Capital Allocation and Product Market Competition During a Financial Crisis

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This study shows that the 2007-2008 financial crisis and the resulting dislocation in capital markets have notably differential impacts on firms according to their internal/external finance dependence. We find evidence of capital reallocation across firms during the financial crisis: firms having relied on internal funds prior to the crisis increase external capital and investments during the crisis, whereas firms having depended on external finance significantly contract their external capital and investments during the crisis. External finance dependent firms curtail their financing due to their lack of accessibility to debt and equity capital during the crisis, which, in turn, attributes to reduction in investment. In contrast, internal finance firms raise additional debt in order to expand their investment during the crisis. The differential effects of the crisis between internal and external finance dependent firms suggest that there is a shift in capital allocation during the crisis from external finance dependent firms to internal finance firms. Further, the shift appears to be driven by internal finance firms' strategic actions to hamper external finance dependent firms' financing and competition ability during the crisis. Financing and investment activities of internal finance dependent firms during the financial crisis are accompanied by their taking of greater market share. Our findings suggest that the credit crunch created by the crisis provides unequal opportunities for firms and that financially strong firms exploit their weakened competitors, consistent with the implication of the long-purse theory of predation.