Pan-Pacific Conference XXXIV. Designing New Business Models in Developing Economies

2. DEVELOPMENT OF HYPOTHESIS
Existing literature has advanced mainly two
hypotheses—risk mitigation hypothesis and
overinvestment hypothesis—on the associations between
CSR and costs of equity and debt capitals (Goss and
Roberts, 2011, Harjoto and Jo, 2011; Menz, 2010).
Several studies show evidence supporting the risk
mitigation hypothesis that socially responsible companies
are generally considered to have low idiosyncratic risk
(Boutin-Dufresne and Savaria, 2004; Soppe, 2004). One
of the potential sources of lower risk associated with
corporate social performance (CSP, hereafter) is through
less risky future cash flows, whereby better CSP can
lower the likelihood of costly law suits and/or increased
regulatory intervention and compliance costs associated
with social and environmental issues. Accordingly,
lenders have an incentive to incorporate a borrower’s
corporate social performance in their assessment of the
firm’s risk and loan pricing; hence, banks may price
these positive activities into a lower loan spread.
On the contrary, a firm’s CSR engagement may be
viewed from the perspective of a principal-agent relation
between managers and shareholders. Barnea and Rubin
(2010) argue that a firm’s top managers have an interest
in over-investing in CSR if it provides private benefits of
personal reputation building as good citizens such as an
environmentally-conscious CEO, possibly at the expense
of shareholders. For example, as personal reputation
increases due to publicized CSR engagements by CEO,
he or she may improve future marketability in CEO labor
market. Overconfident CEO tends to pursue
overinvestments in general that are not aligned with the
best interests of shareholders, as documented in the
behavioral finance literature. Bartkus et al. (2002) also
suggest that managers may overinvest in philanthropy for
managerial self-interests at the expense of shareholders
beyond an optimal level, which would hurt firm value.
Accordingly, the overinvestment hypothesis posits that a
firm’s CSR engagement is an overinvestment for a
manifestation of manager’s diversion of corporate
resources and thus makes the firm more vulnerable to
credit screening by lenders, causing a higher credit
spread charged on the firm’s loans.
While the risk mitigation hypothesis and the
overinvestment hypothesis predict a linear relationship of
CSR engagement with a loan spread in the opposite
direction, the true relationship between CSR engagement
and loan pricing may not be linear. When the risk
mitigation hypothesis is combined with the
overinvestment hypothesis, the joint hypothesis may
suggest a non-linear relationship of CSR engagement
with a loan spread. As posited by the risk mitigation
hypothesis, a firm’s CSR engagement would make the
firm less vulnerable to negative events (Godfrey, 2005;
Peloza, 2006; Zhang et al., 2010) and thus lower the firm
risk, leading to a lower loan spread. This negative
relationship would, however, hold true up to an optimal
level of CSR engagement. Beyond the optimal threshold
of CSR investment, the overinvestment hypothesis
dictates in a way that creditors would view the borrowing
firm’s CSR overinvestment as a waste of free cash flows
due to the firm’s agency problems, thus compromising
the benefit of CSR engagement and increasing the loan
spread. Hence, as a borrowing firm marginally increases
CSR engagement, the benefit increases at a decreasing
rate. Accordingly, the benefit of CSR engagement may
be U-shaped, rather than monotonic, relative to the loan
spread.
Our hypothesized relationship of CSR with the
cost of bank loan is consistent with the implications of
prior CSR research. McWilliams and Siegel (2001)
hypothesize an ideal level of CSR investment that
optimizes cost of providing CSR, while still satisfying
demand for CSR from various stakeholders by
considering supply and demand aspects of CSR
investment. Godfrey (2005) also suggests that there
exists an optimal level of CSR from the risk mitigation
perspective. He argues that because a firm’s CSR
investment should be just enough to fully insure the
firm’s risky assets against potential loss, CSR
investments beyond this optimal level would impose
additional costs without any insurance value. Our
hypothesis is also supported by the empirical evidence in
Ye and Zhang (2011) which finds a U-shaped
relationship between CSR and debt financing costs for
Chinese firms. Their results indicate firms with
extremely high or low CSR are associated with higher
costs of debt, while firms with moderate CSR command
lower costs of debt.
Based on the joint hypotheses of the risk
mitigation hypothesis and the overinvestment hypothesis,
we state our main hypothesis as follows:
Hypothesis: A firm’s CSR engagement is nonlinearly
related to its loan spread, first decreasing the
loan spread up to an optimal level of CSR engagement
and then increasing the loan spread beyond it.
3. DATA
Sample bank loans are collected from Thomson
Reuters LPC DealScan database over the period of 1991-
2008. The DealScan database cumulates loan data,
mostly syndicated loan data, from various sources
including government filings. We screen DealScan for
loan facilities originated in U.S and match loan samples
with firm-level financial, stock return, and analyst
information from Compustat, CRSP, and the Institutional
Brokers Estimates System (IBES), respectively. Our
selection procedure leads to a final sample of 5,810 bank
loans.
Each borrowing firm’s CSR ratings are obtained
from KLD’s Socrates database. The KLD database is the
most comprehensive and widely used data on CSR
research and includes social ratings for more than 3,000
companies listed on the Russell 2000, S&P 500 and
Domini 400 Social indexes over consecutive periods.
The KLD ratings are on thirteen dimensions of CSR; the
first seven dimensions of community, corporate
governance, diversity, employee relations, environment,
human rights, and product quality & safety offer bases
for strength and concerns ratings, while the second six
dimensions of product, alcohol, gambling, firearms,
military, tobacco and nuclear power are purely
exclusionary screens, for which firms can only register
concerns.
4. MAIN RESULTS AND CONCLUSION
Employing a large sample of more than 5,000 bank
loans over the period of 1991-2008, our results show that
both CSR strengths and CSR concerns of borrowing
firms are significantly but oppositely related to their loan
spreads; hence, a borrower’s CSR strengths (concerns)
work to lower (increase) the loan spread.
More importantly, as a borrower marginally
increases CSR engagement, the loan spread declines at a
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