Finance for Industry
Previous Studies Flawed

Previous studies of the provision of finance for industry have been deeply flawed, argued Research Fellows Margaret Bray and Colin Mayer at a lunchtime meeting on 6 December. Studies such as those for the Wilson Committee have lacked a coherent theoretical framework and hence a precisely defined set of questions to be answered. The analysis also requires more detailed data than has been used in previous studies. Bray and Mayer outlined plans for a major CEPR research study, to be launched by them and Jeremy Edwards, which will analyze capital markets and the provision of finance to the corporate sector in five countries. Such a study is particularly relevant in view of recent proposals for new institutions and legislation to channel funds to British industry.

Colin Mayer is a Fellow of St Anne's College, Oxford, and Margaret Bray is a Fellow of Churchill College, Cambridge. They are both Research Fellows in the Centre's Applied Economic Theory and Econometrics research programme. They spoke at a lunchtime meeting organized by the Centre, one of a regular series of meetings at which Research Fellows discuss policy-relevant research. Financial support for this lunchtime meeting was provided by a grant from the German Marshall Fund of the United States. The views expressed by Bray and Mayer are not necessarily endorsed either by the German Marshall Fund or by CEPR, which takes no institutional policy positions.

The London and New York capital markets are often cited as examples of sophisticated and efficient financial structures, providing flexible opportunities for companies to raise external finance. They have nevertheless encouraged a pattern of corporate finance that has not been mirrored in other countries: the relationship between finance and industry in the UK and US might be characterized as one 'at arm's length'. The two sectors are relatively distinct, and contact between them is for the most part limited to capital market transactions. In addition, government involvement in corporate finance has largely been restricted to fiscal incentives and macroeconomic policies, and the direct provision of funds for industry has (with the exception of public corporations) been very limited.

Such features of capital markets have important implications for the provision of finance for industry, and it is widely thought that this provision may have affected the activities and performance of the corporate sector in different countries. The research directed by Bray, Edwards and Mayer will explore the development of financial markets in five OECD countries and examine the factors that have established the patterns of finance that are observed today. The research, in common with previous studies, will consider the role of government institutions and the influence of taxation in directing funds, but its most novel feature will be the emphasis on the role of information in determining capital flows.

Over the past decade, Bray and Mayer noted, there have been significant developments in the economic analysis of financial markets. These new approaches have emphasized the crucial importance of information flows between borrower and lender in shaping the terms on which finance is provided. The availability of information affects the functioning of markets and the role that financial intermediaries play in facilitating transactions. Bray and Mayer argued that this 'information-based' approach provided a comprehensive theoretical framework for analyzing financial institutions and for comparing the performance of financial systems in different countries. Such international comparisons were essential, they noted, because there are substantial cross-country variations in the manner in which finance is provided to industry. Increasing penetration of domestic markets by overseas financial institutions will tend to erode differences in banking practices. In addition, market instruments are now taking the place of bank lending, and this may reduce the role of the banks in providing funds to industry. The new study will analyze how external pressure may impose such changes on the financial sector and assess their consequences for corporate borrowing.

The new theory of 'informational asymmetries' has been cast mainly in general terms, and there has been little empirical investigation. Bray and Mayer outlined the CEPR initiative. The research is designed initially to compare the performance of banks and other financial institutions in France, Germany, Japan, the UK and the US. Such comparisons will provide further insights, and the project will estimate the cross-country differences in the costs of funding equivalent investment projects. In addition, the theoretical framework will be used as the basis for an explanation of cross-country variations in bank lending practices. The economic significance of these differences in lending practices is of obvious interest to policy makers as well as to the financial community.

The project will make use of new detailed data on bank lending. Economic theory suggests that collateral requirements, margins, maturity of loans and the allocation of risks between lenders and borrowers will be affected by the relationship between the bank and its customers. This relationship in turn is reflected in the degree of monitoring of loans, the active participation of lenders in investment decisions, representation on company boards and equity shareholdings by the lender. Macroeconomic factors and tax measures will provide important background information. But it is the detailed data on loan contracts that will distinguish this study from earlier analyses and provide a unique insight into lending practices.

The project will begin in early 1986 with a preliminary study of the United Kingdom, the United States and Japan. In the second phase, lasting a further two years, Bray, Edwards and Mayer will conduct detailed empirical analyses of France, Germany, Japan and the US. The final product will be a collection of country studies that employ a common framework. Individually the studies will provide self-contained assessments of the financial systems of the five countries; as a group they will provide a unique basis for comparing alternative methods of funding industry, concluded Mayer.

The discussion which followed touched on how one might best estimate the costs of financing 'equivalent investment projects'. It was argued that lenders did not evaluate the details of a firm's individual investment projects but instead assessed the firm's overall strategy or the entrepreneurial abilities of its managers. Mayer acknowledged these difficulties but argued that detailed information on loan contracts would help disentangle these influences. Another contributor suggested that the concentration on domestic finance would mean that only lending to small or medium size companies could be examined, but Mayer disagreed. Even large corporations make extensive use of domestic borrowing, he noted.