The Relationship Between Supervisory Architecture and Firm Investment

Financial LIFO and Firm Investment are two interrelated concepts that directly impact the investment decision making process. Financial leverage relates to the increased borrowings costs associated with a firm’s current asset base (its assets vs. its liabilities). This concept is useful for predicting the behavior of prices, and firms should consider financial leverage when formulating their overall investment strategy. However, financial leverage does not tell us exactly what a firm should invest in, only how much. To solve this problem, the analysis of firm investment strategies should be done by looking at both the strengths and weaknesses of each method.

Firm Investment

In order to conduct a comparative analysis between financial risk management systems using firm fixed investment and firm financial architecture, the European supervisory architecture was used. The European Union (EU) is comprised of numerous countries with different legal structures, norms, policies and objectives. The study therefore focused on four central European countries: Ireland, Portugal, Spain and Greece. For purposes of the paper we classified the four into three groups: (a) those in the medium-to-high investment quality countries; (b) those in low-to-moderate investment quality countries; (c) the remaining ones in the euro area countries

Within the context of this paper, the four types of firm investment themes were then separated into categories. As the levels of investment quality varied across the EU, the banking union was found to be a significant force shaping the overall distribution of firm risk. The bank supervision and supervisory practices analyzed in the working paper were found to have very limited effects on firm investment decisions, especially when comparing against other types of instruments such as credit default swaps and debt securities.

The next step was to relate the level of centralised supervision with the different policy tools available at the national level. The main channel for bank supervision was the bank board. The degree of bank supervision varied significantly across countries and regions. In most cases, a centralised body overrode independent regional banks. The study therefore found that overall, there was little effect of the concentration of bank supervision across the EU.

One exception to this was the situation in Ireland, where the Irish banking union was found to have a greater degree of bank supervision than other countries. This resulted in the identification of the situation in terms of firm investment decisions. Although the final analysis showed that the Irish banking union did not exert a direct or indirect effect on firm investment decisions, the overall impact of the supervisory architecture was found to be negative. The implications of this are discussed in the following section of the Working Paper.

The results imply that the design of the internal cash flow mechanism by the banks was found to have a negative effect on firm investment decisions, particularly in comparison with decisions made in other countries. When internal funds management is given a higher priority over other considerations, it is likely that firms will change their investment pattern. Given the focus on firm investment decisions in recent years, the relative importance of the financial statements and the balance sheet in determining the health of an organization can have a direct and negative impact on its business model. These findings suggest that firms need to consider carefully the role of the internal cash flow mechanism in determining their long-term viability.