Managerial Social Capital and Financial Development: A Cross‐Country Analysis

• Date: 01 February 2016
• Published date: 01 February 2016
• DOI: http://doi.org/10.1111/fire.12097

The Financial Review 51 (2016) 37–68

Managerial Social Capital and Financial

Development: A Cross-Country Analysis

David Javakhadze

Florida Atlantic University

Stephen P. Ferris∗

University of Missouri

Dan W. French

University of Missouri

Abstract

This study examines the issue of whether managerial social capital, defined as aggregate

benefits of social obligations and informal contacts formed through social networks, has an

impact on financial development. Utilizing a large cross-country sample for the period 1999–

2012, we provide evidence that higher levelsof social capital have a positive effect on financial

development. We are able to examine different types of social connections for our sample

firms and find that informal and nonprofessional relationships matter the most for financial

market development. These findings are robust to alternative model specifications, variable

measurement, and estimation techniques.

Keywords: s ocialcapital, social networks, financial development

JEL Classifications: F19, G29, Z13

∗Corresponding author: University of Missouri, Robert J. Trulaske,Sr. College of Business, 407 Cornell

Hall, Columbia, MO 65211; Phone: (573) 882-6688; E-mail: ferriss@missouri.edu.

The authors acknowledge assistance from Chris Try and Joseph Guagenti of BoardEx and Lada Micheas

from the University of Missouri Social Science Statistics Center. We also appreciate helpful comments

from Mary Lynn Davidek.

C2016 The Eastern Finance Association 37

38 D. Javakhadze et al./The Financial Review 51 (2016) 37–68

1. Introduction

A considerable body of modern finance and economics literature documents

a strong positive relation between the level of financial development, defined as

the ease with which any entrepreneur or company with a sound project can obtain

financing (Rajan and Zingales, 2003), and economic growth in countries around the

world (Demirg¨

uc-Kunt and Maksimovic, 1998; Levine and Zevros, 1998; Levine,

2003; Demetriades and Andrianova, 2004; Bekaert, Campbell and Lundblad, 2005).

Because the factors that determine financial development are not fully understood,

examining these factors has become an increasingly important research topic in recent

years.1

Both theory and some exploratory survey evidence suggest that social capital,

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

(Woolcock, 1998), could be an important determinant of financial development.

Empirical investigation of a link between social capital and financial developmentto

date, however, has been limited. This is surprising in light of our existing theoretical

and empirical knowledge regarding the determinants of financial development. The

purpose of this study is to address that omission by investigating the implications

of social capital for financial market development. Particularly, we ask the question:

does the social capital in managerial social networks with financiers affect national

financial development?

Social capital is emerging as one of the most prominent topics in modern social

science research. It can encourage certain socioeconomic effects that have the po-

tential to facilitate national economic development. At the same time, improvements

in social capital have been associated with democratic participation and the support

of democracy. Powerful agents such as the World Bank and various national gov-

ernments have embraced social capital as a strategy to mitigate market shortcomings

and minimize reliance on costly state interventions to promote financial development

(e.g., Dasgupta and Serageldin, 2000; Woolcock and Narayan, 2000; Grootaert and

Van Bastelaer, 2002; Bebbington, Guggenheim, Olson and Woolcock, 2004).

Social capital alleviates potential impediments to financial developmentthrough

its effects on trust, information-sharing, and contract enforcement. Baier (1986, pp.

234–235) defines trust “as the trustor’s expectation of being the recipient of the

trusted party’s good will.” Trust is important because, as La Porta, Lopez-de-Silanes,

Shleifer and Vishny (1997) argue, public and private institutions, including financial

markets, are less effective in countries exhibiting lowlevels of trust. Guiso, Sapienza

and Zingales (2004) posit that financial exchange depends not only on the legal

enforceability of contracts, but also on the extent to which both parties of a financial

contract trust each other. Guiso, Sapienza and Zingales (2008) show that a lack of

1Existing studies discuss a large number of exogenous and endogenous factorsthat could explain financial

development: legal tradition, institutions, macroeconomic policies, openness, political economy factors,

geography, and culture (for an extensivereview, see Huang, 2010).

D. Javakhadze et al./The Financial Review 51 (2016) 37–68 39

trust reduces the demand for equity, and therefore, firms findit more difficult to raise

equity capital in a low-trust environment. They find that trust has a positive effect

on stock market participation and conclude that differences in trust help to explain

cross-country differences in financial development.

Social capital induces efficiency within the social structure because it provides

a means of creating trust (Dasgupta, 1988). Further, social capital can trigger agents

to adopt more altruistic preferences that are a major source of trust (Camerer, 2003;

Fehr and Schmidt, 2003). Since social capital fosters trust, it has the potential for

being a positive influence on financial market development.

A number of authors link information-sharing to financial development. Infor-

mational transparency promotes capital market development because investors in a

transparent environment are more confident in their security valuation and there-

fore have a greater willingness to invest. Pagano (1993) argues that the existence

of transparency increases investor confidence and has a large positive impact on the

development of financial markets. Japelli and Pagano (1999) find that the breadth

of credit markets is directly related to the characteristics of the information-sharing

mechanisms that reduce information asymmetry. Mayer and Sussman (2001) de-

scribe how stricter regulations on information disclosure and accounting standards

affect financial development. Benston (1973), Fischel and Grossman (1984), and

Miller (1991) show that private stock exchanges reduce information asymmetry by

mandating optimal disclosure and monitoring compliance of listed firms, thus en-

couraging securities market development. La Porta, Lopez-De-Silanes and Shleifer

(2006) document that laws mandating disclosure benefit stock market development.

Social capital facilitates the sharing of information and reduces information

asymmetry within a network (e.g., Hong, Kubik and Stein, 2004; Kuhnen, 2009).

In addition, information sharing can promote efficiency by reducing costly search

for information (e.g., Granovetter, 1973; Shiller and Pound, 1989; Montgomery,

1991; Barr, 2000; Rauch and Casella, 2001). Because the reduction in information

asymmetry between the firm and its investors increases investor confidence while

promoting financial development, we propose that social capital encourages financial

development.

The effective enforcement of contracts is essential for financial market devel-

opment. La Porta, Lopez-De-Silanes and Shleifer (2006) show that legal regulations

facilitate private enforcement and foster financial development. Other studies such

as Coffee (2007), Roe and Siegel (2009), Jackson and Roe (2009) and Daines and

Jones (2012) demonstrate that active law enforcement in the corporate and securities

area promotes stock market development. La Porta, Lopez-de-Silanes, Shleifer and

Vishny(1997, 1998) show that legal traditions influence the degree of investor protec-

tions and the efficiency of contract enforcement, thereby affecting the development

of financial systems. Pistor, Raiser and Gelfer (2000) highlight that both the quality

of the legal system and the effectivenessof contract enforcement are crucial for finan-

cial development. Barth, Caprio and Levine (2003) find that the private monitoring

of contract compliance is positively correlated with the size of the banking sector.