Customer–supplier relationships and non-linear financial policy response

We investigate whether changes in the capital structure of major customers play an important role in determining the firm’s financial policy. Following Leary and Roberts (2014) and using average customer idiosyncratic equity return shocks, we find that a firm’s leverage ratio is negatively and nonlinearly affected by the leverage ratio of its major customers. This “customer effect” occurs only when the idiosyncratic equity shock to the customer firms is negative. Consistent with the prediction of the modified pecking order theory that firms are more concerned about excessively high leverage ratios than excessively low leverage ratios, supplier firms tend to significantly reduce their long-term debt in response to increases in the leverage ratios of their major customers but are insensitive to the inverse change. Finally, consistent with the stakeholder theory and the dynamic trade-off theory, we find that this capital structure correlation is more pronounced for firms producing specialized or unique products, firms with lower profitability, firms with weaker operational capabilities, firms that take more risks, firms whose customers operate in more competitive industries, and firms whose customers are more financially vulnerable. Our results contribute to identifying the dynamics and determinants of corporate capital structures.