Journal of Corporate Finance 41 (2016) 363–387

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Journal of Corporate Finance

journal homepage: www.elsevier.com/locate/jcorpfin

Trust and corporate cash holdings

Evan Dudley a,⁎, Ning Zhang b
a
Smith School of Business, Queen's University, Goodes Hall, K7L 3N6 Kingston, Ontario, Canada
b
Smith School of Business, Queen's University, Kingston, Ontario, Canada

a r t i c l e i n f o a b s t r a c t

Article history: We examine the relation between the level of trust in a country and corporate cash holdings.
Received 8 March 2016 The precautionary savings motive predicts that firms located in countries with less trusting so-
Received in revised form 13 October 2016 cieties will hoard more cash in order to compensate for reduced access to capital markets. The
Accepted 15 October 2016
agency hypothesis predicts that shareholders in countries with low levels of societal trust will
Available online 17 October 2016
pressure firms to disgorge cash. The first theory predicts a negative relation between trust and
corporate cash holdings while the second theory predicts a positive relation between these two
variables. Using data on firms located in 54 countries around the world, we find evidence in
Keywords: favor of the agency-based explanation for the relation between trust and corporate cash hold-
Societal trust ings. Overall, our results highlight the role played by informal institutions in shaping corporate
Cash holdings financial management.
Corporate governance
© 2016 Elsevier B.V. All rights reserved.
Financial management
Marginal value of cash
Informal institutions

1. Introduction

The notion of trust is central to financial relations between counterparties. Trust is defined by Gambetta (2000), “as meaning
that the probability that someone will perform an action that is beneficial is high enough for us to consider engaging in some
form of cooperation with him”. Using empirical measures of trust, researchers have demonstrated that trust plays an important
role in economic development (Fukuyama, 1995), bilateral trade (Guiso et al., 2009), financial development (Guiso et al.,
2004), peer-to-peer lending (Duarte et al., 2012), venture-capital activity (Bottazzi et al., 2012) and cross-border acquisition ac-
tivity (Ahern et al., 2015). However, the role of trust in corporate finance's most basic activity, capital raising, is unexplored.
This is surprising in light of the fact that “virtually every commercial transaction has within itself an element of trust, certainly
any transaction conducted over a period of time” (Arrow, 1972).
Part of the reason for the poor showing of trust in corporate finance is that repeated interactions between two parties can
overcome lack of trust or distrust. Specifically, when describing the relation between a principal and an agent, two different
types of trust are relevant. The first notion is personal trust, which is a set of beliefs about a specific person. This notion involves
repeated interactions between two individuals. For example, this version of trust describes the relation between a customer and a
supplier or long-term investors and management. This type of trust evolves over time and is empirically difficult to measure. The
second notion of trust, societal trust, is easier to measure, but has a less obvious relation with capital-raising activities of the firm.
Societal trust refers to a set of beliefs about the behavior of a group of individuals. This notion of trust is rooted in deep-seated
beliefs about others and it involves a person's cultural and religious backgrounds. Trust, defined in this manner, is also referred
to as “social capital” and is correlated with economic success (Fukuyama, 1995) and firm size (La Porta et al., 1997).

⁎ Corresponding author.
E-mail addresses: evan.dudley@queensu.ca (E. Dudley), ning.zhang@queensu.ca (N. Zhang).

http://dx.doi.org/10.1016/j.jcorpfin.2016.10.010
0929-1199/© 2016 Elsevier B.V. All rights reserved.
364 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

In this article, we examine the effect of societal trust on a particular dimension of corporate financial policy, the firm's cash
holdings. We argue that societal trust is empirically relevant in describing the relation between a firm's insiders and its share-
holders and their attitudes towards corporate cash holdings. Corporate finance theory offers two possible reasons for why this no-
tion of trust may affect a firm's cash policy. The first reason involves the firm's desire for precautionary savings. Firms with
managers whom shareholders view as less trustworthy, or whose potential investors are distrustful, may have difficulty raising
external capital, and may find it costlier to access capital markets. Financial constraints of this type lead to deadweight losses
through inefficient liquidation when a firm's insiders don't have enough capital to pledge for positive net-present-value invest-
ment projects (Holmstrom and Tirole, 1998). We therefore expect societal trust to have a negative effect on corporate cash hold-
ings according to this hypothesis.
The second reason trust may matter for a firm's cash holdings is related to corporate insiders' propensity to divert resources
away from outside investors. In this case, shareholders are concerned that managers use the firm's internal resources on projects
that benefit insiders at the expense of outside shareholders. In order to mitigate such incentives, outside shareholders may choose
to put pressure on management to disgorge cash by paying dividends or by repurchasing shares on a regular basis. By depriving
the firm from using this cash to finance its investments, this pressure also forces the firm to access capital markets whenever it
requires funds, and it gives outsiders an opportunity to exercise control at that time by withholding capital (Jensen, 1986). Con-
sequently, firms with insiders who are perceived to be untrustworthy may face more pressure to disgorge cash, while firms with
managers perceived to be trustworthy can accumulate greater cash reserves. We therefore expect societal trust to have a positive
relation with corporate cash holdings according to this hypothesis.
We examine the two competing hypotheses using a large sample of firms across 54 countries between 1992 and 2012. Follow-
ing prior studies such as La Porta et al. (1997) and Guiso et al. (2008), we measure trust on a country-level basis based on each
country's citizens' average response to the following question in the World Values Survey (WVS): “Generally speaking, would you
say that most people can be trusted or that you need to be very careful in dealing with people?” We show that societal trust pos-
itively affects corporate cash holdings.1 Specifically, firms in countries with higher levels of trust hold more cash, which is consis-
tent with the hypothesis that agency concerns lead shareholders to force insiders to disgorge cash in low-trust countries. We also
find that the effect of trust on cash holdings is stronger when country-level measures of governance and shareholder rights are
weak. Our findings are robust to controlling for economic output, cultural indices as well as firm-level characteristics, country,
year and industry fixed effects.
We provide additional support for our main argument by documenting the effect of societal trust on payout policy. Share-
holders in low-trust countries pressure the firm's managers to distribute cash through dividends that commit the firm to higher
total payouts in the long term. Specifically, firms operating in low-trust countries pay a greater proportion of their excess cash in
the form of dividends, where excess cash equals the amount of cash net of the predicted amount necessary to meet the firm's
demand for investments and operations. Overall, firms in low-trust countries pay a greater proportion of excess cash in total pay-
out (dividends plus share repurchases) than do firms in high-trust countries.
We also examine whether the effect of societal trust is greater when the level of private trust in the firm's management and
insiders is low. Intuitively, the development of private trust about the firm's insiders may, over time, crowd out the effect of so-
cietal trust on outside shareholders' beliefs about corporate insiders' behavior. We measure the degree of private trust between
insiders and outsiders with the firm's history of interactions with outside investors and with the number of analysts who follow
the firm. Both of these measures affect how trust relates to corporate cash holdings. Specifically, the effect of trust on corporate
cash holdings is lower in firms that have raised a significant amount of capital from the equity or debt markets in the past. More-
over, the effect of societal trust on cash holdings is lower in firms with more analyst following. Our results suggest that societal
trust substitutes for private trust and/or information about management in firms that have high degrees of information asymme-
try, and with whom outsider investors interact infrequently. Our results are robust to using alternative proxies such as firm size
and financial reporting quality to measure information asymmetry.
Our final set of tests examines how investors perceive societal trust. We measure the value of societal trust with the marginal
value of cash to the firm's shareholders. According to the agency hypothesis, the value of an extra dollar of cash should be more
valuable for firms located in high-trust countries. To determine the value effects of trust on cash resources, we follow Faulkender
and Wang (2006) and measure the marginal value of cash holdings. Based on these regressions, we find that moving from a low-
trust country to a high-trust country increases the marginal value of cash. Overall, our results support the agency hypothesis
whereby shareholders allow the firm to hold more cash when shareholders view managers as more trustworthy.
Our paper builds on an existing strand of literature that focuses on the role played by formal and informal institutions on cor-
porate policy. Early studies of corporate liquidity policy focus on preserving financial flexibility (Opler et al., 1999; Whited and
Riddick, 2009, Acharya et al., 2007), and on agency problems between insiders and outsiders (Nikolov and Whited, 2014,
Harford, 2002, Harford et al., 2008). However, formal institutions also play a significant role in governing firms' financial manage-
ment (Pinkowitz et al., 2006). More recently, focus has shifted to the role played by informal institutions such as societal trust and
culture on corporate financial policies. Specifically, Li et al. (2013) find that cultural characteristics related to the level of individ-
ualism and uncertainty avoidance impact corporate risk-taking. Chen et al. (2015) extend this analysis to corporate cash holdings
and find that both of these variables affect corporate cash holdings around the world. In a contemporaneous paper to ours, Xie

1
A recent stream of literature investigates whether this survey question measures trust as it is understood in Gambetta (2000). Sapienza et al. (2013) provide em-
pirical evidence that the response to this question is related to participants' beliefs about others' behavior rather than their personal preferences such as risk aversion
and altruism.
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 365

and Xin (2015) examine the role of trust in corporate policy, and they document a positive relation between societal trust and
corporate cash reserves. Our paper differs from theirs in several ways. First, our study incorporates both countries in the World
Values Survey as well as in the European Values Study. As such, our results make conclusions on how social trust works around
the world that are more generalizable. Second, we distinguish and highlight the difference between private and societal trust.
Third, we further identify the economic channels by examining the effect of trust on corporate payout policy.
Overall, we contribute to the finance literature by showing that societal trust is an economically significant determinant of cor-
porate financial policy. This finding is important because the firm's managers (or insiders in a closely held family firm) do not
exist in a vacuum. Both their decisions and their ability to analyze their firm's prospects are the product of the society and cultural
norms to which they belong. Moreover, informal institutions shape the formal institutions that regulate and enforce the way eco-
nomic agents interact with one another in society.2 In a recent commentary, Hirshleifer (2015) calls for more studies to look at
how social norms and moral attitudes affect financial behavior and decisions. Our study echoes his inquiry by showing that soci-
etal capital affects corporate financial policy.
We proceed as follows. Section 2 develops the hypotheses and describes how societal trust relates to a country's social insti-
tutions, Section 3 describes the data, Section 4 presents our main results, Section 5 performs robustness tests and Section 6
concludes.

2. Background and hypotheses development

The notion of trust has many interpretations. The one we employ is the notion of “calculative” and “institutional trust” de-
scribed in Williamson (1993). This notion of trust involves the calculation of individuals based on their subjective beliefs about
the gambles that they face, and these beliefs take into account societal culture, regulation and professionalization. Carlin et al.
(2009) develop a theoretical framework in which this type of trust is present in a population of agents, and in which principals
infer the level of trust based on the performance of their investments. Our treatment of trust follows their analysis in the follow-
ing respects. First, trust is a function of a country's legal institutions that make sure agents honor their fiduciary obligations. Sec-
ond, trust has a cultural component that is based on social norms prevalent in a country. Third, we measure societal trust as
opposed to private trust. Societal trust evolves little over time. In contrast, private trust may evolve as members of a principal-
agent pair repeatedly interact with each other.
The distinction between private and societal trust is important in our context because societal trust matters more for parties
that interact infrequently with each other. For example, we would expect that societal trust becomes less important over time in
firms that repeatedly raise capital externally (i.e., by issuing equity or debt). When a firm frequently raises capital from capital
markets, then interactions between the firm and its investors occur more often than if the firm relied exclusively on its internal
resources to finance its investments. Moreover, because of the public nature of these interactions, the quality of the information
disclosed when firms go to capital markets may be very different than disclosures to outside shareholders made by firms that pri-
marily rely on internal resources.
We formulate our hypotheses in terms of the firm's cash holdings. Cash holdings are important because they provide liquidity
when the firm wishes to finance investment expenditures or cover cash shortfalls (Opler et al., 1999). Moreover, cash holdings
enable managers to engage in asset transformation to a greater degree than with the firm's fixed assets (Myers and Rajan,
1998). Consistent with Myers and Rajan's (1998) predictions, a large literature on corporate cash holdings finds that cash holdings
are governed by shareholders' concern that the firm's internal resources may be squandered by management (Pinkowitz et al.,
2006; Harford, 2002).
We use these findings to motivate our hypotheses. Our first explanation for corporate cash holdings highlights the precaution-
ary savings motive for holding cash. According to this line of reasoning, corporations hold more cash if they believe access to fu-
ture financing is either costly or difficult to obtain. External financing may be costly because of transaction costs (Keynes, 1936) or
because of information asymmetries (Myers and Majluf, 1984). Societal trust affects both of these channels. For instance, investors
in untrusting societies are less likely to participate in the stock market (Guiso et al., 2008). Societal trust involves social interac-
tions, and social interaction increases stock market participation (Hong et al., 2004). Furthermore, lower participation rates in-
crease the equity risk premium required by investors (Brav et al., 2002). Thus higher societal trust reduces the costs of raising
equity because equity investors require a lower risk premium on their equity investment in the firm in more trustworthy
countries.
Greater trust also facilitates the collection and dissemination of knowledge (Guiso et al., 2008). Increased knowledge dissem-
ination affects the costs of raising external capital if investors favor stocks about which they are informed (Merton, 1987; Coval
and Moskowitz, 2001). Increased collection and dissemination of knowledge also reduces the information costs of raising equity
and debt capital when investors discount the value of securities offered by firms with greater information asymmetries (Myers
and Majluf, 1984). Thus, higher societal trust reduces the costs of raising external finance because trust reduces the cost of
obtaining information about the firm and it increases the quality of available information. Because external capital is more expen-
sive to raise in low-trust countries, firms rely on internal resources by accumulating cash reserves.
To summarize, the precautionary savings hypothesis predicts that cash holdings are larger and more valuable in low-trust
countries. The precautionary savings hypothesis does not make any prediction with respect to how the effect of trust on cash

2
For instance, Aghion et al. (2010) present evidence that a lack of trust leads to more regulation despite the corruption associated with low-trust countries' govern-
ment institutions.
366 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

holdings varies with the quality of a country's formal institutions, such as the rule of law, the quality of governance and the ac-
countability of government to the people. The precautionary savings motive implies our first hypothesis.

Hypothesis 1a. Societal trust reduces cash holdings, and this relation is invariant with respect to country governance quality.

According to the agency hypothesis, the potential for conflicts between inside and outside shareholders leads outside share-
holders to exert pressure on management to disgorge free cash flows instead of saving them (Jensen and Meckling, 1976;
Berle and Means, 1932). The reason is that firms that disgorge cash will not squander valuable internal resources on bad projects
or on projects that benefit insiders at the expense of outsiders. The pressure to disgorge cash will be smaller in countries with
high levels of societal trust because agents in these countries are more likely to honor their fiduciary obligations, and to follow
social norms of behavior that protect outside investors in the firm. It follows that shareholders of firms located in countries
with low levels of societal trust would prefer that management pay out its cash to its shareholders rather than hoard it. Trust pos-
itively affects corporate cash balances according to this hypothesis.
The agency hypothesis also predicts that the effect of trust on corporate cash holdings should vary with the quality of a
country's formal institutions. The reason is twofold. First, shareholders may have greater means at their disposal to force manage-
ment to disgorge cash to shareholders in countries with stronger governance and better investor protection. This effect predicts a
stronger effect of trust on cash holdings in countries with better governance. Second, shareholders may be less worried about ex-
propriation in countries in which their rights are better protected. This effect implies a weaker effect of trust on cash holdings in
countries with better governance quality.
We formulate our first hypothesis as follows.

Hypothesis 1b. Societal trust positively affects cash holdings, and this relation is stronger in countries with weaker governance quality.

The propensity to squander corporate resources and engage in empire building at the expense of outside shareholders need
not be the main friction driving the agency hypothesis. Managers may instead accumulate cash in order to insulate themselves
from competitive pressures in a desire to live the “quiet life” instead of active empire building (Bertrand and Mullainathan,
2003).3 According to this formulation, shareholders in low-trust countries pressure managers to disgorge cash that would other-
wise be used to continue operating unproductive plants and facilities, and to “buy peace” with their workers. As such, we inter-
pret the agency hypothesis broadly as encompassing any managerial preferences that are not conducive to increasing shareholder
wealth.

2.1. Private versus societal trust

As discussed above, societal trust is important in describing the relation between two parties that interact infrequently. When
interactions are infrequent, there is no scope for private trust to supplant societal trust, and if the horizon is finite, it is less likely
that there will be a built-in governance mechanism such as reputation concerns that protects the participants' interests (see
Fukuyama, 1995). We therefore expect the effect of societal trust on corporate cash holdings to be more important in firms
that infrequently raise external capital, and that have greater degrees of information asymmetry.
This type of cross-sectional variation in the relation between trust and cash holdings can occur under both the precautionary
savings and agency hypotheses. Under the former hypothesis, the effect of trust on corporate cash holdings is more negative in
firms with greater information asymmetries because external financing is costliest when investors know little about the firm.
Under the latter hypothesis, the effect of trust on corporate cash holdings is more positive in firms with greater information
asymmetries because shareholders have less information about how management will use the firm's internal resources. These ar-
guments imply the following two mutually exclusive hypotheses.

Hypothesis 2a. (precautionary savings channel). The effect of trust on corporate cash holdings is more negative when the frequency
with which firms accessed capital markets in the past is low, and when the degree of information asymmetry between corporate insiders
and outsiders is large.

Hypothesis 2b. (agency channel). The effect of trust on corporate cash holdings is more positive when the frequency with which firms
accessed capital markets in the past is low, and when the degree of information asymmetry between corporate insiders and outsiders is
large.

2.2. Trust and the marginal value of cash

We also examine investors' valuation of the firm's cash holdings. This is an important question because trust is a measure of
investor beliefs about how insiders will manage the firm's internal resources. We expect trust to influence corporate cash hold-
ings' contribution to the value of the firm under both hypotheses. Based on arguments made above, the precautionary savings
hypothesis predicts that trust has a negative effect on the value of corporate cash holdings, and the agency hypothesis predicts
a positive effect of trust on the value of corporate cash holdings. We formulate the following two mutually exclusive hypotheses.

3
We thank an anonymous reviewer for suggesting this discussion.
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 367

Hypothesis 3a. (precautionary savings channel). Trust has a negative effect on the marginal value of cash.

Hypothesis 3b. (agency channel). Trust has a positive effect on the marginal value of cash.

2.3. The joint determination of societal trust, formal institutions and cultural values

Trust and social institutions evolve jointly. Williamson (1996) writes that the “import of culture, for purposes of economic or-
ganization, is that it serves as a check on opportunism”. Strong societal norms inhibit strategic behaviors (such as breach of con-
tract), lead to better enforcement of existing laws and increase individuals' remorse after behaving opportunistically. It follows
that societal trust may determine and be determined by the form and strength of social institutions and the level of corruption
in a society. For example, in Aghion et al. (2010), distrust leads to more regulation and more corruption as non-entrepreneurial
citizens are worried about expropriation by un-civic entrepreneurs. Consistent with their argument, Stulz and Williamson (2003)
show that informal institutions such as religion and language can predict the quality of a country's creditor rights better than
measures of economic growth and openness. Thus, both formal institutions and informal institutions are jointly determined,
and this may confound the interpretation of our results.
We adopt several approaches to address this issue. First, as in other studies, we control for the quality of a country's legal and
regulatory institutions by employing measures of government effectiveness, regulatory quality, corruption, political stability, rule
of law, voice and accountability, shareholder rights and economic development. We also control for societal culture along six di-
mensions identified by Hofstede (1980): individualism, power distance, uncertainty avoidance, long-term orientation, indulgence
and masculinity. These variables capture the impact of the shareholders and managers' personal preferences on corporate cash
holdings such as the degree of risk aversion and the investment horizon. To further address this issue, we make use of instrumen-
tal variables regressions. However, it may be the case that societal trust proxies for some unobserved factor that is correlated with
cash holdings (an omitted variable problem). While it is hard to think of such a factor other than one of those listed above, we
provide empirical evidence that we believe rules out the omitted variables problem explanation for our results.

3. Data and sample description

We construct our measure of societal trust (Trust) from the World Values Survey (WVS) and European Values Study (EVS). This
survey is carried out in several waves over the sample period.4 Our measure uses the following question from the WVS and EWS:

Generally speaking, would you say that most people can be trusted or that you need to be very careful in dealing with people?

We define the variable Trust as the percentage of people who respond that most people can be trusted. We linearly interpolate
and fill this variable for years between the two adjacent surveys. Because the answer to this question is aggregated at the country
level, it addresses whether there exist “advantages and opportunities accruing to people through membership of certain commu-
nities.” (Guiso et al., 2004). More importantly, the properties of this survey question are well understood and it is an appropriate
measure of trust. For instance, Guiso et al. (2004) find that the WVS measure of trust is positively related to financial development.
Moreover, Sapienza et al. (2013) establish that the WVS survey is related to people's beliefs about the trustworthiness of others.
We collect country level variables from other sources. The Worldwide Governance Indicators project gathers data on country-
level governance along the following six dimensions: Regulatory Quality, Control of Corruption, Political Stability, Rule of Law,
Voice and Accountability and Government Effectiveness (see Kaufmann et al., 2009). These dimensions are further described in
Table A1 of Appendix A. We measure the strength of shareholder rights with the country-level measures of governance quality
developed by the Worldwide Governance Indicators research project. To the extent that the dimensions of governance are highly
correlated, we calculate the first principal component of this set of variables as Score. As such, Score, is used to control for a com-
mon countrywide governance factor that is correlated with trust.5 We obtain data on Gross Domestic Product (GDP) per capita
from the World Bank. Finally, we obtain the Hofstede cultural indicators from Geert Hofstede's website.6
We examine the properties of the WVS measure of trust in Table 1, which reports the average level of trust and the six dimen-
sions of country governance, as well as GDP per capita. As shown in Panels A, B and C, there is a positive association between
trust, GDP per capita and country-level governance. There is also variation in the level of trust across countries and within geo-
graphical regions. For example in South America, trust varies between 0.08 (Peru) and 0.21 (Mexico). We conclude that there
is sufficient cross-sectional dispersion in the level of trust across countries to identify variations in the effect of trust on corporate
financial policies.
We merge country-year level data with firm-level data from Worldscope across 54 countries spanning 1992 to 2012. Table 2
reports summary statistics on firm-level characteristics. For the sake of brevity, we report two sets of summary statistics. The first

4
Specifically, the World Values Survey is carried out in five waves over our sample period, 1990–1994, 1995–1998, 1999–2004, 2005–2009 and 2010–2014. The
European Values Survey is carried out in four waves over our sample period, 1989–1993, 1999–2001, 2008–2010 and 2005–2010. We use the integrated longitudinal
file to construct our Trust measure.
5
Results reported in Section 4 show that that the effect of trust on cash holdings is similar in direction and magnitude when we use explicit measures of shareholder
rights developed by La Porta et al. (1998) and others.
6
This data is obtained from http://geert-hofstede.com/countries.html.
368 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table 1
Trust and property rights around the world.

Panel A: Trust and country governance

This panel reports average levels of trust and various country-level measures of governance around the world.

Country Year Range Trust Government Regulatory Control of Political Rule of Voice and
Effectiveness Quality Corruption Stability Law Accountability

Argentina 1994–2013 0.17 0.00 −0.29 −0.37 −0.12 −0.45 0.28

Australia 1992–2013 0.47 1.72 1.54 1.93 1.07 1.73 1.46
Austria 1992–2013 0.35 1.83 1.53 1.90 1.18 1.84 1.42
Belgium 1992–2013 0.32 1.75 1.24 1.39 0.97 1.31 1.40
Brazil 1995–2013 0.09 −0.07 0.21 −0.03 −0.12 −0.29 0.34
Bulgaria 2006–2013 0.18 0.08 0.60 −0.23 0.32 −0.12 0.50
Canada 1992–2013 0.42 1.88 1.56 2.08 1.04 1.71 1.53
Chile 1992–2013 0.18 1.22 1.50 1.44 0.54 1.21 0.89
China 1995–2013 0.56 −0.03 −0.25 −0.44 −0.43 −0.42 −1.49
Colombia 1993–2013 0.10 −0.15 0.14 −0.34 −1.73 −0.68 −0.38
Croatia 2006–2013 0.20 0.60 0.48 0.01 0.58 0.13 0.46
Cyprus 2006–2013 0.10 1.44 1.26 1.09 0.53 1.11 1.04
Czech Republic 1996–2013 0.28 0.84 1.07 0.34 0.86 0.85 0.93
Denmark 1992–2013 0.70 2.07 1.80 2.43 1.21 1.87 1.60
Egypt 1998–2013 0.27 −0.38 −0.39 −0.50 −0.68 −0.12 −1.00
Finland 1992–2013 0.58 2.07 1.70 2.39 1.46 1.93 1.58
France 1992–2013 0.23 1.54 1.07 1.35 0.63 1.41 1.24
Germany 1992–2013 0.36 1.70 1.46 1.90 1.01 1.62 1.36
Greece 1992–2013 0.23 0.68 0.75 0.34 0.38 0.78 0.95
Hungary 1995–2013 0.24 0.83 1.07 0.52 0.87 0.82 1.02
India 1992–2013 0.32 −0.08 −0.36 −0.42 −1.11 0.13 0.38
Indonesia 1992–2013 0.47 −0.37 −0.24 −0.77 −1.33 −0.64 −0.42
Ireland 1992–2013 0.39 1.61 1.67 1.62 1.23 1.60 1.39
Israel 1993–2013 0.23 1.17 1.09 1.07 −1.27 0.99 0.62
Italy 1992–2013 0.32 0.64 0.87 0.35 0.72 0.65 1.04
Japan 1992–2013 0.41 1.24 0.89 1.21 1.04 1.30 1.00
Jordan 2007–2013 0.31 0.11 0.26 0.18 −0.43 0.34 −0.76
Luxembourg 1992–2013 0.28 1.87 1.73 2.01 1.39 1.77 1.52
Malaysia 1992–2013 0.09 0.98 0.57 0.34 0.23 0.51 −0.31
Mexico 1992–2013 0.21 0.19 0.36 −0.34 −0.61 −0.57 0.09
Morocco 1998–2013 0.17 −0.10 −0.15 −0.19 −0.35 −0.08 −0.62
Netherlands 1992–2013 0.57 1.93 1.81 2.18 1.22 1.73 1.59
New Zealand 1992–2013 0.52 1.80 1.83 2.33 1.25 1.84 1.63
Nigeria 2010–2013 0.15 −1.06 −0.70 −1.12 −2.07 −1.18 −0.76
Norway 1992–2013 0.70 1.94 1.41 2.18 1.33 1.91 1.60
Pakistan 1993–2013 0.25 −0.57 −0.60 −0.97 −1.81 −0.81 −0.92
Peru 1994–2013 0.08 −0.23 0.42 −0.28 −0.95 −0.65 −0.16
Philippines 1992–2013 0.06 −0.06 0.04 −0.46 −1.09 −0.33 0.09
Poland 1995–2013 0.21 0.59 0.79 0.43 0.66 0.61 0.99
Portugal 1992–2013 0.16 1.09 1.09 1.21 1.07 1.15 1.34
Romania 2006–2013 0.13 −0.27 0.57 −0.20 0.18 0.00 0.42
Singapore 1992–2013 0.23 2.13 2.01 2.22 1.10 1.49 0.01
Slovenia 2001–2013 0.21 1.00 0.78 0.88 1.01 0.96 1.05
South Africa 1992–2013 0.16 0.63 0.45 0.43 -0.23 0.07 0.70
South Korea 1992–2013 0.30 0.86 0.68 0.38 0.38 0.86 0.64
Spain 1992–2013 0.29 1.43 1.19 1.15 0.04 1.24 1.22
Sweden 1992–2013 0.66 1.98 1.52 2.28 1.28 1.84 1.59
Switzerland 1992–2013 0.46 1.96 1.63 2.13 1.34 1.87 1.52
Taiwan 1992–2013 0.31 0.97 1.05 0.66 0.77 0.85 0.79
Thailand 1992–2013 0.42 0.26 0.25 −0.22 −0.32 0.22 0.02
Turkey 1992–2013 0.10 0.10 0.28 −0.18 −1.02 −0.02 −0.25
United Kingdom 1992–2013 0.35 1.76 1.83 1.95 0.62 1.65 1.32
United States 1992–2013 0.38 1.67 1.55 1.53 0.58 1.53 1.26
Venezuela 1998–2013 0.16 −0.99 −1.08 −1.00 −1.12 −1.34 −0.61

Panel B: GDP and corporate cash holdings

This panel reports average levels of per capita GDP in natural logarithm, Score, average cash holdings scaled by total assets, median cash holdings scaled by
total assets, the number of unique firms and the number of observations by country.

Country GDP Score Average cash Median cash # firms # firm-year observations

Argentina 9.05 −0.36 0.08 0.06 65 533

Australia 10.30 3.92 0.23 0.13 1737 10,970
Austria 10.41 4.01 0.13 0.08 87 681
Belgium 10.36 3.34 0.13 0.08 125 1006
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 369

Table 1 (continued)

Panel B: GDP and corporate cash holdings

This panel reports average levels of per capita GDP in natural logarithm, Score, average cash holdings scaled by total assets, median cash holdings scaled by
total assets, the number of unique firms and the number of observations by country.

Country GDP Score Average cash Median cash # firms # firm-year observations

Brazil 8.64 0.06 0.14 0.11 110 594

Bulgaria 8.76 0.49 0.10 0.03 163 600
Canada 10.31 4.06 0.22 0.11 2595 13,104
Chile 8.82 2.84 0.08 0.04 145 1439
China 7.49 −1.18 0.18 0.14 2140 14,227
Colombia 8.13 −1.18 0.08 0.06 30 229
Croatia 9.51 0.94 0.09 0.05 86 351
Cyprus 10.24 2.70 0.10 0.04 68 210
Czech Republic 9.32 2.03 0.09 0.05 30 143
Denmark 10.62 4.55 0.15 0.08 185 1781
Egypt 7.49 −1.19 0.17 0.13 86 484
Finland 10.36 4.60 0.13 0.08 147 1598
France 10.30 3.02 0.15 0.10 863 6719
Germany 10.36 3.75 0.15 0.08 837 6913
Greece 9.73 1.63 0.09 0.05 275 1897
Hungary 8.99 2.12 0.11 0.05 39 294
India 6.47 −0.51 0.07 0.03 2040 10,531
Indonesia 7.18 −1.45 0.13 0.08 334 2906
Ireland 10.38 3.76 0.16 0.10 85 664
Israel 9.96 1.63 0.21 0.13 88 475
Italy 10.17 1.77 0.12 0.08 278 2202
Japan 10.51 2.77 0.17 0.14 2963 31,358
Jordan 8.35 −0.04 0.12 0.05 120 520
Luxembourg 11.09 4.25 0.15 0.11 22 124
Malaysia 8.57 1.01 0.13 0.08 952 7314
Mexico 8.81 −0.30 0.09 0.06 126 1273
Morocco 7.62 −0.55 0.10 0.05 48 203
Netherlands 10.41 4.33 0.12 0.07 49 498
New Zealand 9.97 4.41 0.10 0.03 133 897
Nigeria 7.87 −2.72 0.10 0.08 33 69
Norway 10.86 4.29 0.18 0.11 271 1972
Pakistan 6.50 −2.22 0.12 0.06 128 1130
Peru 7.98 −0.69 0.08 0.04 92 717
Philippines 7.18 −0.66 0.14 0.08 143 1270
Poland 8.88 1.69 0.11 0.06 386 1973
Portugal 9.63 2.87 0.06 0.03 83 718
Romania 9.02 0.31 0.11 0.04 99 359
Singapore 10.28 3.74 0.18 0.14 726 5501
Slovenia 9.84 2.35 0.10 0.04 40 174
South Africa 8.37 0.90 0.14 0.09 317 1827
South Korea 9.60 1.61 0.15 0.10 1731 12,024
Spain 9.93 2.64 0.10 0.06 123 732
Sweden 10.50 4.34 0.16 0.09 499 3604
Switzerland 10.81 4.32 0.17 0.12 247 2608
Taiwan 10.03 2.12 0.18 0.14 830 7762
Thailand 7.97 0.15 0.10 0.05 449 3652
Turkey 8.57 −0.35 0.14 0.07 247 1623
United Kingdom 10.29 3.81 0.17 0.09 2419 16,550
United States 10.56 3.39 0.19 0.10 4304 42,346
Venezuela 8.82 −2.46 0.09 0.06 15 79

Panel C: Correlations

This panel reports the sample correlations of country and firm-level variables. Correlations are measured using firm-year observations based on the panel of
firms located across 54 countries. Pearson's (Spearman's) correlation coefficients are presented in the lower (upper) triangle. Italic indicates significance at
the 1% level or better.

Variables Trust Cash log(Cash/TA) Score Government Regulatory Control of Political Rule of Voice and GDP LLSV Anti-
Effectiveness Quality Corruption Stability Law Accountability selfdealing

Trust 0.12 0.13 0.21 0.20 0.16 0.27 0.24 0.23 0.05 0.22 −0.35 0.01
Cash 0.14 0.78 0.13 0.14 0.14 0.13 0.09 0.14 0.07 0.17 −0.05 0.06
log(cash) 0.14 1.00 0.08 0.10 0.08 0.08 0.11 0.09 −0.01 0.16 −0.06 0.02
Score 0.30 0.06 0.06 0.96 0.96 0.97 0.85 0.98 0.86 0.88 0.26 0.01
Government 0.23 0.07 0.07 0.95 0.94 0.95 0.81 0.95 0.74 0.86 0.25 0.13
Effectiveness

(continued on next page)

(continued on next page)
370 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table 1 (continued)

Panel C: Correlations

This panel reports the sample correlations of country and firm-level variables. Correlations are measured using firm-year observations based on the panel of
firms located across 54 countries. Pearson's (Spearman's) correlation coefficients are presented in the lower (upper) triangle. Italic indicates significance at
the 1% level or better.

Variables Trust Cash log(Cash/TA) Score Government Regulatory Control of Political Rule of Voice and GDP LLSV Anti-
Effectiveness Quality Corruption Stability Law Accountability selfdealing

Regulatory 0.20 0.08 0.08 0.93 0.91 0.94 0.77 0.93 0.78 0.86 0.19 0.14
Quality
Control of 0.26 0.07 0.07 0.97 0.95 0.91 0.80 0.95 0.79 0.83 0.25 0.09
Corruption
Political 0.32 0.08 0.08 0.71 0.65 0.57 0.69 0.82 0.64 0.81 0.14 −0.09
Stability
Rule of Law 0.35 0.09 0.09 0.96 0.90 0.89 0.92 0.66 0.84 0.88 0.27 0.03
Voice and 0.30 0.03 0.03 0.90 0.81 0.78 0.84 0.59 0.87 0.73 0.35 −0.23
Accountability
GDP 0.34 0.19 0.19 0.67 0.63 0.68 0.65 0.52 0.75 0.64 0.09 −0.07
LLSV −0.24 −0.06 −0.06 0.06 0.04 0.05 0.11 0.11 0.07 −0.07 −0.10 0.21
Anti-selfdealing 0.13 0.05 0.05 0.08 0.16 0.26 0.11 −0.21 0.09 −0.10 −0.02 0.16

is for the sample of firms used in the cash regressions. This subsample is smaller because it requires five years of observations to
estimate the volatility of cash flows for each firm year. Based on this sample, the median firm holds 10.5% of its total assets in the
form of cash. The second set of summary statistics consists of the variables used to estimate the marginal value of cash holdings.

Table 2
Summary statistics.
This table reports firm-level summary statistics for all of the variables used in the study. Variable definitions are located in Table A1.

Variable N Mean P25 Median P75 Std

Country-level variables
Trust 994 0.316 0.185 0.299 0.408 0.169
TrustHI 984 0.380 0.240 0.355 0.488 0.195
TrustHE 982 0.372 0.212 0.340 0.486 0.199
Score 994 1.970 −0.037 2.299 3.868 2.027
GDP 994 9.386 8.488 9.818 10.380 1.259
LLSV 975 3.439 2.500 3.500 4.000 1.063
Anti-selfdealing 975 0.482 0.283 0.444 0.642 0.227
Banking 964 44.161 8.090 20.408 48.312 90.224

Firm-level variables
Variables used in the cash holding regression
Cash/AT 229,428 0.165 0.041 0.105 0.220 0.178
Log(Cash/AT) 229,428 −2.462 −3.189 −2.254 −1.512 1.356
Cash/Net Assets 229,409 −2.243 −3.147 −2.144 −1.264 1.589
Ln(Cash/Net Assets) 229,409 0.366 0.043 0.117 0.283 1.106
Size 229,428 12.226 10.932 12.171 13.468 1.971
Leverage 229,428 0.252 0.026 0.183 0.416 0.248
MTB 229,428 2.348 0.812 1.456 2.644 2.977
Capx 229,428 0.056 0.015 0.035 0.071 0.066
RD 229,428 0.019 0.000 0.000 0.009 0.050
WC 229,428 0.035 −0.068 0.025 0.142 0.178
Payer 229,428 0.550 0.000 1.000 1.000 0.497
CFO 229,428 0.044 0.004 0.060 0.114 0.141
Std(CFO) 229,428 0.085 0.034 0.058 0.101 0.086
Financing 229,428 0.041 −0.003 0.000 0.037 0.134

Variables used in the MVCash regression

Exret 342,400 0.026 −0.284 −0.047 0.226 0.488
ΔCash 342,400 0.017 −0.037 0.003 0.056 0.146
ΔE 342,400 0.016 −0.037 0.007 0.055 0.184
ΔNA 342,400 0.111 −0.060 0.060 0.256 0.507
ΔRD 342,400 0.001 0.000 0.000 0.000 0.006
ΔInt 342,400 0.001 −0.003 0.000 0.004 0.019
ΔDiv t 342,400 0.001 0.000 0.000 0.003 0.015
Casht − 1 342,400 0.244 0.052 0.140 0.316 0.285
Lev 342,400 0.267 0.034 0.206 0.445 0.250
NF 342,400 0.052 −0.001 0.000 0.051 0.177
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 371

4. Trust and cash balances

This section investigates the relation between trust and cash holdings in both a univariate setting and a multivariate setting
that controls for firm and country-level variables. Fig. 1A, which plots mean cash holdings (deflated by total assets) for each coun-
try relative to the country's level of societal trust, illustrates our main finding. As shown, cash holdings increase with the level of

Fig. 1. A. Plot of country cash holdings against societal trust, measured using the World Values Survey The vertical axis reports the mean over firms and years in
each country of the ratio of cash to total assets. The horizontal access reports the level of societal trust averaged over years for each country, as reported in the
World Values Survey. Fig. 1B. Plot of country log cash holdings against societal trust, measured using the World Values Survey The vertical axis reports the
mean over firms and years in each country of the natural logarithm of cash to total assets. The horizontal access reports the level of societal trust averaged
over years for each country, as reported in the World Values Survey.
372 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

societal trust. This result is consistent with the agency hypothesis. Fig. 1B, which reports the mean log cash holdings, confirms this
finding using the dependent variable employed throughout the multivariate analysis.
One possible concern about the interpretation of this finding is that societal trust is correlated with country-level measures of
economic development and shareholder rights that are associated with higher cash holdings. Univariate correlations indicate that
this is the case. As shown in Table 1 Panel C, the correlation between trust and score (our measure of governance) is 30%. Trust is
also positively correlated with GDP per capita (34%), negatively correlated with the revised shareholder rights index (−24%) (de-
fined in La Porta et al. (1998) and revised by Djankov et al. (2008)), and positively correlated with the anti-self-dealing index
(13%) measure of shareholder rights, also developed by Djankov et al. (2008).7 In order to control for these variables, we estimate
a multivariate regression at the firm-year level and include the above variables as controls in addition to our primary measure of
trust. We control for unobserved differences between industries and define industry classifications using the Fama-French 48 in-
dustries based on reported Standard Industrial Classification (SIC) codes (Fama and French, 1997). We also include country fixed
effects in order to control for time-invariant unobserved country-level determinants of corporate cash policy. The baseline regres-
sion is as follows.

Cash holdingsijkt ¼ α þ β1 Trust kt þ β2 Scorekt þ β3 firm−characteristics þ Ind j þ Yr t þ Cntryk þ uijkt ð1Þ

Our primary dependent variable for cash holdings is the natural logarithm of cash and marketable securities scaled by total
assets. Trustkt denotes the response to the World Values Survey for country k in year t and Scorekt is the first principal component
of governance, regulatory quality, control of corruption, political stability, the rule of law and the voice of freedom for country k in
year t. We include a set of firm-characteristics that measure the firm's operating, investing and financing activities. Finally, Indj, Yrt
and Cntryk capture industry, year and country effects, respectively.
Table 3 reports multivariate regression results. Column (1) reports estimates of Eq. (1) with our preferred definition of the de-
pendent variable, the natural logarithm of the ratio of cash holdings scaled by book assets. As shown, the coefficient on Trust
equals 0.528 (t-stat = 2.49, statistically significant at the 5% level) after controlling for firm characteristics that are known to
be associated with corporate cash policy. Trust has an economically significant effect on firms' cash holdings. Increasing trust
from the 25th to the 75 percentile increases the cash balance by 11.8%. We also note that the sign on the control variables is con-
sistent with prior results in the literature. For instance, more profitable hold more cash as do firms with greater cash-flow vola-
tility. High growth firms (firms with a high market-to-book ratio) have less cash, as do firms with more leverage.8
Columns (2) to (4) report the same regression estimates with alternative definitions of the dependent variable that either omit
taking the natural logarithm or deflate cash by net assets (total assets minus cash). The results are robust to these alternative
specifications. Taken together, both the univariate and multivariate results support the agency hypothesis (formulated in
Hypothesis 1b) about the effect of trust on corporate cash holdings.

4.1. Trust and payout policy - further evidence on the economic channel

The key argument behind the agency hypothesis is that in low-trust countries shareholders prefer that managers disgorge cash
by paying dividends or by repurchasing shares rather than hoarding it for empire building. In order to provide additional support
for this channel, we examine the effect of trust on corporate payout policy. Specifically, we examine how cash holdings, societal
trust and the interaction of these variables relate to the firm's payout policy. Since firms require a minimum level of cash to meet
their investment needs and to fund their day-to-day operations, we focus this part of the analysis on the amount of excess cash,
defined as the difference between cash and the predicted amount given the firm's investment-opportunity set and existing oper-
ations. We follow Harford et al. (2008) and measure excess cash as the residual from a regression of cash holdings on firm size,
leverage, growth options, profitability, ratio of working capital to assets, cash flow volatility, R&D to sales, capital expenditures to
assets and acquisition to sales, as well as industry and year indicator variables. Holding investment and financing policy constant,
the agency hypothesis implies that higher levels of trust lower the proportion of excess cash that the firm pays out to share-
holders. Intuitively, the total payout ratio is lower in high-trust countries because shareholders permit managers in these coun-
tries to hold more cash than in low-trust countries.
Firms may return money to shareholders in the form of dividends or share repurchases. Accordingly, trust may affect how the
firm transfers excess cash to shareholders. Because dividends imply a long-term commitment to a higher payout ratio but share
repurchases do not, we expect societal trust to have a larger effect on the relation between excess cash and dividends paid than
on the relation between excess cash and share repurchases. Thus under the agency hypothesis, cash reserves in low-trust coun-
tries are kept low by paying out a greater proportion of excess cash to shareholders in the form of dividends. To empirically test
this hypothesis, we regress the change in total payout, the change in dividends and the change in share repurchases on excess
cash and its interaction with trust.
Table 4 reports the results of this analysis. Following Harford et al. (2008), the dependent variable in column (1) is the annual
change in total payout (dividends plus share repurchases) net of the mean total payout in the firm's industry scaled by lagged
total assets. We adjust firm payouts by the industry mean in order to control for variations in payout policy across industries.

7
The anti-self-dealing index is based on private enforcement mechanisms that govern a specific self-dealing transaction.
8
In unreported tests, we find that our results are robust to running the study design at the country–industry-level of aggregation.
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 373

Table 3
Baseline regression estimates.
This panel reports a regression of cash balances at the firm-year level. In column (1), the dependent variable equals the natural logarithm of cash and marketable se-
curities to total assets. Columns (2) to (4) use alternative definitions of the dependent variable. T-statistics are in parentheses and standard errors are clustered by firm
and by year. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. Variable definitions are in Table A1.

(1) (2) (3) (4)

Cash holdings

Measures Main Alternative measures

ln(Cash/TA) Cash/TA ln(Cash/Net Assets) Cash/Net Assets

Trust 0.528** 0.111*** 0.720*** 0.491***

(2.49) (5.16) (3.04) (4.50)
Score −0.312*** −0.0179*** −0.337*** −0.0633***
(−5.80) (−2.76) (−5.35) (−3.29)
GDP 0.101* 0.0230*** 0.133** 0.0356**
(1.84) (4.09) (2.16) (2.07)
Size −0.0129*** −0.00948*** −0.0303*** −0.0468***
(−2.81) (−15.00) (−5.73) (−9.95)
Leverage −2.041*** −0.253*** −2.416*** −0.710***
(−40.84) (−47.09) (−43.98) (−31.67)
MTB −0.0139*** −0.00201*** −0.0173*** −0.00774***
(−5.39) (−5.03) (−5.27) (−3.78)
Capex −1.721*** −0.383*** −2.457*** −2.097***
(−11.38) (−27.32) (−15.52) (−13.33)
RD 4.091*** 0.759*** 5.513*** 3.631***
(21.97) (22.73) (24.39) (11.70)
WC −1.181*** −0.204*** −1.541*** −0.902***
(−13.92) (−24.27) (−16.50) (−29.33)
Payer 0.0231 0.000880 0.0303 0.0531***
(0.88) (0.30) (0.98) (3.45)
Financing 1.195*** 0.215*** 1.604*** 1.107***
(17.35) (13.59) (15.97) (8.54)
CFO 0.700*** 0.0357*** 0.628*** −0.762***
(9.63) (2.81) (6.65) (−8.04)
Std(CFO) 1.285*** 0.217*** 1.694*** 1.136***
(17.05) (19.78) (18.86) (12.25)
Year fixed effects Yes Yes Yes Yes
Industry fixed effects Yes Yes Yes Yes
Country fixed effects Yes Yes Yes Yes
N 229,428 229,428 229,409 229,409
adj. R-sq 0.330 0.410 0.360 0.241

As shown, greater amounts of excess cash lead to more total payouts, but this effect is smaller in high-trust countries, as evi-
denced by the significantly negative interaction term between excess cash and societal trust. Column (2) reports the regression
estimates with the change in industry-adjusted dividends. As shown, greater amounts of excess cash lead to a larger dividend
and this effect is stronger in low-trust countries. Taken together, columns (1) and (2) indicate that firms in low trust countries
pay a greater proportion of their excess cash to shareholders in the form of dividends. Column (3) reports the effect of trust
on the relation between excess cash and share repurchases. As shown, the coefficient on excess cash is not significant. Moreover,
the interaction effect of this variable with trust is (weakly) significantly positive but economically weak in comparison to divi-
dends. This finding suggests that shareholders in low-trust countries pressure the managers to distribute excess cash in a way
that commits the firm to higher total payouts in the long term. Overall, firms in low-trust countries pay a greater proportion
of excess cash in total payout (dividends plus share repurchases) than do firms in high-trust countries.

4.2. Trust, repeated interactions and information asymmetry

We next investigate the effect of trust on corporate cash holdings when there is opportunity for both parties to develop private
trust through repeated interactions with each other. We measure this aspect of the relationship between corporate insiders and
outsiders along two separate dimensions. The first dimension consists of the frequency with which the firm raised external equity
or debt in the past three to five years (i.e., from year t − 3 or t − 5 to t − 1). The second dimension involves the firm's infor-
mation environment as measured by the number of financial analysts who follow the firm.
We measure equity issues using the sale of common and preferred stocks each year. We measure debt issues as the annual
change in total debt. To capture significant external financing events, we identify external financing activity whenever the sum
of equity and debt issues is N 5% of total assets in any year during the past three or five years. Specifically, Financing 3Y (Financing
5Y), equals one if the amount of new capital raised from the equity or debt market is N 5% of total assets in any one year during
the past three (five) years and zero otherwise. We interact Trust with Financing 3Y and Financing 5Y.
374 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table 4
Trust and cash holdings as they relate to payout policy.
This table examines the relation between payout decisions and societal trust. The dependent variables are the change in industry-adjusted dividends and repurchases.
All the dependent variables are industry-adjusted on a yearly basis using the Fama-French 48 industry classification system. The firm's cash position is the unexplained
portion of cash holdings. Specifically, the residual from regressing cash holdings on firm-specific characteristics represents the firm's excess cash holdings. The control
variables for the cash regression in the first stage include firm size, leverage, growth options, profitability, ratio of working capital to assets, cash flow volatility, R&D to
sales, capital expenditures to assets, and acquisition to sales as well as industry and year indicator variables. Additional control variables include: Excess return (defined
as the realized return minus market return), Growth (defined as the sales growth), WCAP (defined as the net working capital minus cash), leverage (defined as the
market leverage ratio), P/E (defined as the price-earnings ratio), and size (defined as total assets). T-statistics are in parentheses and standard errors are clustered
by firm and by year. Superscripts ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. All models include industry and year indicators as well
an intercept term.

(1) (2) (3)

Dependent variable Δind. Adjusted (Dividends + Repurchases) Δind. Adjusted Dividends Δind. Adjusted Repurchases

Excess cash ∗ Trust −0.122** −0.104*** 0.0345*

(−2.49) (−4.01) (1.66)
Excess cash 0.0755*** 0.0534*** −0.000625
(4.42) (5.72) (−0.09)
Trust 0.428*** 1.204*** 0.328***
(2.68) (12.63) (4.34)
Score −0.000927 0.0703*** −0.0480***
(−0.04) (5.44) (−3.94)
GDP 0.114*** 0.357*** −0.00549
(3.53) (21.02) (−0.36)
Excess return 0.0861*** 0.0905*** −0.0452***
(6.27) (14.93) (−5.63)
Leverage −0.906*** −0.546*** −0.244***
(−40.97) (−46.62) (−20.70)
Size 0.0717*** 0.0407*** 0.0273***
(25.29) (27.61) (17.06)
Growth 0.157*** 0.0957*** 0.0135
(9.02) (12.28) (1.50)
WC −0.162*** −0.0125 −0.0723***
(−4.67) (−0.73) (−3.99)
P/E −0.744 0.802 −1.620**
(−0.63) (1.64) (−2.43)
Year fixed effects Yes Yes Yes
Industry fixed effects Yes Yes Yes
Country fixed effects Yes Yes Yes
N 157,115 215,452 157,115
adj. R–sq 0.010 0.023 0.002

We present the results in Table 5. As shown, the effect of societal trust is large and statistically significant at the 1% level for
firms that have not engaged in external financing in the prior three- or five-year period, but is significantly smaller for those who
have. Both regressions show that having raised equity or debt capital in the past reduces the effect of societal trust on cash hold-
ings. For example, in column (2), the coefficient in the non-issuing group equals 0.662 (t-stat = 3.16) compared with only 0.45 in
the issuing group and the difference is significantly different.
Panel B reports cross-sectional variation tests using indicators to capture whether the firm is followed by one or more analysts
(Have analyst), whether the firm has more analysts than the median firm in the country (More analyst) and the number of ana-
lysts (log(# analysts)). Intuitively, having an analyst follow the firm implies that outside investors are better informed about the
firm's prospects, and therefore less reliant on societal trust in their inferences about management ability and behavior. We obtain
data on analyst following from Institutional Brokers' Estimate System (IBES) International. As shown in column (1), the effect of
trust in firms with no analyst following is statistically and economically significant. In contrast, this effect is significantly smaller in
firms followed by one or more analysts. The results are qualitatively the same when we control for country-level differences in
analyst following (column 2) or use the raw number of analysts (column 3). Overall, the results of this section are consistent
with Hypothesis 2b but not 2a, suggesting that trust matters most when the firm's information environment is poor, and when
investors have had little opportunity to develop private trust in management.
Finally, following Zhang (2006) and Dechow and Dichev (2002), we employ firm size and financial reporting quality as two
additional measures of information asymmetry. As discussed in Zhang (2006), small firms typically have less information available
for the market than large firms. This may be because small firms have fewer customers, suppliers and a limited shareholder base,
and cannot bear high disclosure preparation costs. We measure firm size using total assets. Specifically, the indicator variable
Large size takes a value of one if total assets are higher than the median firm in the country for a given year.9 Our second measure
of information asymmetry is accruals quality, calculated based on the modified Dechow and Dichev (2002) model proposed by
McNichols (2002). Specifically, we regress working capital accruals on property, plant and equipment (PPE) and the change in

9
Results and inferences are qualitatively similar if we use market value of equity instead.
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 375

Table 5
Cross-sectional variation in the relation between trust and cash holdings.
This table reports the cross-sectional variation regressions of cash policy. The dependent variable is the natural logarithm of cash scaled by total assets. The unit of ob-
servation is the firm-year. All regressions contain country, year and industry fixed effects. T-statistics are in parentheses and standard errors are clustered by firm and by
year.

Panel A: Past financing activity

Financing3Y (Financing5Y) equals to one if the annual amount of new equity and debt issuance in any of the past three (five) years is higher than 5% of total
assets and zero otherwise.

(1) (2)

log(Cash/TA)

Trust 0.604*** 0.662***

(2.94) (3.16)
Trust ∗ Financing3Y −0.147***
(−2.83)
Financing3Y −0.0162
(−0.67)
Trust ∗ Financing5Y −0.212***
(−3.53)
Financing5Y 0.0163
(0.62)
Firm characteristics Yes Yes
Year fixed effects Yes Yes
Industry fixed effects Yes Yes
Country fixed effects Yes Yes
N 229,428 229,428
adj. R-sq 0.331 0.331

Panel B: Analyst following

Have analyst equals to one if the firm-year is covered by at least one analyst and zero otherwise. More analyst equals to one if the number of analysts following
the firm is greater than the median firm in this country each year and zero otherwise. log(# of analyst) is the natural logarithm of the number of analysts.

(1) (2) (3)

ln(Cash/TA)

Trust 0.842*** 0.790*** 0.851***

(3.94) (3.69) (4.13)
Trust ∗ Have analyst −0.652***
(−9.05)
Have analyst 0.324***
(11.40)
Trust ∗ More analyst −0.623***
(−8.90)
More Analyst 0.287***
(11.08)
Trust ∗ log(# of analyst) −0.238***
(−9.68)
log(# of analyst) 0.101***
(9.11)
Firm characteristics Yes Yes Yes
Year fixed effects Yes Yes Yes
Industry fixed effects Yes Yes Yes
Country fixed effects Yes Yes Yes
N 229,428 229,428 229,428
adj. R-sq 0.332 0.331 0.331

Panel C: Firm size and financial reporting quality

Large size equals to one if total assets is higher than the median firm in this country each year and zero otherwise. High AQ equals to one if accruals quality is
higher than the median firm in this country each year and zero otherwise. Accruals quality is defined as the negative of the five-year rolling-window standard
deviation of the residual terms from the modified Dechow and Dichev (2002) regression from McNichols (2002). Specifically, the modified Dechow and
Dichev regression estimates working capital accruals on ΔRev –ΔAR, net PPE and lagged, contemporaneous and lead cash flows from operations.

(1) (2)

Log(Cash/TA)

Trust 0.898*** 0.594***

(4.21) (2.81)
Trust ∗ Large size −0.701***
(−8.87)
Large size 0.277***
(8.41)

(continued on next page)

376 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table 5 (continued)

Panel C: Firm size and financial reporting quality

Large size equals to one if total assets is higher than the median firm in this country each year and zero otherwise. High AQ equals to one if accruals quality is
higher than the median firm in this country each year and zero otherwise. Accruals quality is defined as the negative of the five-year rolling-window standard
deviation of the residual terms from the modified Dechow and Dichev (2002) regression from McNichols (2002). Specifically, the modified Dechow and
Dichev regression estimates working capital accruals on ΔRev –ΔAR, net PPE and lagged, contemporaneous and lead cash flows from operations.

(1) (2)

Log(Cash/TA)

Trust ∗ High AQ −0.124***

(−4.08)
High AQ 0.696***
(4.68)
Firm characteristics Yes Yes
Year fixed effects Yes Yes
Industry fixed effects Yes Yes
Country fixed effects Yes Yes
N 229,428 229,428
adj. R-sq 0.332 0.331

revenues minus the change in accounts receivable as well as lagged contemporary and lead cash flows from operations. We scale
all variables by lagged total assets. We define the negative of the standard deviation of the residual term from year t − 4 to t as
accruals quality so that higher values indicate better accruals quality. As argued in Francis et al. (2007), information asymmetry is
high if accruals map poorly into cash flows or other firm fundamentals known to be associated with accruals (fixed assets and
cash-sales changes). The indicator variable High AQ takes a value of one if the accruals quality is higher than the median for a
given country in a year. We present the results in Panel C. The coefficients on the interaction terms Large size ∗ Trust and High
AQ ∗ Trust are both negative and statistically significant at the 5% level, consistent with the hypothesis that trust matters most
when the information availability is poor.

4.3. Trust, country governance and financial development

We explore how the effect of trust varies across firms located in countries with differing levels of governance quality. As ex-
plained above, the precautionary savings hypothesis does not predict any difference in the effect of societal trust on corporate
cash balances across countries with differing levels of governance quality. In contrast, the agency hypothesis predicts that coun-
try-governance quality can either increase or decrease the effect of trust on corporate cash balances.
We investigate these relations by interacting country-governance quality (measured with Score or one of its six components)
with trust in a multivariate regression. Panel A of Table 6 reports these results. As shown in column (1), the effect of trust is sig-
nificantly different in countries with higher levels of governance (measured with Score). The interaction term between Trust and
Score is negative and statistically significant at the 5% level in column (1), implying that trust has a greater effect on corporate
cash holdings in countries with lower levels of governance. Both this finding and our earlier results are consistent with the agency
hypothesis. This interaction effect is also economically important. Adding the coefficient on Trust with the product of the coeffi-
cient on the interaction term and the 25th percentile of score equals 0.935. In comparison, the effect of trust at the 75th percentile
of Score equals 0.072 or approximately 90% less. As such, we conclude that trust matters more in countries with poor levels of
governance.
We next investigate whether the interactive effect is driven by a particular dimension of country governance by splitting the
governance measure into its six constituent components based on information provided by the World Governance Index. To the
extent that the six governance measures exhibit high correlations, we estimate a separate regression for each dimension. Specif-
ically, each dimension of the World Governance Index is included in the regression as a stand-alone variable, along with its inter-
action with Trust. As shown, the effect of societal trust remains statistically and economically significant after controlling for
individual dimensions of country governance. Moreover, the interactive effect documented in column (1) does not seem driven
by a particular dimension of Score. For example, column (2) reports the effect of societal trust controlling for government effec-
tiveness, a measure of the quality of public services and their degree of independence from political pressure. The coefficient on
Trust equals 1.242, with a t-statistic of 5.36. The interaction of Government effectiveness with Trust is negative and statistically sig-
nificant at the 1% level, implying that the effect of societal trust is smaller when government effectiveness is greater. Regulatory
quality and the rule of law also interact significantly, but not Control of corruption, Political stability and Voice. Overall, these results
are consistent with Hypothesis 1b, but not with Hypothesis 1a.
Lastly, in column (8), we investigate whether measurable dimensions of culture affect the coefficient on trust.10 Specifically,
we include the six Hofstede cultural indices in order verify that trust is not measuring a component of culture that relates to a
person's preferences. As shown, the effect of trust on corporate cash holdings remains both statistically and economically

10
In column (8), our sample size is slightly smaller due to the availability of the Hofstede cultural indices.
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 377

significant after controlling for these other dimensions of a country's culture. This result indicates that we are measuring the effect
of investors' beliefs with respect to others rather than individual preferences that are correlated with societal trust.

4.3.1. Trust and shareholder rights

We next investigate whether the effect of trust on corporate cash holdings is distinct from the level of shareholder rights. As
shown in Table 1, trust and shareholder rights are significantly correlated. Furthermore, prior evidence on the relation between

Table 6
Country governance and the effect of trust on cash policy.

Panel A: Interaction with country governance

This panel reports regressions in which Trust is interacted with Score and its subcomponents. The unit of observation unit is a firm-year. Each of the six
dimensions of country governance is interacted with trust in a separate regression (columns 2–7). Column (8) includes the Hofstede cultural indicators. Firm
characteristics are included but not reported. T-statistics are in parentheses and standard errors are clustered by firm and by year.

(1) (2) (3) (4) (5) (6) (7) (8)

ln(Cash/TA)

Trust 0.927*** 1.242*** 1.082*** 0.922*** 0.791*** 1.387*** 0.696*** 0.517**

(3.95) (5.36) (4.29) (3.92) (3.81) (5.42) (3.40) (2.44)
Score −0.238*** −0.315***
(−4.02) (−5.84)
Score ∗ Trust −0.221**
(−2.23)
Government effectiveness −0.222**
(−2.54)
Government effectiveness ∗ Trust −0.747***
(−3.93)
Regulatory quality −0.283***
(−3.63)
Regulatory quality ∗ Trust −0.451**
(−2.33)
Control of corruption −0.124
(−1.39)
Control of corruption ∗ Trust −0.220
(−1.16)
Political stability −0.130
(−1.63)
Political stability ∗ Trust −0.0833
(−0.44)
Rule of law 0.163
(1.48)
Rule of law ∗ Trust −0.575**
(−2.55)
Voice −0.335**
(−2.44)
Voice ∗ Trust −0.314
(−1.49)
Power distance −0.00899***
(−3.22)
Individuality 0.00485*
(1.74)
Masculinity 0.00834***
(3.10)
Uncertainty avoidance −0.0172***
(−7.26)
Long term orientation 0.0308***
(6.79)
Indulgence 0.0129***
(3.67)
GDP 0.0917 0.1000** 0.0905 0.0960 0.0745 0.0720 0.108 0.105*
(1.60) (1.99) (1.61) (1.51) (1.13) (0.99) (1.46) (1.91)
Firm characteristics Yes Yes Yes Yes Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes Yes Yes Yes Yes
Industry fixed effects Yes Yes Yes Yes Yes Yes Yes Yes
Country fixed effects Yes Yes Yes Yes Yes Yes Yes Yes
N 229,428 229,428 229,428 229,428 229,428 229,428 229,428 226,632
adj. R-sq 0.331 0.330 0.330 0.329 0.329 0.328 0.329 0.329

(continued on next page)

378 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table 6 (continued)

Panel B: Interaction with shareholder rights indices

This panel reports the results after controlling for the investor protection index. Column (1) replicates column (3) of Table 2 in Dittmar et al. (2003). We
restrict the sample to 1998 for the sake of comparison. The investor protection index in column (1) is the original index reported in La Porta et al. (1998).
Columns (2) to (4) estimate the entire sample with year fixed effects and use the updated investor protection index reported in Djankov et al. (2008).
T-statistics are in parentheses and standard errors are clustered by firm and by year.

(1) (2) (3) (4)

ln(Cash/TA)

1998 sample Full sample

Trust 0.731*** 3.100*** 2.485***

(10.17) (11.55) (7.07)
LLSV −0.156*** 0.121*** 0.356***
(−12.90) (8.85) (14.92)
LLSV ∗ Trust −0.601***
(−7.97)
Score −0.272*** −0.155*** −0.116***
(−15.46) (−5.37) (−3.85)
Score ∗ Trust −0.197*** −0.215***
(−5.03) (−5.31)
Anti-selfdealing 1.382***
(13.31)
Anti-selfdealing ∗ Trust −3.049***
(−6.22)
GDP 0.0192 0.407*** 0.401*** 0.323***
(1.26) (11.78) (15.55) (12.20)
Common Law −0.321*** −0.376***
(−9.65) (−12.70)
Firm characteristics Yes Yes Yes Yes
Year fixed effects – Yes Yes Yes
Industry fixed effects Yes Yes Yes Yes
N 7206 229,044 229,044 229,044
adj. R-sq 0.263 0.301 0.308 0.304

Panel C: Interaction with credit market development

This panel reports the results when Trust is interacted with Banking. Banking is calculated as the ratio of country i's domestic credit provided by the banking
sector over its GDP. All variables are defined in Appendix A. T-statistics are in parentheses, and robust standard errors are clustered by country.

(1)

ln(Cash/TA)

Trust 0.992***
(4.45)
Trust ∗ Banking −1.49***
(−5.00)
Banking 0.597***
(5.18)
Firm characteristics Yes
Year fixed effects Yes
Industry fixed effects Yes
Country fixed effects Yes
N 221,307
adj. R-sq 0.328

corporate cash holdings and shareholder rights is mixed, leaving open the direction of the effect of shareholder rights (and thus
societal trust) on cash holdings.11
We use two different measures of shareholder rights. The first measure is the updated and corrected version of the sharehold-
er rights measure (LLSV) described in La Porta et al. (1998). The second measure is the anti-self-dealing index developed by
Djankov et al. (2008).12 The corrected version of shareholder rights index (LLSV) and the index of anti-self-dealing are obtained
from Djankov et al. (2008). Higher values of each index indicate stronger shareholder rights. Panel B of Table 6 reports the regres-
sion results. We first replicate the effect of shareholder rights on corporate cash holdings documented in Dittmar et al. (2003). We
restrict the set of observations to the 1998 calendar year and include industry fixed effects as in their original specification. As

11
Dittmar et al. (2003) find that cash holdings are lower in countries with stronger shareholder rights, but Harford et al. (2008) find a positive relation between share-
holder rights and corporate cash holdings in a sample of U.S. firms. Kalcheva and Lins (2007) paint a more nuanced picture and show that corporate cash holdings de-
crease with firm-level shareholder rights in countries with weak investor protection.
12
We do not include country fixed effects in this analysis as both the LLSV index and the anti-self-dealing index are country-specific and not time-varying.
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 379

shown in column (1), there is a negative relation between shareholder rights and corporate cash holdings. The coefficient esti-
mate of −0.156 is similar in magnitude to their estimate of −0.11 reported in Table 2, column (3) of their paper. We next in-
clude trust and shareholder rights (LLSV) in the regression equation using the whole sample period. As shown, the effect of
trust is positive and significant, and the magnitude of the coefficient is similar to estimates reported in Table 3. The sign on
the shareholder rights index changes from negative to positive when we expand the sample and control for country governance.
We further probe whether the effect of trust is weaker in countries with poor shareholder rights. We measure the relative ef-
fect of trust across countries with varying levels of shareholder rights by interacting trust with LLSV. As shown in column (3), the
interaction term between trust and LLSV is significantly negative. The last column confirms that this result also holds when we
replace LLSV with the anti-self-dealing index. We conclude that trust matters more in countries with weaker shareholder rights,
which is consistent with earlier results on the differing effect of trust across countries with different levels of governance quality.

4.3.2. Trust and financial development

We next examine the effect of financial development on the relation between societal trust and cash holdings. Higher moni-
toring intensity by the firm's creditors may affect the relation between trust and cash holdings, and this fact may weaken the ef-
fect of trust on cash holdings. We expect monitoring intensity by debt markets to strengthen with the level of credit market
development.
We test whether societal trust is less important when financial development is high by interacting Trust with the measure of
credit market development used in Rajan and Zingales (1998). Our proxy for the credit development of country j in year t is Bank-
ing, defined as the ratio of a country's domestic credit provided by the banking sector over its GDP, where the quantity of bank
credit and country GDP are obtained from the World Bank. Panel C of Table 6 shows that a more developed banking sector re-
duces the effect of trust on corporate cash holdings. As shown, the coefficient on the interaction term between Trust and Banking
is negative and statistically significant at the 1% level, suggesting that the effect of societal trust on cash holdings is more impor-
tant when financial development is weak.
Overall, we conclude that the effect of trust on corporate cash holdings is robust to controlling for shareholder rights, country-
level governance measures, unobserved country-level heterogeneity, as well as dimensions of a country's culture that relate to in-
dividual preferences. Moreover, trust matters most when the quality of a country's formal institutions is weak, as evidenced by
the significantly negative interaction effects between societal trust and the governance and shareholder rights indices.

4.4. Instrumental variables estimates

A potential concern with our findings is that cash balances vary across countries along some unobserved dimension or char-
acteristic that may also correlate with societal trust. For example, trust is positively correlated with economic growth, which is
also correlated with corporate profitability and the level of cash holdings. In order to address this concern, we employ two iden-
tification strategies, both based on instrumental variable regressions. The first strategy instruments trust with religion. Religion is
a more primitive aspect of societal culture that predicts differences in creditor-rights across countries (Stulz and Williamson,
2003). Moreover, the component of religion that is related to trust is correlated with economic growth (Blum and Dudley,
2001). For this strategy to work, it must also be the case that the effect of religion affects cash holdings only through the instru-
mented variable, e.g., societal trust. However, religion is correlated with individual preferences related to an individual's attitude
towards risk, which may also affect corporate financial policies (Hilary and Hui, 2009; Kumar et al., 2011). In order to ensure that
religion affects cash holdings via the societal trust mechanism and not this alternative channel, we control for cultural character-
istics such as individualism and uncertainty avoidance that are related to people's attitudes towards risk, as measured with the
Hofstede (1980) indices described above.
We obtain the data on the fraction of the population that practices a religious denomination from Maoz and Henderson
(2013). Survey data taken at five-year intervals provide information on the proportion of adherents to each religion, and we lin-
early interpolate the missing observations. Panel A of Table 7 reports the first-stage regressions of trust on religion at the country-
year-industry level. The sign of the effects of Protestant and Catholic on Trust in column (IV1) are consistent with Blum and Dudley
(2001). They argue that the rejection of the Catholic sacrament of penance by the Protestant religion increased the cost of defec-
tion from any contractual relationship by protestants. Specifically, Protestants “were subject to a strict system of norms defined by
their peer group”, making the perceived penalty of defection in such relationships severe. In contrast, for Catholics, feelings of
guilt after defection could be relieved by the sacrament of penance, and defection could be excused by cooperation in a subse-
quent game with the injured party (Blum and Dudley, 2001 pages 217–218).
In order to test whether the relation between trust and cash holdings is endogenous, we perform a Hausman test and compare
the ordinary least squares estimates with the two-stage least squares estimate. The Hausman test strongly rejects the null hypoth-
esis that the two estimators are equivalent, which confirms the endogeneity of trust and cash holdings. Our first-stage estimates
also reject the null hypothesis of weak instruments, as the F-statistic testing the joint significance of the instruments in the first-
stage is N10.13 Panel B reports the instrumented effect of trust on cash holdings. As shown, the sign and significance of the coef-
ficient on trust are consistent with our earlier results.

13
Staiger and Stock (1997) suggest the rule of thumb that instruments are weak if the first-stage F-statistic is b10.
380 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table 7
Instrumental variable estimates.

Panel A: First-stage regressions

This panel reports the first-stage instrumental variable estimates using 2SLS. The unit of observation is the firm-year. Columns (1) and (2) instruments trust
with religion and the ethnic fractionalization index, respectively. Protestant, Catholic, Muslim, Judaism and Buddhist measure the proportion of the population
that follows a given religious denomination. Ethnic fractionalization is the ethnic fractionalization score described in Alesina et al. (2003). First stage variables
also include firm-level controls, year and industry fixed effects, as well as the Hofstede (1980) cultural indices. T-statistics are in parentheses, and robust
standard errors are clustered by firm.

Trust

(IV1) (IV2)

Protestant 0.300***
(0.004)
Catholic −0.042***
(0.004)
Muslim −0.132***
(0.008)
Judaism −6.088***
(0.148)
Buddhist 0.167***
(0.003)
Ethnic fractionalization −0.128***
(0.004)
Firm-level controls Yes Yes
Year FE Yes Yes
Industry FE Yes Yes
Cultural indices Yes Yes
N 214,608 214,608
adj. R-sq 0.685 0.553

Panel B: Second stage regressions

This panel reports the second-stage instrumental variable estimates using 2SLS. T-statistics are in parentheses, and robust standard errors are clustered by
firm. Diagnostic statistics test for endogeneity and instrument relevance. The Hausman test is based on the different between the 2SLS estimates (consistent)
and OLS estimates (efficient). The F-test tests for the joint significance of the instruments (Protestant, Catholic, Muslim, Judaism and Buddhist) or (Ethnic
fractionalization) in the first stage.

Log(Cash/TA)

(IV1) (IV2)

Trust 1.511*** 1.291***

(0.118) (0.286)
Score −0.111*** −0.109***
(0.013) (0.013)
Log(GDP) 0.354*** 0.354***
(0.016) (0.016)
Size −0.011*** −0.010***
(0.004) (0.004)
Leverage −2.045*** −2.046***
(0.027) (0.027)
MTB −0.015*** −0.015***
(0.002) (0.002)
CAPX −1.782*** −1.777***
(0.076) (0.077)
RD 4.012*** 4.004***
(0.099) (0.099)
WCAP −1.211*** −1.216***
(0.036) (0.036)
Payer 0.022* 0.020*
(0.012) (0.012)
Financing 1.208*** 1.211***
(0.028) (0.028)
CFO 0.705*** 0.695***
(0.036) (0.037)
Std(CFO) 1.269*** 1.258***
(0.061) (0.062)
Year FE Yes Yes
Industry FE Yes Yes
Cultural indices Yes Yes
N 214,608 214,608
adj. R-sq 0.32 0.32
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 381

Table 7 (continued)

Panel B: Second stage regressions

This panel reports the second-stage instrumental variable estimates using 2SLS. T-statistics are in parentheses, and robust standard errors are clustered by
firm. Diagnostic statistics test for endogeneity and instrument relevance. The Hausman test is based on the different between the 2SLS estimates (consistent)
and OLS estimates (efficient). The F-test tests for the joint significance of the instruments (Protestant, Catholic, Muslim, Judaism and Buddhist) or (Ethnic
fractionalization) in the first stage.

Log(Cash/TA)

(IV1) (IV2)

Diagnostics
Hausman test endogeneity 257.30 12.61
P-value 0.00 0.01
F-test first stage 3235.87 859.21
P-value 0.00 0.00

One potential issue with the use of religion as an instrument is that religion and economic growth are endogenous (Trevor-
Roper, 2001). This concern applies to our study as well because economic growth is likely to affect corporate profitability and
therefore corporate cash holdings. To deal with this concern, we employ an alternative instrumental variable based on the degree
of ethnic fractionalization within each country in our sample. The main advantage of this variable is that its relation with econom-
ic growth is less endogenous than religion (Alesina et al., 2003). We use the measure of ethnic fractionalization developed by
these authors as our measure of ethnic diversity.14
Previous research shows that the ethnic composition of a country's population significantly affects societal trust at both region-
al and country levels of aggregation. Putnam (2007) documents that inhabitants of diverse neighborhoods tend to withdraw from
collective life, to distrust their neighbors and to vote less. Explanations for this finding are based on the difficulty of enforcing co-
operative norms in more diverse groups, and “ethnic biases and in-group preferences that make people distrustful of members of
out-groups” (Koopmans and Veit, 2014). Consistent with these earlier studies, we find that ethnic fractionalization (Ethnic frac-
tionalization) is negatively associated with societal trust. As shown, the coefficient on Ethnic fractionalization in Panel A equals
−0.128 and is statistically significant at the 1% level. It also passes the instrumental variable relevance test (F-statistic N 10).
Panel B reports the effect of societal trust instrumented with Ethnic fractionalization. As shown in column (2), the effect of trust
is positive and significant and of the same magnitude as in column (1). Interestingly, the magnitude of the instrumented coeffi-
cients in both columns is several orders of magnitude larger than the non-instrumented value. For instance, using Ethnic fraction-
alization as the instrumental variable, the point estimate equals 1.29, indicating that moving from the 25th to the 75th percentile
of trust increases the ratio of cash to assets by 29%. Instrumenting trust with religion implies a similarly large effect compared to
our baseline regression result. The large magnitude obtained with the instrumental variable models suggests that trust may be
correlated with unobserved informal institutional qualities that affect corporate cash holdings. We conclude that, controlling for
the potential endogeneity of trust and corporate cash holdings, trust has an economically significant effect on the firm's cash
policy.

4.5. Trust and the marginal value of cash

In this section, we estimate the marginal value of cash holdings to the firm's stockholders. The effect of trust on the marginal
value of cash is measured by applying the method of Faulkender and Wang (2006). Specifically, we estimate the change in share-
holder value on the change in cash as well as other balance sheet and income statement items. We measure the change in share-
holder value as the share return in excess of each country's market benchmark return. Since both the dependent and independent
variables are scaled by the market value of equity, the coefficient on the change in cash measures the incremental dollar value to
shareholders of an additional dollar of cash.
We measure the effect of trust by interacting the annual change in cash with trust. In order to control for the quality of the
country's governance and economic development, we also interact the change in cash with Score and GDP per capita. Specifically,
we estimate the following regression:

ΔC it ΔC it ΔC it ΔC it ΔNAit
Rit −RMkt ¼ γ 0 þ γ 1 þ γ2  Trust it þ γ 3  Scoreit þ γ 4  GDP it þ γ 5  Trust it
MEit−1 MEit−1 MEit−1 MEit−1 MEit−1
ΔNAit ΔNAit C it−1 ΔC it ΔC it C it−1
þ γ6  Scoreit þ γ7  GDPit þ γ8 þ γ 9 Lit þ γ10 þ γ 11 Lit
MEit−1 MEit−1 MEit−1 MEit−1 MEit−1 MEit−1
ΔEit ΔRDit ΔInt it ΔDivit NF it
þ γ12 þ γ 13 þ γ 14 þ γ 15 þ γ16 þ γ 17 Trust it þ γ18 Scoreit þ γ 19 GDP
MEit−1 MEit−1 MEit−1 MEit−1 MEit−1
þ fixed effects þ eit ð2Þ

where ΔX indicates a change in X from year t − 1 to t, and Rit equals the stock return over year t, RMkt equals the country's market
index return over year t, MEit − 1 equals the firm's market value of equity at time t − 1, Cit − 1 equals cash, Intit equals annual

14
We obtain this data from Romain Wacziarg's website at http://www.anderson.ucla.edu/faculty_pages/romain.wacziarg.
382 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

interest payments, Divit equals the common dividend paid in year t, Eit equals earnings before extraordinary items, NAit equals as-
sets net of cash, NFit equals net financing, Lit equals market leverage, RDit equals research and development expense. These control
variables capture changes in firm characteristics that may be correlated with the firm's financial policy, payout policy or invest-
ment policy. All firm characteristic variables except market leverage are deflated by the market value of equity in year t − 1.
This deflation allows us to interpret the coefficient estimates as the marginal values of the right-hand-side variables.
As discussed in Section 2, the precautionary-savings motive hypothesis predicts that the effect of trust on an extra dollar of
cash is negative, and the agency hypothesis makes the opposite prediction. Specifically, Hypothesis 3a predicts that γ2, the inter-
action term between trust and the change in cash, is negative, and Hypothesis 3b predicts that this coefficient is positive. Given
earlier findings in the literature that better country governance improves the valuation of cash (Pinkowitz et al., 2006), we expect
γ3 to be positive. In order to simplify the interpretation of the results, the trust-related variables, Score and the logarithm of GDP
per capita are demeaned in each of the interaction terms. As such, the coefficient γ1 measures the marginal value of cash for a
firm with zero leverage, zero cash holdings located in a country with mean values of trust, governance and GDP.
We present the results in Table 8. Column (1) reports estimates of equation (2) without fixed effects. In column (2), we in-
clude year, industry and country fixed effects. As shown, higher levels of trust increase the marginal value of cash, as evidenced
by the statistically significant positive coefficient on the interaction term between the change in cash and trust. This result indi-
cates that societal trust increases the value shareholders put on the firm's internal resources, consistent with Hypothesis 3b. These
results are robust to including year, industry and country fixed effects (column 2), as the inclusion of these controls does not af-
fect the magnitude of the coefficient on the interaction term. Consistent with earlier results in the literature, country governance
(measured with Score) has a positive effect on the marginal value of cash, indicating that cash is valued more highly in countries
with better governance.

4.5.1. Economic impact of trust on the marginal value of cash

We assess the economic significance by adding the coefficient on the change in cash to the product of the coefficient on the
interaction term with trust with either the 25th or the 75th percentile of trust. As in Faulkender and Wang (2006), we set cash
and leverage to zero. Thus, we obtain the marginal value of cash for the firm located in a country with mean levels of trust, gov-
ernance and GDP per capita. Panel B reports these estimates. As shown, the marginal value of cash equals $1.13 based on column
(1) and (2) estimates. In comparison the marginal value of cash for U.S. firms obtained in Faulkender and Wang (2006) equals
$1.47, while Dittmar and Mahrt-Smith (2007) find that the marginal value of cash in an international setting equals $1.09.
The effect of trust on the marginal value of cash is economically significant, controlling for the effect of formal institutions on
the value of cash holdings. For instance, based on column (2) estimates, firms located in countries with levels of trust one stan-
dard deviation below the mean have a marginal value of cash of $1.09. In comparison, the marginal value of cash equals $1.19 for
firms located in countries with trust that is one standard deviation above the mean. It follows that moving from a low-trust coun-
try to a high-trust country increases the marginal value of cash by $0.10.
For purposes of comparison, we execute a similar computation for Score using estimates from the regression reported in col-
umn (2). The marginal value of cash when Score is one standard deviation below the mean is $1.02. The corresponding value
when Score is one standard deviation above the mean is $1.26. Thus moving from a low-governance quality country to a high-
governance quality country increases the marginal value of cash by $0.24. We conclude that the effect of trust on the marginal
value of cash is close to half of the effect of a country's formal institutions. Overall, the results of this section are consistent
with the agency hypothesis, and they illustrate the role societal trust plays in shaping investors' valuation of the firm.

5. Robustness tests

5.1. Excluding countries with high-trust levels

The majority of observations in our sample consists of firm-year observations for firms that are located in the United States,
the United Kingdom, Canada or Japan. All of these countries have high trust scores. In order to ensure that our results are not
driven by these countries, we exclude firms located in the United States, United Kingdom, Canada and Japan, respectively. As
shown in Panel A of Table 9, the economic and statistical significance of the effect of trust on corporate cash holdings remains
similar when we remove these firms from the sample. We conclude that a specific subsample of firms that belong to high-
trust countries does not drive our results.

5.2. Construct validity of societal trust measure

One concern is that trust, as measured by the WVS, captures the response of the average citizen and therefore does not reflect
the level of trust of the firms' current and potential investors. Thus, our measure of trust would be more accurate if we knew the
level of trust of the country's stock-market investors. To assess the sensitivity of our baseline result to this assumption, we adopt
an approach similar to Pevzner et al. (2015) and create two alternative trust measures, TrustHI and TrustHE, respectively, based on
different subsets of respondents to the WVS.
The WVS partitions respondents according to their annual income and education. We base our first measure of trust (TrustHI)
on answers provided by individuals whose income is in the top tercile of the country's income distribution, as reported to the
WVS. The second measure of trust (TrustHE) uses survey responses of respondents who achieved a university-level education.
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 383

Table 8
Trust and the marginal value of cash.

Panel A: Regression estimates

This panel reports results of regressing annual excess return on ΔCash and its interaction with trust and other firm characteristics. Trust, Score and GDP are
demeaned. T-statistics are in parentheses and standard errors are clustered by firm and by year.

(1) (2)

Ri,t-RM

ΔCash 1.130*** 1.139***

(30.70) (32.54)
ΔCash ∗ Trust 0.328** 0.303**
(2.20) (2.31)
ΔCash ∗ Score 0.0444 0.0580**
(1.32) (2.43)
ΔCash ∗ GDP −0.0192 −0.0369
(−0.48) (−1.26)
ΔNAt 0.102*** 0.116***
(5.90) (8.43)
ΔNA ∗ Trust 0.0878* 0.0766
(1.65) (1.35)
ΔNA ∗ Score 0.00537 0.00739
(0.53) (0.76)
ΔNAt ∗ GDP −0.0128 −0.0111
(−0.82) (−0.82)
Casht − 1 ∗ ΔCash −0.824*** −0.787***
(−11.69) (−13.21)
Lev ∗ ΔCash −1.151*** −1.191***
(−15.60) (−16.55)
Casht − 1 0.207*** 0.222***
(8.53) (8.69)
Lev −0.309*** −0.358***
(−8.87) (−15.82)
ΔE 0.463*** 0.453***
(17.26) (17.38)
ΔRD 1.194*** 1.364***
(2.58) (3.24)
ΔInt −2.010*** −1.709***
(−8.65) (−8.49)
ΔDiv 1.733*** 1.943***
(5.07) (8.05)
NF 0.0755** 0.0931***
(2.50) (4.61)
Trust 0.0231 −0.115
(0.33) (−0.67)
Score −0.0190* −0.00613
(−1.69) (−0.20)
GDP 0.0100 0.0666
(0.68) (1.23)
Year fixed effects No Yes
Industry fixed effects No Yes
Country fixed effects No Yes
N 342,400 342,400
adj. R-sq 0.141 0.168

Panel B: Marginal value of cash estimates

This panel reports the marginal value of cash estimates. These estimates are calculated using the coefficients on the change in cash and the interaction terms
between ΔCash and Trust and ΔScore and Trust, setting leverage and lagged cash balances to zero.

(1) (2)

MV cash $1.13 $1.14

MV cash: Trust = −1SD $1.07 $1.09
MV cash: Trust = +1SD $1.19 $1.19
MV cash: Score = −1SD $1.04 $1.02
MV cash: Score = +1SD $1.22 $1.26

Intuitively, people with higher incomes and higher education levels are more likely to be equity investors. Table 9 Panel B reports
the regression results using these two measures. As shown, measures of trust are positively associated with corporate cash hold-
ings. Moreover, the coefficient estimates are close in magnitude to the baseline estimates reported in Table 3, which confirms the
construct validity of our measure of trust.
384 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table 9
Additional robustness analyses.

Panel A: Excluding countries with highest number of observations

This panel reports the effect of trust on cash holdings after excluding the United States, the United Kingdom, Canada, and Japan. Tstatistics are in parentheses
and standard errors are clustered by firm and by year.

(1) (2) (3) (4)

log(Cash/TA)

Excluding US Excluding US, UK Excluding Excluding

US, UK, CA US, UK, CA, JP

Trust 0.466** 0.528** 0.570*** 0.532**

(2.20) (2.38) (2.77) (2.45)
Firm characteristics Yes Yes Yes Yes
Fixed effects Year, industry and country
N 187,082 170,532 157,428 126,070
adj. R-sq 0.263 0.271 0.279 0.273

Panel B: Cash holdings using alternative trust measures

This panel reports the results of using alternative measures of trust. In column (1), TrustHI is defined as the percentage of high-income people who responded
that most people can be trusted. High-income people are defined as people who responded that their incomes are in the top tercile of their countries. In
column (2), TrustHE is defined as the percentage of high-education people who responded that most people can be trusted. High-education people are defined
as people who responded that their highest education is the university-level. T-statistics are in parentheses and standard errors are clustered by firm and by
year.

(1) (2)

log(Cash/TA)

TrustHI 1.067***
(5.29)
TrustHE 0.501***
(2.75)
Firm characteristics Yes Yes
Fixed effects Year, industry and country
N 229,090 229,428
adj. R-sq 0.331 0.330

Panel C: Marginal value of cash using alternative trust measures

The panel reports marginal value of cash estimates as described in Table 8 using alternative measures of trust. In column (1), TrustHI is defined as the
percentage of high-income people who responded that most people can be trusted. High-income people are defined as people who responded that their
incomes are in the top tercile of their countries. In column (2), TrustHE is defined as the percentage of high-education people who responded that most people
can be trusted. High-education people are defined as people who responded that their highest education is the university-level. T-statistics are in parentheses
and standard errors are clustered by firm and by year.

(1) (2)

Ri,t-RM

ΔCash ∗ TrustHI 0.333***

(−2.77)
ΔCash ∗ TrustHE 0.338**
(−2.50)
Control variables Yes Yes
Fixed effects Year, industry and country
N 341,930 337,551
adj. R-sq 0.163 0.169

As a final robustness check, we also estimate the marginal value of cash equation using the alternative measures of trust based
on high-income earners and high-education respondents to the WVS. Using these estimates (reported in Panel C) yields almost
identical coefficients to those reported in Table 8.

6. Conclusion

We explore the role played by societal trust in shaping firms' financial policy. We test two competing hypotheses about the
effect of trust on corporate cash holdings. The precautionary savings hypothesis predicts that firms located in high-trust countries
hold less cash because they enjoy better access to financial markets. The agency hypothesis predicts the opposite. According to
this hypothesis, outside investors put less pressure on insiders to disgorge cash in countries where societal trust is high.
We document three findings that support the agency hypothesis. We first show that societal trust has a positive effect on firm
cash holdings. This result is robust to controlling for firm characteristics and country governance quality, as well as country fixed
effects. Second, we find that the effect of trust on cash holdings is strongest in firms located in countries with weak institutions
 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387 385

and in firms with high information asymmetries and low levels of private trust between insiders and outside shareholders. Third,
we show that investors value cash more highly in firms that are located in countries with higher levels of societal trust. Instru-
mental variable tests suggest a causal interpretation of the effect of trust on cash holdings.
Our findings highlight the role played by societal trust in shaping corporate financial policy. Societal trust becomes more im-
portant when formal institutions such as the quality of a country's institutions and the strength of shareholder and creditor rights
are weak. We contribute to the corporate finance literature by highlighting the role played by informal institutions such as a
country's social capital in shaping corporate financial policy. This finding is important because prior evidence on the determinants
of cash holdings focuses primarily on the role of formal institutions and firm-level measures of governance.

Acknowledgements

We thank Mike Welker, Ali Nejadmalayeri (discussant) and workshop participants at the IFABS 2015 Corporate Finance Con-
ference for their comments. We also thank Jeff Netter (the editor) and an anonymous reviewer for very helpful comments.

Appendix A. Appendix

Table A1
Variable definitions.

Variable Definitions

Country-level variables
Trust This captures societal trust, calculated based on responses to the WVS question: “Generally speaking, would you
say that most people can be trusted or that you need to be very careful in dealing with people?” Specifically, it is
defined as the percentage of people who responded that most people can be trusted. We linearly interpolate
and fill this variable for years between the two adjacent surveys.
TrustHI This captures societal trust, calculated based on responses to the WVS question: “Generally speaking, would you
say that most people can be trusted or that you need to be very careful in dealing with people?” Specifically, it is
defined as the percentage of high-income people who responded that most people can be trusted. High-income
people are defined as people who responded that their incomes are in the top tercile of their countries. We
linearly interpolate and fill this variable for years between the two adjacent surveys.
TrustHE This captures societal trust, calculated based on responses to the WVS question: “Generally speaking, would you
say that most people can be trusted or that you need to be very careful in dealing with people?” Specifically, it is
defined as the percentage of high-income people who responded that most people can be trusted.
High-education people are defined as people who responded that their highest education is the university-level.
We linearly interpolate and fill this variable for years between the two adjacent surveys.
Score This captures country-year specific level of investor protection. It is the first principal component of component
of governance (Govern), regulatory quality (Regquality), control of corruption (Ctrlcorruption), political
stability (Polstability), rule of law (Ruleoflaw) and voice and accountability (Voice) as described in Kaufmann et
al. (2009) and at http://info.worldbank.org/governance/wgi).
GDP Natural logarithm of GDP per capita. (source: worldbank.org)
Hofstede Culture Indices Country-level cultural indices along four dimensions (individualism, power distance, uncertainty avoidance and
masculinity)
Banking This captures the development of banking infrastrucature. It is calculated as the ratio of country i's domestic
credit provided by the banking sector over its GDP. (source: worldbank.org)
LLSV The shareholder rights index from Djankov et al. (2008).
Anti-selfdealing Index The anti-selfdealing index from Djankov et al. (2008).
Government Effectiveness Government effectiveness captures perceptions of the quality of public services, the quality of the civil service
and the degree of its independence from political pressures, the quality of policy formulation and
implementation, and the credibility of the government's commitment to such policies. (source:
http://info.worldbank.org/governance/wgi)
Regulatory Quality Regulatory quality captures perceptions of the ability of the government to formulate and implement sound
policies and regulations that permit and promote private sector development. (source:
http://info.worldbank.org/governance/wgi)
Control of Corruption Control of corruption captures perceptions of the extent to which public power is exercised for private gain,
including both petty and grand forms of corruption, as well as “capture” of the state by elites and private
interests. (source: http://info.worldbank.org/governance/wgi)
Political Stability Political Stability and Absence of Violence/Terrorism measures perceptions of the likelihood of political
instability and/or politically-motivated violence, including terrorism. (source:
http://info.worldbank.org/governance/wgi)
Rule of Law Rule of law captures perceptions of the extent to which agents have confidence in and abide by the rules of
society, and in particular the quality of contract enforcement, property rights, the police and the courts, as well
as the likelihood of crime and violence. (source: http://info.worldbank.org/governance/wgi)
Voice and Accountability Voice and accountability captures perceptions of the extent to which a country's citizens are able to participate
in selecting their government, as well as freedom of expression, freedom of association and a free media
(source: http://info.worldbank.org/governance/wgi)

(continued on next page)

386 E. Dudley, N. Zhang / Journal of Corporate Finance 41 (2016) 363–387

Table A1 (continued)

Variable Definitions

Firm-level variables
Variables used in the cash holding and
payout regressions
ln(Cash/TA) Natural logarithm of cash and cash equivalent scaled by total assets.
Cash Cash and cash equivalent scaled by total assets.
ln(Cash/Net Assets) Natural logarithm of cash and cash equivalent scaled by net assets.
Cash/Net Assets Cash and cash equivalent scaled by net assets.
Size Natural logarithm of total assets.
Leverage Sum of long-term debt plus debt in current liabilities, divided by total assets.
MTB Market to Book ratio of equity.
Capex Capital expenditure scaled by total assets.
RD R&D expenses scaled by total assets.
WCAP Net working capital, defined as the difference between current assets and current liabilities excluding cash and
cash equivalent, scaled by total assets.
Payer An indicator variable that takes one if a firm pays dividend and zero otherwise.
CFO Cash from operations, scaled by total assets.
Std(CFO) Standard deviation of sales scaled by lagged total assets over the five-year rolling window.
Financing Cash from new equity issuance and debt issuance, scaled by total assets.
Growth Sales growth from year t − 1 to t
Excess return Difference between the firm's return and the market return
P/E Price-to-earnings ratio
ΔIndustry adjusted dividends Annual change in dividends industry adjusted on a yearly basis using the Fama-French 48 industry
classifications (scaled by total assets)
ΔIndustry adjusted repurchases Annual change in share repurchases industry adjusted on a yearly basis using the Fama-French 48 industry
classifications (scaled by total assets)
Variables used in the MVCash
regression
Exret Annual excess return, calculated as the difference between the annual return and market return.
ΔCash Change in cash and cash equivalent lagged scaled by market value of equity.
ΔE Change in earnings before extraordinary items plus interest, deferred tax credits and investment tax credits,
scaled by lagged market value of equity.
ΔNA Change in net assets where net assets are defined as total assets minus cash holdings, scaled by lagged market
value of equity.
ΔRD ΔRD is change in R&D expenditures, scaled by lagged market value of equity.
ΔInt Change in interest expense, scaled by lagged market value of equity.
ΔDivt Change in common dividends paid, scaled by lagged market value of equity.
Casht − 1 Cash balance from last year, scaled by lagged market value of equity.
Lev Market leverage ratio, defined as total debt over the sum of total debt and the market value of equity.
NF Total equity issuance minus repurchases plus debt issuance minus debt redemption, scaled by lagged market
value of equity.
Instrumental variables
Protestant Percentage of protestants. (source: www.correlatesofwar.org)
Catholic Percentage of Catholics.
Muslim Percentage of Muslims.
Judaism Percentage of Jewish.
Buddhist Percentage of Buddhists.
Ethnic fractionalization Ethnic fractionalization score.
(source: http://www.anderson.ucla.edu/faculty_pages/romain.wacziarg)

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