Does societal trust make firms more trustworthy?

This study examines whether social capital can enhance financial stability. Specifically, we investigate the effects of societal trust on firm default risk in relation to two primary aspects. First, since lower levels of trust induce higher credit costs, it implies more severe adverse selection and thus a higher default risk, when the level of information availability is constant. Second, insufficient societal trust may exacerbate moral hazard because of the low social cost involved. We explore these associations by using a comprehensive cross country sample of 287,405 firm-year observations from 44 countries spanning the period of 1988–2017. We find that both investigated measures of default risk are significantly higher in regions that exhibit low trust. In addition, supporting above two conjecture, we demonstrate that negative associations are weaker when firms exhibit greater transparency and in economies with stronger formal institutions. •Societal trust is negatively related to corporate default risk.•Trust exert smaller effects among firms that are more transparent.•The substitutive relation between trust and formal institutions•Formal institutions help to mitigate moral hazard.