Validating our measure
Our research shows that our new measures indeed capture political risk. For example, the mean score for overall political risk increases significantly around federal elections. Furthermore, we show that our measure correlates with firm-level outcomes – such as volatility, investment, employment, political donations and lobbying activities – in a way that is highly indicative of reactions to political risk. Standard models predict than an increase in any kind of risk, and thus also an increase in the firm’s political risk, should trigger a rise in the firm’s stock market volatility and decrease its investment and employment growth.
In contrast to these “passive” reactions to overall risk, firms may also “actively” manage political risk by donating to campaigns or lobbying politicians. According to the literature, such active management of political risks should be concentrated among large but not small firms, because large firms internalize more of the gain from swaying political decisions than small firms. Our results are consistent with all these predictions.
Political risk at the firm level
Interestingly, we find the incidence of political risk across firms is far more heterogeneous and volatile than previously thought. The vast majority of the variation in our measure is at the firm level rather than at the aggregate or sector level, which means that the risks are not always felt industry-wide. This focus on the firm-level, as well as the fact that most companies act to mitigate the perceived risks of new policies before these are in place, confirms the usefulness of analyzing earnings calls to gauge the effects of uncertainty. In the paper, we also show that this heterogeneity and volatility of political risk can “add up” to decrease the efficiency of resource allocation in the economy, which ultimately has macroeconomic consequences.
One encouraging consequence of developing a new measure and making the data available to other researchers is witnessing the range of applications in which people have started to use our measure. These include studies about the politics of tax evasion and on the consequences of higher carbon emissions on stock prices. Our team is currently working on exploring the role of political risk on credit markets and on asset pricing. We have also developed a separate measure for the exposure of firms in the UK, the EU, and the rest of the world to Brexit and are currently exploring the likely economic and political consequence of the UK leaving the European Union.
Ultimately, the lesson learned is that Accounting Transparency matters not just to better understand a firm’s (economic) performance, but that it is source of information about a broad range of (unexpected) issues, including the state of the economy as a whole.
Read the full article by Tarek Alexander Hassan, Stephan Hollander, Laurence van Lent and Ahmed Tahoun “Firm-level political risk: measurement and effects” in The Quarterly Journal of Economics, https://doi.org/10.1093/qje/qjz021.