Andrew Tylecote: Management School, University of Sheffield
The development of financial systems
1.Trends in intermediation
Debt intermediation
In the case of debt intermediation there is a bank which takes money deposits,
typically from households, and then lends them out, typically to firms. The
alternative, without intermediation, is for the firms to issue fixed interest
securities on the financial markets which the households buy. Disintermediation
is a move from the first situation to the second. How can one justify having that
extra institution in the middle 'intermediating'? Only if it can provide what the
households and firms need better than they could without it. The household
needs liquidity for at least part of those assets and safety for all of them. The
bank can certainly provide it with liquidity and may also provide the safety, by
having a large number of diverse assets (and perhaps central bank support -see
below). It can then provide the firm with a large part - perhaps all - of its debt
finance in one transaction, with the necessary information being passed from one
organisation to the other in the same process (including the hunch of the bank
manager that the person (s)he is talking to is trustworthy). The firm then avoids
the transactions costs of operating on the securities market - which will have a
large fixed element, working against the small firm.
The importance of size
The larger the firm requiring capital, the lower the unit costs of operating on the
financial markets and providing the necessary information - indeed for a very
large company much of that information will be provided free by newspapers etc.,
responding to public interest. Although bank interest rates will also be lower for
large borrowers, they will not fall so far, because they have to reflect not only the
transaction with the borrower but that with the depositor. For sufficiently large
borrowers there will be an interest rate available on securities which is lower
(even after transactions costs) than bank loans while providing the lender with a
higher rate than available on bank deposits. It is therefore not surprising that
governments in developed countries hardly ever get their finance from bank
loans: they get a much better bargain by issuing securities. Due to the increasing
size and age of companies, the general trend is to decreasing intermediation of
debt - that is, towards 'securitisation'. Increasing size and age both mean that
public knowledge of the company's value increases and a market in its securities
is relatively cheap to operate. Thus of the fixed interest capital employed by
large Japanese manufacturing companies, the proportions of bank debt and
bonds changed from 89.5% bank loans, 10.5% bonds in 1977 to 52.4% bank
loans, 47.6% bonds in 1990 (Charkham, 1994, p.99, T.3.7; book values).
Still, the disintermediation of the financial system has its limits. On the demand
side, there will always be many firms too small to be able to raise money through
securities, and on the supply side households will always want to have a
proportion of their assets in a form more liquid than securities though less liquid
than cash - i.e. in bank deposits. (That proportion may well fall, if only through
the development of credit cards which allow households to spend without having
money in the bank, thus providing a substitute for liquid assets.) We shall see
below that there are enormous variations among countries in the extent of
financial disintermediation among countries, and discuss why.
Equity intermediation
There is also scope for intermediation of equity, whereby shares in firms are
owned by other institutions rather than households directly. This sort of
intermediation is actually increasing, and it is being pushed up by much the same
forces as are pushing debt intermediation down - the increasing size and age of
firms. With small firms equity holdings are generally very direct. Most very small
firms after all do not have shares in any formal sense - they are owned by one
individual or a partnership. The next stage, as firms get bigger, is private
companies with shareholdings but no stock exchange listing. Then comes plc
(public limited company) status, in which the firms' shares are quoted on the
stock exchange. This involves a fixed expense which makes little sense below a
certain size. Likewise, as a firm gets older there is less and less likely to be a
founding family which wishes to retain control by keeping it private.
A stock exchange quotation does not automatically lead to intermediation of
equity ownership but it makes it possible. At the same time it makes debt
disintermediation easier. The listing of the shares creates a need for information
about the firm. When that need is satisfied by the firm and others - like financial
journalists - it sharply reduces the cost of providing a market in its securities.
Thus the two processes reinforce one another.
In fact there are at least three kinds of equity intermediation which may develop.
The most familiar kind in Britain is by financial institutions like investment trusts,
insurance companies and pensions funds. One advantage for people with modest
wealth of owning shares and securities indirectly in this way is that they own part
of a properly diversified portfolio which (even if they had the expertise) they
could not put together on their own, because it would require uneconomicallysmall holdings of each share. Even more to the point, particularly with pension
funds, are the tax advantages given to saving in this manner. These are justified
by the fact that it is mostly saving for old age, to provide funded pensions, i.e.
pensions which are paid out of accumulated funds. Britain and the United States,
in that order, have a great deal of financial intermediation of equity. (Table 2.)
Table 2: Ownership of common stock, by category (as percentage of
outstanding common shares):
Households
Non-financial
enterprises
Public sector
Foreigners
Banks
Life insurance
companies
UK
(1989
)
20.0
8.0
USA
(1990)
54.4
n.a.
19.4
39.3
23.9
50.5
23.1
25.2
3.0
9.0
---
--6.4
0.5
2.9
7.1
20.0
8.1
4.3
12.8
3.5
0.6
4.2
25.2
13.2
2.6
4.1
2.5
0.9
3.6
20.0
Other insurance
companies
Pension funds
Mutual funds
Germany
(1988)
Japan
(1990)
2.7
2.6
32.0
8.0
France
(1989)
26.5
6.6
--3.4
Source: Charkham, 1994, p.105.
One reason why in other countries there is much less financial intermediation is
that there is an attractive alternative way of getting a good pension. This is
provided by 'unfunded' Pay As You Go pension systems: those working now pay
out of their salaries for the pensions of people retired now, and (they hope) the
next generation will do the same for them in due course. They hope: PAYG
systems are looking less and less sustainable in the advanced world, with the
prospect of demographic shifts which will leave more and more pensioners
depending on (relatively) fewer and fewer workers. Accordingly other countries
are looking for ways of persuading those currently at work to save for 'funded'
pensions, like the British.
The second kind of equity intermediation is industrial, where non-financial
companies own shares in other non-financial companies. The obvious motive for
that is control: in Japan, for example, reciprocal shareholding among industrial
companies allows their managers to protect each other from control (or takeover)
from outside. In Germany, Italy and some other countries in Continental Europe
it is not uncommon for family X to have a 51% shareholding in firm A which in
turn has 51% of firm B.......(See Table 2.)
The third kind is intermediation by financial institutions but with control in mind.
This has arisen in countries like Germany and Japan with a strong tradition of
bank lending to industry, in which banks have come to own major shareholdings
in large firms. In many cases they have acquired the stakes at times of crisis
when the firm could not meet its debt obligations and handed over shares in lieu.
They find them convenient alongside large loans to the firms because they give
them influence which helps in keeping the loan safe. (See Table 2 again.)
2. Trends in the proportions of debt and equity in industrial finance
There are some trends at work to decrease firms' debts as a fraction of their
assets, and others at work to increase them. Increasing size reduces the need for
new finance. This is particularly true for diversified companies. Positive cash flow
activities ('cash cows') are matched to ones with negative cash flows. With such
reinvestment of profit, shareholders are in effect providing new equity finance
without being asked. This may account for the considerable fall in debt/equity
ratios in Japan and Germany, from the high levels of the 1970s. However tax
treatment also plays a role, which is now tending to push in the other direction.
In every country debt is more tax-efficient as a source of finance, because there
is no tax on the profits the firm uses to pay interest, only on those which remain
to pay dividends. As a result, debt/equity ratios have gone up sharply in the US
and UK, since 1980, from very low levels. (There is one sort of change which
pushes debt up very sharply: a 'leveraged management buyout' in which
managers take over control of a firm or part of a firm with the assistance of a
large issue of bonds.) Why there was the big difference in initial levels among
the two pairs of countries, we will explain later. See Figure 3, p.490, of F X
Browne, 'Corporate Finance: stylized facts and tentative explanations', Applied
Economics, 1994, 26, 485-508.
3. Trends in the degree of concentration of holders of immediate claims.
To understand what we mean by this complicated term, let us take as an example
the very simplest sort of financial system is where each firm has one shareholder,
and gets all its debt capital in loans from one bank. Here the degree of
concentration of holders of immediate claims on firms would be at a maximum.
Clearly new and small firms are most likely to operate like this - unless they are
so new and small that they get informal direct finance (friends and family) more
readily than bank loans. Disintermediation - securitisation - of debt finance will
naturally have a 'deconcentrating' effect because the securities of each firm will
usually be in many different hands. Likewise big firms may find it convenient to
have several banks.
The marketisation of shares leads in the same direction, for a while, but then
comes intermediation of equity. Whether that leads to reconcentration of share
ownership depends on the type of financial institution involved. Pensions funds
and insurance companies generally follow the standard 'hedging' principles and
build up diversified portfolios with few shares in each firm. Where the
intermediaries are banks or non-financial companies, as in Germany and Japan,
the aim of share ownership is not risk-spreading but control: so they
reconcentrate.
Questions: If a country moves from reliance on Pay as You Go pensions towards a
'funded' system, what effect will that have on the degree of debt intermediation?
what will it do to the degree of concentration of holders of immediate claims?
4. Stock exchange-based and bank-based financial systems: stages of
evolution or entrenched national differences?
These three factors allow us to categorise financial systems and to understand
their evolution: broadly speaking, as we have seen, they will tend to evolve
(1) towards a low degree of debt intermediation and a high degree of equity
intermediation;
(2) from a high to a low degree of concentration of both debt and equity
ownership.
That at least has been the way the situation in the most 'mature' advanced
economies - Britain and the United States - has moved over the last century or
so. These two 'Anglo-Saxon economies now have what can be called stock
exchange-based financial systems. In this type of system, a stock exchange
quotation is the norm for any firm large enough to bear the transactions costs
involved (see Table 3).
Table 3: Market capitalisation of quoted companies as % of GDP.
(Charkham) (Prowse)
USA
48
UK
88
81
Japan
37
Germany
19
14
France
25
Switzerland
81
Netherlands
54
Italy
9
Belgium
30
Denmark
17 (1987)
Spain
13 (1987)
Notes:
1. The Charkham figures are for 1992 except where shown. The Prowse figures
are for 1985 and are adjusted for the double-counting of shares associated with
intercorporate shareholdings.
2. The quoted companies are domestic ones. Where these have a stock of assets
abroad which much exceeds the investment by foreign multinationals within the
country, it will push up the figure shown; vide Switzerland. Since state-owned
firms are not included, a large state sector will reduce the figure shown; vide
France and Italy.
Source: Charkham, 1994, p.301; Prowse, 1994, p.30.
The economy is dominated by large firms. Firms look to the Stock Market as a
major source of equity and other finance, and also as a market for corporate
control - seeking to establish a good reputation and correspondingly high share
price so that they can take over others rather than be taken over themselves.
Banks are not used as a major source of risk capital, since their lending is
transactional rather than relational: each loan is seen as one-off and to be
secured against collateral, against the 'carcass value' of the firm, rather than as
part of an on-going relationship in which the bank's risk is reduced by thorough
knowledge of the firm's prospects.
(The role of banks varies considerably and has changed over time. For example,
in the UK in the 1960s and 70s, while the system of lending in the UK was
formally very short-term - on overdraft - and against collateral, in practice many
companies, large and small, built up a close relationship with one bank and at
certain times depended heavily on it for support. This only gave way to generallytransactional relationships in the 1980s, after financial deregulation. There was a
similar evolution in the United States. [Browne, 1994, Table 1, shows that while
bank loans to the corporate sector remained at much the same level in the US
and UK in the 1980s as they had in the 1970s, relative to total non-financial
assets, their variance - which he takes as a measure of their role as 'shock
absorbers' - dropped to less than half and less than a third respectively, of its
1970s level. ]
What of the other, 'younger' advanced economies? One possibility is that the
most 'mature' economies present the others with the image of their own future.
When they grow up they will look more or less like us. Create the same
circumstances (in this case economic maturity, in some sense) and you will
produce broadly the same result: this is very much the implication of mainstream
theory with its tendency to assume stable equilibrium, negative feedback
systems. The alternative view is that economies are path-dependent: history
counts, perhaps because there are important positive feedbacks.
So far as financial systems go, there seems to be something in both views.
Perhaps the most important reason why history does count, is the speeded-up
nature of late development. Economies like Germany's in the early 19th century
and Japan's in the late 19th century did not simply grow as Britain had, a century
or two previously: they tried to strike out towards where Britain (and other
leaders) then were, and close the gap on them as rapidly as possible. That meant
that they needed massive infusions of capital, particularly into their heavy
industries, and that the key firms there had to grow very fast. The process
involved a great deal of risk for the firms involved; but far from being able to deal
with this in the textbook way by depending mainly on equity, the equity markets
in these countries were as underdeveloped as the rest of their economies. The
only way to get the capital together that was needed in industry was to 'hoover
up' the savings of landowners and the middle class, who would most certainly not
entrust them to the stock market, such as it was. (Though they might not have
known the phrase 'systematic risk', they learnt to the cost of some of them from
stock market crashes that there was a lot of it about.) Banks, with luck and good
regulation, they might trust: at least the bank was legally bound to give them
their money back, which in the 19th century, a period of little if any inflation,
would do. (In Japan the tradition was to fear all private financial institutions and
stock markets equally - which led people to save in the government post offices
etc; so the public sector then acted as banker to the rest, including the privately
owned banks.) But how then could the banking system be protected from the
riskiness of its investments?
There were broadly two solutions to the fragility of the bank-based system.
Solution 1 was to devise arrangements to give the major banks such good
information about industry, so good an understanding of it, and so much control
over it, that the risk was drastically reduced. The central bank would back them
up as lender of last resort in a real crisis. Solution 2 was that the state in some
way took over the risk of lending to industry. Countries might combine the two
approaches, or move between them, or pick one and stick to it. In Germany there
was a particularly successful example of Solution 1, devised mostly in the 1870s,
although since 1945 this has been supplemented by a strong system of publicsector banks built up by regional and local government to lend to small and
medium enterprises. Either way, the financial systems which developed were
essentially bank-based, rather than stock exchange-based, and to a large extent
they stayed that way.
In the bank-based system, small firms account for a much larger fraction of the
economy, for reasons which will be discussed below. Only a small number of large
firms are public companies quoted on the Stock Exchange (see Table 3 on
Germany, France, Italy, Denmark and Spain) and even these companies do not
rely on it heavily as a source of funds, nor do they concern themselves much with
it as a market for corporate control - they do not fear takeover bids or seek to
make them. Instead they - and a fortiori the other, private companies - look to
banks as their main source of external funding. Firms' relationship with banks is
accordingly close, and lending is relational, that is each loan is seen as part of a
long-term relationship in which the firm is bound to inform the bank fully as to its
position and prospects, and the bank is committed to support the firm through
bad times, in return for influence over its policy and personnel. Much lending is
long-term. Where a large firm borrows from more than one bank, one of them is
normally recognised as 'lead' or 'house' bank and maintains oversight of the
firm's financial position.
The continental European countries, together with Japan, Korea and Taiwan, have
long had essentially bank-based systems, although most of them are now moving
in the other direction. The more southerly European countries (France, Italy,
Spain, Portugal, Greece and Austria) at some point or other adopted, and stayed
with, 'solution 2' in which the state plays a dominant role, mainly through
ownership of banks, and/or direct ownership of industry. (So did Korea and
Taiwan.) In Japan and Germany too, as we saw above, state finance of various
kinds plays a significant role.
Are we then going to treat the modern Anglo-Saxon financial system as the sort
that naturally develops in a mature economy, and bank-based systems as an
artificial sort cobbled together under state control to meet rather special needs of
rapid industrialisation? Before we do that, we had better check how the AngloSaxons reached their present condition. It turns out that both the UK and the US
used to rely much more heavily on banks than they do today, and in both there
was some more-or-less conscious decision to change. Will Hutton (The State
We're In, revised edn., pp.119-20) shows how provincial banks in the industrial
areas of Britain were developing a system of 'relational lending', up to the late
1870s. The crucial moment came in 1878 when the City of Glasgow Bank and
the West of England and South Wales District Bank both faced liquidity problems,
appealed for support to the Bank of England to tide them over, were refused, and
collapsed. After that the main British banks took the point and withdrew from
such lending to industry. In the US however, as in Germany, industry went on
being able to depend heavily on bank finance, which as Hutton points out helps to
explain why they succeeded where Britain failed in the capital-hungry new
electrical, chemical and motor industries. In the US the crucial turn away from
bank finance came much later, in the 1930s, when Congress imposed restrictions
on it in the aftermath of the Crash (Roe, 1994). What these Anglo-Saxon retreats
from bank finance had in common is that they were decided by central
institutions - the Bank of England in one case, Congress in the other - which had
other priorities than fast industrial development. They were no more 'natural'
developments than the German and Japanese alternatives, and they helped to
force the US and UK industrial structures towards domination by very large firms
which could cope relatively well without much bank finance, in a way that isn't
particularly natural either. But what was the stock market doing all this time wasn't it supposed to be providing the necessary risk finance in those new
industries?
The function of stock markets has never been to finance the innovative
investment strategies of industrial firms, either as new ventures or going
concerns. The purpose of a stock market is to provide wealthholders with
not only access to shares but also the ready prospect of selling those
shares - that is, liquidity. (Lazonick and O'Sullivan, 1996, p.15)
References
Browne, F.X. (1994) Corporate Finance: Stylized Facts and Tentative
Explanations, Applied Economics, Vol 26 (Issue 5) p485-508
Charkham, J. (1994) Keeping Good Company: A Study of Corporate
Governance in Five Countries, Oxford, Oxford University Press
Hutton, Will (1996) The State We're In, revised edition, London, Vintage
Lazonick, W. and O’Sullivan, M. (1996) Organisation, finance and
international competition, Industrial and Corporate Change, Vol1,
(no.1) p1-36.
Prowse, S. (1994) Corporate governance in an international perspective:
a survey of corporate control mechanisms in the United States, United
Kingdom, Japan and Germany, Bank of International Settlements Economic
Papers (no.41)