1.4Raising Capital in International Markets

Capital markets have truly become global. U.S. firms raise funds from almost all parts

of the world. Similarly, U.S. investors provide capital for foreign as well as domestic

firms. Afirm can raise money internationally in two general ways: in what are known

as the Euromarkets or in the domestic markets of various countries.

Euromarkets

The term Euromarketsis something of a misnomer because the markets have no true

physical location. Instead, Euromarketsare simply a collection of large international

banks that help firms issue bonds and make loans outside the country in which the

firm is located. Firms domiciled in the United States could, for instance, issue dollar-

denominated bonds known as Eurodollarbondsoutside the United States or yen-

denominated bonds known as Euroyen bondsoutside Japan. Or a German multina-

tional could borrow through the Euromarkets in either British pounds, Swiss francs or

Euros.

Direct Issuance

The second way to raise money internationally is to sell directly in the foreign mar-

kets, or what is called direct issuance. For example, a U.S. corporation could issue a

yen-denominated bond in the Japanese bond market. Or a German firm might sell stock

to U.S. investors and list its stock on one of the U.S. exchanges. Being a foreign issuer

in a domestic market means satisfying all the regulations that apply to domestic firms

as well as special regulations that might apply only to foreign issuers.

¹¹Eckbo and Masulis (1992), Hansen (1988), and Hansen and Pinkerton (1982) discuss the various

trade-offs between underwritten and rights offerings. Rights offerings may also be more popular in

Europe because of regulatory reasons.

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Chapter 1

Raising Capital

19

1.5MajorFinancial Markets outside the United States

We now focus on three important countries—Germany, the United Kingdom, and

Japan—to analyze how their financial systems differ from the U.S. financial system.

These three countries have the largest capital markets outside the United States.

Germany

Germany has the third largest economy in the world, behind the United States and

Japan. However, its financial system is quite different from those of the other major

economies. In particular, German firms rely much more on commercial banks to obtain

their capital.

As a member of the European Union and a participant in the Euro, Germany is at

the heart of Europe. The German business and government establishment is eager to

build Finanzplatz Deutschlandinto an even larger player in world financial markets.

Frankfurt is a major banking center in continental Europe as well as the home of the

European Central Bank. It is also the home of Eurobourse, operator of the Frankfurt

stock exchange, as well as of Eurex, the world's largest derivative exchange.

Universal Banking.One of the most important differences between the U.S. and Ger-

man financial systems is that Germany has universal banking—its banks can engage

in both commercial and investment banking—which is precluded in the United States

under the Glass-Steagall Act (although, as noted earlier, the situation in the United

States is about to change). The three largest banks, Deutsche Bank, Dresdner Bank, and

Commerzbank, are universal banks. German firms generally do business with one main

bank, a Hausbank,which handles stock and bond placements, extends short- and long-

term credit, and possibly has an ownership position in the firm. For German multina-

tionals, the main bank is usually one of the Big Three. There are, however, several

large regional banks, such as Bayerische HypoVereinsbank and DG Bank, that are

nearly the equivalent of the Big Three in terms of financing German firms.

Public vs. Private Capital Markets.Asecond difference between Germany and the

United States has been that, historically, public equity has not been an important source

of funds for firms. Alarge portion of German firms are privately financed. The Ger-

man stock market capitalization at the end of 1999 was roughly 60 percent of GDP,

compared with about 200 percent in the United States. This is changing rapidly, how-

ever, as Germany consciously attempts to develop an equity culture. In 1999, more than

$23 billion worth of equity was raised on the public markets. There were 168 IPOs,

which is more than the total number of IPOs from 1985 to 1993.

Corporate Governance.The third difference between the German and the U.S. cap-

ital markets lies in the area of corporate governance, which is in turn affected by the

first two differences. By law, listed German firms have two-tiered boards of directors.

The Vorstand, or management board, is composed of company executives who man-

age the firm on a day-to-day basis. The Aufsichtsrat,or supervisory board, consists of

10 to 20 members, half of which must be worker representatives. The other half of

this board is elected by shareholders; these directors are similar to outside directors

in the United States. It is common for these directors to be substantial shareholders in

the firm either directly or indirectly as representatives of the banks, insurance com-

panies, or families that have financed the firm. Kester (1992) estimated that banks and

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20Part IFinancial Markets and Financial Instruments

insurance firms own about 20 percent of the stock in German firms; the comparable

figure in the United States is about 5 percent. Large-block shareholdings probably

account for roughly 60 percent of the total stockholdings in Germany; that figure is

about 10 percent in the United States.

Banks can vote the shares they own, as well as the shares they hold in “street

name,” that is, those shares owned by customers but held in bank brokerage accounts

and mutual funds. These additional shares give banks more voting power and thus

greater influence than their own shareholdings would command per se. However, recent

tax law changes now make it easier for corporations to sell their holdings in other cor-

porations, leading to a gradual dismantling of the cross-holdings in Germany.

OtherDifferences between the United States and Germany.The German financial

system has several other, less salient differences from the U.S. system. In Germany, a

number of specialized banks restrict their activities to specific industries such as ship-

building, agriculture, and brewing. The Landesbanken,owned by state governments and

regional savings bank associations, are active in financing German firms. Several of

them (for example, Bayerische Landesbank and Westdeutsche Landesbank) are among

the 10 largest banks in Germany. Finally, foreign commercial banks in Germany have

approximately 5 percent of the market share of total assets, but they conduct much

more than 5 percent of the transactions in, for example, Eurobond issues, foreign cur-

rency trading, and derivatives.

Deregulation.Deregulation in Germany, as in the United States, is changing the mar-

kets and the way firms raise capital. Until the early 1990s, the commercial paper mar-

ket was nonexistent in Germany.¹²In 1991, the government abolished a tax that dis-

couraged transactions in commercial paper and the Ministry of Finance no longer

required the approval of domestic debt issues. This deregulation led to the emergence

of a growing commercial paper market, making it the fourth largest in Europe, and a

growing bond market. Although the domestic bond market is small, German Eurobond

placements in recent years have been orders of magnitude larger and growing.

Japan

At first glance, the Japanese financial system appears similar to that of the United

States. Commercial and investment banking are separate and firms must file registra-

tion statements to issue securities. The Tokyo Stock Exchange is the second largest in

the world, after the New York Stock Exchange, and the Japanese also have active mar-

kets in bonds, commercial paper, and Euromarket offerings. However, this superficial

similarity masks a financial system that is markedly different from that in the United

States. In particular, banks are much more influential in Japan than in the United States,

and cross-ownership with interlocking directorships is much more common. We now

touch briefly on these two important aspects of Japanese finance.

The Role of Japanese Banks.Exhibit 1.9 shows that many of the 10 largest banks

in the world are located in Japan. Measured by assets, the 10 largest Japanese banks

have many times the assets of the 10 largest U.S. banks—in an economy that is less

than two-thirds the size of the U.S. economy. Japan’s largest banks are called “city

banks,” something of a misnomer because they are nationwide banks. These city banks

¹²Commercial

paper is described in Chapter 2.

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EXHIBIT1.9Assets of the 10 Largest Banks in the World

		Total Assets (in Billions of
Bank Name	Headquarters Location	Dollars)

Mizuho	Tokyo, Japan	1,500
Deutsche-Dresdner	Frankfurt, Germany	1,200
Sanwa-Tokai-Sakura	Tokyo, Japan	1,000
Sumitomo-Sakura	Osaka, Japan	980
UBS	Zurich, Switzerland	687
Citigroup	New York, NYUSA	668
Bank of America	Charlotte, NC USA	617
Bank of Tokyo-Mitsubishi	Tokyo, Japan	579
HypoVereinsbank	Munich, Germany	540
ABN Amro	Amsterdam, Netherlands	507

Source: Wall Street Journal,March 14, 2000, page A25. The WSJ total bank asset numbers are based on 1998 fiscal

year-end results (fiscal 1999 results for Japanese banks).

are the primary suppliers of funds to Japanese firms. Acity bank serves as the so-called

main bank for each large industrial corporation in Japan.

Historically, banks have been the major source of funds for Japanese firms, fur-

nishing more than half the financing needs of Japanese firms in the 1970s and 1980s.

In recent years, however, as Japanese bond markets have developed, this proportion has

fallen to approximately one-third of the funds needed.¹³

As in Germany, many Japanese firms are affiliated with a “main bank” which takes

an active role in monitoring the decisions of the borrowing firm’s management. Fur-

thermore, additional lenders, such as other banks and insurance companies, look to the

main bank for approval when loaning a firm money. Finally, the banks have significant

powers to seize collateral, both as a direct lender and as a trustee for secured bond

issues.¹⁴

The influence of Japanese banks is further enhanced by their stock ownership. In

contrast with the United States, Japanese banks can hold common stock, although the

holdings of any single bank in a firm are limited to 5 percent of a company’s shares.

Even though 5 percent is not a large block, banks collectively own more than 20 per-

cent of the total shares outstanding. When combined with insurance companies, the

ownership percentage of financial institutions rises to 40 percent. Astudy by Kester

(1992) estimated that the top five shareholders in major Japanese firms own about 20

percent of the shares, forming a voting block that cannot be ignored. The large-block

shareholders frequently meet to exchange information about the financial condition of

the firm, and representatives of the main bank do not hesitate to step in when the firm

experiences difficulties.

Cross-Holdings and Keiretsus.The large cross-holdings of Japanese firms are a sig-

nificant feature of the Japanese financial system. Japanese corporations typically own

stock in other Japanese corporations, which in turn also own stock in the corporations

13

See Hodder and Tschoegl (1993).

¹⁴Ibid.

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22Part IFinancial Markets and Financial Instruments

that partly own them. Akeiretsuis a group of firms in different industries bound

together by cross-ownership of their common stock and by customer-supplier relation-

ships. Kester provides an example of Mitsubishi keiretsumembers, which as a group

hold 25 percent of the shares of the group members’companies. The substantial cross-

holdings of customers and suppliers means that firms are less subject to contractual

problems. For example, an automobile manufacturer may be less likely to sue the com-

pany supplying its steel if the steel company owns a significant percentage of the auto-

mobile company’s stock and the automobile company owns a significant percentage of

the steel company’s stock. For similar reasons, group members tend to help one another

when a member of the group experiences financial difficulties.

Deregulation.Until the 1980s, Japan’s bond and stock markets were highly regulated,

effectively preventing Japanese firms from raising money in the public markets. For

instance, most firms could not issue unsecured bonds until 1988. Moreover, firms could

not issue foreign currency bonds (for example, Eurobonds) and swap the proceeds into

yen until 1984, and the Ministry of Finance did not allow a commercial paper market

until 1988.

The main bank system and the influence of the main bank appear to be waning as

a result of the deregulation of Japanese financial markets that began in the 1980s. One

piece of evidence that bank debt has become a less important source of funds is that

debt and equity issues have grown dramatically in the last two decades. It seems likely

that further deregulation—abolishing the separation of commercial and industrial bank-

ing and removing limits on debt issues—will occur, leading to even more public cap-

ital and a concomitant reduction in the influence of the main bank.¹⁵

United Kingdom

Along with New York and Tokyo, London is one of the great financial centers of the

world. Among those three financial centers, it has the distinction of being the oldest

and the most international. Just as “Wall Street” connotes both a physical location and

the set of capital markets and associated firms in the United States, “the City” refers

to both a physical location in London and the set of markets and firms that do busi-

ness there.

Though the activities of the City started in the 1600s, it assumed its dominant posi-

tion in the 18th century and remained in that position until World War I. Following the

economic disruptions of two world wars and the Great Depression, London’s place as

the leading financial center of the world gradually gave way to New York and, more

recently, Tokyo. Nonetheless, London remains the leading market for international

transactions in stocks, bonds, and foreign exchange.

Deregulation: The Big Bang.Like many financial markets, London benefited from

deregulation in the 1980s. As international capital flows increased in the 1970s, Lon-

don was in danger of losing business to other markets. In particular, fixed brokerage

commissions were causing large institutional investors to take their trade elsewhere.

In response to competitive pressures, the London Stock Exchange instituted a wide-

ranging series of changes in October 1986 that have come to be known as the “Big

Bang.”The Big Bang produced four major changes:

¹⁵See

Hoshi, Kashyap, and Scharfstein (1990).

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Chapter 1

Raising Capital

23

1.The elimination of fixed commissions.

2.The granting of permission to foreign banks and securities firms to enter the

British market on their own or to buy domestic firms, thus exposing British

domestic firms to intense competition.

3.The elimination of the system of wholesale traders (jobbers) and retail traders

(brokers) in favor of a system where members were free to act as both

brokers and dealers.¹⁶

4.The introduction of a computerized trading system, much like the Nasdaq

system in the United States.¹⁷

The results of these reforms were dramatic. Average transaction costs fell by 50

percent or more. Before the Big Bang, five jobbers (brokers) handled essentially all the

transactions. After the Big Bang, more than 30 securities firms became market makers.

With increased competition, lower costs, and the increase in stock prices, trading in

London quadrupled in the two years following the Big Bang.

Just as stock exchange members were exposed to more competition in the 1980s,

so too were other financial firms. The Big Bang induced many more international banks

to do business in London. Of the more than 500 banks in London in 1996, nearly two-

thirds were foreign banks or subsidiaries of foreign parents. These foreign banks hold

more than 80 percent of nonsterling deposits and about 20 percent of sterling deposits.¹⁸

Thus, in both numbers and funds, foreign banks are a major force in London. Because

London is the center of the Euromarkets, all the major U.S. and Japanese banks have

subsidiaries there. The extensive interbank buying and selling of deposits explains the

dominance of LIBOR, the London interbank offered rate, which is the interest rate at

which banks in London borrow and lend to each other. It also is the benchmark rate

used to set the rate on loans all over the world.

The Banking Sector.Although the British banking system has a much more inter-

national flavor than the American system, in other respects it is surprisingly similar. In

the past, a British firm’s commercial banking and investment banking needs were ser-

viced by separate banks, even though this was not mandated by law as it was in the

United States. This appears to be changing. The Bank of England, which regulates

banks in the United Kingdom, has not discouraged universal banking, but historically

there have been two main types of banks: clearing banks, which are similar to com-

mercial banks in the United States, and merchant banks, which are similar to U.S.

investment banks. The four largest clearing banks—National Westminster, Barclays,

HSG, and Lloyds—perform the same services as U.S. commercial banks. The merchant

banks, the largest of which are SBC Warburg, Morgan Grenfell (now owned by

Deutsche Bank), and Dresdner Kleinwort Benson, perform the same functions as invest-

ment banks in the United States.

Because the United Kingdom has no law similar to the Glass-Steagall Act, banks

are free to engage in whatever businesses they wish. As a result, clearing banks have

established subsidiaries to undertake the full range of investment banking activities, and

16

See Chapter 3 for a discussion of brokers and dealers.

¹⁷See

Chapter 3 for a discussion of exchanges, including the National Association of Security Dealers

Automated Quotation System (Nasdaq).

¹⁸The

pound sterling, often shortened to sterling, is the currency of the United Kingdom. Hence,

nonsterling deposits refer to U.S. dollar, yen, Swiss franc, and Euro deposits in London banks.

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24Part IFinancial Markets and Financial Instruments

merchant banks have moved from solely financial advising (for instance, underwriting,

syndication, and portfolio management) to become securities dealers and brokers in

stocks and bonds. Given the increased competition in both commercial and investment

banking, a consolidation of banks seems likely in the United Kingdom, similar to that

taking place in the United States.

The similarity between the banking structures in the United States and the United

Kingdom also extends to the influence of banks on the management of domestic firms.

In contrast to the power of the banks in Germany and Japan, U.K. banks, like U.S.

banks, are not strongly involved in the firms with which they do business. Stock own-

ership by banks is not prohibited, but banks have seemingly been reluctant to assume

the risks entailed in equity ownership. Despite the banks’reluctance to hold major

stakes, the U.K. equity market is almost completely dominated by institutional investors.

About 85 percent of the common stock of U.K. firms is held by institutions such as

insurance companies, pension funds, and mutual funds. Trading by these institutions

accounts for more than 90 percent of the volume on the London Stock Exchange.

Although U.K. banks have not been major equity holders, they have traditionally

been an important source of funds for firms. While the most important source of funds

for U.K. firms is internal, accounting for roughly 50–70 percent of total sources, banks

supply about 75 percent of the external capital raised by U.K. firms.

Public Security Markets.In terms of raising new debt and equity, the U.K. public

markets occupy a middle position. They are relatively more important than public mar-

kets in Germany and Japan but less important than those in the United States. For

instance, from 1970 to 1992 more than 340 firms a year went public in the United

States. Comparable figures for Germany are 8–10 firms a year; for Japan, 35–45 firms

a year; and for the United Kingdom, which has a much smaller economy than either

Germany or Japan, 50–60 firms a year.

The process of going public in the United Kingdom is similar to the process in the

United States. The firm hires an underwriter who advises the firm about timing and pric-

ing and helps in the preparation of a prospectus. In the United Kingdom, however, shares

are sold in several different ways that are not observed in the United States. For example,

when a firm uses an offerforsale by tender, the shares are auctioned off, with the price

set at the minimum bid that leads to the sale of the number of shares desired. When plac-

ingsecurities, which combines aspects of a private placement and a public sale, up to 75

percent of the issue may be privately placed with institutions, but at least 25 percent must

be offered to the public market. In contrast with the United States, seasoned equity issues

are nearly all accomplished through rights offerings. By law, U.K. firms must offer share-

holders the rights unless shareholders have granted a temporary waiver.

Like the capital markets in other financial centers, the London market is experi-

encing the difficulties of adjusting to a global capital market. The London Stock

Exchange, like the U.S. exchanges, is struggling with how best to organize trading

across many different kinds of financial instruments. In June 2000, it became a pub-

licly traded company and lately there has been talk of a unified European exchange.

The clearing banks and merchant banks are attempting to figure out which combina-

tions make sense and which lines of business are profitable. British firms, like their

counterparts elsewhere, are bypassing traditional financial intermediaries and are going

directly to the capital markets to obtain financing. It is hard to predict when and how

these forces will work themselves out, but we can be reasonably certain that the out-

come will make London an even more international market than it is today.

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