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A Discussion Of Banks Controlling Major Equity In Large Industrial Companies Essay, Research Paper

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 found 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

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