Do firms in countries with poor protection of investor rights hold more cash?

Aaron Kravitz, for their help with the data collection. We are grateful to Ole-Kristian Hope, Jan Mahrt-Smith, and seminar participants at the University of Toronto for useful comments. Abstract Managers make different decisions in countries with poor protection of investor rights and poor financial development. One possible explanation is that shareholder-wealth maximizing managers face different tradeoffs in such countries (the tradeoff theory). Alternatively, firms in such countries are less likely to be managed for the benefit of shareholders because the poor protection of investor rights makes it easier for management and controlling shareholders to appropriate corporate resources for their own benefit (the agency costs theory). Holdings of liquid assets by firms across countries are consistent with Keynes' transaction and precautionary demand for money theories. Firms in countries with greater GDP per capita hold more cash as predicted. Controlling for economic development, firms in countries with more risk and with poor protection of investor rights hold more cash. The tradeoff theory and the agency costs theory can both explain holdings of liquid assets across countries. However, the fact that a dollar of cash is worth less than $0.65 to the minority shareholders of firms in such countries but worth approximately $1 in countries with good protection of investor rights and high financial development is only consistent with the agency costs theory. 2 1. Introduction Recent work shows that countries where institutions that protect investor rights are weak perform poorly along a number of dimensions. In particular, these countries have lower growth, less well-developed financial markets, and more macroeconomic volatility. 1 To measure the quality of institutions, authors have used, for instance, indices of the risk of expropriation, the level of corruption, and the rule of law. Since poor institutions could result from poor economic performance rather than cause it, authors have also used the origin of a country's legal system (La 2003) as instruments for the quality of institutions. For the quality of institutions to matter for economic performance, it has to affect the actions of firms and individuals. Recent papers examine how dividend, investment, asset composition, and capital structure policies are related to the quality of institutions. 2 In this paper, we focus more directly on why firm policies depend on the quality of institutions. The quality of institutions can affect firm policies for two different reasons. First, a country's protection of investor rights may influence the relative prices or …