In his Nobel Lecture in 1994, Douglass C. North emphasised that “institutions are the humanely devised constraints that structure human interaction. They are made up of formal constraints (e.g., rules, laws, constitutions), informal constraints (e.g., norms of behavior, self-imposed codes of conduct), and their enforcement characteristics.”

No surprise, then, that research in sociology, political science, public policy, and economics has consistently shown that in almost any given geographical area, social norms and social networks - which these researchers titled ‘social capital’ - can either promote or constrain behaviors of people residing in that area, depending on whether the particular behaviors are deemed as congruent or contradictory to the prescribed norm. Surprising though, there is little scientific evidence relating geography-based social capital to corporate decisions, despite that corporate decisions are made by executives who are themselves susceptible to geography-based social influences.

To address this myself, Hao Zhang from Rochester Institute of Technology, Qiang Wu from Rensselaer Polytechnic Institute, and Iftekhar Hasan from Fordham University investigated various consequences of social capital in U.S. counties on publicly listed corporations with corporate headquarters located in the county. Our studies, published in the Journal of Accounting Research, Journal of Financial Economic, Journal of Financial & Quantitative Analysis, and Journal of Business Ethics, found that social capital engenders benefits for shareholders, the corporations in the areas, and the society at large.

The effect of social capital on behaviour

There is considerable debate on how to constrain corporate tax avoidance and other corporate activities that are generally considered by people outside the corporate sector as socially irresponsible. We found that social capital can help. Social capital reduces the extent and the severity of corporate tax avoidance, discourages corporate activities that are deemed by external third parties as socially irresponsible (e.g., antitrust, emissions, layoffs, product safety), and encourages those that are regarded as socially responsible (e.g., charitable giving, work-life balance, minority contracting).

By deterring opportunistic corporate activities that potentially benefit shareholders at the expense of stakeholders (e.g., employees, suppliers, customers, the communities in which the firm operates), social capital can engender benefits for the society at large. However, such deterrence effects could be costly to shareholders and the corporations. We found no evidence to support this conjecture. In contrast, we found that social capital also engenders benefits for shareholders and the corporations.

Specifically, banks reduce loan spreads and relax loan terms when lending to corporations headquartered in areas with higher levels of social capital. Bond investors similarly demand lower returns for investing in bonds issued by these corporations. Additionally, executives in corporations headquartered in areas with higher levels of social capital refrain from opportunistic pay practices that unduly favor themselves at the expense of shareholders, such as backdating options; and, this heightened self-restrain in pursuing rent extraction in compensation leads to a lower level of excessive CEO pay in firms headquartered in counties with higher levels of social capital.  

In all of these studies, we use the same empirical proxy for social capital. Our proxy reflects the ramification of cooperative norms and social networks in a local, small-scaled, geographically-bounded community (i.e., in a U.S. county). Cooperative norms are based on voluntary participation in activities that produce the individuals with little direct economic benefits (i.e., participation in voting and census surveys). Social networks are the total number of non-profit and social organizations including sports club, bowling centers, fitness centers, etc. Our intuition is that dense social networks help to more effectively communicate and enforce the attendant code of conduct associated with cooperative norms. As such, our works show that social norms in even a small-scaled, local community can infiltrate large, for-profit organizations such as publicly listed corporations and affect the decision making process in these organizations by coercing executives and companies to adopt behaviors and practices that conform to the prevailing norms in the areas in which they reside.

Striking results

It is unsurprising that executives and companies would adopt behaviors and practices accordingly to the prevailing expectations in the society. Executives and board members know the importance of their companies’ reputation. They also recognize that reputation is a matter of perception, which is driven, in part, by prevailing beliefs and expectations among people outside the corporate sector. Reputational risks arise when companies fail to adapt to these societal expectations. To mitigate potential threats to their companies’ reputation, executives and companies should adopt behaviors and practices that conform to the prevailing societal expectations.

Even so, our results are still remarkable because they demonstrate the effects of social norms in small-scaled, local communities on publicly listed corporations, which could be quite tenuous. Corporations are large organizations with multiple stakeholders who often have conflicting expectations, providing plausible rationale to ignore, or even violate, expectations of one group in favor of expectations of another. Executives are elites in the society who often comingle with others with equally high socio-economic status in their own estates or in private golf clubs, creating a strong in-group that needs not share the social norms in the local areas in which the executives reside. Indeed, the neo-classical economic perspective dictates that for-profit entities should use their resources to increase profit so long as it stays within the rules of the game. There is widespread concern that executives and corporations, driven by the profit motive and using the pretext of shareholder value maximization, would disregard social norms in conducting business, particularly when the norms of behaviors are shared only among people in small-scaled, local communities. Our works show that this concern is unwarranted.

Our research are based on observations from thousands of U.S. companies over at least 20 years. The takeaway for corporate decision makers is straightforward. Most U.S. executives and companies do consider social norms as an important rule of game in their decision making, even if they are from local communities. Shouldn’t you?

Further reading:

• Does Social Capital Matter in Corporate Decisions? Evidence from Corporate Tax Avoidance Journal of Accounting Research, Vol. 55, No. 3, 2017