Corporate Finance
Banks and bonds

Despite the rapid growth of the Euromarkets during 1972-90, which saw international bond issues increase eightfold in real terms, little is known about their operation or their contribution to corporate financing. Large companies use syndicated bank credits and Eurobonds to raise finance, and Euromarkets may yield valuable information on the factors that influence firms' choice between intermediated and market sources of finance.
In Discussion Paper No. 570, Phil Davis and Programme Director Colin Mayer analyse all Eurobond issues and syndicated bank credits by UK and US firms since 1972, focusing on the size of the respective markets, the scale, frequency and maturity of issues and the patterns of their issuance. They also analyse the determinants of their maturity and estimate a model of firms' choice between bank and bond finance, which provides a remarkably accurate description of the data. Davis and Mayer then use these findings to evaluate four contending theories of financial intermediation.
First, they dismiss theories based on economies of scale, which argue that banks provide small amounts of finance more cheaply than markets. Syndicated credits are larger on average than Eurobonds, although scale economies may apply to the financing of small firms. Nor do they find any conclusive evidence to support `monitoring' theories, which state that firms are initially restricted to bank finance but progress to bond finance as they grow and mature. Firms often continue to obtain bank finance after they have issued bonds, and such theories explain neither the restrictive covenant provisions that frequently accompany syndicated bank loans nor the shorter maturity of bank finance.
Davis and Mayer seek to account for these differences with `control' theories, which emphasize the incomplete nature of contracts that necessitate covenants and short maturities to protect both parties. These suggest that bank finance will be associated with higher-risk loans and that maturities will be inversely related to risk, which Davis and Mayer find to be true for their chosen sample. Finally, the authors dismiss `commitment' theories, in which repeated interaction between borrowers and lenders discourages exploitation. International credit markets are not characterized by long-term relations, and firms frequently change the lead banks that arrange syndicated credits and bond issues, although commitment may play a role in domestic bank lending.
Davis and Mayer conclude that control theories are more consistent with observed patterns of firm behaviour than monitoring or commitment theories or those based on scale economies. Bond and bank finance are not perfect substitutes: high-risk projects and large-scale investments require banks' involvement to control the risks to which lenders are exposed, even for the largest firms.

Corporate Finance in the Euromarkets and the Economics of Intermediation
Phil Davis and Colin P Mayer

Discussion Paper No. 570, August 1991 (AM)