Business Networks, Firm Connectivity, and Firm Policies

Abstract

I examine firm financial policies under a network structure of customer-supplier relationships. In this network, negative economic shocks that occur to one firm can affect other firms' profitability through their relationship-specific connections, leading to a contagion effect. I demonstrate theoretically that when external financing is costly, firms connected to the distressed firms will find it optimal to extend financing in order to preserve their relationship-specific synergies. Empirically, I show that firms strongly connected in the network will choose more conservative financial policies. Using firms' closeness centrality in the network as a proxy for the strength of their connections, I find that central firms choose lower leverage, higher cash holdings, and lower payout. To alleviate potential endogeneity concerns, I use mergers of firms' secondary neighbors to instrument for network structure changes. Compared to withdrawn mergers, the secondary neighbors of mergers experience increases in closeness, which lead them to adopt more conservative financial policies following the mergers.Finally, to validate the channels behind my results, I use several exogenous shocks including 9/11 and show that firms closely related to the distressed firms increase their trade credit demand and reduce their investment following negative shocks.