Identifying the “financialization” of the nonfinancial corporation in the U.S. economy: A decomposition of firm-level balance sheets

ABSTRACT

This paper develops the concept of the “financialization” of the nonfinancial corporation (NFC) by laying out the key stylized facts describing NFC financial behavior between 1950 and 2014 via a detailed decomposition of firm-level balance sheets. In the existing literature, the concept of the “financialization of the nonfinancial corporation” remains ambiguous; as such, clarification of the trends that have occurred in NFC financial behavior is an important prerequisite for analyses of why NFC behavior has changed and with what consequences. By systematically delineating the evidence for the “financialization” of NFCs, this paper contributes to the literature by establishing precisely how NFC financial behavior has changed in the post-1980 U.S. economy. The growing “financialization” of nonfinancial corporations is summarized by an increased share of financial assets in NFC portfolios, increasing indebtedness and equity repurchases among large firms, and deleveraging among smaller firms. The paper concludes by introducing the behavioral insights gained by approaching these stylized facts from a conceptual standpoint emphasizing the interdependence of portfolio and financing decisions and, thus, the links between the changes in financial behavior across NFC balance sheets.

KEYWORDS:

• Corporate finance
• financialization
• shareholder value

JEL CLASSIFICATIONS:

• G3
• E12
• B5

Notes

¹The analysis uses Compustat data; variable definitions are summarized in Table A1 in the appendix.

²See Kregel (1998, 2014) for analysis of changes within the financial sector over this period, including those related to interest rate deregulation. Of particular relevance to the discussion here is the expansion of shadow banking and nonbank liquidity in the economy, used primarily to finance the acquisition of financial assets rather than to fund physical capital accumulation.

³Shareholder value orientation, and the implications for NFC balanced sheets are discussed further in the section on stock repurchases and the discussion below.

⁴The qualitative trend holds when capital and financial assets are instead measured as the across-firm yearly mean, or when normalized by total assets. The fact that the mean and median move together highlights that the portfolio shift occurs across the size distribution of firms; this point will be addressed further below. Here, asset stocks are normalized by sales, rather than total assets, to avoid possible biases stemming from the fact that an increase in financial assets relative to assets requires by definition a decline in nonfinancial assets relative to assets. Instead, sales provide a useful proxy for firm size.

⁵The post-1990 acceleration in cash holdings is correlated with the growing dominance of a “downsize and distribute” allocation regime (Lazonick and O’Sullivan, 2000), as well as the increasing entrenchment of shareholder value orientation; see below for further discussion of shareholder value orientation.

⁶This shift toward core competence occurs across firms within the United States, but also captures increasingly globalized production, whereby U.S. firms focus less on heavy manufacturing, and more on “light” aspects of production, such as branding and marketing. Milberg and Winkler (2013) cite the example of corporations like Gap, which no longer engage in manufacturing and instead earn their profits through the marketing, branding and sale of already-manufactured goods.

⁷Furthermore, citing the expansion of international financial markets such as Eurodollar markets, Krippner (2012) contends that there is no a priori reason to expect that nonfinancial activities abroad exceed financial activities abroad for NFCs. Krippner supports this claim with aggregate-level evidence that international portfolio income (i.e., financial income) earned by U.S. NFCs is comparable in scale to domestic portfolio income. The data required to make similar comparisons at the firm level are unavailable.

⁸The industries are agriculture, forestry and fishing; mining; construction; manufacturing; transportation, communications, electric, gas and sanitary services; wholesale trade; retail trade; services; nonoperating establishments; and conglomerates. High tech includes high-tech manufacturing, communications services, and software and computer-related services. Details on the industrial classifications are in Table A2 in the appendix.

⁹The industrial composition of the sample over time is summarized in Table A2 in the appendix for five-year periods between 1950 and 2009, both for the full sample and each size quartile of firms. For a clearer sense of industrial composition, the next two largest industries—transportation and communications, and retail—are also included in Table A2. The sample registers a relatively small decline in the total share of manufacturing—from 58.6 percent of total assets in 1950–54 to 45.4 percent in 2005–9—such that, for the entire period, the sample is dominated by manufacturing firms. After manufacturing, transportation is consistently the second largest industry, comprising at least 30 percent of total assets in each subperiod, and high tech grows over time, peaking in 2000–2004.

¹⁰While all three industries record high ratios of financial assets to sales in 2000, this ratio is particularly high for tech firms, and is primarily concentrated in cash and other short-term investments. Note that this observation point corresponds to the tech boom, at which time there was considerable M&A activity in tech. During the 1980s and 1990s, innovation sustained tech firms’ growth, and earnings were reinvested in the growth of the firm. Beginning in the mid-1990s, however, these tech firms also transitioned to the “downsize and distribute” business model introduced earlier, at which time we note a significant shift in their portfolio composition and balance-sheet structure.

¹¹It seems unlikely that the firm-size decompositions are dominated by differences in industrial composition by firm size. Table A2 points to broadly similar industrial shifts across size quartiles—namely, a rise in services and tech, and a decline in manufacturing—although there are differences in the relative magnitude of these shifts by firm size. Smaller firms move more decisively into both tech and services, and accordingly exhibit a greater decline in manufacturing. Among the largest quartile of firms, on the other hand, manufacturing is far more stable, and services barely exceed 5 percent of total large-firm assets in 2005–9.

¹²The differences between small and large firms are mirrored by differences between newer versus well-established firms, and size and age are strongly correlated in the sample. There are clear theoretical reasons to expect an intersection between firm size and age: both well-established and large firms have advantages of incumbency, networks in product markets, access to external finance, possibly bond ratings, and larger absolute stocks of cash and other resources with which to compete.

¹³Debt is defined as total debt and, therefore, distinguishes neither between bank and bond debt nor by length to maturity.

¹⁴Similar average patterns within broad industrial groups may mask important differences in the behavioral motivation for acquiring debt across broad industrial categories, narrower subcategories and firm size. R&D intensive industries, for example, may borrow in order to invest in innovation, whereas other firms may borrow to finance acquisitions. Tech start-ups, on the other hand, have used initial public offerings (IPOs) to avoid borrowing. Different motives for borrowing also extend to firm size, and empirical evidence suggests and large firms, in particular, may increasingly borrow to finance stock repurchases (Mason, 2015).

¹⁵Note that the dramatic, but volatile, increase in repurchases shown in Figure 5 occurs simultaneously with more gradual dividend growth, such that—relative to firm income—total NFC payouts to shareholders exhibit a secular increase over the post-1980 period (Grullon and Michaely, 2002; Lazonick, 2009b).

¹⁶Due to availability of repurchase data, Figure 5 covers only the post-1970 period.

¹⁷The procyclicality of repurchases is consistent with the expectation that one advantage of repurchases over dividends as a form of shareholder payouts—from the perspective of management—derives from the discretionary nature of repurchase programs: declining dividend payouts are likely to be met with greater market hostility than declining repurchases, which are expected to be intermittent.

¹⁸The relationship between the acquisition of financial assets and investment in physical capital may be contingent on a range of mediating factors. For example, in the context of increasing sales volatility, financial investments (particularly in liquid financial assets) may be complementary to capital investment. Davis (2013) finds evidence of complementarities between financial investments and capital investment among NFCs in the post-1970 U.S. economy, and Orhangazi (2008a) finds differential effects of financial profits on NFC investment by firm size.

¹⁹Data for the components of financial income are not available for the full post-1950 period. Note also that the patterns in Figure 6 are replicated in more detailed size subsamples.

²⁰Furthermore, there are likely complementarities between financial profits and nonfinancial profits, which cannot be distinguished within these averages. For example, consider an auto manufacturer that earns profits from the provision of financing for its own industrial product.

²¹Note that a stated theoretical rationale for designing incentives to enforce shareholder value maximization is to “disgorge the cash” (Jensen, 1986) and, as such, “successful” implementation of shareholder value principles is designed to be linked to shifts in the structure of NFC balance sheets. Within the economics literature, this rationale signifies a marked departure from the Modigliani–Miller view of the firm (Tirole, 2006), according to which a firm‘s financial structure is irrelevant for its non-financial outcomes (Modigliani and Miller, 1958).

²²A version of the graph in Figure 7 appears in Mason (2015).

²³Shareholder value orientation and growing shareholder payouts also have important implications for labor that have not been elaborated in this paper. In particular, a “downsize and distribute” business model implies not only growing distribution of earnings to shareholders but also a downsizing of the corporate labor force (see Lazonick [2009a] for a discussion of the implications of shareholder value orientation for labor and employment relations in the U.S. economy).