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University of Cambridge, UK
Traditionally, the typical demander of financing is a corporation, either a large publicly listed firm or a small or medium enterprise (SME). The corporations typically issue contracts, promising either a fixed series of payments and a final face value with priority over other financiers (debt), or the residual value after... read moredebt-holders have been paid off (equity). Intermediate forms of financing (private or bank debt or preferred shares) have alternative specifications of the amount to be repaid and the degree of control rights granted. The suppliers of finance are largely households. Standard financing models have involved a financial intermediary such as a bank bringing together suppliers and demanders of finance.
Most of the research questions in these areas have focused on portfolio allocation decisions (for households and individual investors), and the financing decision for the firm (largely extensions of capital structure theory and information asymmetries). Roles played by the financial intermediaries in this process involve reducing information asymmetries (by playing monitoring or certification roles), aggregating loan assets to reduce risk to investors (by asset securitization processes) and offering insurance (either by securitization or by offering derivative insurance and other innovative financial products).
In the first part of this lecture series, we examine the traditional financing patterns employed by firms – the initial financing decision, the choice to go public, and the choice between debt and equity. We examine the role played by financial institutions in facilitating this process.
In the past few years however, especially in the wake of the financial crisis, some of these roles have been shown to have weaknesses. For example, asset securitization involves aggregating loans to reduce risk. However, since the loans are not held on the financial intermediary’s books, there is little incentive for the intermediary to monitor the loans. Loans were granted to borrowers who had little ability to repay because the lending agents had flawed incentives to issue as many loans as they could. Rating agencies, in turn, were under pressure to issue favorable ratings to borrowers. Buyers of the asset-backed securities felt little need to monitor the loans since they had been rated extremely highly by rating agencies. Overall, the lack of monitoring and the rise of information asymmetry helped worsen the financial crisis.
Over the past few years, an increasing number of borrowers and lenders have been interacting directly using new financial models. These models use alternative approaches to solving the central problem of information asymmetry in borrowing and lending. In the second part of the series, we examine these new financing models. Five examples are listed below.
Microcredit or microfinance institutions (MFIs) serve individual borrowers (or very small enterprises). Traditionally banks do not provide financial services to clients with no formal title to assets or with very little cash income (on the order of €2 per day). There are two reasons for this lack of service. First, the banks incur significant fixed transactions costs to manage these accounts – managing a hundred tiny transactions is extremely expensive, far more so than making one large loan to a wealthier borrower. Second, since the borrowers have little in the way of marketable assets, banks cannot secure loans with collateral.
The emerging field of microfinance deals with making a profit when lending to these types of borrowers. The solution to the monitoring problem was to monitor groups of borrowers who in turn were given incentives to monitor each other. Group lending with joint liability promotes initial screening of clients, and monitoring to verify client health and reduce ex post moral hazard. It reduces the information asymmetry problem in selection, monitoring and auditing. While the traditional view of typical microfinance clients is that they are located in countries associated with the bottom of the pyramid loan market, it is important to note that a substantial proportion of microfinance assets are located in developed countries as well. However, the numbers are considerably larger. For example, the EU defines microcredit as a loan of less than €25,000. In the US, it is defined as the extension of credit up to $35,000 while in Canada, microfinance loans are restricted to a maximum of $25,000.
Group lending is not a solution in developed countries since the unemployed micro-entrepreneurs may be located in towns far away from each other. In addition, the level of literacy, including financial literacy, is much higher than in developing countries. There are additional issues as well. Developed countries usually maintain welfare systems that provide unemployment benefits. Fears of losing these benefits have the potential to create poverty traps that inhibit people from starting their own firms. Existing larger banks and regulators have convergent interests – banks attempt to protect their markets and regulators attempt to protect small savings through regulation. As a result, in many developed countries, only banks are allowed to take micro-savings while existing insurance companies provide micro-insurance. In developed countries, pure MFIs typically provide only microcredit, in contrast with those operating in developing countries where microfinance includes many products.
While microfinance has proven to be a factor in reducing poverty levels across countries in Asia, the magnitude of this significance has been debated in the literature. For examples, studies have found that micro-investments yield high returns, but these exhibit declining returns to scale. Microfinance has also created a number of other problems. For example, investors in microfinance institutions prefer high growth rates, profits and the potential for scale. Many MFIs respond by stripping their operations down to one or two products and growing as fast as possible. They also operate in easier to reach areas to minimize costs and increase profits. Consequently, there is a high degree of competition among micro-finance organizations in the same area, all with incentives to loan officers tied to disbursements and collections. Since in many cases, the MFIs’ financial systems do not keep pace with growth and since in most low-income countries, there is no centralized credit scoring agency, borrowers can obtain loans from several providers at the same time or take out one loan to repay another from a different MFI. Finally, joint liability does not help when there is a large-scale natural disaster that affects all individuals in a particular area. These disasters are particularly common in developing countries where the level of infrastructure spending is low.
Peer-to-peer (P2P) lending is another increasingly important financing model. Most peer-to-peer loans are unsecured loans obtained from a collection of individuals without the participation of a bank. The key development facilitating the growth of P2P lending has been the Internet. Borrowers post a request for funds and explain why they needed the money. An intermediary such as Zopa and RateSetter in the UK, Auxmoney in Germany, Society One in Australia or Prosper, and Lending Club in the US aggregates loan requests, runs credit checks, monitors and collects monthly payments and collects a commission for its services. How do these systems solve the information asymmetry problem? How do peer-to-peer lending networks work without financial intermediaries to certify the quality of the business opportunity?
Research has shown that lenders incorporate both hard and soft data while deciding their funding decisions. For example, personal characteristics of applicants (including photographs of attractive founders) have a significant impact on the terms of the loans extended. Network effects (the number of friends listed for each borrower) also influence the demand for investment opportunities. Effective lending networks provide both types of data. To illustrate this process, consider the approach taken by Prosper.com. Users join Prosper.com by providing an email address, which is verified by the website. To protect privacy, the true identity of borrowers and lenders is never publicly revealed on the website. All users are identified with user names that are chosen when signing up. This would appear to make it more difficult to verify the borrower’s credit quality.
However, Prosper.com collects a set of hard data on each potential borrower. To engage in a transaction, users must provide additional verification. Borrowers must reside in the United States, have a valid social security number, a valid bank account number, a minimum FICO credit score, and a valid driver’s license and address. The details are verified by Prosper.com, which also extracts a credit report from Experian, a major U.S. credit reporting agency. Prosper.com lenders are also subject to verification of the social security number, driver’s license number, and bank account number.
Beyond the credit score and other hard data, Prosper.com also aggregates soft information. Any Prosper.com member with a verified email account can also create or join a friendship network. To form friendships, the inviting member fills out the friend’s email address and a short message on Prosper.com. Prosper.com then generates an email message with a link that the recipient can click to establish a friendship. Although Prosper.com users are normally identified by user IDs (e.g., “banker234”), members on either end of a friendship tie know the real person behind the ID. Thus, friends can link user IDs of a borrower who defaults to the actual identities of the defaulter, potentially imposing social stigma costs on borrowers with friends. The important point is that a member’s friend information is highly visible on the members’ profile pages. Friendship data are prominently displayed in a listing. Indeed, it is one of the most prominent pieces of information outside the credit information and listing data about the borrower. Lin, Prabhala and Viswanathan (2013) show that friendship ties act as a strong signal of credit quality. Borrowers with friends, especially those that are likely to be credible signals of quality, are significantly less likely to default.
Crowdfunding is a third alternative financing method. Unlike P2P lending, charity sites, or investment sites, crowdsourcing is a form of micro-patronage. Patronage is an ancient concept. An artist approaches a rich patron to secure funding for an art project. The patron receives little financial reward for the project, but does obtain social or other benefits from being a patron of the arts. Crowdfunding aggregates micro-patrons, each of who would not be willing to finance a whole project, to finance a small fraction of many different projects.
The format for the earliest formal organization, Kickstarter, started in 2009, illustrates how crowd funding works. Kickstarter is a site where creative people attempt to obtain start-up money to get their projects off the ground. Projects might involve music, film, art, design, food, publishing and technology. For example, an artist might seek to record a CD, produce a short film or develop a new watch. The artist describes the project with a video, a description and a target dollar amount. Kickstarter lists the project for free. If donors pledge enough money to meet the target by the deadline set, then the artist gets the money for the project. Kickstarter charges 5%, and Amazon.com’s credit card service charges another 3-5%. If however, not enough money is raised by the deadline, the project is cancelled, the donors are not liable for any cash, and Kickstarter takes nothing.
The important difference between the classic crowdsourcing model and P2P lending is that these are not investments. The donor’s pledge will never return any financial gain, even if the play, movie or gadget becomes a huge hit. In some cases, the artist promises a memento of the donor’s financial involvement — a T-shirt or a CD, for example, or a chance to preorder the item being developed — but nothing else tangible. The donor’s pledges are also not tax-deductible, marking the difference between crowdsourcing and traditional charity sites.
As in the case of P2P lending, crowdsourcing platforms are proliferating. In April 2013, the passage of the JOBS act made it legal for businesses and startups to give equity to investors who will get an actual financial return instead of a T-shirt or CD. This has caused a boom in crowdfunding platforms with over 450 platforms listed in 2013. The increasing proliferation of business models has led to a blurring between the classic crowdfunding model and the P2P model, with many of the same problems being observed in each area.
Beyond the information asymmetry issues associated with P2P sites, social pressures are particularly strong for classic crowdfunding sites where the donors receive little for their funds except social benefits of being patrons. In some cases, founders have been unable to keep up with investor demand generated through this process. Mollick (2013) finds that the vast majority of crowdfunded efforts appear to attempt to deliver promised goods, but most projects are delayed.
Moving from individuals and very small businesses, the next set of financing models considers small and medium enterprises. After the financial crisis in 2008, banks in both Europe and the US considerably reduced lending capacity. SMEs are usually tied to bank financing because of information asymmetry in credit analysis. Because of the drop in lending capacity, SMEs are trying to reduce this reliance. Specifically, in several countries across Europe, notably in Germany, Italy, and the UK, borrowers are issuing listed and unlisted corporate micro-bonds directly to customers and local retail investors, bypassing banks completely. This is the ‘Self-Issued Bond’ (SIB) market. The German and Italian markets are considerably larger than the UK market: several hundred German issuers have issued SIBs in Germany while only a handful of them have done the same in the UK.
The UK market started with large firms such as Royal Bank of Scotland, Tesco Bank, and National Grid issuing bonds in multiple tranches. But over time, the market has attracted a more diverse range of mid-market companies such as interdealer broker ICAP and specialist lender Intermediate Capital Group. A significant proportion of these bonds are listed - the Order Book for Retail Bonds (Orb) platform was launched on the London Stock Exchange in February 2010 and about £2.5bn has now been raised from retail investors looking for higher-yielding investments.
Islamic finance is a final form of alternative financing model. Interest-bearing loans (Riba) and speculative trading are both banned under Islamic financing. Islamic laws prohibit Muslims from paying or receiving interest, taking out mortgages, carrying balances on credit cards, or investing in any fixed income securities. However, many Islamic finance contracts can also be seen as variants of traditional financing contracts in the West. For example, depositors in Islamic banks are classified as shareholders who earn dividends when the bank makes a profit and lose a portion of their savings when the bank posts a loss. Islamic law allows partnership finance (mudaraba) and profit and loss sharing (musharka). A mudaraba contract is an agreement where an investor (Islamic bank) entrusts capital to an agent for a project. Profits are based on a pre-arranged and agreed-on ratio. This is akin to a limited partnership where one party contributes the capital while the other runs the business. The profit is distributed based on a negotiated percentage of ownership. Similarly, musharaka is similar to a joint venture where the Islamic bank and client both provide capital and manage the project. Profits are shared in pre-agreed ratios but losses are split in proportion to equity participation.
In practice, Islamic banking diverges from the ideal version. All deposits (including investments) are typically explicitly or implicitly guaranteed. The Profit-Loss-Sharing principle is never strictly applied. In some cases, the bank guarantees the expected rate of return on deposits. In others, the financing is carried out by mark-up leasing and lease purchase transactions related to trade financing. Examples of these kinds of arrangements include declining balance co-ownership financing arrangements that involve financing for home purchases that does not involve the payment of interest.
The purpose of this series of talks is to systematically examine changing patterns in corporate financing from the traditional debt vs. equity choices to more innovative types of financing. As noted, the series will be split into two parts.
Traditional forms of corporate financing will be discussed. These include the choice between debt and equity as driven by interactions between taxes, financial distress costs (Tradeoff theory) and asymmetric information (pecking order).
New models of finance will be discussed. These include models of microfinance, crowd-sourcing, financing for small and medium enterprises and Islamic finance.