Finance and Growth Introduction 2024-2025 PDF

Empirical Banking Finance and Growth INTRODUCTION Stefano Caiazza 2024-2025  The research questions (1) Is the Financial System essential for growth? (2) What is better to promote long-term economic growth between the banking and financial market...

Empirical Banking Finance and Growth INTRODUCTION Stefano Caiazza 2024-2025  The research questions (1) Is the Financial System essential for growth? (2) What is better to promote long-term economic growth between the banking and financial markets? Since the 19th century, many economists have argued that bank-based systems are better at: Mobilizing savings Identifying good investments Exerting sound corporate control, particularly during the early stages of economic development and in weak institutional environments Others, however, emphasize the advantages of markets in allocating capital: Providing risk management tools Mitigating the problems associated with excessively powerful banks Finance risky projects (higher expected return), while banks are less inclined to do so  Puzzle 1 Problem: Why should finance matter for growth? The influential neoclassical view states that only real variables matter, and nominal variables, such as money, inflation, and nominal interest rates, do not influence real growth. Robert Lucas (1988) states that economists badly over-stress the role of the Financial System. However, nominal variables matter from growth (i.e., monetary policy).  Puzzle 2 Problem: High costs associated with evaluating companies, managers, and market conditions. Savers may not have the skill to collect, process, and produce information on possible investments → return/risk combinations. Consequence: High information costs may prevent capital from flowing to its highest value use. Solution: Financial intermediaries may reduce the costs of acquiring and processing information, thereby improving resource allocation. But the financial market? Which is the better for growth?  Puzzle 3 Agency Costs Problem. Conflict of interest among CEOs, shareholders, and bondholders may negatively affect GDP growth. Shareholders vs. CEO: Personal Benefits: The CEO could be interested in maximizing his benefits, not shareholders’. Asset Dilution: The CEO might wish to increase share capital while stockholders do not. Shareholders (and CEO) vs. Bondholders: Dividend Payout Policy: Payout reduces retained earnings: bondholders want “excessive” dividends not to be paid. Claim Dilution: Issue new debt of equal or higher priority to dilute bondholder claims. Underinvestment (debt overhang): Low level of investments financed by debt (Myers, 1977). Asset Substitution: Invest in hazardous projects (Jensen and Meckling, 1976).  Asset Dilution: it has two different aspects: i) Increasing the number of shares outstanding leads to a possible decrease in earnings per share ii) Reduction or loss of control for the majority shareholder Dividend Payout Policy: Shareholders may aim to receive dividends, while bondholders would prefer profits to remain within the firm, as a reserve against future losses or for higher profitable investments. Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. Underinvestment (debt overhang): A highly indebted corporation will reduce investments as existing borrowers are the primary beneficiaries of the profit of new investments, leaving little incentive for the corporation to undertake new projects. Asset Substitution: A corporation could sell a project as low-risk to get favorable terms from creditors. After receiving funds, they could use the proceeds for riskier projects, passing the risk to creditors. When asset substitution occurs, managers undertake risky investments that maximize equity shareholder value at the expense of debtholders’ interests.  Puzzle 3 Consequence: Low level of investments and low growth rate. Solution for shareholders: Literature identifies several possible solutions to agency costs. We are interested in comparing banks/stock exchanges. A highly liquid stock market where prices are highly informative. Then: It is possible to link managerial compensation to the revaluation of stock prices. In this case, the CEO’s target is aligned with the shareholders’ target. Solution for bondholders: A standard debt contract may be preferable because it requires less monitoring: The investor receives a fixed amount and does not verify the state when the return exceeds a certain threshold. The investor receives the total return of the project (lower than the fixed amount above) and verifies the state when the return is below the threshold. This can be thought of as bankruptcy. Debt or Equity: Which is better for growth?  Debt Overhang IMF wp 2020 (https://www.imf.org/en/Publications/WP/Issues/2020/12/18/Leverage-Shocks-Firm-Level-Evidence-on-Debt-Overhang-and-Investment-49965) 1.8 million nonfinancial firms from 52 countries during the period 1997–2018, with a total of 10.4 million firm-year observations The subscripts i, s, c, and t denote firm, sector, country, and time, respectively. Firm is a vector of company-specific control variables (total assets, profitability, etc.). Macro is a set of country-specific variables (real GDP per capita, real growth rate, etc.). The 𝜂𝜂𝑖𝑖 coefficient denotes the firm-specific fixed effects capturing time-invariant unobservable factors. The 𝜂𝜂st coefficient denotes the set of sector-year fixed effects capturing unobserved time-invariant heterogeneity among firms across sectors and common shocks to firms belonging to the same industry in a given year. The 𝜂𝜂cs coefficient does the same for country sector groups. 𝜀𝜀ist is an idiosyncratic error term that satisfies the standard assumptions of zero mean and constant variance. Robust standard errors are clustered at the firm level to account for the fact that observations of a firm are correlated and, thus, do not contain as much information as unclustered errors. Debt Overhang Debt Overhang  Puzzle 4 Risk(s). Consequence: The higher the risk, the lower the willingness to invest. Three types of risk (Allen&Gale, 1995) Cross-sectional → Stock markets Intertemporal → Banks Liquidity → Banks can mitigate the risk, but they might default Stock markets or banks for growth?  Banks: pros and cons Banks have greater incentives to search for information on valuable projects in atomistic markets. Banks don’t have to disclose information collected to exploit this monopolistic position. By contrast, information collected by market participants is immediately revealed, and therefore, it is incorporated into stock prices. If information reveals a company in temporary difficulty but with good prospects, the company can be purchased. However, takeovers are only sometimes socially beneficial, as they may benefit the raider. If information reveals a company in trouble without good prospects, it may experience a run to sell the shares. Crash and / or panic. Banks, closely linked to their creditors, could have too much influence on them: Banks can extract rent from companies because they have much private information. In the case of debt renegotiation or liquidity injection, banks have a lot of bargaining power. They can extract more of the future profits of the firms → This may reduce the incentive of the company to undertake innovative projects. Banks could be more risk-averse and support conservative and low-growth strategies. Large banks may influence corporate decisions or fail to bankrupt distressed firms because of a long-run relationship. Pag: 688-702 (letter G)  Theoretical Channels Financial markets and intermediaries facilitate the allocation of resources, across space and time, in an uncertain environment. Capital accumulation: the Financial System influences the rate of capital formation either by altering the savings rate or by reallocating savings among different capital-producing technologies. Technological innovation: the financial system influences the rate of technological innovation. These results are achieved: Mobilizing savings (pooling, i.e., structured finance) Acquiring information about investments Monitoring manager and exerting corporate control Facilitating risk management (liquidity and idiosyncratic risk) Facilitate Exchange  On the Mechanics of Economic Development R. Lucas JME, 1988 University research produces a production factor called KNOWLEDGE, used both in the industrial and research production sectors. Y = f [K, (1-u)L ×E] (Industrial production function) ΔE = g(u)×E (University research production function) ΔK = sY- δK (Capital accumulation equation) Where u is the fraction of the labor force L employed in university research, and E is the stock of knowledge