Chapter 18
Aristotle, Infrastructure, and Capital

Aristotle had some very non-capitalistic views on money and wealth; however, he was also a big believer in private property and the market system and won praise from Austrian economist and libertarian leaning writer Murray Rothbard. In Mr. Rothbard’s essay61 on Aristotle he points out that the philosopher understood the importance of having market systems and believed they are extremely important for the proper functioning of society as they allow people to get what they want and need. Aristotle also strongly favored private property as a critical tenant in running a society’s legal and economic system and he recognized that laws and institutions are critical to the functioning of markets and prosperity.

The ability to raise capital is based on investors trusting they will have recourse to get paid back. Therefore to attract capital and to have a fluid capital market, the legal and financial infrastructure is as important as any physical infrastructure in a country. Rules-based capitalism and institutions that support it are keys to success.

Economic theories on comparative financial systems often contrast market-centric systems to nonmarket or bank-centric economies. The United States and United Kingdom. are often cited as market-oriented economies. Countries like France and Japan are often cited as more bank-centric systems. Market-based economies have more varied sources of capital, such as established and diverse markets for stocks and bonds. The markets can take on somewhat more exotic structures, like converts, warrants, and securitizations. Bank-centric economies tend to primarily have much less diversified capital markets and the bulk of funding comes from banks. In some cases there is an intricate network of national and regional banks and sometimes banks with industry specialization. This latter system typically allows for more regulatory control over capital and more standardization of the types of financing available. That can result in only certain types of companies and projects getting capital, stifling innovation. It also means that if the bank system faces problems, there are limited alternative financing resources to access.

In reality the lines are increasingly blurred between market and bank-centric systems. The more market centric, the more flexible and innovative the market is. Increased communication technology helps market systems react quicker and have more data on which to make decisions. Technology is changing traditional barriers and allowing new entrants to force their way into all markets. It can not just be the access and sourcing of capital that improves, it also must be improvements in information for the investors. Better information will allow the lenders to more appropriately asses the level of risk worth taking and let them price the risk appropriately. This should allow quicker response times to financial needs and can help avoid liquidity crunches from ballooning into a financial crisis.

Mortgage Lending and Fintech—Changing Things Up

In some countries, homeownership is very high, for example, in Romania62 it was 97% in 2018. In the United States it is estimated to be about 64%.63 It is one of the biggest investments and stores of capital for many people around the globe. Financial technology is changing how and who finances home loans.

The ability to borrow and refinance homes in many countries is a major part of capital flow and profitability to banks. In the United States there is a massive amount of federal and state regulation around mortgage lending that increased after the 2008 crisis. Despite the incredible myriad of regulations, which typically benefits incumbent operators, companies like Quicken Loans are changing the process for home loans. If you want to fully understand the difference between the legacy real estate lenders and how they are being challenged walk into a bank and say you want to get a mortgage and see how it progresses and the time it takes. Then go on to a site such as Quicken Loans and go through the process. The latter is faster, less cumbersome, and more pleasant. Supporting documents can be downloaded and the lender can verify by accessing records, which can be done in a centralized location that creates the ability to be scalable and have more control than some bank branch structures.

A study undertaken by the Federal Reserve Bank of New York64 found some exceptional results for “fintech” (financial technologies) lenders, in part defined as non-deposit taking institutions. The market share of these lenders grew from 2% in 2010 to 8% in 2016. The mortgages typically closed about 20% faster than traditional banks and closing times did not increase as much during busy periods as they do with bank lenders. Additionally, default rates were lower. It is critical that newer fintech lenders also use technology to maintain credit information on the borrowers to keep these default rates low.

As more homeowners become comfortable using these types of lenders the speed and ease of the system may lead to a meaningful increase in refinancing. There are already fintech companies in other areas of lending that are increasing the access to capital for consumers, small businesses and students as well. One of the dangers is that this may all make getting loans too easy and too much leverages creeps into the system.

As newer forms of capital raising increase it will disrupt some of the organizations that regulators have the most control over. These developments will put pressure on traditional bank systems to attract both sides of their balance sheets, deposits and loans. This may also weaken central banks’ and treasury departments’ control over capital flows and factors that impact the velocity of money. Of course, traders like to trade, salesmen like to sell, and regulators like to regulate, therefore, they will likely find ways to regulate new capital sources and transaction methods. While there is a constant struggle between the benefits and the detriments of regulation on the financial industry, one benefit is that when an industry is regulated there is more data available to analyze, but that is definitely not worth the price of heavy-handed innovation stifling regulation.

The more choices in capital structures and the access to varied capital the better. Different companies need specific types of capital structures and even the same company needs different types of capital structures during its lifetime. Mr. Milken wrote in an article that he used to debate his late friend Nobel laureate Merton Miller about whether capital structure was an important part of management’s job and if it impacted the valuation of a company. Mr. Milken was right in the view that the capital structure has a huge influence on valuation and risk. Just as importantly, he points out that capital structures have to evolve and be dynamic.65 This means that the ideal capital structure for a company will vary depending on many factors including where the company and industry are in their life-cycle and numerous macroeconomic factors.66

Sometimes capital is considered a competitive advantage. Uber, Airbnb, and WeWork are all innovative companies with first mover advantages that have touted their access to capital as an advantage over other start-ups that might compete with them. If capital access continues to increase more quickly and it is readily available, it will become less of a competitive advantage. It was not that long ago that some of the incumbents that these innovative new economy companies were threatening, thought they had a capital advantage. Frequently, incumbents have an opportunity to move quickly against competitors, but often may fear undermining their existing invested capital. Imagine a retailer that did not want to undermine all of the investment in retail locations, so it chose to avoid diluting the value of its stores and chose not to sell products on the internet, this would have resulted in falling way behind the competition.

There are cases where incumbents have tried to suppress innovation in what appears to have been an effort to protect invested capital, and it has led to failure. Kodak is a great example of this. Kodak was founded in 1888 and became one of the largest makers of film and cameras. At its peak Kodak was estimated to control 70% of the photographic film industry. Eventually digital cameras crushed the market for physical film and cameras. By 2012 the damage caused by the development of digital photography and bad corporate decisions forced Kodak to file for bankruptcy. Ironically, in 1975 an engineering team at the company actually invented the first digital camera. Management was likely trying to protect its existing market and the investment in it rather than looking ahead; they could not suppress a major innovation.67,68

The ability of technology to improve access to capital and quickly supply more information for investors to monitor and check on their investments is changing the economic landscape. Capital movement is faster. It can rapidly get repriced and moved to where it is needed. This can smooth out market disruptions. Nations’ infrastructures can help facilitate it and regulators need to monitor and set rules for newer forms of capital access without suppressing innovation. All of these changes make it more difficult for analysts to monitor where capital is flowing. Capital will likely move much more quickly than the data.

Selected Ideas from Part 5

Topic Concepts Investment Impact
Capital Source Financial capital is now more rapidly available in varied forms and sources. This should be good for long-term positive trends in the economy as capital can go where needed more rapidly.
Cost of Capital It is critical that information flow keeps up with capital flow, risks can be assessed and priced correctly. If money becomes too easy and at too low a cost, it may be too easy for bad investments to destroy capital.
Capital Flows In long periods of growth, capital may be more available to high growth start-ups than incumbents. Although more flexible capital flows will help the broad economy, it may increase winners and losers at a more microlevel.
Capital Investment Technology and innovation are changing how to look at capital investment. Rapid innovation is accelerating declines in value of physical plants. More investment is being made in nontangible capital. These factors make typical balance sheet book value a less valuable data point.
More Capital Capital is generally more available for more market participants. This is likely to weaken the concept that capital is a competitive advantage, as anyone with a lead can easily be caught.
International Capital International capital flows have increased with trade. Capital flows info gives insights into drivers of economies. If capital goes somewhere, it has to leave somewhere.
Human Capital Human capital is as critical in an investment as physical and financial capital. Human capital should not just be a factor in country investing but must be analyzed when corporate investing, too.
Human Capital Investment Do not just examine current statistics, but also the structure supporting employees. You want to examine the flexibility and thoughtfulness in the structures put in place to support the human capital when investing.
Capital Infrastructure Laws, enforcement, stability, and transaction structures allow for the best returns on capital. New technologies should allow lower and more secure transaction costs, which may increase volatility but allows for more flexibility.
Capital Regulation New capital sources are making it more difficult for regulators. Regulators are challenged to manage new technologies and capital sources that are more global, but they risk hurting innovation.
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