The effect of state-level corruption on performance and risk of financial institutions

Abstract

Purpose This study aims to investigate the effect of public corruption on the performance and risk of financial institutions domiciled in the USA.. Design/methodology/approach This study uses the US Department of Justice’s (DOJ) Public Integrity Section Reports to proxy corruption. The analysis is performed by bank size and includes robustness checks for omitted variables and endogeneity concerns. Findings The results show that a corrupt environment is associated with lower bank performance without a reduction in risk. Larger banks tend to underestimate the increase in credit risk. Small- and medium-size banks seek to “re-capture” returns in corrupt districts by reducing their liquidity. Research limitations/implications The implication of this research is that financial institutions do not thrive in corrupt environments and are unlikely to participate in corrupt practices. Overall, this study documents the tangible harm inflicted by corrupt practices. Practical implications A practical implication is that banks may attempt to re-capture lower returns resulting from corrupt environments by extending more risky loans, specifically, commercial real estate loans. Social implications This study demonstrates the costly impact of corruption on large and small banks. While larger banks report higher share of non-performing loans, smaller banks show an increase in the provision for loan and lease losses, suggesting that smaller banks may be more risk averse. Originality/value Prior studies investigate corruption in US firms while excluding financial institutions. This study fills this gap by investigating the effect of public corruption on the performance and risk of financial institutions domiciled in the USA.