Journal of Financial Economics

REF 106 Financial system and value creation

In this paper we review the literature on credit allocation and value creation of banks. We focus on relationship banking that occurs when a bank and a borrower engage into multiple interactions and when both parties invest in obtaining some counterparty specific information. We summarize how relationship banking generates costs and benefits for both firms and banks, but argue that on average it generates value for both of them. The impact however hinges substantially on whether we are in normal times versus crisis times. We further discuss how credit allocation as measured by industry specialization impacts firms and banks. At last we review the recent literature on securitization and relationship banking to study how securitization impacts the effects of relationship banking.

Do more liquid firms create more value? At first glance, liquidity should at best have a second-order effect on firm valuation. However, several economic theories supported by strong empirical evidence document that investors require higher expected returns as a compensation for the costs and the risks that they bear when holding illiquid assets. In addition, illiquidity is responsible for the increase of direct and indirect issuing costs.

Finance is used to intermediate savings between retail savers and borrowers. The size of finance (in terms of jobs, value added and profits) is normally expected to evolve in line with the size of intermediation of savings carried out between lenders and borrowers. If intermediating savings becomes riskier for financial intermediaries (with respect to default and liquidity risks), one also expects profit margins demanded by finance to rise. We will study this relationship between size and role of finance in the United States and the euro zone.

The increase in the size of finance (up 50% between 1995 and 2011 in the United States and 25% in the euro zone) is easily accounted for by the similar increase in the size of the activity of intermediating savings. The growth in the relative profitability of finance in comparison with other sectors (33% over the same period for both economies) can also be explained by the rise in borrowers’ default risk premia. The high level of finance’s relative profitability in comparison with other activities cannot of course be explained only by changes in the size and risk of financial intermediation. However, the similarity between the weight of finance and the size of savings and intermediated assets is striking.

Even though insurance is of primordial importance in domestic economies and internationally and its role in the development process is at the agenda of international organizations such as UNCTAD, the World Bank and the IMF, its relative importance and its value-added remain difficult to assess. Like other financial services, insurance has grown in quantitative importance as part of the general economic development and it also has become qualitatively more important due to the increase of risks and uncertainties in most societies. This paper presents the traditional approaches to the economic measurement of insurance and discusses the possible measures of its value-added in the economy.

Three major difficulties arise when thinking about the links between finance and growth. The first one is defining and measuring “financial development”. The second is extricating the crossed causal relationships between the development of financial systems and growth. And the third one address the definition of efficient public policies, policies that might result in a good balance between market imperfections and the costs of inefficient regulatory policies, but also likely to guide the financial development in order to maximize its impact on long-term growth. On each of these three problems, substantial progress has occurred over the last twenty years but important questions are still pending.

The measurement of the output of banks in current and constant prices as part of the National Accounts is a contentious topic, partly related to the conventions of the System of National Accounts. This paper provides an introduction to this topic and highlights the points of contention. Results from recent studies are presented that argue how bank output at current prices is overstated in the National Accounts, while real growth in Europe is biased relative to the United States, making cross-country growth comparisons hard to rely on.

This article describes the measurement of the banking sector production in national accounts, outlining the principles and the calculation method. It also deals with the thoughts in progress about the quality and relevance of that measure, which could lead to a change in calculation methods in the short run. Lastly, it shows the main evolutions of French banks activity under the prism of national accounts, during the past thirty years.

Initially created to secure the funding of specialized sectors or industries, cooperative banks have developed an added value distribution pattern between themselves and the associated members whereas keeping flexible capitalistic tools. Since the late 1950s, their customer basis has widespread dramatically and the French banking law of 1984, which set up the legal framework of universal banking, made them face two challenges: internal modernization to fit with the new competition on their historical markets and efficient strategic planning to break onto new business lines or new markets despite their new competitor disadvantages. They try to achieve these targets by using and harnessing capitalistic structures and mechanisms (shareholder incorporation, listing on financial markets…). Hence ambiguous targets of added value distribution and Group “heads” having to deal with conflicts of interests.

Measuring bank’s added-value is challenging. In its first part, this paper presents a definition and a method to compute added-value in the banking sector. This method highlights the respective contributions of the commercial bank and investment bank activities. It tends to show that shareholders bore the bigger part of the burden during the financial crisis. In a second part, the sound basis needed to promote the development of the banking sector are brought about with a model analyzing the different sources of value and the factors impacting them.

This paper focuses on the proliferation of financial innovations as a decisive force affecting the stability of the financial services industry. A fundamental feature of more recent financial innovations is their focus on augmenting marketability which makes banks and financial markets more intertwined. We argue that the more intertwined nature of banks and financial markets adds complexity and induces opportunistic decision making and herding. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability.

Building on this, the paper discusses whether capital regulation and market discipline might be effective at countering the elevated instability. We will argue that market forces might be at odds with financial stability and point at institutional and regulatory changes that might be needed. In particular, structural remedies are advocated in order to reduce the complexity of financial institutions.

Banks play a key role in financing the euro zone economy. They act as intermediaries by turning savings into lending, transform short-term resources into long-term funding and hedge risks for non-financial companies. The recent crisis has prompted a drastic strengthening of prudential regulation for banks and led to major changes in the euro zone’s banking system, which is still adapting to the new environment. This is the price to pay for bolstering the stability of the financial system and the wider economy. However, the measures being considered by some of the countries hardest hit by the financial crisis, such as ring-fencing or even banning certain activities, are not necessarily appropriate or relevant to the euro zone. They could actually even weaken a banking model which has proved resilient during the crisis.

This paper describes briefly the different methods which are currently utilized in practice to assess the creation of value by reporting entities, and the recommendations which have been published by the stock market regulatory authority to improve the transparency and the accuracy of the methods used by issuers to communicate such financial information to the investors. It then discusses the benefits of an internationalization of accounting standards for a better comparability of the measure of value created by different entities .The paper acknowledges the inherent limitations of current accounting standards for a complete depiction of the market value of an entity, in particular their shortcomings with regards to internally generated intangible assets.

Corporate governance rules tend to focus on shareholders’ equality and strengthening board monitoring. Although these features intend to protect investors, results of empirical analyses indicate that the one-size-fits-all model may destroy shareholders’ value for certain firms. Allowing each firm to develop the particular mix of management and monitoring that best suits its individual needs is often preferable to increase firm’s value.

To discuss the potential and conditions of validity of macro-prudential policies for supporting long term wealth creation, the paper discusses the two dimensions that have now become standard, namely the search for financial stability at every point-in-time, which is the prevention of contagion within the financial system, and the objective of financial stability over-time, i. e. the reduction of the pro-cyclical nature of the financial system. The first approach is illustrated by the new scheme for the identification of Global Systemically Important Financial Institutions (G-SIFIs), elaborated by the Financial Stability Board and the Basel Committee. The second approach presents the micro-prudential mechanisms that have been developed to reduce the risk of pro-cyclicality of prudential regulation but also the macro-prudential instruments that have been put forward in order to provide the proper incentives to financial institutions in order to contribute to long-term growth. The paper also concludes by insisting on the further work still necessary in order to better articulate all the macro-prudential tools currently proposed, as well as the need to make strategic choices and to be able to review them, as more experience is gained with the concrete implementation of those instruments.

As a highly concentrated and interconnected market of operators, the money market is particularly sensitive to any kind of uncertainty relating to the quality of its actors’ balance sheets. It has therefore changed over the past three years to adapt to both asymmetric information and uncertainty. The loss of confidence in the reliability of the big financial institutions’ balance sheets has entailed a significant decrease in unsecured transactions, the development of collateralization and the strengthening of the security procedures that preside over transactions and positions (loan insurance). These changes aimed to invigorate the refunding market and controlled by the Central Bank strengthen the link between government debt and the banks’ balance sheets at a time when the pressure of market discipline on the former is mounting. They also lead the Central Bank to take riskier positions and potentially bail out a bank (the clearing house) that has proved insolvent, and not only short of liquidity.

Which is the optimal number of bank relationship for a company? Taking just into account transaction costs the answer should be one. However, data suggest that this number changes according to the size, the period of observation, and also to the country of firms. Thus, relying on both theoretical and empirical studies, this article tries to identify the optimal structure of the bank relationship of a company and the various relevant factors at work. We highlight that if a very opaque firm should have concentrated bank relationship, this conclusion changes when factors such as the different nature of the information produced by the firm or as its environment are taken into account.

Being a distinct public tool for managing foreign currency reserves of many countries Sovereign Wealth Funds (SWFs) used to choose safe investments such as public securities or corporate bonds. However, given the global change over the last decade, which is characterized by low bond yields, SWFs have been driven, just like all long-term investors, to diversify their investments and to include in their portfolios a broader array of assets often offering exceptional profits but raising the specter of high risk levels. The 2008 financial crisis has brought considerable losses for all investors having invested in this array of assets and SWFs are among them. Nevertheless SWFs are still invested in these risky assets because they remain return-attractive, especially after the turmoil caused by the sovereign debt crisis.