Abstract
The purpose of this study is to investigate how firms responded to the deterioration of bank health during the financially turbulent periods in the 2000s in making investment decisions and in meeting demand for liquidity. A rise in uncertainty regarding the ability to obtain external funds may have induced firms to rely on internal funds to finance investment activities. Therefore, we shed light on the cash flow sensitivity of investment and cash holdings by estimating firmlevel investment and cash holdings equations using panel data for Asian firms in the 2000s. Our sample firms are from countries at different stages of financial development. The sample enables us to analyze the different roles played by internal funds in the financial and investment policy of firms in a financialenvironment with different stages of development. We find that the cash flow sensitivity of investment and cash holdings rises as bank health deteriorates. Moreover, the impact of non-performing loans on the cash flow sensitivity of investment and cash holdings is more prevalent across firms, irrespective of firm age, in countries with a higher level of financial intermediary development. Our findings suggest that as financial intermediaries develop, firms become more dependent on bank credit so that bank-dependent firms are more vulnerable to external shocks that hit the financial system. Therefore, when bank health is impaired, bank-dependent firms increase their reliance on internal funds and raise their propensity to save cash flow to materialize potentially profitable investment opportunities in the future.
Highlights
The financial market plays an important role in allocating limited financial resources to the most efficient uses
We find that the cash flow sensitivity of investment and cash holdings rises as bank health deteriorates
The impact of non-performing loans on the cash flow sensitivity of investment and cash holdings is more prevalent across firms, irrespective of firm age, in countries with a higher level of financial intermediary development
Summary
The financial market plays an important role in allocating limited financial resources to the most efficient uses. As bank health deteriorates, the cash flow sensitivity of investment and cash holdings rises more sharply for firms in countries with greater financial intermediary development. This finding seems a bit contradictory to the conventional wisdom that financial development mitigates external financial constraints, and investment and cash holdings become less sensitive to cash flow. We explain the main features of our analysis in the course of overviewing the extant literature on the role of cash flow in the investment and cash holding behavior of firms
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