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European Supervisory Improvements

Financial leverage refers to a company’s ability to increase its total equity (leveraged asset) by using only retained and liquid assets. However, it should be noted that financial leverage does not necessarily translate into increased market share or profit. Instead, it is more accurately described as the ability to take advantage of opportunities at a lower cost. For example, a major financial leverage factor for many small-scale manufacturers is their ability to build facilities that are highly automated. While automation reduces overhead and labor costs, it also decreases profitability because most manufacturers would rather have workers make fewer mistakes and produce fewer defective products.

Firm Investment

Another factor that effects firm investment strategies is interest rates. Interest rates affect both total revenue and absolute returns. In particular, low interest rates have had a negative impact on industrial companies because these firms depend heavily on short term cash balances. Consequently, they have scaled back their rate expectations and have consequently delayed investments in plant and equipment that will produce cash flow streams that can support larger long term obligations. In addition, some firms have switched from fixed rate investments to floating or swap rate investments because floating rates are more stable than fixed interest rates over the long term.

The final factor that is likely to result in changes in firm investment strategies relates to changes in government supervision. With increasing prosperity and globalisation, there are growing concerns that domestic governments are not able to effectively manage economic activities. As a result, there is a growing call for more intrusive and powerful government supervision of the financial system. Theoretically, centralised banks may move away from the traditional role of conducting normal interest rate decisions and adopt more proactive roles, such as undertaking forward looking asset allocation policies, directly monitoring financial indicators, or taking other actions to ensure financial stability.

The two ideas – increased bank supervision and increased firm investment activity – reflect the two major perspectives on the supervision of banking systems. The key difference between these two ideas is the degree of intrusion into the decision-making process. On the one hand, increased bank supervision will involve more interactions between bank managers and central managers. This will involve more detailed discussions and evaluations of the operational risks of various investment projects. On the other hand, supervisory guidelines will likely be more rigid and noxious in nature, directly counteracting any potential increases in bank supervision. Both concepts therefore represent significant changes to the current supervisory framework.

In this context, we note that several recent papers, most importantly those by Orbis and van Rooy and published in the Journal of Economic Theory highlight the importance of incorporating financial risk into the decision-making process at the firm level. Most importantly, our research shows that, through an empirical analysis of four European countries (Belgium, Spain, Italy and Portugal), that firms with a supervisory architecture based on a “reinsurance” concept experience much higher returns on equity and capital than firms that employ a more discretionary approach in terms of taking on external exposure. Interestingly, while the re-insurance concept applies equally to all firms involved in international banking, it is specifically applied to banks in the European Union (EU).

In conclusion, we argue that some form of joint management of investment portfolio is necessary to effectively manage the European firm investment portfolio. Supervisory improvements in Europe have tended to focus primarily on the re-insurance concept, without taking into account other important elements such as re-insurance of balance sheets, and / or re-insurance of credit risk. There has been limited implementation of a single supervisory mechanism for banking across the EU, and most banks still only have one supervisor – the single regulator of central banks in the euro area. While these constraints do not mean that there are no opportunities for improving supervision of banks, they do mean that changes to the regulatory architecture of banking over time will likely be towards greater degree of integration and more targeted supervisory techniques. As such, the benefits from the most recent global crisis will be significantly less than the systemic damage done.