Is the Relation Between Business Cycles and Leverage Mediated by Structural, Institutional or Cultural Factors?

In traditional financial theorizing, business cycles are of limited relevance for the understanding of capital structure mechanisms. A number of other dimensions are more important (agency costs, market timing, signaling, etc.), and business cycles proxies are not robust in empirical studies (Frank and Goyal, 2009). Recent research has evidenced that, based on a pan-European sample of listed firms, two conflicting mechanisms coexist: a pro-cyclical one, related among other things, to the primary importance of the disciplining role of debt. The other mechanism, contra-cyclical, is to be observed among firms with concentrated ownership. It is derived from risk-related considerations, comparative benefits and costs of entrenchment or discretion, and it is fostered by incentive-alignments (Reuter, 2010). We suggest that the contra-cyclical effect is underestimated in the literature, because it is of limited relevance in the paradigmatic U.S. role model with broad and liquid stock markets, strong shareholders' rights, and dispersed ownership. Based on a sample of listed European firms, we show that both the pro- and contra-cyclical mechanisms are mediated by structural, cultural and institutional factors. We show that, on contextual dimensions corresponding to the U.S. context, some pro-cyclicality is observed, while there is limited or no contra-cyclicality (the first mechanism dominates in aggregate). This observation is reversed when contextual dimensions are opposite to that of the U.S. (the second and opposite mechanism dominates). Further, it encompasses varying dimensions of capital structures (cyclicality of leverage, market timing, dividend policies) and it extends to the following dimensions of context: ownership dispersion, institutional anchoring, transparency and risk, structural firms' variables, the quality of the contracting environment, or still measures of national cultures, particularly the one related to bank-based macro-financial systems. Overall we complement existing institutional approaches, which emphasize the relatedness in varying contextual national dimensions.