Patterns Of Corporate Financing And Financial Systems Convergence

A Single Financial Space in Europe?

Murinde et al. (2000) investigate whether there has been some convergence in the EU in terms of the structure of the financial systems as well as the patterns of corporate financing activities by banks, bond markets, stock markets and non-financial corporates (NFCs) themselves through retained earnings. First, a test for convergence is used to investigate the possibility of a shift towards a sustained increase in the relative share of bank financing as a percentage of the overall capital structure of NFCs, given an initial level (say at 1972), in a manner that suggests the economies are moving towards a bank-orientated system as well as a pattern of corporate financing that relies predominantly on bank debt. Second, the convergence test is applied to determine whether there has been a shift towards a sustained increase in the relative share of equity (and/or bond) financing as a percentage of the overall NFC investment financing, given an initial level, in a manner that suggests the economies are moving towards a capital market-orientated system as well as a pattern of corporate financing that relies predominantly on bonds and equity issues. Finally, the convergence test is applied to determine whether there has been a shift towards a sustained increase in the relative share of internal finance as a percentage of the total NFC investment financing, given an initial level, in a manner that suggests the managers of the NFCs behave in conformity with the pecking-order theory of financing choices and hence utilize retained earnings first before they resort to debt, equity or bond financing. The overall results also shed light on whether the financial systems of EU member countries are converging towards a 'bank-orientated' or a 'capital market-orientated' model. See also Chapter 4 by Dermine in this book.

General method of moments (GMM) estimation is applied on a dynamic fixed effects model for convergence on a panel of OECD flow of funds data for seven EU member countries with special reference to the financing of NFCs, hence shedding light on the interaction between the financial and real sectors in the context of the convergence criteria. The study covers the period in which there has been substantial financial innovation, liberalization and regulatory reform; the process started in the 1970s in some of the countries under study here (for example, the UK; see Mullineux, 1987a) and accelerated in the 1980s, particularly from the mid-1980s in the UK and France (Mullineux, 1987b; Bertero, 1994). Broadly, as noted in Section 2, the 1970s can be regarded as the decade of internationalization and the 1980s as the decade of securitization leading into an explosion in the use of derivatives in the late 1980s and early 1990s. During this period, exchange rate controls have been progressively lifted both outside and within Europe, banking systems and stock exchanges have been deregulated and reformed and new regulatory and supervisory systems have been devised through the work of the Basle Committee. The net result of these international processes, combined with the single financial market programme within the EU (Mullineux, 1992), has been an increase of competition within and between member-country banking systems and between these systems and capital markets, particularly with regard to providing finance to NFCs. The process of securitization might be expected to have led to convergence in the EU and, if it continues, to encourage further convergence. The growing competition among alternative financial systems within the EU and between the EU and other countries can also be expected to force convergence. A similar array of financial products has increasingly become available in all countries as 'gaps' in the market are progressively identified and exploited.

However, Brealey and Myers (2000, pp. 383-4) report that for all NFCs in the US over 1981-94, internally generated cash was the dominant source of corporate financing and covered, on average, 75 per cent of capital expenditures, including investment in inventory and other current assets; the bulk of required external financing came from bank debt; net new stock issues were very minimal. The observation is consistent with the findings by Rajan and Zingales (1995) in their international comparisons of capital structures in seven OECD countries, as well as the evidence by Corbett and

Jenkinson (1994), Bertero (1994) and Edwards and Fischer (1994) in selected OECD countries. However, these studies also find some evidence of a shift from bank loans to direct financing from the capital (and particularly the bond) markets as part of the securitization process associated with the financial liberalization of the 1980s.

Nevertheless, in the context of the EU countries, the observed patterns of corporate financing seem to mask the sharp dichotomy in the structure of financial systems. A contrast is drawn between Anglo-Saxon (capital market-orientated) financial systems, as represented by the UK, and continental (banking-orientated) financial systems, as typified by Germany and most of continental Europe (Doukas et al., 1998, p. 10). In a conventional sense, the term 'banking orientated' involves bank lending via the creation of demand deposits in connection with a debt contract between the bank and the borrower, deposit taking and the provision of associated money transmission services to the public. Nevertheless, banks, especially in the EU, are increasingly engaging in both banking and securities business, that is, universal banking, fund management and, more recently, insurance business ('bancassurance' or 'Allfinance'). The term 'bank orientated', therefore, may have various interpretations. It could mean a system in which banks are the dominant institutions providing both indirect (or intermediated debt) finance and access to direct finance from the money and capital markets via instruments such as commercial bills and paper (money market debt finance), bonds and euronotes (capital market debt finance) or shares (capital market equity finance), inter alia. The key distinctions here are between direct and indirect finance and between debt and equity financing. Since banking fundamentally involves the provision of indirect debt finance, 'bank orientated' could more narrowly be taken to mean that the most important source of external financing for NFCs is bank loans.

With reference to the EU, therefore, a bank-orientated system could be viewed as one in which banks are the key financial institutions as regards corporate governance by virtue of being both providers of debt finance and the key institutional holders of equity, as in the universal banking system of Germany (and to some extent France; Bertero, 1994). In contrast, in capital market-orientated systems the key institutional shareholders are pension and insurance funds. This is especially true in the UK, where share ownership remains heavily concentrated (see Mayer, 1994). Hitherto, the institutional shareholders in the UK have not exercised their voting rights (including proxy voting rights) as actively as the German Grossbanken (Deutsche, Dresdner and so on). The capital markets in the UK also influence management behaviour via the threat posed by aggressive mergers and acquisitions activity. In contrast, in continental Europe, unsolicited takeover bids have, at least until recently, been largely unknown.

The relative merits of the bank- and capital market-orientated systems is integral to the policy debates on the evolution of financial systems in the EU member countries following the Single European Market of 1993. If direct financing is increasing relative to bank financing, the capital markets will have a greater role to play in the future in hitherto bank-dominated financial systems. To the extent that bank-orientated systems are more 'long termist', this trend may lead to a spread of 'short termism' in investment and 'research and development' expenditure decisions. Counteracting this development, and helping to deepen capital markets in previously bank-dominated systems, the privatization of pensions, in response to an ageing population, and the associated budgetary pressures being caused by maintaining 'pay-as-you-go' state pension schemes, will lead to a buildup of pension funds. These funds will increasingly invest in shares (equities) as restrictions requiring large proportions of the funds in domestic government bonds are removed in response to competitive pressures to achieve acceptable returns for the investors. Because pension funds are dealing with long-term savings, they naturally take a strategic view and this should help counteract any bias towards short termism. The creation of the single currency area within the EU (Euroland) has already boosted the development of a European corporate bond market. The continued rapid growth in the euro-based corporate bond market should further reduce the role of bank loans as a source of corporate debt finance.

The question remains, however, whether the different financial systems in the EU have exhibited a tendency to converge over time, following the Single European Market of 1993. In the context of EU financial systems and the patterns of corporate financing, the 'convergence criterion' reflects the expectations of EU member countries that the launching of a borderless Europe in January 1993 would impact on the financial systems of these economies by facilitating the achievement of a single financial space in the EU. This moved a step closer with the decision to proceed with the creation of a single currency adopted by most of the EU states in January 1999. In Euroland, convergence can be expected to accelerate. See also Chapter 4 by Dermine and Chapter 5 by Gardener, Molyneux and Williams in this book.

Evidence on Convergence in the EU

Although the data used by Murinde et al. (2000) are different from those used by Corbett and Jenkinson (1994), Bertero (1994) and Edwards and Fischer (1994), the main findings are consistent with the general conclusions in the literature. These authors, as well as Mullineux (1996), find that the level of bank financing is similar in gross terms in Germany and the UK, the two countries that are de facto characterized by different banking systems. Our results do not exhibit convergence perhaps because much further convergence cannot be expected, given the level of similarity in bank financing in these countries as documented by the above authors.

However, Murinde et al. (2000) obtain results which suggest that over time and across the seven EU member countries the NFCs have generally shifted towards the use of equity finance for new investment; the stock markets have also increasingly become important as a means of raising equity finance for new investment by NFCs. However, the UK remains a bit of an outlier. These results are interpreted as providing reliable evidence that the EU member countries are converging towards a capital market-orientated system, in the context of an increase in the relative share of the equity market (compared to that of banks and bond markets) in the overall financing of new investment by NFCs. It is also shown that the nominal exchange rate and the interest rate are not potent monetary policy instruments in facilitating the convergence of the equity markets in the seven EU member countries.

Further evidence suggests that there has been a tendency towards convergence among the EU member countries in terms of the use of company bond finance by NFCs. It is shown that over time and across the seven countries the NFCs have shifted towards the use of bond issues to finance new investment. Moreover, as noted previously, the formation of Euroland can be expected to accelerate the growth of the euro-dominated corporate bond market if the US is any guide.

The evidence on convergence with respect to internal finance is consistent with the results obtained by Corbett and Jenkinson (1994), Bertero (1994) and Edwards and Fischer (1994) who find that high levels of internal financing are confirmed for the UK and Germany, particularly in the net figures and after noting that capital transfers can be regarded as internal sources for publicly owned corporations in Germany. These studies also find that in the Spanish case, perhaps surprisingly given the relatively early stage of financial sector restructuring in that country, internal financing counts for a very high level of investment financing while, in net terms, bank financing and, in the 1990s, equity financing, make a negative contribution.

As they participate in a single market inaugurated in 1993 and as a result of the ongoing restructuring of their banking systems, EU member countries may expect convergence of their financial systems on the evolving 'continental' European model. This model depicts heavy reliance on internal financing with bank-intermediated lending decreasing in importance and increasingly competing with direct financing via equity and bond markets (especially the euronote and bond markets) in the declining market for the external financing of investment. This might be the main plausible interpretation of the evidence obtained in this study. We find that there is a shift towards convergence, conditional as well as unconditional, with respect to equity financing and internal financing of NFCs in seven EU member countries; however, the shift is less pronounced with respect to bond issues, while there is hardly any convergence at all with respect to bank debt (or the banking system). However, a great leap forward has occurred in the development of the corporate bond market following the adoption of the euro in January 1999, further undermining the dominance of bank debt finance and pointing to convergence on the US financial system, where the corporate bond markets are much more developed. In some countries, the banks are also progressively diversifying into the provision of underwriting and brokerage (of financial instruments) services to the NFCs, who previously borrowed from them more heavily via bank loans. The results of this study may be interpreted as suggesting that the 'continental European universal banking' model, in the sense of banks combining lending and securities business, is becoming relevant for the EU as a whole.

All in all, the EU Single Market launched in 1993 and the ongoing restructuring of banking systems in most EU countries are expected to facilitate convergence of the financial systems in the EU towards the 'continental model'. This is also true of the UK, given the virtual disappearance of indigenous independent investment banks. It is only in the US that investment banks flourish as separate entities. It is also argued that convergence will occur in terms of the patterns of corporate financing in the EU. Models are specified for each of the four elements of the capital structure of NFCs, and are estimated and tested using data from the OECD flow of funds tables for the 1972-96 period for seven EU member countries: Finland, France, Germany, the Netherlands, Spain, Sweden and the UK. The study uncovers a number of interesting findings. First, there is no significant evidence of a tendency towards convergence among the EU member countries in terms of the use of bank debt by NFCs. Thus, contrary to the expectations of many policy makers and media pundits, it would appear that over time and across the seven countries the NFCs have not shifted towards the use of bank debt for financing new investment. Nor is there reliable evidence that the EU member countries are converging towards a bank-orientated system, in the sense of an increase in the relative share of the banking system in the overall financing of new investment by NFCs. These results seem to be impervious to a monetary policy stance involving exchange rate or interest rate instruments.

In general, however, the evidence suggests some form of overall convergence of the EU financial systems on a continental variant of the AngloSaxon model, depicting heavy reliance on internal financing with bank-intermediated lending decreasing in importance but increasingly competing with direct financing via equity and bond markets in the declining market for the external financing of investment. Following the repeal of the Glass-Steagall Act in 1999, the US financial system may well tend to converge on the same point as large corporations seek both credit lines and the underwriting of securities issues from their 'bankers'.

Retirement Planning For The Golden Years

Retirement Planning For The Golden Years

If mutual funds seem boring to you, there are other higher risk investment opportunities in the form of stocks. I seriously recommend studying the market carefully and completely before making the leap into stock trading but this can be quite the short-term quick profit rush that you are looking for if you am willing to risk your retirement investment for the sake of increasing your net worth. If you do choose to invest in the stock market please take the time to learn the proper procedures, the risks, and the process before diving in. If you have a financial planner and you definitely should then he or she may prove to be an exceptional resource when it comes to the practice of 'playing' the stock market.

Get My Free Ebook


Post a comment