«Suresh Sundaresan 1 Columbia University “.[R]ecent crises have underscored certain financial structure vulnerabilities that are not readily ...»
Developing multiple layers of
financial intermediation: the complementary roles of
corporate bond markets and banks
Suresh Sundaresan 1
“…[R]ecent crises have underscored certain financial structure vulnerabilities that are not readily
assuaged in the short-run but, nonetheless, will be increasingly important to address in any endeavour
to build formidable buffers against financial distress. Among the most important, in my judgment, is the
development of alternatives that enable financial systems under stress to maintain an adequate degree of financial intermediation even should their main source of intermediation, whether banks or capital markets, freeze up in a crisis.” [Italics are mine.] “Before the crisis broke there was little reason to question the three decades of phenomenally solid East Asian economic growth, largely financed through the banking system, so long as rapidly expanding bank credit outpaced lagging losses and hence depressed the ratio of non-performing loans to total bank assets. The failure to have alternative forms of intermediation was of little consequence so long as the primary means worked. That is, the lack of a spare tyre is of no concern if you do not get a flat. East Asia had no spare tyres. The United States did in 1990 and again in 1998.” 1. Introduction In Asian economies, banks have traditionally been the main institutions performing the vital role of financial intermediation. Thanks to various government initiatives, banks have established extensive branch networks to tap savings from remote corners of their economies, and extend loans to both the public and private sectors. Indeed, the culture of bank financing is fairly deep-rooted for corporate borrowers in many Asian countries. However, relying almost exclusively on this single source for access to capital and intermediation can be problematic when there is a financial crisis that dries that source up. The East Asian crisis of 1997 was just such an event.
The ability of the corporate bond market to pick up the slack when the banking sector experienced problems in the United States back in 1990 is a constructive and shining example of a situation in which the corporate bond market provided a much needed safety valve, when the banking sector was vulnerable. Likewise, prudent measures on the part of central banks, along with the actions taken by commercial banks, helped to offset the potentially debilitating influence of disrupted corporate bond markets in the 1998 crisis, following the Russian default and Long-Term Capital Management (LTCM) failure. The growth of high-yield bond markets and recent developments in credit derivatives markets in the United States also point to the importance of the multiple layers of access to credit, managing and transferring credit risk.
The positive US experience could serve as a useful baseline model for Asian economies in the process of building their own complements to solely (or largely) bank-based financial intermediation.
As the Asian economies expand, and become more open to trade and financial flows, it will be increasingly essential that they have the infrastructure of multiple layers of financial intermediation in which commercial banks and corporate bond markets thrive and provide healthy competition to each The author is Chase Manhattan Bank Professor of Finance and Economics at Columbia University and can be reached at 811 Uris Hall, 3022 Broadway, New York, New York 10027, USA, or by e-mail at firstname.lastname@example.org. This paper was prepared for a BIS/PBC seminar on developing corporate bond markets in Asia held in Kunming, China on 17-18 November
2005. Thanks to Eli Remolona of the BIS for many informal discussions on the topic.
See Greenspan (2000).
24 BIS Papers No 26 other in the provision of credit and intermediation. They will also need more market-based management of credit risk. Making all this happen will require careful planning and sustained effort.
The rest of this paper is devoted to a discussion of the steps necessary to pave the way for this process.
Section 2 of the paper articulates the areas where developmental efforts have to be concentrated in order to promote a public corporate bond market. While there are many areas that require simultaneous attention from policymakers and regulators, the paper will dwell on two important dimensions: a) legal frameworks, bankruptcy reform and investor protection (Section 3); and b) transparency of secondary markets in corporate debt (Section 4). Section 5 briefly discusses some of the issues identified in Section 2 (but not discussed in Sections 3 or 4) and draws conclusions.
2. Developing corporate bond markets Development of multiple and complementary institutions for performing financial intermediation takes time and effort and cannot be accomplished in the short run. Significant efforts have already been undertaken in Asian economies in this regard, as the other chapters in this volume have abundantly illustrated.
The supply of and demand for credit and liquidity is at the heart of financial intermediation. In order to develop an alternative to intermediation driven primarily by banks, it is necessary to simultaneously
make progress on a number of fronts:
• Free flow of capital and market-based interest rates Legal frameworks, bankruptcy reform and investor protection 3 • • Corporate governance standards to mitigate wasteful agency costs, and control premiums to reduce the cost of corporate borrowing • Prudent regulatory frameworks that promote self-regulation, but establish enforcement of disclosure-based rules • Provision of stable and reliable government benchmark yield curves even when governments are running a surplus (the Australian and the US experiences are illustrative of the benefits of this policy).
• Developing transparent and efficient primary and secondary markets (the recent initiative by the Securities and Exchange Commission (SEC) in the United States to create TRACE (Trade Reporting and Compliance Engine) is worth studying in this connection).
Broadening the investor base through the creation of bond funds 4 • • Open access to currency and credit markets • Provision of market mechanisms for credit risk transfer, such as credit default swaps, collateralised debt obligations, etc Various chapters in this volume have focused on each of these topics. I will therefore restrict my attention in this paper to issues of bankruptcy reform and market transparency.
See La Porta et al (1997, 1998 and 2002) See Ma and Remolona (2005) and Reserve Bank of Australia Bulletin (2003).
BIS Papers No 26 3. Legal frameworks, bankruptcy reform and investor protection The respect for law, the nature of the legal code and the ability to enforce contracts determine the willingness of lenders and borrowers to participate in credit markets. In Table 1, which is based on studies by the World Bank and International Finance Corporation, I provide a comparison of some Asian economies with the more mature markets. The legal rights index in the second column measures the degree to which collateral and bankruptcy laws are designed to expand access to credit, as well as access to collateral for secured lenders. Higher scores reflect better access to both credit and collateral.
While Korea has made progress on all dimensions, other Asian countries appear to have some serious structural deficiencies. Contract enforcement delays are rather high in India, Thailand, Malaysia and China. As a percentage of debt, enforcement costs are very high in India, China and Malaysia. When enforcement is a problem, banks may rely on short-term debt (as argued in Diamond (2004)), which may pose significant asset-liability mismatch problems for corporate borrowers in Asian economies. In order to reduce the maturity mismatch problem and improve the debt capacity of the corporate sector, reform in the areas of legal framework, bankruptcy code/judiciary reform and corporate governance must be undertaken.
Likewise, the length of the bankruptcy process is ten years in India, and bankruptcy costs (as a percentage of estate) range from 38% in Thailand to 4% in Korea. On average, the cost of bankruptcy stands at 17% in Asia, which compares with an average of 7% for more mature economies.
The ex ante cost of borrowing will reflect these costs: rational lenders will charge a premium to participate in markets characterised by poor contract enforcement and tardy bankruptcy procedures.
At the limit, the debt capacity of the economy will be adversely affected by these deficiencies. Several emerging economies in Asia, including China and India, have undertaken reform of their bankruptcy codes. In discussing what might be important features of a bankruptcy code, Hart (1999) has identified the following aspects. First, the code should punish borrowers for not honouring contractual commitments, which is accomplished through suspension of dividends and enforcement of absolute priority when a firm files for bankruptcy. Second, the code should deliver efficient ex post outcomes, ie the total value of all claims should be maximised. This is difficult in practice as secured creditors may have a liquidation bias, and existing management may have a continuation bias. Third, the code should provide some value to borrowers in the process of financial distress resolution. Specifically, the process should permit illiquid but potentially solvent corporate borrowers to have a reasonable shot at reorganisation rather than being relegated to liquidation. Debt renegotiation, partial forgiveness of prior debt and exchange offers are very much in this spirit. It is also important to encourage the development of mechanisms such as Debtor in Possession (DIP) financing for borrowers already in financial distress. DIP financiers provide liquidity to distressed firms precisely when they are illiquid. In 26 BIS Papers No 26 order to encourage the development of such mechanisms, a bankruptcy code should provide suprapriority rights to such lenders.
In turning to investor protection, we must evaluate how well Asian economies compare to G-3 countries, which themselves are not immune to corporate fraud, as cases such as Worldcom and Enron have demonstrated. I now present some estimates on how well Asian economies have fared on accounting standards, rule of law, judicial efficiency, contract repudiation and expropriation risk. The source for this information (presented in Table 2 below) is the International Institute for Corporate Governance and the IMF. Low scores along each dimension reflect poor standards, and high scores indicate tight standards. Table 2 shows that Asian countries have some way to go in persuading investors that contract repudiation and expropriation risk are not significant. Judicial efficiency is still a major problem, especially in Thailand.
Note that the G-3 countries have a score of 9.5 or better on all dimensions with the exception of accounting standards. In the area of rule of law, Asian countries fare poorly in comparison to G-3 countries.
Large infrastructure investments, such as the building of highways, ports, power plants, etc, provide an ideal environment for the development of bond markets. This has been especially true in China, and there is great potential in India. However, in order to ensure that investors view corporate and public sector bonds as a core part of their savings portfolios, it is imperative that sweeping legal and judicial reforms are introduced to ensure swift and fair enforcement of contracts, adherence to the rule of law, and efficient financial distress resolution. As seen in the table above, contract repudiation and threat of expropriation are particular areas that require improvement.
4. Developing efficient primary and secondary markets Corporate debt obligations vary along a dizzying array of dimensions: credit quality (as reflected in agency ratings); market capitalisation (with issue sizes varying from a few million dollars to more than $1-2 billion); contractual provisions (callability, puttability, convertibility and the like); seniority (senior or subordinated); security (secured or unsecured), etc. All this means that corporate bonds (unlike government debt in many economies) are not commodities that lend themselves to trading arrangements that work well for standardised contracts such as futures.
The presence of significant informational asymmetry between corporate borrowers and lenders also means that the primary market where corporate borrowers raise capital must reflect the diversity of corporate borrowers. For highly rated corporate borrowers who over a period of time have established their credentials through repeated borrowings and a track record of timely repayments, corporate bond borrowing may actually offer an opportunity to disintermediate. Specifically, borrowers can bypass the banking sector and tap directly into savings, thereby reducing the cost of bank intermediation. For established big corporate borrowers, public bond markets with registered bond issues may be a very desirable alternative. For other corporate borrowers, bank credit may continue to be the dominant BIS Papers No 26 alternative: even for non-investment grade borrowers, the continued resilience of the high-yield bond market in the United States over the last three decades is a reminder that public bond markets may prove to be a valuable alternative at lower ends of the credit spectrum. Indeed, bank credit often requires collateral, seniority and onerous covenants. At times when demand from investors is strong, corporate borrowers are able to replace bank debt with public bond issues, which often have less onerous covenants, and may be junior and unsecured. There are other times when access to highyield markets can be costly (due to reduced demand from investors and an increased need for monitoring of the borrowers by lenders), and corporate borrowers prefer to take bank loans. These substitution possibilities require the development of a transparent, liquid and, eventually, an efficient bond market.