Trends In Corporate Governance

The competing financial systems ('Anglo-Saxon' versus 'Germanic', or 'market' versus 'bank-orientated') debate is often couched in terms of implications for corporate governance and indeed society as a whole. The debate is often somewhat confused as a result of the influence of 'financial myths' (Mishkin, 2001, Ch. 1). We have already noted that internal, rather than externally supplied, finance is the major source of investment finance for both large corporates and SMEs. We have also noted that in all countries SMEs are largely dependent on banks for external finance, and that banks are the major suppliers of finance to the non-financial business sector. Only in the US is the corporate bond market a major alternative (to loans) source of debt finance, although the introduction of the euro has resulted in accelerated development of the European corporate bond market. Even in the US, banks remain the main suppliers of debt finance, however, and it is only the large corporates that can tap the traditional bond market, while 'growth firms' in the new technology sectors can increasingly tap the higher-risk 'junk bond' market. Further, the 'equity market' is a market in second-hand stocks through which ownership is transferred. In years of high merger and acquisition activity and share 'buy-backs' the net supply of new equity finance through the market is frequently negative in the US and the UK. Markets specializing in financing new companies, again usually in the new technology sectors (for example, NASDAQ and the Neur Markt), tend to be net suppliers of equity, but often as a result of replacing and expanding the investments of venture capitalists and other private equity holders. The latter have been growing in importance as an alternative to banks for early-stage 'growth' firms in the technology sector.

In sum, even in Anglo-Saxon systems, banks remain the dominant sources of finance, the more so as the commercial banks diversify from making loans into wider, securities-related, corporate finance. Hence the bank versus market-dominated distinction is outmoded. We have also noted that the, generally liberalizing, reregulation of banks and other financial institutions is also driving to convergence of the scope of 'banks' and other financial institutions (on the 'continental' European model), hence the Germanic versus Anglo-Saxon distinction between financial systems is losing meaning too.

It is, however, true that a larger proportion of indirect finance is, at least for the larger firms, being provided through bond (debt), equity and money (commercial paper and bills and notes) markets. As such, there is convergence on an 'Americanized' continental European system, that is, one in which the main players are diversified bank and insurance companies (and also some specialized investment banks for a while) and mutual and pension funds, but financial markets are becoming increasingly important. The insurance, mutual and pension funds are, however, increasingly becoming the dominant institutional investors as pensions are progressively being privatized and banks disengage from cross-shareholdings in Japan and the EU (particularly Germany).

The convergence of financial systems is leading to a convergence of corporate governance mechanisms. For the, largely private, SME sector there is less change. Banks remain the key players in their governance unless management control is diluted by taking on equity finance from outside (private equity, venture funds). For larger firms that have issued equity to the public and/or taken on bond financing, institutional investors can be expected to play an increasing role in governance relative to banks; but banks will also remain key actors. Given the, seemingly growing, importance of internal finance in larger firms, good management is necessary to ensure that efficient use is made of retained earnings. Here issues pertaining to the structure of management boards, the role of non-executive directors, and whether the roles of chairman and chief executive officer should be separated become increasingly important. Further, stock markets play a role in providing a market for corporate control to keep the managers on their toes. Behind the markets are the institutional shareholders, who must decide which shares to hold in their portfolios and in what proportions.

Through the institutional shareholders, the interests of small investors and pensioners are represented and legislation can be used to encourage investors to take account of ethical and environmental considerations in constructing their investment portfolios (for example, the 1999 pensions fund legislation in the UK).

The interests of stakeholders other than shareholders can also be brought to bear through legislation on management board membership (for example, requiring worker and/or consumer representation, as is the case in a number of countries). By such means the tiger of global capitalization can be tamed and capital will be directed in such a way as to ensure its most efficient (from social as well as financial or economic perspectives) use. Growth will be enhanced and poverty reduced as a result. Social auditing will increasingly complement traditional financial auditing. To achieve this, however, countries must adopt common accounting standards, and adopt best practices in financial sector regulation and, partly as a result of the former, conformable corporate governance (including bankruptcy procedures) systems.

Thus, some important conclusions may be drawn from the above trends in corporate governance in the global financial space. It is noted that the growth in internal finance (retained earnings) exacerbates the principal -agent problem. The growth in direct finance reduces the role of banks in corporate governance and this tendency is enhanced by their declining role as institutional investors through cross-shareholdings (particularly in Germany and Japan). Bondholders (often banks and other financial institutions), not just shareholders, are increasingly important. However, banks remain the key monitors of SMEs. Stock markets, through secondary trading, are markets for corporate control as well as sources of new finance through initial public offerings (IPOs). Institutional shareholders (insurance, pension and mutual funds) are increasingly the key players in corporate governance (though individual shareholdings have increased dramatically in the last five years in the US and continental Europe, but increasingly not in the UK); these shareholders are playing a more active role in ensuring that companies have good management structure and internal controls. However, the increased emphasis on shareholder value may lead to short termism (as opposed to long termism associated with universal banking). If the US is typical, the benefits of greater innovation and flexibility may outweigh any costs of short termism. Further, short termism tends to increase pressure to distribute profits as dividends, reducing capital 'hoarding' for internal investment. Stakeholders other than shareholders may, however, need protecting. This could be done through social auditing (a precursor is recent UK pension legislation).

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