From Book Value Of Equity To Market Value Of Equity

Realization of shareholder value can begin by tracing the sources of value increments in excess of book value of equity (BVE). For universal banks, the BVE is the sum of: (i) the par value of shares when originally issued; (ii) the surplus paid in by investors when the shares were issued; (iii) retained earnings on the books of the bank; and (iv) reserves set aside for loan losses (Saunders, 1996). Depending on the prevailing regulatory and accounting system, BVE must be increased by unrealized capital gains associated with assets such as equity holdings carried on the books of the bank at historical cost and their prevailing replacement values (hidden reserves), as well as the replacement values of other assets and liabilities that differ materially from historical values due to credit and market risk considerations -that is, their mark-to-market values.

We thus have the presumptive adjusted book value of equity (ABVE), which in fact is not normally revealed in bank financial statements due to a general absence of market-value accounting across broad categories of universal banking activities - with the exception of trading-account securities, derivatives and open foreign exchange positions, for example.

As in non-financial firms such as McDonald's, Coca-Cola or any other publicly traded firm, shareholder interests in a universal bank are tied to the market value of its equity (MVE) - the number of shares outstanding times the prevailing market price. MVE normally should be significantly in excess of ABVE, reflecting as it does current and expected future net earnings, adjusted for risk. The MVE/ABVE so-called 'Q' ratio can, however, be either higher or lower than 1, and is clearly susceptible to enhancement through managerial or shareholder action. If it is significantly below 1, for example, it may be that breaking up the bank can serve the interests of shareholders - if ABVE or more can be realized as a result - in the same way as restructurings have raised shareholder value under appropriate circumstances in industrial companies.

Assuming a universal bank's MVE exceeds ABVE, what factors can explain the difference? Exhibit 9.2 begins with ABVE and sequentially identifies incremental-value sources to arrive at MVE, which are explained in the following sections.

Exhibit 9.2 Book, market and potential equity values in universal banks Economies of Scale

Whether economies of scale exist in financial services has been at the heart of strategic and regulatory discussions about optimum firm size in the financial services sector - can increased size increase shareholder value? In an information- and distribution-intensive industry with high fixed costs, such as financial services, there should be ample potential for scale economies - as well as potential for diseconomies of scale attributable to administrative overheads, agency problems and other cost factors once very large firm size is reached. If economies of scale prevail, increased size will help create shareholder value. If diseconomies prevail, shareholder value will be destroyed. Bankers regularly argue that 'bigger is better' from a shareholder-value perspective, and usually point to economies of scale as a major reason why.

Economies of Scope

There should also be ample potential for economies and diseconomies of scope in the financial services sector, which may arise either through supply- or demand-side linkages.3

On the supply side, scope economies relate to cost savings through sharing of overheads and improving technology through joint production of generically similar groups of services. Supply-side diseconomies of scope may arise from such factors as inertia and lack of responsiveness and creativity that may come with increased firm size and bureaucratization, 'turf' and profit-attribution conflicts that increase costs or erode product quality in meeting client needs, or serious cultural differences across the organization that inhibit seamless delivery of a broad range of financial services.

On the demand side, economies of scope (cross-selling) arise when the all-in cost to the buyer of multiple financial services from a single supplier - including the price of the service, plus information, search, monitoring, contracting and other transaction costs - is less than the cost of purchasing them from separate suppliers. Demand-related diseconomies of scope could arise, for example, through agency costs that may develop when the multi-product financial firm acts against the interests of the client in the sale of one service in order to facilitate the sale of another, or as a result of internal information transfers considered inimical to the client's interests. Management of universal banks often argues that broader product and client coverage, and the increased throughput volume this makes possible, represents shareholder-value enhancement.

Network economics associated with universal banking may be considered a special type of demand-side economy of scope (Economides, 1995). Like telecommunications, banking relationships with end-users of financial services represent a network structure wherein additional client linkages add value to existing clients by increasing the feasibility or reducing the cost of accessing them - so-called 'network externalities' which tend to increase with the absolute size of the network itself. Every client link to the bank potentially 'complements' every other one and thus potentially adds value through either one-way or two-way exchanges through incremental information or access to liquidity. The size of network benefits depends on technical compatibility and coordination in time and location, which the universal bank is in a position to provide. And networks tend to be self-reinforcing in that they require a minimum critical mass and tend to grow in dominance as they increase in size, thus precluding perfect competition in network-driven financial services. This characteristic is evident in activities such as securities clearance and settlement, global custody, funds transfer and international cash management, forex and securities dealing, and the like. And networks lend to lock in users in so far as switching costs tend to be relatively high, creating the potential for significant market power.

X-efficiency

Besides economies of scale and scope, it seems likely that universal banks of roughly the same size and providing roughly the same range of services may have very different cost levels per unit of output. There is ample evidence of such performance differences, for example, in comparative cost-to-income ratios among banks both within and between national financial services markets. The reasons involve efficiency differences in the use of labour and capital, effectiveness in the sourcing and application of available technology, and perhaps effectiveness in the acquisition of productive inputs, organizational design, compensation and incentive systems - and just plain better management.

X-efficiency may be related to size if, for example, large organizations are differentially capable of the massive and 'lumpy' capital outlays required to install and maintain the most efficient information technology and transactions processing infrastructures. Exhibit 9.3 shows information technology spending levels that only large banks can afford. If such spending levels result in higher X-efficiency, then large banks will gain in competition with smaller ones from a shareholder-value perspective. However, smaller organizations ought to be able to pool their resources or outsource in order to capture similar efficiencies. From a shareholder-value point of view, management is (or should be) under constant pressure through their boards of directors to do better, to maximize X-efficiency in their organizations, and to transmit this pressure throughout the enterprise.

Empirical Evidence of Economies of Scale, Scope and X-efficiency

What is the evidence regarding economies of scale, economies of scope and X-efficiency with regard to bank performance?

Individually or in combination, economies (diseconomies) of scale and scope in universal banks will be either captured as increased (decreased)

Citicorp 1

Chase i

Deutsche Bank ~1

Crédit Lyonnais ~1

Barclays i

Bank of America NatWest

UBS H

Crédit Agricole NationsBank I

Bankers Trust I

ABN-AMRO

SBC I

Banc One

First Chicago I___

Source: The Tower Group, 1996.

Exhibit 9.3 Estimated major bank IT spending levels ($ billions)

profit margins or passed along to clients in the form of lower (higher) prices resulting in a gain (loss) of market share. They should be directly observable in cost functions of financial services suppliers and in aggregate performance measures.

Studies of scale and scope economies in financial services are unusually problematic. The nature of the empirical tests used, the form of the cost functions, the existence of unique optimum output levels, and the optimizing behaviour of financial firms all present difficulties. Limited availability and conformity of data present serious empirical problems. And the conclusions of any study that has detected (or failed to detect) economies of scale and/or scope in a sample selection of financial institutions does not necessarily have general applicability.

Many such studies have been undertaken in the banking, insurance and securities industries over the years (see Exhibit 9.4). Estimated cost functions form the basis of most of these empirical tests, virtually all of which found that economies of scale are achieved with increases in size among small banks (below $100 million in asset size). More recent studies have shown that scale economies may also exist in banks falling into the $100 million to $5 billion range. There is very little evidence so far of scale

Exhibit 9.4 Economies of scale and scope in financial services firms - the evidence

Economies of

Economies of

scale beyond

scope among

small levels of

outputs

output (size)

Domestic Banks

Benston et al., 1983

No

No

Berger et al., 1987

No

No

Gilligan and Smirlock, 1984

No

Yes

Gilligan et al., 1984

No

Yes

Kolari and Zardkoohi, 1987

No

No

Lawrence, 1989

No

Yes

Lawrence and Shay, 1986

No

No

Mester, 1990

Yes

No

Noulas et al., 1990

Yes

?

Shaffer, 1988

Yes

?

Hunter et al., 1990

Yes

No

McAllister and McManus, 1993

No

?

Pulley and Humphrey, 1993

?

Yes

Foreign Banks

Yoshika and Nakajima, 1987 (Japan)

Yes

?

Kim, 1987 (Israel)

Yes

Yes

Saunders and Walter, 1991 (worldwide)

Yes

No

Rothenberg, 1994 (European Community)

No

?

Thrifts

Mester, 1987

No

No

LeCompte and Smith, 1990

No

No

Life Insurance

Fields and Murphy, 1989

Yes

No

Fields, 1988

No

?

Grace and Timme, 1992

Yes

?

Securities Firms

Goldberg et al., 1991

No

No

Source: Saunders (1996).

Source: Saunders (1996).

economies in the case of banks larger than $5 billion. An examination of the world's 200 largest banks (Saunders and Walter, 1994) found evidence that the very largest banks grew more slowly than the smaller among the large banks during the 1980s, but that limited economies of scale did appear among the banks included in the study. Overall, the consensus seems to be that scale economies and diseconomies do not result in more than about 5 per cent difference in unit costs. So, for most universal banks scale economies seem to have relatively little bearing on shareholder value in terms of Exhibit 9.2.

With respect to supply-side economies of scope, most empirical studies have failed to find such gains in the banking, insurance and securities industries, and most of them have also concluded that some diseconomies of scope are encountered when firms in the financial services sector add new product ranges to their portfolios. Saunders and Walter (1994), for example, found negative supply-side economies of scope among the world's 200 largest banks - as the product range widens, unit costs seem to go up.

As shown in Exhibit 9.4, scope economies in most other cost studies of the financial services industry are either trivial or negative. However, the period covered by many of these studies involved institutions that were rapidly shifting away from a pure focus on commercial banking, and may thus have incurred considerable costs in expanding the range of their activities. If this diversification effort involved significant sunk costs - which were listed as expenses on the accounting statements during the period under study - that were undertaken to achieve future expansion of market share or increases in fee-based areas of activity, then we might expect to see any strong statistical evidence of diseconomies of scope between lending and non-lending activities reversed in future periods. If the banks' investment in staffing, training and infrastructure in fact bears returns in the future commensurate with these expenditures, then neutrality or positive economies of scope may well exist. Still, the available evidence remains inconclusive.

It is also reasonable to suggest that some demand-related scope economies may exist, but that these are likely to be very specific to the types of services provided and the types of clients involved. Strong cross-selling potential may exist for retail and private clients between banking, insurance and asset-management products (one-stop shopping), for example. Yet such potential may be totally absent between trade-finance and mergers and acquisitions (M&A) advisory services for major corporate clients. So demand-related scope economies are clearly linked to a universal bank's specific strategic positioning across clients, products and geographic areas of operation (Walter, 1988). Indeed, a principal objective of strategic positioning in universal banking is to link market segments together in a coherent pattern - what might be termed 'strategic integrity' - that permits maximum exploitation of cross-selling opportunities, and the design of incentives and organizational structures to ensure that such exploitation actually occurs.

With respect to X-efficiency, a number of authors have found very large disparities in cost structures among banks of similar size, suggesting that the way banks are run is more important than their size or the selection of businesses that they pursue (Berger et al., 1993a, 1993b). The consensus of studies conducted in the United States seems to be that average unit costs in the banking industry lie some 20 per cent above 'best practice' firms producing the same range and volume of services, with most of the difference attributable to operating economies rather than differences in the cost of funds (Akhavein et al., 1996). Siems (1996) finds that the greater the overlap in branch-office networks, the higher the abnormal equity returns in US bank mergers, while no such abnormal returns are associated with increasing concentration levels in the regions where the bank mergers occurred. This suggests that shareholder value in the mega-mergers of the mid-1990s was more associated with increases of X-efficiency than with reductions in competition.

Specifically with respect to X-efficiency in universal banking, Steinherr (1996) has assessed the profit performance and earnings variability of segmented and universal financial institutions worldwide during the late 1980s. Segmented and universal banks are found to have achieved roughly the same profit levels, but universal banks were found to have both lower cost levels and (interestingly) lower credit losses, which the author attributes to better monitoring of their clients based on private (non-public) information that universal banks may enjoy over their segmented counterparts. One explanation for this finding may be that Hausbank relationships, which represent an important aspect of universal banking in some countries, include the periodic conversion of bank debt to equity as part of credit workouts of non-financial clients in trouble, thus obviating the need to realize the extent of credit losses.

Taken together, these studies suggest very limited scope for cost economies of scale and scope among major universal banks. Scope economies, to the extent that they exist, are likely to be found mainly on the demand side, and tend to apply very differently to different client segments. It is X-efficiency that seems to be the principal determinant of observed differences in cost levels among banks.

Perhaps contrary to conventional wisdom, therefore, there appears to be room in financial systems for viable financial services firms that range from large to small and from universal to specialist in a rich mosaic of institutions, as against a competitive landscape populated exclusively by 800-pound gorillas.

Absolute Size and Market Power

Still, conventional wisdom may win out in the end if large universal banks are able to extract economic rents from the market by application of market power - an issue that most empirical studies have not yet examined. Indeed, in many national markets for financial services suppliers have shown a tendency towards oligopoly but may be prevented by regulation or international competition from fully exploiting monopoly positions. Financial services market structures differ widely among countries, as measured for example by the Herfindahl-Hirshman index,4 with very high levels of concentration in countries such as the Netherlands and Denmark and low levels in relatively fragmented financial systems such as the United States. Lending margins and financial services fees, for example, tend to be positively associated with higher concentration levels. So do cost-to-income ratios. Shareholders naturally tend to gain from the former, and lose from the latter.

Exhibit 9.5 shows the impact on market-to-book values of British banks after the UK clearing cartel was created in the 1920s, followed by market-to-book erosion after the cartel was abolished in the 1970s. Differences in competitive structure are also illustrated in Exhibit 9.6, which compares the price-to-book ratios of US money-centre banks to major regional banks, with the latter operating in substantially less-competitive markets than the former.

The Value of Income-stream Diversification

Saunders and Walter (1994) carried out a series of simulated mergers between US banks, securities firms and insurance companies in order to test the stability of earnings of the 'merged' as opposed to separate institutions. The authors evaluated the 'global' opportunity-set of potential mergers between existing money-centre banks, regional banks, life insurance companies, property and casualty insurance companies and securities firms, and the risk characteristics of each possible combination. The results were reported in terms of the average standard deviation of returns, along with the returns and risk calculated for the minimum-risk portfolio of activities. The findings suggest that there are potential risk-reduction gains from diversification in universal financial services organizations, and that these gains increase with the number of activities undertaken. The main risk-reduction gains appear to arise from combining commercial banking with insurance activities, rather than with securities activities. In the two-activity case, the best (lowest-risk) merger partners for US money-centre banks were property and casualty insurers. In the three-activity case, the

Clearing banks Deregulation cartel formed

Source: Anthony Saunders and B. Wilson, Bank Capital Structure: A Comparative Analysis of the U.S., U.K. and Canada, New York; University Salomon Center Working Paper, June 1996.

Exhibit 9.5 Market-to-book equity value, UK

Exhibit 9.6 Price-to-book ratios of US money-centre and major regional banks

3Q/96

2Q/96

1Q/96

4Q/95

3W95

Money-Centre Banks Average

191

166

165

152

150

BankAmerica

172

159

151

134

135

Bank of Boston

222

170

163

153

173

Bankers Trust

157

138

135

124

123

Chase Manhattan

196

169

170

155

137

Citicorp

246

214

216

186

174

First Chicago

183

149

161

150

149

J.P. Morgan

164

162

160

159

156

Major Regional Banks Average

221

188

217

205

199

Banc One

219

178

185

179

179

Corestate Financial

258

219

220

226

229

First Union

218

193

187

179

153

Fleet Financial

200

169

187

174

144

Nations Bank

199

181

174

147

158

Norwest Corp.

276

228

250

229

225

Wells Fargo

177

150

313

299

308

Source: Goldman Sachs & Co., 1996.

Source: Goldman Sachs & Co., 1996.

lowest-risk merger combination turned out to be between money-centre banks, regional banks and property and casualty insurers. In the full five-activity case (an average of 247,104 potential merger combinations among financial firms in the database), the standard deviation of returns was 0.01452, well below the average risk level for money-centre banks (0.02024) on a stand-alone basis.5

Such studies, of course, may exaggerate the risk-reduction benefits of universal banking because they ignore many of the operational costs involved in setting up these activities.6 Moreover, to the extent that these ex post risk measures reflect existing central-bank safety nets, they may underestimate the ex ante risk in the future. At best, such results may be viewed as illustrative of the risk-reduction potential of universal banking.9 It seems unlikely that the diversification benefits in terms of risk reduction outweigh the negative earnings implications of less-than-optimum intra-firm capital allocation from the perspective of universal bank shareholders.

Access to Bail-outs

It is certainly possible that the purported advantages of universal banking structures can result in a competitive landscape that is dominated by a small number of large institutions. In such a case, failure of one of the major institutions is likely to cause unacceptable systemic problems, and the institution will be bailed out by taxpayers - as happened in the case of comparatively much smaller institutions in the United States, Switzerland, Norway, Sweden, Finland and Japan during the 1980s and early 1990s. If this turns out to be the case, then too-big-to-fail guarantees create a potentially important public subsidy for universal banking organizations and therefore implicitly benefit the institutions' shareholders.

On the other hand, 'free lunches' usually do not last too long, and sooner or later such guarantees invariably come with strings attached. Possible reactions include intensified regulation of credit- and market-risk exposures, stronger supervision and surveillance intended to achieve early closure in advance of capital depletion, and structural barriers to force activities into business units that can be effectively supervised in accordance with their functions even at the cost of a lower level of X-efficiency and scope economies. The speed with which the central banks and regulatory authorities reacted to the 1996 Sumitomo copper trading scandal signalled the possibility of safety-net support of the global copper market, in view of major banks' massive exposures in highly complex structured credits. The fact is that too-big-to-fail guarantees are alive and well for all large banks - not only universal banks - as is public concern about what restrictions on bank activities ought to accompany them.

Conflicts of Interest

The potential for conflicts of interest is endemic in universal banking, and runs across the various types of activities in which the bank is engaged. The matrix presented in Exhibit 9.7 provides a simple framework for a taxonomy of conflicts of interest that may arise across the broad range of activities engaged in by universal banks. The major types of conflicts include the following:7

• Salesman's stake It has been argued that when banks have the power to sell affiliates' products, managers will no longer dispense 'dispassionate' advice to clients. Instead, they will have a salesman's stake in pushing 'house' products, possibly to the disadvantage of the customer.

Investor

Portfolio Manager

Underwriter

Lender

Board rep.

Adviser

Investor

Portfolio manager

Underwriter

Lender

Board rep. Adviser

Exhibit 9.7 Universal banking conflict matrix

Exhibit 9.7 Universal banking conflict matrix

• Stuffing fiduciary accounts A bank that is acting as an underwriter and is unable to place the securities in a public offering - and is thereby exposed to a potential underwriting loss - may seek to ameliorate this loss by 'stuffing' unwanted securities into accounts managed by its investment department over which the bank has discretionary authority.

• Bankruptcy-risk transfer A bank with a loan outstanding to a firm whose bankruptcy risk has increased, to the private knowledge of the banker, may have an incentive to induce the firm to issue bonds or equities - underwritten by its securities unit - to an unsuspecting public. The proceeds of such an issue could then be used to pay down the bank loan. In this case the bank has transferred debt-related risk from itself to outside investors, while it simultaneously earns a fee and/or spread on the underwriting.8

• Third-party loans To ensure that an underwriting goes well, a bank may make below-market loans to third-party investors on condition that this finance is used to purchase securities underwritten by its securities unit.

• Tie-ins A bank may use its lending power activities to coerce or tie in a customer to the 'securities products' sold by its securities unit. For example, it may threaten to credit ration the customer unless it purchases certain investment banking services.

• Information transfer In acting as a lender, a bank may become privy to certain material inside information about a customer or its rivals that can be used in setting prices or helping in the distribution of securities offerings underwritten by its securities unit. This type of information flow could work in the other direction as well - that is, from the securities unit to the bank.

Mechanisms to control conflict of interest - or more precisely, disincentives to exploit such conflicts - may be either market based, regulation based, or some combination of the two. Most universal banking systems seem to rely on market disincentives to prevent exploitation of opportunities for conflicts of interest. The United States has had a tendency since the 1930s to rely on regulations, and in particular on 'walls' between types of activities. In most countries, however, few impenetrable walls exist between banking and securities departments within the universal bank, and few external firewalls exist between a universal bank and its non-bank subsidiaries (for example, insurance).9 Internally, there appears to be a primary reliance on the loyalty and professional conduct of bank employees, both with respect to the institution's long-term survival and the best interests of its customers. Externally, reliance appears to be placed on market reputation and competition as disciplinary mechanisms. The concern of a bank for its reputational 'franchise' and fear of competitors are viewed as enforcing a degree of control over the potential for conflict exploitation.

Shareholders clearly have a stake in the management and control of conflicts of interest in universal banks. They can benefit from conflict exploitation in the short term, to the extent that business volumes and/or margins are increased as a result. On the one hand, preventing conflicts of interest is an expensive business. Compliance systems are costly to maintain, and various types of walls between business units can have high opportunity costs because of inefficient use of information within the organization. Externally, reputation losses associated with conflicts of interest can bear on shareholders very heavily indeed, as demonstrated by a variety of recent 'accidents' in the financial services industry. It could well be argued that conflicts of interest may contribute to the MVE/ABVE ratios of universal banks falling below those of non-universal financial institutions.10

Conglomerate Discount

It is often alleged that the shares of multi-product firms and conglomerates tend (all else equal) to trade at prices lower than shares of more narrowly focused firms. There are two reasons why this 'conglomerate discount' is alleged to exist.

First, it is argued that, on balance, conglomerates use capital inefficiently. Recent empirical work by Berger and Ofek (1995) assesses the potential benefits of diversification (greater operating efficiency, less incentive to forgo positive net present value projects, greater debt capacity, lower taxes) against the potential costs (higher management discretion to engage in value-reducing projects, cross-subsidization of marginal or loss-making projects that drain resources from healthy businesses, misalignments in incentives between central and divisional managers). The authors demonstrate an average value loss in multi-product firms of the order of 13-15 per cent, as compared to the stand-alone values of the constituent businesses for a sample of US corporations during the 1986-91 period. This value loss was smaller in cases where the multi-product firms were active in closely allied activities within the same two-digit standard industrial code (SIC) classification.

The bulk of the value erosion in conglomerates is attributed by the authors mainly to overinvestment in marginally profitable activities and cross-subsidization. In empirical work using event-study methodology, John and Ofek (1994) show that asset sales by corporations result in significantly improved shareholder value for the remaining assets, both as a result of greater focus in the enterprise and value gains through high prices paid by asset buyers. Such findings from event studies of broad ranges of industry may well apply to the diversified activities encompassed by universal banks as well. If retail banking and wholesale banking are evolving into highly specialized performance-driven businesses, one may ask whether the kinds of conglomerate discounts found in industrial firms may not also apply to universal banking structures as centralized decision making becomes increasingly irrelevant to the requirements of the specific businesses themselves.

A second possible source of a conglomerate discount is that investors in shares of conglomerates find it difficult to 'take a view' and add pure sectoral exposures to their portfolios. Shareholders in companies like General Electric, for example, in effect own a closed-end mutual fund comprising aircraft engines, plastics, electricity generation and distribution equipment, financial services, diesel locomotives, large household appliances, and a variety of other activities. GE therefore presents investors who may have a bullish view of the aircraft engine business - which they would like reflected in their portfolio selection - with a particularly poor choice compared with Rolls Royce, for example, which is much more of a 'pure play' in this sector. Nor is it easily possible to short the undesirable parts of GE in order to 'purify' the selection of GE shares under such circumstances. So investors tend to avoid such stocks in their efforts to construct efficient asset-allocation profiles, especially highly performance-driven managers of institu tional equity portfolios under pressure to outperform equity indexes.

The portfolio logic of the conglomerate discount should apply in the financial services sector as well, and a universal bank that is active in retail banking, wholesale commercial banking, middle-market banking, private banking, corporate finance, trading, investment banking, asset management and perhaps other businesses in effect represents a financial conglomerate that prevents investors from optimizing asset allocation across specific segments of the financial services industry.

Both the portfolio-selection effect and the capital-misallocation effect may weaken investor demand for universal bank shares, lower equity prices, and produce a higher cost of capital than if the conglomerate discount were absent - this in turn having a bearing on the competitive performance and profitability of the enterprise.

Non-financial Shareholdings

The conglomerate issue tends to be much more serious when a universal bank owns large-scale shareholdings in non-financial corporations, in which case the shareholder obtains a closed-end fund that has been assembled by bank managers for various reasons over time, and may bear no relationship to the investor's own portfolio optimization goals. The value of the universal bank itself then depends on the total market value of its shares, which must be held on an all-or-nothing basis, plus its own market value.

There are wide differences in the role banks play in non-financial corporate shareholdings and in the process of corporate governance (Walter, 1993) (these are stylized in Exhibit 9.8):

• In the equity-market system, industrial firms are 'semi-detached' from banks. Financing of major corporations is done to a significant extent through the capital markets, with short-term financing needs satisfied through commercial paper programmes, longer-term debt through straight or structured bond issues and medium-term note programmes, and equity financing accomplished through public issues or private placements. Research coverage tends to be extensive. Commercial banking relationships with major companies can be very important - notably through backstop credit lines and short-term lending facilities - but they tend to be between buyer and seller, with close bank monitoring and control coming into play mainly for small and medium-sized firms or in cases of credit problems and workouts. Corporate control in such 'Anglo-American' systems tends to be exercised through the takeover market on the basis of widely available public information, with a bank's function limited mainly

Exhibit 9.8 Alternative bank-industry linkages to advising and financing bids or defensive restructurings. The government's role is normally arm's length in nature, with a focus on setting ground rules that are considered to be in the public interest. Relations between government, banks and industry are sometimes antagonistic. Such systems depend heavily on efficient conflict-resolution mechanisms.

• The second, bank-based approach centres on close bank-industry relationships, with corporate financing needs met mainly by retained earnings and bank financing. The role of banks carries well beyond credit extension and monitoring to share ownership, share voting and board memberships in such 'Germanic' systems. Capital allocation, management changes, and restructuring of enterprises is the job of non-executive supervisory boards on the basis of largely private information, and unwanted takeovers are rare. M&A activity tends to be undertaken by relationship universal banks. Capital markets tend to be relatively poorly developed with respect to both corporate debt and equity, and there is usually not much of an organized venture capital market. The role of the state in the affairs of banks and corporations may well be arm's length in nature, although perhaps combined with some public sector shareholdings.

• Third, in the so-called 'crossholding approach', interfirm boundaries are blurred through equity cross-links and long-term supplier-customer relationships. Banks may play a central role in equity cross-holding structures - as in Japan's keiretsu networks - and provide guidance and coordination as well as financing. There may be strong formal and informal links to government on the part of both the financial and industrial sectors of the economy. Restructuring tends to be done on the basis of private information by drawing on these business-banking-government ties, and a contestable market for corporate control tends to be virtually non-existent.

• The state-centred approach - perhaps best typified in the French tradition - involves a strong role on the part of government through national ownership or control of major universal banks and corporations, as well as government-controlled central savings institutions. Banks may hold significant stakes in industrial firms and form an important conduit for state influence of industry. Financing of enterprises tends to involve a mixture of bank credits and capital market issues, often taken up by state-influenced financial institutions. Additional channels of government influence may include the appointment of the heads of state-owned companies and banks, with strong personal and educational ties within the business and government elite.

These four stylized bank-industry-government linkages make themselves felt in the operation of universal banks in various ways. The value of any bank shareholdings in industrial firms is embedded in the value of the bank. The combined value of the bank itself and its industrial shareholdings, as reflected in its market capitalization, may be larger or smaller than the sum of their stand-alone values. For example, firms in which a bank has significant financial stakes, as well as a direct governance role, may be expected to conduct most or all significant commercial and investment banking activities with that institution, thus raising the value of the bank. On the other hand, if such 'tied' sourcing of financial services raises the cost of capital of client corporations, this will in turn be reflected in the value of bank's own shareholdings, and the reverse if such ties lower client firms' cost of capital. Moreover, permanent bank shareholdings may stunt the development of a contestable market for corporate control, thereby impeding corporate restructuring and depressing share prices which in turn are reflected in the value of the bank to its shareholders. Banks may also be induced to lend to affiliated corporations under credit conditions that would be rejected by unaffiliated lenders, and possibly encounter other conflicts of interest that may ultimately make it more difficult to maximize shareholder value.

Franchise Value

The foregoing considerations should, in combination, explain a significant part of any difference between the adjusted book value of equity and the market value of equity of a universal bank. But even after all such factors have been taken into account and priced out, there may still be a material difference between the resulting 'constructed' value of equity and the banks' market value (see Exhibit 9.2). The latter represents the market's assessment of the present value of the risk-adjusted future net earnings stream, capturing all known or suspected business opportunities, costs and risks facing the institution. The residual can be considered the 'franchise' value of the bank. Much of it is associated with reputation and brand value. Franchise value may be highly positive, as in the case of Coca-Cola for example, or it could be significantly negative, with the firm's stock trading well below its constructed value or even its adjusted book value -for example, if there are large prospective losses embedded in the bank's internal or external portfolio of activities.

Demsetz et al. (1996) argue that the franchise value of banks also serves to inhibit extraordinary risk taking - they find substantial evidence that the higher a bank's franchise value, the more prudent management tends to be. This suggests that large universal banks with high franchise values should serve shareholder interests (as well as the interests of the regulators) by means of appropriate risk management as opposed to banks with little to lose.

Credit Repair Strategies Revealed

Credit Repair Strategies Revealed

Are you falling off in Debt? Stuck in a bad Credit? Undergoing much hassle with those hard & frequent Credit Calls? … Or maybe you are just now experiencing hard time to secure any loans for yourself? - Then this may be the most important letter you'll ever read for today... Discover The Insider Secret Manual That Allows You to Repair Credit score, Enjoy Your Freedom To Get Approved On Any Loans You Wants Even If You Have No Credit Building Experience Or Suffering From Deep Negative Credit History!

Get My Free Ebook


Post a comment