Corporate Finance and Its International Perspective Considering Legal and Regulatory Influences on Financial System Development

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Corporate Finance and Its International Perspective Considering Legal and Regulatory Influences on Financial System Development

1.0 INTRODUCTION

There is no doubt that the business world is now international. Advances in information exchange have created one global economy, accessible to all investors, both personal and corporate. This exponentially increases the number and complexity of financial decisions managers must make to be successful.

The present market situation, the mood among consumers and enterprises, and the resulting effects on the global economy are posing ever greater challenges. Only those companies and organizations which have a clear insight into this situation and the ability to see the “bigger picture” can make well-founded decisions and thereby optimize business process and achieve greater efficiency and profitability. In order to meet these increased requirements, analytical applications are indispensable as a means of evaluating and increasing a company’s performance. This requires the correct processes in value management and effective support for these processes through the use of informatics.

The goal of financial management in a for-profit business is to make decisions that increase the value of the stock, or, more generally, increase the market value of the equity.The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation.There is the possibility of conflicts between stockholders and management in a large corporation. We called these conflicts agency problems and discussed how they might be controlled and reduced. The advantages of the corporate form are enhanced by the existence of financial markets. Financial markets function as both primary and secondary markets for corporate securities and can be organized as either dealer or auction markets.

2.0 CORPORATE FINANCE

Corporate Finance is the specific area of finance dealing with the financial decisions corporations make, and the tools and analysis used to make the decisions. The discipline as a whole may be divided between long term, capital investment decisions , and short term, working capital management. The two are related in that firm value is enhanced when return on capital, a function of working capital management, exceeds cost of capital, which results from the longer term, capital decisions. Corporate Finance is closely related to managerial finance, which is slightly broader in scope, describing the financial techniques available to all forms of business enterprise, corporate or not.

Theoretical and empirical studies of corporate finance comprise an extremely large body of literature and deal with a very large number of specialized questions. The main journal for articles on research in corporate finance is the Journal of Finance (published in the United States by the American Finance Association); followed by the Journal of Financial Economics. Other specialist journals exist, and articles on corporate finance are also published in a large number of wider-ranging economics journals.

Corporate finance has three main areas of concern:

a. Capital budgeting: What long-term investments should the firm take?

b. Capital structure: Where will the firm get the long-term financing to pay for its investments? Also, what mixture of debt and equity should it use to fund operations?

c. Working capital management: How should the firm manage its everyday financial activities?

Underlying all the specialized research questions in corporate finance is one fundamental question: what is the relation between:

Ø Corporations’ decisions on investing in productive (physical) assets and issuing financial liabilities, and

Ø Markets in the financial liabilities (equities and debt) which they issue?

3.0 COMPONENTS OF INTERNATIONAL CORPORATE FINANCE

Corporation with significant foreign operations are often called international Corporations or multinationals. Such corporations must consider many financial factors that do not directly affect purely domestic firms. These include foreign tax rates different exchange ‘interest rates from country to country, complex accounting methods for foreign operations, foreign tax rates, and foreign government intervention.

The basic principles of corporate finance still apply to international corporations; like domestic companies, these firms seek to invest in projects that create more value for the shareholders than they cost and to arrange financing that raises cash at the lowest possible cost. In other words, the net present value principle holds for both foreign and domestic operations, although it is usually more complicated to apply the NPV rule to foreign investments.

One of the most significant complications of international finance is foreign exchange. The foreign exchange markets provide important information and opportunities for an international corporation when it undertakes capital budgeting and financing decisions. As we will discuss, international exchange rates, interest rates, and inflation rates are closely related. There we mention some main consideration under international perspective of corporate finance.

1. International Economic Framework

a) International Finance and the International Challenge for Risk

b) Balance of Payments

2. Understanding International Currencies

a) International Monetary Arrangements and Adjustment Mechanisms

b) Currency Trading and Parity Relationships

c) Creating and Adjustment Currency Positions (Speculation, Hedging, Currency Options)

d) Advanced Topics in Forecasting, Hedging and Options

e) Exposure Measurement and Management

3. International Investment

a) Investing in Foreign Operations

b) International Capital Budgeting

c) Corporate Tax Considerations

d) Political Risk

4. International Capital Markets

a) Global Capital Markets

b) Eurobonds

c) Medium-Term and Short-Term Funds

d) Customized Risk Control Agreements (Swaps, Forward Rate, Interest Rate)

Typically, international corporate financing decisions involve a choice of three basic approaches:

Ø Export domestic cash to the foreign operations

Ø Borrow in the country where the investment is located

Ø Borrow in a third country.

4.0 LEGAL AND REGULATORY INFLUENCES ON FINANCIAL SYSTEM DEVELOPMENT

In the postwar period, dramatically different systems of corporate finance and governance have emerged among the major industrialized countries. Even the casual observer notices large differences between the way firms finance and govern themselves in the United States on the one hand and in Japan and Germany on the other. Why should corporate finance and governance systems differ so dramatically across countries? The difference poses a problem for the theory of corporate finance and governance. Theoretically, there is a single best way to organize and finance firms. Since we should expect finance and governance systems to converge to this optimum, we ought not to find much difference in these mechanisms across countries. The large differences are actually observed thus suggest accidents of history or culture or factors that theory ignores—such as differences in the laws, rules, and regulations that govern the financial systems of industrialized countries.

Recently, much has been written in the scholarly and policy-oriented literature on the relative merits of the different corporate finance systems in the developed countries. There is, however, little focus on the reasons are observed such differences despite the problems these differences pose for the theory of corporate finance. Many studies appear implicitly to assume that the outcomes that observed are essentially cultural or historical accidents. And much of the discussion on the relative superiority of one system over another ignores the possibility that these systems are the products of particular legal and regulatory environments that may be difficult to create in other countries.

It is argued that there are, in fact, large legal and regulatory differences among the United States, Japan, and Germany that affect the corporate financial systems in place. The differences are essentially of three kinds. First is the severity of the legal and regulatory restraints on large investors’ being “active” investors in firms. U.S. laws are in general much more hostile to investors’ taking large influential stakes in firms than are the laws of Japan or Germany. Second is the degree to which sources of nonblank finance are actively suppressed. For much of the postwar period, the development of securities markets in Japan and Germany has been impeded by discriminatory taxation, regulatory fiat, and cumbersome mandated issuance procedures. Third is the degree to which corporate securities markets have been “passively” suppressed by the absence of any strong mandated, standardized disclosure requirements by firms wishing to issue securities to outside investors. U.S. disclosure requirements have been much more severe than those in Japan or Germany. These differences may have been important in determining the relative speed of securities markets development if there is a large public good aspect to the production of information by firms seeking external finance that only the imposition of government-backed disclosure requirements can solve.

These legal and regulatory differences are largely responsible for the very different systems of corporate finance and governance in the United States, Japan, and Germany. One natural question is which system is superior in terms of providing external finance at the lowest cost? The academic literature on this topic does not yield a clear conclusion as to the more efficient system, or whether any efficiency differences are large enough to be of practical relevance. However, it is pointed out that this literature ignores that changes in technology, the globalization of financial markets, and the changing structure of the firm may have made the Japanese and German systems of finance and governance less attractive systems over time. There is evidence that the U.S. system of finance, for example, is more favorable to the growth of new, high-technology companies than are the German and Japanese systems.

Perhaps in response to the perceived advantages of the U.S. system, the legal and regulatory environments of the German and Japanese systems are changing rapidly, and securities markets are being substantially deregulated in an effort to increase their importance as a source of firm finance. However, it is important to realize that the regulatory environment of the U.S. financial system is changing, too, albeit much more slowly than the German or Japanese system, as financial institutions are being given more latitude to be active investors in firms. Thus, over the long term, the legal and regulatory environments of all three countries appear to be converging, and the focal point of this convergence is not the Japanese/German or U.S. system as it currently stands but an entirely new environment where financial institutions are free to be active investors and where corporate securities markets are unhindered by regulatory obstacles.

These issues are fundamental to the theory of the firm, corporate finance, and corporate governance that have engaged academic debate for many years. However, recently they have taken on a policy relevance not experienced before. In the United States, there has been an intense, ongoing debate about the most preferred methods of financing and governing firms. And in the last few years, both Japan and Germany have substantially deregulated their corporate securities markets. In addition, the stark differences between these systems provide alternative paths of development for policymakers in a whole host of countries considering revamping their financial systems. These include developed countries such as France and Italy, as well as the excommunist countries of Central Europe and many of the emerging market countries of Latin America and Asia, which all face decisions about how to craft the outlines of their rapidly developing financial markets. In doing so, they would undoubtedly appreciate an understanding of the factors behind the differences in the major industrialized countries’ financial systems and their relative costs and benefits. This report addresses these issues by describing in detail the important characteristics of the corporate financing systems in the United States, Japan, and Germany, examining why such differences exist, and comparing some of their strengths and weaknesses.

In the following section, is describing the corporate finance and governance system in the United States, Japan, and Germany, highlighting the major differences. Then focus on the major legal and regulatory factors that are believed as the main determinant of these differences. Finally, it looks at why the Japanese/German system and the U.S. system may be converging and exploring some implications of this convergence.

Ø CORPORATE FINANCE AND GOVERNANCE ACROSS COUNTRIES

All corporate finance markets must address two generic information problems faced by firms attempting to raise funds from outsiders: sorting problems and incentive problems.

Sorting problems arise in the course of selecting investments: firm owners and managers typically know much more about their business than do outsiders, and it is in their interests to accent the positive while downplaying potential difficulties. Sorting problems and their implications for corporate finance were first analyzed by Leland and Pyle (1977) and Ross (1977), who emphasized that the choice of capital structure was important in minimizing such problems. More generally, potential outside financiers must conduct extensive information gathering and verifying activities in order to minimize such information asymmetries.

Incentive problems arise in the course of the firm’s operations. Firm managers have many opportunities to benefit themselves at the expense of outside investors. Jensen and Meckling (1976) were the first to address these issues. They stressed that a combination of methods is usually needed to align the incentives of managers and investors, including the use of an appropriate capital structure, collateral, security covenants, and direct monitoring. Diamond (1991) highlighted the role of reputation in mitigating incentive problems: managers of firms that have a stake in maintaining a good reputation with outside investors have strong incentives not to act opportunistically at the investors’ expense.

Information problems vary in severity across firms. The firm’s age, size, growth rate, and line of business all influence the degree of information problems it poses to outside investors. For example, firms with heavy investments in tangible fixed assets pose less severe information problems to investors because they may be able to offer some of their fixed assets as collateral to potential creditors and because monitoring the sale of fixed assets or their transformation from one use to another is likely to be easier than it is for more liquid assets. Conversely, firms that focus on research and development may have wide scope for discretionary behavior, since the risk implicit in a particular research and development program cannot easily be monitored or controlled by outside investors. Finally, other things being equal, small firms pose greater information problems than large firms. Smaller firms do not produce detailed information about themselves and are often too young to have a credible reputation. Larger, public firms make available detailed information about their activities and have a bigger stake in maintaining a good reputation among potential financiers.

The following section describes the structure of U.S., Japanese and German corporate financial markets and how they address these information problems.

Ø THE U.S. SYSTEM

The U.S. system is developed broadly and deeply enough to allow a large variety of suppliers of finance to compete with one another in a number of different finance markets. These markets differ from one another partly in the degree to which they are designed to mitigate the information problems posed by firms. This differentiation provides a natural selection mechanism as to which firms use which markets. While banks play an important financing role, they are more limited by regulation than in Japan or Germany. Conversely, more liberal regulation of securities markets permits a greater role for securities financing than in Japan or Germany.

Figure 1: Short-Term Liabilities of Nonfinancial Business, 1994

Although banks dominate U.S. short-term finance markets, they have much competition from finance companies, savings institutions, and the commercial paper market, which is an option for larger, more highly rated firms (Figure 1). While banks are still an extremely important source of funds for small firms, over the past fifteen years rapid consolidation of the banking industry has led to a decrease in small business lending. Bank lending to large firms has also shown declines in recent years, possibly owing to increasing competition from other intermediaries and from securities markets.

Securities markets play a more important role in long-term financing than in short-term financing, and they play a more important overall role in corporate financing than in most other countries (Figure 2). The public bond market is the largest source of long-term finance because it caters to the biggest firms that have the largest capital needs.

Figure 2: Issuance of Long-Term Securities, 1990–94

The public equity market is also an extremely important source of long-term funds for large firms and small, fast growing firms that make initial public offerings. Two private markets the private bond and private equity markets are often the only realistic sources of long-term finance for small and middle market companies. These markets involve the issuance of securities that are exempt from registration with the Securities and Exchange Commission and, thus, free from much of the expense in money and time of the registration process and the continuing reporting and disclosure requirements. The largest of these private markets is the private placement, or private bond, market. It offers long-term debt at fixed interest rates and is a significant source of funds for middle-market firms with annual revenues between $100 million and $500 million that are generally not large enough to issue public bonds. The private equity market consists of equity investments in small and medium-sized firms professionally managed by specialized intermediaries, mostly limited partnerships.

Just as firms vary in the degree to which they suffer from sorting and incentive problems, U.S. corporate finance markets differ in the extent to which they are designed to mitigate these problems. Thus, as shown in Table 1, small firms are forced to raise funds in markets that have developed the greatest safeguards to mitigate information problems, such as the private equity and bank loan market. Medium-sized firms may be able to tap the private bond market, while larger or more promising middle market firms may be able to issue public equity. Large firms that suffer least from information problems gravitate toward the markets with the fewest such safeguards and where capital is the cheapest, such as the public bond and commercial paper markets.

Two common features in the bank loan, private placement, and private equity markets safeguard against the most severe information problems that occur in smaller firms. First, investors in these markets have the expertise and resources to obtain and analyze information about the firms that solicit them for money, helping to mitigate the sorting problem. Second, investors use various control mechanisms to influence the firm after funds are invested to ensure that it makes proper use of their capital, which helps mitigate the monitoring problem.

For example, tight covenants in bank loans and private placements help control risk and constrain opportunistic behavior. Private equity investors use a number of mechanisms to give them influence, including board representation and voting rights. In addition, they will typically control the firm’s access to subsequent capital. Fast-growing firms depend crucially on the initial investors to either provide subsequent capital themselves or find other investors to do so. Finally, management is almost always given a significant stock ownership, which more closely aligns management’s incentives with those of the private equity investors.

Table 1: Capital Sources for Firms

	Firm Size
	Small	Medium	Large
Information Availability	Low	More	High
Sorting/incentive problems:	High	Less	Low
Capital sources	Angle Capital Private Equity Bank Loans	Private Equity Bank Loans Private Bonds Public Equity	Bank Loans Public Equity Public Bonds Commercial Paper

Large, public firms share some of small firms’ information problems, though to a lesser extent. The public bond and equity markets have a number of characteristics that help mitigate these problems. First, there are a host of stock and bond analysts, ratings agencies, and other advisors that analyze the operations and reports of large firms and offer opinions about whether the firm is worthy of new capital. Second, the public equity market is highly liquid, making the threat of a takeover of a firm that is performing poorly a credible one in many cases, helping to discipline management to act in shareholders’ interests.

Ø THE GERMAN/JAPANESE SYSTEMS

Although there are some differences, methods of finance and governance in Japan and Germany share a number of important characteristics. In particular, they both look very different from those of the United States.

First, there has been a much less diverse spectrum of finance markets available to firms in Japan or Germany than in the United States. Japanese and German firms, regardless of their size or the severity of their information problems, have traditionally relied more on bank financing than have U.S. firms, while securities markets have been much less important. For example, from 1970 to 1985, intermediated loans (principally from banks) comprised 85 percent of the total gross external financing of Japanese nonfinancial firms, with only 15 percent sourced from bond and equity markets.8 German nonfinancial firms raised 88 percent of their gross external funds from intermediated loans over the same period, with only 12 percent from securities markets.

Table 2 Stock Market Capitalization, 1985

(As a Percentage of GNP)

	United States	Japan	Germany
Unadjusted	51	71	29
Adjusted	48	37	14

SOURCES: Borio (1990) and national data.

Another important characteristic of the financial systems of Germany and Japan is the closeness of ties between banks and their corporate borrowers, which are much tighter than the traditional arm’s length relationships observed in the United States. One important aspect of these tight relationships is the ownership of equity of nonfinancial firms by banks. Unlike in the United States, banks are the most important large shareholders in firms in both countries. In Japan, they own over 20 percent of the outstanding common stock of nonfinancial firms. In Germany, they own 10 percent, but under current law they have great flexibility to vote according to their own wishes the additional 14 percent of common stock owned by individuals but held by banks in trust for them. In contrast, U.S. banks own negligible amounts of nonfinancial firms’ equity.

Table 3 Composition of Companies’ Credit Market Debt, 1985

(As a Percentage of Total Credit Market Debt)

	United States	Japan	Germany
Securities	55	9	6
Intermediated Debt of which, From banks	45 36	91 NA	94 88

SOURCES: Borio (1990) and national data.

Banks consequently have a potentially powerful position as active monitors in both Germany and Japan. First, they have typically comprised the lion’s share of external finance to firms and may, therefore, exercise influence through their control of the firm’s access to external funds. Second,

Table 4 Summary Statistics of Ownership Concentration of Large Nonfinancial Corporations

(Percentage of Outstanding Shares Owned by the Largest Five Shareholders)

	United States	Japan	Germany
Mean	25.4	33.1	41.5
Median	20.9	29.7	37
Standard Deviation	16.0	13.8	14.5
Minimum	1.3	10.9	15
Maximum	87.1	85	89.6
Mean Firm Size1 (millions of US$, 1980)	3,505	1,835	3,483
Mean firm size2 (millions of US$, 1980)	1,287	811	1,497

¹ Measured by total assets.

² Measured by market value of equity.

SOURCES: For the United States and Japan, Prowse (1992); for Germany, Prowse (1993). Size data converted to US$, using 1980 average exchange rates and deflated by U.S. consumer prices. The loans they make are often short-term in nature. In normal times, they would be rolled over on an almost automatic basis, but should questions arise about management strategy or quality, the bank always has the option of not renewing the loan at a fairly frequent interval. Finally, their large shareholder status means that they have both the incentive and ability to directly monitor management through their presence on the board and the votes they can exercise at the shareholders meeting.

Unlike U.S. banks, banks in Germany and Japan have effectively acted as insiders to firms. They have had great access to information about the firm’s operations and have had the ability to engage in monitoring and influencing management. Banks’ dual role as important lenders and shareholders has given them a primary role in the financing and governing of firms.

Ø U.S. AND GERMAN/JAPANESE SYSTEMS COMPARED

These differences between corporate finance systems show up in a variety of ways. First, the relative importance of corporate securities markets across industrialized countries differs dramatically. Stock market capitalization (as a share of gross domestic product) is much larger in the United States than in Japan and Germany after adjustment for the double-counting associated with inter-corporate shareholding (Table 2). Corporate bond markets also differ dramatically in size across countries. In Japan and Germany, less than 10 percent of nonfinancial corporations’ credit market debt was in the form of securities in 1985, compared with more than 50 percent in the United States (Table 3). These differences also show up in the financing patterns of individual large firms in the three countries. For example, in 1994, the two largest firms in Germany, Daimler-Benz and Siemens, had long-term debt securities outstanding accounting for 10 percent and 2 percent, respectively, of their total assets. In Japan, the numbers for Toyota and Nissan were 10 percent and 4 percent, respectively. In contrast, the percentage of total assets financed by long-term bond securities for two of the largest U.S. firms were 30 percent for Ford and 20 percent for GE.

Corporate ownership structures in the Untied States, Japan, and Germany also differ markedly. Ownership concentration is significantly higher in Japan and Germany than in the United States (Table 4). The holdings of the largest five shareholders average over 40 percent in Germany, 33 percent in Japan, and only 25 percent in the United States. Many of the large shareholders in Japan and Germany are banks with lending ties to the firm.

Another major difference is the frequency of corporate takeovers. The market for corporate control is much less active in Japan and Germany (Table 5). Part of the reason for the much greater merger and acquisition activity in the United States is, of course, the larger number of companies listed on the stock market. However, even after normalizing the dollar value of mergers and acquisitions by stock market capitalization, the U.S. merger market appears fifteen to twenty times more active than those in Japan or Germany.

Table 5 Average Annual Volumes of Completed Domestic Mergers and Corporate Transactions with Disclosed Values, 1985–89

	United States	Japan	Germany
Volume (in billions of US$)	1,070	61.3	4.2
As a percentage of total market capitalization	41.1	3.1	2.3

SOURCES: For the United States and Germany, Securities Data Corp., Mergers and Corporate Transactions database; for Japan, Yamaichi Securities Corp., as reported in Beiter (1991).

Hostile takeovers are also very much less frequent in Japan or Germany than in the United States. Table 6 illustrates the paucity of hostile offers (whether ultimately successful or not) in continental Europe compared with those in the United States (no comparable data for Japan are available). The differences across countries in actual, completed hostile takeovers are even more striking. Since World War II, for example, there has only been four successful hostile takeovers in Germany (see Franks and Mayer 1993). Kester (1991) claims that the use of takeovers in large Japanese firms is very infrequent. Conversely, in the United States, almost 10 percent of the Fortune 500 in 1980 has since been acquired in a transaction that was hostile or that started off as hostile.

Ø LEGAL AND REGULATORY DETERMINANTS OF CORPORATE FINANCIAL SYSTEMS

Much of the scholarly and policy-oriented literature is silent on the reasons for the differences in corporate finance and governance systems across countries. Studies that do focus on differences in the legal and regulatory environment mistakenly focus on only one aspect of it: differences in the degree to which banks are allowed to be active investors in firms.

Table 6: Hostile Takeovers and Leveraged Buyouts as a Percentage of All Attempted Transactions, 1985–89

	United States	Rest of Europe
Hostile takeovers	17.8	9.6
Leveraged buyouts	20.0	2.7

SOURCES: Securities Data Corp.; Mergers and Corporate Transactions database.

In fact, there are large legal and regulatory differences among the United States, Japan, and Germany that affect the corporate financial systems in place. These differences are of three kinds. First is the aforementioned severity of the restraints on large investors being active investors in firms. Second is the degree to which sources of non-bank finance are actively suppressed.

Finally, there are differences regarding disclosure requirements by firms wishing to issue securities. All these differences play a role in determining the different outcomes observed across countries. I consider them in turn.

Table 7: Legal and Regulatory Constraints on Corporate Control

Institution	United States	Japan	Germany
Banks	Stock ownership prohibited or requires prior approval of Federal Reserve Board and must be “passive.” Source: Glass–Steagall and Bank Holding Company Act.	Prior to 1987 banks could hold up to 10 percent of a firm’s stock. After 1987 can hold up to 5 percent. Source: Anti-Monopoly Act.	No restrictions, apart from some generous prudential rules.
Life insurance companies	Can hold up to 2 percent of assets in a single company’s securities; can hold up to 20 percent of assets in equities. Source: New York insurance law.	Can hold up to 10 percent of a firm’s stock. Source: Anti-Monopoly Act.	Can hold up to 20 percent of total assets in equities. Source: Insurance Law.
Other insurers	Control of non-insurance company prohibited. Source: New York insurance law.	Can hold up to 10 percent of a firm’s stock. Source: Anti-Monopoly Act.	No restrictions.
Mutual funds	Tax penalties and regulatory restrictions if ownership exceeds 10 percent of a firm’s stock. Source: Investment Company Act, Internal Revenue Service.	No restrictions.	No restrictions.
Pension funds	Must diversify. Source: ERISA.	No restrictions.	No restrictions.
General	Securities and Exchange Commission notification required for 5-percent ownership. Antitrust laws prohibit vertical restraints. Insider trading laws discouraging active share holding. Bankruptcy case law makes creditor in control of firm liable to subordination of its loans.	—	Regulatory notification required for 25-percent ownership.

SOURCES: For the United States, Roe (1990); for Japan and Germany, various national sources.

Ø RESTRAINTS ON OWNERSHIP OF CORPORATE EQUITY.

As Table 7 documents, financial institutions in Japan and Germany are generally given much more latitude to own shares in and exert control over firms than they are in the United States.

In the United States, financial institutions face significant constraints on their ability to take large stock positions in firms and use them for corporate control purposes. Banks are simply prohibited from owning any stock on their own account. Bank holding companies cannot own more than 5 percent of any unaffiliated, non-subsidiary, non-bank firm without Federal Reserve Board approval, and their holdings must be passive. Bank trust departments are allowed to hold equity for the beneficial owners. However, they cannot invest more than 10 percent of their trust funds in any one firm, and there are often other trustee laws that encourage further fragmentation of trust holdings. Other financial institutions also face strict rules governing their equity investments. New York insurance law, which currently governs almost 60 percent of total life insurance industry assets, places a limit of 20 percent of a life insurer’s assets, or one-half of its surpluses, that can be invested in equity, and a limit of 2 percent of its assets that can be invested in the equity of any one firm. Other states have similar rules. Property and casualty insurers are prohibited outright from owning a non-insurer. Mutual funds are subject to tax and regulatory penalties if they own more than 10 percent of the stock of any one firm. Pension fund investments are governed by the Employment Retirement Income Securities Act of 1974 (ERISA). ERISA requires all pension funds to be diversified, allowing little room for an influential position in a company.

U.S. securities laws discourage concentrated, active shareholding by investors in general. First, all entities acquiring 5 percent or more of a company must file with the SEC, outlining the group’s plans and revealing its ownership and sources of finance. Second, any stockholder who exercises control over a firm may be liable for the acts of the firm. Third, insider trading rules restrict large active shareholders from short-term trading of stock they own. Thus, Bhide (1993) reports that pension fund managers are reluctant to own more than 10 percent of a firm because this would restrict the liquidity of their stake, which by law they have a responsibility to protect. Finally, the legal doctrine of equitable subordination discourages all creditors from taking equity positions in the firm, since their loans are subject to subordination should they exert control.

In Japan, there are far fewer regulations constraining particular financial institutions from holding corporate stock or from using the stock they own for corporate control purposes. The sole restrictions derive from the Anti-Monopoly Act, which until 1987 limited a bank’s holdings of a firm’s shares to 10 percent (the limit has since been lowered to 5 percent). Insurance companies are similarly restricted to owning at most 10 percent of a firm. Antitrust laws and insider trading legislation on paper look similar to those of the United States. However, there is widespread recognition that they are not enforced by the authorities.

Table 8: Legal and Regulatory Constraints on Nonfinancial Firms’ Access to Non-bank Finance

Instrument	Japan	Germany
Commercial paper	Issuance prohibited until November 1987.	Issuance discouraged until 1992 by issue authorization procedure and securities transfer taxes.
Domestic bonds	Stringent criteria for issuance of straight and convertible bonds until 1987.	Issuance discouraged until 1992 by issue authorization procedure and securities transfer taxes.
Eurobonds	One-year approval period for foreign bond issuance until 1982; restrictions on issuance of Euroyen bonds until 1984; withholding tax on interest income of nonresidents until 1985; Eurobond issuance restrictions eased further in 1992.	Issuance abroad required prior notification of the authorities and was subject to maturity restrictions until 1989; issuance of foreign currency bonds prohibited until 1990.
Equity	Heavy taxes on equity transactions until 1988.	New share issues must be offered to existing shareholders first. One-percent corporation tax on all equity issues until 1992. Secondary trading in equities subject to securities transfer tax until 1992, ranging from 0.1 percent to 0.25 percent. Annual net asset tax of 1 percent on corporate net assets, payable irrespective of net income position.

SOURCES: Döser and Broderson (1990); Takeda and Turner (1992).

The institutional structure of the German financial system is based on the universal banking principle. Universal banks can hold whatever share of equity they like in any nonfinancial firm, limited only by a number of prudential rules that do not appear to be particularly binding. Antitrust laws have not been used to discourage inter-corporate shareholdings as they have in the United States. And for much of the postwar period, there was no explicit legislation against insider trading: Germany has only recently adopted the European Community standards regarding the establishment of minimum levels of shareholder protection.

Ø SUPPRESSION OF SOURCES OF NON-BANK FINANCE IN JAPAN AND GERMANY.

Table 8 documents some of the legal and regulatory restraints on access to external non-bank finance by nonfinancial firms in Japan and Germany in the postwar period. Unlike in the United States, significant obstacles have confronted firms wishing to raise external finance from sources other than banks until the mid-1980s in Japan and until very recently in Germany.

Table 9: Selected Results from a Survey of the Implementation of OECD Guidelines on the Disclosure of Information by Multinational Enterprises (Number of Firms)

Country	Implementation of guidelines on disclosure of operating results1			Implementation of guidelines on disclosure of Intra-group pricing policies2
	Full	Partial	Not implemented	Full	Partial	Not implemented
United States	34	19	0	29	0	18
Japan	2	21	0	2	0	17
Germany	0	19	0	0	0	15

¹ Includes industrial and financial firms.

² Industrial firms only.

SOURCE: OECD, “Disclosure of Information by Multinational Enterprises,” Working Document by the Working Group on Accounting Standards, no. 6, 1989.

Until the early 1980s, Japanese firms had no direct recourse to capital markets for external finance. The domestic bond market was open to only a few government-owned firms or electric utilities. The Bond Issuance Committee set severe eligibility requirements on issuers of corporate bonds through a detailed set of accounting criteria that in 1979 only permitted two firms to issue unsecured bonds domestically. These requirements were gradually relaxed in the mid-1980s, so that, by 1989, about 300 firms were eligible to issue unsecured straight bonds. Similar restrictions on access to the Eurobond market were relaxed in stages from 1982. Commercial paper issuance was prohibited by the authorities until 1987. While not directly restricted, equity issuance was discouraged by heavy taxes on transactions in equities until 1988. Restrictions on non-bank finance in Germany have been significant until even more recently. Issuance of commercial paper and longer term bonds was hampered by requirements under the issue authorization procedure and the securities transfer tax (see Deutsche Bundesbank 1992). The issue authorization requirements included obtaining prior approval by the Federal Ministry of Economics. Such approval was granted if the issuer’s credit standing was satisfactory and if a bank supported the application. While this procedure was a formality for large German firms, it added to the effective cost of a bond issue because firms could not generally issue the bonds at a time of their own choosing but were forced to wait for approval from the ministry. The securities transfer tax often imposed a considerable burden on the secondary market for corporate securities, particularly at its short end. Foreign issuance of corporate debt has been subject to similar restrictions. Equity issuance and secondary trading of equities historically have been subject to a variety of taxes that have generally made equity uncompetitive with bank loans as a form of external finance (see Döser and Broderson 1990). Most important, however, has been the legal requirement for employee representation on boards of publicly listed firms, which has discouraged many private firms from going public (see Borio 1990). Overall, these restrictions have made securities issuance “not a viable alternative for most German businesses.”

Ø FOSTERING NON-BANK FINANCE IN THE UNITED STATES THROUGH DISCLOSURE REQUIREMENTS.

Quite apart from the active discrimination against non-intermediated forms of finance, the lax disclosure requirements in Japan and Germany may have been an additional (passive) factor in discouraging the development of securities markets. Firms in the United States wishing to issue securities to the public have been required to disclose much more information than those in Japan and Germany. Results from a recent Organization for Economic Cooperation and Development survey, which rated the degree of information disclosure by firms relative to OECD guidelines, illustrate this pattern. Table 9 illustrates the results for two areas of disclosure – operating results and intra-group pricing policies. Two-thirds of U.S. firms surveyed had fully implemented the OECD disclosure guidelines for operating results; the rest had partially implemented them. In Germany none of the firms surveyed and in Japan less than 10 percent of those surveyed had fully implemented the guidelines. The results for disclosure of intra-group pricing policies (and other areas not reported here) reveal a similar pattern.

There is a fairly intense academic debate as to the effects of mandated corporate disclosure requirements, with no conclusive answer. One hypothesis is that mandated disclosure rules help firms make credible commitments to outside investors to provide honest and timely disclosure and protection from market manipulation or insider trading. In this view, for strategic, competitive reasons firms may not have sufficient incentives voluntarily to provide the financial information outside investors would require to consider extending such finance (for example, they may be afraid that competitors could take advantage of such information). Thus, absent a regulatory requirement for adequate disclosure to outside investors, the development of a liquid market for corporate securities may be effectively impeded. Proponents of such a view include Dye (1990), Dye and Magee (1991), and Demski and Feltham (1994).

The alternative hypothesis is that regulation unduly constrains the choices of firms and investors and prevents efficient contracting. In this view, firms have sufficient incentives to provide the optimal amount of disclosure to obtain external financing and regulations mandating such disclosure are, at best, irrelevant and, at worst, burdensome and costly on both firms and investors. Proponents of this view include Bentson (1973), Leftwich (1980), Watts and Zimmerman (1986), and Phillips and Zecher (1981).

Ultimately, the effect of mandated disclosure requirements is an empirical issue. Unfortunately, only a limited amount of research bears on this topic. Stock price studies of firms before and after the 1933 Securities Act suggest that mandated disclosure regulations impose costs on firms (see Benston 1973 and Chow 1983). On the other hand, Sylla and Smith (1995) explain the differing speeds of development of stock markets in the United States and U.K. since 1800 on differences in mandated disclosure rules. They attribute the faster development of the stock market in the U.K. in the nineteenth and early twentieth centuries to the various companies act between 1844 and 1900 that required substantial disclosure by firms wishing to issue equity.

Disclosure requirements were significantly less onerous in the United States until the 1930s, when the Securities Acts of 1933 and 1934 went beyond even what the British had put in place. Sylla and Smith claim these disclosure rules were responsible for putting the United States ahead of the U.K. in terms of the size and depth of the stock market in the immediate postwar period.

While this debate is far from settled, it is possible that the marked differences in disclosure requirements among countries may, in part, be responsible for the differences in the relative speeds of development of corporate securities markets.

Ø COSTS AND BENEFITS OF DIFFERENT SYSTEMS OF FINANCE AND GOVERNANCE

There has been much debate about the efficiency of the different systems of corporate finance and governance that are observed in the industrialized countries, with no clear consensus. While the academic and policy-oriented literature often finds specific advantages in a particular country’s financing and governance systems, it has not found demonstrably cheaper capital for firms or obviously superior mechanisms of corporate control in any one country.

The academic literature to date makes the following points: first, there are some advantages in fostering tight ties between banks and firms. Prowse (1990), Hoshi et al. (1990a), Lichtenberg and Pushner (1993), Cable (1985), and Elston (1993) all provide evidence suggesting that the concentrated holding of debt and equity claims by financial institutions in Germany and Japan mitigates the information problems of external finance and governance to a greater extent than in the United States, where ties between banks and firms are more arm’s length.

However, there are also advantages to having large, active corporate securities markets. Porter (1992) and Sahlman (1990) provide evidence that the U.S. system appears better at funding emerging companies and new (often high-technology) business activities than the German or Japanese system. Franks and Mayer (1992) argue that such a comparative advantage is the reason for the predominance of high technology firms in the fields of oil exploration, biotechnology, pharmaceuticals, and computer software in the United States. Porter also claims that liquid U.S. capital markets are able to reallocate capital from low- to high-growth sectors more efficiently than those of Japan and Germany. The specific advantages of each system do not appear to translate into overall measurable differences in either the cost of external financing or the effectiveness of the corporate control mechanism. There are legions of cost of capital studies with no clear message as to which system delivers external finance to firms at the lowest cost. And Kaplan (1993a, 1993b) reports that top management turnover exhibits similar sensitivities to measures of poor firm performance in the United States, Japan, and Germany. Conversely, both systems clearly have their embarrassing examples of breakdowns in corporate control. The German and Japanese systems appear particularly susceptible to potential problems involving “who monitors the monitor?” The U.S. system appears to have particular weaknesses when, for one reason or another, hostile takeovers pose no credible threat to current management. Overall, it may well be that neither system clearly dominates the other. After all, firms from all three countries have been competing internationally with each other for years, yet no obvious winner has emerged.

Perhaps the most important consideration in evaluating the effectiveness of each system is the system’s long-run stability, a factor many studies ignore. It appears that the legal and regulatory environment that sustains the corporate finance system in Japan and Germany is not stable, but is changing rather rapidly. These changes may be a result of a conscious decision by policymakers in these countries to capture some of the aforementioned advantages of the U.S. system in financing emerging high-technology ventures. Or they may have resulted from the fact that legal and regulatory systems have costs, both economic and political, the bulk of which may have little to do with the particular mechanism of corporate finance and governance they support and which have increased in response to changes in the power of vested interests, financial innovations, and other market developments.

Japan is the clearest example of this phenomenon. The regulatory and legal structure of the Japanese financial system has been changing since the 1970s under both domestic and international pressure for reform. One aspect of Japanese deregulation has been the gradual removal of restrictions on non-bank finance. Rosenbluth (1988) argues that the strict regulation of Japanese corporate finance in favor of bank lending until the early 1980s proved unsustainable in the face of growing competition from the Euromarkets and the decline in profitability of domestic bank lending after the removal of interest rate controls.

Ties between banks and large firms in Japan that have easy access to the Euromarkets and the developing domestic bond market are weakening substantially in response to this deregulation, as the financing patterns of many firms are changing (Hoshi et al. 1993 and Kester 1991). While Japanese nonfinancial firms obtained only 15 percent of their total gross external financing from securities markets between the years 1970 and 1985, from 1986 to 1990 they obtained over 30 percent from bond and equity markets. What these changes mean for the mechanisms of corporate control employed in Japan is not clear. It may mean that takeovers start to become more frequently used to discipline management. However methods of corporate control evolve, and there will likely be significant changes from the previous regime.

The German legal and regulatory environment has also shown recent signs of changing. As part of the attempt to compete with London as a center of finance, many of the restrictions on corporate finance has been relaxed. In addition, other aspects of the German legal and regulatory framework will have to change under planned European Economic Community reforms. As in Japan, this may increase the role of securities markets in the financing of German firms. Again, how methods of corporate control will change is unclear.

The U.S. financial system has also been changing, albeit much more slowly than those in Japan and Germany. Some restrictions, such as the SEC’s rules on shareholder activism, have already been loosened and have led to some institutional investors flexing their muscles somewhat. However, the wide variety of different laws that support the U.S. system of corporate control portfolio regulations on financial institutions, tax laws, antitrust rules, and securities laws means that any changes are likely to be evolutionary rather than revolutionary.

5.0 CONCLUSION

In this report it has shown that differences in the legal and regulatory environment pertaining to corporate ownership by financial institutions and to corporate securities market development have been of great importance in determining differences in the finance and governance systems observed across the industrialized countries. It follows that as these legal and regulatory environments change, so will methods of finance and governance. As noted above, there is clearly some long-term convergence going on in the legal and regulatory environments of the United States, Japan, and Germany, and the focal point of this convergence is not the Japanese / German or U.S. system as it currently exists but an environment in which banks are free to conduct investment and commercial banking activities (including active investments in firms) and corporate securities markets are unhindered by regulatory and legal obstacles.

What will be the primary mechanisms of corporate finance and control in such a system? This is a difficult question because there do not have models among the developed industrialized countries we can look at that embody such a legal and regulatory environment. The closest to this model might arguably be the United States in the early twentieth century. In the United States in the 1920s, firms had relatively free access to non-bank finance, securities markets were relatively active, and there were few restrictions on the ability of financial institutions to take equity and debt positions of a size to confer some control. In this system, there might plausibly be some firms that would solve their financing and governance problems better by using intermediated finance from intermediaries that also take active equity positions in the firm, while others might better rely on securities markets for external finance and an active takeover market for corporate control. Just how and why this “mix” occurs is a subject worth further investigation in the form of a more detailed analysis of this period in U.S. financial history.

For the United States, the movement toward a more deregulated environment for financial intermediaries should not necessarily be viewed with trepidation. As pointed out, there are some clear advantages to be gained from letting banks and other financial intermediaries form tighter ties with the firms to which they lend. Perhaps the biggest concern relates to the issue of deposit insurance. Allowing commercial banks to engage in investment banking activities, including the holding of corporate equity, clearly requires a thorough review of the implications for the deposit insurance