Supply Chain Risk: Changes in Supplier Composition and Vertical Integration

Global supply chains are incredibly complex and are poorly understood. Wars, natural disasters, port closures, and cyberattacks make supply chains highly vulnerable. Yet, even though recent events highlight that supply chain shocks are an important source of disruption, we know little about whether firms systematically update their investors about the ex-ante probability that such shocks may occur and any perceived changes in this source of risk. We are also unable to quantify the effects of supply chain risk on corporate policies.

In our paper titled ‘Supply Chain Risk: Changes in Supplier Composition and Vertical Integration’, which is available for download on SSRN, we construct a measure of supply chain risk using textual analysis, and investigate how firms’ policies are affected by supply chain risk. Our newly developed measure enables us to study which firms are most affected by supply chain risk, and the extent to which supply chain risk affects firms’ policies and industrial structure. We perform a textual analysis of earnings conference calls to construct measures of the first two moments of supply chain shocks faced by US listed companies. We define the first moment of supply chain shocks as associated with the sentiment of supply chain discussions (eg the positive or negative tone of the discussion about the supply chain) and the second moment, supply chain risk, by focusing on words capturing risk and uncertainty within that discussion.

All US companies between 2002 and 2020 discuss topics related to supply chains in connection to risk and uncertainty. This indicates that supply chain risk is important and so far neglected in the economics and finance literature. Importantly, supply chain risk is positively correlated with stock price volatility, while supply chain sentiment is associated with positive returns. While unsurprisingly supply chain risk and supply chain sentiment are negatively correlated, the actual correlation is only -4%, indicating that we can independently measure supply chain risk and sentiment.

Supply chain sentiment turns negative and supply chain risk increases on average in conjunction with events that are known to have disrupted supply chains, such as the 2011 Japanese earthquake and the Thai floods. The increase in supply chain risk and drop in supply chain sentiment appear unprecedented during the Covid-19 pandemic. Furthermore, supply chain risk appears to be higher for firms in industries that use differentiated products as inputs, consistent with the intuition that these goods are hard to substitute and any delays and bottlenecks cause severe disruption.

Even though macroeconomic and industry level uncertainty matters, the way firms discuss supply chain risk appears to be highly idiosyncratic. Most of the variation in supply chain risk is explained by firm-specific shocks rather than time- or industry-specific shocks. Supply chain risk is higher for firms that have suppliers on different continents and are small relative to their suppliers, suggesting that they have limited bargaining power. Firms that have many suppliers in a given industry are less exposed to supply chain risk, suggesting that hold-up problems and lack of diversification in input sources magnify supply chain uncertainty. Large firms, possibly having more complex supply chains, are more exposed to supply chain risk.

We also investigate what actions firms take to manage increases in supply chain risk. First, firms appear to actively manage supply chain risk by investing more and increasing the number of their suppliers, and by establishing relationships with suppliers that can be considered industry leaders and with nearby suppliers.

In addition, we find that supply chain risk affects the boundaries of the firm and industrial structure. The benefits of common ownership of different stages of the production process are expected to increase when there is uncertainty about the availability of inputs (Williamson, 1971). Accordingly, firms that report high supply chain risk are involved in more vertical mergers and acquisitions (M&As). Financial constraints limit firms’ ability to perform M&As, potentially hampering their long-term competitive advantage.

Our results suggest that higher supply chain risk could be associated with changes in the geography and organization of economic activity, with protracted long-term effects on the performance of different geographical areas. Exploring these issues is an exciting area for future research.

Nuri Ersahin is an Assistant Professor of Finance at the Broad College of Business of Michigan State University.

Mariassunta Giannetti is a Professor of Finance at the Stockholm School of Economics.

Ruidi Huang is an Assistant Professor of Finance at the Cox School of Business of the Southern Methodist University.

This post is published as part of the OBLB series on ‘The Corporate Sustainability Due Diligence Directive Proposal’.