1. Aspects of the Financial System

Arnis Jankovskis

Summary for article problems 2007

Enjoy!

1. Aspects of the Financial System

1.1.Rajan and Zingales: „Financial Systems, Industrial Structure and Growth”

Main findings:

Developed financial system causes economic growth
Financial development makes it easier for firms with illiquid assets (no physical collateral neccesary to get credit from banks) to obtain financing.
For most industries, hybrid of relationship-based and arm’s length system is the best.
Legal infrastructure neccesary to sustain a large banking system or arm’s length markets tends to diminish the risk.

Research approach:

Authors look trough various recent researches, pick up main ideas of them, and put all this in one picture in order to analyze impact of financial systems on economic growth.

Other findings:

There is a correlation between finance development and growth. But it is hard to determine causal direction:
Finance development causes growth, or
Economic growth causes finance development (Say’s Law is true: „Demand creates it’s own supply” – „Where enterpriese leads, finance follows”.)
If „Enterprise leads, finance follows”, than financial development must be very fast, in order to respond to growth
But, it isn’t fast. Financial markets and institutions doesn’t appear instantaneously, because:
Large fixed costs and time needed to set up financial infrastructure
Hard for private enterprises to get all gains from financial infrastructure (especially, if gains are spread over a long period of time) => nobody wants to invest.
If there is no pre-existing infrastructure, only rich individuals with will (or rich government) can create it. Happened in America – finacial sector developed in order to meet enormous financing needs of railroads (~1850).
Finacial market needs liquidity – but it takes time to get it
Liquidity: Ability of an agent to fastly sell asset without giving a discount (sell for a market price)
Chicken and Egg problem: People will not trade in a market unless thay think it is liquid, and market will not be liquid, unless people trade in it.
Market is liquid only if there are a large number of uninformed investors willing to trade. If there are only experienced, informed traders, they will not trade, because they will think: „Well, if you are willing to sell me this stock, and I know you are smart, than you must know something I don’t know, so better I don’t buy it”.
Uninformed investors will come to the market only if they are confident that market is fair, and have accumulated some positive experience in it (or heard good things about market from others). But this takes time.
It takes time to perfect financial contracts.
„Trial and error” process – it takes time to learn how to price contract, how to make sure that contract protects against innovative transactions (have no „holes”), how to make sure that other party will respect contract etc.
Institutions that help to enforce contracts – Exchanges, Audit agencies, Rating agencies etc., take time to build in .
It takes time for financial system to build good reputation, which is essential for its succesful existence.
It takes time for people in financial system to learn how to work, build relationships with customers etc.
=> Financial markets and institutions do not appear on demand, they evolve slowly. => finace development cause economic growth, not vice versa.
Despite problems with testing (determination of direction of causality in tests – what causes what), there is an empirical evidence that finance development causes economic growth. Even if sometimes economic growth in one industry causes finance system development (like Railroads in America ~1850), afterwards developed finance system causes economic growth in other industries.
How exactly finance development helps economic growth:
Growth in number of firms in indsutry. New firms are more dependent on external finance than established firms, therefore financial development strongly improves prospects of such firms, also making them more competetive against established ones (because old, big firms don’t need financial development so much). If these young firms are also innovative, finance development may also cause Schumpeterian „waves of creative destruction”.
Growth in size of existing firms. This effect 2x weaker than previoues one. Although large firms typically finance more of their growth from internal funds, underdeveloped financial markets constrain their growth, because:
Even though they need little external finance, it may prove to be very important for growth
These firms need to continously re-assure investors about growth prospects, but only in developed financial systems there are adequate corporate governance tools, that allow companies to grow beyond some specific level.
In countries, that have better accounting standards (better developed financial system):
Industries which use more equity to fund investment, tend to grow faster and do more R&D. (Why? Growth: Because equity financed firms tend to have less hard, but more intangible assets (i.e. growth opportunities). In poorly developed financial systems noone will want to finance such intangibles, because all will want a collateral – a hard asset. This will make such equity financed companies to have more hard asstes than they want. R&D: In well developed financial system, as it becomes easier to finance intangible assets, industry grows faster, and therefore have more funds to invest in R&D – intangible itself.)
Industries, where workers have high skill levels, tend to grow faster and do more R&D. (Why? Skilled workers = intangible asset.In developed financial systems, firms can finance this intangible).
Main idea: In developed financial system firms can raise finance easier: collateral (hard asset) matters less, intangible assets and future cash flows (growth opportunities) can be financed. This also makes life easier for start-ups, whose main assets are intangibles – ideas and project opportunities.
Two different financial systems – Relationship vs. Arm’s length system (Bank/controlling owner oriented vs. Market oriented).
Two primary goals of financial system – to channel resources to their most productive use and to ensure that an adequate portion of the return flows to financier.
In Relationship-based system, financier ensure return by having a power over the financed firm (ownership, „main lender”, „main supplier” etc.). Financier tries to create monopoly over financed firm – create barriers (lack of transperancy, regulation etc.), so that it is costly for other parties to invest in this firm.
In Arm’s lenght system, financier is protected by explicit contacts and high transperancy. This system can survive only where legal enforcment is good (all parties respect contracts, law offer a helping hand if contracts aren’t detailed enough (common law)).
Which system is better? It depends...
Relationship-based system is better, because:
Banks have close relationship with companies. If company gets in trouble, saving it may be socially desirable (people don’t lose work etc.). In market-system firm would go bancrupt, because noone would risk financing it. But in relationship-based system, bank may decide to finance it – give the firm lower interest rate financing now, but charge higher rate afterwards. Bank can be sure of this potential long-term gain, because firm will stay with it – in market-based system firm would recover, and then run away towards cheaper financing without saying thank-you to the bank who saved it.
Easier life for young firms in concentrated markets –same reasoning – bank helps risky start-ups, if it knows that in the case of success these firms will remain long-term customers, therefore banks charge lower interest rate when firm develops, and higher rate later, when firm has grown.
Relationship-based system is worse, because:
Poor price signals. Investment decisions are not driven by prices => self fulfilling – prices become less effective in providing economic directions, because they reflect less information.
In arm’s lenght system resource allocation not perfect also – as outsiders have little power, management do empire-building („agency costs of free cash flows” (c) M.Jensen). However there is a cure, when problem becomes exscessive – takeovers.
In relationship-based system no such cure.
Japan – investment of firms with no bank ties very sensitive – invest much when cash-flows big, invest little when cash-flows little
Earlier explanation – ties with banks make it easier for firms to obtain external funding for positive NPV investments when own cash-flows are insufficient.
Recent evidence – continious acces to bank funding on favorable terms allows companies to ignore signal sent by poor cash-flows and contionue investing in negative NPV projects.
Market power. Information about projects is private (to banks) – this depresses managements effort to make innovations.
Illiquidity.Concentrated information makes financial assets illiquid – only firm’s bank knows enough information to value its debt. If banks gets into the trouble, it is hard for other investors to buy this loan (financial asset), as they don’t have information about the firm.
Assets financed by each system:
Relationship-based system do better when financing physical asset intensive industries, as they are more traditional and well understood – this makes an absence of market price signals about firms profitability less a problem. Also, physical assets are usually liquid and good collateral.
Arm’s length systems are better in financing high technology R&D based industries, with illiquid assets
But why then most risky, illiquid and inovative firms are financed by venture capitalists – „relationship-based system”?
Venture capitalists are a bridge between both systems, combining the best of them.
Good from R-based system: financier has a control over firm, looks after managements moves.
Smaller costs: Venture capital reduces illiquidity of financed firm – make all standardized, transperent, not dependent on founder – in order to sell financed company aftre some time. Why sells – because financing needs of firm becomes too big for venture capitalist, and also limited life (i.e. 10 years) of venture capital partnerships.
As America is doing well, and Japan not so well, one would like to say, that arm’s length system is better. But it depends. One thing we can say – r-based system is riskier:
As information is concentrated, firms become illiquid investments (noone other than banks with information will want to finance them). Therefore banks take great risk when financing firms – this accumulates great risk of financial system in the country. When there is a crisis in the economy, government usually saves banks by giving them capital. This „shelter” creates adverse selection – bank start risking even more (no downside).
As information is concentrated and there are no good price signals (firms – illiquid), it is hard to recognize healthy firms from „walking-deads”. Therefore outside investors will not come to invest in these firms, thus reviving system – they will wait until system sorts itself out.
How to reduce r-based systems risk?
Let inside a country foreign intermediaries (banks):
They have vast outside resources, thus will survive crisis.
They may affect risk-management practices and increase local bank efficiency.
They may serve as avenue for outsiders to invest in a countrys firms after crisis – uninformed foreign investors invest trough banks who have concentrated information.
Main effect – government will stop saving local banks, because even if they crush, financial system will not. This will eliminate adverse selection.
But letting them in is dangerous – if there is a huge foreign capital in the country, and crisis starts, foreign investors may run away, taking their capital with them – this may trigger serious economic downturn (Asian crisis).

1.2.Rajan and Zingales: „The great reversals: The politics of financial developement in the 20th century”

Main findings:

There was a reversal in financial developement (finding, incosistent with pure structural theories of financial market developement)
Trade openness is positively correlated with financial market developement, especially when cross-border capital flows are free and significant
Interest group politics are important factor in financial developement across countries
Institutions might slow or speed-up interest group activities.

Research approach:

Collect various indicators of financial developement of developed countries over 20th century to prove that financial developement changes much faster than demand possibly could.
Test in cross-section of countries if financial developement is positively correlated with the exogenous component of country’s openness to trade (correcting for the demand for finance)
Test two hypothesis:
For any given level of demand for financing, a country’s domestic financial developement should be positively correlated with trade openness at a time when a world is open to cross-border capital flows.
The positive correlation between a country’s trade openness and financial developement should be weaker when worldwide cross-border capital flows are low.

Other findings:

Why so many countries still have underdeveloped financial sectors?
Absence of demand?
No. Many countries have similar level of economic developement but very different level of financial developement. (i.e. France in 1913 had similar GDP per capita as USA, but much bigger stock market as fraction of GDP).
Structural barriers to supply?
Loads of literature, saying that a country’s „structure” matters.
Not enough social capital?
Wrong legal, cultural or political system?
Common law countries have better minority investor protection and more developed equity markets (La Porta)
If it is so, then:
Financial sector should rise to meet demand, when structural barriers are gone.
Demand for finance should change much over time – country either is pre-disposed towards finance, or isn’t.
But,
Countries were more financially developed in 1913 than in 1980
Financial developement fell in all countries after 1929, and recovered only around 1980.
In 1913 most continental European countries were better financially developed than USA (even france with French Civil law) – now vice versa.
Disruption in demand caused by the Great Depression and the Second World War is not sufficient to explain this reversal. Economies of hardest hit countries recovered in two decades, and also such a delay wasn’t seen after WW1.
=> structural theories aren’t incorrect, but they are incomplete –they miss some variable factors to explain variance in financial development, major of which – political forces in favor of a such developement.
Incubents in financial sector and industry can be hostile to arm’s lenght markets, because they introduce competition.
Hovewer, if country opens borders, incubents opposition is muted
2 questions:
Why some countries become more open than others at some time...do the incubents not oppose opening up?
They have no choice – too small or too close to other countries – if most important parts of the world are open, „grey trade” over the borders and exporters will force country to open.
How can we prove causal relation? (It may happen, that incubents who favor openness also favor financial developement).
We can.
Define financial developement: In financially developed setting, any (identity and connections must be irrelevnt, only quality of underlying assets or ideas must matter) entrepreneur or company can obtain finance easily, investors anticipate an adequate return with confidence, let risks rest where they can best be borne, and this all must happen at low cost.
Results of research:
Financial systems were highly developed in 1913.
While richest countries generally had more developed financial sectors, countries with same GDP per capita may have had very different financial sectors.
Countries, that were most financially advanced in 1913 were not neccesarely as advanced recently.
Indicators of financial developement fall then rise between 1913 and 1999 (reversal)
The interest group theory of financial developement
Financial markets cannot develop without government intervention
Financial development – not allways win-win:
Industrial incubents: Lose privileged access to funds – other firms now also cen get finance and develop
Financial incubents: Lose relationships, their old skills become redundant, while new ones of credit evaluation and risk management becomes neccesary.
=>, incubents will lobby politics not to let competition get in. However, they can also simply ask to put direct barriers on trade, instead of slowing financial developement. However, this is more costly:
Such barriers are hard to enforce – innovation will find a way around those barriers
Such barriers are very visible – ctizens will see this, and turn against politics.
Slow developement of financial markets and direct barriers are usually complements – they probably serve the same purpose.
What determines outcome?
In an industrialized economy, incubets are large in size and small in number – they will collectively decide against financial developement, and all those for it will not be able to do anything.
Financial developement will happen only when BIG political change happens, or when incubents start wanting financial developement.
If country is open to trade – only goods: Industrial incubents now face competition – they have less profits and more need for investing in new technologies to face competitors => they need more external finance. However they will not neccesarely press for financial developement – they may instead ask government to subsidize them, or go for stronger financial repression to get all domestically available financing. Finacial incubents also don’t press for developement – it is more profitable to give more financing to existing relationships, than to get new clients in a competition taht would occur from financial developement.
If country is open to trade – only capital: Industrial incubents will not face competition in goods market – they will not need much external finance, and also noone from outside would lend to them because they are too non-transperant. => They will lobby against financial developement, so that new domestic competitors also don’t get finance from outside. Financial sector will lose some profits – because industrial incubents will now have a chance to get outside financing (or to threaten to do so) => domestic financial firms will have the same risk but lower return. However they not ask for financial developement (more transperancy), because industrial incubents would oppose them.
BUT, if country is open to trade – both capital and goods:
Large and healthy industrial incubents now will push for financial developement – they will now face strong foreign competitors, therefore don’t care if small competitors in home country also get financing as a result of financial developement – they will care only to be able to get as cheap financing as foreign competitos can – and this can be done only by achieving better transperancy.
Large and unhealthy industrial incubents will also not oppose financial developement – as their cash flows diminish, they will need more financing – but it will be much harder to obtain, because their „old friends” („relationship banks”) will no more give them cheap financing on cosy terms – now when there is a competition in financial sector, banks will understand thet their clients can easily run away from them, and will not give a helping hend to unhealthy firm just in sake of long-term return from relationship.
Financial incubents now will start lending to small firms, because new, competetive financial market will destroy benefits of relationships. As these small firms are non-transperant and risky, financial incubents will ask for financial developement. Later, when they have increased their skills, domestic financial intermediaries will start to look for foreign clients. But in order to enter foreign financial markets, they will have to open domestic market to foreign banks. When foreign intermediaries will enter, as they are not a part of domestic socail and politic networks, they will push for transperency, therefore causing even stronger financial developement.
=> Financial sector should develop only when country is opened both to goods anc capital trade.
Main results of testing this theory:
Financial developement is positively correlated with trade openness, especially when cross-country capital flows are strong. (If they are weak, incubents are strong enough to oppose them).
Reversal in financial developement can be explained by diminution of cross-country capital floes, that started during the Depression, and continued after WW2 until breal down of Bretton Woods agreement.
Why countries collectively shut their borders in 1930s and 1940s, and opened them up only recently?
Countries shut their borders in 1930s because of the Great Depression. Huge uneployment asked for government intervention, but government couldn’t intervene much as long as country followed a Gold Standard. Therefore, countries abandoned the Gold Standard and started to devalue their currency to make domestic firms more competetive. To protect themselves form devaluation of other currencies, governments imposed tariffs, and this led to protectionism.
After WWII, America came out with its industries untouched, therefore it pressed for more trade. Other developed countries agreed, but in return asked for restrictions on cross-border capital flows – their citizens wanted governments to provide various kinds of insurance, but this could be done only if capital flows were restricted. As a result – Bretton Woods agreement.
Why then financial markets in America developed better then elswhere?
Amercia had ability never to let any small group of incubents to get too powerful (They set up Federal Reserve to undercut the power of JP Morgan, made Glass Steagall act to reduce power of large banks, refused to save Drexel Burnham).
Does structure matter? (La Porta)
Yes, but it doesn’t directly aid financial developement, as Laporta says! In common law countries it is easier for interests groups to have their way:
Governence system ir more decentralized and easy to capture
Legal system also is easier to capture
=>, finacial developemnt in civil law countries was slower NOT becausecommon law is friendlier to investors as La Porta says, but because it was easier for interest groups (incubents) to opress dinancial developement in civil law countries!

1.3.La Porta, Lopez-de-Silanes, Schleifer and Vishny (LLSV): „Law and Finance”