Does the Market Respond to the Corruption?: Revisiting External-Internal Finance Relationship debate

This study examines whether capital markets respond to firm-level corruption by lowering access to external financing. Using a global panel of non-financial listed firms from 77 countries over 1998-2018, we analyze how corruption-measured using Refinitiv's firm-level "Policy, Bribery and Corruption Score"-affects the intensity of equity and debt financing. We classify firms into financially constrained and unconstrained groups based on multiple criteria and estimate panel regressions with extensive firm-, industry-, year-, and country-fixed effects. Our results show that corruption is associated with higher financing frictions, with the effect concentrated in debt markets. Equity issuance is largely insensitive to corruption, whereas debt financing falls significantly as corruption increases, consistent with creditors' heightened concerns about enforcement and information risk. These effects remain robust across alternative definitions of financing constraints, nonlinear and rescaled corruption measures, and additional institutional and macro-risk controls. We also find that corruption increases the external-cash flow sensitivity of firms, suggesting that corrupt firms face more market frictions. These patterns are especially pronounced among financially unconstrained firms. Overall, the findings highlight that capital markets-particularly debt markets-discipline firms with higher corruption exposure, revealing an important channel through which institutional weaknesses translate into financing frictions.