Supervisory Architecture and Economic Fluctuations

The relationship between firm size and firm investment decisions is complex. It is also seen that the influence of financial leverage to firm investment decisions is major for large information asymmetric firms. But no direct relationship is seen between leverage and investment in high-innovation firms. Instead, this paper identifies three main drivers of firm size and financial returns: Firm characteristics, financial conditions, and the policy framework. We then examine how these three drivers relate to firm investment choices in terms of financial return and the implications of their selection for managers.

Firm Investment

Our main argument is that bank supervision and regulation can be an effective tool for controlling firm investment. Our key result is that supervisors can use effective bank supervision and regulation to implement policies that can control and contain risks that are directly or indirectly associated with firm investment decisions. As a consequence, our analysis helps refine the literature by showing that supervisory policies adopted by banks are able to yield positive results in terms of bank supervision and regulation, especially for medium to large size banks.

Our main argument is that there are three important drivers of bank supervision and regulation. These are the quality of local economy supervision, externalities of external banking supervision and the institutional characteristics of banks. We identify three important drivers of firm investment decisions through a process of statistical analysis.

As Figure 1 shows, we find that firms make most of their economic decisions during the normal business cycle; during this period they are usually able to absorb the costs of bank supervision and regulation because they are operating at full capacity. However, the two drivers of firm investments changes dramatically during the crisis period. During the crisis period, financial markets become unstable and incentives to save cash diminish.

The decline in lending rates and bond yields, combined with higher costs of holding credit spread over term periods, causes credit quality risk to increase and spreads to widen. The effects of these issues on firm investment decisions are therefore magnified during times of high turbulence in the credit markets. In order to deal with these issues, international policy makers have been looking towards the European supervisory architecture as a means of ensuring adequate supervision of the banking system. The implementation of the European supervisor is also part of the response to the global crisis period.

Supervisory arrangements for banks include the deposit insurance schemes (DIBS), liquidity ratios and credit scores. In the US, these policies were based on Glass Steeple-Matter (GSM), with savings banks being regarded as the only lenders with ‘pure money management’. With the introduction of the European System of Deposit Insurance (ESID), all depositors are protected from the risks associated with bank overdrafts. The introduction of the European Financial Strategy (FOS) has led to the gradual liberalisation of internal cash flow and credit risk management in the European countries.