Financial Crisis, Corporate Governance and the Value of Cash Holdings

We study how corporate governance impacts the deployment of internal capital when external financing is costly. Using the 2008 financial crisis as a quasi-natural experiment and difference-in-difference estimation strategy, we show that the propensity to invest out of pre-crisis cash reserves is highest for weakly-governed firms. Weakly-governed firms finance additional investment using short-term debt and allocate a higher fraction of post-crisis excess cash towards building up cash balances. Contrastingly, well-governed firms have a higher propensity to allocate excess cash towards increasing the value of pledgeable assets and use accumulated cash balances to reduce short-term debt financing. Well-governed firms trade-off the cost of cash holdings against the benefit of minimizing future demand for costly external financing; effectively hedging against foregoing profitable future investment opportunities. Overall, optimal amount of internal capital increases with the cost of external financing