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

Capital market vs. Banking oriented Systems: Influences on Corporate Strategy and Corporate Finance Rudolf Volkart Professor in Corporate Finance, Director Swiss Banking Institute, University of Zurich Agenda - Introducing remarks - System-related aspects, and tendencies

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

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  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 Swiss Banking Institute University of Zurich

  2. 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

  5. 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)

  7. Investment & financing decisions (1) • Pure, stringent theory: separation theorem • Reality: Firm’s 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

  8. 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.)

  9. 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)

  10. 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.)

  11. 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

  12. 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

  14. 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

  15. 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. …”

  16. 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]

  17. 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!

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