Firm And The Firm To The Bank example essay topic

The question touches to two important and obviously interrelated issues, that of the need and form of corporate control and that of the role of the financial system in resource allocation. During the last two decades the Modigliani - Miller proposition which stated that there is no relationship between corporate capital structure and the real performance of firms, has been increasingly disputed as the importance and power of financial institutions is realised. In general, a distinction is drawn between "market" and "bank" oriented financial systems, which are thought to correspond to the financial arrangements of the US and UK on the one hand, and of Germany, Japan and to some extent France on the other. The former are said to rely much more on the equity and stock markets for company finance and corporate control with banks having relatively little direct links with industry and providing relatively little finance.

In the Japanese / German "system", on the other hand, banks have much closer ties with firms, often hold significant equity positions in these companies, are represented in the board of directors and consequently provide a greater proportion of company finance. The superior performance of the Japanese and German industry to that of the Anglo-Saxon countries is often thought to indicate that the former have a "superior" financial system. We should bear in mind, however, that the distinctions are not always as clear. Japan, has also a large stock market and the equity holdings of financial institutions are high in Britain too, although the equity holdings of institutions in UK are concentrated in pension funds and life insurance firms rather than banks, though the exact significance of that is not clear. Also, we must be aware of the ever present data problems, especially when making international comparisons.

A recent study has foun that, in fact, bank loans form a greater proportion of investment finance for British firms than German firms. Another point that has to be made is that the apparently "superior" performance of the "bank-based" economies need not be an outcome of the financial system as obviously many more factors are at work here. Even more significantly the causation may run the other way round since high growth would probably require high investment rates and hence high gearing ratios. Mayer, however, replied that the electronics industry in the UK and US which also experienced quite high growth and high investment, in fact, has an even lower proportion of external finance.

Nevertheless, the view that banks are willing to lend more if only the firms asked them to, is quite popular and it implicitly puts the blame for the unimpressive British performance on the managers and corporations. Other findings that stock market financed investment is more profitable to debt financed one, with internally financed projects being the less profitable of all, could be interpreted to imply that it is indeed the managers' rather than the financial sector's fault, who prefer internal capital so as to avoid control and be slack; alternatively it could be interpreted that the financial sector is uninterested in industry, except in cases where the returns are truly exceptional. The essay question asks about banks owning equity in industrial corporations but this does not seem to be a crucial feature in the interactions of the financial system with corporate performance. The distinction between equity holdings and bank loans is increasingly blurred given the process of securisation in the last 2 decades. The two elements which are probably the most important are first, the extent of monitoring banks do over the firms they have relations with, i.e. whether they follow a "hands-on" approach or are passive to management decisions, and second, whether the banks "lock in" specific firms. Both these features have important -and controversial- implications for both the efficiency of credit allocation and the degree of corporate control.

Banks holding equity stakes is only important to the extent that it affects these two features of banks' and firms' behaviour and as we will see later on it is probably not very important. As far as resource allocation is concerned, the ability to "lock in" a company, particularly when it is still small and new, allows the bank to take a more long-term view and leads to better risk allocation. Most new firms, or new projects, tend to incur losses for, say, the first five years until they manage to start earning profits so that many of them do not survive that long. Thus, banks would be very hesitant in lending them since the fear of default would be very high; charging very high interest rates to offset this risk is likely to worsen even further the chances of survival of these firms and perhaps attract "unwise" entrepreneurs. Rationing of credit is, thus, widespread and new firms and projects are often prevented from taking place. If, however, the banks locks itself to the firm and the firm to the bank, then the bank may be willing to accept lower interest payments while the firm is still young and fragile in exchange to more advantageous terms and higher profits in the long-run.

If the 2 parties had not committed to each other, then the firm could, once it became big and respectable financially, abandon the bank which had helped it grow and draw funds more cheaply from the market. This is a powerful argument, though it has to be established that this is what happens in Germany and Japan, especially as far as small firms are concerned. The famous Japanese bank-industry links, for example, are mainly between big companies and big banks rather than small innovative and high-risk firms. The argument loses much of its significance when it is valid only to relatively big firms since these firms are less constrained for finance. Still, when a bank is locked in a firm, it is generally more likely to support it in times of trouble.

Indeed the attitude of Japanese and German firms towards firms in danger of default is supposed to be much more supportive, though again the extent of the different behaviour of these countries with the UK and the US is controversial. A potential problem with locking in is that it has a tendency towards monopolistic situations both in the financial and the industrial sectors. When a firm is locked in with a bank, this means that it will not be available to search the market to find the cheapest source of finance. This lack of competition is likely to increase costs and inefficiency within the banking sector. Oligopolistic influences may be exercised over the industrial sector as well, since when banks are "locked" in one (or more) firms in an industry, they would be unwilling to fund new entrants. Other problems include that as the banks take some of the risks from the companies, we may have over-insurance resulting in managerial slack or overly risky behaviour.

Furthermore, the arrangements which are likely to result from such intimate relationships between firms and banks are likely to be excessively secretive -as is often the case in Germany- leading to unaccountability and perhaps corruption as in Japan. The extent of involvement of the banks on the management of firms -which is clearly related to the extent of "locking in" - is also likely to influence credit and resource allocation. One may argue that the more information the banks have about the firm, the more likely they are to make the "correct" decisions on which projects and firms o finance and on what terms. On the other hand, it is argued that it would be better is this knowledge were widely available since many agents are more likely to end up with a better outcome. The conclusion to such a debate would be largely dependent on our opinion about the Efficient Markets Hypothesis, in other words the ability of a decentralised, competitive system to allocate funds and determine asset prices, through the stock and bond markets. However, the proportion of funds drawn from the stock market is surprisingly low so, indicating that perhaps its "excessive" volatility and, perhaps its short-termism does not make it a popular medium of finance for most firms.

It is perhaps strange to notice, however, that often much of the volatility and "irrationality" of these markets is in fact attributed to these financial institutions which are here claimed to provide a more long-term and sober approach to industrial funding. The second issue we have to examine is that of corporate control. This issue has arise because of the separation of ownership from control as share ownership has been dispersed and hence the control of owners over their company is diminished. The significance of this separation is highly controversial with some arguing that this has altered the whole nature of capitalism as managers are socially conscious and less concerned with profit maximisation, while others point out that there has been little evidence of a slackening of the profit motive. In any case, most recognise that managers -and by extension all firm employees- are likely to have other objectives to solely profit maximisation - the most frequently proposed are sales maximisation and slackening of work effort. Therefore, a high degree of bank involvement and control over corporations is often thought to prevent the "managerial thesis" from being realised.

Once again, there is considerable debate regarding the extent and effectiveness of financial control in the non-anglo saxon economies. Indeed a number of corporate troubles in Germany has indicated that financial control may well be overrated. There are many possible ways for financial institutions to exercise control or influence over firms. One possible way is to own stocks and exercise its influence through shareholders' voting. This is unlikely to be very effective, though as rarely questions of great strategical importance are put to the vote while in most cases banks do not own a controlling proportion of shares. It has also been proposed that banks exercise influence by threatening to sell their shares but this is unlikely to be of major importance as the banks would also lose if they sold their shares quickly.

Representation on the board of the company is another possible way but again in most cases, these boards are largely ceremonial and the bankers themselves often seem not to give them much attention. Thus the most common way for banks to exert influence is in indirectly consulting the managers, based on the power that they have from providing a large part of the firm's finance, irrespective of whether that is in the form of shares or bank loans. It should be noted here that the importance of and the need for such financial control is significant only when the market fails to do that by itself. Those who again believe in the EM, would see takeovers as an effective way of keeping the managers in check. There are numerous problems with takeovers, however, due to imperfect and asymmetric information and short-termism.

Another question that arises is that if such close relations between firms and banks are thus mutually beneficial, why don't all banks in all countries do the same. We also have to examine whether the interests of the financial institutions are identical with those of the shareholders of the non-financial firms. In a sense their interests differ since the owners of the firms want to maximise profits while banks want to maintain solvency. In the long run, however, the best way to guarantee solvency is to maximise profits so, though banks may be more cautious than perhaps required for short-run profit maximisation, there will probably be no important conflict of interest in the long-run. Nevertheless, problems may arise when banks control more than one firm in an industry in which case it may encourage collusion (which is probably in the firms' interests, though it may not be in society's interests) or at worst run down one of the firms or encourage its takeover / merger to reduce competition. Again, the problems of accountability and secrecy are relevant here.

I would like to conclude with the "optimistic" view that, to a large extent, the two types of financial systems are not completely mutually exclusive so that it could be possible to combine some of their best features. I can see no particular reason why competitive and dynamic financial markets are incompatible with a banking structure which is more responsive and closer to industry. Already there are signs that, for example, the pension funds in US and to some extent the UK have abandoned their "obsession" with short-term performance and are switching to index linked portfolios which could be a basis for both a more stable and efficient stock market and, hopefully, greater relations between firms and financial institutions.