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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 Central bank papers submitted by Working Group members Ayrer, B, C Upper and T Werner: “Stock market valuation of old and new economy firms”, Deutsche Bundesbank paper, April 2001. Antoniewicz, RL: “Financing of ‘New Economy’ firms in the United States”, Federal Reserve Board draft paper, April 2001. Bakhshi, H and J Larsen: “Investment-specific technological progress in the United Kingdom”, Bank of England working paper, 2001. Berk, JM: “New economy, old central banks? Monetary transmission in a new economic environment”, De Nederlandsche Bank paper, September 2001. Boisvert, S and C Gaa: “Innovation and fragmentation in Canadian equity markets”, Bank of Canada paper, June 2001. Bosomworth, A and S Grittini: “New economy, the equity premium and stock valuation”, European Central Bank paper, June 2001. Brandolini, A and P Cipollone: “Multifactor productivity and labour quality in Italy, 1983-1999”, Banca d’Italia draft paper, April 2001. Brayton, F and D Reifschneider: “US macroeconomic performance since the mid-1990s: the FRB/US view”, Federal Reserve Board draft paper, April 2001. Brierley, PG and A Kearns: “The financing patterns of new and old economy firms in the UK”, Bank of England draft paper. Bugamelli, M and P Pagano: “ICT and factor complementarities in the Italian manufacturing”, Banca d’Italia paper, April 2001. Bugammelli, M, P Pagano, F Paternò, AF Pozzolo, S Rossi and F Schivardi: “Ingredients for the new economy: How much does finance matter?” Banca d’Italia draft paper, June 2001. Casolaro, L and G Gobbi: “Information technology and productivity change in the banking industry”, Banca d’Italia paper. Cayen, J-P: “Venture capital in Canada”, Bank of Canada paper, June 2001. Cette, G, J Mairesse and Y Kocoglu: “The contribution of information and communication technology to French economic growth”, Banque de France and Université de la Méditerranée paper, February 2001. Covitz, D and N Liang: “Recent developments in the private equity market and the role of preferred returns”, Federal Reserve Board draft paper, June 2001. Davies, SM and DC Smith: “Trends in external corporate financing”, Federal Reserve Board paper, June 2001. Duvivier, A: “Financing and risks of internet startups: A preliminary assessment”, Banque de France paper, 2001. Fornari, F and M Pericoli: “Characteristics of stock prices in TMT and traditional sectors”, Banca d’Italia paper, 2001. Fornari, F and M Pericoli: “A macro-sector perspective of TMT and traditional stock prices”, Banca d’Italia paper, 2001. Fujita, K and T Matsuno: “Financing the ‘New Economy’ firms in today’s Japan”, Bank of Japan paper, June 2001. Houben, A and J Kakes: “Fostering the ‘New Economy’: The role of financial intermediation”, De Nederlandsche Bank draft paper, June 2001. Kahn, J, MM McConnell and G Perez-Quiros: “The reduced volatility of the US economy: Policy or progress?” Federal Reserve Bank of New York draft paper, January 2001. Lalonde, R and D Lecavalier: “The US miracle”, Bank of Canada paper, April 2001. Liang, N and S Weisbenner: “Who benefits from a bull market? An analysis of employee stock option grants and stock prices”, Federal Reserve Board draft paper, March 2001. Liu, Y: “An overview of angel investors in Canada”, MFA paper, 2000. Macklem, T and J Yetman: “Productivity growth and prices in Canada: What can we learn from the US experience?” Bank of Canada paper, January 2001. Mehran, H and J Tracy: “The impact of employee stock options on the evolution of compensation in the 1990s”, Federal Reserve Bank of New York draft paper, January 2001. Mouriaux, F and F Verhille: “The difficulty of pricing ‘New Economy’ stocks”, Banque de France paper. Osler, CL: “Corporate governance and the market for corporate control: Lessons from the US”, Federal Reserve Bank of New York paper, June 2001. Oulton, N: “ICT and productivity growth in the UK”, Bank of England paper, April 2001. Pozzolo, AF: “An empirical investigation of bank secured lending”, Banca d’Italia paper. Sauvé, A and N Fleuret: “The telecoms sector in France: Financial structure and banking risks”, Banque de France draft paper, April 2001. Scheuer, M: “Measurement and statistical issues related to the ‘new economy’ with IT equipment and software in Germany and the United States as a case in point”, Deutsche Bundesbank draft paper, April 2001. Wieland, M: “Financing patterns of Deutsche Telekom: Evolving from state enterprise to TMT firm”, Deutsche Bundesbank paper, June 2001. Other literature Baldwin, F and D Sabourin (2001): “Impact of the adoption of advance information and communication technologies on firm performance in the Canadian manufacturing sector”, Statistics Canada Research Paper Series No 174. Bessen, J (2000): “The skills of the unskilled in the American industrial revolution”, Research on innovation Working Paper. Black, S E and L M Lynch (1999): What’s driving the new economy: the benefits of workplace innovation, NBER Working Paper 7479, revised October 2000. Breshanan, T F and M Trajtenberg (1992): “General purpose technologies: engines of growth?’” NBER Working Paper no 4148, Cambridge, MA. Brynjolfsson, E, L M Hitt and S Yang (2000): “Intangible assets: how the interaction of computers and organizational structure affects stock market valuations”, MIT Sloan School of Management Working Paper. Campbell, J Y, M Lettan, B G Malkiel and Y Xu (2001): “Have individual stocks become more volatile? An empirical exploration of idiosyncratic risk,” Journal of Finance, vol LVI, no 1, February. Carter, M E and L J Lynch (2001): “An examination of executive stock option repricing”, in Journal of Financial Economics. Cohen, B (2000): “Credit spreads and equity market volatility”, BIS Quarterly Review, November, p 10. DeLong, J B and L H Summers (2001): The “new economy”: background, questions and speculations, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, August. Goldin, C and L F Katz (1998): “The origins of technology-skill complementarity”, Quarterly Journal of Economics, vol 1B (June), pp 683-732. IMF (2001): World Economic Outlook, October, Washington. Lawless, Peter (2002): Basel II-Changing the way banks track exposures, MetaMatrix, Inc, 16 May. Loughran, T and J R Ritter: “Why don’t issuers get upset about leaving money on the table in IPOs?” University of Notre Dame and University of Florida Working Paper, 2000. McKinsey Global Institute (2001): US productivity growth 1995-2000. Morgenson, Gretchen(2002):”Another slap at democracy on Wall Street”, New York Times, 1 September OECD (2001): “Measuring the ICT sector”, Paris. Peterson, M (2001): “The accidental credit investors”, Euromoney, August, pp 28-35. Pilat, D and F C Lee (2001): Productivity growth in ICT producing and ICT using industries: a source of growth differentials in the OECD? OECD/STI Working Papers 2001/4, Paris. Ritter, J R (2001): Some factoids about the 2000 IPO market, http://bear.cba.ufl.edu/ritter. Terlin, S and K Whelan (2000): “Explaining the investment boom of the 1990s”, Federal Reserve Board Finance and Economics Discussion Series. Varian H R (2001): “High-technology industries and market structure”, paper presented at the Jackson Hole Symposium of the Federal Reserve Bank of Kansas City, August.