Appunti comparing financial systems

TOURNAMENT

The tournament has two functions:

1. it provides an incentive for junior managers to make more effort at their current tasks;
2. it screens managers according to ability.

Both are necessary to increase the value of the firm. Greater effort by lower-level managers leads to greater efficiency. Higher ability among top-level managers leads to better strategic planning. Furthermore, there may be a useful complementarity between these two functions of the tournament.

Suppose that the performance measure used to promote managers becomes more informative of ability the higher the level of effort. Then making managers compete by putting in more effort will actually produce a more accurate screening mechanism, even though effort is a substitute for ability from the point of view of an individual manager.

Apart from the informational reasons, the fact that managers compete against each other in a tournament makes it a more effective incentive mechanism from the shareholders' point of view.

Compared to a profit-sharing scheme, this has no screening function and will not produce the same incentive for effort.

In a profit-sharing scheme, the manager's reward depends on a measure of group performance (profit).

In the tournament, his reward depends not just on a message of group performance, but also on his own performance relative to his peers, as observed by other managers. The manager is rewarded if his effort or ability is high relative to other managers.

Every manager has an incentive to increase group performance, as he would in a profit-sharing scheme.

In addition, he has an incentive to do well relative to his peers.

This may lead to higher effort than in the case of a profit-sharing scheme.

So the promotion tournament has advantages even if there is no constraint on the shareholders' ability to substitute pecuniary payments for promotion and even if growth is not necessary to create opportunities to reward managers.

The rewards of ability and effort may

Consist of the high salaries, bonuses, and similar rewards received by top management, but they may also consist of the intangible satisfaction of control and visible success. Growth of the firm increases these rewards.

As lower-level managers compete more vigorously for promotion, they are simultaneously increasing the potential prize and thus increasing the incentives for making effort.

The fact that the size of the prize depends positively on the effort of all the managers, which in turns depends positively on the size of the prize, suggests the possibility of multiple equilibria:

1. If everyone chooses a high level of effort, the prize will be large, and it will be optimal to make a big effort;
2. However, low effort produces a small prize, which generates a low level of effort.

Allen (1993) has applied these ideas in a macroeconomic context, arguing that high rates of economic growth create incentive opportunities. Fast-growing economies, such as Germany during the 1950s and

1960s and Japan during the 1960s through to the 1980s, may have better incentives, which in turn feed back into higher growth rates.

GROWTH

In a growing economy, failing to give people raises in line with the average per capita growth rate will have a large effect on their welfare.

This threat provides good incentives to managers at all levels of the organization to work hard.

For example, managerial salaries that grew at Japan's average per capita growth rate during the 1960s would have increased by 140%.

By contrast, managerial salaries in the United States, which grew at the average during the same period, would have increased only by 28%.

This difference means that Japanese managers who failed to receive the average wage because of a lack of effort would pay a much larger penalty than U.S. managers who adopted this course of action. Higher growth will therefore mean better incentives and better performance. It is self-reinforcing since it allows good incentives, which helps spur

further growth.

THE MARKET FOR INTERNAL FUNDS

The observation by Mayer and others that retained earnings is the primary method of finance in many countries underlines the importance of internal capital markets.

There is a large literature on the operation and rationale for such markets.

Internal capital markets differ from external capital markets because of asymmetric information, investment incentives, asset specificity, control rights, or transaction costs.

There has also been considerable debate on the relationship between liquidity and investment.

Corporate Savings

CHANGING FINANCIAL SYSTEMS

The fundamental model of financial system in most handbooks is that in which households save in order to lend to firms which invest.

However, in all developed financial systems in recent years, more and more lending activity has been devoted to meeting the needs of the personal or household sector.

Even if there remains net lending from households to firms, it may be small because firms rely so heavily

Upon retained funds. Intersectoral lending (from households to firms) may then easily be dwarfed by lending between deficit and surplus units within the same sector (from firms to firms or from households to households), or dramatically inverted (from firms to households).

Moreover, one of the most interesting explanations of the financial crisis of 2007-2009 is that of the global saving glut.

This macroeconomic phenomenon is closely connected to the corporate saving glut, a microeconomic phenomenon little considered by traditional economic theory but actually decisive in the process of aggregate saving formation.

THE CORPORATE SAVING GLUT

The notion of global saving glut denotes the excess of saving over investment in the world economy between 2002 and 2007, which was reducing interest rates and encouraging risky financial investment.

But the trend of the global saving rate has been going downward since the late 70s. Thus the saving glut cannot be attributed to an increase of the global saving.

rate above its long-term average.

In 2010 the McKinsey Global Institute stressed the increasing importance of the corporate sector in the global supply of capital. Today about 2/3 of the supply of capital in the developed countries comes from the corporate sector.

In 2005 The Economist was already arguing that the global saving glut was generated by an excess of corporate saving (the difference between undistributed profits and capital spending), which turned into "net lending" by the corporate sector.

SOME UNEXPECTED EMPIRICAL EVIDENCES

Since 2002 the excess of gross saving over fixed investment in the OECD corporate sector has been unusually large.

Over the period 2001-2005, it rose more than the aggregate external surplus (indirect partial measure of aggregate saving) of the emerging market economies. Countries with external surplus are consuming less then they produce. They are saving and becoming worldwide surplus units.

Around two thirds of the increase in

undistributed profits was generated by the financial sector, but this sector contributed to the increase in net lending less than the non-financial sector.

In 2005 JP Morgan noted that in the global rise in savings the increase in G6 corporate saving was about five times that of the emerging countries.

CORPORATE SAVING AS A PROPORTION OF TOTAL PRIVATE SAVING

Increasing corporate gross saving is a longer-period phenomenon, showing a trend as share of GDP that began to rise in late 1970s. 203

CHANGES IN NET SAVINGS ($ BILLIONS)

CHANGES IN NET LENDING BETWEEN 2001 AND 2005 ($ BILLION)

This level of saving by corporations was immediately recognized as unprecedented, and as producing an unnatural economic result: the corporations were becoming net lenders while the households were becoming net borrowers. (Things were turned on their head!)

UTILIZATION OF THE CORPORATE NET SAVINGS

In the United States most of the increase of corporate savings in the early 2000s was initially utilised to repay debt, but

subsequently it was utilised to buy back shares.

The European corporations showed a similar behaviour, but on a more limited scale than in the United States, with the exception of the United Kingdom, where corporate savings were indeed comparable with that of the US.

Between 2003 and 2006 Chinese corporations saw their profits rise markedly in all the productive sectors, but most of these increased profits were held as retained earnings, with very low dividend payout ratios.

The financial sector has contributed for about one-fifth of the overall increase in corporate netàlending. The change in the corporate saving rate was initially explained as a short-term response to the previous excess of investment of the 1990s, in the context of the equity market bubbles in the developed countries and the excessive capital inflows in the emerging countries before the Asian financial crisis.

SOME THEORETICAL AND EMPIRICAL EXPLANATIONS

Usually economists do not deal separately with the corporate saving

rate because they assume that households, owning corporations, include corporate saving decisions in their own saving decision. But corporations might also be viewed as particular institutional decision-makers, which remain outside the schemes of intertemporal choice between present and future consumption. Lower investment decisions do not necessarily become higher consumption decisions, but they can also imply liquidity holding.

According with OECD's analysis, the large-scale expansion of corporate net lending was the transitory effect of the sum of two different phenomena:

1. In the financial sector, it was accounted for with short term financial variables (money growth and real house prices).
2. In the non-financial sector, it was interpreted as partly due to the cyclical downturn since 2001.

Many panel regressions suggest a significant influence of the business cycle on the corporate saving glut: more than one quarter of the increase in aggregate OECD corporate net