Regulation af Debt and Equity

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Regulation af Debt and Equity Richard W. Kopcke and Eric S. Rosengren* At the heart of economic development and capital formation is the transfer of resources from those who would save to those who would
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Regulation af Debt and Equity Richard W. Kopcke and Eric S. Rosengren* At the heart of economic development and capital formation is the transfer of resources from those who would save to those who would invest. When the capacity to accomplish these transfers efficiently is lacking, growth is impaired, and less profitable investments may displace some that are more promising. In the United States, much of this transfer of resources flows through a nexus of financial markets and institutions. Banks, insurance companies, pension funds, savings and loan associations, and other financial intermediaries fill an important role in this financial system by offering savers an attractive means of accumulating claims while offering investors attractive terms for accepting claims. Without these intermediaries, each financial contract must accommodate at once the specific, often incompatible motives of savers and investors. For example, households seeking relatively liquid assets or insurance coverage might find little common ground with businesses seeking financing for factories. Consequently, the evolution of our financial system is guided, to a great degree, by the opportunity for profit which attracts enterprises that either would match savers with investors of complementary interests or would mediate the distinct interests of savers and investors, converting the primary securities issued by investors into assets valued by savers. The features of our financial system are shaped by public controls and subsidies, as well as by the various motives of savers and investors. Financial transactions allocate the risks as well as the returns of the *Vice President and Economist, and Assistant Vice President and Economist, Federal Reserve Bank of Boston. 174 Richard W. Kopcke and Eric S. Rosengren underlying investments, not only among the parties to those transactions but also among others. The design of these arrangements also may either diminish or increase the total risk posed by uncertain investments to the economy. Because of agency costs, externalities, and competitive pressures, financial transactions may impose unacceptable risks on the economy without offering adequate compensation. Accordingly, the regulation of securities offerings, the conventions governing markets, and the regulation of intermediaries may control the risks created by these contracts. These regulations, by design, influence both the volume of financial transactions and the means by which funds flow from savers to investors. The goal of policy is to foster contracts that allocate risks and returns in an acceptable fashion without arbitrarily impeding the efficient transfer of resources. In order to meet this goal, private and public regulations must change with economic conditions as well as the motives of savers and investors, so that the allocation of risks and returns remains appropriate. Otherwise, the cost of these regulations may exceed their benefits. This paper concludes that the regulations governing financial intermediaries promote debt financing by businesses. Savers are attracted to the insured and guaranteed liabilities issued by intermediaries, who, in turn, place these funds mainly in new debt securities. Although regulations allow some intermediaries such as pension funds and insurance companies to buy stock, these intermediaries tend to acquire the existing equity of established corporations, not the newly issued equity of developing enterprises. Regulations that restrict intermediaries from holding equity may tend to make the economy less stable by dividing the interests of investors from those of intermediaries and by encouraging intermediaries to hold riskier debt in order to earn a competitive rate of return on their capital. Instead of emphasizing restrictions on assets, often favoring debt over equity, regulators should rely on capital controls by enforcing substantial minimum capital requirements, to be financed by common stock. While equity is inherently riskier than debt, public policy does not necessarily promote financial security or economic stability by requiring intermediaries to acquire debt rather than equity interests. With such an emphasis on debt, the cost of equity financing may be relatively great and relatively volatile, especially for developing enterprises that are not well-known in capital markets. Furthermore, by dividing the interests of investors from those of their bankers, such restrictions encourage intermediaries to supply less credit or seek premature repayment on projects whose prospects appear to dim. Financial intermediaries exist to bridge the differences between the motives of savers and those of investors. When regulations sharpen the distinctions between the REGULATION OF DEBT AND EQUITY 175 incentives of entrepreneurs and the incentives of those financing investments, economic activity and the prices of assets may become less stable as opinions change about the future returns on investment projects. The first section of this paper describes the role of banks, pension funds, life insurance companies, and other intermediaries in transferring funds from savers to investors. During the past three decades, households essentially have been exchanging equities for deposits, insurance policies, or annuities. In this volume, Merton argues that financial intermediaries can repackage debt and equity of firms to satisfy investor demand. This may be prevented if financial intermediaries have a limited capacity for acquiring equities, especially those of developing enterprises. This change in the composition of households financial wealth tends to diminish the supply and increase the relative cost of equity financing. The second section describes the risks created by financial intermediation. By reshaping rather than eliminating risks and by reducing the rate of return on equity of regulated financial institutions, thereby making them less competitive with unregulated enterprises, existing regulations do not necessarily make financial intermediaries secure. Furthermore, by insuring or guaranteeing the liabilities of qualifying intermediaries or investors, the government tends to commit itself to maintaining the values of many assets, thereby constraining the options of macroeconomic policymakers. The model in the third section describes the influence of regulations on an intermediary s behavior. Banks covered by deposit insurance are encouraged to make loans with lower expected returns and greater probabilities of default than they would otherwise. Binding capital requirements can foster this disposition. To the degree that regulators are not privy to the risks inherent in banks loans, restricting the types of assets that banks can acquire may not reduce the risks that they bear very substantially. The Flow of Funds from Saving to Investment In accumulating wealth, households forgo current consumption in favor of increasing their opportunity for future consumption. This saving comprises investing directly in capital goods (homes, plants, durable equipment), acquiring the primary securities of others who invest in capital goods (loans, commercial paper, bonds, stock), or purchasing the indirect securities of intermediaries who, in turn, acquire either primary securities (deposits, annuities, insurance policies) or capital goods. While households directly control the disposition of much of their saving, some is undertaken on their behalf by businesses and 176 Richard W. Kopcke and Eric S. Rosengren intermediaries that retain a portion of their earnings in order to finance new investments. Most of households saving each year is invested in capital goods. Purchases of consumer durables and residences amount to about 20 percent of disposable income, while the acquisition of financial assets has averaged just over 10 percent of income (table 1). Because those households purchasing capital goods ordinarily finance their investments partly by tapping the savings of other households, net saving amounted to just over 20 percent of disposable income during the last four years, while net financial saving was only about 4 percent of income. 1 The Composition of Financial Saving In principle, both the volume of households saving and its allocation depend on the opportunities and services offered by the various financial assets. Some assets are attractive because they are safe, insured, or liquid; others appeal, despite their greater risks, because they offer some chance of extraordinary returns; the stream of payments offered by other assets coincides closely with the timing of future expenditures anticipated by savers; still other assets offer insurance against misfortunes; and, when outsiders do not understand fully investors opportunities and motives, savers also value those financial arrangements that encourage investors to divulge information or to respect the interests of savers. Although the acquisition of both primary and indirect assets has been an important means of saving throughout our history, the composition of household portfolios has been shifting to favor indirect securities over primary securities (tables 1 and 2). Banks, insurance companies, pension funds, and other intermediaries have introduced convenient products that, as surrogates for stocks and bonds, apparently remove some of the hurdles that deter savers, as outsiders, from financing investors. Altogether, the indirect securities issued by intermediaries rose from approximately 20 percent of household financial wealth earlier this century to about 50 percent today. Since the 1950s, the subsidence of primary securities in households financial wealth has been due entirely to savers shifting their financial assets from equity toward other securities. Equity in corporations and partnerships formerly accounted for almost 60 percent of the portfolio; 1 This net financial sa~ing corresponds most closely, but is not identical to, the concept of household saving in the national income and product accounts. Table 1 Composition of Household Saving Percent of Disposable Income: Gross Purchases of Real Assets and Financial Assets Gross Purchases of Real Assets , Purchases of Financial Assets Percent of Purchases of Financial Assets: Primary Securities Equity Corporate Equity 19, Noncorporate Equity Debt Securities U,S. Government Securities Indirect Securities Deposits Pension Fund Reserves Life Insurance Reserves , Percent of Disposable Income: Increase in Liabilities Notes: For tables 1 and 2, real assets include residential structures, consumer durables, and nonprofit plant and equipment. Corporate equities include all corporate equities held directly by households and equities held indirectly in mutual funds. Debt securities include U.S. Government securities, tax-axempt obligations, open market paper, mor[gages, corporate bonds, and securities credit held directly by households as well as credit market instruments held indirectly through mutual funds or money market mutual funds. Deposits include all checking, savings, and time deposits held directly by households as well as credit market instruments held indirectly through mutual funds or money market mutual funds. Source: Disposable income 1900 to 1929, U.S. Department of Commerce, Historical Statistics of the United States, p All other data 1900 to 1929, Raymond W. Goldsmith, A Study of Saving in the United States, vol. I, p All data 1955 to 1988, Board of Governors of the Federal Reserve System, Flow of Funds. Table 2 Composition of Household Assets Percent of Total Assets: Real Assets Financial Assets Percent of Financial Assets: Primary Securities Equity , Corporate Equity , , Noncorporate Equity Debt Securities , U.S. Government Securities ,0 Indirect Securities , Deposits , Pension Fund Reserves , , Life Insurance Reserves Percent of Total Assets: Total Liabilities Source and Notes: See table REGULATION OF DEBT AND EQUITY 179 today its share is approximately 40 percent. Even though equities represent the single most important asset in households financial wealth, these securities, which tend to be held by a very few of the most wealthy households, have played a relatively modest role in transferring resources from savers at large to investors. Instead, equity generally represents the cumulative value of investors retained earnings in their own enterprises. Of the remaining financial assets, bank deposits, pension fund obligations, primary debt securities (mostly government debt), and the obligations of life insurance companies occupy the largest share of households wealth. Bank deposits (comprising the accounts of commercial banks and thrift institutions) are held by most households, representing the broadest source of new funds for investors. Although these deposits have accounted for an increasing share of households financial wealth, they are not growing as quickly as the reserves of pension funds (comprising the reserves of private pension plans and state and local government retirement funds), the third largest component of wealth. Because many employers and households participate in pension plans, these intermediaries also represent a broad source of funds for investors. Life insurance reserves today account for only 3 percent of households financial assets, less than one-half their share of the 1950s. The Composition of Financing for Investors Businesses may finance their investments either with internal funds (retained earnings), which are equity, or with external funds, which may be either equity or debt. Since the 1950s, external funds have provided at least 60 percent of the financing of nonfinancial corporations (table 3), and, following a familiar historical pattern, debt accounted for more than 85 percent of this external funding. 2 After deducting capital consumption from equity, debt accounted for almost 60 percent of the financing of net investment by nonfinancial corporations from the 1950s to the 1980s. The relative stability of corporations ratio of debt to assets, compared to the substantial volatility in their sources of funding, suggests 2 Goldsmith 1955, 1973; Navin and Sears 1955; Taggart 1986; Baskin 1988; Kopcke 1989b. Although these figures suggest that nonfinancial corporations relied on equity financing more during the first 30 years of this century than they have subsequently, these estimates probably overstate the contribution of new equity issues. Flow of funds accounts include the initial public offerings of established proprietorships and partnerships that convert to corporations. Such conversions were more significant during the early twentieth century than they have been since Furthermore, before 1930, much of the new equity was issued by one corporation to acquire the outstanding equity of another, the value of which is not subtracted from new equity issues in Goldsmith s data. Table 3 Financing of Nonfinancial Corporate Business Percent of Total Sources of Funds: Net Equity Financing Debt Financing External Financing Percent of External Financing: Equity Issues , Debt Issues Percent of Total Assets: Real Assets Financial Assets Equity Financing Debt Financing Percent of Debt Financing: Credit Market Instruments Note: Balance sheet items for 1900 through 1929 are for the end year of each period rather than a period average. Source: Data for 1900 to 1929, Raymond W. Goldsmith, 1973, Institutional Investors and Corporate Stock--A Background Study, p. 42. Data for 1955 to 1988, Board of Governors of the Federal Reserve System, Flow of Funds. REGULATION OF DEBT AND EQUITY 181 that corporations choose their financing in order to manage their degree of leverage. 3 If, at any time, one blend of debt and equity financing is preferable to others and if this optimal blend varies with the cost of obtaining debt versus equity financing, then the terms under which financial intermediaries obtain funds and the terms under which they are willing or able to advance funds will influence both the choice of leverage by businesses and their rate of investment (Gurley and Shaw 1955, 1956, 1960; Brainard and Tobin 1968; Tobin 1969, 1982). Because intermediaries, such as banks, insurance companies, and pension funds, occupy an increasingly important role in supplying businesses with external funds, their willingness or ability to supply equity versus debt financing influences the financial structures of businesses and their cost of capital. While most intermediaries acquire considerable amounts of debt (tables 4 and 5), few hold significant amounts of equity (tables 4 and 6). Most intermediaries, including the important banking enterprises, by regulation or custom essentially hold no equity other than that of their related enterprises. Insurance companies and the rapidly growing pension funds together have obtained their equity on secondary markets from households, which have been liquidating their positions since the 1950s (table 1). Accordingly, the acquisition of equity by insurers and pension funds seldom supplies new financing directly to corporations. 4 Because the major source of new equity financing for businesses has been retained earnings, many rapidly growing firms that are not well-known in capital markets often turn to other nonfinancial corporations for funds, frequently leading to mergers and acquisitions. Moreover, trade credit extended by nonfinancial corporations (not including consumer credit or loans by subsidiary finance companies) in 1988 amounted to 10 percent of their total assets or almost 40 percent of their financial assets. 5 The financial office of a business that can obtain ample financing at favorable terms is itself a potential financial intermediary. 3 Although the Modigliani-Miller theorem and some of its refinements suggest that leverage may be immaterial for a corporation (Taggart 1985), when capital markets are not perfect or returns are diminishing, the choice of leverage may become important (Navin and Sears 1955; Jensen and Meckling 1976; Baskin 1988; Kopcke 1989a, 1989b). 4 Stock markets provide shareholders a convenient means of liquidating their stakes. This opportunity may indirectly finance capital formation by encouraging entrepreneurs or venture capitalists to invest in growing enterprises. This pattern of financing depends on the motives and regulations governing investors as well as those influencing intermediaries and savers (see footnote 3). s The trade credit reported as a liability of nonfinancial corporations in 1988 was about one-fifth of total liabilities (other than equity), an amount that exceeded bank loans to these corporations and which equaled six-tenths of the face value of corporate bonds. Table 4 Composition of Assets of Financial Intermediaries Percent of Total Assets Commercial Banking Capital-Asset Ratio 19.4 Corporate Equity 1.0 Debt 91.9 Thdfts Capital-Asset Ratio 22.7 Corporate Equity 1.5 Debt 93.6 Pension Funds Corporate Equity 0 Debt 0 Life Insurance Companies Capital-Asset Ratio 14.3 Corporate Equity 5.5 Debt 74.5 Other Insurance Companies Capital-Asset Ratio 49.8 Corporate Equity 23,5 Debt 46,5 Investment Trusts Corporate Equity 0 Debt 0 Security Brokers and Dealers Capital-Asset Ratio 27.3 Corporate Equity 9.1 Debt , , , , Distribution of Assets among Financial Institutions Percent of Total Assets of Financial Institutions Commercial Banking Thrifts ,3 19, Pension Funds Life Insurance Companies ,2 12, ,7 17, Investment Trusts Finance Companies Other Insurance Companies Money Market Mutual Funds Security Brokers and Dealers 3.5 3, , Notes: In calculating capital-asset ratios, data on real assets for commercial banks from 1984 to 1988 are for FDIC-insured banks only. Thrifts includes savings and loans, mutual savings banks, and credit unions. Credit unions are included in the capitapasset ratio only from 1972 to Investment trusts includes REITs, CMOs, and mutual funds. All data for 1900 to 1929 are from
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