sou · GOB311d5 · 2001-01-01 00:00:00 — sou 2000 11 d5 (Fi 1997:14) tillsattes för att utreda den svenska finansiella sektorns internationella konkurrenskraft. Utredningen har givit ett antal svenska och utländska experter i uppdrag att utarbeta specialstudier till utredningen. Dessa 27 studier har löpande offentliggjorts via utredningens hemsida på internet och redovisas som separata bilagor till betänkandet. Bilagorna har i vissa fall som syfte att ge en sammanfattande bild över forskningsläget på viktiga områden, i andra fall till att djupare analysera vissa centrala frågeställningar. De analyser och slutsatser som läggs fram i dessa bilagor är respektive författares egna och sammanfaller inte nödvän- digtvis med utredningens ståndpunkt. De 27 specialstudierna finns samlade i fyra volymer. Volym A innehåller fem bilagor som alla granskar finanssektorns betydelse för tillväxten. I volym B:s nio bilagor avhandlas de olika funktioner som finanssektorn har i samhällsekonomin. Volym C:s sju bilagor behandlar en mängd övriga frågor som t.ex. skatter, arbetskraft och regleringar. Volym D innehåller de sex bilagor som har skrivits på engelska. Den finansiella sektorns samhällsekonomiska Den svenska finansiella sektorns utveckling i Det finansiella systemet och den ekonomiska tillväxten: Svenska erfarenheter 1834-1991 Finansiell utveckling och ekonomisk tillväxt: Fyra perspektiv på finansmarknaderna och tillväxten – Finansiellt system, makt och Den finansiella sektorns funktioner Sparande, investeringar och förmögenhet – en analys med inriktning på sammansättning och förändring av hushållens sparande och Sparandets nivå och placeringsformer: Konsekvenser för finansmarknaderna under de kommande 30 åren i Kreditgivningen och den svenska finansiella och dess internationella konkurrenskraft Clearing och avveckling av svenska värde- Skatternas betydelse för den finansiella sektorns De svenska finansiella marknadernas integration Finansiella regleringar och konkurrenskraft Finansiella intermediärers roll i det finansiella systemet – En översikt av den akademiska Arbetskraft och konkurrenskraft i den svenska , Industrial Structure, and Raghuram G. och Politics, and Financial Development Raghuram G. och Perspectives on The Political Economy of Banking and Financial Regulation What Is Optimal Financial Regulation? . Herring och . Santomero Consolidation and Strategic Positioning in Banking with Implications for Productivity in an International Perspective , Industrial Structure, and Raghuram G. * Supplement number 23 to the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. Views, suggestions, and opinions expressed in this study represent the personal views of the authors and not necessarily those of the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. *. Gidwitz Professor of Finance, , Area, . 1101 , , IL 60637, . **Professor of Finance, , Area, . 1101 , , IL 60637, . Volym D:10 Supplement 23 Kort sammanfattning (in Swedish) ....................................................... 1 Finance development and Growth................................................. 1.1Why dont financial markets and institutions appear Evidence on Financial Development and Growth ...................... Financial Development and Growth: Details ............................. 2 Relationship vs Arms length systems ........................................... An Example: Credit ................................................................. 2.2Do relationship based systems always lead to worse investment decisions?............................................................... The distortions in relationship based systems ............................ The kinds of assets financed by each system............................. Venture Capital: A between two worlds ......................... Why a relationship based system is more risky ......................... How to reduce risk in a relationship based system..................... Conclusion: And the winner is ...................................................... , Industrial Structure, and Growth Volym D:11 Kort sammanfattning (in Swedish) Hur påverkar utvecklingen av den finansiella sektorn den industriella tillväxten? Vilken effekt har den på industrins sammansättning och företagens storleksfördelning? Hur skiljer sig olika typer av finansiella system när det gäller sårbarhet i krislägen? Denna studie diskuterar och försöker ge svar på denna typ av frågor, baserat på aktuell forskning. Den första delen av denna studie fokuserar på de teoretiska och empiriska argumenten varför finansiell utveckling underlättar industriell tillväxt. I den andra delen jämförs två typer av finansiella system: det institutionella, relationsbaserade systemet och det marknadsbaserade arms length-systemet utifrån vad som förefaller mest gynnsamt för industriell tillväxt. Speciellt fokuseras på vad som ser ut att vara en ny framgångsrik hybrid – riskkapitalfinansiering. I den sista delen ställs frågan hur olika slag av system reagerar vid makroekonomiska störningar och systemrisker. En viktig slutsats är att utvecklingen av ett lands finansiella marknader och finansinstitut dramatiskt kan öka tillväxten i branscher och företag som behöver en stor del extern, långfristig finansiering. Särskilt intressant är att finansiell utveckling leder till uppkomsten av fler företag inom branscher vars tillgångar till stor del är immateriella som forskning och utveckling. Detta gäller i hög grad för små teknik- baserade företag. Följaktligen underlättar finansiell utveckling struktur- utvecklingen i den industriella sektorn. Volym D:12 Supplement 23 How does the development of the financial sector affect industrial growth? What effect does it have on the composition of industry, and the size distribution of firms? What is the relative importance of financial institutions and financial markets, and does it depend on the stage of economic growth? How do financial systems differ in their vulnerability to crisis? This study attempts to provide an answer to these questions based on the current state of empirical research. This is not, however, meant to be a comprehensive survey. Instead, we hope to present our own point of view, bolstered by the available empirical evidence. The first section of this study will focus on the theoretical rationale and empirical evidence for why financial development aids industrial growth. In the second section, we compare and contrast two types of financial system: the institution-heavy relationship based system, and the market-intensive arms length system. We will ask which type of system is more suitable for industrial growth. In particular, we will focus on what seems to be a recent successful hybrid – venture capital financing. In the last section, we will ask how each kind of system responds to macro-economic volatility and systemic risk. We will conclude with some policy conjectures. Our main conclusions are the development of a countrys financial markets and institutions dramatically increases the growth of industries, such as Computers or Pharmaceuticals, that need a lot of external, long- term finance. interestingly, financial development leads to more firms being born in industries whose assets are largely long term, or in industries where assets are largely intangible ones such as R&D. Thus financial development facilitates the spread of new ideas and leads to the creative destruction of the old. By freeing those with ideas from the need for personal wealth to finance them, financial development creates equality of opportunity for everyone in society, something that hitherto has only been a dream. By increasing the variety and sources of financing, financial development also decreases risk. The sources of financial development, however, are not explored in this study. , Industrial Structure, and Growth Volym D:13 Introduction*** How does the development of the financial sector affect industrial growth? What effect does it have on the composition of industry, and the size distribution of firms? What is the relative importance of financial institutions and financial markets, and does it depend on the stage of economic growth? How do financial systems differ in their vulnerability to crisis? This study attempts to provide an answer to these questions based on the current state of empirical research. This is not, however, meant to be a comprehensive survey. Instead, we hope to present our own point of view, bolstered by the available empirical evidence. The first section of this study will focus on the theoretical rationale and empirical evidence for why financial development aids industrial growth. In the second section, we compare and contrast two types of financial system: the institution-heavy relationship based system, and the market-intensive arms length system. We will ask which type of system is more suitable for industrial growth. In particular, we will focus on what seems to be a recent successful hybrid – venture capital financing. In the last section, we will ask how each kind of system responds to macro-economic volatility and systemic risk. We will conclude with some policy conjectures. *** This study was presented at the Symposium on the International Competitiveness of the organized by in 1999. The comments of and are greatly appreciated. Volym D:14 Supplement 23 1 Finance development and Growth There is a long literature debating the impact of finance on growth – dating at least as far back as Schumpeter (1911) – that emphasizes the positive influence of the development of a country's financial sector on the level and the rate of growth of its per capita income. The argument essentially is that the services the financial sector provides – of reallocating capital to the highest value use without substantial risk of loss through moral hazard, adverse selection, or transactions costs – are an important catalyst of economic growth. empirical work seemed consistent with this argument. For example, on the basis of data from 35 countries between 1860 and 1963, Goldsmith (1969, p. 48) concludes that a rough parallelism can be observed between economic and financial development if periods of several decades are considered and there are even indications in the few countries for which data are available that periods of more rapid economic growth have been accompanied, though not without exception, by an above-average rate of financial development. Nevertheless, studies such as these simply suggest correlation. As Goldsmith puts it There is no possibility, however, of establishing with confidence the direction of the causal mechanism, i.e., of deciding whether financial factors were responsible for the acceleration of economic development or whether financial development reflected economic growth whose mainsprings must be sought elsewhere. While Goldsmith was somewhat pessimistic about the possibility of establishing causation, other economists have expressed downright skepticism that financial development is anything but a sideshow to economic development. (1952, p. 86) is representative of a school, which seems to believe that institutions follow Says law of demand creating its own supply when she claims where enterprise leads, finance follows. Others such as (1988) argue that the importance of financial development for economic growth has been overemphasized. The importance of financial markets and institutions in a modern economy is undisputed, and fairly well documented elsewhere, see (1997) and and Bodie (1995), for example. What is more hotly debated is whether financial markets and institutions develop automatically to industrial and individual needs, or whether they take an inordinate time, and special circumstances, to build, and cannot be taken , Industrial Structure, and Growth Volym D:15 The evidence suggests the latter. Let us first understand why this might be the case, then examine the evidence. 1.1Why dont financial markets and institutions appear instantaneously? Clearly, there are large fixed costs and a physical time to build in setting up financial infrastructure. Furthermore, it may be hard for private enterprise to internalize all the gains to doing so, especially if these gains are spread over a long period of time. If there is no pre-existing financial infrastructure, the economy needs either the fortuitous combination of rich individuals with the will at a time when there is a sudden large demand for financing, or a farsighted government that can pool resources, for the infrastructure to be set up. (1977) suggests this is, in fact, what happened in the . The financial sector, especially investment banks and the corporate bond market, developed to meet the enormous financing needs of railroads in the mid-nineteenth century. The infrastructure was later available to meet the less concentrated needs of industrial firms around the turn of the century. Even after the set-up costs are incurred, a financial market needs liquidity – the ability for an agent (a seller or borrower) to get full value for her goods. A number of factors determine a markets liquidity but perhaps most important is that a large number of persons think of that particular market as the natural location for their trades. Thus there is a chicken and egg problem with liquidity – people will not trade in a particular market unless they think the market is liquid, but the market will not be liquid unless they trade. This again implies that the continued vitality of a market often requires that rare event that serves to co- ordinate expectations. For example, the Government issued in large numbers to finance the war effort during the First World War. People who would otherwise not touch a financial security bought these bonds for patriotic reasons. Peach (1941) argues that it was the successful experience these investors had with the bonds that made them willing to invest in arms length securities issued by corporations, giving corporate securities markets liquidity, and leading to the enormous expansion of these markets in the 1920s. generally, economic theory suggests that a market becomes liquid when, somewhat counter-intuitively, there are a large number of uninformed investors willing to grease the wheels of trade. This is because when a market consists only of informed, experienced traders, everyone is trying to second-guess the counterpartys information from Volym D:16 Supplement 23 the way they trade, and few trades take place. The reasoning is if you are willing to sell me this stock and I know you are smart, I wonder what it is you know that I do not, and I am less willing to buy. The difficulty of providing uninformed investors the confidence to participate in the market when, by their very nature, they will not collect a great deal of information is, in our view, one of the most important impediments to market liquidity. Investors obtain such confidence, not from a detailed scrutiny of the financial press but from word-of-mouth about salient events, and articles in the popular press. There is some evidence of this. Initial public offerings of stock that have higher first day returns in the attract more analyst following, perhaps because huge initial returns make these story stocks that are written about in the popular press attracting investor interest. These stocks also have higher trading volumes, a natural consequence of more uninformed interest.1 But there is a downside to attracting the uninformed. A broad-based unpleasant experience can equally easily drive them from the market and word of mouth about such a salient event will take a long time to die down. The bottom line is that liquidity is based on past experience, takes a long time to nurture, and could be somewhat fragile for new markets. Financial contracts also take time to perfect. There is a process of trial and error in which institutions initially, and eventually markets, learn the nuances of a financial contract, how to price it, what covenants to build in, how to withstand legal scrutiny, and how to obtain effective enforcement.2 The institutions such as exchanges, audit agencies, custodial services, rating agencies, etc., that help the smooth enforcement of arms length contracts take time to set up, and more time to perfect their trade in local conditions. Financial intermediaries also take time to set up and become effective. As (1998) argues, institutions intermediate where financial contracts are incomplete, either because contingencies cannot be fully foreseen in the case of innovative transactions, or because the contingencies are too complex to describe up front. The institution uses its reputation to bond itself, and its bargaining power to achieve negotiated outcomes that are superior to those that can be obtained through direct transacting in the market place. A good reputation is crucial for an intermediary because this is what convinces to trust it when contracts do not fully protect them, but reputations take time to build, see Kreps and (1982) and (1989), for 1See and Servaes (1997). 2See (1998). , Industrial Structure, and Growth Volym D:17 example.3 An institution may also be able to bond itself by putting its monetary capital or future rents at stake, but we have already argued that monetary capital may not be available in concentrated form in economies with primitive financial sectors. Moreover, even if available, monetary capital alone may not be particularly effective in providing to , see Boot, , and Thakor (1993). Finally, financial intermediaries take time to build for the same reasons that large industrial firms take time to build, see and Zingales (1998a). It takes time for employees to learn to work with each other, to build relationships with , and to build routines that ensure the smooth functioning of the organization. Moreover, all this learning cannot take place instantaneously, it has to be sequenced, else it could risk overwhelming the command and control capabilities of the organization. For all these reasons, it is quite possible that financial markets and institutions do not appear on demand, they evolve slowly. Thus the pre- existing state of financial development could have a significant effect on economic growth. Recent evidence seems quite persuasive that this is indeed the case. 1.2Evidence on Financial Development and Growth The rekindling of interest on the empirical connection between financial development and growth owes much to King and (1993). 3 In every financial innovation, there are outcomes that are not anticipated up front, and have to be worked out amicably between intermediary and client. This is where the intermediary's reputation plays a part. Some intermediaries develop reputations for being un-cooperative, which hurts their business. An incident reported by Euromoney (, p. 35) is suggestive. In 1987, sought bankruptcy protection after being ordered to pay $ 10.5 billion in damages to Pennzoil. Even though was far from insolvent, the filing put it in technical default on a swap contract with . The details of the swap contract allowed either party to walk away even if they owed money when one party defaulted (this limited-two-way-payment is deservedly obsolete). owed $ 10 million on the swap. The expectation was that it would waive the default given that it was merely technical. Euromoney reports that top BankersTrust management looked at the situation, weighed the banks relationship with – not itself known for showing much mercy to its bankers – and took the windfall gain. has refused to deal with ever since. Volym D:18 Supplement 23 study 80 countries over the period 1960-1989 to see whether the pre- determined component of financial development predicts long run economic growth. They find that beginning-of-decade measures of a countrys financial development – such as the ratio of liquid liabilities of the financial system to GDP, the share of domestic credit allocated by banks, or the ratio of domestic credit to private enterprises to GDP – are strongly related to the countrys economic growth, capital accumulation, and productivity growth over the subsequent decade. The economic size of the effects is also large. If in 1970, had increased the share of domestic credit allocated by banks as opposed to the central bank from 26 percent to the mean for developing countries (about 57 percent), would have grown about 0.9 percent faster each year in the 1970s, and by 1980 per capita GDP would have been 9 percent above its actual level, King and (1993, p. While the evidence in this paper sheds additional light, it does not lay to rest all doubts about causality. The skeptic could still offer a number of arguments. First, both financial development and growth could be driven by a common omitted variable such as the propensity of households in the economy to save. Since endogenous savings (in certain macroeconomic models) affects the long run growth rate of the economy, it may not be surprising that growth and initial financial development are correlated. This argument is also hard to refute with simple cross-country regressions. In the absence of a well accepted theory of growth, the list of potential omitted variables that financial sector development might be a proxy for is large, and the explanatory variables to include a matter of conjecture. Second, there is a potential problem of anticipation. Financial development – typically measured by the level of credit and the size of the stock market – may predict economic growth simply because financial markets anticipate future growth; the stock market capitalizes the present value of growth opportunities, while financial institutions lend more if they think sectors will grow. Thus financial development may simply be a leading indicator rather than a causal factor.4 One way to deal with the first problem, that of omitted variables, is to keep effects other than financial development . An ingenious paper by Jayaratne and Strahan (1996) does precisely this. 4 and Zervos (1998) attempt to deal with this by using stock market liquidity rather than market capitalization as a measure of financial development. Market expectations could also be built into liquidity, see Shleifer and Vishny (1992), though to a much lesser extent than into market capitalization. , Industrial Structure, and Growth Volym D:19 1972 and 1991, a number of states in the did away with regulations preventing banks from opening multiple branches within the state. The authors argue that de-regulation was tantamount to a jump in the development of the financial sector within the state, because it allowed scale economies to be realized through bank mergers, old inefficient management to be shunted out, and new management to be given better incentives. They find that annual growth rates increased by 0.51 to 1.19 percentage points a year after de-regulation. Of course, one could ask again whether financial sector reform leads to economic growth, or vice versa. Did states liberalize anticipating greater need for financing because of economic growth? Jayaratne and Strahan argue that if this was the case, the volume of bank lending should have exploded after de-regulation. It did not! Instead, they argue that de-regulation led to improvements in loan quality, and this led to better growth. It is hard to make the case that state legislatures de- regulated anticipating the improvement in loan quality. Jayaratne and Strahan essentially follow a difference in differences approach by asking what happens in a state after de-regulation. As a result, concerns about whether the states that de-regulated were somehow special are mitigated. and Zingales (1998b) follow a similar approach but with an important twist.