12.1 Borrowing and lending problems in nancial intermediation

performance to the detriment of long-run investment, innovation and growth. This is

a complex issue on which the evidence is inconclusive. Those who suspect that some-

thing is wrong with the service offered to rms by the UK system begin by pointing

to some combination of the following, each of which is true as it stands.

Firstly, critics point to the poor investment and growth record of the UK economy

over the past 30–40 years, when compared with competitors like Germany and Japan.

Secondly, they can draw quite striking contrasts between the nancial systems

that operate in Germany (especially) and in the UK. The former is often described as

a ‘bank-based’ system, while the latter (like that of the US) is described as ‘market-

based’. What this means is that in Germany a comparatively small proportion of

rms are quoted on the stock exchange. In Germany, at the end of 2004, there were

764 quoted companies on the Frankfurt Stock Exchange compared with over 2,400

in the UK. This means that banks play a much more central role and since they have

both a debt and an equity stake which cannot be readily traded, they take a much

closer interest in the operation of the rms which they nance. They generally

have representation on company boards and they develop long-term relationships

with their clients. By contrast, the debt and equity of UK rms is dispersed in very

active nancial markets where it can be and is readily traded. A high proportion

of it (65 per cent in 1998) is held by non-deposit-taking institutions (NDTIs) such

as pension funds and unit and investment trusts that feel no particular long-term

commitment and need take no very close interest in rms’ decisions since they can

sell their interest at any moment.

Thirdly, and reinforcing this perception, is the observation that NDTIs in the UK

hold shares for a comparatively short period of time – only two to three years – with

investment and unit trusts being the ‘worst offenders’. This rapid turnover of stock

holding is sometimes referred to disparagingly as ‘churning’.

Lastly, this idea of eeting commitment was reinforced by the merger and take-

over booms in the UK and US in the late 1990s. The criticism here was that some

large rms, with the support of their banks, were able to grow by acquisition rather

than by investing in and developing their core businesses, because they needed only

to acquire stakes in the target company from a small number of institutional share-

holders. NDTIs, it was argued, could be encouraged to sell their stakes quite easily

since they were always more interested in maximising their short-term wealth than

in waiting for the value of their shareholdings to increase as a result of the underly-

ing protability of the rms.

As we said at the outset, each of these observations is broadly true. The big difculty,

however, lies in connecting them with low investment and growth. The argument is,

presumably, that in the UK rms are owned ultimately by institutions which want

to see share prices rise in the short term. If they do not, the system makes it cheap

and easy for institutions to sell the shares, and this puts rms in danger of takeover.

Therefore, directors make investment decisions which maximise the short-term share

price regardless of the long-term consequences. Specically, it is argued, they will

tend to pay out a high proportion of prots as dividends, instead of reinvesting for

the future, and/or where they do reinvest it will be in projects which produce only

a short-term prot. Plausible as it may sound, there are some problems with this.

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Chapter 12 • Financial market failure and nancial crises

Since the average turnover of shareholdings can be measured and is high, let us

accept that institutions concentrate on short-term performance. Does this necessarily

affect rm behaviour? Consider a rm whose directors decide on a major investment

project whose returns are expected to be substantial but lie a long way in the future.

To make matters worse, let us suppose that they even cut this year’s dividend in order

to nance the project. According to the ‘short-termist’ argument, institutional share-

holders will sell their stakes. The rst question is: How does this affect the rm? Firstly,

note that the shares must be bought by someone else, probably another institution.

The argument must presumably be that if enough shareholders sell, the price must

fall and this raises (a) the cost of capital and (b) the likelihood of a takeover when

the rm is seen as a ‘bargain’ by a predator. Unless and until the rm is looking to

raise new capital for an investment project, however, the rst is irrelevant. The rm

may reasonably hope that by the time the raising of new capital becomes an issue,

the benets of its last project will have been recognised and the share price will have

recovered. The latter, the takeover threat, is relevant. In the event of a takeover,

the existing management may be made redundant. At worst, the rm may be closed

down. At best, the management will have to adjust to new directors and owners;

managers’ power will be reduced. In the circumstances, managers may have a good

reason for concentrating on keeping the share price high.

The fundamental objection to the ‘short-termist’ argument that many would make,

however, is that it depends upon the equity markets mispricing shares, and this

violates both some cherished beliefs and a certain amount of evidence about the

way in which equity markets and traders work.

Specically here, critics would say that the short-termist argument violates both

the dividend irrelevance theorem (DIT, explained in Chapter 6)and the efcient markets

hypothesis(EMH).The dividend irrelevance theorem, remember, starts from the idea

that the price of an asset represents the present value of its discounted future income

stream. For equities, this income stream involves both dividends and capital appre-

ciation. Then, on certain assumptions, a reduction in dividends used to nance new

projects is necessarily compensated for by an increase in the rate of capital appreci-

ation. (One of the assumptions of course is that the new investment is protable!)

According to the DIT, therefore, dividends and capital growth are interchangeable

in the determination of a share’s price. It is the future earnings themselves, not just

the part paid out as a dividend, that should be discounted in order to arrive at the

correct present value. Provided that institutions understand the DIT, dividend policy

should not affect the share price and there should be no incentive for rms to ‘buy’

short-term popularity with high payouts.

The EMH states that nancial markets make the best use of all available informa-

tion in determining a share’s price. Thus if a rm cuts its dividend in order to increase

retained earnings, the market should know this and it should be able to form its

own (reliable) judgement of the likely future protability of the project and the rm.

According to the EMH these long-term earnings will be just as fully reected in the

share’s price as its current dividend. If this is true, long-term investment projects

should not depress the share price with the risk that the rm becomes a takeover

target.

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