GFDR 2015 2015 Long-Te Term Finance Chapte pter 2 2: The he Use - - PowerPoint PPT Presentation

GFDR 2015 2015 – Long-Te Term Finance Chapte pter 2 2: The

he Use sers o s of Lo Long-Term F Finan ance e

GFDR SEMINAR SERIES FEBRUARY 9, 2015

Use of long-term finance by firms

 Why would a firm want to use long-term vs. short-term finance?  What are the implications for firm performance?  Which factors can limit firms’ access to long-term finance?

• Firm characteristics and evidence
• Cross-country characteristics and evidence

 Policy recommendations

Why would a firm want to use long-term vs. short-term finance?

 Match maturity of assets and liabilities: use long-term debt to purchase fixed assets or equipment (Hart and Moore 1995)

• Empirical evidence for Ecuador, India, Italy, the UK, the US (Graham and Harvey

2001; Jaramillo and Schiantarelli 1996; Schiantarelli and Sembenelli 1997; Schiantarelli and Srivastava 1996; Stohs and Mauer 1996)

 Long-term debt minimizes risk of having to refinance in bad times

• “Liquidity risk” of short-term debt: lenders may be reluctant to refinance if

borrower experiences a negative shock or credit market conditions deteriorate (Diamond 1991, 1993; Graham and Harvey 2001)

• Firms that expect to experience positive shocks may want to refinance debt

frequently to obtain better loan terms later (Barclay and Smith 1995; Diamond 1991; Guedes and Opler 1995)

What are the implications of long-term finance for firm performance?

 Theoretical literature is inconclusive on how debt maturity affects investment and firm performance

• Long-term debt allows firms to invest in projects that bring in returns in a

long time horizon, including new technologies, which may increase firm productivity and profitability (Hart and Moore 1995)

• Long-term debt can reduce managers’ incentives, hampering investment

and firm performance (Jensen 1986; Myers 1977; Rajan 1992)

 Empirical evidence is needed, but it’s challenging to identify causal effects vs. correlations

• Many studies carefully control for confounding factors, but can still be

subject to estimation bias

Empirical evidence suggests long-term finance increases firm investment

 Cross-country study shows a positive relationship between long-term finance and firm performance - unless it is provided in the form of directed credit (Demirguc-Kunt and Maksimovic 1998)  Within country evidence on long-term debt and performance is less clear

• Positive relationship: Ecuador, India, Italy, UK (Jaramillo and Schiantarelli 1996;

Schiantarelli and Sembenelli 1997; Schiantarelli and Srivastava 1996)

• No or negative relationship: China, US (Cull, Liu and Xu 2014; Jiraporn and Tong 2010;

Li, Yue and Zhao 2009)

 Within country studies find a positive effect of long-term debt on investment

• Studies for the US and Belgium use decline in credit availability during recent financial

crisis to assess causal effect of long-term credit on firm investment (Almeida et al. 2012; Duchin, Ozbas and Sensoy 2010; Vermoesen, Deloof and Laveren 2013)

Small firms use less long-term finance than larger firms

26 34 38 5 10 15 20 25 30 35 40 Small Firms (< 20) Medium Firms (20 - 99) Large Firms (> 100)

%

Average % of Purchase of Fixed Assets Financed from External Sources

 World Bank Enterprise Surveys

• 123 countries
• 2006 to 2014
• Firm size defined based on number
• f employees

 Lenders often have less information

• n smaller firms than on large firms,

which makes them reluctant to provide long-term debt to small firms (Custódio, Ferreira and Laureano 2013; Magri 2010)

Differences in use of long-term finance across firm size are driven by bank credit – use of equity is limited for all firms

11 6 4 5 20 8 3 3 26 6 4 2 5 10 15 20 25 30 Bank Trade credit Equity Other

%

Sources of External Finance for Purchases of Fixed Assets

Small Firms (< 20) Medium Firms (20 - 99) Large Firms (> 100)

Firms in developing countries finance a lower share

• f purchases of fixed assets externally

38 37 29 20 5 10 15 20 25 30 35 40 45 High Income Upper Middle Income Lower Middle Income Low Income

%

Average % of Purchase of Fixed Assets Financed from External Sources

 World Bank Enterprise Surveys

• 123 countries
• 2006 to 2014
• Representative at the country level
• Broad coverage of low and lower

middle income countries (not many high-income countries)

Firms in developing countries have fewer long-term liabilities than firms in high-income countries

66 78 92 80 92 97 20 40 60 80 100 120 Small Firms (< 20) Medium Firms (20 - 99) Large Firms (> 100)

%

Median % of Firms Reporting Any Long- Term Liabilities

Developing Countries High-Income Countries

 Balance sheet data from ORBIS (Demirguc-Kunt, Martinez Peria and Tressel 2015a)

• 87 countries
• 2004 to 2011
• Data not necessarily representative
• f firms in each country
• Mostly includes high-income and

upper middle income countries

Firms’ loan maturities are shorter in developing than in high-income countries

59 37 36 23 10 20 30 40 50 60 70 High Income Upper Middle Income Lower Middle Income Low Income

Months

Average maturity of loan or line of credit

 World Bank Enterprise Surveys

• 43 countries
• 2006, 2007, and 2009
• Duration of firms’ most recently

received loan or line of credit

Macroeconomic and political stability are associated with greater use of long-term finance

 Low inflation, little corruption, and strong property rights protection imply lower country risk and lower price of long-term debt

• Beck, Demirguc-Kunt and Maksimovic (2008), Broner, Lorenzoni, and

Schmukler (2012), Demirguc-Kunt and Maksimovic (1999), Fan, Titman and White (2012)

Financial development matters for firms’ access to long-term finance

Source: Demirguc-Kunt, Martinez Peria and Tressel (2015a)

Sound legal institutions can increase firms’ use of long-term finance

 Sound legal institutions allow lenders to enforce claims and reduce need to rely on the disciplinary role of short-term debt  Creditor rights, bankruptcy laws, overall contract enforcement, efficiency of the legal system are correlated with use of long-term finance

• Bae and Goyal (2009); Demirguc-Kunt and Maksimovic (1999); Demirguc-Kunt, Martinez

Peria and Tressel (2015a); Fan, Titman and White (2012); Kirch and Terra (2012); Qian and Strahan (2007)

 Gopalan, Mukherjee and Singh (2014): debt recovery tribunals in India caused firms to use more long-term debt instead of short-term debt

• Causal estimates based on variation in introduction of the debt recovery tribunals across

states and time

Information sharing through credit bureaus fosters long-term finance

 Information sharing through credit bureaus reduces lenders’ need to monitor and discipline firms through short-term debt (Magri 2010)  Firms’ average loan maturity lengthens after the introduction of a private credit bureau, but not after the introduction of a public credit registry (Martinez Peria and Singh 2014)

20 40 60 2002 2003 2004 2005 2006 2007 2009

Months Year

Average loan maturity

Credit bureau reformers Non-reformers

Most credit bureau reformers introduced a credit bureau in 2004 or 2055

Collateral registries for movable assets can help firms obtain long-term loans

 Firms often need to post assets as collateral for long-term loans

• Movable assets, such as machinery or equipment, typically account for a

large share of assets

• Banks in developing countries may be reluctant to accept movable assets

if these are not listed in a registry

 Introduction of registries for movable assets is associated with an increase in the maturity of bank loans to firms (Love, Martinez Peria, and Singh 2013)

Good corporate governance can allow firms to use more long-term debt

 Monitoring firm managers through independent boards and stronger shareholder protections can substitute for monitoring through short-term debt  Corporate governance reforms that improve shareholder rights are associated with a decrease in short-term vs. long-term debt (Anginer, Demirguc-Kunt, Maksimovic, and Tepe 2015)

Policy recommendations regarding the use of long-term finance by firms

 Governments should strive to provide

• A stable political and macroeconomic environment
• A contestable, well regulated financial system
• Sound legal institutions for contract enforcement
• An effective corporate governance framework

 Specific institutions that have been shown to foster use of long-term finance by firms include

• Credit bureaus
• Collateral registries for movable assets

 Financial development matters for firms’ access to long-term finance

• But subsidies, directed credit, and government banks are likely to backfire

The U e Use e of

• f L

Lon

• ng-Ter

erm F Finance b e by Ho Househo holds

Use of long-term finance by households

Why would households want to use long-term financial instruments? What are the risks associated to the usage of long-term finance? Who uses long-term financial products? Which factors can limit household usage of long-term finance? Policy recommendations in promoting long-term finance by households

 LTF allows households to protect from life-cycle challenges (Yaari, 1965; Davidoff, Brown and Diamond, 2005)

• Longevity/aging: products to save for retirement
• Health shocks: health and long-term care insurance products
• Death of breadwinner: life insurance products

 LTF facilitates lumpy purchases such as housing

• As collateral, housing allows to smooth consumption (Lustig and Van Nieuwerburgh, 2004) and can facilitate business start

(Adelino, Schoar and Severino, 2013; Wang, 2012)

 LTF allows for longer-term investments such as human capital

• Theoretical and empirical evidence on the sensitivity of human capital accumulation to borrowing constraints (H. Jacoby,

1994; H. Jacoby, E. Skoufias, 1997; K. Beegle and others, 2003)

 Long-term saving instruments allows saver households to reap term premium (Merton 1971, 1973)

Why would households want to use long-term financial instruments?

 Borrowing and investing in LTF markets also entail risks

• Vulnerable consumers can be marketed financial instruments that they do not understand and are unable to service
• Evidence on pension, mortgage and insurance markets suggests that lack of information of consumers together with

incentives of financial providers who want to exploit short comings in understanding leads to substantial errors in financing choices

(Hastings and Tejeda-Ashton, 2008; Lara-Ibarra, 2011; Rocha and Rudolph, 2010)

 Active government interventions to promote greater household participation may backfire, as in the case of U.S. subprime mortgages

• A key contributing factor to the subprime mortgage crisis in the U.S. was the overextension of credit to non-

creditworthy borrowers and the relaxation in mortgage-underwriting standards (GFDR 2013, GFDR 2014)

• As a consequence, many homeowners in the U.S. took out mortgages exceeding their means (Mian and Sufi, 2009;

Mian and Sufi, 2011)

What are the risks associated to the usage of long- term finance?

Insurance markets across countries

Depth and size of insurance markets varies substantially among low and high-income countries

 Erik Feyen, Rodney Lester, and Roberto Rocha (2011)

• Annual data for 90 countries for the

period 2000-2008

• Study compiles data from sources

including: AXCO, IMF, WDI and national sources

Main drivers explaining cross-country differences in the development of insurance markets

Source: Erik Feyen, Rodney Lester, and Roberto Rocha (2011)

Findings from several cross-country studies suggest that the most important predictors of the size and growth of the insurance sector are*: Income and inflation Population and population density (proxies for larger markets and pools to share risks) Institutional factors such as:

• the existence of private competitors
• solid legal frameworks
• developed credit and bond markets

* Erik Feyen, Rodney Lester, and Roberto Rocha (2011); Beck and Webb

(2003); Donghui and others (2007); Browne and Kim (1993)

Mortgage markets across countries

Mortgage depth and penetration indicators show that housing finance markets are severely limited in many countries

Mortgage depth Mortgage penetration

Mortgage depth is less than 10% for most countries Only few countries (Denmark, Switzerland, the Netherlands) have mortgage depth higher than 80% In 50% of countries, less than 4% of adults have an outstanding loan to purchase a house

 Anton Badev, Thorsten Beck, Ligia Vado, and Simon Walley (2013)

• Data for up to 148 countries compiled from Global Findex and from countries’ central banks, financial

regulatory/oversight agencies, or housing finance agencies

Source: Housing Finance Information Network (HOFINET)

Main drivers explaining cross-country differences in the development of mortgage markets

Cross-country empirical studies on the determinants of the development of mortgage markets find that*:

Unlike the banking system, the mortgage sector tends to develop

• nly when countries reach higher income (lower inflation) levels

Stable macroeconomic conditions are a critical element for the development of mortgage markets Stronger creditor rights, collateral and bankruptcy laws are positively linked to more developed mortgage markets Government-owned banks and regulatory restrictions on banks’ real estate activities are negatively associated to the development

• f this market

*Badev et al (2013), Warnock and Warnock (2008)

Usage of insurance products among households

 Even within a region or country, usage of insurance products remains higher among wealthier, more educated households  But disparities in usage of insurance products by households vary by country/region

Percentage of adults with health insurance by income quintiles and education in ECA and LAC

Source: 2011 Global Findex Data

0% 10% 20% 30% 40% 50% poorest 20% second 20% middle 20% fourth 20% richest 20%

Europe and Central Asia

completed primary or less secondary completed tertiary or more 0% 10% 20% 30% 40% 50% poorest 20% second 20% middle 20% fourth 20% richest 20%

Latin America and the Caribbean

completed primary or less secondary completed tertiary or more

Usage of mortgages among households

Even within a country or region, the fraction of adults with a mortgage is higher among higher income households

Source: 2011 Global Findex Data

0% 5% 10% 15% 20% 25% 30% 35% 0% 2% 4% 6% 8% 10% 12% poorest 20% second 20% middle 20% fourth 20% richest 20%

Percentage of adults with a mortgage

East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa South Asia Sub-Saharan Africa High Income

Market failures that can explain within-country differences in the usage of LTF products

 Lack of financial awareness, financial literacy and product transparency

• Growing evidence shows that financial illiteracy may restrain households from using financial products or from

managing them correctly (Hastings and Tejeda-Ashton, 2008 ; Lara-Ibarra, 2011)

• People with low levels of financial literacy think less about retirement and most of them have not planned for

retirement at all (Lusardi and Mitchell, 2009)

• People who make mistakes in interest and future value calculations tend to borrow more and save less (Stango and

Zinman, 2009)  Challenge: Financial education may be important, but there is a considerable knowledge gap in how best to

deliver it  Recent randomized control trials (RCTs) can help draw some lessons on recommended delivery mechanisms and intervention features

Evaluation of a High-school financial education program in Brazil

 Bruhn, de Souza Leao, Legovini, Marchetti, Zia, 2011  School-based intervention targeted to the youth

• opportunity for repeated instruction and exercises that allow for

sustained learning

 Intervention spanned 17 months and had positive effects on spending behavior

• Students from treated schools more likely to save for future

purchases

• Effects persisted for the second follow-up (16 months later)

Fraction of students who save money for future purchases rather than buying on installments

Evaluation of Financial Education through South African Soap Opera

 Berg and Zia (2013)

• Innovative delivery channel of financial education
• financial education through a popular television soap opera in South Africa,

“Scandal!”  One of the main characters borrowed excessively through shop credit, gambling, and falling into a debt trap; and eventually seeking help to find her way

• ut

 Individuals in the treatment group borrowed significantly more from formal sources and through longer term debt compared to the control group  Entertainment media can be an effective tool for influencing key financial decisions

Evaluation of Financial education short modules in Mexico City

 Bruhn, Lara and McKenzie, 2013 Evaluation of voluntary and free financial education courses

• ffered to the general population in Mexico City

 Half a day course that consists of modules on saving, retirement, credit cards and responsible use of credit  Participation rate was low (18%), even among the sample of interested individuals  Six months after attending training:

• No impact on borrowing behavior
• No impact on awareness of retirement products
• No impact on retirement savings

 Saving outcomes improved modestly, but administrative data suggests that the savings impact is relatively short-lived

Median Savings Account Balance

Policy recommendations in promoting long-term finance by households

As with firms, government policies to promote long-term finance for households should focus on:  Maintaining a stable macroeconomic environment such as low inflation and a sound macroeconomic framework  Promoting financial institutions and markets that are competitive and stable

• by introducing regulation for healthy entry and exit, and by promoting strong institutional framework for

contract enforcement

Addressing markets failures and removing policy distortions. In particular for households:

• Strengthening financial literacy, consumer regulation, disclosure rules and provision of investment

default options

• Delivering financial education is challenging. Evidence suggests that comprehensive courses targeted to

groups that might benefit more tend to achieve better results