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Why does the structure of the financial system matter?

Speech to be delivered by Eugenio Domingo Solans Member of the Governing Council and of the Executive Board of the European Central Bank Seminar on financial structures sponsored by Caixa Galicia on the occasion of its 25th anniversary Santiago de Compostela 13 June 2003

Introduction

Ladies and Gentlemen,

It gives me great pleasure to address you today, and I should like to start by congratulating Caixa Galicia on its 25th anniversary. The famous American comedian Bob Hope once typified a bank as "a place that will lend you money if you can prove that you don't need it". As we all know, this description does not give credit to the extremely important role that banks - including, of course, savings banks - fulfil in a modern economy. Nowadays, economic life would simply not be possible without the wide range of services and products that banks offer to various sectors of society.

This is certainly also the case for the euro area, where banks have traditionally performed a very important role in channelling funds from savers to borrowers. Indeed, bank lending has been - and is still - the most important single source of finance for both enterprises and households in the euro area. However, other sources of finance, such as stocks and debt securities, have also achieved significant roles. Since the introduction of the euro and the start of the single monetary policy in January 1999, the integration of financial markets in the euro area has progressed considerably, resulting in deeper and broader markets for financial services. The most prominent examples are the integration of the money market, the explosive growth of the euro-denominated corporate debt market and a wave of consolidation among financial intermediaries and stock exchanges. These are very fundamental changes which, in my view, will undoubtedly promote further competitive forces and enhance the efficiency of financial markets in Europe.

All of these developments have significant repercussions for the financial structure of the euro area, which can be defined as the whole framework of financial markets, financial instruments and financial institutions in a given place at a given point in time. Today, I shall examine why the structure of the financial system matters. I shall firstly discuss what the existing literature tells us on this, and how finance and monetary theories have given us an insight into the specific role and functions of the financial structure for an economic system and economic development. Then, I shall look more at the policy implications of developments in the financial structure, in particular with regard to monetary policy and financial stability concerns. Finally, I shall conclude by presenting some lessons for the future.

Finance, the financial structure and the financial system

The former Vice Chairman of the Federal Reserve Board and current economics professor Alan Blinder once remarked that "having looked at monetary policy from both sides now, I can testify that central banking in practice is as much art as science. Nonetheless, while practising this dark art, I have always found the science quite useful".

Following this theory, I shall now discuss some developments in the science of economics, in particular theories on corporate finance, which are relevant for understanding the financial structure as well.

For the European Central Bank (ECB), theories on corporate finance are important for a number of reasons. First, insights into the determinants of corporate finance decisions can be used to further develop our knowledge on the relationship between corporate finance and financial and economic developments in the euro area. Second, investigations of the link between corporate finance and financial intermediation in modern financial theory may result in a better understanding of the monetary transmission process in this area. Third, analysis of the determinants of the financial structure of an economy, its contribution to economic development and comparative advantages and disadvantages of different financial structures can contribute to the ongoing intensifying discussion on the comparative positive and negative aspects of the financial structures in the euro area, the United States and Japan. Finally, this analysis can contribute to the position of the ECB in the discussion on the need for structural reforms in the euro area, which is without any question one of the major challenges this area is currently facing.

Theories on corporate finance, which can be defined as the study of the way firms are financed, investigate the financing decisions of non-financial firms and seek to design a so-called optimal capital structure, which in general consists of a certain combination of debt and equity. [1] The foundation of the modern theory of corporate finance was established by Modigliani and Miller when they introduced their so-called "irrelevance" hypothesis regarding the financing of the firm in 1958. [2] According to this theorem, the market value of a firm and its cost of capital are independent of its capital structure, assuming that there is sufficient information with no transaction costs or taxes.

In due course, however, theories on corporate finance have been developed on the basis of excluding the assumptions of the Modigliani-Miller theorem one by one. First, by allowing for the existence of taxes and bankruptcy and liquidation costs, it has been investigated whether firms try to achieve specific target-debt ratios. [3] Second, the Modigliani-Miller theorem has been modified from the perspective that financial markets and corporate financing decisions are characterised by agency costs and the presence of asymmetric information. [4] Third, concepts from the literature on corporate control and corporate governance have been introduced in corporate finance theory as well. [5]

During the past two decades, elements of corporate finance theory have been integrated into theories on financial intermediation and financial structure. The result of this development has been that the traditional separation between finance theory on the one hand and monetary theory on the other has become increasingly blurred. One development has been the introduction of models of financial intermediation, which include the allocative effects of information asymmetries in financial markets and which take account of corporate financing decisions. [6] These models assert that informational problems could lead to inefficiencies in financial markets that may have real effects on the economy and consequences for the choices of sources of corporate finance. [7] Thus, they refute the basic proposition of the Miller-Modigliani theorem that financial structure has no impact on economic processes. Furthermore, some of these models argue that the existence of information asymmetries and monitoring costs in financial markets may lead to situations of credit rationing. [8] In other words, the existence of macrofinancial information asymmetries result in adjustments of microcorporate financing decisions. In this sense, there is an interlinking relationship between the macrofinancial structure of an economy and the microcapital structures of individual non-financial firms that constitute the backbone of this economy.

I have now arrived at the relationship between corporate finance and financial structure. Financial structures are generally classified in terms of the significance of indirect versus direct finance. In financial structures characterised by indirect or bank-based finance, surplus funds of savers are channelled to entities short of funds (e.g. households, companies and governments) through financial intermediaries that are mostly monetary financial institutions such as banks. By contrast, in direct or market-based finance, borrowers obtain funds directly from lenders by issuing securities or financial instruments in financial markets. In practice, both indirect and direct finance exist in financial structures, although their importance varies from economy to economy.

Because of adverse selection problems, investors are not able to differentiate clearly between good and bad firms that issue securities and will therefore only generally be willing to invest their savings in securities of very well-known corporations. Thus, adverse selection problems hamper the development of direct finance and are mean that indirect finance is still the principal source of corporate financing in most countries. Furthermore, moral hazard problems related to debt and equity contracts are partly responsible for the predominance of indirect finance. Financial intermediaries such as banks and venture capital firms function as monitors which collect information that allows the potential costs arising from moral hazard behaviour on the side of borrowers, as well as adverse selection problems, to be limited. Thus, financing through financial intermediaries is an effective solution to mitigate adverse selection and moral hazard problems that arise in transactions between lenders and borrowers.

Central banks and financial structure

Let me now turn to the policy implications concerning developments in financial structure, both for monetary policy as well as for financial stability. Interestingly, many central banks were founded by governments who wanted to enjoy the financial advantages they felt could be obtained from such banks. [9] Thus, their tasks were far from what the functions of modern central banks are perceived to be today. Later on, the central role played by these banks and their "political power" as the governments' bank, the control over the coins' reserves as well as their ability to provide extra cash discounting commercial bills, made them the bankers' bank. In addition, their privileged legal status naturally resulted in a degree of centralisation of banking reserves at the central bank. Almost inevitably, the responsibility that this status entailed led central banks to develop their roles in relation to monetary management and to the support of and responsibility for the health of the banking system at large.

I shall now discuss the relationship between monetary policy and financial structure. As we all know, the conduct of monetary policy takes place through the banking system and the financial markets. Thus, as I argued earlier, central banks are interested in knowing financial structures because they play an important role in shaping the transmission of monetary policy.

The channels through which the interest rate changes decided by the central bank affect the economy constitute the monetary policy transmission mechanism. [10] Any change to the policy-controlled interest rate affects market interest rates and prices of financial assets. These interest rate and asset price changes are then transmitted to the rest of the economy, affecting spending decisions and ultimately the inflation rate. In an environment of well-developed and efficient financial markets, monetary policy normally affects household spending via its impact on interest rates and prices. On one hand, a change in the interest rate may induce households to modify their decisions related to the consumption of goods and services and residential investment. On the other hand, changes in asset prices may affect households' wealth directly and thus their consumption. Firms' expenditure in fixed and inventory investment depends on the cost of capital they are faced with and the relation between the market value of capital and its replacement cost. These values are related to interest rates and prices as well. The exchange rate and the expectation channels of monetary policy transmission also play a role in this complex web of economic interactions.

The magnitude and speed of the pass-through of monetary impulses depend on various features of the financial system, such as the importance and the role of banks and capital markets respectively, the maturity structure of non-financial sector financing and the prevalence of variable and fixed interest rate contracts. Other institutional characteristics such as the tax system, corporate governance, banking relationships and competition in the banking sector may also have implications for monetary policy.

With the aim of implementing the best possible monetary policy for the euro area as a whole, the Eurosystem has had to make great efforts towards developing a euro area-wide approach to understand economic and financial developments. Furthermore, in many aspects of the economy, including financial structures, an understanding of national structures is essential for a through comprehension of the same structures at the euro area level.

The euro area is characterised by a large presence of so-called small and medium-sized enterprises, which account for about 60% of private sector employment. Partly related to that, links between firms and banks are marked by relationship lending, where banks and customers build up agreements on terms of credit, implying for instance secured access to credit lines at pre-set prices. Thus a reduction in the availability of relationship lending could have an effect on the euro area's economy and on the workings of monetary policy. Recent developments in banks' structure and banking competition seem to point to a reduction in relative terms of the scale of relationship lending activities. In turn, this could affect the euro area business cycle and the transmission of monetary policy as the liquidity insurance provided by banks to small and medium-sized enterprises decreases.

A thorough knowledge of financial structures is also important for central bankers because of financial stability concerns. Central banks began to be involved in financial stability in relation to their role as the bankers' bank. They lent to commercial banks and held their liquidity reserves in the forms of deposits. As a matter of prudent management of their activities, central banks needed to evaluate the financial soundness of the commercial banks. Thus, central banks were naturally prompted to address financial stability concerns, irrespective of the attribution of formal supervisory tasks. Today, central bank activity in this area is focused on both the so-called systemic stability and the stability of individual institutions.

The traditional focus of the analysis of financial stability has been the assessment of credit risks related to financial cycles. These risks notwithstanding, recent changes in the financial system have brought about additional concerns. More traditional financial systems were characterised by a clear-cut separation between institutions and markets. [11] . Thus, the exposure of banks to market volatility was limited, as they largely focused on the transformation of deposits into illiquid loans. Furthermore, there was also a clear separation between banks, insurance companies and brokerage companies, as well as between the products they managed. Most importantly of all, domestic financial systems tended to be insulated from one another. Financial crises taking place in these financial systems followed broadly similar patterns. A lending boom and consequentially a significant rise in asset prices was typically followed, at the turn of the business cycle, by failures of some banks.

Recent developments in the financial structure have resulted in a breakdown of these separations. Markets and banks and their role in the context of firms' financing have become integrated, and banks and other financial institutions have increasingly merged. Banks also typically administer many of the investment funds, are part of holding companies along with insurance groups, and are major participants on securities markets. Other notable developments are the increased securitisation of banks' balance sheets and the use of instruments of credit risk transfer. Furthermore, national markets are no longer isolated entities, rather they are embedded in a complex system of financial interlinkages, which calls for close international co- operation. Financial instability no longer depends only on the soundness of the banking system but may also emanate from other financial institutions. A rapid increase in banks' financial market-related activities has heightened their exposure to swings in prices on financial markets, implying that banks' stability may be increasingly vulnerable to market instability. On the other hand, financial integration provides banks with enhanced possibilities for risk management.

Concluding remarks

I would now like to conclude. Financial structures are crucial to the allocation of resources in a modern economy. They can be compared with a system of arterial circulation in a body, which is the economy as whole. In order for the body to function, blood needs to circulate. If blood stops flowing, the body dies. Similarly, if money stops flowing, the economy dies. Hopefully, we, as central bankers, are in a way trying to ensure that blood pressure is either too low or too high. This task requires a thorough knowledge of how the flow of money works. Most people tend to have a good understanding of the financial system they are most familiar with, for instance the one they grew up with. They also tend to extend the characteristics of this system to financial systems in other countries. This is obviously not a satisfactory approach for an institution like the ECB, which is faced with the reality of a diversified euro area system every day. The terms of reference of any analysis on financial structures has changed from a domestic to a supranational perspective. This poses a considerable challenge to the ECB and to the Eurosystem as a whole. That is why initiatives such as this seminar and publications aimed at increasing the understanding of the euro area financial system are of particular significance.

  1. [1] L. Zingales, "In Search of New Foundations", Journal of Finance, 2000, Vol. LV, No.4, p.1623-1653; F. Allen, "The Changing Nature of Debt and Equity: A Financial Perspective", Proceedings "Are the Distinctions between Debt and Equity Disappearing?", Conference organised by the Federal Reserve Bank of Boston, October 1989, p.12-38; J. Corbett, "Financial Structure and Corporate Governance: Japan in International Perspective", in "Financial Markets in the Changing World", Hitotsubashi University, 1993, p. 172-209.

  2. [2] F. Modigliani and M.H. Miller (1958), "The cost of capital, corporation finance and the theory of investments", American Economic Review, 48, p.261-297.

  3. [3] J.R. Graham and C.R. Harvey (1999), "The theory and practice of corporate finance: Evidence from the field , mimeograph.

  4. [4] M.C. Jensen and W.H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure", Journal of Financial Economics, 1976, 3, p.305-360; M. Harris and A. Raviv, "The Theory of Capital Structure", Journal of Finance, 1991, 46, p.297-355.

  5. [5] O.E. Williamson, "Corporate Finance and Corporate Governance", Journal of Finance, XLIII, 1988, 3, p.567-591; A. Shleifer and R.W. Vishny, "A Survey of Corporate Governance", Journal of Finance, 1997, LII, 2, p.737-783.

  6. [6] B.S. Bernanke and M. Gertler, "Agency Costs, Net Worth and Business Fluctuations", American Economic Review, 1989, 79, no.1, March, p.14-31; C.E. Walsh, Monetary Theory and Policy, 1998, MIT Press.

  7. [7] B. Greenwald, J.E. Stiglitz and A. Weiss, "Informational Imperfections in the Capital Market and Macroeconomic Fluctuations", American Economic Review, 1984, 74, May, p.194-200.

  8. [8] J.E. Stiglitz and A. Weiss, "Credit Rationing in Markets with Imperfect Information", American Economic Review, 1981, 71, no.3 (June), p.393-410; S.D. Williamson, "Costly Monitoring, Loan Contracts, and Equilibrium Credit Rationing", Quarterly Journal of Economics, 1987, 102, no.1, February, p.135-145.

  9. [9] C. Goodhart, "Central banking" in the Palgraves dictionary.

  10. [10] ECB, Report on Financial Structures, 2002.

  11. [11] T. Padoa Schioppa, Central banks and financial stability: exploring a land in between, 2003.

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