Banks and capital markets: A two-way nexus

Biagio Bossone 18 December 2010



Financial regulation is being rethought. One area where the conventional wisdom is being redrawn is the interaction of banks and capital markets. For years, banks and capital markets have been viewed as competing sources of financing (e.g. Jacklin 1987, Jacklin and Bhattacharya 1988, Diamond 1997, and Allen and Gale 1999 and 2002). This “banks versus markets” distinction suggests that one sector, either banks or markets, develops at the expense of the other. As a result, regulators have tried to find a balance between the two.

In a recent Vox column, Song and Thakor (2010) emphasise that these two intermediaries can actually be complementary to one another. The authors point to securitisation and risk-sensitive bank capital requirements as interconnections of the two sectors. With securitisation, banks certify borrowers’ credit quality and the capital market finances the borrowers, thereby lowering financing frictions. In turn, capital market development lowers the cost of bank equity capital, and thus enables banks to raise the extra capital needed to take on riskier loans that they would otherwise reject.

The interconnections argument challenges the traditional “banks versus markets” distinction. It invites us to analyse the architecture of the financial sector from a different perspective. In this context, it is worth exploring the following questions: What does the empirical evidence say about banks-capital markets interconnections? How do interconnections actually work? And what structural and policy implications can be drawn?

The two-way nexus: The evidence

Let us look first at how banks support capital markets.1 If banks have a comparative advantage in assessing credit quality, then granting and renewing bank loans should provide positive signals to outside investors (Fama 1985, Diamond 1991), especially when the borrowing firms do not have an established reputation. James (1987) analyses the impact of loan announcements on firms’ stock returns, and compares it with that of other financings. He finds that bank loan agreements convey positive information to investors on borrowing firms’ prospects in that these firms show higher excess returns around the event date than for alternative financings. Lummer and McConnell (1989) discriminate between the announcement effects of new bank credit agreements and renewals or cancellations of already existing agreements, and find that the information that banks transmit to capital markets arises more from the monitoring taking place over the course of ongoing relationships than from the screening of borrowers at loan initiation. 

At a deeper level, Best and Zhang (1993) examine the information content of bank loan agreements, and claim that bank monitoring and screening are especially valuable when public signals are noisy and firms’ prospects deteriorate. They observe that when analyst past prediction errors on firm earnings are high, announcement day excess returns are significant, while the opposite holds when prediction errors are low. They observe also that for firms that receive positive earning forecast revisions, loan announcement excess returns are insignificant, whereas for firms that receive negative or noisy earning forecast revisions, loan announcements produce significant excess returns. Slovin et al. (1992) show that the information value produced by the banks through screening and monitoring varies with the size of the firm. Announcement day excess returns decrease for large borrowers, for which more information is publically available. Billet et al. (1995) estimate that loan announcements from higher-quality lenders – presumably endowed with better monitoring abilities – are more informative to investors than loan announcements from lower-quality lenders. Finally, Dahiya et al. (2003) show that the termination of banking relationships through loan sales conveys negative signals to the market about firm prospects2.

Evidence also indicates that bank lending reduces the information costs associated with accessing equity and securities markets. Firms with an established lending relationship experience less severe underpricing when they go public (James and Weir 1990), and existing lending relationships lower the cost for firms seeking to access capital markets, as reflected by lower at-issue yield spreads on public debt issuances (Datta et al. 1999). Drucker and Puri (2005) present evidence showing that, especially for noninvestment-grade firms, a concurrent lending relationship is associated with both lower fees for the underwriting and discounting of yield spreads. Yasuda (2005) confirms that bank relationships are particularly valuable for junk-debt and first-time issuers, and Drucker and Puri (2007) report estimates indicating that commercial bank entry reduces underwriting fees and gross spreads of equity offerings.

Finally, the evidence available suggests that expanding bank activities into capital markets by allowing banks to hold equity stakes in firms might generate efficiency gains. Li and Masulius (2004) find that, by holding stakes in a firm’s equity, underwriters reduce IPO underpricing when they underwrite. They also show that gross spreads on IPOs decrease in the underwriters’ shareholdings of the firm.

In a 2004 paper, 
Jong-Kun Lee and I looked at how capital markets support banks – the other nexus – and predicted and tested strong efficiency effects (Bossone and Lee 2004). We studied production efficiency in bank intermediation under what we called the “Systemic Scale Economies” hypothesis, whereby the production of bank intermediation services features increasing returns in the scale of the financial system where it takes place. As we found, banks that operate in systems with larger (deeper and more efficient) capital markets face relatively lower costs of risk absorption and reputation signalling than banks operating in smaller capital markets3. Our evidence showed that access to larger capital markets reduces bank costs by providing banks with more efficient instruments of risk management and reputation signalling, which enable them to economise on the financial capital required by higher production. In particular:

  • larger capital markets help banks to improve their screening of borrowers4, monitor their investment more efficiently, and signal their risk attitude through information other than (and possibly complementary to) accumulated financial capital. Banks operating in systems with large capital markets attain the same degree of protection against financial distress, and the same reputation-signalling effect, with lower capital-to-asset ratios than those operating in smaller systems;
  • larger capital markets enable banks to manage their financial capital with relatively fewer non-financial resources. As banks increase their output and adjust their financial capital position accordingly, they may need to mobilise additional (non-financial) resources to manage and protect their financial capital;
  • in larger capital markets, with higher-quality information provision and investors’ greater signal-extraction capacity, signalling is more efficient and banks can economise on the financial capital needed to indicate a given level of reputation or risk safety.

Structural and policy implications

The evidence found is consistent with the conclusion that banks and capital markets are interconnected and mutually beneficial. Clearly, the informational externalities springing from capital markets strengthen the competitiveness of only those banks that are best equipped to benefit from efficient use of information, while they inevitably penalise less equipped banks. In turn, banks that invest in greater information-extraction and risk-management capacity have the potential to expand into capital-market business activities where demand for cross-sectional risk-sharing services is high and growing relative to consolidating loan and deposit markets (Allen and Santomero 2001). Dynamically, capital market development prompts banking to shift from activities that stand to lose from competition with non-bank services to activities that exploit complementarities with capital markets (Bossone et al. 2003).

The presence of strong, two-way bank-capital market interconnections leads to important policy considerations:

  • The interconnections exalt banks’ special role as credit assessors. This role rests on the exclusive information that banks extract from the borrowers (through lending relationships) for the purpose of preserving the quality of their balance sheet. Banks should thus be induced to intensify their direct relationship with borrowers, and to deepen their inner knowledge of their borrowers’ business. Also, when securitising loans, banks should be required to retain ownership of a critical (uninsured) share of the loans to be securitised. This would strengthen banks’ incentive to make best use of their information extracting and risk-management capacity, and would force them to uphold their responsibility for sound credit quality analysis. Allowing full dispossession of performing loans weakens banks’ responsibility, thereby eroding their signalling power and distorting investment decisions;
  • On their side, investors should be called on to scrutinise carefully the loans securitised, repackaged and sold on the market by the banks, and should be fully aware of the risk content of the loan packages. The original “credit message” should not be lost along the market chain. Transparency of loan structured products, and information on banks’ credit assessment capacity, are critically important for investors to perform an undistorted reading of bank signalling. Investors should conduct a thorough credit analysis of structured products, possibly extending it to the originated assets, and make sure they understand the product structures and their underlying variables. They should supplement external credit ratings with their own analysis, and have a clear understanding of how rating agencies assign ratings to products;
  • A virtuous co-evolution of banks and capital markets requires the development of supportive financial infrastructure – including legal, institutional, information, market and transaction rules and technologies. Such developments make a wider range of risk-sharing instruments available and attractive to investors, and provide them with more information on alternative investment options. Lower information cost and the diffusion of market evaluation services facilitate the financing of new companies and ideas. Incentives encourage investors to select activities that incorporate relatively more intangibles and feature higher knowledge-intensity (Bossone et al. 2003);
  • Strengthening the role of banks in encouraging and supporting firms to access capital markets expands the information provision on enterprises that would otherwise fly below the radar screen of nonbank investors; it improves firms’ external financing conditions and enhances their chances to grow. Banks should be allowed to broaden their scope of activities beyond their traditional business boundaries, provided that sound supervisory and regulatory systems are in place. This would make possible for them to diversify their revenue sources and offset the rent losses due to competition from nonbank financial intermediaries;
  • However, in systems whose scale is too small to justify the development of efficient domestic capital markets, allowing banks and firms to access larger financial systems is vital as it would enable them to exploit greater Systemic Scale Economies. This can be achieved through different channels, including by allowing entry of foreign intermediaries into domestic markets, importing financial (and financial infrastructural) services from abroad, linking the local economy to regional or international capital market infrastructures, or sharing capital market infrastructure with regional partners (Bossone et al. 2001).


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1 For comprehensive reviews of the empirical research on how banks support capital markets, see Drucker and Puri (2007), and Kutsui et al. (2007).

2 The evidence indicates that the positive excess returns around loan announcements that were detected contrasts with the strongly negative announcement effects of equity, the moderately negative excess returns around convertible debt issuance, and the insignificant excess returns surrounding straight public debt announcements (see Asquith and Mullins 1986, Eckbo 1986, Mikkelson and Partch 1986, and Masulis and Korwar 1986).

3 We also found that banks operating in larger financial systems have relatively lower production costs than banks operating in smaller systems.

4 This effect rests on the assumption that banks use capital market information like other nonbank investors do. As capital markets aggregate (and reflect on asset prices) the views of a wide range of different investors, they provide multiple checks on individual firms and, hence, the best indicators possible of the true value of the firms.



Topics:  International finance

Tags:  capital markets, financial regulation, banks

Senior Adviser Finance, Competitiveness and Innovation Global Practice, World Bank


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