Corruption is a threat to financial stability because it warps policy for the sake of private gain. It enables industrial tycoons to buy political favors and steal public funds that could be used to improve education, healthcare and infrastructure. Corruption also contributes to stock market crashes and national emergencies like war, debt crises and economic collapse. In the United States, it has been a leading cause of financial crisis such as the stock market crash on October 3, 1929 and the Great Depression. The lack of regulation bought by robber barons in the Gilded Age allowed them to profit from speculation and fraud, and cost ordinary citizens their life savings.

In this paper we look at the effect of corruption on the stock markets using panel two-way fixed-effect estimations with monthly data from 1995 to 2014 for BRIC economies. We find that corruption negatively affects returns on stocks (SR) but this impact is more pronounced for developing economies than for developed ones. We also find that the effect of corruption on SR depends on institutional dimensions such as democratic accountability, bureaucratic quality and law and order and that the interaction with these institutions is complex.

We conclude that the overall negative impact of corruption on SR is smaller as democracy matures within a country because a high level of democracy can counteract the bad effects of corruption. We also find that the impact of corruption on SR is more pronounced for defence companies than for those in other sectors. Disclosure of corruption risk can be helpful to investors as it reduces information asymmetry in the market.