The Link Between Corporate Social and Financial Performance: Evidence from the Banking Industry

Transcription

1 The Link Between Corporate Social and Financial Performance: Evidence from the Banking Industry W. Gary Simpson Theodor Kohers ABSTRACT. The purpose of this investigation is to extend earlier research on the relationship between corporate social and financial performance. The unique contribution of the study is the empirical analysis of a sample of companies from the banking industry and the use of Community Reinvestment Act ratings as a social performance measure. The empirical analysis solidly supports the hypothesis that the link between social and financial performance is positive. KEY WORDS: Community Reinvestment Act Rating, financial performance, social performance Introduction Attempts to scientifically examine the nature of the relationship between corporate social performance (CSP) and financial performance (FP) have established that the relationship is complex and the investigation process is theoretically and methodologically intractable (Carroll, 2000; Griffin and Mahon, 1997; Rowley and Berman, 2000). Nevertheless, a better understanding of the link between corporate social performance and financial performance (CSP-FP) would be invaluable to managers, stockholders, and, either directly or indirectly, all of the stakeholders of a corporation. Many important questions that must be answered by the stakeholders of a corporation will be affected by the nature of the CSP-FP link. For example, what resources should managers direct to socially responsible activities? How should stockholders react to resource allocations for social purposes? How can public policy best promote socially responsible behavior? These are only a few obvious examples of the issues that are related to the CSP-FP link. The purpose of this investigation is to extend earlier research on the relationship between corporate social and financial performance. A reasonable person might question the need for additional investigation because a rich body of evidence already exists on this topic. 1 However, previous evidence has resulted in contradictory conclusions, although a growing number of analyses indicate a positive link. Furthermore, almost all of the previous evidence was derived from samples composed of firms from multiple industries (Griffin and Mahon, 1997). Finally, various measurement issues that plague this type of research have not been resolved. This investigation is believed to make a contribution to the debate by providing empirical evidence from a single industry that has a set of unique characteristics that offer additional insights into the question and also mitigate some of the measurement problems of earlier research. Previous empirical evidence on the CSP-FP Link Griffin and Mahon (1997) provide a summary of the empirical evidence on the CSP-FP link that spans the twenty-five year time period 1972 until In one of the earliest papers cited by Griffin and Mahon (1997), Bragdon and Marlin (1972) asked the straightforward, but important question Is pollution profitable? Early empirical investigations by Vance (1975), Belkaoui Journal of Business Ethics 35: , Kluwer Academic Publishers. Printed in the Netherlands.

2 98 W. Gary Simpson and Theodor Kohers (1976), and Alexander and Bucholz (1978) tested the relationship between stock market returns and a dimension of corporate social performance. Pioneering empiricists who investigated the CSP-FP link were often interested in a single dimension of CSP, e.g. environmental pollution. Over the twenty-five year period since empirical investigation of the CSP-FP link began, many innovations in methodology were introduced. Researchers conducted cross-sectional studies over multiple industries with accounting data from large corporations as the measure of financial performance (Griffin and Mahon, 1997). The measurement of CSP moved from single dimension measures to multidimensional measures like the Fortune Survey of Corporate Reputation and the KLD index developed by Kinder, Lydenberg, Domini & Co., Inc. (Griffin and Mahon, 1997). Questions about the efficacy of empirical research on the CSP-FP link remain despite numerous improvements in the methodology (Griffin and Mahon, 1997; Carroll, 2000). Griffin and Mahon (1997) summarized the findings of the numerous articles they reviewed and came to the following conclusions: (1) No definitive consensus exists on the empirical CSP- FP link, (2) While a substantial number of studies have found a negative relationship, most of these studies compared the reaction of the stock market to potential illegal activities or product problems, (3) Some studies have been inconclusive because they found both a positive and negative link in the same study, and (4) The largest number of investigations found a positive CSP-FP link. Roman et al. (1999) reviewed the work of Griffin and Mahon (1997) and concluded that the preponderance of the evidence indicated a positive relationship between CSP and FP because Griffin and Mahon (1997) included many flawed investigations that found a negative CSP-FP link. Several empirical investigations since the review article by Griffin and Mahon (1997) have found a positive CSP-FP link. Frooman (1997) conducted a meta-analysis of 27 event studies that analyzed the relationship between stock market reaction and socially irresponsible and illegal behavior. He concluded that the market reacted negatively to firms that committed socially irresponsible or illegal acts, which is evidence for a positive CSP-FP link. Waddock and Graves (1997) analyzed a total of 469 S & P 500 companies with regression analysis. A weighted composite measure of CSP similar to a KLD index was used for CSP and three accounting measures (return on equity, return on assets, and return on sales) were used for FP. Waddock and Graves (1997) included size, risk, and industry as control variables and tested various econometric specifications of the model including lagged variables. Their results supported a positive CSP-FP link. Stanwick and Stanwick (1998) conducted a regression analysis of multiple cross-sections for the years with approximately 115 firms in each cross-section. They used the Fortune Survey of Corporate Reputation as the measure of CSP which was the dependent variable in a regression equation. The return on sales, size, and environmental performance variable based on the EPA Toxic Release Inventory Report were used as independent variables. Stanwick and Stanwick (1998) found a significant positive relationship between CSP and FP. Preston and O Bannon (1997) compared CSP and FP for 67 large U.S. corporations over the eleven-year period They used three components of the Fortune Survey of Corporate Reputation to represent CSP and return on assets, return on equity, and return on investment to represent FP. Preston and O Bannon (1997) found a positive CSP-FP link. McWilliams and Siegel (2000) tested the CSP- FP link with a regression model that used a dummy variable indicating inclusion of a firm in the Domini 400 Social Index (DSI 400) as the measure of CSP. The DSI 400 is a portfolio of socially responsible companies developed by Kinder, Lydenberg, and Domini, Inc. which developed the KLD index. McWilliams and Siegel (2000) used an average of annual values for the period for 524 large U.S. corporations in a regression model that included a measure of financial performance as the dependent variable. CSP, industry, and expenditures for research and development were independent variables. The results suggest that inclusion of the research and development variable in the model causes the CSP variable to be insignificant leading McWilliams and Siegel (2000) to the

3 The Link Between Corporate Social and Financial Performance 99 conclusion that there may not be a CSP-FP link if the regression model is properly specified. Griffin and Mahon (1997) identified several issues in the literature that they believe should be addressed in future empirical investigations. First, a large majority (78 percent) of the studies they reviewed used samples from multiple industries. The problem with this approach is that the unique characteristics of an industry make the nature of CSP unique based on different internal characteristics and external demands (Griffin and Mahon, 1997). Rowley and Berman (2000) also suggest that CSP research should be narrowly defined in operational terms to a specific industry or setting. The nature of stakeholder actions appears to be an important influence on CSP and different industries face different portfolios of stakeholders with different degrees of activity in different areas (Griffin and Mahon, 1997; Rowley and Berman, 2000). Griffin and Mahon (1997) argue that multiple industry studies confound the relationship between stakeholders and appropriate measures of CSP and FP unique to those stakeholders. The empirical investigations show that industry is an important variable in multiple industry analyses. Focusing on a single industry emphasizes internal validity rather than the external validity of multiple industry analyses. The most important contribution of the present investigation is the analysis of a large sample of firms from the same industry. While a few other studies, including Griffin and Mahon (1997), have analyzed individual industries, the samples have been small. Another important advantage of concentrating on a single industry is that the econometric specification of the FP function can be more complete because unique characteristics of the industry can be included. Several of the econometric issues suggested by Waddock and Graves (1997) and McWilliams and Siegel (2000) are addressed in the present analysis of the banking industry. The second issue raised by Griffin and Mahon (1997) is that multiple measures of FP should be used. Many previous investigations used only one measure of FP. They also argue that accounting measures rather than market-derived measures should be used because market measures may be picking up more than just FP. This study employs two accounting measures of FP that are recognized throughout the banking industry and are believed to accurately reflect the financial performance of banking firms. The third issue addressed by Griffin and Mahon (1997), Carroll (2000), and many other scholars in the field, is the measurement of CSP. Griffin and Mahon (1997) and Carroll (2000) argue for multiple sources of information to produce a comprehensive metric of CSP. The CSP metric used in the present investigation of the banking industry is not represented as a complete measure of CSP but we submit that it is multidimensional and unique. The important contribution of the CSP measure is that it is a unique measurement of CSP for a specific industry that has not been used before in CSP- FP analyses. The Community Reinvestment Act Ratings and social performance measurement The Community Reinvestment Act of 1977 (CRA) mandated that depository institutions serve their communities (Spong, 1994). CRA was passed to insure that commercial banks meet the credit needs of the markets where they hold public charters to do business, especially the needs of low-income customers (Spong, 1994). Banks were required to provide private funding for local housing needs and economic development (Spong, 1994). The legislation is generally known as an attempt to restrict the practice of redlining but the act covers a broader spectrum of bank functions. As a result of CRA, regulatory authorities are required to examine banks to develop a rating which summarizes the degree of compliance into four categories: (1) outstanding, (2) satisfactory, (3) needs to improve, and (4) substantial noncompliance (Spong, 1994). The ratings are based on twelve assessment factors: (1) Communication with members of the community to ascertain credit needs, (2) Extent of involvement by the board of directors in CRA activities, (3) Marketing efforts to make the types of credit offered known in the community, (4) The extent

4 100 W. Gary Simpson and Theodor Kohers of loans originated in the community, (5) The extent of bank participation in government loan programs, (6) The geographic distribution of credit applications, approvals, and denials, (7) The record of branch office openings and closings and extent of service provided at the offices, (8) Practices to discourage credit applications, (9) Discriminatory or other illegal practices, (10) Participation in community development projects or programs, (11) The institution s ability to meet community credit needs, and (12) Other relevant factors which could bear upon the extent to which the institution is helping to meet the credit needs of the community (Evanoff and Segal, 1996). The CRA rating is partly based on compliance with major pieces of lending discrimination legislation such as the Fair Housing Act, Equal Credit Opportunity Act, and Home Mortgage Disclosure Act (Catalano, 1993). However, the CRA rating considers factors beyond simple compliance with the law, e.g. bank officers visiting with local customers, small businesses, community leaders, and nonprofit organizations to find ways to provide needed services for the community. The board of directors is required to approve and oversee the policies designed to comply with the CRA. Supervisory agencies have the authority to consider the level of noncompliance with the provisions of the CRA when a bank or bank holding company requests approval to acquire another institution, open or relocate an office, or create a bank holding company (Spong, 1994). Noncompliance can result in banks or bank holding companies being denied the ability to expand and merge, an important business activity in the modern banking industry (Spong, 1994). Banks are required to make their CRA ratings publicly available and keep a file which contains any public comments over the last two years (Spong, 1994). Banks with poor performance under CRA may be examined more frequently. The core business of commercial banks is lending the deposits of customers to other customers who need loans. Meeting the credit needs of a community is central to the economic and social health of that community. The CRA rating is an indication of the social responsibility banks exhibit in this core activity. The dimensions of social performance measured by the CRA rating are not exhaustive but do cover several of the critical facets of the external social performance of the industry. The measurement of corporate social performance The conceptual development of CSP has migrated from a rather narrow classical economic viewpoint articulated by Friedman (1962), among others, to a much broader view. Carroll (1979) developed one of the earlier versions of a comprehensive view of CSP. In a recent discussion of CSP, Carroll (2000) reiterated his view that CSP should be a comprehensive assessment of a firm s social performance relative to most social issues and stakeholders. The recent literature indicates that many academics support a complex, multidimensional construct (Wartrick and Cochran, 1985; Wood, 1991; Roman et al., 1999; Griffin and Mahon, 1997; Swanson, 1999; Rowley and Berman, 2000). The problems associated with measuring a comprehensive theoretical construct of CSP are daunting. As previously mentioned, individual facets of CSP have been measured with the EPA Toxics Release Inventory, Corporate 500 Directory of Corporate Philanthropy data, product recalls, and illegal acts. Attempts to obtain a more comprehensive measure of CSP have relied on the Fortune reputation survey, the KLD index, and the Domini 400 Social Index. One problem with the more comprehensive metrics is that they do not cover enough firms to provide a large sample in one industry. The Fortune reputation survey is based on the opinions of senior managers that may be confounded with financial performance (Brown and Perry, 1994). The KLD index is a more comprehensive measure but is subject to questions associated with how the different components should be weighted and the fact a component can potentially be both a strength and weakness (Griffin and Mahon, 1997). To no one s surprise, an ideal empirical measure of a comprehensive conceptual construct of CSP does not now exist. Carroll (2000) argues

5 The Link Between Corporate Social and Financial Performance 101 that unless a better empirical measure of the comprehensive construct of CSP can be developed, empirical research probably should not be done and, if done, it should not be labeled as CSP. Griffin (2000) and Rowley and Berman (2000) suggest that a universal measure may not be desirable. Griffin (2000) argues that a comprehensive measure of CSP means that time, culture, industry, and contextual variables do not make a difference. Griffin (2000) goes on to say that a universal measure of CSP potentially oversimplifies a complex construct. Griffin (2000) and Rowley and Berman (2000) appear to be saying that investigation of CSP in an operational setting has value. The measure of CSP for the banking industry employed in this investigation is obviously not a universal measure. It is not a single dimension measure either. The CRA rating is a multidimensional construct distilled into a single measure that describes several aspects of social performance in a unique operational setting. The use of the CRA rating as a measure of CSP has advantages and disadvantages. We gain a fairly homogeneous set of contextual circumstances by choosing one industry e.g. limited direct pollution of the environment, a relatively homogeneous production process where product safety and employee safety are minimal concerns, similar stakeholder configurations, similar expenditures on R&D, and a constant regulatory framework. 2 The banking industry is a unique opportunity to obtain a sample with a substantial number of companies in the same industry. The methodology used to develop the social performance measure is relatively homogeneous because regulatory authorities apply a standardized procedure that assesses outcomes through on-site examinations of the organization. 3 We lose some generality as a result of holding industry constant and lose direct comparability to other research by not using a social performance measure commonly used in other research, e.g. KLD index. Theoretical framework and hypothesis development The link between corporate social and financial performance has been alternatively hypothesized to be positive, negative, and neutral. The ability of researchers to offer rational theoretical justification for each of the possible positions demonstrates the need for both a more unified theory and reliable empirical verification. Waddock and Graves (1997) and Preston and O Bannon (1997) offer a summary of previous conceptual explanations for a negative, neutral, and positive relationship between CSP and FP. A negative relationship is consistent with the neoclassical economist s argument that positive social performance causes the firm to incur costs that reduce profits and shareholder wealth (Waddock and Graves, 1997; Preston and O Bannon, 1997). Preston and O Bannon (1997) offer a managerial opportunism hypothesis as a rationale for a negative CSP-FP link. They suggest that when financial performance is strong, managers will reduce expenditures on social performance because they can increase short-term profitability and increase their personal compensation that is tied to short-term profitability. Conversely, when financial performance is poor, managers will attempt to divert attention by expenditures on conspicuous social programs. The finding of a neutral (no) relationship is explained by the thesis that the general situation of the firm and society is so complex that a simple, direct relationship between CSP and FP does not exist (Waddock and Graves, 1997). McWilliams and Siegel (2001) argue for a neutral, or nonexistent, relationship between CSP and FP from a framework based on a supply and demand theory of the firm which assumes shareholder wealth maximization. They argue that firms produce at a profit-maximizing level, including the production of social performance. This leads each firm to supply different amounts of social performance based on the unique demand for CSP the firm experiences. In equilibrium, the amount of CSP produced by firms will be different but profitability will be maximized and equal.

6 102 W. Gary Simpson and Theodor Kohers Several explanations for a positive CSP-FP link exist. First, one perspective is that a tension exists between the explicit costs of the firm, e.g. interest payments to bond holders, and the implicit costs of the firm, e.g. product quality or safety costs (Waddock and Graves, 1997). Attempts by the firm to lower implicit costs by socially irresponsible actions are hypothesized to result in higher explicit costs. In a similar vein, Preston and O Bannon (1997) describe a social impact hypothesis which suggests that meeting the needs of various nonowner corporate stakeholders will have a positive impact on financial performance. A second viewpoint suggests that the actual costs of CSP are minimal compared to the potential benefits to the firm (Waddock and Graves, 1997). For example, the cost of providing employee benefits may be much less than the productivity gains that result. A third argument is that good management will do most things well, including the determinants of both social and financial performance (Waddock and Graves, 1997). A fourth explanation is the financially successful firm has slack resources as a result of its superior financial performance that can be devoted to social performance (Waddock and Graves, 1997; Preston and O Bannon, 1997). Finally, Waddock and Graves (1997) suggest that there may be a positive CFP- FP link because of a simultaneous relationship combining slack resources and good management which results in a virtuous circle between CSP and FP. When no single accepted theoretical foundation with clear empirical predictions exists, hypothesis development requires some judgement. Two factors drive the hypothesis tested in this investigation. First, we find the most convincing theoretical arguments to be the slack resources hypothesis and the good management hypothesis, which predict a positive relationship. In light of these two hypotheses, the concept of a feedback process that results in a virtuous circle is also reasonable. Second, previous empirical evidence supports a positive link between CSP and FP. The hypothesis tested is: H 0 : The relationship between social performance and financial performance in the commercial banking industry is either zero or negative. H 1 : The relationship between social performance and financial performance in the commercial banking industry is positive. Methodology Sample and data The sample was taken from all national banks examined for CRA compliance in 1993 and All banks that were assigned ratings of outstanding and needs improvement were included in the sample. Banks receiving satisfactory ratings were omitted to provide a clear separation between banks with high social performance and low social performance. No banks receiving a rating of substantial noncompliance were included because the category included a very small number of banks. The result was a total sample of 385 banks with 284 banks rated outstanding and 101 rated needs to improve. The rating and dates were taken from various news releases from the Comptroller of the Currency. The Comptroller of the Currency is a division of the U.S. Treasury that is the primary regulator of nationally chartered banks. Only national banks were used to hold the examination and regulatory process constant. The time period of 1993 and 1994 was used to hold constant the rating process as regulatory emphasis could change over time. The CRA rating is developed for each individual commercial bank in the U.S. (Spong, 1994). Commercial banks are restricted to a limited set of activities by federal law. So, they are not involved in multiple industries, as a large conglomerate corporation will be (Spong, 1994). Individual banks may be owned by bank holding companies, which are more diversified financial service providers, but the CRA rating applies to the individual bank, not the bank holding company. The banks included in this sample are in the basic business of banking which includes accepting deposits, making loans, providing safekeeping, and making payments through checking and electronic systems. The nature of the regu-

7 The Link Between Corporate Social and Financial Performance 103 latory framework, which restricts the activities of individual commercial banks, provides some assurance that the sample units are from a single industry. The accounting data for the financial variables were taken from call reports filed with the Comptroller of the Currency. The information for the state level bank performance variables was taken from FDIC Statistics on Banking and the data for the local economic conditions variables were taken from Employment and Earnings of the Bureau of Labor Statistics, Survey of Current Business of the Bureau of Economic Analysis, and Statistical Abstract of the United States. The variables used in the analysis are described in Table I. Financial performance measures Two measures of FP that are generally considered to capture major dimensions of financial performance in the banking industry were utilized: return on assets (ROA) and loan losses to total loans. 4 The return on assets is probably the most widely recognized measure of financial perfor- TABLE I Variable definitions Variable name Return on assets Loan losses Variable description Financial performance Net operating income/average total assets Net charged-off loans/average total assets Social performance CRA rating Dummy variable which equals 0 if CRA rating is needs improvement and 1 if the CRA rating is outstanding Total assets Holding company Assets per office State return on assets State personal income Population Cost of funds Capital ratio Loan ratio Earning assets Overhead expenses State bankruptcies Nonperforming assets State nonperforming assets Control Natural logarithm of average total assets Dummy variable which equals 1 if the bank is an affiliate of a bank holding company and 0 if the bank is an independent bank Natural logarithm of average total assets/number of offices operated by the bank Weighted-average return on assets for all banks in the state where the bank is located Annual percentage change in personal income for the state where the bank is located Natural Logarithm of the total population of the city where the bank is located Weighted-average rate paid on interest bearing deposits Equity capital/average total assets Average total loans/average total assets Average interest earning assets/average interest bearing liabilities Total noninterest expenses/average total assets Annual percentage change in the number of personal and business bankruptcy petitions filed in the state where bank is located (Nonaccrual loans + loans 30 days or more past due + repossessed real estate)/(average total loans + repossessed real estate) Weighted-average ratio of (non-performing loans/average total loans) for all banks in the state where the bank is located.

8 104 W. Gary Simpson and Theodor Kohers mance in the industry. Return on assets measures the ability of bank managers to acquire deposits at a reasonable cost, invest these funds in profitable loans and investments, and profitably perform the daily operations of the bank. For most banks, the largest portion of total assets is loans and the largest amount of revenues comes from interest on loans. As a result, the ability to make collectible loans directly affects net income and capital, which determine financial success. Loan losses can be a major expense for banks and the ratio of loan losses to loans is an important indicator of the success of the credit function. Statistical procedures The financial performance measures were calculated the calendar year preceding the calendar year in which the examination was conducted. This was done because the CRA ratings were based on the social performance of the bank in the period prior to the date of the examination. Then t-tests for differences in group means were calculated for the financial performance measures. The two groups were banks with an outstanding CRA rating and banks with a needs to improve rating. Two regression equations were estimated with the financial performance measures as the dependent variable and the CRA rating as the independent variable, plus a set of control variables. The financial measures were used as dependent variables because the a priori profit function of a bank and the a priori determinants of loan losses are fairly well understood. The a priori determinants of the CRA rating, i.e. the measure of social performance, are not well developed. This econometric specification implies that corporate social performance, i.e. the CRA rating, causes financial performance because financial performance is the dependent variable in the equation. However, equally reasonable theoretical justification exists for the proposition that financial performance causes social performance. If the CRA rating was used as the dependent variable and financial performance as one independent variable in a regression equation, any ability to impute causation from financial performance to social performance would be dependent on the correct specification of the other variables that determine the CRA rating. Unfortunately, these independent variables are very likely not the same as those in the profit function or loan loss function. We cannot test the proposition that financial performance causes the CRA rating by simply switching the financial performance and social performance variables in the profit function and loan loss function. Given the lack of a well developed a priori model of the determinants of the CRA rating, simple regression analysis cannot establish causation. 5 The regression analysis can test for the existence and direction of a relationship between FP and CSP, but not the cause of any observed relationship. The control variables for the ROA equation were designed to hold firm size, risk, asset portfolio composition, local economic environment, holding company affiliation, level of investment in branch offices, cost of funds, and overhead expenses constant. Banks do not directly account for R&D expenditures in their financial statements but any expenditures for R&D that might exist would probably be included in overhead expenses. The control variables for the loan loss equation were included to hold constant firm size, risk of the loan portfolio, size of the loan portfolio, and economic conditions in the local loan market. Industry effects were held constant in both equations by using only firms from the same industry. Ordinary least squares regression was used to estimate the regression parameters and standard regression diagnostics were performed to evaluate the reliability of the results (Greene, 1997). Results Tests for difference in group means The results of the group means tests reported in Table II give a strong indication that the link between corporate social and financial performance is positive. The mean return on assets for the group of banks rated outstanding was percent compared to percent for the banks that received a needs to improve rating.

9 The Link Between Corporate Social and Financial Performance 105 TABLE II Tests for differences in group means Financial performance Social performance group Group mean t-value (probability) Return on assets Outstanding 1.750% 5.06 Needs to improve 0.984% (0.00) Loan losses Outstanding 0.478% 3.37 Needs to improve 0.812% (0.00) Note: t-values are a pooled variance estimate and probabilities are for a one-tailed test. The sample size was 385 with 284 banks rated outstanding and 101 rated Needs to Improve. The t-statistic for the difference in group means indicates that the probability of this difference being observed by chance was almost zero, i.e. the null hypothesis was rejected with a high level of confidence. This difference in profitability between the banks with high social performance and the banks with lower social performance is not only statistically significant but also substantial in absolute terms. The return on assets for the high CRA rated banks is almost twice the return on assets of the low CRA banks, i.e. the high social performance banks were 78 percent more profitable than low social performance banks. The results of the group means test for loan losses also provide strong support for the hypothesis that the link between social and financial performance is positive. The mean for the loan losses variable was percent for the banks with an outstanding CRA rating and percent for the banks with a CRA rating of needs to improve. This indicates the high social performance banks experienced approximately one-half of the loan losses experienced by the banks with low social performance. Once again, the difference in an absolute sense is substantial. The difference in means for the two groups was significantly different from zero at the probability level. Regression analysis The regression results reported in Table III support the results of the group means test. The null hypothesis of no relationship or a negative relationship between the CRA rating and return on assets was rejected at the probability level as indicated by the positive regression coefficient for the CRA rating variable. The adjusted R-square for the regression equation was and most of the control variables were significant at the 0.10 level which indicates the equation was reliable. The regression equation with loan losses as the dependent variable and CRA rating as the independent variable revealed that the null hypothesis could be rejected at the probability level. The sign of the regression coefficient for the CRA rating variable was negative which indicates better financial performance for banks with high social performance, i.e. high social performance banks had lower loan losses. The R- square of and the fact that most of the regression coefficients in the equation were significant indicates the results of the analysis were dependable. Implications of the results The findings of this investigation are important because they validate a strong positive relationship between CSP and FP in a different operational setting than previously tested. These results from the banking industry corroborate the mounting body of evidence developed from large S & P 500 or Fortune 500 corporations. Much of the previous evidence for a positive relationship between CSP and FP was based on the same type of firms, i.e. large, national corporations. The fact that an analysis of a unique CSP

10 106 W. Gary Simpson and Theodor Kohers TABLE III Regression coefficients and statistics Independent and control variables Dependent variable Dependent variable Return on assets Loan losses CRA rating (0.016) (0.001) Total assets (0.373) (0.000) Holding company (0.074) Assets per office (0.082) State return on assets (0.000) State personal income (0.251) (0.121) Population (0.146) Cost of funds (0.045) Capital ratio (0.001) Loan ratio (0.046) (0.004) Earning assets (0.003) Overhead expenses (0.406) State bankruptcies (0.479) Nonperforming assets (0.000) State nonperforming (0.000) Adjusted R Square F-Statistic Probability Note: The intercept term in the regression equation is not reported. The probabilities for a one-tailed test are in parentheses. All control variables were not used in every equation.

11 The Link Between Corporate Social and Financial Performance 107 measure in a single industry with a sample of firms that are appreciably smaller found a positive CSP-FP link argues for the robustness of the relationship. The findings of the present analysis are also convincing because of the magnitude of the observed differences and the fact that important variables such as industry and R&D expenditures were held constant. The results of this investigation are consistent with the theoretical constructs of corporate social performance that predict a positive CSP-FP link. Albeit, several arguments exist for a positive CSP-FP link and our evidence does not support any of these more than any other. Nevertheless, the evidence does help rule out the theoretical descriptions of the nature of corporate social performance that predict a negative and neutral CSP-FP link. This alone may facilitate the task of developing a better theoretical understanding of corporate social performance. The results of this analysis are consistent with the good management hypothesis, the slack resources hypothesis, the virtuous circle explanation, and the social impact hypothesis discussed previously. These results are also consistent with the positive cost-benefit explanation that the costs of being socially responsible are outweighed by associated improvements in productivity, or other factors, which will improve financial performance. From the viewpoint of stockholders and managers, the results of this analysis are consistent with the view that the resources required to be socially responsible are not so high as to make the firm unprofitable. Furthermore, the possibility exists that firms may even receive a competitive advantage from social performance expenditures which create favorable stakeholder relationships (Waddock and Graves, 1997). For example, a bank could increase the probability of receiving permission from regulators to acquire another institution by investing the necessary resources in social performance to assure a good CRA rating. However, we do not prove that social performance has positive benefits for stockholders because managers may simply allocate slack resources to benefit one group of stakeholders, e.g. customers or the community, and harm stockholders by reducing the earnings available for dividends. Managers could also use slack resources as a way to reduce conflict with various stakeholder groups to make their lives easier but reduce earnings available for the stockholders. While negative implications for stockholders are possible when the firm has slack resources, it is equally possible that good management tends to value social performance and has the ability to create high levels of both CSP and FP. This explanation is attractive because all stakeholders benefit. Waddock and Graves (1997) argue that a positive link between CSP and FP implies that good CSP and good management are the same thing when CSP is defined in terms of the stakeholder relationships considered important to the performance of the firm and not discretionary activities, e.g. philanthropy. Recall that the activities required to receive a high Community Investment Act rating were tied to the daily activities of the firm in serving customers and the community. These activities are central to the business of banking and our evidence is consistent with the idea that good management and good CSP are the same. Conclusion This investigation based on data from a sample of commercial banks extends the research on corporate social performance and financial performance by providing empirical support for a positive CSP-FP link. The analysis employs a measure of social performance unique to the banking industry that has not been used in previous research. The results from the banking industry are consistent with much of the previous evidence developed from the analysis of Fortune 500 corporations. Evidence supporting a positive CSP-FP link in a unique operational setting supports the idea that a positive CSP-FP link is a universal phenomenon. Numerous theoretical explanations have been offered to support a negative, positive, and neutral CSP-FP relationship. The implication of this research, when taken in conjunction with previous empirical evidence, is that future research efforts should concentrate on a theoretical explanation for a positive CSP-FP link. Simultaneously, empirical investigation of the

12 108 W. Gary Simpson and Theodor Kohers CSP-FP link in other unique operational contexts appears to be a valuable direction for future research. One of the limitations of this analysis is that we do not test why a positive CFP-FP link may exist. The absence of an accepted theoretical construct with precise empirical predictions makes the analysis of causation difficult. Several conceptual arguments are consistent with a positive CFP-FP link but each has different implications. Empirical tests to isolate specific hypotheses that explain why a positive CSP-FP link might be observed would be a valuable direction for future research. A second and related limitation of this investigation is that we do not establish if CSP causes FP, FP causes CSP, or there is some feedback relationship. A valuable direction for future research would be the application of econometric techniques to help determine causation when a complete theory is not available, e.g. Granger-Sims Causality tests. The use of the Community Investment Act rating as a measure of CSP has some advantages, but is also a limitation because it is not a broad, comprehensive measure of CSP. We have only evaluated a few important facets of CSP. Future research to develop effective comprehensive measures of CSP would be valuable, but admittedly difficult. Another limitation is that the length of the time period covered in the study should be longer. In spite of the limitations of this investigation and the need for additional research, the results of this analysis are encouraging because the prospect of a positive CSP-FP link means that firms can be both socially responsible and financially successful. Notes 1 Refer to Griffin and Mahon (1997), Roman et al. (1999), and Frooman (1997) for a summary of the previous evidence. See Griffin (2000), Rowley and Berman (2000), Swanson (1999), and Carroll (2000) for a discussion of several important issues associated with research in corporate social performance. 2 Commercial banks do not face the same social responsibility challenges of pollution, product safety, and employee safety encountered by other firms, but they do have a social and legal responsibility because they lend to firms that pollute, produce unsafe products, etc. 3 Griffin and Mahon (1997) argue that rating firms by independent third parties with largely objective screening criteria is an improvement over largely perceptual data, e.g. the Fortune survey. 4 Return on equity (ROE) was not used because it is highly correlated with return on assets (ROA) in the banking industry. By definition ROE = ROA (Total Assets/Total Capital). The relationship between total assets and total capital is tightly regulated in the banking industry causing ROE to convey about the same information on financial performance as ROA. Almost all of the banks in the sample were smaller banks that did not have common stock traded in an active market so market returns were not used as a measure of FP. 5 The use of econometric techniques to test for causation when a prior reasoning cannot provide the appropriate specification requires a procedure like the Granger-Sims causality test but this approach also has limitations (Pindyck and Rubinfeld, 1998; Greene, 1997). References Alexander, G. J. and R. A. Buchholz: 1978, Corporate Responsibility and Stock Market Performance, Academy of Management Journal 21, Belkaoui, A.: 1976, The Impact of the Disclosure of the Environmental Effects of Organizational Behavior on the Market, Financial Management 5, Bragdon, J. H. and J. T. Marlin: 1972, Is Pollution Profitable?, Risk Management 19, Brown, B. and S. Perry: 1995, Halo-Removed Residuals of Fortune s Responsibility to the Community and Environment A Decade of Data, Business and Society 34, Carroll, A. B.: 1979, A Three-Dimensional Model of Corporate Social Performance, Academy of Management Review 4, Carroll, A. B.: 2000, A Commentary and an Overview of Key Questions on Corporate Social Performance Measurement, Business and Society 39, Catalano, J.: 1993, A Clearer Focus on Your CRA Examination, ABA Bank Compliance (Spring), Evanoff, D. D. and L. M. Segal: 1996, CRA and Fair Lending Regulations: Resulting Trends in

13 The Link Between Corporate Social and Financial Performance 109 Mortgage Lending, Economic Perspectives: Federal Reserve Bank of Chicago (Nov. Dec.), Friedman, M.: 1962, Capitalism and Freedom (University of Chicago Press, Chicago). Frooman, J.: 1997, Socially Irresponsible and Illegal Behavior and Shareholder Wealth, Business and Society 36, Greene, W. H.: 1997, Econometric Analysis (Prentice Hall, Upper Saddle River, New Jersey). Griffin, J. J.: 2000, Corporate Social Performance: Research Directions for the 21st Century, Business and Society 39, Griffin, J. J. and J. F. Mahon: 1997, The Corporate Social Performance and Corporate Financial Performance Debate: Twenty-Five Years of Incomparable Research, Business and Society 36, McWilliams, A. and D. Siegel: 2001, Corporate Social Responsibility: A Theory of the Firm Perspective, Academy of Management Review 26, McWilliams, A. and D. Siegel: 2000, Corporate Social Responsibility and Financial Performance: Correlation or Misspecification?, Strategic Management Journal 21, Preston, L. E. and D. P. O Bannon: 1997, The Corporate Social-Financial Performance Relationship: A Typology and Analysis, Business and Society 36, Pindyck, R. S. and D. L. Rubinfeld: 1998, Econometric Models and Economic Forecasts (Irwin McGraw-Hill, Boston). Roman, R. M., S. Hayibor and B. R. Agle: 1999, The Relationship Between Social And Financial Performance: Repainting a Portrait, Business and Society 38, Rowley, T. and S. Berman: 2000, A Brand New Brand of Corporate Social Performance, Business and Society 39, Spong, K.: 1994, Banking Regulation: Its Purposes, Implementation, and Effects, Kansas City, Federal Reserve Bank of Kansas City. Stanwick, P. A. and S. D. Stanwick: 1998, The Relationship Between Corporate Social Performance and Organizational Size, Financial Performance, and Environmental Performance: An Empirical Examination, Journal of Business Ethics 17, Swanson, D. L.: 1999, Toward an Integrative Theory of Business and Society: A Research Strategy for Corporate Social Performance, Academy of Management Review 24, Vance, S. C.: 1975, Are Socially Responsible Corporations Good Investment Risks?, Academy of Management Review (August), Waddock, S. A. and S. B. Graves: 1997, The Corporate Social Performance-Financial Performance Link, Strategic Management Journal 18, Wartrick, S. L. and P. L. Cochran: 1985, The Evolution of the Corporate Social Performance Model, Academy of Management Review 10, Wood, D. J.: 1991, Corporate Social Performance Revisited, Academy of Management Review 16, W. Gary Simpson Department of Finance, College of Business Administration, Oklahoma State University, Stillwater, OK, , U.S.A. simpson@okstate.edu Theodor Kohers Department of Finance and Economics, College of Business and Industry, Mississippi State University, Mississippi State, MS, U.S.A. tkohers@cobilan.msstate