Swiss Banking Institute

1
Capital market vs. Banking oriented Systems
Influences on Corporate Strategy and Corporate
Finance

• Rudolf Volkart
• Professor in Corporate Finance, DirectorSwiss
  Banking Institute, University of Zurich

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Agenda

• - Introducing remarks
• - System-related aspects, and tendencies
• - Shared values by market players
• - Investment financing decisions
• - Financial structure theory and practice
• - Further implications from CMOS and BOS
• - So what?

3
Introducing remarks

• New Study by Credit Suisse Economic
  Research Economic Briefing Systems of
  Corporate Financing (Zurich 2005)
• Remarkable, interesting conclusions
• Main points shared by the speaker partly as
  starting point for the subsequent considerations

4
System-related aspects, and tendencies (1)

• Neither pure capital market (CMOS) nor banking
  oriented systems (BOS)
• Swiss system named as hybrid more important
  the Nestlés versus SMS-firms
• Convergence of financial systems internationally
• Convergence of firms financial patterns
• Interlinks by securitization and instruments
• In general different legal system features

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System-related aspects, and tendencies (2)

• Different ownership structure and governance
• Private and institutional shareholders, banks,
  conglomerates, etc.
• Need for strong corporate governance and timely
  transparent information in CMOS
• Corporate control and governance as disciplining
  factors, activism by institutionals
• Strengthened disclosure (GAAP, IFRS) and
  governance (SOX, other)

6
Shared values by market players

• Risk-return principle as main orientation
• Information needs, transparency, ratings
• Risk-adjusted discount rates cost of capital as
  expected (required) rate of return
• Bonds, loans Risk-adjusted pricing by
  risk-adequate interest rates (promised return)
• Reducing agency problems and risks, namely debt
  agency (bondholders event risk)

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Investment financing decisions (1)

• Pure, stringent theory separation theorem
• Reality Firms investment and financing side
  interdependent
• Insufficient access to (new) capital may limit
  investments (financial slack)
• Drawbacks from investment strategy to financing
  decisions (e.g. market segment)
• Strategic implications from access to capital,
  D/E, information needs, and regulation

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Investment financing decisions (2)

• Ownership (public versus family owned company!)
  can influence financial and investment policy
• Pressure by substantial shareholders on
  Dividends, share buybacks drawback on
  investments (Ascom, Saurer, etc.)
• Management discretion and attitude on decision
  making in international acquisitions (Mittal -
  Arcelor, Pepsi - Danone, etc.)

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Financial structure theory and practice (1)

• Corporate taxes (Modigliani / Miller)
• Trade-off theory (bankruptcy, financial distress)
• Agency theory managerial debt agency
• Pecking order theory (subsequence-oriented)
• Leverage effect on return and risk ROE, EPS
• Market timing, financing flexibility, windows of
  opportunity
• Financial slack, risk policy (limiting firm risk)

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Financial structure theory and practice (2)

• Debt financing CMOS offers broader set of
  instruments, including bank credits
• Hybrid instruments BOS filling up the gap
  compared to CMOS?
• Equity CMOS gives access to external equity
  stronger shareholders position IPO as exit
  solution (private equity, venture capital, etc.)
• Differences in the relationship between firm and
  investors (banks, capital markets, etc.)

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Financial structure theory and practice (3)

• Open information and value reporting (CMOS)
  versus closed information flows (BOS)
• Investor orientation (community) in CMOS
  intensified information communication (lower
  cost of capital, harmonizing interests, etc.)
• Differences in governance mechanisms, protecting
  shareholders and debtholders
• Influence on financing decision capital market
  transactions versus bank (syndicated) loans

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Further implications from CMOS and BOS (1)

• Differences in bankruptcy financial distress
• Influence on managerial and debt agency
• ROE-, EPS-games flexibility opportunities
• Big international firms Access to different
  financial markets (not financial system related)
• Small firms Private ownership, bank loans
• Middle size firms (!) Access to capital markets
  may differ among national financial systems

13
Further implications from CMOS and BOS (2)

• Listed companies show different behavioral
  patterns
• Playing the expectations management game
• Earnings guidance (prospective, pro-active)
• Earnings management (ex-post, re-active)
• Tendency to short-term-ism (quarterly profits)
• Empire building, managerial welfare

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So what? (1)

• Besides the concepts of CMOS or BOS general
  legal determinants of financial systems
• Firm specific characteristics dominating factor
  over financial system issue
• Firm size, ownership, business model, etc.
• Generic view of the firm (start-up, growth, MBO,
  IPO, going private, restructuring, etc.)
• Market and bank orientation completing, not
  competing alternatives

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So what? (2a)

• We survey managers in 16 European countries on
  the determinants of capital structure across
  countries. Financial flexibility and earnings per
  share dilution are the primary concerns of
  European managers (). Managers also value
  hedging considerations and use window of
  opportunity in raising capital. European
  managerial views are largely similar to that of
  the U.S. managers reported in Graham and Harvey
  (2001) and the evidence provides modest support
  for the trade-off and the pecking-order theories
  of capital structure.

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So what? (2b)

• However, there is substantial variation in
  managerial views across European countries. Our
  cross-section analysis supports that both legal
  and institutional factors influence managerial
  views, although sensitivity to these factors
  varies widely (). Our evidence suggests that
  capital structure choice in each country may be
  the result of a complex interaction of many
  institutional features including its legal
  environment.

Bancel, F./Mittoo, U. R. The Determinants of
Capital Structure Choice A Survey of European
Firms, Working Paper (2003), http//207.36.165.114
/Denver/Papers/FranckBancelPaper.pdf - 15.2.2006
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So what? (3)

• Capital structure and financing policy many
  puzzling factors
• Theory overstates strategic view, as shown in
  capital structure theory
• Practice looks at opportunities and follows
  pragmatism, before all related to strategy
• Behavioral aspects may not be understated!