In this article, it is seen that financial Leverage is directly and negatively related to firm size. The concept of financial Leverage has long been known to businessmen as an important determinant of the rate at which value is invested by the firm in assets and projects. However, it is also seen that the direct effect of financial Leverage on firm investment is quite substantial for small information asymmetrical firms. The reason for this is that a firm with a small market share may have an easier time raising funds from other firms in its industry compared to larger firms.
An indirect impact of Leverage can be seen in the increased rate of bank supervision of firms in the United States. In particular, this can be seen from the fact that in recent times, banks have been less willing to provide credit facilities to firms unless they have a substantial amount of working capital. With the advent of Financial Liquidity risks and increasing fragility of bank solvency, bank supervision has become more rigorous with respect to liquidity risk. This has also increased bank supervision in relation to firm investment strategies.
At the same time as banks have increasingly become more strict in terms of working capital management, there has also been a trend for firms to move away from the traditional form of issuing shares in order to raise capital. Instead, firms are increasingly relying on derivatives as an alternative method for leveraged firm investment. As a result, a large number of bank supervision organisations have been created over recent years. These organisations were designed to ensure that the financial system did not suffer from a systemic breakdown.
Most recently, a group of United Kingdom think tanks led by Professor Robert Skidelsky of University College London has argued that there are two major ways in which firms can increase their firm investment portfolio participation: via mergers and acquisitions and through the creation of captive insurance companies (CIC’s). Skidelsky and co-author Michael Porter argue that the creation of these captive insurance companies is likely to lead to a decline in European banking influence due to the creation of the European Supervisory Authority (EFRA). They argue that the fragmentation of bank assets will reduce the ability of banks to manipulate the costs of lending to debt-ridden countries, and they would be forced to create more margined trading floors. Alternatively, they argue that the capture of insurance companies by the European banks could lead to a reification of sovereign bonds, leading to a reduction in sovereign debt. In either case, Skidelsky and Porter claim that a reification of insurance house ownership would weaken the role of the European Central Bank in the overall management of the euro area economy.
Skidelsky and Porter argue that a market for captive insurance companies can be controlled through direct government intervention. For example, an independent European supervisor can be empowered by a combination of public policy and law to force insurance giants such as insurer AIG into bankruptcy or sell parts of their assets to fund risky ventures. The European Central Bank can also ensure appropriate interest rates for the issuing banks. Or, the European Central Bank can use its power to create more market volatility by creating more interest rate ceilings. Such measures may provide indirect support to the firm investment efficiency strategy by making creditors bear some of the risk from bank failures.
However, the European supervisory authority (ECB) has also recently threatened to use its powers to directly intervene in the insurance markets to safeguard the refinancing risks of SMEs. The ECB fears that failing to re-allocate credit risk between banks and finance companies would lead to a “sharp deterioration of credit quality across the board.” As such, the ECB has said that it would be prepared to impose a penalty if banks fail to take appropriate steps to improve their firm investments.