Tuesday, May 10, 2016

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Sudarshan Jayaraman
New research by Simon professor Sudarshan Jayaraman and S.P. Kothari of Massachusetts Institute of Technology explores in depth the impact of greater cross-border financing on domestic banks and their relationship with manufacturers.

Economists have long understood the banking sector’s impact on manufacturing firms. The financial crisis of 2007 to 2009 and the ensuing economic slowdown have highlighted the connection between these sectors. While most research has focused on understanding how shocks to the banking sector are transmitted to the industrial sector, Jayaraman’s research shows that the effects also work the other way around.

“The banking sector always affects the industrial sector, and researchers pay a lot of attention to this. However, we show that it flows both ways: Changes happening to the industrial sector affect the banking sector as well,” Jayaraman says.

The authors look at what has happened in banking from the time that manufacturers stopped relying on domestic banks and started borrowing from international markets. The benefits of foreign financing for industrial firms are well understood, but its effects on the banking sector are relatively unexplored.

They found unintended consequences for domestic banks as a result of regulatory initiatives set in place to increase firms’ access to foreign financing. Their paper focuses on one such initiative, the introduction of the International Financial Reporting Standards, a common set of accounting rules implemented across more than 100 countries in 2005. The objective of the standards is to create greater harmony in disclosure practices among countries to increase cross-border capital flows.

While firms benefit from greater availability of capital, US banks must take on more risk to compete more fiercely with these alternative financiers, the authors write.

“Although we don’t examine the implication of this risk-taking on banking system stability, an extension of our results is that such behavior increases bank fragility,” Jayaraman adds.

In addition to financial reporting standards, advances in communication technology have made it easier for manufacturers to locate financing alternatives in foreign countries and markets.

“We also show that information is now flowing globally, and that benefits firms in search of capital,” Jayaraman says. “They don’t have to rely on domestic banks anymore.”

The paper is forthcoming in The Accounting Review. —Sally Parker

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