A good financial system appears to accelerate economic growth.[1] In fact, at least rudimentary finance may be necessary for any growth at all. Raghu Rajan and Luigi Zingales give the example of a bamboo-stool maker in Bangladesh, who needed 22 cents to buy the raw materials for each stool. Unfortunately, she did not have the 22 cents and had to borrow it from middlemen. She was forced to sell the stools back to the lenders in repayment for the loans and was left with only 2 cents’ profit. Because of a lack of finance, she was never able to break out of this cycle of poverty. In contrast, they give the example of Kevin Taweel and Jim Ellis, two Stanford MBAs, who were able to purchase their own business soon after graduating. They had insufficient capital of their own but were able to raise seed funding to search for the right acquisition, and then additional funding to complete it.[2] Taweel and Ellis were the beneficiaries of a modern financial system, including a sophisticated private-equity market.
It is easy to understand the connection between financial and economic development by considering a very simple financial decision. Suppose you must decide whether to extend credit to a small business. If you are in the United States, you can almost instantaneously pull down a Dun and Bradstreet report via the Internet on any one of several million businesses. This report will show the company’s financial statements, the average size of its bank balances, and whether it pays its bills on time. You will also receive an overall credit score for the company. Such widely available credit information reduces the cost of lending and increases the availability of credit. It also means that no one lender has a monopoly of information, which increases competition among suppliers of credit and reduces the costs to borrowers. In contrast, good credit information is not readily available in most developing economies, and lenders to small businesses are both few and expensive.
Of course, finance matters. But does the nature of a country’s financial system matter as long as it is advanced? Does it matter whether a developed country has a market-based or bank-based system? Both types are effective, but each has potential advantages.
1. Risk and Short-Termism
If you look back to Figure 33.2, you will see that in different countries, the amount of risk borne by households in their financial portfolios varies significantly. At one extreme is Japan, where households hold more than half of their financial assets in bank accounts. Much of the remainder is in insurance and pension funds that, in Japan, mainly make fixed payments and are not linked to the stock market. Only a small proportion of household portfolios are linked to the stock market and to the business risk of Japanese corporations. European households also have relatively little direct exposure to the risks of the corporate sector. At the other extreme, households in the United States have large investments in shares and mutual funds.
Of course, someone has to bear business risks. The risks that are not borne directly by households are passed on to banks and other financial institutions and finally to the government. In most countries, the government guarantees bank deposits either explicitly or implicitly. If the banks get into trouble, the government steps in and society as a whole bears the burden. This is what happened in the crisis of 2007-2009.[3]
Some people argue that firms are free to “invest for the long run” in bank-based systems where financial institutions absorb business risks and few individuals invest directly in the stock market. The close ties of Japanese and German companies to banks are supposed to prevent the dreaded disease of short-termism. Firms in the United States and United Kingdom are supposedly held captive by shareholders’ demands for quick payoffs and therefore have to deliver quick earnings growth at the expense of long-term competitive advantage. Many found this argument persuasive in the late 1980s when the Japanese and German economies were especially robust.[4] When market-based economies surged ahead in the 1990s, views changed accordingly. If short-termism is a problem in market-based economies, why not provide incentives for shareholders to hold on to their shares? France, for example, already has adopted a rule that gives extra voting rights to long-term shareholders. The danger is that disenfranchising new investors may serve to entrench incompetent managers.
2. Growth Industries and Declining Industries
Market-based systems seem to be particularly successful in developing brand-new industries. For example, railways were first developed in the United Kingdom in the nineteenth century, financed largely through the London Stock Exchange. In the twentieth century, the United States led development of mass production in the automobile industry, even though the automobile was invented in Germany. The commercial aircraft industry was also mainly developed in the United States, as was the computer industry after World War II, and more recently the biotechnology and Internet industries.[5] On the other hand, Germany and Japan, two countries with bank-based financial systems, have sustained their competitive advantages in established industries, such as automobiles.
Why are financial markets better at fostering innovative industries?[6] When new products or processes are discovered, there is a wide diversity of opinion about the prospects for a new industry and the best way to develop it. Financial markets accommodate this diversity, allowing young, ambitious companies to search out like-minded investors to fund their growth. This is less likely when financing has to come through a few major banks.
Market-based systems also seem to be more effective at forcing companies in declining industries to shrink and release capital.[7] When a company cannot earn its cost of capital and further growth would destroy value, stock price drops, and the drop sends a clear negative signal. But in bank-based financial systems, uneconomic firms are often bailed out. When Mazda faltered in the 1970s, Sumitomo Bank guaranteed Mazda’s debts and orchestrated a rescue, in part by exhorting employees within its keiretsu to purchase Mazda cars. Sumitomo Bank had an incentive to undertake the rescue because it knew that it would keep Mazda’s business when it recovered. In the 1990s, Japanese banks continued to lend to “zombie” firms long after it became clear that prospects for their recovery were hopeless. For example, a coalition of banks kept the Japanese retailer Sogo afloat for years, despite clear evidence of insolvency. When Sogo finally failed in 2000, its debts had accumulated to ¥1.9 trillion.[8]
3. Transparency and Governance
Despite all these advantages of market-based systems, serious accidents happen. Think of the many sudden, costly corporate meltdowns after the telecom and dot-com boom of the late 1990s. In the last chapter, we noted the $100 billion bankruptcy of WorldCom (reorganized as MCI and now part of Verizon). But the most notorious meltdown was Enron, which failed in late 2001.
Enron started as a gas pipeline company, but expanded rapidly into trading energy and commodities, and made large investments in electricity generation, broadband communications, and water companies. By the end of 2000, its total stock market value was about $60 billion. A year later, it was bankrupt. But that $60 billion wasn’t really lost when Enron failed because most of that value wasn’t there in the first place. By late 2001, Enron was in many ways an empty shell. Its stock price was supported more by investors’ enthusiasm than by profitable operating businesses. The company had also accumulated large hidden debts. For example, Enron borrowed aggressively through special-purpose entities (SPEs). The SPE debts were not reported on its balance sheet, even though many of the SPEs did not meet the requirements for off-balance-sheet accounting. (The fall of Enron also brought down its accounting firm, Arthur Andersen.)
The bad news started to leak out in the last months of 2001. In October, Enron announced a $1 billion write-down of its water and broadband businesses. In November, it consolidated its SPEs retroactively, which increased the debt on its balance sheet by $658 million and reduced past earnings by $591 million.[9] Its public debt was downgraded to junk ratings on November 28, and on December 2, it filed for bankruptcy.
Enron demonstrated the importance of transparency in market-based financial systems. If a firm is transparent to outside investors—if the investors can see its true profitability and prospects—then problems will show up right away in a falling stock price. That, in turn, generates extra scrutiny from security analysts, bond rating agencies, and investors. It may also lead to a takeover.
With transparency, corporate troubles generally lead to corrective action. But the top management of a troubled opaque company may be able to maintain its stock price and postpone the discipline of the market. Market discipline caught up with Enron only a month or two before bankruptcy.
Opaqueness is not so dangerous in a bank-based system. Firms will have long-standing relationships with banks, which can monitor the firm closely and urge it to staunch losses or to cancel excessively risky strategies. But no financial system can avoid occasional corporate meltdowns.
Parmalat, the Italian food company, appeared to be a solidly profitable firm with good growth prospects. It had expanded around the world, and by 2003 was operating in 30 countries with 36,000 employees. It reported about €2 billion in debt but also claimed to hold large portfolios of cash and short-term liquid securities. But doubts about the company’s financial strength began to accumulate. On December 19, 2003, it was revealed that a €3.9 billion bank deposit reported by Parmalat had never existed. Parmalat’s stock price fell by 80% in two weeks, and it was placed in administration (the Italian bankruptcy process) on December 24. Investors learned later that Parmalat’s true debts exceeded €14 billion, that additional billions of euros of asset value had disappeared into a black hole, and that its sales and earnings had been overstated.
It’s nice to dream of a financial system that would completely protect investors against nasty surprises like Enron and Parmalat. Complete protection of investors is impossible, however. In fact, complete protection would be unwise and inefficient even if it were feasible. Why? Because outside investors cannot know everything that managers are doing or why they are doing it. Laws and regulations can specify what managers can’t do but can’t tell them what they should do. Therefore, managers have to be given discretion to act in response to unanticipated problems and opportunities.
Once managers have discretion, they will consider their self-interest as well as investors’ interests. Agency problems are inevitable. The best a financial system can do is to protect investors reasonably well and to try to keep managers’ and investors’ interests congruent. We have discussed agency problems at several points in this book, but it won’t hurt to reiterate the mechanisms that keep these problems under control:
- Laws and regulations that protect outside investors from self-dealing by insiders.
- Disclosure requirements and accounting standards that keep public firms reasonably transparent.
- Monitoring by banks and other financial intermediaries.
- Monitoring by boards of directors.
- The threat of takeover (although takeovers are very rare in some countries).
- Compensation tied to earnings and stock price.
In this chapter, we have stressed the importance of investor protection for the development of financial markets. But don’t assume that more protection for investors is always a good thing. A corporation is a kind of partnership between outside investors and the managers and employees who operate the firm. The managers and employees are investors, too: They commit human capital instead of financial capital. A successful firm requires co-investment of human and financial capital. If you give the financial capital too much power, the human capital won’t show up—or if it does show up, it won’t be properly motivated.
25 Jun 2021
24 Jun 2021
23 Jun 2021
24 Jun 2021
24 Jun 2021
25 Jun 2021