comparative corporate governance

So, how does the increasing resourcefulness of financial institutions affect the functioning of corporate governance? Well, in many ways as I will show. But let’s start with the cause of this evolution: the increasing variety of financial instruments, that is.

People that are familiar with the Swiss economy might remember the uproar that was created by Martin Ebner, when he first introduced a new equity instrument in Switzerland, which he got to know during is stay in the US. The so called Stillhalteroptionen allowed Ebner to issue options on shares of Swiss companies in his possession, which he blocked in a depot. The advantage was that these very expensive shares could be split into smaller parts, which were affordable for the small saver. This was a first step in Ebner’s quest to transform the Swiss into a people of shareholders…but that is another story.

What is important for the question of corporate governance, is the fact that the introduction of this instrument had an important impact on the evolution of the financial markets in Switzerland and that this kind of innovation of financial instruments seems more and more to reach not only equity but also debt markets. In fact, the functioning of Stillhalteroptionen resembles what is usually called securitisation of loans. This latter development means that banks grant loans to corporations and issue, then, themselves bonds on this loan portfolio. This allows them – among other things – to transfer the risk of the loans to the purchasers of the bonds. The same can be done with bonds, or in general with any kind of debt. This kind of securitisised loans are usually called Collateral Debt Obligations (CDO).

A multiplicity of very complex instruments and ways of financing debt has been created recently. What is important for my purpose is that the issuing of this kind of debt instruments is less and less the exclusive hunting ground of commercial (or universal) banks. In fact hedge funds, who are often ready to take considerable risks, have become important actors on this market.

This evolution has, according to Gillian Tett, lead to an increased accessibility of finance notably for companies that are in financial trouble. One remembers the negotiations between ‘financially challenged’ companies and banks for new loans (e.g. Swissair). This situation has, according to Tett, considerably changed in recent years: “[W]hereas these companies would have once been forced to turn to commercial banks [in order to obtain new loans], there is now a growing tendency for troubled companies to use hedge funds or other sources of capital […] (FT September 27, 2006).

Now, what does this mean for the functioning of corporate governance? One important consequence is of course that the role of banks changes in important ways. Banks used to play a central role in the functioning of the economy especially in countries with strong universal banks – i.e. banks that are active both as commercial banks (loans) and investment banks (equity issuing etc.) - such as Switzerland and Germany. Universal banks grant loans to corporations, they issue equity for corporations, advise them in merger and acquisition activities and controlled, moreover, important portions of voting rights during the Annual General Meeting of these companies through a proxy voting system that allows them to vote for bank clients that did not wish to attend the AGM. This is why Continental European Corporate Governance Systems are usually called ‘bank-centred’ systems.

The central role of banks and their multiple channels of influence on industrial companies gave periodically rise to criticism of the power of banks and their damaging influence on industrial development. The most extreme theories postulated that banks consciously accepted the bankruptcy of a company that was under their controlled in order to get the maximum out of the company’s assets.

In Switzerland, the Anti-Trust Commission was mandated in the 1970s to elaborate a report on the power of banks (Oddly enough, the report of 1977 concludes that – despite the multiple channels of influence that are shown by the report – the banks actual influence on industrial companies is very limited).

Be that as it may, the recent evolution of corporate finance led to a situation where industrial companies do not seem to rely so much on banks anymore, but they take out loans from other financial institutions or rise capital directly on equity markets (in the latter case, one speaks of disintermediarisation). Consequently, industrial companies are more and more independent from banks.

Yet, banks are not just the victim of this evolution, but they reorient themselves voluntarily their activities towards more profitable activities than loans. This becomes apparent when we consider that small- and medium-sized enterprises, who cannot raise funds on capital markets as easily as large companies, complain about the “credit crunch” that results from banks reluctance to grant loans. A glance at the composition of the balance sheet of Swiss banks illustrates the decreasing importance of loans for bank income (see graph below): If in 1955 more than 70% of the income of Swiss banks came from interests (i.e. from loans granted to corporations and individuals), by 2003 this proportion had fallen to about 40%. At the same time commission and fee income, from M&A advising and issuing activities for industrial corporations, has increased to reach about 40%, the rest stemming from trading activities.

Source: Swiss National Bank, Annual reports, various years

One important consequence of the disintermediarisation and the strategic reorientation of banks away from the loan business, which goes together with the increasing independence of industrial companies, is the anonymisation of relations between banks and industrial companies. In fact, credit activities are usually considered to be relationship-based activities, implying close personal ties between borrower and lender and an active monitoring by lenders of their loans. This was a central feature of Continental European corporate governance systems and limited the strength of market forces. Corporate finance through investment in equity, on the other hand, is market-based and does not necessitate any particularly close relationship between investor and issuer. This brings us to the downside of the increased independence of industrial companies from banks. By using more and more securitised finance instruments – as well for debt as for equity – companies become more dependent on financial markets. And this is precisely why we find so much change in corporate strategies in countries like Switzerland.

In fact, many of the recent evolutions in corporate governance in Switzerland and other European countries can be explained by this increasing dependence on financial markets. Thus, the abolition of discriminating voting right distortions (giving more voting rights for the same capital investment to traditional blockholders than to minority shareholders), the increasing transparency of annual accounts (use of international accounting standards) and more generally a better communication and protection of minority shareholders are all expression of this evolution. Maximising the value of the firm – i.e. the price of its shares – and its profitability are more fundamental trends that can be – in part – explained by the change in corporate finance.

‘So what?’ could one say, ‘why is this important?’ In fact, as technical and far away from everyday life these evolutions of the corporate governance system might seem at first glance, they can have a very concrete meaning to many people…as is shown, for instance, by PSA Peugeot Citroën’s announcement of a plan to layoff 10’000 in order to increase the company’s profitability (NZZ, September 27, 2006).

# posted by Gerhard Schnyder @ 5:11 AM