FINANCIAL STABILITY
I turn now to the principles that should underlie reforms to deal with the weaknesses exposed by the crisis, while preserving, and if possible enhancing, the unique contribution that finance can make to material well-being. These principles should apply not only to the current environment, but to the financial and economic landscape as it may evolve over time. Inparticular, they should be consistent with an increasingly integrated world economy, in which national borders play a smaller and smaller role in the organisation of economic activity. They should also be consistent with a world in which reconciling the financing needs of governments with the availability of credit to the market economy is almost certain, unfortunately, to be a continuing challenge. I will group my remarks under six headings: (i) the problem of “too big to fail”;
(ii) capital and liquidity standards at financial institutions;
(iii) systemic instability and pro-cyclicality;
(iv) improving efficiency of capital markets;
(v) infrastructure; and
(vi) the role of public sector interventionThe existence of institutions that are perceived as too big (or too important) to be allowed to fail can enhance the incentives to socially undesirable risk-taking. As a result, economic distortions are created while such institutions are active, and a potential charge on taxpayers arises when they run into difficulties. Prudently managed and successful enterprises are penalised by comparison. It should not be difficult to agree on the principle that all institutions in a competitive market economy should face the threat of failure as a result of bad business judgment. Indeed it will not be possible to say that a financial system is fit for its 21st century purpose until the anomaly of “too big to fail” is removed. To make the threat of failure credible, however, it must be possible for all financial institutions, no matter how large or complex, to be sold, merged or wound down without creating unacceptable risk to the broader economy. This is not the case at the moment. Standard bankruptcy procedures are not well-suited for financial institutions. A financial institution cannot function in bankruptcy in the same way as a commercial enterprise. It cannot obtain temporary protection from its creditors, because access by creditors is its raison d’être. Moreover, large financial institutions play such a pivotal role in their respective economies, that governments may be reluctant to accept the consequences of their failure. There are, in my view, four key prerequisites of an acceptable regime that maintains market discipline while permitting the orderly winding down of a failing institution:
(i) imposing losses on stakeholders that are predictable and consistent with the avoidance of moral hazard;
(ii) avoiding significant damage to “innocent bystanders”, especially when this would provoke a loss of confidence in otherwise sound financial institutions;
(iii) minimising the ultimate costs borne by taxpayers; and
(iv) sharing equitably across countries the residual burden of resolving troubled institutions that have international operations. To meet these prerequisites, a specialised resolution regime for large financial institutions needs to be developed. What is important in this connection is not only that there is a regime
CONTRIBUTION OF FINANCIAL SECTOR
In the wake of the recent crisis, it is perhaps not surprising that many have focused on the capacity of the financial sector, and banks in particular, to impose negative externalities on the rest of the economy (Haldane, 2010). Such negative externalities encompass both the direct fiscal costs of supporting financial institutions at risk of failure, and the indirect costs from the recessions that almost invariably accompany large-scale financial distress. If costly crises are seen as the financial sector’s main impact on the rest of the economy, it follows that more or less any actions to limit risk-taking by financial institutions can be justified. In fact, of course, a well-functioning financial system plays an essential role in generating high levels of saving, promoting the efficient allocation of investment, and smoothing economic fluctuations stemming from non-financial causes.
By facilitating informed risk-taking, it is a key element in achieving optimal levels of productivity growth, and rising living standards. The importance of this contribution can be seen in the divergence in economic performance between countries with open and those with repressed financial systems (Caprio and Honohan, 2001). Such a comparison suggests that the contribution of finance to economic performance should be measured by the enhancement of total factor productivity to which the financial system gives rise. It is, however, extraordinarily difficult to quantify this, and to disentangle the individual contributions made by different aspects of the financial system. Still, this does not prevent identifying some of the ways in which the effectiveness of the financial sector is likely to be related to economic performance.
The first, and least controversial, is in the provision of a payment system. No market economy can function without a payment system, and it has long been accepted that banks are the most efficient way of providing this. Some have tended to see this function of the banking system as uniquely important, and the only one that needs to be protected by public policy intervention. This is the fundamental starting point of the “narrow banking” school, whose advocates argue that if the payment mechanism is fully protected, there is no special public interest in how the rest of the financial system is organised.
Insulating the payment system, however, does not by itself guarantee either the stability or the efficiency of the credit supply mechanism. Typically, it is interruptions in credit supply that transmit financial stress to the real economy. And it is inefficiencies in credit allocation that hold economies back from achieving optimal growth. Bubbles and their subsequent bursting are the most obvious manifestation of this. But more than just being a channel for credit intermediation and making payments, the financial system adds value in at least three other substantive ways. First, by converting illiquid and uncertain claims into liabilities that better match the asset-holding preferences of savers, a financial system can both add to the liquidity of non-financial sectors, and increase the overall level of saving within an economy. Maturity transformation is a key way in which the financial system adds value to the rest of the economy, but, as we have seen in the recent crisis, the leverage with which it is typically associated can also be a major source of vulnerability.
In designing a financial system for the 21st century, therefore, we should seek to preserve the benefits of maturity transformation for users of financial services, while at the same time making the system robust to a unexpected erosion of liquidity, caused for example by sudden loss of confidence. Second, and perhaps most important, the financial system is the basic way in which an exchange economy deals with problems of asymmetric information. The extension of credit from ultimate lenders to ultimate borrowers is rife with asymmetric information. Before a loan is made, adverse selection results from the fact that a potential borrower has better information than a potential lender about the risks and returns from an investment.
The growth of a financial system is the social mechanism for overcoming problems of asymmetric information and thus permitting a higher level of utility-enhancing exchange. A bank or other intermediary interposes itself between ultimate borrowers and ultimate lenders who would otherwise be discouraged from contracting by asymmetric information. The financial intermediary does this by putting its own capital at risk. Its incentive to do so is the spread it makes between borrowing and lending rates. Its ability to do so comes from the specialised resources it can apply, as a “delegated monitor” (Diamond, 1984), to assess credit risks, and to enforce restrictions on borrower behaviour. A financial institution can survive and prosper if the value of the additional information it generates exceeds its cost, and if it is able to derive private value from this information. The interposition of a financial intermediary is not the only way of transforming maturities, or generating information on creditworthiness. Securities markets can perform a similar function. Just as with banks, however, the effectiveness of securities markets relies on the availability of high-quality information. Also like banks, information will only become available if those that generate it are compensated for the costs of doing so. In securities markets, however, information provision can be impeded by “free rider” problems, about which I will have more to say later. And although specialised information providers, such as the accounting profession and rating agencies, attest to valuations and creditworthiness, they can be subject to conflicts of interest, as we have seen. Moreover, excessive reliance on external information providers can nurture “herding” behaviour. A central role therefore remains for the proprietary activities of trading entities, whose individual views combine to reveal a fair market price. Having a multiplicity of strong institutions making continuous prices is an essential component of efficient capital markets. A third way in which the financial system can promote high-quality growth is by providing a means of hedging against some of the uncertainties of investment.
We know that physical loss insurance is a necessary backstop for virtually all real economic activity. Without such insurance, uncertainty would result in a reduction in productive investment and lower rates of economic growth. In addition, however, financial risks in high-value projects can be productively hedged through the use of derivative instruments. These include standardised products to cover interest and exchange rate risk, as well as the risk of commodity price fluctuations. They may also include customised structured products to cover more complex or idiosyncratic risk. It will be important that a reformed financial system does not place obstacles in the way of the appropriate use of instruments that reduce financial risk..
What Is a Financial System?
A financial system consists of institutional units and markets that interact, typically in a complex manner, for the purpose of mobilizing funds for investment and providing facilities, including payment systems, for the financing of commercial activity. The role of financial institutions within the system is primarily to intermediate between those that provide funds and those that need funds, and typically involves transforming and managing risk. Particularly for a deposit taker, this risk arises from its role in maturity transformation, where liabilities are typically short term (for example, demand deposits), while its assets have a longer maturity and are often liquidity (for example, loans). Financial markets provide a forum within which financial claims can be traded under established rules of conduct and can facilitate the management and transformation of risk.
Within a financial system, the role of deposit takers is central. They often provide a convenient location for the placement and borrowing of funds and, as such, are a source of liquid assets and funds to the rest of the economy. They also provide payments services that are relied upon by all other entities for the conduct of their business. Thus, failures of deposit takers can have a significant impact on the activities of all other financial and nonfinancial entities and on the confidence in, and the functioning of, the financial system as a whole. This makes the analysis of the health and soundness of deposit takers central to any assessment of financial system stability.
WHAT IS FINANCIAL CORPORATIONS?
The term “bank” is widely used to denote those financial institutions whose principal activity is to take deposits and on-lend or otherwise invest these funds on their own account. In many countries, “banks” are defined under banking or similar regulatory legislation for supervisory purposes. In the Guide, banks and other deposit takers (other than central banks) are included within an institutional sector that is known as “deposit takers.” Deposit takers are defined as those units that engage in financial intermediation as a principal activity—that is, channel funds from lenders to borrowers by intermediating between them through their own account.
• have liabilities in the form of deposits payable on demand, transferable by check, or otherwise used for making payments; or
• have liabilities in the form of instruments that may not be readily transferable, such as short-term certificates of deposit, but are close substitutes for deposits in mobilizing financial resources and are included in measures of money broadly defined.Commercial banks, which typically take deposits and are central to the payment system, fall under the definition of deposit takers. These banks, which participate in a common clearing system, may be known as deposit money corporations. Other types of institutions that may be covered by the definition include institutions described as savings banks (including trustee savings banks, as well as savings and loan associations); development banks; credit unions or cooperatives; investment banks; mortgage banks and building societies (where their particular specialization distinguishes them from commercial banks); and micro-finance institutions that take deposits. Government-controlled banks (for example, post office savings banks and rural or housing banks) are also deposit takers if they are institutional units separate from the government and they meet the definition of a deposit taker outlined . This list is not exhaustive, and classification as a deposit taker depends on the function of the corporation, and not on its name.
Within an economy, the definition of deposit takers should encompass a group of institutions that meet the definition of banks and similar institutions under banking or other legislation, because like the statistical definition for deposit takers, a common legal criterion for a bank is the taking of deposits. If some institutions are banks in a legal sense but not deposit takers as described above, in following the Guide they should still be classified as “deposit takers,” but in any associated description of the FSI data the status of these institutions should be explained, with some indication of their importance to the data disseminated.
DEBT VULNERABILITY PRIOR TO THE GREAT RECESSION
While remaining broadly stable between 2001 and 2004, corporate sector indebtedness rose markedly in the euro area and in many advanced economies in the years preceding the financial crisis, as documented . Such debt accumulation was primarily in the form of bank credit, while debt issuance remained broadly stable. As is often the case, such a build-up of bank credit was preceded by, or went together with, a process of financial innovation in the banking industry.This process was characterised by a rapid expansion of securitisation and increasing reliance on market-based funding, which allowed banks to offload risk and increase their leverage.
At the same time, the heterogeneous pattern across euro area countries suggests that country-specific developments did play an important role in fuelling credit expansion and, hence, led to excessive debt levels. These excessive debt levels are illustrated in Chart for the year 2008 by means of three alternative indicators: the deviation from the historical average, from the euro area median, and from the long-term trend, as estimated by applying the Hodrick-Prescott filter.
As noted above, theoretical insights and narrative evidence on fi nancial crises characterise the expansionary phases preceding periods of financial instability as times of subdued uncertainty and low pricing of risk, in which there is a certain euphoria with regard to real and fi nancial asset prices, and over-optimism with regard to income and wealth prospects, which again fuels the provision of credit and investment. Some of these aspects appear to be confi rmed by evidence from the latest euro area fi nancial crisis.
In the years leading up to the crisis, volatility in financial markets was particularly subdued both domestically and internationally, by historical standards . The euro area implied stock and bond market volatilities plateaued at a low level between the end of 2004 and the beginning of 2007, before following a fl uctuating upward trend thereafter. Similarly, in the United States, the implied stock market volatility declined from mid-2002 to a historic low at the beginning of 2005, and remained broadly constant until the bubble burst.
US implied bond market volatility lagged stock market volatility. Such subdued fi nancial market volatility was accompanied by low-cost debt issuance for the euro area corporate sector; between 2005 and the second quarter of 2007, euro area corporate bond spreads remained, on average, at around basis points. This was substantially below the average of 100 basis points recorded between 2001 and 2004, and below the level prevailing during the fi nancial crisis
FIRMS’ FINANCING CONDITIONS, INDEBTEDNESS
How did financing conditions and debt patterns for the corporate sector interact with the macroeconomic environment, prior to and during the financial crisis? To what extent did this interaction add to instability? Has the corporate sector’s behavioural response to various shocks been a mitigating factor or a fiscal drag for the euro area economy during the financial crisis? In attempting to shed light on these issues, the assessment in this chapter is centered on two distinct, yet interrelated, parts.
In the relevance of the intermediation process in the banking system in determining the terms and conditions for corporate sector fi nancing is acknowledged. The emphasis is on economic activity in the broad sense and the fact that the latest financial crisis serves as a stark reminder of the importance of financing and credit frictions for investment decisions. Banks’ balance sheet and capital positions, and borrower credit risk are considered to be relevant supply-side factors in the provision of bank credit during the crisis. In particular, credit supply factors are found to account for almost one-third of the contraction in real GDP at the peak of the crisis.
At the same time, in such periods of tightening bank lending conditions, the substitutability of bank credit with alternative sources of financing (see Chapter 1) appears to have prevented an even more pronounced contraction in investment and, hence, in economic activity. More importantly, the ECB’s monetary policy has proved to be effective in containing any disorderly deleveraging of banks and thus in avoiding an even more abrupt credit crunch. The focus is primarily on the corporate sector’s debt cycle from a medium-term perspective. The latest euro area crisis is first contextualised with regard to broader international and historical crisis episodes. The result shows that the key aspect to understanding the severity of the crisis and future economic patterns is the particularly intense accumulation of debt in some euro area economies.
A number of economic factors played a role in the formation of such a debt overhang. Subdued uncertainty, widespread under-pricing of risk and loose financing conditions in some countries appear to have created a self-reinforcing feedback loop in which macroeconomic imbalances (in the form of excessive borrowing in the corporate sector and over-investment in selected euro area economies) built up. As predicted by theoretical insights and empirical evidence, the excessive rise in leverage sowed the seed for the financial crisis and conditioned the severity of the downturn; investment (and output) losses were generally commensurate with the intensity of corporate debt accumulation prior to the crisis.
Indebtedness ratios began to decline only later on in the recession, and the decline has been sharper in those euro area countries which had experienced intense debt accumulation in the run-up to the crisis. Nonetheless, there is significant heterogeneity across countries in terms of the level of indebtedness and also in the pace of deleveraging during the crisis. Further deleveraging of NFCs is expected in the future in the euro area, specifically in selected countries, as firms attempt to repair their balance sheet vulnerabilities. The extent to which the corrective adjustments represent a drag on the economy in the transition towards more sustainable debt levels depends primarily on the macroeconomic channels through which the adjustment process may occur. Reduction of indebtedness brought about by bank constraints on the provision of new credit or corporate decisions to scale back investments could prove to be very costly for the economy at large.
POLICY IMPLICATIONS
A quite striking observation to emerge from the empirical analysis is that in no country do securities markets contribute a large proportion of corporate sector financing. In some countries, the average net contribution was close to or less than zero. Equity markets are particularly deficient in this respect. That is not to say that equity markets do not perform an important function.
They may promote allocative efficiency by providing prices that guide the allocation of resources or productive efficiency through reallocating existing resources via, for example, the takeover process. But in terms of aggregate corporate sector funding, their function appears limited. Instead, a majority of external finance comes from banks. Why? Neither transaction costs nor taxation were found to provide adequate descriptions of corporate financing patterns in different countries.
One interpretation for the preponderance of bank finance is that financial intermediaries perform a central function in diminishing one of the most serious deficiencies of financial markets: asymmetries in information. According to this view, banks play an important role in collecting and processing information that markets are unable to do or can do only at high cost. There is almost certainly a large element of truth in this story.
But the analysis of the section 12.3 suggested that imperfect information is not an adequate description on its own. Information gathering can be quite effectively performed by institutions other than banks. Furthermore, the distinguishing feature of banks in different countries does not appear to be the nature of or the way in which they collect information. Instead, it is the extent to which and the form in which institutions influence the activities of firms that appear to show marked variations across institutions and countries.
Is control direct in the form of representation on the boards offirms or indirect in the form of takeovers? Do financial institutions or individual shareholders initiate changes in control? How easy is it to form coalitions of shareholders or bond holders and how serious are free-rider problems of control? The analysis in the previous section suggested that control theories provide a good basis for understanding the 10 stylized observations of this paper. They emphasize the managerial functions of financial institutions and suggest that the central role of banks comes from their ability to intervene and take control at comparatively low cost.
If this is right, then the implication of both the empirical observation of a preponderance of external finance coming from banks and control models of corporate finance is that banks may be superior to markets in promoting economic development and growth.
This may be particularly true in the early stages of development of both economies and firms before reputations have been established and adequate incentives exist to bring borrowers' and lenders' interests into line. In the longer term intermediaries may be less central to the development of firms.13 But in the early stages of the growth of firms and economies an efficient banking system may be an essential requirement for expansion.
TAXATION
The first point to note about taxation is that in virtually every country of this study (with the possible exception of Finland) debt finance has been favored over equity. This stands in marked contrast to the universal preference for equity finance (including retentions) over debt finance. More generally, in records a poor relation between tax incentives to employ different forms of finance in the eight countries of the study and actual financing proportions. On the left-hand side, table ranks the tax incentive to use debt in preference to retentions, new equity issues in preference to retentions and new equity in preference to debt. Countries at the top have the highest incentive to use the first form of finance in each case. On the right-hand side, it reports actual financing proportions of this paper.
The most striking country in the first Germany, which has the highest incentive to use debt in relation to retentions and the second lowest use of debt relative to retentions. The United Kingdom has the lowest debt-to-retentions ratio and the third highest tax incentive. The picture is not very much better for the ratio of new equity to retentions where Germany now has the third lowest new equity proportion and the highest incentive and the United Kingdom still has the lowest proportion and the fourth highest incentive. It might be objected that comparisons of internal and external financing proportions and incentives are distorted by transaction costs and investment requirements.
The third part of the table may therefore be regarded as more instructive. There the most striking case is Finland, which has the highest incentive to use new equity in preference to debt and the second lowest proportion.
There are several objections that can be raised against this type of comparison. There are well-known problems in comparing tax incentives across countries. The figures on which are based come from an OECD extension of the King-Fullerton (1984) study. These derive tax incentives created by both corporate and personal taxation on the basis of a Modigliani and Miller (as against a Miller) equilibrium model of the economy.
They do not 322 Colin Mayer take account of cross-border tax incentives to locate, finance, and invest in different countries, and they have been found to be very sensitive to respecifications of the model. In addition, the tax incentives in the OECD study relate to investment in equipment, not structures, and tax-exempt institutions, not households. In fact, the ranking of incentives is virtually identical for structures and equipment but is sensitive to the assumed tax rate of investors.
Finally, the tax incentives refer to one year, 1983, while the financing proportions are averages over the period of the study, 1970-85. Averaging over the period 1982-84 revealed that the ranking of external to internal financing proportions is similar around the date of measurement of tax incentives. Despite all these possible sources of inaccuracy, there would have to be a remarkable level of mismeasurement for taxation to provide a credible explanation for observed financing proportions.
FINANCING INDUSTRIES
There are two sources of information available for studies of aggregate corporate financing patterns in different countries. The first is national flow-of funds statements. These are records of flows between different sectors of an economy and between domestic and overseas residents. The relevant statement for this exercise is flows to and from nonfinancial enterprises. The second source is company accounts. These are constructed on an individual firm basis but are often aggregated or extrapolated to industry or economy levels. Both sources have their merits and deficiencies. In theory, flow-of-funds statistics provide a comprehensive coverage of transactions between sectors. Company accounts are only available for a sample, often quite small, of a country's total corporate sector. However, the data that are employed in company accounts are usually more reliable than flow-of-funds. As Appendix A describes, flow-of-funds are constructed from a variety of different sources that are rarely consistent. As a consequence, statistical adjustments are required to reconcile entries. As described in Mayer (1987, 1988) and Appendix B to this paper, the methodology employed in the Centre for Economic Policy Research Study of the Financing of Industry differs in several respects from that used by previous researchers. Greater emphasis is placed on flows of finance instead of stocks. Figures are recorded on a net (of accumulation of equivalent financial assets) as well as a gross funding basis. Financing proportions are aggregated over different time periods using a weighted as well as a simple average of individual years' proportions. Appendix B argues that these procedures achieve a greater degree of international comparability than has been available hitherto. In report weighted and unweighted average financing proportions for the five countries of the international study (France, Germany, Japan, the United Kingdom, and the United States) and for Canada, Finland, and Italy using flow-of-funds statistics. In reports unweighted averages of net financing as a proportion of capital expenditures and stock building. Table 12.2 shows weighted averages of net financing using straight line depreciation over 16 years from 1970 to 1985. Table 12.3 records unweighted averages of gross financing as a proportion of total sources of finance.2 The weighted and unweighted averages are similar.
The United Kingdom has the highest proportion of retentions (107% excluding public enterprises, 97% including public enterprises on a weighted net financing basis). Italy has the lowest, but, even here, over half of investment in physical assets and stocks is funded from retentions. This is not just a consequence of the procedure of netting uses of finance from sources. Even on a gross basis U.K. corporations obtain just over 70% of their total sources from retentions and U.S. corporations just under 70%.
the United Kingdom are not merely a consequence of low industrial growth. Two relatively high growth industrial sectors (chemicals and allied firms, and electrical engineering) recorded financing proportions that were equal to or in excess of those in other industries . However, there are marked differences in financing proportions of different size of firms within industries. Since 1977, the U.K. Department of Trade and Industry has categorized firms by two size groups:
(1) large
(2) medium and small companies.below records the following:
Small- and medium-sized firms are considerably more reliant on external finance than large firms. A smaller proportion of small- than large-company finance comes from securities markets. Confirmation for the greater role of banks in small company financing comes from an examination of stock as well as flow proportions in table .
FINANCIAL SYSTEM & CORPORATE FINANCE
Over the past decade there has been increasing interest in the role of institutions in the financial and real activities of the corporate sector. That interest is most clearly reflected in the plethora of models on imperfect information that have recently appeared in the finance literature. Several attempts have been or are currently being made to establish the empirical significance of these models for the financial behavior of firms.
This volume reports the results of a number of such studies. However, a majority of this work is confined to one country, namely the United States, and examines only a small segment of a country's total financial system at any one time. It is therefore difficult to judge the broader significance of these models for the overall functioning of a financial system and to determine the extent to which they are relevant to different countries. It is well known that there are significant variations in the structure of different countries' financial systems.
Since Marshall there has been much discussion about the role of banks in the German financial system. Schumpeter, Gerschenkron, and Cameron all pointed to banks as an engine of growth of the German economy. More recently, similar consideration has been given to the role of banks in the Japanese economy and contrasts have been drawn Colin Mayer is professor of corporate finance at City University Business School in London and codirector of the Centre for Economic Policy Research's program in applied microeconomics.
This paper is part of the Centre for Economic Policy Research's "International Study of the Financing of Industry." The CEPR study is being financed by the Anglo-German Foundation, the Bank of England, the Commission of the European Communities, the Economic and Social Research Council, the Esmee-Fairbairn Charitable Trust, the Japan Foundation, and the Nuffield Foundation. This paper was presented at the NBER Conference, "Information, Capital Markets and Investment Conference," Boston, May 1989. The author is grateful to conference participants for their comments, and especially to Roger Farmer and Glenn Hubbard. Ian Alexander provided excellent research assistance. 307 308 Colin Mayer between the importance of banks and securities markets in Japanese and Anglo-Saxon financial systems, respectively.1 Prima facie, banking systems would be expected to avoid some of the information deficiencies associated with securities markets.
A primary rationale for the existence of banks is that they perform screening and monitoring functions that individual investors can only undertake at high cost. Resource allocation, credit availability, and terms of loans may all, therefore, be superior under a bank-based than a market financial system. On the other hand, transaction costs may be lower in the absence of intermediation, and taxation may militate in favor of market-based sources of capital. There are then several factors that finance theory suggests should influence the financing patterns of different countries' corporate sectors. The purpose of this paper is to compare the industry financing of eight developed countries and to evaluate these patterns in the context of alternative theories of corporate finance. International comparison of the financing of industry is a familiar subject.
However, it is probably fair to say that, to date, it has only shed limited light on the functioning of different financial systems. In large part this is due to the unreliability of the underlying data. There are, for example, well-known problems associated with international comparisons of corporate sector gearing: the valuation of assets, the treatment of reserves and goodwill, and the double counting of intrasector flows all present serious difficulties. The extent to which such inconsistencies can be overcome by ad hoc corrections is questionable. One justification for a reexamination of this subject at this time is that more reliable methods of comparison have been developed that overcome many of the problems that have afflicted previous studies.
Problems remain but the degree of comparability reported in this paper is almost certainly greater than that of previous studies and probably about as great as existing data allow the researcher to achieve at an aggregate level. The results suggest 10 stylized facts about corporate finance. These concern forms of finance in different countries and the relation between different forms of finance over time. The stylized observations are reported . In alternative theories of corporate finance are discussed, and their relevance to explaining the observed financing patterns is considered. This is not supposed to be a test of alternative theories, merely an examination of the extent to which they are consistent with aggregate financing patterns in different countries.
Theory and observation bear directly on many of the issues that have been central to policy debates about financial systems. In particular, there is currently much discussion about the relative merits of banks and markets for promoting economic growth. As noted above, banks have traditionally been regarded as central to the promotion of economic growth. More recently, disillusionment with the role of banks in developing countries has intensified in the face of widespread corruption and bank failures. The World Bank (1989) 309 Financial Systems, Corporate Finance, and Economic Development has, as a consequence, advocated the use of both securities markets and banks in promoting economic growth. Likewise, as the emergence of a unified market in 1992 promises to create a high degree of homogeneity across the financial systems of member states, the strengths and weaknesses of different financial systems have been brought to the fore of policy discussions. considers the implications of both empirical observations and theoretical models for the relative merits of securities markets and banks in promoting economic growth.
