The past few decades have witnessed increasing influence of the financial sector on the broader economy. Finance supports investments, increases the productive capacity of the economy, and constitutes a key ingredient for long-term economic prosperity (Levine 2005). But the Global Crisis vividly demonstrated that a larger financial sector is not necessarily better (Beck et al. 2014). Excessive lending growth drove up levels of private debt, causing major stability concerns with real repercussions for the economy in the aftermath of the crisis (Shularick and Taylor 2012, Mian and Sufi 2014). Understanding the role of the financial sector in the provision of firm financing has therefore become more relevant than ever. Our main question of interest is to what extent firm financing has changed among different groups of EU countries, the US, and Japan ten years after the crisis (Kalara and Zhang 2018).
Financial systems in the EU
Comparing financial systems across countries is complicated. Financial systems are complex, they differ significantly between countries, and they change over time. Depending on the relative proportion of finance that is channelled through banks or markets, these systems are often classified as being bank-based or market-based. In bank-based financial systems, monetary financial institutions (‘banks’) remain the main vehicle of capital allocation and investment, while in market-based financial system, securities markets are equally or more important than banks for transferring the necessary funding towards firms. Continental Europe and Japan are traditionally considered to be bank-based systems, in contrast to market-based systems found in Anglo-Saxon countries. Although the distinction between bank- and market-based systems has recently become less clear as banks have become increasingly more market oriented, the paradigm of bank- versus market-based systems nevertheless provides us with a useful tool for comparing the development of financial systems.
Using a principal components analysis as in Bijlsma and Zwart (2013), we categorise the EU countries into four homogenous groups with similar financial sector characteristics in 2015. Bank-based countries (Germany, Portugal, Ireland, Spain, Italy, Austria, Greece) have large banking sectors and rely less on market financing. Market-based countries (Belgium, Denmark, France, the Netherlands, Sweden, Finland, the UK), which are closest to resembling the financial system of the US, have more developed equity markets. Furthermore, we distinguish a group of Eastern European countries (Croatia, Bulgaria, Estonia, Poland, Hungary, Cech Republic, Slovenia, Slovakia, Latvia, Lithuania, Romania) that joined the EU more recently. These countries are found to have smaller financial markets compared to older member states. The last group contains the outliers – countries that could not be classified in the other three categories (Cyprus, Malta, Luxembourg). These countries have a disproportionately large banking sector relative to their size and are often considered tax havens.
Bank financing under pressure
Bank finance remains a dominant source of firm financing especially in the bank-based economies. Figure 1 shows the stagnation of bank credit to non-financial firms after the crisis. While all EU countries have experienced a decline in bank lending to firms since 2009, the decline is strongest in the bank-based and Eastern European countries. It has not returned to the pre-crisis levels anywhere except in the US and Japan. These findings are consistent with the restructuring of bank balance sheets after the crisis. Due to Basel III regulations, banks have had to reduce their balance sheets to strengthen their capital positions, and they have done so especially on cross-border activities. For example, De Haas and van Lelyveld (2014) show that multinational bank subsidiaries had to slow down credit growth almost three times as fast as domestic banks. This was in particular the case for subsidiaries of banking groups that relied more on wholesale funding.
Figure 1 Bank credit to non-financial firms
Shift in capital market financing from stocks to bonds
Capital market financing constitutes another important funding mechanism for firms. While the stock market took a significant hit everywhere after the crisis, the recovery path has been quite distinctive across different countries (Figure 2). Whereas the stock market capitalisation as a percentage of GDP in 2016 exceeded its pre-crisis level in the US, Japan, and market-based EU countries, the bank-based EU and Eastern European countries are still lagging far behind their pre-crisis levels, imposing additional constraints for market-based financing in these countries.
Figure 2 The fluctuation of stock market capitalisation
However, stock market capitalisation may simply reflect price movements, rather than the degree of equity funding obtained by firms from the stock market. We further examine the issuance of new shares by listed companies and venture capital investments and find that equity markets have been shrinking globally since 2000, reflected by the decline in new share issuance and venture capital financing in Figures 3a and 3b. The development of new share issuance after the Global Crisis varies across countries. As shown in Figure 3a, while new share issuance experiences a substantial decline in almost all country groups, except the Eastern European countries, it has recovered to some extent in the market-based and bank-based EU countries since 2012. We observe some increase in venture capital financing only in the US after the crisis in Figure 3b.
Figure 3 The decline in equity market activity
(a) Issuance of listed shares
(b) Venture capital investments
Note: Greece is not included in the bank-based countries in Figure 4a. This is to avoid one-off impact of the Greek bailout program, see Kalara and Zhang (2018: 16).
Owing to low interest rates, corporate bonds have become an attractive source of financing (Figure 4). For instance, corporate bond issuance as a share of GDP in the market-based EU countries has grown on average from 10% to 15% over the past decade.
Figure 4 The development of the corporate bond market
Alternative finance is on the rise
Alternative forms of financing, for example factoring (as well as crowdfunding and angel investments; see Kalara and Zhang 2018) have seen rapid growth during the last years. They have become increasingly relevant for financing small and medium- sized enterprises (SMEs).
Finance through factoring occurs when a company (called a factor) buys invoices from another firm at a discount and then collects the debts. The goal of the seller is to meet his immediate cash needs and to outsource debt collecting. The volume of factoring financing as a percentage of GDP, as shown in Figure 5, is much higher in the EU countries than in the US and Japan. We find an increase in the factoring volumes in the EU, while the US and Japan show a small but steady decrease. The increase in the bank-based and market-based EU countries is remarkable, as both groups show an increase of more than 50% during 2007-2016. This may have helped to ease the financing difficulties of European SMEs after the crisis. However, alternative finance remains a niche market. The volumes of financing through these new forms are significantly lower than through, for example, bank financing.
Figure 5 The rise of factoring
In all, the Global Crisis has put bank finance under pressure. Bank credit to non-financial firms has declined considerably after the crisis and stagnated during recent years, posting constraints to economic recovery and future growth especially in bank-based Europe. For these countries, a shift to market-based financing could be desirable due to the shortage of bank credit. Although stock market and venture capital financing have declined since 2000, we observe some increase in corporate bond financing, especially in the market-based EU countries. Alternative finance is growing rapidly, which may have helped to alleviate the financing difficulties of SMEs to some extent, but it remains a small part of the overall financing activity of firms.
Authors’ note: This column is summary of a CPB discussion paper (Kalara and Zhang 2018).
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