An international analysis of CEO social capital and corporate risk‐taking

• Published date: 01 January 2019
• Author: Stephen P. Ferris,Tijana Rajkovic,David Javakhadze
• DOI: http://doi.org/10.1111/eufm.12156
• Date: 01 January 2019

DOI: 10.1111/eufm.12156

ORIGINAL ARTICLE

An international analysis of CEO social capital

and corporate risk-taking

Stephen P. Ferris

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David Javakhadze

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Tijana Rajkovic

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1

Department of Finance, University of

Missouri, 404 F Cornell Hall, Columbia,

MO 65211-2600, USA

Email: ferriss@missouri.edu

2

College of Business, Florida Atlantic

University, FL 33431-0991, USA

Email: djavakhadze@fau.edu

3

Lucas College of Business, San Jose State

University, San Jose, CA 95192-0066, USA

Email: tijana.rajkovic@sjsu.edu

Abstract

This study examines the effects of CEO social capital on

corporate risk-taking around the world. We document a

significant positive relation between CEO social capital and

aggregate corporate risk-taking. Further, we find that CEOs

with large social capital prefer riskier investment and

financial policies. We also determine that the effect of CEO

social capital on corporate risk-taking is moderated by the

extent of legal protections provided to shareholders, the

financial development, and the culture of the country in

which a firm is incorporated. Our results are robust to

alternative proxies of risk-taking, alternative model

specifications, and tests for endogeneity.

KEYWORDS

corporate risk-taking, social capital, social networks

JEL CLASSIFICATION

G30, Z13

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INTRODUCTION

Contemporaneous corporate finance emphasizes the importance of the CEO's personal characteristics,

attitudes, and preferences for explaining corporate risk-taking. Graham, Harvey, and Puri (2013) find

that behavioral traits such as optimism and managerial risk-aversion are related to corporate risk-taking

practices. Cain and McKeon (2016) show that a CEO's personality trait known as sensation seeking has

The authors would like to thank the two anonymous referees and John Doukas (the editor) for helpful comments and

suggestions.

Eur Financ Manag. 2019;25:3–37. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.

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important implications for the riskiness of firm policy choices. Hilary and Hui (2009) document that a

CEO's religion is related to corporate riskiness. Hutton, Jiang, and Kumar (2014) argue that the

personal political preferences of CEOs influence corporate behavior, and Hirshleifer, Low, and Teoh

(2012) find that overconfident CEOs increase their investments in risky projects. In this study, we

extend that line of inquiry by examining the effect of an important but previously unexamined factor,

the CEO's social capital, on corporate decisions about risk-taking.

Social capital, defined as the information, trust, and norms of reciprocity inherent in a social

network (Woolcock, 1998), has been widely examined in social science disciplines such as economics,

sociology, political science, and anthropology (e.g., Dasgupta, 2005; Fafchamps, 2002; Knack &

Keefer, 1997; Portes, 1998; Putnam, 1993; Schneider, 2006) but has received only limited attention in

academic finance.

Using a panel of firms from 45 countries, we ask whether the social capital of CEOs due to their

social networks influences firms’risk-taking practices. Because our study uses an international sample,

we also examine how network effects are altered by investor protection standards, financial

development, and characteristics of national culture. Our empirical findings reinforce a growing

awareness among finance researchers that managerial social capital matters for corporate decision-

making.

A number of studies document the ability of social networks to alter uncertainty and risk. Genicot

and Ray (2005) and Bloch, Genicot, and Ray (2008) show that social capital offers a mechanism of

informal insurance which can increase risk-taking.

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Brass and Burkhardt (1993) contend that

with increased ties and access, an individual's power within a social network is strengthened. The

approach-inhibition theory of Keltner, Gruenfeld, and Anderson (2003) argues that the experience of

power drivespeople to take more risks. From agencytheory, studies such as Amihud and Lev(1981) and

Hirshleifer and Thakor (1992) find that one of the major reasons for low managerial risk-taking is the

career concerns of executives. Granovetter (1973), Schneider (2006), and Zhou (1992) determine that

social capital in social networks is instrumental for access to jobs. Nguyen (2012) shows that socially

connected CEOs are more likelyto find new employment after departure. The consistency acrossthese

studies leads us to hypothesize that social capital has a positive effect on corporate risk-taking.

The marginal effect of CEO social capital on increasing corporate risk-taking should be stronger

when investor protection standards are weak and financial markets are underdeveloped. We contend

that in countries with poor investor protection standards and low financial development, dominant

insiders and non-equity stakeholders have incentives to be conservative in directing corporate

investments (Morck, Wolfenzon, & Yeung, 2005; Roe, 2003; Stulz, 2005). Strong investor protection

(financial development), however, reduces these incentives, leading the firm to a more appropriate

level of risk-taking. John, Litov, and Yeung (2008) explicitly document a significant positive

relationship between corporate risk-taking and investor protection. Acemoglu and Zilibotti (1997)

argue that as financial markets develop, risk avoidance decreases because risk-sharing is more readily

achievable.

In the absence of strong legal protections of investors and well-developed financial market

mechanisms, social capital matters more because investors in those countries cannot rely on the

legal system and market mechanisms alone to protect their interests. Thus, we argue that social capital

should have stronger effects on risk-taking when investor protection standards are weak and financial

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Based on Arnott and Stiglitz's (1991) informal insurance model, Mobarak and Rosenzweig (2013) show that informal

insurance through a social network structure leads to more agricultural risk-taking in rural India. Miller and Paulson (2007)

find that household gambling increases with the quality of informal insurance.

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markets are underdeveloped because in such an environment corporate risk-taking choices are less

optimal from the shareholders’perspective.

The nature of agency conflict and information asymmetry varies substantially across countries in

part because of the characteristics of national culture. A number of studies (e.g., Giannetti & Yafeh,

2012; Griffin, Guedhami, Kwok, Li, & Shao, 2014) document that national culture matters in corporate

decisions. From a corporate risk-taking perspective, Li, Griffin, Yue, and Zhao (2013) use cultural

values developed by Hofstede (1980, 2001) and Schwartz (1994, 2004) and document a positive

relation between national individualism and corporate risk-taking and negative relations between

national uncertainty avoidance and corporate risk-taking and national harmony and corporate risk-

taking.

If certain characteristics of national culture induce managers to take more risk, then shareholders’

effectiveness in countering managerial incentives for a ‘quiet life’(Bertrand & Mullainathan, 2003)

will depend on the cultural attributes. Consequently, if CEO social capital matters for firm-level

efficiency manifested in increased risk-taking, then it should exert stronger influence in countries

where national cultural attributes do not enhance managerial risk-taking incentives.

To test the effect of social capital on risk-taking, we use the BoardEx databases provided by

Management Diagnostics Limited (London, UK). This dataset contains relational links between

executives based on prior overlap in employment, education, and membership in non-profit

organizations. Recent studies such as Fracassi (2016) and Engelberg, Gao, and Parsons (2012) employ

this database to estimate corporate social connections. We use the BoardEx database to develop our

CEO social capital measure estimated as the number of individuals with whom the CEO shares a

common educational, employment, or social history.

We obtain a number of important findings. We discover that social capital does influence corporate

risk-taking, where risk-taking is variously measured as the annualized standard deviation of monthly

stock returns or as the standard deviation of the return on assets. Disentangling the mechanism, we

determine that CEO social capital alters the riskiness of specific corporate investment and financial

policy choices. Specifically, we find a positive association between CEO social capital and R&D

expenditures (and financial leverage), and a negative association between CEO social capital and asset

liquidity. We also observe that the effect of CEO social capital in increasing corporate risk-taking is

stronger in markets characterized by financial underdevelopment and to a lesser extent by the weak

legal protection of investors. Further, we show that attributes of national culture also moderate CEO

social capital effects.

This study contributes to the modern finance literature in several ways. First, our study adds to the

emerging literature on the effect of social networks on corporate decision-making. El-Khatib, Fogel,

and Jandik (2015) show that CEOs with higher network centrality measures engage in more and value-

destroying acquisitions. Engelberg et al. (2012) document that social connections between banks and

borrowers through managerial interpersonal linkages reduce borrowing costs. Cai, Walkling, and Yang

(2016) report a positive relation between a firm's social connections and trading costs. Cohen, Frazzini,

and Malloy (2008) find that social networks are an important mechanism for information flows that

shape asset prices in the mutual fund industry. Cai and Sevilir (2012) show that social connections

improve information flow between a target and an acquirer. Fracassi and Tate (2012) document that

well-connected CEOs pursue acquisitions that destroy value. Different from these studies, our research

question directly focuses on the effects of CEO social capital on the broad issue of corporate

risk-taking, including specific corporate policies.

Second, our research also contributes to the literature examining the effects of CEO social capital

on corporate policy choices around the world. We complement the findings of Javakhadze, Ferris, and

French (2016) which examine the effects of managerial social capital on the investment sensitivity of

FERRIS ET AL.

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