financial performance.

Similar to what I wrote in an earlier blog post, the main lesson here is that companies can and often should go beyond what regulation requires them to do. Within the above context, it is often easier and quicker to improve firm level trust than country level trust. Another important lesson is that corporate governance and investor protection should not be seen in isolation from the rights of important stakeholders, such as employees. Again, this suggests that corporate governance should not be reduced to compliance and "best" practice.