The European Financial Crisis and Firms' Cash Holding Policy: An Analysis of the Precautionary Motive

This paper analyzes the relation between the 2008 European financial crisis and firms’ cash holding policies from a precautionary motive perspective. After considering how the European financial crisis affected the cash holding policy across different period times, we focus on whether these variations come from changes in precautionary motives. We find a positive effect for the short crisis period and a negative effect for long crisis period for the full sample. We also find evidence that for financially constrained firms, the relation between cash volatility and cash holding is positive for short crisis period but turns negative for the long crisis period. Policy Implications • Banks in Europe, while preparing their corporate governance effectiveness policies, should consider that the crisis effect on cash holding decisions is not homogeneous for firms. • In their financial plans, EU policy makers and European banks need to focus on European firms’ and investors’ precaution (financial uncertainty) levels. • Regulators should consider that lower uncertainty causes to firms to do less cash holding in a crisis period. • Financial authorities and financial markets should better consider the design of policies based on financial constraints and precautionary motives. • Policy makers should design policies that optimize the efficient use of liquid resources both at the banking and firm levels The question concerning which factors affect a firm’s cash holding policy is one of the most widely discussed issues in finance literature. Cash levels are strongly related to a firm’s hedging policies, which is a key decision for firms, especially in a crisis environment. Prior research shows that firms have four motives for holding cash: a transaction motive; a tax motive; an agency motive; and a precautionary motive (Bates et al., 2009). The extant literature identifies the precautionary as one of the most important, and recent literature has continued to focus on this motive. For example, Hadlock and Pierce (2010) find that a high level of cash holdings is related to financial constraints, in that firms hold elevated levels of cash for precautionary reasons. Song and Lee (2012) show that changes in a firm’s precautionary motive, rather than changes in firm characteristics, can explain increased cash holdings. In addition, Dur an et al. (2016) discuss the role of the precautionary motive on family firms’ cash holding policies, and Duchin et al. (2017) address the precautionary motive in relation to risky assets. The precautionary motive theory for holding cash predicts that firms hoard internal funds to finance possible future investment projects in order to avoid a possible shortage of external funds and to prevent sales and investment opportunity shocks. However, crisis periods can severely affect firms’ precautionary motive. In 2008, the International Monetary Fund highlighted the magnitude of the problem in global financial markets: ‘The financial market crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression, inflicting heavy damage on markets and institutions at the core of the financial system’. This large shock to the financial markets caused huge uncertainty among market actors (Kahle and Stulz, 2013) that lasted across many years. In 2012, Europe was still coping with uncertainty problems, and the economic position of some countries, such as Greece or Ireland, was worse than it was at the beginning of the crisis (Stiglitz, 2012). Stiglitz (2012) finds that in 2012 the financial crisis continued to have negative effects on Europe’s financial © 2020 University of Durham and John Wiley & Sons, Ltd. Global Policy (2020) 11:Suppl.1 doi: 10.1111/1758-5899.12768 Global Policy Volume 11 . Supplement 1 . January 2020 84