The
Industrial Organization of Banking and Financial Markets in Europe
Training and Mobility of
Researchers Network
Research
During the period March 2001 to February 2002, members of the CEPR and IAE-CSIC nodes have continued working on some of the ongoing projects and have started working on new ones.
The role of competition in banking in the context of a transforming sector has been evaluated by Vives (CEPR, 2001). He used industrial organization and modern financial intermediation analysis to study the relationships between the level of competition, risk-taking incentives, and the regulatory frame. The consequences for market structure of the liberalization process and the need for competition policy in the sector have been highlighted.
It is widely recognised that the regulatory capacity of domestic authorities is usually very limited, especially in LDC’s. Discipline may sometimes come from abroad. Vives (forthcoming) and Gale and Vives (forthcoming) examine the costs and benefits of external discipline (dollarization, foreign short-term debt) from the point of view of the stability of the financial system of an emergent LDC economy. External discipline solves the time-inconsistency problem of central bank policy to help banks in trouble but at the cost of excessive liquidation of projects. These results can be applied to assess the desirability of dollarization in a range of countries and the potential role of the IMF as International LOLR.
Some forms of banking regulation are implicit taxes. Other forms of explicit taxation interact with various forms of regulation. This is the case, for instance, with capital income taxation and banks’ solvency requirements. Caminal (IAE-CSIC, 2002) develops a model of financial intermediation to analyse the impact of various forms of taxation. The model considers in a unified framework various functions of banks: monitoring, transaction services and asset transformation. The analysis focuses on: (i) competition between banks and alternative financial arrangements (investment funds and organised security markets), (ii) regulation, and (iii) banks' monopoly power and risk taking behaviour.
In the corporate government literature it is common to portray stakeholders and managers as “natural allies,'' arguing that shareholders and stakeholders may as well form an implicit alliance, to the extent that they both have a common interest in favouring a more efficient management. Cespa and Cestone (Young Researcher, IAE-CSIC) (2002) challenge this view and propose a theoretical model where stakeholders (environmentalists) may actively interfere in corporate life, while managerial decisions are subject to corporate governance and environmental rules. It is shown that while, for given sets of rules, stakeholders may side with incumbent managers to form ex-post alliances, under some conditions stakeholders and small shareholders may both benefit when ex ante tighter corporate governance rules and tighter pro-stakeholder rules are imposed on firms. This result can help understand who benefits from a legal stakeholder protection as opposed to a vague managerial mandate to keep an eye on stakeholder welfare. It can also rationalise recent pressures by shareholder activists towards an institutionalisation of social objectives, as an attempt to deprive managers of the monopoly of relationships with social and environmental activists.
Fabbri (Young Researcher, IAE-CSIC) (2002a) analysed the relation between the quality of judicial enforcement and the allocation of credit to households at a theoretical and empirical level. The theoretical part provides a simple model that outlines two main effects through which the allocation of credit is affected by the working of the judicial system: a minimum collateral requirement, which affects the probability to be liquidity constrained and the price of credit, which affects the equilibrium debt amount. In the empirical part, she tested the theoretical predictions using Italian data and finds that the working of justice affects the probability of being credit constrained: moving from low-costs to high-costs judicial districts increase the probability of being credit constrained by around 35%. Moreover, the amount of debt of non-rationed households decreases if the quality of judicial enforcement worsen in the area of residence. The magnitude of this second ranges from 22% to 70%.
In addition, Fabbri (2002b) investigated the interaction between legal institutions and financial arrangements and the effects that these have on corporate decisions and aggregate activity, both theoretically and empirically. She has developed a two-country general equilibrium model with overlapping generations and asymmetric information in the credit market. She showed that firms located in the country providing tighter legal enforcement to the creditors’ rights receive a larger amount of external finance at a lower price and have a larger size. She also finds that the leverage ratio is independent of the quality of legal institutions. At the aggregate level, countries with higher creditors’ protection enjoy a larger aggregate output level and a bigger capital stock. In the empirical part, she provides evidence that confirms the theoretical predictions by using new data sets at firm and regional level for Spain and Italy.
The Salerno team looked at the extent to which banks exchange their private information about about borrowers’ characteristics and their indebtedness which is an often-neglected determinant of the degree of credit market competition. This lacuna was partly filled by Marco Pagano and Tullio Jappelli in a number of papers. Jappelli and Pagano (2001) pointed out that banks’ information-sharing activity can have four effects on their lending policies. First, it improves the banks’ knowledge of applicants’ characteristics and permits a more accurate prediction of their repayment probabilities. Second, it increases the degree of competition in the credit market and thereby reduces the informational rents that banks could otherwise extract from their customers. Third, it can operate as a borrower discipline device. Finally, it eliminates borrowers’ incentive to become over-indebted by drawing credit simultaneously from many banks without any of them realising. At the empirical level, these theories predict that information sharing arrangements can increase lending and reduce default rates.
To test these predictions, Jappelli and Pagano (forthcoming) have constructed a new international data set on private credit bureaus and public credit registers. They have found that indeed bank lending is higher and proxies for default rates are lower in countries where lenders share information, regardless of the private or public nature of the information sharing mechanism. They also found that public intervention is more likely where private arrangements have not arisen spontaneously and creditor rights are poorly protected. Jappelli and Pagano (2002) use the operation of credit bureaux and public credit registers in Europe to extract potential lessons for upgrading credit registers in other countries. The European experience highlights a set of important issues. First, European privacy protection laws affect greatly the amount and type of information shared between lenders. Second, credit bureaux tend to originate from local lenders. Third, in Europe as elsewhere there are powerful forces pushing towards consolidation of the credit bureaux industry. While this process reflects the "natural monopoly" feature of the industry, its pace has been accelerated by technological factors and, especially within Europe, by the increasing international integration of capital markets.
Many assume that the ongoing process of financial integration – within the borders of Europe as well as worldwide – is making geography irrelevant to financial markets. Indeed, as the regulatory barriers created by national jurisdictions are attenuated or disappear, some transaction costs disappear and this has very large consequences for financial markets, particularly for security markets. However, one of the key findings of several Network papers is that geography still tends to affect and shape financial markets, though in ways that are more subtle than in the past, especially via informational channels and agglomeration effects.
The increasing degree of capital market integration, partly arising from EMU, is one of the most impressive experiments in the effect that institutional barriers have on securities markets. However, geography is still far from irrelevant – not just in banking, where cross-border entry can be impeded by incumbent banks and by regulatory restrictions at the national level – but also in securities markets. Although these markets are increasingly integrated, it still matters where shares are listed. For instance, European public companies increasingly sought listings abroad in 1986-97.
Pagano, Roell (CEPR) and Zechner (CEPR) (2001) have documented that during this period European companies have become more ‘footloose’, and most of their foreign listings have been in the U.S. The listings by E.U. firms in U.S. exchanges have quadrupled (from 53 to 207). Conversely, the listings by US firms in E.U stock exchanges have decreased by one third (from 465 to 316). This development has occurred only since the mid-1980s. Before that date, the U.S. markets attracted very few foreign listings (in the NYSE these grew from 23 to 55 between 1956 and 1985), whereas foreign listings in London and German exchanges rose much between 1975 and 1985 (202 and 48, respectively), and also Paris, Vienna and Stockholm had relatively large increases (29, 11 and 7 respectively). The key issue then is to understand what triggered this “one-way transatlantic flow” of cross-listings after the mid-1980s.
Some indications come from the characteristics of the European companies listing abroad, and more particularly from the differential characteristics of those listing in the U.S. and those listing in other European countries. Large companies and firms that were recently privatised have a considerably higher probability of cross-listing both in the US and Europe. But aside from this, the characteristics of the European companies that list in the US are quite different from those of the companies that list within Europe. High-growth companies, with a large fraction of foreign sales and high-tech products, are likely to cross-list in the U.S. but not in Europe, whereas past profitability increases the probability to cross list in Europe but not in the U.S. – probably a reflection of the more stringent listing requirements of European exchanges. In short, the U.S. stock market attracted the most dynamic and international European companies.
This begs the question of which characteristics of the U.S. market may be responsible for this outcome: the size of the capital and product market, the expertise in analysing high-tech companies, the liquidity of the stock market, or the accounting standards and shareholder protection. To try and address this question at a more general level, Pagano, Randl (Young Researcher, Salerno), Roell and Zechner (both CEPR) (2001) examined which exchange or country characteristics attract cross-listings, using a sample of 13 European exchanges and 3 U.S. ones. They found that European companies are more likely to cross-list in exchanges with more liquid and larger markets, with a tendency to cluster by industry and in countries with better investor protection, more efficient courts and bureaucracy, and similar language and legal institutions. Therefore, at least part of the answer lies in international differences of the legal setting. This naturally leads to the related research area of ‘law and finance’, which currently is one of the hottest research areas in finance, and has received considerable attention from researchers based at Salerno (see for instance Lombardo and Pagano, 2002).
One of the key open issues at the borderline between banking and corporate finance is why we should have publicly designed bankruptcy procedures, and what is the optimal design of such procedures. In principle, one could let private contracting take care completely not only of the terms of financing contracts but also of the procedures to be used in case of default. Publicly designed and enforced bankruptcy rules are instead necessary if private contracting were to create inconsistent and competing claims in case of default, or in any event if private contracting were to result in inefficiencies.
Manove, Padilla (CEPR) and Pagano (2001) identified one inefficiency of private debtor-creditor contracting under perfect competition. Because of market imperfections in the banking industry, banks may screen their customers too little if they are able to secure strong protection via collateral. This may lead to market equilibria in which cheap credit is inappropriately emphasised over project screening. Restrictions on collateral requirements and the protection of debtors in bankruptcy may redress this imbalance and increase credit-market efficiency.
Goodhart (LSE), Schoenmaker (Ministry of Finance (NL)) and Dasgupta (LSE), used a database covering some 91 supervisory agencies in order to examine how important various skilled experts are in the regulatory process and the relative usage of different kinds of such experts. They aimed to explore what kind of perspective supervisors in different institutional settings may adopt: a macro-oriented perspective or a more micro-approach? The answer to this question is relevant, as there is evidence that any financial crises have been macro-induced.
It was concluded that central banks employ more economists and fewer lawyers in their supervisory/financial stability wing than non-central bank supervisory agencies. Also, there are significant economies of scale in financial supervision, though this can be measured by several alternative variables (e.g. the relative scale of bank intermediation). Finally, there do not appear to be major economies of scope. A more complex financial system with a well-developed stock market would need both more supervisors as well as more skilled ones.
Elena Carletti (LSE) investigated, in a simple model of overlapping moral hazard problems between banks and firms, how the number of bank relationships affect banks incentives to monitor their borrowers and how, in turn, these decisions affect loan rates and firms' choice between single and multiple relationships. Her analysis showed that multiple lenders monitor less than a single lender. This is because they face duplication of effort and sharing of benefits in monitoring. However, as a consequence of diseconomies of scale in monitoring, multiple lenders do not necessarily require a higher loan rate. The firms' choice between single and multiple relationships is not univocal, depending on the relative severity of bank moral hazard as compared to firm moral hazard.
Goodhart (LSE) in his work on Operational Risk, proposed a definition of such kind of risk and gave a critique of the Basel proposal for Operational Capital Requirement. He concluded that there is both, little focus or sensible basis for imposing a specific Operational Risk Capital Requirement. To reduce Operational Risk (especially fraud), it should be better to control the incentives (pay structure) than the Capital Ratio.
Jean-Charles Rochet (IDEI) and Xavier Vives (CEPR) looked at the classical doctrine of the Lender of Last Resort, elaborated by Thornton (1802) and Bagehot (1873), which asserts that the Central Bank should lend to “illiquid but solvent” banks under certain conditions. Several authors have argued that this view is now obsolete: when interbank markets are efficient, a solvent bank cannot be illiquid. Rochet and Vives provided a possible theoretical foundation for rescuing Bagehot’s view. Their theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. Instead they built a model of banks’ liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot find liquidity assistance in the market. They derived policy implications about banking regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort as well as on the disclosure of the Central Bank.
Danielson (LSE), Paul Embrechts (ETHZ), Goodhart, Keating (Finance Development Centre), Muenniech (LSE) and Hyun Song Shin (LSE) developed their response to the Basel II proposals. It is their view that the Basel Committee of Banking Supervision, in its Basel II proposals, has failed to address many of the key deficiencies of the global financial regulatory system and even created the potential for new sources of instability. They highlighted their concerns that the failure of the proposals to address key issues can have destabilising effects and thus harm the global financial system. In particular, there is considerable scope for under-estimation of financial risk, which may lead to complacency on the part of policy makers and insufficient understanding of the likelihood of a systematic crisis. Furthermore, it is unfortunate that the Basel Committee has not considered how financial institutions will react to the new regulations. Of special concern is how the proposed regulations would induce the harmonisation of investment decisions during the crises with the consequence of destabilising rather than stabilising the global financial system.
The LSE team also carried out studies in the field of Information disclosure and Value-at-risk. Hyun Song Shin looked at the subject of disclosure and asset returns. Public information to financial markets often arrives through the disclosures of interested parties who have a material interest in the reactions of the market to the new information. When the strategic interaction between the sender and the receiver is formalised as a disclosure game with verifiable reports, market prices observed in equilibrium can be given a simple characterisation that relies only on the face value of the announcement. Also, this characterisation predicts that the return variance following a bad outcome is higher than it would have been if he outcome were good. When investors are risk averse, this leads to negative serial correlation of asset returns.
Danielson, Hyun Song Shin and Zigrand produced a paper entitled “Asset Price Dynamics with Value-at-risk Constrained traders”. Risk management systems in current use treat the statistical relations governing asset returns as being exogenous, and attempt to estimate risk only by reference to historical data. These systems fail to take into account the feedback effect in which trading decisions impinge on prices. They investigated the consequences for asset price dynamics of the widespread adoption of such techniques and illustrated through simulations of a general equilibrium model that, as compared to the case when such techniques are not used, prices lower, have time paths with deeper and longer troughs, as well as a greater degree of estimated volatility. The magnitudes can sometimes be considerable. Far from promoting stability, widespread adoption of such techniques may have the perverse effect of exacerbating financial instability.
On the subject of Corporate Finance, Stephen Morris (Yale) and Hyun Song Shin (LSE) studied how creditors of a distressed borrower face a coordination problem. Even if the fundamentals are sound, fear of premature foreclosure by others may lead to pre-emptive actions, undermining the project. Recognition of this problem lies behind corporate bankruptcy provisions across the world, and it has been identified as a culprit in international financial crises, but has received scant attention from the literature on debt pricing. Without common knowledge of fundamentals, the incidence of failure is uniquely determined provided that private information is precise enough. This affords a way to price the coordination failure. There are two further conclusions. First, coordination is more difficult to sustain when fundamentals deteriorate. Thus, when fundamentals deteriorate, the onset of crisis can be very swift. Second, "transparency" in the sense of greater provision of information to the market does not generally mitigate the coordination problem.
David de Meza (University of Exeter) and David Webb (LSE) produced a paper on “Saving Eliminates Credit Rationing” in which they argued that equilibrium credit rationing, in the sense of Stiglitz and Weiss (1981), implies the borrower faces an infinite marginal cost of funds. Infinitesimally delaying the project to accumulate more wealth is therefore advantageous to the borrower. As a result, the well-known conditions for credit rationing cannot be satisfied.
Frederic Loss (Young Researcher, LSE), who was hired during this period, was involved in work studying risk management. His paper, ‘Hedging, Agency Costs and Corporate Size’, studied firms' hedging demand where hedging is used by managers to reduce agency costs between them and employees. It is shown that the manager's information on the employee's action is a determining factor of the firms' hedging demand. The less the manager's information on the employee's action, the higher is the firm's hedging demand. Therefore, when a merger between firms leads to a loss of information for the manager, the hedging demand of the merged firms is generally higher than the ones of the non-merged firms.
He also worked with Antoine Renucci (IDEI) on a paper which investigated a negative externality of new business creation. They showed that when being perceived as a good manager is a necessary condition to establish a firm in the future a priori talented managers may indulge in undertaking risky projects now. Indeed, such a choice renders more difficult the updating of believes process regarding their actual types. Unfortunately, this in turn leads them to perform less effort, which comes at the expense of economic efficiency. Hence, the career concerns we examine do not discipline good managers. However, they showed that employers can reduce managerial slack by resorting to financial markets monitoring.
In addition, Loss studied corporate risk management in a context with financial constraints and imperfect competition in the product market. He showed that the interactions between firms heavily affect their hedging demand. As a general rule, the firms' hedging demand decreases with the correlation between firms' internal funds and investment opportunities. Thus when the hedging demand of a firm is high in the case where investments are strategic substitutes, its hedging demand is low in the case where investments are strategic complements. He concluded by proposing another interpretation of his model in terms of technical choice.
The intertemporal CAPM predicts that an asset's price is equal to the expectation of the product of the asset's payoff and a representative consumer's intertemporal marginal rate of substitution. In their paper, Bengt Holmström (CEPR) and Jean Tirole (IDEI) developed an alternative approach to asset pricing based on corporations' desire to hoard liquidity to fulfil future cash needs. Their corporate finance approach to market finance suggests new determinants of asset prices such as the distribution of wealth within the corporate sector and between the corporate sector and the consumers. Also, leverage ratios, capital adequacy requirements, and the composition of savings affect the corporate demand for liquid assets and thereby interest rates. The paper first sets up a general model of corporate demand for liquid assets, and obtains an explicit formula for the associated liquidity premia. It then derives some implications of corporate liquidity demand for the equity premium puzzle, for the yield curve, and for the state‑contingent volatility of asset prices.
Tirole (2001) developed an economic analysis of the concept of shareholder value, describes its approach and discusses some open questions. It emphasises the relationship between pledgeable income, monitoring and control rights using a unifying and simple framework. His paper then provides a first and preliminary analysis of the concept of the stakeholder society. It investigates whether the managerial incentives and the control structure described in the first part can be modified so as to promote the stakeholder society. It shows that the implementation of the stakeholder society strikes three rocks: dearth of pledgeable income, deadlocks in decision‑making, and lack of clear mission for management. While it fares better than the stakeholder society on those three grounds, shareholder value generates biased decision‑making; the paper analyses the costs and benefits of various methods of protecting non-controlling stakeholders: covenants, exit options, flat claims, and enlarged fiduciary duty.
In the wake of recent twin currency‑banking crises, experts have expressed concern about a number of pervasive features in international lending: the strong debt bias, the liability dollarization, and the short maturities. This paper revisits the debate from a "dual‑and‑common agency" perspective. Its take is that, in private lending arrangements, the investors' prospect of recouping their investment depends on the behaviours of borrowers with whom they contract and of the borrowers' government, with whom they don't. This dual‑agency problem translates into a common agency one in which pair-wise optimal contracts exert externalities on each other through their impact on country incentives. Tirole (2001) first looked at whether and when countries borrow too much or too little in the aggregate. He then shifted his attention to structure issues and analysed whether and when equity portfolio investment, international portfolio diversification, domestic currency denomination and longer maturities enhance borrowing countries' access to international lending. His work thereby relates a country's level and quality of access to international capital markets to a variety of institutional features such as the level of domestic savings, their location (home vs abroad), the extent of control rights held by political authorities, and the interests of dominant domestic political forces.
In an earlier paper (1998) Holmström and Tirole offered a simple model of aggregate liquidity shortages. That paper argued that the government could play a useful role as an intermediary between consumers and firms to the extent that it can make commitments on behalf of (future) consumers. Publicly supplied liquidity, however, is costly due to tax distortions. Foreign investors may be in a better position to provide liquidity services, particularly when country shocks are idiosyncratic. They followed this up with a further study to explore how the introduction of a foreign supply of liquidity affects the earlier analysis of liquidity management. How should a country optimally make use of its limited access to foreign and domestic insurance opportunities? They showed that a country that is credit‑constrained will typically demand less than full insurance against aggregate shocks even if international investors find all its pledgeable income acceptable. Furthermore, when the country's income is not fully pledgeable to foreigners, domestic liquidity supply will remain an important source of insurance.
Roberta Dessi (Young Researcher, IDEI) examined how managers may be given incentives to exert effort, and to implement efficient implicit contracts with workers. Under certain assumptions, this can be achieved by tying managerial compensation to shareholder value. However, if reputation effects are weak, it is more efficient to adopt an incentive scheme in which the manager is punished by outside investor intervention when performance fallls below a critical level, and otherwise retains control, receiving a fixed reward. The required form of outside intervention can be implemented through a financial structure combining “hard” debt with a relatively dispersed ownership structure.
A large body of theoretical literature suggests that capital structure plays an important role as a managerial incentive mechanism. What of the evidence for the agency approach? Cross-sectional empirical studies have identified a positive effect of leverage on expected performance (measured by Q) for firms with low growth opportunities. However, this evidence does not take into account the endogeneity of capital structure decisions. In their paper, Dessi and Robertson (Cambridge) investigated the determinants of capital structure and performance, allowing for endogeneity and dynamics. Their results suggest that conclusions reached by previous studies which did not take into account the endogeneity issue should be treated with caution. Their main findings are consistent with the implications of agency models, where debt is chosen endogenously.
Dessi also looked at how new (capital-constrained) entrepreneurial firms should be financed. When active monitoring by a large investor is needed to induce efficient investment decisions, what is the optimal allocation of control rights and cashflow rights among entrepreneurs and different types of investor? She addressed these questions, taking into account the possible incentives for the entrepreneur and the large investor to collude and pursue private benefits at the expense of other investors and found that the threat of collusion has an important effect on contract design, and on financing constraints (hence aggregate investment). Under plausible assumptions, optimal (collusion-proof) contracts are consistent with several commonly observed characteristics of venture capital financing: (a) the use of convertible securities, (b) the separate allocation of control rights, (c) the practice of syndication.
Loic Sadoulet (Young Researcher, ECARES) examined a simple extension to existing credit contacts for the poor ("microfinance contracts"), that would allow financial institutions to provide repayment insurance to their clients. The proposed contract uses the repeated nature of loans to build credit records that borrowers in good standing can use to insure themselves against default in case of adverse income shocks. After documenting borrowers' desire for insurance using data from a microfinance program in Guatemala, he derived sufficient conditions for the proposed contract to reduce borrower vulnerability while improving repayment rates. These conditions are quite similar to those that credit-card and automobile-insurance companies seem to apply to deter moral hazard and adverse selection among their subscribers. He concluded with a discussion on why institutions lending to the poor may face particular implementation programs because of the history of past failures of credit programs for the poor.
The literature on political campaigns has thus far mainly focused on the positioning of parties. Little work has been done on how parties communicate their platform to the electorate. Yet, with the proliferation and fragmentation of the media outlets, "getting the message out" has become increasingly important and expensive. In a model in which parties divide their budget between "creative costs" (the costs of designing the political message) and "media costs" (costs of distributing the message), Sadoulet, together with David Soberman (INSEAD), examined how respective budget levels affect parties' advertising strategies during a political campaign, and how these affect their respective loci of electoral support. He used these results to investigate how the political landscape is affected by campaign spending limits.
With widely publicized high repayment rates, microfinance is gaining a great deal of attention. Using data from Guatemala, Sadoulet and Carpenter (Federal Reserve Board) examined risk matching in credit groups. The existing literature often assumed that joint-liability will lead groups to form homogeneously in risk, and that risk heterogeneity emerges only as a second-best. They found they do not, even accounting for matching frictions. Data on mutual help within groups provided evidence consistent with the hypothesis that group lending provided insurance among borrowers. This intra-group insurance suggests that current credit contracts can be improved by incorporating insurance provisions.
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