Guilty by location: The cost of financial misconduct

When a country experiences civil unrest, foreign investors pull out. This is a scenario we are all too familiar with. But would this also hold true with financial misconduct? Would a region experiencing a wave of corporate financial misconduct taint its resident businesses, including those not involved in fraudulent undertakings, thus reducing financiers’ willingness to provide capital?

This concern might well be one of the reasons behind the Monetary Authority of Singapore’s (MAS’) initiative to set up two departments to combat money laundering and terrorism financing – to minimise the possibility of financial misconduct and contain any financial fallout thereafter.

As a small island state, Singapore cannot afford a wave of financial misconduct that may jeopardise its status as a safe, corruption-free global business hub and one of Asia’s leading financial centres.

That banks and other financial providers would be wary of financial misconduct is not new. When a firm’s financial statements are not viewed as credible, it is difficult to estimate its ability to repay loans, or, should it default, the value of its assets upon liquidation. This uncertainty increases its borrowing cost.

Lack of trust

In the same vein, a firm’s history of financial misconduct reflects poorly on the trustworthiness of its management. This lack of trust will entail additional costs to borrow, or, at the very worst, result in no financing altogether.

But what if a firm’s financial misconduct implicates other firms not involved in the scandal? In particular, could it be that nearby firms can have their financial standing ruined as they are deemed “guilty by association”, or, in this case, “guilty by location”?

Being located in a city that is viewed as corrupt – due to the actions of some, but not all, of its resident firms – affects a firm’s ability to raise capital, which in turn affects its ability to grow and survive.

My co-researchers and I explored this possibility. As Singapore has yet to experience such a situation, we needed to find other regions that are comparable in many facets and yet differ in their propensity of financial misconduct. This problem is compounded by the variations of regulations and enforcement institutions across countries.

As a result, we focused on cities in the United States such as Cleveland, Dallas, Denver, Indianapolis, Miami and Philadelphia. These cities are in relatively similar stages of economic development and are subject to much of the same financial regulations.

In particular, we are able to observe serious corporate frauds and financial misconduct within each city, which allows us to generate a city-level measure of per capita fraud of its resident firms. We observed that cities tend to experience waves of financial misconduct, with ebbs and flows.

We find that being located in a city that is viewed as corrupt – due to the actions of some, but not all, of its resident firms – affects a firm’s ability to raise capital, which in turn affects its ability to grow and survive.

Following increases in corporate misconduct occurrences in a city, credit market conditions tighten for resident firms. Spreads are 15 to 20 basis points higher and loan covenants become stricter. And these are the relatively lucky ones as other firms find it difficult to raise any financing.

In general, we find that firms in these cities raise less debt as a percentage of assets and less external capital. These effects are amplified for firms that have low or no credit ratings.

Beyond such financing consequences on the resident firms, regional financial misconduct also weighs heavily on investment and employment. This is especially the case for financially-strapped firms in declining industries. They tend to raise less capital and exhibit declines in investment and employment relative to otherwise similar firms in cities with less financial misconduct.

Failure rate

We also notice that in the three years following a spike in regional misconduct, firms are more likely to go bankrupt. Indeed, cities with higher average rates of financial misconduct tend to have higher average rates of corporate failure.

Taken together, our findings indicate that because a firm’s location can affect how it is perceived by lenders and other sources of financing, its location can have a profound effect on its real decisions and ultimately its survival.

That trust and reputation play a key role for firms raising external capital cannot be over-emphasised. When a city has a clean reputation with little corporate financial misconduct, this reputation rubs off on its resident firms. The trust built over time can reduce deadweight costs, such as writing more complete contracts, and allow resources to be directed to more productive activities.

In Asia, where the notion of guanxi or networking is part of the culture, some businesses operate on gentlemen’s agreement with only a handshake. When a city is mired in corporate corruption, writing more complete contracts not only takes time but can also be somewhat of a cultural sting.

MAS’ establishment of the two departments to undertake enforcement actions against regulation breaches in the banking, insurance and capital markets, as well as to oversee policy and supervision responsibilities related to illicit financial activities, is a step in the right direction.

This initiative lessens the likelihood of such waves of corporate financial misconduct and promotes Singapore as a safe global business centre.

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