Market-based vs Bank-based Economies (PDF)

Empirical Banking Market-based vs bank-based economies Stefano Caiazza 2024-2025  Allen and Gale (AL) compare two financial systems: The German one The US one (Implicit) definition of Market-based and Bank-based economies, also called Market-orient...

Empirical Banking Market-based vs bank-based economies Stefano Caiazza 2024-2025  Allen and Gale (AL) compare two financial systems: The German one The US one (Implicit) definition of Market-based and Bank-based economies, also called Market-oriented economies and Bank-oriented economies. https://www.aeaweb.org/jel/guide/jel.php The Germany The U.S.  Comparison Why do we observe these differences? Comparison  Comparison of risks: The household side The Household side: CROSS-SECTIONAL RISK SHARING Markets allow agents to diversify portfolios, hedge idiosyncratic risks, and adjust the riskiness of portfolios to suit their risk tolerances. Different agents can exchange risks at a given point in time. The completeness of the markets (claims with different returns and risks) is essential. Markets allow individuals to diversify their portfolios, covering themselves against idiosyncratic risk and adjusting the riskiness of the portfolio according to their risk tolerance. If markets were complete, individuals could insure themselves against this risk. But, if markets are incomplete….  Comparison of risks: The household side The Household side: INTERTEMPORAL RISK SHARING Markets could be incomplete, or participation could be incomplete. Possible motivations for incomplete market participation of some “generations”. Some “young workers” may face limitations in market access due to income and expenses (purchase of a home, education of children), and they start saving fairly late in life. Transaction costs and asymmetric information could shrink participation in the market. When markets are incomplete or participation is incomplete, there may be a role for intermediaries to share risks that are too expensive to hedge through the market….. In the U.S., the actual value of the stock market approximately halved after the oil shock in the early 1970s and stayed at this level for the rest of the decade. Households that had provided for retirement by investing in the stock market and needed to liquidate shares to pay for consumption were forced to substantially reduce their standard of living. By contrast, in the 1980s, the stock market approximately doubled in real value, and the process was reversed; households whose savings were invested in the stock market increased their consumption substantially. Dow Jones – 100 Years Historical Chart (log scale) 2024 2021 2000 2002 1965 2009 1929 1970 1974 1916 1980 1982 1942 1915 1920 1932 http://www.macrotrends.net/1319/dow-jones-100-year-historical-chart Dow Jones – 24 Years Historical Chart Dec 2019 Jan 2021 Mar 2020 Oct 2007 Feb 2009  Comparison of risks: The household side Since markets are incomplete, some risk is not diversifiable. This unsatisfied demand for risk sharing can be provided by long-lived institutions such as banks. Financial institutions expose individuals and firms to a lower risk than markets because the market valuation of assets can fluctuate for reasons not depending on their fundamentals. Intertemporal smoothing is based on the idea that individuals accept lower than market returns in some states of the world to obtain higher than market returns in other states. How is it possible? German households save for retirement and other purposes primarily in bank accounts and other debt-like instruments. Although Germany also experienced an oil shock, the value of these savings was not halved. In the ’80s there was a sustained boom in Germany as in the U.S. but the value of households’ saving did not increase. German investors could consume the planned amount as banks drew on reserves to maintain payouts.  Comparison of risks: The household side Intertemporal smoothing could be achieved through Intergenerational risk sharing: banks can hedge stock price fluctuations (gain and losses) while the market cannot because the different generations participate in the market at different points in time. For a generation to liquidate its position by selling stocks (securities) in the market, another generation must be willing to purchase such stocks (securities). Young people may not have the savings needed to purchase the bonds sold by older people. Intertemporal smoothing: Banks, through reserves, can provide insurance against fluctuations in stock prices, balancing gains and losses over time. Households are not able to do it. Intertemporal smoothing could be achieved through asset accumulation: banks eliminate risk by accumulating low-risk assets, i.e., liquid assets, while, in the market, the risky asset dominates the safer asset.  Which is the best financial structure? From a theoretical point of view, it seems that an intermediated financial system can achieve a higher level of welfare than a market-based system. German banks hold a high level of reserves German banks are cautious, maybe because of the regulation imposed by the Bundesbank In general, if investors are relatively homogeneous, there is a slight advantage to cross- sectional risk sharing and little cost to adopting the German model, which allows intertemporal risk smoothing. On the other hand, if there is enough heterogeneity that the benefits from cross-sectional risk sharing outweigh the benefits from intertemporal risk smoothing, the U.S. model may be preferable. One might expect that a more extensive set of alternatives, markets plus financial intermediaries, would make individuals better off than intermediaries alone. In other words: Is it possible to have a financial system that simultaneously obtains the benefits of cross-sectional risk sharing and intertemporal risk smoothing?  Which is the best financial structure? Answer « No »: A financial institution that tries to provide this smoothed return faces the risk of losing customers in favor of the market when market returns are high. Given the risk of disintermediation, a financial institution cannot provide insurance. Answer « No »: Competition between banks and the financial markets could lead banks to take excessive risks to gain market share. Answer « Yes »: One possibility is to create a superbank, which offers a menu of bank accounts with different risk characteristics. One barrier to implementing superbanking is the problem of maintaining liquidity without undermining intertemporal smoothing (Diamond and Dybvig, DD, problem). Surplus agents want to rebalance their portfolio as soon as new information is available in the market. This means selling and buying securities. But this rebalancing creates problems for banks in maintaining liquidity. Another barrier comes from the difficulty of finding variables to which the returns of the various accounts could be indexed. Ideally, these variables should be observable, verifiable, and non-manipulable.  RISK Cross-sectional risk sharing Intertemporal risk smoothing Complete Markets: financial markets Incomplete Markets (instruments and/or participation. Transaction costs, asymmetric Why? Portfolio diversification information, young workers): Bank intermediaries It requires heterogeneity Why? Some risks are not diversifiable. Intertemporal smoothing: agents accept lower returns in some states of the world to obtain higher returns in another states of the World: Intergenerational risk sharing Intertemporal smoothing is reached by: Bank reserves (insurance again fluctuations in stock prices) Asset accumulation: accumulation of low-risk assets, while, in the market, the risky asset dominates the safer asset. SIMULTANEOUSLY BENEFITS OF CROSS-SECTIONAL AND INTERTEMPORAL RISK SMOOTHING NO: in expansionary periods, agents prefer to YES: Superbank invest in financial markets (higher return with Problems of such superbank: acceptable risk) Maintaining liquidity (possible bank crises à la DD) NO: Competition between stock markets and banks Find variables to index superbank accounts increases the probability of banks default  What do intermediaries maximize? It is not easy to say what the objective function of an intermediary is or should be. Neoclassical economics tends to take a dichotomous view of the World according to which some organizations maximize a narrowly defined measure of corporate self-interest and others, such as the State or Regulatory authorities, maximize some measure of the public welfare. Yet, in practice, there are many institutions, particularly financial institutions, for whom neither of these extremes seems appropriate: savings banks, cooperative banks, mutual funds, mutual insurance companies, non-profit organizations, and so forth. Even in cases where it may be possible to identify the organization’s motives as self-interested, it is not clear how to define the target function. The lack of competition in many areas and the large number of banks operating in the public interest in Germany suggest that even this defense of profit maximization may not be adequate. Managers could desire to maximize their utility function.  The firm side Information: The two systems present different levels of information to the public. In the U.S., the large number of publicly listed firms and the SEC requirements about information release means that there is a great deal of information. Implication for the allocation of investment. In contrast, few companies in Germany are publicly listed, and those that are do not release much helpful accounting information (before Basel 2!) Financing: Literature provided evidence that in Germany and the U.S., as well as in other countries, most investment is financed with internally generated funds. Allen and Gale show that at least in the US: Large firms do predominantly use internal finance. Smaller firms, which may have the greatest growth potential, use a significant amount of external finance; their internal funds are insufficient for their needs.  Modigliani-Miller theorem It is one of the essential theories of Corporate Finance (capital structure) due to the contributions of Meyers (1984) and Myers and Majluf (1984). Due to the existence of asymmetric information between managers (insiders) and investors (outsiders), a firm has a clear hierarchy in the choice of sources of financing for investment. To understand why such a hierarchy exists in the presence of information asymmetry, we start from the well-known situation of information symmetry present in the Modigliani-Miller approach. Modigliani and Miller (1958): the capital structure does not affect the firm’s value. The firm's value depends on its assets' ability to create value, and it is irrelevant if the assets originate in internal or external capital. The sources of external financing are also irrelevant. The cost of capital is unaffected by changes in the proportions of debt and equity.  Modigliani-Miller theorem Imagine two firms that generate the same operating income and differ only in their capital structure. Firm U is unlevered. Therefore the total value of its equity EU is the same as the total value of the firm VU. Firm, L, on the other hand, is levered. Therefore, the value of its stock is equal to the value of the firm, less the value of the debt: EL = VL - DL. Which of these firms would you prefer to invest in? If you don’t want to take much risk, you can buy common stocks in the unlevered firm U. For example, if you buy 1% of firm U’s shares, your investment is 0,1VU, and you are entitled to 1% of the gross profits: Now compare this with an alternative strategy. This is to purchase the same fraction of both the debt (DL) and the equity (EL) of firm L. Your investment and return would then be as follows: Both strategies offer the same payoff: 1% of the firm’s profits. In well-functioning markets, two investments with the same payoff must have the same cost. Therefore, 0,1VU must equal 0,1VL: The value of the unlevered firm must equal the value of the levered firm.  Modigliani-Miller theorem Modigliani-Miller’s result holds iff the company operates in a perfect capital market with: No taxation No transaction costs No asymmetric information Taxation: If the interest the company pays is a tax-deductible expense while dividends and retained earnings are not, then the return to bondholders escapes taxation at the corporate level. 28 is how much Firm L saves due to tax-deductible expense and it is called interest tax shield.  Modigliani-Miller with tax In 1963 Modigliani and Miller considered taxation and proposed that firms should employ as much debt as possible. Corporations have an advantage in using debt rather than internal capital, as they can benefit from debt tax shields. This tax shield allows firms to pay lower taxes than they should, using debt capital instead of using only their capital. The theory argues that the more debt is, the more a firm’s value is created. The main benefit of debt is the tax deduction (of interest). Tax deduction: deductions reduce VL = Value of the levered firm the taxable income, i.e., the amount of income before calculation of tax VU = Value of unlevered firm Tax credit: it reduces the amount due tc = Tax rate on interest income for the tax.  The Pecking Order Theory Jensen and Meckling (1976) identified the existence of the agency problem. They consider two kinds of agency costs: a) Agency costs of equity b) Agency costs of debt The conflicts between managers and shareholders lead to agency costs of equity. The conflicts between shareholders and debtholders lead to agency costs of debt.  The Pecking Order Theory Due to asymmetric information, the Pecking Order Theory suggests that companies have a particular order of preference for capital used to finance their businesses. Companies will prefer to use, in the order: Internal finance, i.e., retained earnings Debt Short-term debt Long-term debt Equity Suppose you are the CEO of a corporation operating in a market characterized by asymmetric information. Suppose, alternatively, that: The market is overestimating your corporation The market is underestimating your corporation (1) In what form would you prefer to raise funds? (2) And how would the market react?  The Pecking Order Theory If Pecking Order Theory holds, neither markets nor intermediaries may be influential in allocating economic resources for investment. If external sources of funds (markets or bank intermediaries) are very costly because of transaction costs and asymmetric information, firms will prefer to rely on internally generated funds. However, there is no reason to suppose that each firm will generate precisely the amount of funds required to finance the first-best level of investment. Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations The firm side – Source of financing  The costs of issuing equity Costs are significant for all firms but are particularly high for small firms.  Conclusions A welfare comparison of financial systems in Germany and the U.S. is a complex exercise. Which type of system is desirable depends on various factors, both the household and the firm side. As a country’s circumstances change, it may be optimal to change its financial system.  Market-oriented vs bank-oriented economies Source: World Bank https://www.theglobaleconomy.com/rankings/bank_assets_GDP/ https://datacatalog.worldbank.org/dataset/global-financial-development https://databank.worldbank.org/reports.aspx?source=2&series=FR.INR.LNDP&country=