Corruption is often blamed for stock market crashes. Its effect on stocks is debated however as there are other factors that can trigger a crash such as economic or political crisis, or other external events such as natural disaster. In addition to its negative effect on stocks, corruption can lead to a reputational loss for companies involved in the scandal which may lead them to lose business contracts.

A case in point is the recent revelation that British arms manufacturer BAE bribed Saudi Arabian officials to buy fighter planes. The company’s shares reacted negatively as investors expected it to lose future contracts with the Saudi government because of the bribes.

While it is clear that the presence of corruption lowers stock returns, there is considerable heterogeneity in its effects across countries and institutions. We investigate this by estimating the impact of corruption and its interaction with democracy, bureaucratic quality and law and order on stock returns using a panel two-way fixed effect model.

The results indicate that a higher level of corruption decreases stock returns and that policies to combat corruption should take into account the different institutional dimensions. This is because democracy has a positive effect on stock returns when it reduces corruption and because corruption affects democratic accountability, bureaucratic quality and law and order in different ways.

Furthermore, our findings show that democracy has a U-shaped relationship with corruption, where high levels of corruption increase as democracy matures and then starts to mitigate corruption (Rock, 2009). Our research also finds that autocracies are more corrupt than democracies and that economic freedom reduces corruption.