sou · GOB311d5 · 2001-01-01 00:00:00 — , Industrial Structure, and Growth Volym D:29 Such subsidies, as suggested earlier, would not be possible in more competitive markets. Clearly, it is this kind of ability to internalize joint surplus – that is, to trade off short-run losses for longer-run gains – that led so many , including many economists, to defend the efficiency of relationship based systems. But it is easy to see the problems that can arise in such systems. 2.3The distortions in relationship based systems Perhaps most important, the relationship based system does not pay much attention to market or price signals. And this indifference to price signals becomes self-fulfilling. If investment decisions are not driven by prices, then prices become less effective in providing economic directions because they reflect less information. This is not to say that the arms length system is perfect in the allocation of resources. Because outsiders have power, management can indulge itself far more in empire-building without triggering an intervention by outsiders. This problem has been labeled the agency costs of free cash flows by . The arms length system, however, can use takeovers to rectify this problem when it gets excessive.13 By contrast, the problem of mis-allocation of resources due to the lack of price signals in the relationship system is more severe, because it lacks a self-activating mechanism to correct it. In fact, even if price signals were accurate, the power structures in the relationship based system may not allow movement in a direction indicated by the prices. Evidence of this unwillingness to respond to market signals was provided by a 1991 study by Hoshi, Kashyap, and Scharfstein.14 The study looked at a sample of Japanese firms in the late 1970s to mid 1980s that had close ties to banks and compared their investment 13 If anything, managerial empire-building is less severe in a relationship based system, precisely because financiers have the power to intervene extensively and absorb free cash flows from successful firms. 14 Hoshi, et al (1991). Volym D:30 Supplement 23 behavior with a sample that had no such ties. The investments of firms that had no bank tie were very sensitive to the cash flow the firms generated from operations; when operating cash flows decreased sharply, so did investment spending – and vice versa. By contrast, the investments of firms with strong ties to the banks were significantly less sensitive to the firms' operating cash flow. As suggested earlier, one possible interpretation of these findings is that banking relationships make it easier for firms to obtain external funding for value-adding investments, thus making them less dependent on their own cash flows. But recent events in suggest a different explanation. often than not, the companies' continuous access to bank funding on favorable terms allowed them to ignore the signal sent by their poor cash flows, and to continue investing. By continuing to invest in these circumstances, such firms may well have been destroying long-term value rather than increasing or preserving it. Even if the banks were failing to provide the managers of these firms with the right signals, it appears that the stock market was attempting to do so. For, as the study also reported, the firms with banking relationships in their sample had lower 's q (or market-to-replacement cost) ratios than firms without bank ties (consistent with our earlier conjecture that bank dependent firms are asset intensive, low growth firms). And, to the extent 's q is a reliable proxy for a firm's investment opportunities, the stock market was expressing skepticism about the likely payoff from such investments. Weinstein and Yafeh (1998) suggest that such market skepticism was warranted. For while Japanese firms with close bank ties may have had greater access to funds when their operating cash flows declined, such access did not enable them to achieve higher profits or growth rates than their peers. Peek and (1998) provide additional evidence that relationships can distort the allocation of funds. In the early 1990s, Japanese banks increased their lending to the U.S. commercial real estate market. At their peak in 1992, the U.S. subsidiaries of Japanese banks accounted for one fifth of all commercial real estate loans held in the U.S. Then, in response to a severe decline in real estate prices in , the Japanese banks cut back their lending in the U.S. even as U.S. prices were rising (and lending by non-Japanese banks increasing) while at the same time expanding their lending in the domestic Japanese market where prices were plummeting. Thus, rather than cutting their losses in – or at least not abandoning their profitable opportunities in the U.S. – Japanese banks poured more money into their unprofitable Japanese relationships. , Industrial Structure, and Growth Volym D:31 In sum, one downside of a relationship based system is that price signals are obscured. The consequence could be a widespread and costly misallocation of resources. By contrast, there is a virtuous circle at work in market-based economies: In the process of relying on prices for guidance, the arm's- length transactions that predominate in these economies also have the beneficial effect of making prices more informative. Thus, the more transactions that come into the market, the more likely decisions made on the basis of price are likely to be the right ones. Another consequence of prices being obscured in a relationship based system is that the financiers information is largely private especially when the projects being financed consist of intangible assets such as intellectual property. Since the creation of intellectual assets requires substantial endeavor on the part of management, the rent sharing entailed in a relationship system can depress management effort, making innovation, especially of the entrepreneurial kind in high technology industries, a rare commodity. Because information is so concentrated in a relationship based system, financial assets become very illiquid. Since the relationship is specific to the intermediary and borrower, the intermediary becomes indispensable to collecting on loans. As a result, the intermediary can extract sizeable rents from investors also, see and (1998), because they need the intermediarys skills to realize the value of the intermediarys loan portfolio. Anticipating these rents, investors will charge the intermediary a high cost of capital. Moreover, the financial asset will be illiquid in the sense that it will trade in the market for true value (the amount that can be collected from borrowers) less the rent accruing to the intermediary because of its indispensable relationship specific skills. The illiquidity of financial assets makes it very costly for the financial system if the intermediary gets into trouble since more liquid outsiders cannot take over its assets easily. Volym D:32 Supplement 23 2.4The kinds of assets financed by each system All this then suggests why pure relationship based systems tend to have a comparative advantage in financing physical asset intensive industries rather than high technology R&D based industries. For one, physical capital intensive industries are typically more traditional and well understood. As a result, the absence of market signals about their profitability is less likely to be a problem in making investment decisions. Second, because they are well understood, it is unlikely that a large amount of rents will accrue to the financing intermediary. Moreover, the borrower has the collateral to entice fresh lenders if the existing one proves demanding. Finally, since loans are well collateralized by physical assets, they are liquid, so the concentration of information is less important a barrier for the intermediary to finance its assets. Conversely, arm's length systems will have a comparative advantage financing industries with intangible assets, hence and Mayers finding that equity- and skill-based industries tend to do more R&D in economies with better developed accounting standards. An intriguing recent study fortifies our view that relationship based systems are more capable of financing projects where the ratio of tangible to intangible assets is large. and (1995) study the financing arrangements of 250 public firms in the . They find that firms with relationships to single banks tend to use less bank debt in proportion to total debt as their market to book ratio (a measure of the ratio of intangible to tangible assets) increases. By contrast, when firms have relationships with multiple banks, the ones with higher market to book ratios tend to use more bank debt in proportion to total debt. This suggests that firms tend to avoid becoming dependent on a single bank when they have high market to book ratios, perhaps because they fear the bank may have too much power to extract rents and direct strategies, or because the bank itself will find the asset too illiquid. By contrast, when the firm has multiple banking relationships (effectively an arms length system), no single bank has too much power. Since public markets can obtain information about the firm from multiple sources, the cost of borrowing more from banks to fund is small relative to the insurance and advice provided by relationships. Thus the revealed preference of firms, in an environment where they can choose the relationship structure that benefits them most, gives us a sense of when a relationship is onerous and when it is not. , Industrial Structure, and Growth Volym D:33 This study also suggests the answer to an apparent contradiction. If relationships are inimical to the financing of skill based and high technology industries, then why is it that venture capital, which seems the quintessential form of relationship financing, is so important in their financing even in the most advanced arms length systems. We believe that the conditions under which venture capital arises ensure that the worst problems of the relationship system are tempered by the close proximity of the arms length system. The error leading to the apparent contradiction is to view venture capital as purely a form of relationship financing. In fact, it seems an ideal between relationship and arms length financing, combining the best of both worlds. 2.5Venture Capital: A between two worlds Relationship based finance, as we have seen, has the virtue that the financier has substantial control over the financed, and is able to guide the borrowers moves, as well as thwart any malfeasance. How can the venture capitalist bring these virtues to financing high technology without inflicting the costs associated with relationship financing? In our view, the role of the venture capitalist is to reduce the illiquidity of the financed firm – which is the source of many of the ills of the relationship system – and the existence of a vibrant arms length market is crucial for him to perform his role. His endeavor after financing the firm initially is to prepare to exit. He does this by making the firms management and control processes standardized and bureaucratic, transparent, and easy for arms length investors to take over. The venture capitalist also moves the firm from being an organization dependent on the founder to an organization capable of being run by professional managers. This again makes the firm easier for arms length investors to control since managers are easier to replace than founders.15 Why does the venture capitalist not simply hold on to his stake in the firm and extract rents? The answer is that he obtains much greater returns from taking the firm public. The growth opportunities of the typical successful venture capital financed firm are so high that the venture capitalist would not be able to finance them in entirety without severely rationing his other . As a result, unless the venture 15 For a theoretical analysis of the control role of venture capital, see (1994), for an empirical analysis, see Gompers (1995). Volym D:34 Supplement 23 capitalist makes the firm easy for outsiders to finance – by establishing standardized management procedures and disclosure which make it easy for outsiders to understand, and exert control over, the firm – many of the growth opportunities the firm has access to will lapse. By contrast, if the venture capitalist does prepare the firm for outside control, and takes the firm public in an Initial Public Offering, the Net Present Value of future growth opportunities will be embedded in the stock price, and the venture capitalist will be amply rewarded for his endeavor through his stock holding. The incentives for the venture capitalist are clear, and it is obvious that the presence of an efficient and liquid stock market that can anticipate the firms future opportunities is crucial. Moreover, venture capital partnerships are structured with a limited life, which again serves as a commitment to let go of the firm. The need to exit via the market ensures that prices eventually do matter and discipline the investments that take place. Thus the incentives for innovation, the liquidity, and the price discipline provided by the market are combined through the venture capitalist with many of the benefits of control and long horizons provided by the relationship based system.17 A number of countries have tried to seed the process of venture capital, with the hope of emulating the successes of . Often, this takes the form of making available a fund targeted at high- tech industries, presumably based on the idea that the government can bear risks that private investors may be reluctant to bear. The discussion above points to three other barriers to the emergence of venture capital, all of which may be more important than risk aversion in explaining why private capital does not come forth. First, there should exist industries with a sufficiently high potential growth rate to make venture capital effective – high tech, by itself, is not enough. Second, venture capitalists should possess the rare combination of financial expertise in discerning viable projects from non-viable projects, as well as the managerial expertise in making emerging firms bureaucratized and capable of being controlled without killing their innovative spirit. Third, an outside 16It may not be necessary for the market to be domestic. If domestic accounting practices and corporate governance are adequate, it may be possible for a foreign market to serve as the liquid exit market for venture capitalists. A case in point is Israeli high tech firms that have been choosing the for their Initial Public Offerings. However, may be a special case. 17It is interesting that German banks were performing a similar role to venture capital around the turn of the century, and German public markets were vibrant, Calomiris (1994). It would be useful to understand what changed. , Industrial Structure, and Growth Volym D:35 equity market should exist which is capable of reflecting the venture capitalists contribution in the firm stock price when the firm is taken public (see and Gilson (1998) for an early exposition on the market being an essential exit route for venture capitalists). Simply putting traditional bankers in charge of a pool of funds targeted at high tech firms without giving them hands on experience in an existing venture market, and without creating a vibrant equity market for new issues, will most likely doom official venture capital efforts to failure. In sum, relationship based systems can work very well in the early stages of industrialization where the industries to be financed are physical asset intensive, where the legal system is ineffective, and where skill based or idea based industries are of limited import. But as economies develop and focus more on knowledge intensive industries as engines for growth, a hybrid is perhaps more effective. There is then the need to improve transparency, judicial efficiency, and mechanisms for speedy resolution of financial distress so that arms length markets can function effectively and aid the process of economic growth. Volym D:36 Supplement 23 In the current economic situation where is ascendant while is mired in bad loans, it is tempting to conclude that the arms length system dominates other forms. We believe that is a misreading of the evidence. The does not have a purely arms length system, and even so, to conclude that the system is optimal is probably as wrong as the conclusion in the late 1980s that the Japanese relationship based system was worthy of emulation in its entirety. Nevertheless, if there is one thing the arms length can do better than the relationship system, it is to bear and manage macro-economic risk. Let us understand why. 3.1Why a relationship based system is more risky We have already argued that assets financed by relationship based systems tend to be illiquid since there is transparency and disclosure. and (1998) argue that intermediaries can finance such assets at low cost only by issuing a high proportion of demandable claims. Intuitively, intermediaries in relationship based systems finance assets that only they understand. The only reason that they do not absorb a massive amount of rents as a result of their monopoly position is because they credibly commit to pay out collections to depositors. This requires them to issue hard claims – the hardest being demandable claims subject to runs. Thus in the natural course of financing illiquid relationship assets, financial intermediaries have to take on financial risk. Risk can be mitigated if the intermediation system is well capitalized because capital acts as a buffer. Given the low levels of private capital in emerging economies, historically, the government has created capital for intermediaries by the rates intermediaries pay investors low. This has become infeasible as deregulation and competition has given investors more choice. Consequently, the task of averting the collapse of the system of intermediation in the face of severe macroeconomic volatility has shifted directly to the government. Governments have had to absorb risk by promising the intermediation system capital, implicitly , Industrial Structure, and Growth Volym D:37 or explicitly, in case the system is in danger. But the promise of such contingent capital with it the risk that intermediaries will collectively attempt to game the system through moral hazard. In other words, illiquid assets can only be financed by financially fragile intermediaries, who then impose risk on the system. To reduce risk, the government has to promise intermediaries contingent capital, which in turn causes them to bet on the same risks such as real estate or emerging market lending, knowing fully well that they will be rescued if only they sink together. Moreover, once a relationship based system suffers a severe shock that the government is not able to counter, the flow of credit can collapse quickly. This is because, first, there is a lot of specific knowledge and trust embedded in relationships that cannot be transferred to wealthy unaffected outsiders. The illiquidity of the relationships prevents a quick takeover by, say, foreigners. Second, since property rights are not well established in relationships, it becomes hard to separate healthy unaffected parties from the walking dead. The inefficiency of the judicial system does not help. As a result, the relationship based system tends to share the consequences of an adverse shock somewhat indiscriminately. So, it is no wonder that outside capital does not flow in until the system essentially sorts itself out. Contrast this with the arms length system where the accent is on providing small investors the confidence to invest directly in firms. Clearly, such a system is better able to withstand shock, first, because the healthy can be distinguished from the terminally ill after a shock and can be dealt with differently and, second, because unaffected outsiders have the ability to invest and revive the system, as they obtain confidence from the very same channels that inspire confidence in small investors.18 3.2How to reduce risk in a relationship based system We have argued that elements of both relationships and arms length financing are needed in the modern economy. Moreover, a combination of both may serve to reduce the risk of a financial meltdown. 18 This is not to say that markets do not seize up on particular firms. In fact, many banks advertise their relationship business as a port of safe haven for firms affected by a market storm. Nevertheless, we think it highly unusual for all world markets to be irrationally down on an entire country. Volym D:38 Supplement 23 the economy is more primitive so that arms length financing is not possible? As (1999) shows, the growth of the intermediary sector is correlated with an improvement in creditor rights and contract enforcement. Thus the reliance on relationships, even within the intermediated sector, can diminish as contracting improve. But what if a country urgently needs to reduce risk? Perhaps the quickest, but politically most difficult, way of reducing the aggregate risk of the intermediated sector is to allow massive entry of foreign intermediaries. Using bank level data across a broad cross-section of countries, Demirguc-Kunt, , and Min (1998) show that the extent of foreign bank participation in a domestic economy (as measured by foreign bank assets to total domestic banking assets or the number of foreign banks to total banks) is negatively related to the probability of a financial crisis in that country. What could explain these findings? Clearly, foreign banks may influence local supervisory or risk management practices, as also local bank efficiency. But they could have other spillover effects. Specifically, foreign banks, because of their vast outside resources, will survive a local crisis. Not only does this give them incentive to herd on the same risks as local banks, it also gives the government confidence that a financial crisis will not result in a total meltdown. As a result, the government will be less eager to bail out failed local banks. Moreover, the foreign banks offer an avenue for foreign investors to invest in the local economy despite the absence of safeguards necessary for arms length investing, thus shortening the duration of a purely financial crisis. But taken together, perhaps the most salutary effect is on domestic bank incentives. Knowing that the government will be more reluctant to bail them out, they will be more careful about herding on certain systematic risks. Of course, foreign banks come with their problems including the fact that they are impervious to domestic political compulsions (often a blessing) and they are hard for domestic central banks to control (ditto). We do not believe that emerging markets should unquestioningly open their doors to all forms of foreign capital. In the absence of well developed markets or foreign intermediaries, foreign capital inflows other than foreign direct investment have to be intermediated into the domestic economy by the domestic banking system. Since foreign capital demands substantial safeguards such as implicit or explicit seniority, and a short maturity, in return for putting money in a relatively opaque system, this simply adds another dimension of risk to the domestic banking system. If inflows are large, there is the risk of a rational large scale search for the exits, if the system is shocked (for example, by , Industrial Structure, and Growth Volym D:39 and Zingales (1998c) and and (1999) explain why such inflows could have contributed to the Asian financial crisis.