How labour protection shields against stock price crashes

Employment protection levels can forecast stock price crash risk as far as three years ahead, highlighting the enduring impact of labour protection on equity market stability

Employees play an important role as corporate stakeholders in monitoring their organisations’ voluntary disclosure practices and financial reporting decisions. More specifically, they are at the frontlines regarding whistleblowing for corporate malfeasance and misbehaviour, which can have serious consequences for companies engaged in wrongdoing.

However, the inclination of employees to blow the whistle can be influenced by a number of factors. One of those is the level of labour protection offered at a regulatory level. Traditionally, labour protection regulations have been viewed in relation to employee rights and working conditions. When employees feel more secure in their jobs and clear avenues are established to voice concerns, they're more likely to be vigilant about the company's financial health.

However, if they suspect wrongdoing, strong whistleblower protections empower them to speak up without fear of retribution. This early detection of problems can prevent small issues from snowballing into major disasters, safeguarding investors and the broader market.

Recent research points to a link between robust employee protections, the likelihood of employees to ‘blow the whistle’ – and a decreased risk of stock price crashes as a result. The catalyst for this research was a combination of the growing emphasis on Environmental, Social, and Governance (ESG) factors in evaluating corporate behaviour and the lack of evidence about the role of employees in monitoring corporate misbehaviour, according to Associate Professor Lili Dai in the School of Accounting, Auditing and Taxation at UNSW Business School.

“Specifically, we were motivated by the need to understand the external impact of employment protection mechanisms on future stock price crash risk, which can be a direct consequence of managerial bad news hoarding,” said Associate Professor Dai, who conducted the research in conjunction with Professor Wei Chen from UNSW Business School together with Associate Professor Xiaohua Fang from the College of Business at Florida Atlantic University and Associate Professor Wenjun Zhang from the Rowe School of Business at Dalhousie University in Canada.

The link between labour protection and stock price crashes

The research paper, Labor protection and stock price crash risk: Evidence from international equity markets, is based on an analysis of 36 countries from 1993 to 2013. These countries had a range of employment protection regulations in place for workers (from weak to strong), and the research found there were correlations based on a number of factors between these regulations and stock price crash risk.

Read more: Subcontracting and sweatshops during coronavirus – the wake-up call businesses need?

Specifically, Associate Professor Dai said firms in countries with weaker labour protection exhibit a significantly lower level of future stock price crash risk. “This suggests that weak employment protection incentivises employees to engage in information search and analysis, thereby reducing the effectiveness of managerial bad news hoarding,” he said. This is supported by empirical evidence, which suggests that managers are incentivised to engage in opaque financial reporting in order to manage reported earnings and shelter bad information, leading to higher crash risk.

The research also found that the relationship between employment protection and stock price crash risk is more pronounced for firms with a higher tendency to suppress bad news (as measured by financial reporting opacity and corporate tax avoidance) and in countries with stronger legal enforcement. “We expect that if labour protection regulations are effectively enforced, employment protection will play a greater role in influencing managerial bad news hoarding and thus future crash risk,” the authors stated in the research paper.

A third key finding of the research is that employment protection levels can forecast stock price crash risk as far as three years ahead, according to Associate Professor Dai. “The evidence shows that employment protection has a long-run predictive power for future stock price crash risk, thus lending further support to our conclusion that employment protection exacerbates future stock price crash risk through lowering unemployment risk,” the research paper said.

Understanding the cost-benefit of labour-friendly policies

There are a number of ways firms can benefit from the insights offered in the research paper. Businesses operating in countries with strong labour protection regulations, for example, may find themselves viewed more favourably by investors who recognise the added layer of transparency and risk mitigation. Conversely, companies in regions with weaker regulations might face increased scrutiny and potentially higher insurance premiums. Understanding the connection between employee protection and financial stability can become a crucial element in a company's overall risk management strategy.

“Corporations should carefully weigh the costs and benefits of labour-friendly policies, considering their potential impact on transparency and equity market stability. Enhancing employee whistleblower protections and encouraging the reporting of corporate misconduct could mitigate crash risk,” said Associate Professor Dai, who suggested companies adopt transparent reporting practices and foster a culture of openness where employees feel safe to report concerns. “Implementing comprehensive ESG programs that include strong labour protection policies can also reduce equity risk,” he said.

Improving labour protection to stabilise financial markets

On a macroeconomic level, the research suggests countries with weaker labour protections might see local companies face increased scrutiny from investors wary of hidden risks. Conversely, nations with strong regulations could see their businesses viewed more favourably, attracting investment and potentially lowering insurance costs. Understanding the connection between employee protection and financial stability can become a crucial factor for countries looking to bolster their markets and build investor confidence.

Subscribe to BusinessThink for the latest research, analysis and insights from UNSW Business School

“Our findings suggest a need for a balanced approach to labour protection that safeguards employee rights without inadvertently fostering an environment conducive to corporate misbehaviour. Policymakers should consider the broader implications of employment protection legislation on market stability and investor welfare,” said Associate Professor Dai.

In response, he said policymakers should strengthen legal enforcement mechanisms to ensure that labour protection laws are effectively implemented. “Additionally, policymakers should work towards creating a regulatory environment that balances the need for labour protection with the imperative to maintain market stability and transparency,” he concluded.