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- Financial Markets
The depth of the recent financial turmoil is partly attributed by policymakers and academics alike to excessively high leverage of corporations and banks. Both were heavily indebted at the onset of the financial crisis, as low interest rates may have promoted cheap debt financing prior to the crisis, “exacerbating” the well-known structural tax advantages of debt. Goodhart and Schoenmaker, for example, argue that “removing the tax advantages of debt is vital” to remove the structural bias towards debt financing that encourages companies to take on debt rather than equity (Financial Times, December 30, 2010).Long-run leverage of firms
However, sharp increases of leverage ratios are not a recent phenomenon. Figure 1 shows the evolution of leverage of a sample of UK firms between 1895 and 2009, when the relevant data is available. Leverage ratios are measured as total debt over total book value of assets. It can be seen that starting in the mid-1960s, the ratio increased enormously moving from about 28% in 1965, and reaching almost 60% in 1976. Recent work by Graham, Leary and Roberts (2011) presents a qualitatively similar behaviour for the US corporate leverage.1 Figure 1 suggests that taking a long-term perspective can provide a novel approach to our understanding of corporate leverage, and can offer important insights to the current policy debate.
Figure 1. Mean UK firms leverage, 1895-2009
Sources: Braggion and Moore (2011); Cambridge DTI Databank.
While we believe that many factors might play a role in determining the long-run behaviour of corporate leverage, in this discussion we relate firms’ leverage and debt financing to a key aspect of financial markets－ the secular behaviour of firm-bank relationships. The desire of corporates to borrow from multiple banks operating in a competitive banking market may be an important, yet so far overlooked, driver of corporate leveraging. Competing banks may fail, for example, to fully internalize the consequences of future corporate indebtedness (Bizer and DeMarzo 1992, Degryse, Ioannidou and Schedvin 2011), especially when vying for market share. As a consequence banks may 'overlend'.
In our recent research, using a large sample of UK firms between 1896 and 1986, we document that with the onset of the UK banking sector deregulation in 1971 (also known as Competition and Credit Control) a subsequent and remarkable shift from bilateral to multilateral relationship banking took place (Braggion and Ongena 2013). We then relate such a shift to firms’ use of debt finance and its effect on leverage ratios.
For a large part of the 20th century, the Treasury and the Bank of England actively promoted the existence of a cartel among the big British banks, and supported the introduction of interest rates ceilings and lending controls. In the late 1960s, the government and the Bank of England recognized the inadequacy of this arrangement. From 1971 on, the cartel was progressively dismantled and the UK authorities promoted greater competition among financial institutions. In particular, both ceilings on interest rates and direct credit controls were lifted. Banks were allowed to directly participate in the wholesale market to obtain financing, and reserve requirements were relaxed. Figure 2 shows the evolution of the M3 multiplier from the second half of the 19th century until the end of the 20th century.2 The money multiplier describes the relationship between monetary base and total money supply. We interpret it as a proxy of banks’ willingness and capability to lend. Its value becomes larger if banks’ reserves (either required or voluntary) become smaller. The series is relatively flat for about a hundred years between 1870s-1880s and 1970. After 1970, it displays a sharp growth－ the money multiplier grows from around 4 in 1960 to about 10 in 1986.
Figure 2. UK M3 multiplier, 1871-2005
Sources: Capie and Webber (1985); Bank of England.Banks-firms relationships
Our study shows that the 1971 deregulation affected also the dynamics of banks-firms relationships. Table 1 presents data on all commercial and industrial companies, quoted at the London Stock Exchange between 1896 and 1986. It shows that about 85% of companies in the sample were involved in a single bank relationship between 1906 and 1970. This figure considerably declines to 71% in 1976, and to 60% in 1986. Table 1 also shows that the transition is not driven by temporal changes in the composition of firms included in the sample. The result does not change if we consider only the 602 firms that reported their relationships during the entire transition period. The transition from single to multiple bank relationships is even more pronounced for larger companies－65% of the top 200 companies (in terms of share capital issued), for example, had a single relationship between 1906 and 1966. By 1986 this percentage almost halved to 38%.
Table 1. Number of firm-bank relationships throughout the 20th century in Britain
A more in-depth analysis allows us to more precisely date the acceleration of the transition to multiple banking in the 1970s. The analyses we perform document that especially larger and more transparent firms, as well as firms that had an outstanding debt with their incumbent bank, have a higher need for multiple bank relationships. The result on transparency is especially robust and consistent across various specifications. In particular, we find that firms with better governance (i.e., in terms of applying the one share - one vote principle) and officially listed firms (i.e., with securities that have direct access to a large market) were more likely to switch to multiple banking. Transparent firm headquartered in local banking markets that experienced a surge in competition after the 1971 reform were even more likely to switch.Corporate leveraging
Having established banking-sector deregulation in 1971 as a likely cause of the transition to multiple banking in the UK during the 1970s, we investigate its effects on the corporate leveraging. Identifying a causal relationship that runs from multiple relationships to financial policies is difficult, as unobservable variables that may lead firms to approach an additional bank, may also have a direct effect on firms’ borrowing and leverage ratios. Our identification strategy relies on a difference-in-difference analysis. It also exploits the theoretical predictions of relationship lending models, which imply that when the degree of competition in the banking market is fiercer, the adding of a (so-called ‘inside’) bank will have a stronger impact on borrowing conditions (Rajan 1992, von Thadden 2004, Fischer 1990, Sharpe 1990). As a result, we expect that ‘adders’ post-1970 will display larger changes of their debt composition and leverage ratios. This exercise is particularly meaningful in our context, as the historical evidence suggests that banking deregulation was exogenous to firms’ demand, making it very likely that we identify changes in the supply of capital conditions. Such deregulation was driven by the need of the Bank of England to have a more effective way to conduct monetary policy, rather than aimed at accommodating specific needs of the corporate sector.
- The analysis finds that adders subsequently increase their leverage and bank debt more, and also decrease their trade (and other) credit more than other firms that did not add banks.
Leverage increased by four percentage points more, which given a mean leverage in our sample of 46% implies a semi-elasticity of 7%. Bank debt to total debt ratio increased by four percentage points, a 17% increase with respect to sample average, while trade credit to total debt contracted by three percentage points, corresponding to a decline of 5% vis-à-vis its sample average.Conclusion
Our work uncovers an additional explanation for the increase in corporate leverage, i.e., one that runs from banking sector deregulation and intensifying competition between banks, over firm-bank relationship multiplicity, to corporate leverage and bank debt usage.References
Bizer, D S and M DeMarzo (1992), “Sequential Banking”, Journal of Political Economy 100: 41-61.
Braggion, F and L Moore (2011), “Dividend Policies in an Unregulated Market: The London Stock Exchange, 1895-1905”, Review of Financial Studies 24: 2935-2973.
Braggion, F and S Ongena (2013), "A Century of Firm – Bank Relationships: Did Banking Sector Deregulation Spur Firms to Add Banks and Borrow More?", CEPR, London.
Capie, F and A Webber (1985), A Monetary History of the United Kingdom, 1870-1982, London, Unwin Hyman.
Degryse H A, V Ioannidou and E L Schedvin (2011), On the Non-Exclusivity of Loan Contracts: An Empirical Investigation, CentER - Tilburg University, Tilburg.
Fischer, K (1990), Hausbankbeziehungen als Instrument der Bindung zwischen Banken und Unternehmen - Eine Theoretische und Empirische Analyse, Universitat Bonn, Bonn.
Graham, J R, M Leary, and M Roberts (2011), A Century of Capital Structure: The Leveraging of Corporate America, Duke University, Durham NC.
Rajan, R G (1992), “Insiders and Outsiders: the Choice between Informed and Arm's-Length Debt”, Journal of Finance 47: 1367-1400.
Sharpe, S A (1990), “Asymmetric Information, Bank Lending and Implicit Contracts: a Stylized Model of Customer Relationships”, Journal of Finance 45: 1069-1087.
Von Thadden, E-L (2004), “Asymmetric Information, Bank Lending, and Implicit Contracts: the Winner's Curse”, Finance Research Letters 1: 11-23.
1 A notable difference is that leverage ratios in the US started to increase already after 1948.
2 We thank Massimo Giuliodori for sharing with us these data.