Multinationals and Uncertainty : The Role of Internal Capital Markets

Internal capital markets (ICMs) allow multinational enterprises (MNEs) to transfer liquidity globally, which connects external capital markets when the related entities also raise external funds. This paper studies such connection with a model of ICMs that permits two layers of agency problems: those between (the shareholders of) a MNE and its external lenders and those between a parent company and its subsidiaries. When a parent company faces a limited internal monitoring capacity due to complex multinational operations, subsidiary-level external debt can be used to induce monitoring from local lenders that have informational and supervisory advantages. This encourages a MNE to deploy an optimal blend of parent- and subsidiary-level external debt to maintain the lender's incentive to monitor. The model predicts that, in response to an uncertainty shock in a foreign country, MNEs can counter the negative effect with an inflow of international capital by substituting subsidiary-level external debt with cheaper parent-level external debt as foreign lenders have a stronger incentive to monitor. My paper then tests this prediction with detailed data on US MNEs at both parent and subsidiary levels, utilizing the surge in uncertainty caused by the UK's unexpected decision to leave the European Union ("Brexit") as a natural experiment. Consistent with the model prediction, I document that the uncertainty shock increased the ratio of parent-level external debt to total assets significantly in the consolidated balance sheet of US MNEs with UK subsidiaries, without changing the ratio of total debt to total assets. Meanwhile, the UK subsidiaries of US MNEs substituted external debt with internal debt significantly on their unconsolidated balance sheet, without changing the ratio of total debt to total assets. Given the global influence of non-financial MNEs, this study provides the first evidence that their ICMs constitute an important channel of cross-border spillovers among external capital markets in response to shocks