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A joint Initiative of Ludwig-Maximilians-Universität and Ifo Institute for Economic Research
Venture Capital, Entrepreneurship, and
Public Policy
CESifo Conference Centre, Munich
22-23 November 2002
IT Innovations and Financing Patterns:
Implications for the Financial System
Allen Frankel
CESifo
Poschingerstr. 5, 81679 Munich, Germany
Phone: +49 (89) 9224-1410 - Fax: +49 (89) 9224-1409
E-mail: [email protected]
Internet: http://www.cesifo.de
12 September 2002
IT Innovations and Financing Patterns: Implications for the Financial System1
Allen Frankel, Head of the Secretariat, Committee on the Global Financial System
I.
Introduction
The CGFS: a central bank forum
The Committee on the Global Financial System (“CGFS” or “the Committee”) is a central bank forum
for the monitoring and examination of broad issues related to financial markets and systems. The
quarterly meetings of the CGFS are attended by representatives of the central banks of the G10
member countries and a small number of other central banks. In the mandate it has received from the
Governors of the G10 Central Banks, the CGFS is asked, among other things, to pay particular
attention to the actual and potential changes in financial intermediation and to the incentive structures
built into markets and systems.
In recent years, the Committee has touched on a number of issues that came to be grouped under the
title of issues relating to the financing of the new economy. This was done through discussions of
conjunctural developments, frequently focused on the relative performances of individual segments of
the equity markets, as well as discussions of constructed scenarios. These scenarios were written in the
form of case studies and were focused on potential sources of systemic stress over the short-tomedium term. One particular focus of the scenarios was how public sector financial policies
influenced the manner in which the real economy employed new technologies and how the character
of the new technology itself seemed to influence how its take-up by the real economy was financed.
Over time, the Committee had become aware of the interest in the new economy among member
central banks. This common interest in the topic led to the organization of a Working Group with a
work program organized as a series of informed discussions. That is, the Working Group was required
to explore issues, rather than undertake original work, related to financial aspects of changes in real
economic activity resulting from the use of new technologies. Between the time the Working Group
was given its mandate and when it reported back to the parent in late 2001, circumstances had changed
substantially: downward revisions in US economic growth estimates covering the late 1990s and the
sharp fall in equity prices, particularly of the tech stocks, contributed to the sense that structural
changes in the economy might well be of lower near term significance than some of the more
enthusiastic proponents of the new economy had argued. If anything, this past year, with the ongoing
revelation of corporate scandals, has led to further support for the view that the entire success of the
new economy was achieved by the artful use of smoke and mirrors. Nonetheless, in my view, the
Working Group’s assessment of the significance of changes in technologies employed in the real
economy for the organization of finance and the bearing of risk retains its relevance.2 The attached
chart (Issues discussed by a CGFS Working Group) outlines how the discussion was carried forward.
Investments in IT technology at the firm level
In the course of its deliberations, the Working Group discovered abundant evidence concerning
changes in financing needs; funding patterns and risk profiles of firms related to the specific character
1
The views expressed in this paper are those of the author and do not necessarily reflect those of the Bank for
International Settlements.
2
The Working Group was chaired by Jürgen Stark, Vicepresident of the Bundesbank. The Working Group’s
Report IT Innovations and Financing Patterns was published in February 2002. It is posted on the website of
The Bank for International Settlements (www.bis.org) as a CGFS publication.
New ways of
production
Capital
inflows
Changes in
the time
profile of the
business
cycle
Incentivebased pay
becomes
increasingly
central
(Growing)
gaps between
domestic
saving and
investment
Higher
overall
investment
risk
Rising
expected
income
Raised level
of potential
growth
Higher
productivity
within and
outside the
tech sector
Plausible macro level outcomes
Changing risk-reward profile of
new and of established firms
labour force and
capital stock
Restructuring of
firms
Expansion in
new markets
New
products
Micro/firm level impacts
How to manage
changing risks in
existing financing
relations?
How to address
risks when
providing new
funds?
Role of venture capital
Role of debt financing via
banks and bond markets
Role of equity markets
(including implications for
incentive-based systems of
compensation)
• bridge greater fluctuations in household income
• less need for inventory financing, but increased variability of cash flow at supplier
level
Policy implications
• Is there something special about technology as a source of firm-specific investment
risk?
• Is a greater likelihood of international contagion-like effects adding to the potential
vulnerability of the global financial system?
• Behaviour of temporary “imbalances”
• Possibly closer international co-movement of economies and markets
Changing financing needs over the business cycle
Stability of the financial system:
Changing international financing conditions
Functioning of the financial system:
Empirical evidence: cross-country differences in financing patterns of
firms
Possible systemic aspects
Availability of
collateral
State verification
Valuation of firms
Access to information
Specific issues: how are they addressed in different institutional
environments?
• Differentiating the roles played by various segments of the financial system
• Changes in the functions performed by specific intermediaries and financial
markets
Modify exposures
Re-assessment of
the composition of
risk exposures
impounded in
portfolios
Use statecontingent financial
contracts
Intensify monitoring
Provide consulting
services
Increasing difficulties in forming expectations as macro forecasts become
less reliable
Heightened levels of undiversified risk
General issues for the financial system
Higher expected returns on capital,
but also heightened risk
• Increasing
information
asymmetries
• Track record of
management, but
principal-agent
problems
Established firms
• Heightened information asymmetry
• Lack of managerial
reputation
New firms
Funding needs depending on technology
General issues which could be surfaced by market responses
Issues discussed by a CGFS Working Group
of innovations involving IT technology. This, in turn, led the Group to consider the impact of those
developments on individual segments and the structure of financial markets, including the evolution of
new market segments. The Group also examined possible changes in the character of financial
intermediation. Finally the Group examined implications for the functioning and stability of the
financial system.
The background material for the Group’s discussions was a mix of background sources submitted by
members of the Working Group, including a number of empirical studies and reports on survey
findings.3 It was anticipated that public readers of the report might find the collection of background
materials to be of particular value. This is in major part because it usefully brings together US and
non-US evidence on various topics. In particular, from my perspective, the gathering and discussion of
non-US evidence was of particular value since it encouraged the Working Group to consider the
general hypothesis regarding the organization of firms rather than those relating mainly to firms
involved in the production of IT goods and services.
The boundaries of the firm
Economic theory has treated the boundaries of a firm as coincident with the ownership of assets. In the
classic agency model, an agent’s contribution is simply output that can be measured. It follows that the
effectiveness of incentives within such a framework is a straightforward matter of verifying output
changes. In this regard, classic empirical evidence of differences in productivity at a firm installing
widget sub-assemblies of salaries versus piece rates confirms the value of the classic approach in
situations where jobs are narrowly defined and easily monitored. For a transition from salaries to piece
rates, it has come to be appreciated that piece rates provide strong incentives for hard work and also
encourage the self-selection of a workforce that highly values the structure of incentives.
Working Group members interpreted the growing interest among academic economists in shifting the
focus of discussions of incentives from various kinds of effort to incentives for skill acquisition. Such
a shift reflects an intuitive awareness of the character of changes in the organization of economic
activity that were in train as well as the character of what were thought to be associated changes in
macro outcomes (higher growth rates of productivity and growing premiums for educated labour). On
the other hand, they were aware that treatments had not considered the implications for financial risk
bearing on the organizations of the firm or the distribution of aggregate risk exposures with the
financial system of a more central role for skill-sensitive incentive mechanisms disposed to
decentralisation as a function of changes in exogenous variables.
Evidence reviewed and developed by the Working Group
Black and Lynch (2000) and Bresnahan et al (2001) are frequently cited as having examined the
interaction between information and communication technology (ICT) and other factors within the
firm. The core idea of both pieces is that two main changes are implemented within firms adopting
these new technologies: workplace reorganization and higher demand for skilled workers. In order to
exploit opportunities introduced by computers and related technologies, firms need a labour force
capable of learning new skills. The evidence points to trends toward a reduction in managerial levels
and decentralisation of decision making. It also points to the role played by developments in
information technology, in particular, how IT eroded the strategic value of physical assets and thereby
undercut support for competitive positions of large established firms.
3
Most of the papers can be accessed on the BIS website (http://www.bis.org). The Report’s bibliography is
incorporated into the references section of this paper.
IT innovation, investment opportunities and financial risks
At the centre of the IT innovation “shock” have been advances in the production of IT components. In
its report, the Working Group found that the share of IT in GDP among the G10 countries could be in
a 4% range. By contrast, the share of IT in trade was in a 12% range. The Working Group interpreted
the difference as suggesting the role of international specialisation in the production of IT goods. It
was also aware that its mandate called for consideration of how IT impacted on the way firms are
organized and financed rather than on looking for explanations of the source of international
comparative advantage in the production of IT goods.
II.
IT innovation, investment opportunities and financial risks
Innovation in IT – comprising computer hardware, software and telecommunications equipment4 – has
triggered a period of particularly rapid technological change. At the centre of the IT innovation
“shock” have been advances in the production of IT components, namely semiconductors. Cheaper IT
components have stimulated progress in IT equipment production and, through rapidly falling prices,
have spurred IT use in other sectors. The preparations for Y2K and very optimistic expectations
regarding the business opportunities offered by IT – and in particular the internet – added to the global
demand for IT goods in the late 1990s.
IT innovation, production and competition
The competitive positions of firms that have invested in IT, eg the joint significance of IT investment
and organizational innovations in traditional industries such as textile manufacturing, have been
enhanced.5
IT innovation affects the competitive position of firms both through production efficiency and changes
in the goods markets. A study for the Canadian manufacturing sector shows that the adoption of many
of the new advanced technologies built around computers was associated with increased growth in
labour productivity and market share during the period 1988 to 1997.6 Gains were larger when
software, hardware and network communications were adopted jointly. And again, the adoption of IT
appears to have the greatest impact where it is effectively combined with human cognitive capabilities.
In addition to changes in the production process, IT innovation may alter the competitiveness of
markets.7 IT provides firms with powerful tools for more effective price discrimination. These include
market segmentation through the sale of different versions of basically the same product and, at the
extreme end, the production of goods tailored to the preferences of individual customers. IT is crucial
in this respect not only because it allows such “personalisation” of goods, but also because it enables
firms to collect and process the information necessary to identify consumer taste. Another factor is
supply- and demand side economies of scale (“network effects”). These effects create the possibility of
boosting profits by increasing supply at very small marginal costs and by achieving a “critical mass”
in demand. As a consequence, economies of scale favour business strategies trying to gain market
share or establishing industry standards. Finally, there is substantial competition to rival alternative
technologies such as fibre-optic cable versus high-speed telephone lines.
4
There is no generally agreed definition of IT or the IT sector. In this report, the IT sector is defined as
computer hardware and software producing firms, telecoms service providers and telecoms equipment
manufacturers, and internet firms. The term “tech sector” is used synonymously with “IT sector” in this report (it
should be noted that “tech sector” is often used to capture high-tech industries other than IT, for example
biotechnology).
5
Empirical evidence for factor complementarity between IT, human capital and reorganization is presented in
Bugamelli and Pagano (2001). For the United States, see eg Black and Lynch (2000).
6
See Baldwin and Sabourin, (2001):
7
For an overview, see Varian (2001) and the discussion in DeLong and Summers (2001):
Implications for the character of IT investments
In sum, IT innovation may – through the reorganization of production activities and changes in the
competitive environment – alter the productivity and profitability of firms in the IT sector and in other
industries rather quickly in ways that cannot be readily forecast. As a consequence, individual
investment projects tend to become riskier. However, if the firm successfully adapts to the new
technology, the return on investment can also be expected to be higher than otherwise.
Higher individual investment risk puts a greater onus on risk diversification. The shift towards “soft”,
customised and information-based production probably reinforces the tendency toward higher
idiosyncratic risk.8 As a consequence, a broader range of assets may be required to achieve
diversification. Although the IT innovation “shock” does not necessarily mean increased systematic,
non-diversifiable risk, exploiting the potential for diversification may require portfolio adjustments.
The Working Group developed a consensus to view IT as a general-purpose technology that can alter
efficiency of production processes by improving the availability and dissemination of information and
more decentralized customised production. In turn, the Working Group came to the view that IT was a
much different general-purpose technology from previous examples, such as the steam engine. This
led the Working Group to accept the notion that IT operated primarily through the enhancement of
human capital.
III. IT innovation and firms’ financing needs
Transformation of firms
Firms are becoming increasingly “knowledge-based”. Intellectual property rights account for an
increasingly important part of firms’ assets.
A number of empirical studies reviewed by the Working Group confirmed the increasing weight of
intangibles in innovative firms. For example, Planes et al (2001) discovered disproportionate
investments in intangibles in innovative (somehow defined) as opposed to non-innovative firms.
The corporate control dimensions of financial contracts are important. Firms willing to change their
production processes through internal reorganization are more likely to be profitable. In other words,
effective incentive structures are necessary to exploit potential advantages based on factor
complementarities.
Potentially, IT-based innovation can affect a very broad range of companies in different industries, of
different sizes and at vastly variable stages of product cycles. Indeed, as set out in Brierley and Kearns
(2001) findings for the UK’s financing arrangements vary considerably across firms.
In assessing the firm-level financing of IT-based innovation, three different types of firms can be
considered: new small, high-tech firms seeking start up and early stage finance; established firms in
high tech seeking later stage finance and established firms outside these sectors in the process of
financing their adoption of new technologies. The common belief held by most members of the
Working Group that there should be marked differences between these groupings was confirmed.
The Working Group’s review of available data highlighted difficulties in cross-country comparison.
That is, for the IT sector as such, variations in funding structure reflect differences in sectoral
composition. The available data on specific sectors show more similarities across countries, although
country-specific events can still be discerned. For example, telecoms service providers display
uniformity. In contrast, public equity was the most important source of funding for hardware and
software firms. One common element, irrespective of these differences, is the relatively high
importance of equity funding compared with other sources of funding and with the financing of nonIT sector firms.
8
For empirical evidence on the increase in idiosyncratic risk, see Campbell et al (2001):
New Tech Sector firms
In the course of its discussion, WG members came to differentiate between the financing of new,
small, tech sector firms and new firms in the non-tech economy. It was accepted that “the pecking
order” hypothesis applies to new firms in the non-tech sector but an altered form of that hypothesis is
more appropriate for new firms in the tech sector. The pecking order hypothesis predicts that the first
source of external finance for firms will be debt.
By contrast, it was argued that once the internal funds of non-tech firms are exhausted, such firms will
need to access equity finance. This is because the assets of such firms are intangible (without a
certifiable market value) and therefore unsuitable as collateral for debt finance. Their lack of size and
trading records will also tend to preclude them from meeting the listing criteria for public equity
markets. This reasoning underlies the development by the Working Group of the presumption that
such firms will need to seek private equity finance, especially from the venture capital industry, at an
earlier stage than equivalent non-tech small firms do.
Data related to the funding of the internet sectors assembled by the Federal Reserve Board and the
Banque de France show that the funding structure of the internet sector can be said to have a modified
pecking order. In both France and the United States internet firms relied largely on equity up to 1999.
This analysis led the Working Group to identify the funding of US internet firms in 1999 and 2000 in
high yield bond markets as deviant, an assessment seemingly confirmed by the speed with which the
market subsequently dried up.
Established firms in the tech sector
One major presumed difference between the established firms in the IT sectors and those in other
sectors is the pace of innovation and obsolescence. On the basis of its review of empirical evidence,
the Working Group found that established high tech firms have not faced major difficulties in
accessing debt finance, and greater “maturity” of firms has indeed been associated with greater
reliance on debt financing. By contrast, speculative grade start-up service providers were net issuers of
equity.
With respect to the use of equity financing by established firms, the Working Group concluded that
major differences are discernible between Continental Europe and Japan on the one hand and the
United States and United Kingdom on the other. In the former countries, the equity market is basically
a “one way street” for corporations – ie it is used to raise funds. In the United States and (to a lesser
extent) the United Kingdom, by contrast, the net redemption of equities by established firms indicates
a “two way” use of equity. Evidently, the most important dimension is related to corporate control
mechanisms. First, the link between management compensation and corporate performance through
equity options – a feature particularly widespread in innovative firms – may encourage equity
buybacks as a means of preventing dilution and maintaining the share price. Second, the possibility of
takeover may discipline the behavior of corporate managers. Another dimension that has been
important at times has been the opportunity to raise leverage in order to enhance returns on equity.
More generally, an active “two way” equity market has provided an attractive option for the financing
of restructuring or re-focussing firms.
Financing of established firms outside the tech sector adopting new technologies
For established firms outside the tech sector, adapting to a new technology poses different challenges
for financing. The actual financing demands associated with the adoption of a new technology will
need to be met. But the availability of funding is probably less of an issue. Information asymmetries
are low because the firms tend to have (sometimes very long) track records. This is likely to result in
the firms having access to external financing through public markets or possibly through established
banking relationships. Collateral and internally generated funds will generally be available.
However, the adoption of IT-related innovation and the associated changes in the business model may
tend to increase information asymmetries, and monitoring and agency problems may therefore
become, at least temporarily, more relevant for the providers of external financing. The main problem
associated with investment by non-tech firms in IT capital goods may be the high degree of
uncertainty of the results. Reorganising productive activities in a manner designed fully to exploit the
possibilities offered by more powerful software and computers can involve huge sunk cost.
At the same time, much IT-related innovation provides substantially greater information in usable
form about production processes, risks, and departures from plan than did previous technologies, and
this could facilitate both internal and external monitoring. To the extent, however, that the benefits of
improved monitoring are not passed along to external stakeholders, the combination of uncertainty and
information asymmetries can produce inefficient outcomes.
The growing importance of human capital and of complementarities between labour and capital in
generating returns has implications for the financing of established firms outside the tech sector. The
risk-reward relationship associated with investment in such firms may become more difficult to assess,
given that their value is dependent upon the ability to retain human capital in a rapidly changing
competitive environment. This raises questions about firm valuation and the usefulness of new
methods of credit risk measurement, not only for assessing new economy firms, but also for firms
outside the tech sector.
The Basel Accord
At the BIS, we have become very familiar with the complexity of historical database issues involved
in connection with the revision of the Basel Capital Accord.
The flavour of this complexity is given in the following:
‘There are many good reasons to take a portfolio approach to the risk management of a
financial institution. Doing so requires good financial models for interaction among the
exposures of the institution's various positions and activities (it also involves some
interesting incentive-design challenges for compensation theorists). However, the best
models are obviously only as good as the system for collecting and integrating data
regarding what the positions actually are. More than that, historical data is also needed,
both internally and externally, to help validate the financial models. The Basel II accord
explicitly recognizes that: "...banks [need] to have sufficiently long runs of data that
enable them to assess how well borrowers have withstood normal business stresses and to
factor these assessments into ratings"; and "...coordinated industry-wide data collection
and sharing based on consistent definitions of loss, risks, and business lines."’9
IV. IT innovation and longer-term implications on the financing needs of firms
It is an open question whether IT innovation changes the overall needs of firms in terms of size and
time profile of external financing. It is in particular not clear whether the pace of IT investment that
drove funding needs of IT firms will revert to the level experienced in the late 1990s and whether
some of the funding patterns observed during this period (such as the funding of internet firms in the
high yield bond market) will re-emerge.
However, the introduction of IT-related changes in firm organization can be facilitated by access to
compatible financial contracts. The success of IT innovation is dependent on corporate control
mechanisms embedded in financial contracts. Moreover, financing has to reflect the changing
risk/reward relationship underlying such investment. This reality has been recognised in recent years
through initiatives to create equity in new market segments for innovative firms (such as the Neuer
Markt, and TSE Mothers).
9
Lawless(2002)
How important is the impact of IT innovation outside the tech sector?
Three general observations support the thesis that IT innovation will bring about more substantial
changes outside the IT producing sector itself. One is the sheer size of the non-IT sectors, which
widens the potential scope of IT application as a general-purpose technology. A second factor is the
strong empirical evidence developed by researchers on the role that factor complementarities play in
realising productivity gains. And finally, firm-level empirical studies confirm that the ability (or lack)
of a firm to use IT may strongly influence the level of likelihood of success.
Sector information on IT use is available for Canada, the Netherlands, the United Kingdom and the
United States.10 These studies show that the use of IT is concentrated in the service sector and a few
areas of manufacturing. Among the areas using IT relatively more than the average of the total
economy are general services, trade, finance and insurance. On the manufacturing side, electrical and
optical equipment and machinery are heavy users of IT. These indications underline the widespread
use of IT outside the tech sector. What is not readily discernible from studies to date is to what extent
productivity gains reflect IT investment, combined with complementary changes in firm organization
or other effects from competitive forces affecting firms regardless of whether adapting to new
technology or not.
This being said, the first challenge is to assess the relevance of IT-related changes for the risk-reward
profile of firms. Evidence based on interviews carried out by the Working Group suggests that banks
monitor clients’ use of IT as part of assessments of firms’ future prospects.
V.
Implications for financial stability and for public policy
Risk management and risk allocation
Greater relevance of firm-specific risks and difficulties in evaluating them are likely to affect the
volatility pattern in financial markets and in particular in equity markets. While market volatility need
not necessarily be higher, greater price volatility of individual stocks could become a more frequent or
even persistent phenomenon. Shifts in the structure of price co-movements across firms and sectors
are reflected in reconfigurations of volatility clusters.
As equity market valuation is likely to become more central, such price movements would be easily
transmitted to other markets. One channel of transmission that may involve particular risk is the
reliance on equity market capitalisation of a firm as an indicator for its capacity to service debt. Using
market capitalisation as “implicit” collateral may create incentives for firm management to increase
leverage at times of buoyant equity markets. Declining equity value could then confront creditors with
– possibly very rapidly – deteriorating credit quality and actual losses. Beyond this negative impact on
the profitability of creditors, their likely reaction – a tightening of credit standards – would add to
deferring of financing in equity markets.
Another channel involves the transmission of price volatility, both to real investment through greater
reliance on equity finance and to consumption through equities forming a greater part of household
financial assets and remuneration being linked to equity performance. Possible repercussions on the
financial system, eg in the form of an increased vulnerability of the household sector, would crucially
depend on the distribution of such losses.
The risk management of financial institutions would also have to address the negative consequences of
higher idiosyncratic risks and uncertainties regarding firm valuation. In particular, this would affect
the capacity to employ credit histories to generate debt default histories confidently. Intensified
monitoring would not be limited to IT and other high-tech sectors since borrowers in “traditional”
sectors have become more vulnerable to mistakes related to the choice of technology. Creditors would
need to be realistic and vigilant about the constantly evolving credit risk environment. In addition, the
10
See Pilat and Lee (2001):
question arises whether exposures to the household sector would have to be reconsidered. At the
portfolio level, similar problems would occur if the business links and hence the correlation of default
risk between sectors were to change. Moreover, risk mitigation techniques would have to be adjusted,
for example to the valuation of collateral. If idiosyncratic risk is rising, then portfolio diversification
might require portfolios with higher absolute levels of exposure to generate desired levels of risk than
before.
It is unclear (and perhaps unlikely) that these issues would surface simultaneously and immediately
constitute a concentration of loan problems. However, deterioration could occur quite abruptly (as the
rapid downgrading of telecom firms has demonstrated) and reinforce problems, in particular in an
economic downturn when perceived credit conditions may be deteriorating.
IT innovation may also shift the sector allocation of business-related risks. One dimension of this is an
increasing reliance on compensation that is more variable over the cycle. Rather indirectly, heightened
competition in goods markets and the erosion of producer rents would be beneficial for consumers, but
may expose individuals to higher risk as sources of skills and investable wealth. A related dimension
of risk transfer would be the shift from financial intermediaries to investors in financial markets
through increasing reliance of firms on market-based financing. Business-related risks would be
dispersed more widely across the economy, probably reducing the overall vulnerability of the system.
However, the issue of risk diversification would gain in importance. It is important to see this
development in conjunction with other trends such as the secular shift to private sector management of
savings in CGFS member countries.
Banks could also become increasingly exposed to market risk with a larger component of basis risk
(both through direct holdings of securities and their increasing use as collateral). Assuming such
exposures would be a natural by-product of their monitoring efforts aimed at assessing idiosyncratic
risks. Again, greater onus would have to be put on risk diversification, perhaps reinforced by business
strategies aiming at more specialisation in credit business. As a consequence, issues related to sectoral
exposures or an increasing reliance on credit risk transfer tools would become increasingly relevant.
What does the rise and fall of IT equity markets tell about these risks?
Boom and bust in the IT segment of equity markets and the repercussions on the financial system
provide some insight into the relevance of the issues outlined above and the risks that may be
important when going forward. The following points can be highlighted:
•
On the positive side, the huge loss in equity wealth has not triggered any major default among
financial intermediaries. This suggests that markets have provided for an allocation of risks to
those sectors that have been able to bear them, possibly including the diffusion of IT-sector
related credit exposures through credit risk transfer markets.
•
Valuation problems have been substantial and were probably exacerbated by market practices
that might not have dealt appropriately with the specific information and valuation problems
that characterise new and innovative firms. One example may be the incentives to bring firms
to the public equity market at a very early stage of the corporate lifecycle.
•
Equity market conditions had considerable knock-on effects for other segments of the
financial system. They impacted adversely on provision of venture capital and private equity
to high-tech firms. The drop in equity market capitalisation also reduced the willingness of
banks and other financial institutions to provide new finance to these sectors, as the validity of
earlier assumptions about ease of refinancing existing debt finance through equity markets
was undermined.
•
The difficulties associated with using equity valuations and market capitalisation of high-tech
firms to signal ability of those firms to service debt obligations became apparent. The case in
point is the telecom sector. The inability of some telecom companies to arrange equity market
take-outs of bank debt and rising defaults left banks with unanticipated exposures.
In a longer-term perspective, these experiences can be seen as part of a costly learning process for all
participants, which may have led to significant improvements in risk management and valuation
capabilities. However, the tentative nature of these arguments should be recognised, as it is still too
early to draw final conclusions about the implications of the tech sector exuberance. This is all the
more important, as the IT sector boom and bust may well have some lasting impact. For example, the
evolving equity culture (in particular in Europe) may have weakened as a consequence of the
disappointment of expectations. The sharp decline witnessed in the amount of equity capital raised by
IT firms supports such a view. However, it is reassuring that the extent of equity business, for example
the equity investment of households, remains considerably higher than before. Re-considering and reassessing these implications should be the subject of future investigations.
Implications for public policy and for central banks
The general issue for public policy in the face of a technological shock is that of striking the right
balance between exploiting potential gains and avoiding risks that could threaten the overall system.
Regarding the exploitation of investment opportunities, empirical evidence supports the view that
other policy areas – such as labour market policy or taxation – have been more important in defining
the cost of risk taking and attractive investment opportunities. But financing clearly plays a role in
supporting the re-organization of the corporate sector and in allocating the risks associated with this
process. And this role is likely to increase as market-based incentive mechanisms gain in importance
and the management of financial risks becomes more complex.
The main risks involved in the financing of new technologies are large-scale failures of investment
projects that may damage the financial institutions providing funding and excessive price movements
in financial markets resulting from unrealistic expectations. Against this background, the task of
financial policy is to set a framework of regulation and standards that allow for market-driven
adjustment of financing mechanisms and encourage ongoing improvement in risk management
techniques. Central banks can play an active role in this process.
One aspect is to employ the research capabilities and the knowledge of the financial system combined
in central banks to improve the understanding of the financial impact of technological change. This
could include, for example, identifying mechanisms that potentially amplify swings in expectations or
exploring the implications of changes in idiosyncratic risk on volatility and portfolio diversification.
Another area would be risk management issues involved in the provision of equity-like finance by
financial intermediaries and the re-distribution of risks within the financial sector and to non-banks.
Interviews by the Working Group indicate that further adjustment of risk management of financial
institutions in the light of a changing corporate sector is an issue that banks are paying attention to.11
The other aspect is the active role of central banks in the monitoring of the financial system. Changing
linkages between the real and the financial sphere and across the different segments of the financial
system, and in particular the reallocation of risks across the financial system, underline the need for
systemic and system-wide monitoring. Enhancing this function would probably involve closer
cooperation with supervisors; in particular as the value of firm specific information (including the
relevance of “soft” information) increases as idiosyncratic risks become more important.
Concluding remarks
The central bank community has, in recent years, become increasingly sensitive to the fact that equityrelated financial wealth is an important determinant of economic activity. In the past, this was not the
case since equity markets had prominent roles in only a small number of countries. This awareness has
led to an increasing interest on its part in understanding how and why equity market outcomes matter
for real investment decisions. A presumption underlying this interest is that there have been
fundamental changes in the incentives that affect the organization of economic activity. The Working
Group report can be read as supportive of the notion that changes in the underlying information
11
Notwithstanding this, central banks would probably have an interest in the issues that changing financing
patterns raise for monetary policy, namely possible changes in the monetary transmission mechanism.
technology is reflected in the character of the firm, and in particular the deployment of incentives to
recruit, retain and influence the character of performance of skilled staff in the economy as a whole.
Over the course of the late 1990s, financial market offerings in the US and in other mature economies
are influenced by the heightened importance of incentive based compensation. It has now become an
open issue as to whether financial stability issues have been surfaced by the seemingly poor handling
of conflict interest issues by financial firms which were involved in the transfer of risk bearing
responsibility through use of the financial markets.12
On the one hand, it is not clear what role central banks will play in addressing these issues. On the
other hand, it is clear that central banks, in view of their responsibilities for monetary policy and for
financial stability, have a pressing interest in mastering an understanding of the influence of
technology on the financing of firms and on the manner in which resulting financing risk is placed and
held by various agents. Central banks might also be particularly well suited to conducting monitoring
exercises focused on the robustness of system-wide mechanisms for managing risk.
12
A particularly sharp rebuke was set out in a New York Times column (September 1, 2002) by Gretchen
Morgenson, entitled “Another Slap at Democracy on Wall St.”
Bibliography
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