Now let’s talk finance

The introduction to this book discussed the role of financial securities in a market economy. This section will analyse the behaviour of the investor who buys those instruments that the financial manager is trying to sell. An investor is free to buy a security or not and, if he decides to buy it, he is then free to hold it or resell it in the secondary market.

The financial investor seeks two types of returns: the risk-free interest rate (which we call the time value of money) and a reward for risk-taking. This section looks at these two types of returns in detail but, first, here are some general observations about financial markets.

Section 15.1 The rise of capital markets

The primary role of a financial system is to bring together economic agents with surplus financial resources, such as households, and those with net financial needs, such as companies and governments. This relationship is illustrated below:

To use the terminology of John Gurley and Edward Shaw (1960), the parties can be brought together directly or indirectly.

In the first case, known as direct finance, the parties with excess financial resources directly finance those with financial needs. The financial system serves as a broker, matching the supply of funds with the corresponding demand. This is what happens when an individual shareholder subscribes to a listed company’s share issue or when a bank places a corporate bond issue with individual investors.

In the second case, or indirect finance, financial intermediaries, such as banks, buy “securities” – i.e. loans – “issued” by companies. The banks in turn collect funds, in the form of demand or savings deposits, or issue their own securities that they place with investors. In this model, the financial system serves as a gatekeeper between suppliers and users of capital and performs the function of intermediation.

When you deposit money in a bank, the bank uses your money to make loans to companies. Similarly, when you buy bonds issued by a financial institution, you enable the institution to finance the needs of other industrial and commercial enterprises through loans. Lastly, when you buy an insurance policy, you and other investors pay premiums that the insurance company uses to invest in the bond market, the property market, etc.

This activity is called intermediation, and is very different from the role of a mere broker in the direct finance model.

With direct finance, the amounts that pass through the broker’s hands do not appear on its balance sheet, because all the broker does is to put the investor and issuer in direct contact with each other. Only brokerage fees and commissions appear on a brokerage firm’s profit and loss, or income, statement.

In intermediation, the situation is very different. The intermediary shows all resources on the liabilities side of its balance sheet, regardless of their nature: from deposits to bonds to shareholders’ equity. Capital serves as the creditors’ ultimate guarantee. On the assets side, the intermediary shows all uses of funds, regardless of their nature: loans, investments, etc. The intermediary earns a return on the funds it employs and pays interest on the resources. These cash flows appear in its income statement in the form of revenues and expenses. The difference, or spread, between the two constitutes the intermediary’s earnings.

The intermediary’s balance sheet and income statement thus function as holding tanks for both parties – those who have surplus capital and those who need it:

Today’s economy is experiencing increasing disintermediation, characterised by the following phenomena:

• more companies are obtaining financing directly from capital markets; and
• more companies and individuals are investing directly in capital markets.

When capital markets are underdeveloped, an economy functions primarily on debt financing. Conversely, when capital markets are sufficiently well developed, companies are no longer restricted to debt, and they can then choose to increase their equity financing. Taking a page from the economist John Hicks, it is possible to speak of bank-based economies and market-based economies.

In a bank-based economy, the capital market is underdeveloped and only a small portion of corporate financing needs are met through the issuance of securities. Therefore, bank financing predominates. Companies borrow heavily from banks, whose refinancing needs are mainly covered by the central bank.

The central bank tends to have a strong influence on the level of investment, and consequently on overall economic growth. In this scenario, interest rates represent the level desired by the government for reasons of economic policy, rather than an equilibrium point between supply and demand for loans.

A bank-based economy is viable only in an inflationary environment. When inflation is high, companies readily take on debt because they will repay their loans with devalued currency. In the meantime, after adjustments are made for inflation, companies pay real interest rates that are zero or negative. A company takes on considerable risk when it relies exclusively on debt, although inflation mitigates this risk. Inflation makes it possible to run this risk and, indeed, it encourages companies to take on more debt. The bank-based (or credit-based) economy and inflation are inextricably linked, but the system is flawed because the real return to investors is zero or negative. Their savings are insufficiently rewarded, particularly if they have invested in fixed-income vehicles.

The savings rate in a credit-based economy is usually low. The savings that do exist typically flow into tangible assets and real property (purchase of houses, land, etc.) that are reputed to offer protection against inflation. In this context, savings do not flow towards corporate needs. Lacking sufficient supply, the capital markets therefore remain embryonic. As a result, companies can finance their needs only by borrowing from banks, which in turn refinance themselves at the central bank. This process supports the inflation necessary to maintain a credit-based economy.

In such a context it would be unreasonable for a corporate not to take on some debt. It is difficult to be wise when everybody else is behaving like a fool.

The lender’s risk is that the corporate borrower will not generate enough cash flow to service the debt and repay the principal, or amount of the loan. Even if the borrower’s financial condition is weak, the bank will not be required to book a provision against the loan so long as payments are made without incident.

In a market-based economy, companies cover most of their financing needs by issuing financial securities (shares, bonds, commercial paper, etc.) directly to investors. A capital market economy is characterised by direct solicitation of investors’ funds. Economic agents with surplus resources invest a large portion of their funds directly in the capital markets by buying companies’ shares, bonds, commercial paper or other short-term negotiable debt. They do this either directly or through mutual funds. Intermediation gives way to the brokerage function, and the business model of financial institutions evolves towards the placement of companies’ securities directly with investors.

In this economic model, bank loans are extended primarily to households in the form of consumer credit, mortgage loans, etc., as well as to small enterprises that do not have access to the capital markets.

The growing disintermediation has forced banks and other financial intermediaries to align their rates (which are the rates that they offer on deposits or charge on loans) with market rates. Slowly but surely, market forces tend to pervade all types of financial instruments.

For example, with the rise of the commercial paper market, banks regularly index short-term loans on money-market rates. Medium- and long-term lending have seen similar trends. Meanwhile, on the liabilities side, banks have seen some of their traditional, fixed-rate resources dry up. Consequently, the banks have had to step up their use of more expensive, market-rate sources of funds, such as certificates of deposit.¹

Since the beginning of the 1980s, two trends have led to the rapid development of capital markets. First, real interest rates in the bond markets have turned positive. Second, budget deficits have been financed through the bond market, rather than through the money market.

In Chapter 1, the financial manager was described as a seller of financial securities. This is the result of European economies becoming capital market economies.

The risks encountered in a capital market economy are very different from those in a credit-based economy. These risks are tied to the value of the security, rather than to whether cash flows are received as planned.

The following graphs provide the best illustration of the rising importance of capital markets.

Section 15.2 The functions of a financial system

The job of a financial system is to efficiently create financial liquidity for those investment projects that promise the highest profitability and that maximise collective utility.

However, unlike other types of markets, a financial system does more than just achieve equilibrium between supply and demand. A financial system allows investors to convert current revenues into future consumption. It also provides current resources for borrowers, at the cost of reduced future spending.

Robert Merton and Zvi Bodie have isolated six essential functions of a financial system:

1. means of payment;
2. financing;
3. saving and borrowing;
4. risk management;
5. information;
6. reducing or resolving conflict.

1. A financial system provides means of payment to facilitate transactions. Cheques, debit and credit cards, electronic transfers, bitcoins, etc. are all means of payment that individuals can use to facilitate the acquisition of goods and services. Imagine if everything could only be paid for with bills and coins!

2. A financial system provides a means of pooling funds for financing large, indivisible projects. A financial system is also a mechanism for subdividing the capital of a company so that investors can diversify their investments. If factory owners had to rely on just their own savings, they would very soon run out of investible funds. Indeed, without a financial system’s support, Nestlé and British Telecom would not exist. The system enables the entrepreneur to gain access to the savings of millions of individuals, thereby diversifying and expanding his sources of financing. In return, the entrepreneur is expected to achieve a certain level of performance. Returning to our example of a factory, if you were to invest in your neighbour’s steel plant, you might have trouble getting your money back if you should suddenly need it. A financial system enables investors to hold their assets in a much more liquid form: shares, bank accounts, etc.

3. A financial system distributes financial resources across time and space, as well as between different sectors of the economy. The financial system allows capital to be allocated in a myriad of ways. For example, young married couples can borrow to buy a house or people approaching retirement can save to offset future decreases in income. Even a developing nation can obtain resources to finance further development. And when an industrialised country generates more savings than it can absorb, it invests those surpluses through financial systems. In this way, “old economies” use their excess resources to finance “new economies”.

4. A financial system provides tools for managing risk. It is particularly risky for an individual to invest all of his funds in a single company because, if the company goes bankrupt, he loses everything. By creating collective savings vehicles, such as mutual funds, brokers and other intermediaries enable individuals to reduce their risk by diversifying their exposure. Similarly, an insurance company pools the risk of millions of people and insures them against risks they would otherwise be unable to assume individually.

5. A financial system provides price information at very low cost. This facilitates decentralised decision-making. Asset prices and interest rates constitute information used by individuals in their decisions about how to consume, save or divide their funds among different assets. But research and analysis of the available information on the financial condition of the borrower is time-consuming, costly and typically beyond the scope of the layperson. Yet when a financial institution does this work on behalf of thousands of investors, the cost is greatly reduced.

6. A financial system provides the means for reducing conflict between the parties to a contract. Contracting parties often have difficulty monitoring each other’s behaviour. Sometimes conflicts arise because each party has different amounts of information and divergent contractual ties. For example, an investor gives money to a fund manager in the hope that he will manage the funds in the investor’s best interests (and not his own!). If the fund manager does not uphold his end of the bargain, the market will lose confidence in him. Typically, the consequence of such behaviour is that he will be replaced by a more conscientious manager.

Section 15.3 The relationship between banks and companies

Not so long ago, banks could be classified as:

• Commercial banks that schematically collected funds from individuals and lent to corporates.
• Investment banks that provided advisory services (mergers and acquisitions, wealth management) and played the role of a broker (placement of shares, of bonds) but without “using their balance sheet”.

In the last 15 years, large financial conglomerates have emerged both in the US and Europe. This resulted from mega-mergers between commercial banks and investment banks: BNP/Paribas, Citicorp/Travelers Group, Chase Manhattan/JP Morgan and, more recently, Merrill Lynch/Bank of America.

This trend, eased by changes in regulation (in particular in the US with the reform of the Glass–Steagall Act in 1999), shows a willingness of large banking groups to adopt the business model of a universal bank (also called “one-stop shopping”) in a context of increasing internationalisation and complexity. This is particularly true for certain business lines like corporate finance or fund management, in which size constitutes a real competitive advantage.

Following the 2008 financial crisis, there emerged a certain political willingness to split up large banking groups again, specifically in order to separate deposits from market-related activities. This idea (not only guided by the protection of households’ deposits) has partially materialised in laws (the US, France, the UK) aimed mainly at confining speculative operations and avoiding market activities that impact negatively on deposits.

Large banking groups now generally include the following business lines:

• Retail banking: for individuals and small- and medium-sized corporates. Retail banks serve as intermediaries between those who have surplus funds and those who require financing. The banks collect resources from the former and lend capital to the latter. They have millions of clients and therefore adopt an industrial organisation. The larger the bank’s portfolio, the lower the risk – thanks once again to the law of large numbers. Retail banking is an extremely competitive activity. After taking into account the cost of risk, profit margins are very thin. Bank loans are somewhat standard products, so it is relatively easy for customers to play one bank off against another to obtain more favourable terms. Retail banks have developed ancillary services to add value to the products that they offer to their corporate customers. Accordingly, they offer a variety of means of payment to help companies move funds efficiently from one place to another. They also help clients to manage their cash flows (see Chapter 49) or their short-term investments. A retail banking division also generally includes some specific financial services for individuals (e.g. consumer credit) or for corporates (factoring, leasing, etc.), as such services are used mostly by small- and medium-sized firms.
• Corporate and investment banking (CIB): provides large corporates with sophisticated services. Such banks have, at most, a few thousand clients and offer primarily the following services:
  • Access to equity markets (equity capital markets, ECM): investment banks help companies prepare and carry out initial public offerings on the stock market. Later on, investment banks can continue to help these companies by raising additional funds through capital increases. They also advise companies on the issuance of instruments that may one day become shares of stock, such as warrants and convertible bonds (see Chapter 24).
  • Access to bond markets (debt capital markets, DCM): similarly, investment banks help large- and medium-sized companies raise funds directly from investors through the issuance of bonds. The techniques of placing securities, and in particular the role of the investment bank in this type of transaction, will be discussed in Chapter 25. The investment bank’s trading room is where its role as “matchmaker” between the investor and the issuer takes on its full meaning.
  • Bank financing: syndicated loans, bilateral lines, structured financing; we will study these in Chapter 21.
  • Merger and acquisition (M&A) advisory services: these investment banking services are not directly linked to corporate financing or the capital markets, although a public issue of bonds or shares often accompanies an acquisition.
  • Access to foreign exchange, interest rate and commodities markets: for the hedging of risk. The bank also uses these desks for speculating on its own account (see Chapter 50).
• Asset management: has its own clients – institutional investors and high-net-worth individuals – but also serves some of the retail banking clients through mutual funds. The asset management arm may sometimes use some of the products tailored by the investment banking division (hedging, order execution). This business is increasingly operated by players that are independent (totally or partially) from large banks.

Besides these global banking groups operating across all banking activities, some players have focused on certain targeted services like mergers and acquisitions and asset management (Lazard and Rothschild, for example) or specific geographical areas (Mediobanca and Lloyds Bank, for example).

The 2008 crisis demonstrated the central role played by banks in the economy. They are suppliers of liquidity; they are also an indicator of investor risk aversion. The basic duty of a bank is to assess risk and repackage it while eliminating the diversifiable risk. Whatever their business model, the worst-managed players have been hit: Northern Rock, Fortis, Wachovia for retail banks; Bear Stearns, Lehman Brothers for investment banks; Citi for universal banks. There does not seem to be a better business model – some players are just better managed than others.

Section 15.4 Theoretical framework: efficient markets

In an efficient market, prices instantly reflect the consequences of past events and all expectations about future events. As all known factors are already integrated into current prices, it is therefore impossible to predict future variations in the price of a financial instrument. Only new information will change the value of the security. Future information is, by definition, unpredictable, so changes in the price of a security are random. This is the origin of the random walk character of returns in the securities markets.

Competition between financial investors is so fierce that prices adjust to new information almost instantaneously. At every moment, a financial instrument trades at a price determined by its return and its risk.

Eugene Fama (1970) has developed the following three tests to determine whether a market is efficient:

• ability to predict prices;
• market response to specific events;
• impact of insider information on the market.

In a weak-form efficient market, it is impossible to predict future returns. Existing prices already reflect all the information that can be gleaned from studying past prices and trading volumes. The efficient market hypothesis says that technical analysis has no practical value, nor do martingales (martingales in the ordinary, not the mathematical, sense). For example, the notion that “if a stock rises three consecutive times, buy it; if it declines two consecutive times, sell it” is irrelevant. Similarly, the efficient market hypothesis says that models relating future returns to interest rates, dividend yields, the spread between short- and long-term interest rates or other parameters are equally worthless.

A semi-strong efficient market reflects all publicly available information, as found in annual reports, newspaper and magazine articles, prospectuses, announcements of new contracts, of a merger, of an increase in the dividend, etc. This hypothesis can be empirically tested by studying the reaction of market prices to company events (event studies). In fact, the price of a stock reacts immediately to any announcement of relevant new information regarding a company. In an efficient market, no impact should be observable prior to the announcement, nor during the days following the announcement. In other words, prices should adjust rapidly only at the time any new information is announced.

In order to prevent investors with prior access to information from using it to their advantage (and therefore to the detriment of other investors), stock market regulators suggest that firms communicate before market opening or after market closure, or suspend trading prior to a mid-session announcement of information that is highly likely to have a significant impact on the share price. Trading resumes a few hours later or the following day so as to ensure that all interested parties receive the information. Then, when trading resumes, no investor has been short-changed.

In a strongly efficient financial market, investors with privileged or insider information or with a monopoly on certain information are unable to influence securities prices. This holds true only when financial market regulators have the power to prohibit and punish the use of insider information.

In theory, professional investment managers have expert knowledge that is supposed to enable them to post better performances than the market average. However, without using any inside information, the efficient market hypothesis says that market experts have no edge over the layman. In fact, in an efficient market, the experts’ performance is slightly below the market average, in a proportion directly related to the management fees they charge!

Actual markets approach the theory of an efficient market when:

• participants have low-cost access to all information;
• transaction costs are low;
• the market is liquid; and
• investors are rational.

Take the example of a stock whose price is expected to rise 10% tomorrow. In an efficient market, its price will rise today to a level consistent with the expected gain. “Tomorrow’s” price will be discounted to today. Today’s price becomes an estimate of the value of tomorrow’s price.

In general, if we try to explain why financial markets have different degrees of efficiency, we could say that:

• The lower transaction costs are, the more efficient a market is. An efficient market must quickly allow equilibrium between supply and demand to be established. Transaction costs are a key factor in enabling supply and demand for securities and capital to adjust.

  Brokerage fees have an impact on how quickly a market reaches equilibrium. In an efficient market, transactions have no costs associated with them, neither underwriting costs (when securities are issued) nor trading costs (when securities are bought and sold).

  When other transaction-related factors are introduced, such as the time required for approving and publishing information, they can slow down the achievement of market equilibrium.

• The more liquid a market is, the more efficient it is. The more frequently a security is traded, the more quickly new information can be integrated into the share price. Conversely, illiquid securities are relatively slow in reflecting available information. Investors cannot benefit from the delays in information assimilation because the trading and transaction volumes are low.

  Research into the significance of this phenomenon has demonstrated that there is a statistical relationship between liquidity and the required rate of return. This indicates the existence of a risk premium that varies inversely with the liquidity of the security. The premium is tantamount to a reward for putting up with illiquidity, i.e. when the market is not functioning efficiently. We will measure the size of this premium in Chapter 19.

• The more rational investors are, the more efficient a market is. Individuals are said to be rational when their actions are consistent with the information they receive. When good and unexpected news is announced, rational investors must buy a stock – not sell it. And for any given level of risk, rational investors must also try to maximise their potential gain.

Section 15.5 Another theoretical framework under construction: 
behavioural finance

Since the end of the 1960s, a large number of research papers have focused on testing the efficiency of markets. It is probably the most tested assumption of finance! A number of “anomalies” that tend to go against the efficiency of markets have been highlighted:

• Excess volatility. The first issue with efficient market theory seems very intuitive: how can markets be so volatile? Information on Sanofi is not published every second. Nevertheless, the share price does move at each instant. There seems to be some kind of noise around fundamental value. As described by Benoit Mandelbrot, who first used fractals in economics, prices evolve in a discrete way rather than in a continuous manner.
• Dual listing and closed-end funds. Dual listings are shares of twin companies listed on two different markets. Their stream of dividends is, by definition, identical but we can observe that their price can differ over a long period of time. Similarly the price of a closed-end fund (made up of shares of listed companies) can differ from the sum of the value of its components. Conglomerate discount (see Chapter 41) cannot explain the magnitude of the discount for certain funds and certainly not the premium for some others. It is interesting to see that these discounts can prevail over a long period of time, therefore making any arbitrage (although easy to conceptualise) hard to put in place.
• Calendar anomalies. Stocks seem to perform less well on Mondays than on other days of the week and provide higher returns in the month of January compared to other months of the year (in particular for small- and medium-sized enterprises). Nevertheless, these calendar anomalies are not material enough to allow for systematic and profitable arbitrage given transaction costs. For each of these observations, some justifications consistent with the rationality of investor behaviour can be put forward.
• Meteorological anomalies. There is consistent observation that stock prices perform better when the sun shines than when it rains. There again, although statistically significant, these anomalies are not material enough to generate arbitrage opportunities.

There are some grounds to think that the efficient market theory is not valid. Nevertheless, Eugene Fama, one of the founders of this theory, defends it strongly. He calls into question the methodologies used to find anomalies (in particular for the overreaction of markets).

Behavioural finance rejects the founding assumption of market efficiency: what if investors were not rational? It tries to build on other fields of social science to derive new conclusions. For example, economists will work with neuroscientists to understand individual economic choices. Finance researchers will be helped by psychologists to understand the actual behaviour of investors when they make an investment choice. This allows us to suppose that decisions are influenced by circumstances and the environment.

One of the first tests for understanding people’s reasoning in making a choice is based on lotteries (gains with certain probabilities). The following attitudes can be observed:

• Gains and losses are not treated equally by investors: they will take risks when the probability of losing is high (they prefer a 50% chance of losing 100 to losing 50 for sure) whereas they will prefer a small gain if the probability is high (getting 50 for sure rather than a 50% chance of 100).
• If the difference (delta) in probability is narrow, the investor will choose the lottery with the highest return possible, but if the delta in probability is high, the investor will think in terms of weighted average return. This may generate some paradoxes: preferring Natixis to UBS, UBS to Mediobanca but Mediobanca to Natixis! This could drive an asset manager mad!

The lack of rationality of some investors would not be a problem if arbitrage made it possible to correct anomalies and if efficiency could be brought back rapidly. Unfortunately, anomalies can be observed over the long term.

The theory of mimicry is an illustration of behavioural finance. The economist André Orléan has distinguished three types of mimicry:

• Normative mimicry – which could also be called “conformism”. Its impact on finance is limited and is beyond the scope of this text.
• Informational mimicry – which consists of imitating others because they supposedly know more. It constitutes a rational response to a problem of dissemination of information, provided the proportion of imitators in the group is not too high. Otherwise, even if it is not in line with objective economic data, imitation reinforces the most popular choice, which can then interfere with efficient dissemination of information.
• Self-mimicry – which attempts to predict the behaviour of the majority in order to imitate it. The “right” decision then depends on the collective behaviour of all other market participants and can become a self-fulfilling prophecy, i.e. an equilibrium that exists because everyone thinks it will exist. This behaviour departs from traditional economic analysis, which holds that financial value results from real economic value.

Mimetic phenomena can be accentuated by program trading, which involves the computer programs used by some traders that rely on pre-programmed buy or sell decisions. These programs can schedule liquidating a position (i.e. selling an investment) if the loss exceeds a certain level. A practical issue with such programs was illustrated on 6 May 2010 by the flash crash of the Dow Jones, which lost 9% in 5 minutes before recovering this loss 20 minutes later.

It is easy to criticise but harder to conclude. If some want to destroy efficient market theory, they will have to propose a viable alternative. As of today, the models proposed by “behaviourists” cannot be used (especially in corporate finance), they merely model the behaviour of investors towards investment decisions and products.

Section 15.6 Investors’ behaviour

At any given point in time, each investor is either:

1. a hedger;
2. a speculator; or
3. an arbitrageur.