A comparative analysis of corporate finance systems

1. A comparative analysis of corporate finance systems

2. Abstract This section presents the relative strengths and weaknesses of the three major current corporate finance models: • The Anglo-American Model • The Continental Europe Model • The Far Eastern Model

3. The Anglo-American Model of Corporate Finance • Many large, independent publicly-traded firms, relatively small shareholders (1-5% average ownership) • External financing relies mostly on public capital markets rather than on financial intermediaries. • Banks play no corporate governance role • Most external financing is done in the bond market. • Equity issues are also popular but tend to be less frequent than bond issues

4. The Anglo-American Model of Corporate Finance • Capital markets are very large, liquid, efficient, well regulated • Small shareholders' interests are protected by regulations, corporate governance by-laws, and disclosure requirements • Strong separation of ownership from control. • Corporation are run by qualified professionals who have great operational independence. • Very active market for corporate control

5. The Anglo-American Model of Corporate Finance: Advantages • Corporations can raise large amounts of external financing and effectively spread the financial risk  • Since capital markets are transparent, intensively scrutinized and relatively efficient, the cost of resource allocation is minimized.

6. The Anglo-American Model of Corporate Finance: Advantages • Corporate control is not inherited but rather attained based on professional credentials.  • The existence of well developed equity markets allow growth companies (such as tech start-ups) to evolve and prosper  • The existence of well developed capital markets permits the existence of privately-financed pension systems

7. The Anglo-American Model of Corporate Finance: Disadvantages • Separation of ownership and control leads to managerial entrenchment, excessive perks consumption,  etc. (agency problem) • The monitoring of managers by stockholders is very costly (agency costs) as long as large institutional investors are barred from taking an active role • There is a significant opportunity cost associated with information disclosure

8. The Continental Europe Model of Corporate Finance • Many small and medium-sized, privately-held, family-controlled corporations • Several large and powerful banks play an important role in external financing and corporate governance • There is no separation between commercial and investment banking, and banks are universal financiers • Public capital markets are small and have reduced liquidity. Equity issues are relatively rare (however, their importance is growing)

9. The Continental Europe Model of Corporate Finance • Little mandated information disclosure and little transparency in corporate finance and corporate governance • External financing relies less on formal regulation and legal contracting and more on long-term, informal business relationships • Less reliance on professionally-trained managers, and on stock-based managerial compensation • Relatively inactive market for takeovers and corporate control

10. The Continental Europe Model of Corporate Finance: Advantages • Banks can be very effective corporate monitors and can discipline managers • Bank involvement in corporate monitoring leads to more direct, low-cost, transfer of information • Banks seem better at handling financial distress • Banks are better at multi-year continuous financing

11. The Continental Europe Model of Corporate Finance: Disadvantages • Conflict of interest when banks are the creditors and the shareholders of the same firm. • High potential for abuse and self-dealing since disclosure requirements are very modest and there is little transparency in corporate financing and corporate governance. • Since banks have a monopoly on external financing, the cost of raising capital can be high • As information technology evolves, the comparative advantage of financial intermediaries over public capital markets decreases

12. The Far Eastern Model of Corporate Finance • The national economy is dominated by a very small number of large and powerful industrial groups (Keiretsu in Japan, and Chaebol in Korea) • Each group include large manufacturing, service, distribution, etc companies led and coordinated by a major bank. • Group companies own blocs of each-other's shares and there are frequently interlocking directorships • The industrial groups dominate their home markets and are the major exporters of that country

13. The Far Eastern Model of Corporate Finance • Chaebols are still run by family members or founders • Keiretsus are run mostly by professional managers • Capital markets have little influence in the corporate finance and corporate governance systems • Corporate takeovers are very rare

14. The Far Eastern Model of Corporate Finance: Advantages • Industrial groups represent a model of achieving rapid economic growth with little reliance on foreign investment  • Industrial groups internalize large chunks of the economy and manage coordinated technological systems. • Industrial groups also bar foreign competition from entering the domestic market • Effective and low cost of debt financing • Effective management of small-scale financial distress

15. The Far Eastern Model of Corporate Finance: Disadvantages • Cross subsidies create a free-rider problem and rivalries between group companies. • Internalization of the economy leads to less competition and higher product prices paid by consumers • Industrial groups do not prosper in other countires, i.e., outside Japan or Korea. They only fit one or two cultural models.

16. Conclusions: Which system is the best? What is the objective function to maximize? Each system can only be judged in relation to very narrowly defined criteria There is no all-in-one objective criterion Each corporate finance system is unique in its own way