The Role of Banks in Monitoring Firms: The Case of the Credit Mobilier

THE ROLE OF BANKS IN MONITORING FIRMS

Does the Anglo-American approach to the relationship between banks and firms have significant weaknesses compared with the German and Japanese approach? This book addresses issues in the current literature on corporate finance using historical evidence. In particular it looks at the role of universal banks in relaxing the credit constraints of firms, supervising managers and stabilising share prices. The key issue is whether Anglo-American assetbased financing is more effective than the main-bank approach used in Germany and Japan. Earlier studies have found that firms with a close relationship with a major bank have high market value compared to book value, although it is difficult to determine whether this is cause or effect. The case of the Crédit Mobilier—the first universal bank—is interesting because the bank failed. Had it been the case that links with the bank brought about high and stable share prices or relaxed credit constraints, the bank’s bankruptcy should have precipitated the loss of these benefits. In fact, the bankruptcy had almost no effect on the share prices or the investment behaviour of the relevant firms, casting doubts on the benefits of powerful banks. Elisabeth Paulet is Research Assistant at the European University Institute of Florence. Her main interest is in banking systems from the nineteenth century to the present day.

ROUTLEDGE EXPLORATIONS IN ECONOMIC HISTORY 1. ECONOMIC IDEAS AND GOVERNMENT POLICY Contributions to contemporary economic history Sir Alec Cairncross 2. THE ORGANIZATION OF LABOUR MARKETS Modernity, culture and governance in Germany, Sweden, Britian and Japan Bro Stråth 3. CURRENCY CONVERTIBILITY IN THE TWENTIETH CENTURY The gold standard and beyond Edited by Jorge Braga de Macedo, Barry Eichengreen and Jaime Reis 4. BRITAIN’S PLACE IN THE WORLD A historical enquiry into import controls 1945–1960 Alan S.Milward and George Brennan 5. FRANCE AND THE INTERNATIONAL ECONOMY From Vichy to the Treaty of Rome Frances M.B.Lynch 6. MONETARY STANDARDS AND EXCHANGE RATES Edited by M.C.Marcuzzo, L.Officer and A.Rosselli 7. PRODUCTION EFFICIENCY IN DOMESDAY ENGLAND, 1086 John McDonald 8. FREE TRADE AND ITS RECEPTION 1815–1960 Freedom and trade: Volume I Edited by Andrew Marrison 9. CONCEIVING COMPANIES Joint-stock politics in Victorian England Timothy L.Alborn 10. THE BRITISH INDUSTRIAL DECLINE RECONSIDERED Edited by Jean-Pierre Dormois and Michael Dintenfass 11. THE CONSERVATIVES AND INDUSTRIAL EFFICIENCY, 1951–1964 Thirteen wasted years? Nick Tiratsoo and Jim Tomlinson 12. PACIFIC CENTURIES Pacific and Pacific Rim economic history since the 16th century Edited by Dennis O.Flynn, Lionel Frost and A.J.H.Latham 13. THE POSTMODERN CHINESE ECONOMY Structural equilibrium and capitalist sterility Gang Deng 14. THE ROLE OF BANKS IN MONITORING FIRMS The case of the Crédit Mobilier Elisabeth Paulet

THE ROLE OF BANKS IN MONITORING FIRMS The case of the Crédit Mobilier

Elisabeth Paulet

London and New York

First published 1999 by Routledge 11 New Fetter Lane, London EC4P 4EE This edition published in the Taylor & Francis e-Library, 2002. Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 © 1999 Elisabeth Paulet All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Paulet, Elisabeth, 1962– The role of banks in monitoring firms: the case of the Crédit Mobilier/Elsabeth Paulet. p. cm. Includes bibliographical references. 1. Corporations—Finance—Case studies. 2. Business enterprises— Finance—Case studies. 3. Banks and banking—Case studies. 4. Crédit Mobilier (France) —History. 5. Credit—Case studies. I. Title. HG4026.P329 1999 658.15´224–dc21 98–30729 CIP ISBN 0-415-19539-X (Print Edition) ISBN 0-203-21180-4 Master e-book ISBN ISBN 0-203-21192-8 (Glassbook Format)

It is necessarily part of the business of a banker to profess a conventional respectability which is more than human. Lifelong practices of this kind make them the most romantic and the least realistic of men. John Maynard Keynes

CONTENTS

1

List of figures List of tables Preface Acknowledgements

ix x xiii xiv

INTRODUCTION

1

AGENCY THEORY AND MONITORING A theoretical and empirical interpretation

7

1.1 1.2 1.3 1.4 2

Introduction 7 Presentation of the financial theories 8 The supervisory role of the bank in agency literature 15 General conclusion 24

THE CRÉDIT MOBILIER AND THE FRENCH STOCK EXCHANGE 1853–1914 An empirical perspective 2.1 Introduction 26 2.2 Financial capitalism and data on the Crédit Mobilier in France, 1853–1914 29 2.3 Data available over the period of the two Crédit Mobiliers: Companies involved and preliminary analysis of the data 40 2.4 Excess volatility tests 45 2.5 The effect of the bankruptcy of the Crédit Mobilier on the companies with which it was involved 53 2.6 Bankruptcy effect on the companies not affiliated to the Crédit Mobilier 65

vi

26

CONTENTS

2.7 Comparative analysis of the results obtained for affiliated and non-affiliated companies 71 2.8 Bankruptcy effect on the companies either affiliated or not affiliated to the Crédit Mobilier 73 2.9 General conclusion 74 3

CORPORATE INVESTMENT, CASH FLOW AND FINANCIAL CONSTRAINTS OF FIRMS The case of the Crédit Mobilier

76

3.1 Introduction 76 3.2 The value of association with the Crédit Mobilier on cash flow, investment and market value 78 3.3 Transformation of the raw data according to ‘traditional financial accounting’ 91 3.4 Extensions of the results: description and interpretation of a robustness test 98 3.5 The expression of all variables in real terms 104 3.6 General conclusion 108 4

THE SUPERVISORY ROLE OF THE CRÉDIT MOBILIER Some interpretations

109

4.1 Introduction 109 4.2 The supervisory role of the Crédit Mobilier 111 4.3 Advantages and disadvantages of an association with a bank for the financing of productive projects 116 4.4 The Crédit Mobilier banks: a comparative analysis between France and Germany 124 4.5 The attempt by the Crédit Mobilier’s shareholders to prevent the bank’s bankruptcy 128 4.6 Conclusion 129 5

GENERAL CONCLUSIONS

132

APPENDIX A Data on the Crédit Mobilier

136

A.1 The Crédit Mobilier between 1852 and 1867 136 A.2 The Crédit Mobilier between 1903 and 1914 136

vii

CONTENTS

APPENDIX B Data relative to the general indices (GNP, share prices) for France between 1852 and 1914

140

B.1 General price indices 140 B.2 Share price series 141 APPENDIX C Data relative to the affiliated companies

142

C.1 The whole data 142 C.2 The Compagnie Immobilière 142 APPENDIX D Data relative to non-affiliated companies

146

APPENDIX E Monthly share prices for affiliated companies between 1866 and 1868

148

APPENDIX F Data for investment and cash flow tests

152

Notes Bibliography Index

161 166

174

viii

FIGURES

1.1 1.2 1.3 2.1

Moral hazard with hidden action Adverse selection models Signalling model Prices, dividends, and perfect-foresight fundamental sample 1870–1914

ix

10 10 11 46

TABLES

2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14 2.15 2.16 2.17 2.18 2.19 2.20 2.21 2.22 2.23 3.1

Ownership of the shares of the Immeubles de la Rue de Rivoli Advances to companies, 1856–66 Fluctuations of share prices for affiliated companies between 1855 and 1856 Crédit Mobilier’s liquidation account in 1901 Market product prices by sector Volatility tests for the French, German and American stock markets between 1870 and 1914 Average asset prices for affiliated firms Relative impact of the bankruptcy of the Crédit Mobilier Relative impact of the bankruptcy of the Crédit Mobilier including a dummy variable d1867 Relative impact of the bankruptcy of the Crédit Mobilier including a dummy variable d1867/68 Regression for d1867 Regression for d1867/68 Results for 1866 Results for 1867 Results for 1868 Results for 1866–8 Relative impact of the bankruptcy of the Crédit Mobilier Relative impact of the bankruptcy of the Crédit Mobilier including a dummy variable d1867 Relative impact of the bankruptcy of the Crédit Mobilier including a dummy variable d1867/68 Results for d1867 Results for d1867/68 Cross-section results excluding the Compagnie Immobilière Cross-section results including the Compagnie Immobilière Companies included in the data set

x

32 32 34 36 41 49 54 55 56 57 58 59 61 62 63 64 67 68 69 70 70 73 73 80

TABLES

3.2 (a) (b) (c) 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10

3.11 3.12 3.13 3.14 3.15 3.16 3.17 3.18 3.19 3.20

3.21

3.22

3.23 3.24 3.25

Summary statistics comparing Crédit Mobilier and non-Crédit Mobilier firms Sample 1861–75 Sample 1861–7 Sample 1868–75 Investment regression, 1861–75 Investment regression, 1861–7 Investment regression, 1868–75 Investment regression equation for the whole sample Fixed effect model for 1861–7 Fixed effect model for 1868–75 Fixed effect model for the whole sample Summary statistics comparing Crédit Mobilier and non-Crédit Mobilier firms when introducing a depreciation rate of 5 per cent Investment regression for the whole sample 1861–75 Investment regression over 1861–7 Investment regression over 1868–75 Results for affiliated companies as presented in Becht and de Long’s paper Results for non-affiliated companies as presented in Becht and de Long’s paper Fixed effect model for the whole sample Fixed effect model for 1861–7 Fixed effect model for 1868–75 Fixed effect model for all firms Investment regression equation for affiliated companies and independent firms over the whole sample (a) Case when d = 3% (b) Case when d = 7% Investment regression equation for affiliated companies and independent firms before the bankruptcy (a) Case when d = 3% (b) Case when d = 7% Investment regression equation for affiliated companies and independent firms after the bankruptcy (a) Case when d = 3% (b) Case when d = 7% Cash flow parameters Sample 1861–75 robustness results for Crédit Mobilier firms without the Compagnie Immobilière Sample 1861–7 robustness results for Crédit Mobilier firms without the Compagnie Immobilière

xi

81 81 81 82 84 85 87 88 89 89 89

92 93 94 94 95 95 96 96 97 97 98 98 98 99 99 99 100 100 100 100 101 101

TABLES

3.26 Investment regression equation for all companies over the different samples (a) Investment regression equations when d = 3% (b) Investment regression equations when d = 7% 3.27 Cash flow parameters 3.28 Q parameters 3.29 T-statistics for sample 1861–7 as regards the cash flow parameters 3.30 Summary statistics comparing Crédit Mobilier and non-Crédit Mobilier firms when parameters are expressed in real terms 3.31 Investment regression equation for the whole sample 3.32 Investment regression equation for 1861–7 3.33 Investment regression equation for 1868–75 3.34 Investment regression equations for all firms 3.35 Regression for the whole sample without the Compagnie Immobilière 3.36 Comparison of cash flow and Q parameters 4.1 Financial participation of the Crédit Lyonnais in ‘big deals’ A1 Balance sheet of the Crédit Mobilier from 1853 to 1866 A2 Average profit of the Crédit Mobilier from 1855 to 1865 A3 Share prices of the Crédit Mobilier from 1853 to 1866 A4 Balance sheet of the Crédit Mobilier from 1903 to 1914 A5 Share price series A6 Data available for affiliated companies: share prices A7 Revenues of the Compagnie Immobilière A8 Expenses of the Compagnie Immobilière A9 Share price and dividend distribution, 1855–66 A10 Data for non-affiliated companies A11 Share prices for affiliated companies for 1866 A12 Share prices for affiliated companies for 1867 A13 Share prices for affiliated companies for 1868 A14 Data available for the railway companies A15 Data available for mining industries A16 Data available for the steel industries A17 The Compagnie Immobilière A18 New values of Q when introducing a depreciation rate of 5 per cent A19 Transformation of the data when changing origin A20 Data in real terms

xii

102 102 102 103 103 104

105 105 106 106 106 107 108 122 137 138 138 139 141 144 145 145 145 147 149 150 151 153 154 155 156 157 158

159

PREFACE

Economists seem to agree on the monitoring power of banks as regards their clients. Their arguments are based on the ability of these institutions to collect information on exposure to risk, and on their flexibility to diversify investment. In order to exert this monitoring role, a banker should always evaluate the trade-off between profitability and efficiency. This book examines how universal banks could help relax the credit constraints of firms, improve the supervision of managers and stabilise share prices. The case of the Crédit Mobilier, which went bankrupt in 1867, is a good illustration of the weakness of the monitoring role of banks. It exhibits the potential of enterprises to diversify their investments in order to avoid financial destabilisation. A historical approach adds evidence to this last assertion and casts doubt on the beneficial role of closed relationships with powerful banks. As far as bankruptcy is concerned, the attitude of the central bank is an interesting factor. At that time, the Banque de France and its governors were hostile to the founders of the Crédit Mobilier, the Péreires; consequently, its participation in rescuing the bank was almost non-existent. Beyond the historical context, this fact illustrates the importance of political pressures in financial decision-making. This debate remains very sensitive, particularly in view of the discussions concerning the future of the European central bank. As a whole, the questions mentioned in this essay are still valid today. This book was written in order to present some new ideas regarding the control and monitoring of financial institutions and, more specifically, universal banks. While the flexibility of other structures must be acknowledged, there are moves afoot to create a unified European banking system in which universal banks will have a privileged position on the financial markets. The justification for this concerns their perceived superiority as evaluators of information and risk. The conclusions of the empirical analysis discussed here have a direct bearing on the power of universal banks.

xiii

ACKNOWLEDGEMENTS

This book is based on my Ph.D. dissertation at the European University Institute in Florence, written between 1991 and 1995. I would like to express my gratitude to all the people who supported me at that period: many thanks to Robert Waldmann who has acted with great sensibility as a supervisor; the History Department at the Institute, and especially Peter Hertner, Albert Carrerras and Kirti Chaudhuri, who have always been interested in my research; William Kennedy, who kindly provided me with useful comments and encouragement; and last, but not least, Maurice Levy Leboyer who, through written exchanges, enabled me to form a new opinion on the personality and position of the Péreire brothers in nineteenth-century financial circles. My research led me to collect data in Paris. I am grateful to the personnel of the Paris Archives for their contribution to this work. Much of what follows is based on a simple idea: the Crédit Mobilier and its founders, the Péreires, failed because they encountered difficulties that were due more to external constraints than is usually acknowledged. In other words, environment matters. My own environment in the course of writing the present book has been as follows. For several years Francesc Relaño has endured my ramblings on the course of banking policy over the last century. My parents have provided support during the most austere period of the writing process. My last thought is to dedicate this book to my brother, who will never have the opportunity to read this piece. To Patrick.

xiv

INTRODUCTION

Bankers and investors influence industrial investment through the financial power they exert on the managers of firms. The purpose of this research is to study the interrelations that exist between these managers, their shareholders and the banks which finance investment projects when defining a debt-equity contract. The subject will be approached from two diverse perspectives: the first one is theoretical (Chapter 1), the second empirical (Chapters 2, 3 and 4). Theoretical arguments can be, and have been, advanced to describe how the conflict of interest between managers and owners of firms can be solved. The purpose of the first chapter is to survey the literature on principal-agent theory and the signalling approach which concentrates on these questions. In particular the power of banks will be debated. Two questions are considered: • •

Why might banks want and be able to obtain the power to influence and monitor managers? Why might shareholders benefit if the bank has such power?

Agency and signalling theory are concerned with the information and interest conflicts which can exist between the different economic actors associated with the firm: managers, shareholders and creditors. This theory holds that some agents (the managers) are better informed about the quality of the enterprise than the principals (shareholders, creditors). To resolve the conflict of interest, contracts (implicit or explicit) must be negotiated between the lenders, the creditors, the shareholders and the managers. The term ‘agency’ derives from the fact that corporate decisions are delegated to agents (e.g. managers) who act on behalf of other parties (external investors). The relation between investment and debt is explained by the choice between debt and equity for the financing of a project. The signalling approach makes the assumption that there is asymmetric information as between management and investors: the managers have more information than the shareholders on the value of their enterprise.

1

THE ROLE OF BANKS IN MONITORING FIRMS

The problem is the accurate transmission of such information, to give shareholders the incentive to finance productive projects. Both approaches feature the monitoring role exerted by lenders on borrowers: control remains one of the main factors of agency. The concept of monitoring will presently be examined, focusing on the role of banks in performing this control function. According to agency theory, the bank will have less information about the project than the managers; the role of collateral can be useful in dealing with the problem of adverse selection. Adverse selection arises when lenders cannot distinguish managers of firms who undertake low-risk projects from the ones who realise high-risk projects. Then a contract that is optimal when offered to less risky borrowers also attracts more risky borrowers and thus becomes unprofitable to the lenders. The use of collateral constitutes one way to control this risk. Several other tools will be discussed. Two examples are presented to illustrate the argument: Japan and Germany. The aim of this analysis will be to compare the conclusions reached for these two countries with the results obtained for the Crédit Mobilier. Historians have argued that the influence exerted on industry by banks such as the German Großbanken or the French Crédit Mobilier was substantial during the nineteenth century. The role played by the Großbanken—those banks which, like the Crédit Mobilier, took a great role in the industrialisation of Germany—in monitoring and supervising corporate management was an accepted part of German finance theory in the years before the First World War. The second step of my analysis is to gain, through empirical research, an insight into the role of banks in the financing of enterprises during the period 1850–1913. In particular, I study the Crédit Mobilier’s role in France during the pre-WWI period. This bank, founded by the Péreires in 1852, until it went bankrupt in 1867, contributed largely to French industrialisation. It failed a second time at the beginning of 1900 and merged in 1932 with the Banque de l’Union Parisienne. The Crédit Mobilier has been chosen for two reasons: •

•

Its organisation was similar to that of the German Großbanken. The comparison with these institutions can give some additional insight to the results mentioned in the literature. As the bank went bankrupt, it will be interesting to analyse the impact of this failure on the firms affiliated to it. If a real monitoring role were exerted by the Crédit Mobilier, affiliated firms should have faced difficulties when the bankruptcy occurred.

First the role played by the Crédit Mobilier on the stock market is determined. The level of volatility will be quantified in order to assess the

2

INTRODUCTION

French general economic context between 1852 and 1913. Share price series are then used to investigate the impact of the bankruptcy of the Crédit Mobilier on the stock market for affiliated and non-affiliated companies. Share prices did not fall when the bank failed. The conclusion is that the Crédit Mobilier provided liquidity to firms, but apparently did not seem to be supervising them, and its seal of approval was probably not worth as much as that of J.P.Morgan1 or the Großanken.2 Some remarks must be made concerning the data used to construct the test. During the period statistical sources such as share prices and balance sheets were not always kept according to strict rules. In addition the amount of statistical information available over the period was quite limited because managers were not obliged to publish their accounts. So the validity of our results has to be assessed in the context of a panel data of twenty five companies which provided information on their financial situation. As the Crédit Mobilier seems not to have succeeded in controlling firms, it would be interesting to measure the effect of an association with this establishment on investment policy. The basic theoretical idea is as follows. In their world of perfect information and no agency costs, firms can borrow and invest optimally; liquidity has no effect on the investment decision. In their classic paper, Franco Modigliani and Merton Miller (1958) showed under what conditions financial structure becomes irrelevant for real investment decisions. In a context of asymmetric information this proposition is no longer true. The next step in our research is to analyse the relationship between investment and cash flows between 1860 and 1880. The effect on investment policy of an association with this establishment will then be measured and compared to Großbanken policy during a similar period. This proposed analysis then tests the proposition that the Crédit Mobilier acted like a German-style universal bank. To that intent it examines the effects on the investment behaviour of French firms of affiliation with the Crédit Mobilier. Investment equations for a modified version of Tobin’s Q-model are estimated. Two samples are considered: the first consists of corporations that were affiliated to the Crédit Mobilier, the second includes companies which had to resort to other sources of finance. The focus of this construction is on contrasting the financing of the Crédit Mobilier’s affiliated enterprises with those which, for one reason or another, did not form part of the nexus. The chronological limits of this study are imposed by the data sources: after 1880 the Crédit Mobilier lost its powerful role in the banking sector and thus no records exist after this point. The sample includes fifteen companies: seven were affiliated with the Crédit Mobilier, eight with the Crédit Lyonnais. As each company, in any

3

THE ROLE OF BANKS IN MONITORING FIRMS

event, had a relationship with a bank, the interpretation of the results must be in some sense cautious. Using this evidence, the following two conclusions are reached: 1 2

companies that maintained close ties with the Crédit Mobilier were less liquidity constrained after the bank’s crisis in 1867 than before; unaffiliated companies experienced no more difficulty in financing projects than those which resorted to the Crédit Mobilier.

These results strongly contradict earlier findings. The interpretation will define the context in which they are valid. Some empirical extension of the results is provided. In particular, we intend to develop two different models: the first will try to re-evaluate the book value for all companies entering the sample by introducing a fixed depreciation rate of 5 per cent. This is because I suspect the account figures for book value changed only rarely from year to year. The second proposition is to divide all variables by the general level of prices. If the conclusions are not substantially different they support the arguments mentioned above. An interpretative chapter discusses whether the supervision of the Crédit Mobilier was really effective—if the firms with which it was involved had not anticipated the fall of the bank, and diversified their sources of financing corresondingly. Our empirical results prove that the bank did not really control firms. The regressions suggest that the affiliated firms were more liquidity constrained before the bankruptcy than after. This supports the argument that the firms did not really trust the Crédit Mobilier as a banking institution—they just used it to finance their investment projects. A large part of the economic literature considers that a bank-firm association is always profitable for both parties because: • •

the bank prevents the firm from undertaking projects that are too risky; the firm signals its reputation to the market by having a regular relation with a bank.

The Crédit Mobilier’s case gives no clear evidence to confirm this argument. The question is then: What is the most efficient way to control a firm: an interaction between firms and banks (which means substantially a bank-firm association), or a clear separation of banks and firms (as presented in our first chapter)? In other words, should banks supervise, or just choose whether or not to loan? In particular, we can ask if the principal (the Crédit Mobilier) was not an agent acting for firms which needed liquidity over the period. A comparison between France and Germany is then drawn. Other researchers 3 have shown the efficiency of the German Großbanken

4

INTRODUCTION

(which were explicitly modelled on the Crédit Mobilier). The diverse results obtained in the two cases enable me to say that in many countries the Crédit Mobilier was the inspiration for a new type of banking, but not the model. The last point will be a debate on the rationality or irrationality of the shareholders. In particular, some explanation for their passive attitude in the face of the bankruptcy will be advanced. The last chapter concludes.

5

1 AGENCY THEORY AND MONITORING A theoretical and empirical interpretation

For French business, whether medium or ‘big’, the obsession with independence vis à vis the lender (the bank) was constant. It was with reference to the level of their current bank accounts that the Schneiders of the nineteenth century, for example, calculated their degree of independence and their room for manoeuvre…. The domination of banks over business, if it existed was not achieved without resistance.1 Bouvier (1988:109)

1.1 INTRODUCTION In this chapter the basic concepts of agency and signalling theories applied to the financing of the firm are presented. In particular the chapter will study how a debt-equity contract is defined between the manager of a firm, the shareholders and the bank which provides liquidity. Agency theory, although not quite new, is a part of decision theory which is currently characterised by a dynamic development. The wellknown basic model of decision theory is related to a situation in which one person—the so-called decision-maker—has to make a decision as well as to bear its consequences. This assumption is often unrealistic. Therefore, in agency theory the decision-maker (the agent) and the ‘beneficiary’ of the decision (the principal) are all distinct. A typical example concerns the management of the firm: the agent, the manager of the firm, chooses an investment project. The principal—the shareholders of the firm and (or) the bank which finances the enterprise—partly support the risks involved in this investment. Hence, the common element is the presence of at least two individuals. The first (the agent) must choose an action from a number of alternative possibilities. The action affects the welfare of both the agent and the principal. The principal has the additional function of prescribing payoff rules; that is, before the agent chooses the action, the principal determines a rule that specifies the fee to be paid to the agent as a function of the

7

THE ROLE OF BANKS IN MONITORING FIRMS

principal’s observation. The problem acquires interest only when there is uncertainty at some point and, in particular, when the information available to the participants is unequal. As information is asymmetric between the economic agents, control is one of the main factors of agency. The second part of this chapter will be devoted to the definition of this control mechanism in order to determine which of the two principals, the shareholders of the firm or the bank with which the enterprise is involved, is able to exert effectively this monitoring role. 1.2 PRESENTATION OF THE FINANCIAL THEORIES (a) Basic concepts of agency and signalling theories The financial theory of agency focuses on the relationships between different groups of security holders (equity and bondholders) in the context of optimal financing of the firm. The standard economic theory of agency considers two individuals: a principal, who provides the capital, and an agent (the manager), who provides the effort. Both are assumed to be utility maximisers. Principals value end-of-period wealth which is derived from their share in the realised value of the firm. Agents value their end-of-period wealth stemming from the realised profit. Agency problems arise because, under the behavioural assumption of selfinterest, agents do not invest their best efforts unless such investment is consistent with maximising their own welfare. The agency model is basically a formulation of the principal’s problem of choosing the ‘best’ employment contract for the agent, where ‘best’ is defined in the context of Pareto optimality. A Pareto optimal contract is such that no other contract can improve the welfare of one party without reducing the welfare of the other. Observability of the agent’s effort is really the core of the incentive problem in this theory. While the effort level determines the level of output of the firm (i.e. the end-of-period value or cash flows), the output is also affected by random events that are beyond the control of the agent. An agency problem arises when the consequences of the agent’s efforts cannot be distinguished entirely from the consequences of other random events by observing output alone. In the tradition of the agency theory, the output (payoff) level is mutually observable by the principal and the agent, but the effort level is observable only by the agent. First best contracts induce an optimal risk-sharing between agent and principal. Further adverse selection is often introduced between the two parties. Consider an owner-manager who seeks to finance a project by

8

AGENCY THEORY AND MONITORING

selling securities, while the true nature of the return distribution of the project is unknown to the outside market. Management possesses valuable information about the project that is unavailable to the market. If this information were revealed fully to the market, the market would value the project at V . Otherwise, the market is unable to distinguish a this project from another less profitable project with a value V . This b asymmetry may be corrected, at a cost, through various ‘signalling mechanisms’. In the absence of an unambiguous signal, however, management will obtain less for securities sold than their ‘fair value’ reflected in the true nature of the project A. The difference between the ‘fair’ price and the actual price is the agency cost associated with informational asymmetry. It exists for the issuing of debt as well as new equity securities, provided that there is a differential probability of bankruptcy for the two projects. In their seminal paper, Jensen and Meckling (1976) proposed agency costs as a key tool in evaluating designs of a principal-agent relation. Agency costs were defined as the sum of: 1 the monitoring expenditure by the principal; 2 the bonding expenditure by the agent; and 3 the residual loss, i.e. the monetary equivalent of the reduction in welfare experienced by the principal due to the divergence between the agent’s decision and ‘those decisions which would maximise the welfare of the principal’ (ibid.: 308). The agent receives compensation for his work and supports part of the agency cost (bonding expenditure). Adverse selection can be described through three categories of model. The first is represented by a situation of moral hazard with hidden action. Under moral hazard, it is easier for the principal to observe the manager’s output than his effort. The principal offers a contract to pay the agent based on output which depends on the agent’s effort. We can represent this situation by a game tree. In the model, the principal (P) offers the agent (A) a contract, which he accepts or rejects. After the agent accepts, nature (N) adds noise to the task being performed. Figure 1.1 illustrates this situation. If the principal knows the agent’s ability but not his information level about the potential investment, the problem is moral hazard with hidden action. An example is given by F.Gjesdal (1982), whose paper considers the use of imperfect information for risk sharing and incentive purposes between bondholders and stockholders when perfect observation of actions and outcomes is impossible, making complete contracting infeasible. The incentive problem consists of two parts: the choice of information system and the design of a sharing rule based on the information in the agency problem.

9

THE ROLE OF BANKS IN MONITORING FIRMS

Figure 1.1 Moral hazard with hidden action

Figure 1.2 Adverse selection models

The second case concerns the largest part of the agency literature: adverse selection models. Adverse selection can be represented by Figure 1.2. Kose and Kalay (1982) illustrate adverse selection by analysing the conflicts between two groups (stockholders and bondholders) concerning the riskiness of company projects. They derive an optimal set of contractual arrangements which minimise the cost of this conflict. In that sense, these authors come back to the idea of Myers (1977), who has argued that stockholders who control the firm could attempt to transfer wealth from the bondholders, even by rejecting profitable investment projects. In other words they can choose policies which reduce the market value of the firm. Myers has indicated that self-imposed constraints on dividend pay-outs by stockholders are a possible solution to the problem of under-investment. The debt contract between a bank and the manager of a firm defines the adverse selection problem. According to the recent literature, such as Laffont and Freixas (1988), Gale and Hellwig (1985) and Diamond (1984), the assumption of asymmetric information leads the bank to prefer credit rationing, to an equilibrium between supply and demand at a specific interest rate. The agency relations between a bank and a firm prevent the lender from distinguishing sound creditor risks from bad ones. The requirement of a guarantee can solve such problems and enables the lender to separate good borrowers from the bad ones. In this context Deshons and Freixas (1987) establish two types of loan system: • •

the optimal separating contracts, where good credit risks are identified; the rationing credit solution, where neither guarantee nor interest rate make the selection role possible since the bank is unable to take the surplus of its loan customers.

10

AGENCY THEORY AND MONITORING

Figure 1.3 Signalling model

The latter situation, represented by Figure 1.3, is the signalling model. The agent sends a signal to the principal. For example, the managers of firms transmit information to the shareholders and the creditors of the firm they administer. This activity of signalling has two aspects: • •

the manager of a good firm sends information to the external investors to signal that the enterprise is a good firm; however, the manager of a bad firm might use the same signal to make investors think that the enterprise is a good one, but it is more costly for him to do so.2

A penalty system must be in place to prevent the manager of a bad firm from sending false signals. The problem of signalling in the determination of the debt level of a firm is expressed by the diversification of a security portfolio for a manager-shareholder. If the latter possesses a good productive investment, he will inform the market by the composition of his portfolio. If the project is really good, he will devote a significant part of his savings to it, to the detriment of other projects. As he is the best informed, his less diversified portfolio is a signal which can indicate the value of the project. Leland and Pyle (1977) conclude that the value of the enterprise is positively correlated to the proportion of capital held by the shareholder-manager. But the authors emphasise that this relation is a non-causal statistical relation between the value of the firm and its debt level. Every modification of the manager’s portfolio induces a change in the perception of the future liabilities by the market: it results in a new financing policy, and ultimately another value for the firm. In this context, the level of diversification in the assets held by a firm constitutes the most valuable information as regard the value of the firm. As observed by Jensen and Meckling (1976) or Grossman and Hart (1983), if a firm does not want to be indebted, its risk of bankruptcy is limited but the market will suppose that the maximum performance for the firm has not been attained. In the opposite case, a loan from a bank increases its risk of bankruptcy, which obliges the managers to be more efficient. This argument illuminates the divergence of objectives between the different partners: the

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THE ROLE OF BANKS IN MONITORING FIRMS

shareholders, who seek dividends, the managers, who must signal the value of their organisation by diversifying their portfolio, and the banks, which grant credit and want to avoid losses if the firm goes bankrupt. To conclude these first two points, it seems that the application of agency and signalling theory to finance decisions is concerned with the influence of conflicts between shareholders and managers over the value of the firm, and the resolution of these conflicts by the use of debt. The latter involves an incentive scheme for performance. The debt increases the bankruptcy risk, which is a threat sufficient to encourage the manager to administer efficiently. Bankruptcy will mean for the manager not only loss of his work, but also being held responsible for the situation. In these models, debt is defined by an optimal contract for the firm, and the optimal structure of the enterprise is a combination of debt and stocks. So, the financial parameters justifying the limits of debt policy can be deduced by analysis of the shareholders’ and managers’ points of view (e.g. level of risk of the project, expected profit, etc.). However, these theories have a certain number of limitations. In particular, the same financial indicators have specific roles in each approach. The debt level constitutes a very manipulable variable for the administration of the firm. It signals the quality of an enterprise for Ross (1977). It is the origin of the agency cost for Galai-Masulis (1976) and Jensen and Meckling (1976). The results of these analyses do not seem to be very coherent: an increase in debt or in the part attributed to the manager and shareholders in the capital induces an increase in the market value of the firm, according to the signalling models. But the difficulties due to agency relations then become more and more pronounced. Myers (1977) has taken an interest in this problem. He explains that three financial parameters must be taken into consideration at the same time: the dividend distribution, the amount of investment and the level of debt. Agency costs appear there as one of the essential elements of a new kind of signalling model. For Myers, the existence of debt for an enterprise can generate a sub-optimal level of investment: the nature of equity and the financial structure can be modified such that the investors do not maximise the value of the firm but the value of the stocks, to the prejudice of debt.

(b) Common agency As indicated above, agency theory aims to explain the conflicts of interest and differing information that could exist between the different partners of the firm: managers, shareholders and lenders. Every partner determines the optimal level of debt according to his own interest. The manager wants to find the amount of

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funds he thinks sufficient. For the shareholders and the bank, investment is a way to realise profit. However, the latter actors bear different costs. The shareholders give the manager financial compensation for this work, while the banker pays interest costs for granting the credit (Laffont and Freixas 1988). In this section, possible areas of common interest between these three actors in the financing of the firm will be discussed. In particular the following question will be asked: are these different objectives sufficiently compatible such that the common determination of debt for the firm might be possible? Are there situations where the three partners are led to define jointly the very price to pay, so that the firm could finance its productive activities through an optimal level of debt? When several economic agents must take a decision in which they are all concerned (for example, the conclusion of a debt contract between bank and manager, preserving the solvency of the enterprise and the wealth of the shareholders) the economic argument is both normative (what is the optimal price of debt for a firm?) and strategic (which price results from the confrontation of these different interests?). In fact the shareholder is likely to be in favour of debt which gives him more profit and decreases his level of risk-sharing. However, if the manager invests in high-risk projects, the risk of bankruptcy increases. Lars Stole (1990) has considered the contracting problem facing multiple principals, each of whom wants to contract with the same agent. This has been termed the common agency. Common agency can either be delegated or intrinsic. Under delegated common agency, the choice of contractual relationship is delegated to the agent, who can choose whether to contract with both, one or none of the principals. Alternatively, when common agency is intrinsic, the agent’s choice is more limited: the agent can choose only between contracting with both or with neither. Consider a contracting environment with two principals and one agent. A first possibility is that each principal wants to share the profit of a given outcome which the agent produces. Each agent is represented by a type which describes the characteristic of the projects undertaken by the manager. A direct revelation mechanism incites the agent to announces his type to each principal separately. If the agent contracts only with one principal we return to the literature defining contracts between either shareholders and manager or between bank and manager. If the agent contracts with no one, as he has not enough money to realise the project, he cannot carry it out. The only interesting case is where all parties contract: •

Stage 1 The principals announce the contract which they wish to sign with the manager (agent). A contract specifies a project, a reward scheme for each configuration of the market (principal-agent) and the credit to be granted. We assume that offers between principals and agent are private information.

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•

•

Stage 2 The manager of the firm (agent) announces which of the offered contracts he is willing to accept. The announcement is public information (each agent must inform the principals whether he wishes to deal with that project exclusively or in conjunction with projects of other firms). Public observability of the announcement is not essential, but simplifies the description of an equilibrium. Stage 3 Each principal selects the manager which is willing to undertake the project and to accept the proposed contract. At the same time, principals announce the amount of capital they grant for its realisation. These choices are observable. Assumptions

First, all players are risk-neutral. While risk-neutrality on the part of the principal is not essential, a risk-neutral agent is indispensable in what follows. For example, as mentioned in stage 2, a manager can undertake several projects with differing levels of profitability, which enables him to spread risk. Second, principals are allowed to condition the terms of contracts upon the market. This feature of our model illustrates an important aspect of agency delegation. Since a principal’s decision to abandon a common agent (manager) constitutes an observable change in market environment, competitors may renegotiate their contracts in response. 3 Stage 1 of our model provides a simple way to represent this process of reactive renegotiation: the principal simply announces an amount of funds and an incentive scheme for every possible market configuration. Note, however, that, as long as a principal retains the same agent, other principals cannot respond directly to changes in its contracts since contract offers are private information. Consider now the model described above, but modify the description of the agency delegation process as follows. In stage 1, each principal makes one contract offer (credit incentive scheme) to the same agent (the manager of the firm). In stage 2 this single agent either accepts both offers or neither. If he rejects, principals earn zero profit and the game ends. In this simple model, common agency is intrinsic in the sense that the agent has no alternative to the pre-specified delegation. Bernheim and Whinston claim that: non co-operative behaviour induces an efficient (potentially second best) action choice if and only if collusion among principals would implement the first best level cost.4 In an earlier paper5 they discussed the possibility of collusion between shareholders and bank to reach an equilibrium. This leads us to consider the supervisory role of banks and shareholders in the agency theory.

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Agency as control is tied to compensation in at least three different ways. The first is a causal relation: compensation helps to define the agency relation, much more than the reverse. Compensation’s incentive role (giving the agent an incentive to act in the principal’s interest) is less important than its informative aspect: agents must know what their responsibility is (for example, as regards the solvency of their organisation) and how it changes each time the financial structure is modified. Performance-related compensation for managers may be primarily a vehicle for defining their duty. But if the bonus scheme or other form of incentive compensation is mechanical, conveying little about the kind of performance to be elicited, the scheme does not signal agency relations. This first connection between compensation and agency has to do with bringing agency into the formal organisation. The second connection brings agency into public markets, answering the question: in which direction should the cash flow component of compensation flow? For example, in a financial corporation this constitutes a way to achieve control on managers of firms, by giving them an incentive to maintain a reputation towards their lenders. As a third illustration of the relation between agency and compensation, consider the question of appointment of the different actors of the firm. The manager is the agent not only of the shareholders but also of the bank which finances its projects. Any study of corporate structure must therefore consider two very different interfaces: that between the shareholders and the manager, and that between the manager and the external investors. 1.3 THE SUPERVISORY ROLE OF THE BANK IN AGENCY LITERATURE The bilateral principal-agent question considers that one individual, called the agent (e.g. the manager of a firm) performs duties on behalf of another party, the principal (external investors: e.g. the bank and the shareholders). This theory explains 1 2

why debt was relied upon as a source of capital before debt financing offered any tax advantage relative to equity; why shares are issued when financing a project.6

In this section, I study the theoretical framework concerning the role of banks in monitoring the enterprises with which they are involved. More generally, how do financial institutions affect the allocation of funds for investment?

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Some authors who have considered this question have observed that financial systems differ significantly between countries and across periods, and the question arises how these differences between financial systems have affected the functioning of the different economies. In this section I am going to concentrate on two case studies, Japan and Germany, in order to contrast the results obtained for these two countries with those relating to the Crédit Mobilier in Chapter 2. As a first illustration of this concept, let us consider the paper of Mayer (1988). The author suggests there that there are systematic differences in performance between financial systems in which banks play a prominent role, and those financial systems in which banks are less prominent. He explains these differences in performance in terms of differences in the mechanisms that reduce or eliminate moral hazard between entrepreneurs and financiers. Specifically, he suggests that the more bank-oriented systems of Germany and Japan involve greater commitment on the part of the firm and the bank to a long-term relationship, which allows them to enjoy the benefits of long-term contracting. In this section, the following issue is considered: in what sense is ability to support long-term relationships the clue to assessing financial institutions? The focus of the discussion will be on financial institutions (more specifically, the role of banks in the provision of finance to firms), rather than financial instruments.

(a) Internal finance, external finance and bank finance: theoretical presumption in historical assessment Theoretical framework The manager-debtholder literature has two sub-literatures. First there is the issue of the manager-bondholder conflict. There are numerous theoretical discussions of the role of bond convenants in controlling the manager’s and (or) shareholders’ incentive to increase the risk of the firms. This literature has treated debt mostly as a homogeneous instrument creating incentives, in direct conflict with those associated with equity financing. Second, there is the borrower-lender literature which has developed from the simple examination of the incentive of the borrower to default on a bank loan, to the role of the bank as the delegated monitor of a portfolio of borrowers, i.e., a monitoring role for the bank’s depositors.7 These latter models have served to strengthen the argument that there is a unique information and monitoring role of bank loans and that the phenomenon of credit rationing is due to the nature of information asymmetry in the market. The argument discussed here is richer than the traditional literature briefly presented above. Essentially based on the model of Devinney and Milde (1990), it incorporates the role of ‘inside debt’. Inside debt, as

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defined by Fama (1985), is debt which explicitly incorporates monitoring by giving the debtholders access to otherwise proprietary information. The modelling framework used here is that of an asymmetric information game. Managers are viewed as choosing amongst alternative investment projects which require the same initial outlay but differ in terms of risk. Greater bank monitoring affects the project chosen by the manager, while the bank’s choice of loan contract terms affects management effort. Outside stockholders choose the managerial incentive contract and, hence, the level of risk-sharing between managers and stockholders. The major assumptions of the model presented by Devinney and Milde are the following: 1 The expected payoff of the project, µ is a function of management effort e with the properties µe > 0 and µee < 0. 2 Both debt L and equity S are used to finance the project. 3 All debt is inside debt (bank loan) as defined by Fama (1985). 4 The equity position consists of both ‘inside’ equity and ‘outside’ equity. Inside equity is owned by the management and is a fraction α of the total equity outstanding. The remaining fraction (1–α) is the equity position held by outside owners. 5 Outside shareholders determine the fraction of equity given to the managers, α, and the managers’ fixed income component H. Managers are prohibited from trading the equity of their corporation in the stock market. 6 Banks determine the level of monitoring activities m, the loan size L, and the (gross) loan rate R=(1+r) 7 Managers choose the project, i, and hence its riskiness, σ and the level of effort, e. 8 Banks can monitor the managers’ choice of project (risk) but monitoring is costly. Total monitoring costs are M=νm, where ν is the per unit monitoring cost. 9 Neither outside stockholders nor banks can monitor the level of managerial effort. 10 Stockholder and bank expectations are rational in the sense that they can calculate the management’s response to changes in their decision variables. 11 All decision-makers are risk-neutral. Under these assumptions, how can the bank-stockholders management equilibrium be determined? The manager’s responsibility is to accept or reject the projects and choose their effort. We consider that only one project can be undertaken. The chosen project is characterised by specific µ (its expected payoff) and its riskiness s is observable to the bank but not outside

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stockholders. By assumptions 6 and 8, managers cannot do anything but follow the bank’s instructions regarding s. The effort level choice e=e* is optimal if the marginal expected payoff to the manager is equal to his/her marginal opportunity cost. More specifically the relationship between e* and the decision variables determined by outside shareholders and banks are the following: • • •

an increase in the fraction of internal equity increases the manager’s effort; monitoring leads to higher effort levels by management; increasing the loan size and/or the loan rate will increase the effort until it threatens the solvency of the firm.

Banks can monitor the manager’s choice of s and/or participate in the decision-making process. By increasing monitoring and/or participation, banks can enforce their interest more and more, thus eliminating the tendency of management to undertake higher-risk projects. Then the bank’s decision-making process leads to three components characterising a loan contract: interest R*, loan volume L* and risk s*. The risk, s*, however, is implicitly determined by bank monitoring, m*. This contract specifies the second best solution and is consistent with the manager’s effort response function. The distinction between internal and external debt is similar to that between internal and external equity and can explain the monitoring role of the participants in the financing of investment projects. Theoretical presumption in historical assessment The economic theory stresses the notion of effort to explain the monitoring role of banks and stockholders towards the managers of firms. The main argument of the literature is based on the notion of ‘capital scarcity’. Capital is regarded as scarce because: •

•

in the late nineteenth century, a hundred years after the beginning of the industrial revolution, the adoption of up-to-date technology required large capital outlays; and the failure of some countries to participate in the earlier stages of industrialisation meant there was a lack of accumulated funds that could be used to finance these outlays.

Gerschenkron (1962) studied this notion of ‘capital scarcity’ and applied it in the context of German industrialisation from 1850 to 1914. He observes the prominent role of German banks in providing liquidity for heavy industry with large capital requirements.

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Gerschenkron’s argument is as follows: over the period, the firms’ retained earning were insufficient to finance desired investment. At this point, Gerschenkron raises two questions: 1 2

Why should an insufficiency of internal finance be seen as characteristic of a situation of ‘economic backwardness’? Why should the large-scale provision of external finance to industry require the intervention of banks or government?

The first question really concerns the role of internal finance in an industrially advanced country. It is clear that, in the second half of the nineteenth century, certain advanced technologies required large-scale investments. It is also clear that firms in the less developed countries had not had time to accumulate the funds required for such investment. However, it is less clear why firms in the industrially more advanced country should have retained earnings to such an extent that further industrialisation could be financed without the same level of recourse to outside finance. Gerschenkron’s interpretation is that the involvement of banks or government is needed to provide outside finance to industry on a large scale. External finance from the anonymous markets of our theoretical models is not seen as an alternative. Bank finance here is not necessarily just loan finance. During certain periods, especially prior to 1873, German companies obtained substantial amounts of equity finance from banks. The shares would be held by banks, or by clients of banks acting on the banks’ advice, and in many respects banks were as much involved in equity finance as in loan finance. While share markets were organised, they were certainly not anonymous and free for all. The question is to what extent bank involvement in equity and loan finance was actually necessary. According to Gerschenkron’s argument, bank finance could do something that anonymous organised financial markets could not. So we need to discuss what exactly the comparative advantage of bank finance is. This is the subject of the following section.

(b) The advantage of bank finance versus market finance The discussion of the advantage of bank finance over market finance implies that financial systems are institutions which reduce or eliminate problems of moral hazard or asymmetric information between firms and financiers. Financiers typically have less information about firms than entrepreneurs or managers. Moreover, investors are subject to various types of moral hazard: moral hazard concerning managerial effort, moral hazard concerning the

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THE ROLE OF BANKS IN MONITORING FIRMS

riskiness of the firms strategies and moral hazard concerning reported ex post return realisation. These problems of moral hazard and asymmetric information cause difficulties for the provision of finance to industry.8 Intermediaries are taken to reduce these difficulties by engaging in monitoring and control activities. Diamond (1984) presents an explicit example in which intermediation successfully reduces the agency costs of outside finance under moral hazard. In his analysis, the feasibility of financial intermediation rests on two key propositions: 1

2

Monitoring and control of a firm involve natural scale economies: a single intermediary can monitor and control the firm as effectively as thousand of shareholders—but much more cheaply. If the intermediary has a well-diversified portfolio of firms that he finances, then relations between himself and his own financiers—the final investors—are not much affected by moral hazard and asymmetric information because his own return is approximately riskless, so for him, fixed interest debt finance is feasible and does not involve any moral hazard.

On the basis of these two propositions, Diamond shows that under certain circumstances incentive-efficient allocations cannot be made without intermediation. Diamond’s notion of financial intermediation as delegated monitoring (or delegated control) is closely related to Gerchenkron’s account of bank involvement in firms at the early stage of industrial development, although this is not explicit in Gerschenkron’s work. As emphasised by Mayer, bank initiative and bank participation in entrepreneurial planning may be a way to obtain enough information and control to reduce the moral and informational hazards of finance to a tolerable level. We may therefore look at the imperfect information approach to financial intermediation as the theoretical basis for Gerchenkron’s view that banks were needed to provide outside finance during the early stages of industrialisation in Germany, when capital was ‘scarce and diffuse’ and ‘the distrust of industrial activities…considerable’. In Diamond’s terminology, Gerschenkron’s assumption must have been that the sum of the monitoring costs of the banks and direct agency costs of bank deposits was less than the agency costs of direct finance, perhaps even that the agency costs of direct finance were so high that this was not a genuine alternative at all. According to this approach, supervision seems to be profitable for both the bank and the shareholders, which stand to benefit from higher profits by reducing their agency costs. It will be interesting to analyse which type of contract is induced to exert this control. In other words, are long-term commitments necessary to control firms?

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(c) Monitoring and the definition of contracts between banks and firms ‘Monitoring’ ought to be understood in a broad sense as any form of information-gathering about a firm, its investment prospects and its behaviour. This information is useful because it serves to sort out ‘bad’ projects and/or to punish ‘bad’ behaviour. The literature contains the following justifications for monitoring: • • •

Monitoring of the firm’s profit returns makes it possible to conclude contracts in which the financiers’ claims are related to the firm’s profits.9 Monitoring of the firm’s characteristics, i.e. a creditworthiness test, makes it possible to avoid bad loans.10 Monitoring of the firm’s behaviour during the loan application stage makes it possible to avoid loans to firms that are following too risky an investment strategy.11

In all these examples, the role of monitoring is straightforward. The main distinction is between monitoring that takes place before a contract is agreed, and monitoring of the execution of a contract. The former serves to reduce the proportion of bad loans, the latter serves to improve performance under the agreed contract. Monitoring that takes place before a contract is signed may give rise to an interesting problem of competition for contracts. In the following chapter, when describing the role of the Crédit Mobilier in French industrialisation, this competition will be referred to. In particular, the fight between the Péreires, founders of the bank, and the Rothschilds, as regards the railway companies, illustrate this point perfectly. More specifically, the competition between these two families discouraged monitoring: over 1861–7 the Rothschilds’ first objective was to prevent the Péreires from expanding their financial power. The Rothschilds’ reputation in the market won them preferential access to many companies, including the railways. This competition prevented the Péreires from exerting their control efficiently. Monitoring that takes places after a contract has been concluded stresses the length of the commitment between the firms and the bank that provides the funds. Mayer suggests that financial intermediation may lengthen the investment horizon of firms. He considers a model with two investment periods. There are two types of firms, ‘good’ and ‘bad’. Firms can choose between two investment strategies, short-term and long-term. Both strategies require identical amounts of funds in both investment periods. However, the long-term strategy has a relatively higher expected payoff in the second investment period. Model parameters are specified in such a way that ‘bad’ firms should not

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receive funds in either period. However, ex ante, there is no way for financiers to distinguish between ‘bad’ firms and ‘good’ firms. After the first investment period, a partial distinction may be possible because there are two sources of information: costless observation of first-period returns, and costly monitoring. In the absence of monitoring, banks interpret low first-period return realisations as an indication of poor quality, and discontinue financing. Anticipation of such behaviour induces firms to opt for the short-term investment strategy even though the long-term strategy may eventually be more profitable. This theoretical consideration can be illustrated by two examples: France and Germany. The policy of German banks as regards investment was essentially short-term and concerned enterprises where the expected profit was quite high (the mining industry). However, this does not mean that the German bank never undertook risky projects in the late nineteenth century. According to Tilly, 12 these banks used their information advantages and their freedom from liquidity worries to engage in investment strategies that involved high risks as well as high returns. The commitment of a German bank in a risky project induced a more careful control of the performance of the company. This idea will be developed further in the two following chapters when interpreting the empirical work proposed for the Crédit Mobilier. This last bank was quite different as regards the control it could exert on the companies with which it was involved. Despite the fact that it undertook risky projects, its supervisory role was very limited, and sometimes totally ineffective (as in the case of the Compagnie Immobilière). The real question is how monitoring fits into the overall relationship between the intermediary and the firm. Monitoring as a form of informationgathering about the firm is useful only because the information that is collected has consequences for behaviour and resource allocation within the relationship. The notion of financial intermediation as delegated monitoring must encompass such uses of information as well as the act of collecting the information. This consideration brings us back to the idea of incentive contracts presented in the preceding section. Let us recall the basic concept. From the theory of optimal incentive contracts, we know that even noisy monitoring will improve performance under an optimal incentive contract. 13 By combining this result with the procedure of Diamond that was outlined above, we obtain a new version of financial intermediation as delegated monitoring, one that emphasises the incentive effects rather than the sorting effects of monitoring. An interesting point will be to apply it to the financial systems of the late nineteenth century. Monitoring as an element in an incentive contract relationship is not at all that far from the accounts of Gerschenkron and Mayer.

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Consider Gerschenkron’s observation that banks played a key role in the formation of cartels in German industry. Any cartel is subject to the moral hazard problem that the individual firm has an incentive to under-cut and to serve more than its allotted share of the market. Banks that are involved with several firms in the same industry have an incentive to restrain such behaviour, in order to increase the aggregate gross return they can earn from the industry. In the following chapter we compare these considerations on the German case to that of the Crédit Mobilier. So far we have studied how the interdependence between information provision to firms and information collection about firms affects the functioning of financial intermediation as delegated monitoring. It will be interesting to debate how this delegation takes place effectively.

(d) Financial intermediation as a mechanism of commitment In this section the advantages of a close relationship between bank and firms will be described. Mayer (1988) considers that financial intermediation in the form of a close relationship between the bank and the firm constitutes a mechanism of commitment. Mayer suggests that Japanese banks are more willing to engage in corporate rescues than financiers elsewhere because the bank-firm relation in Japan involves a mutual long-term commitment. Some rather striking quantitative evidence on this point is provided by Hoshi et al.14 For a sample of Japanese firms they found that the cost of financial distress was significantly less for firms that had close relations to a ‘main bank’ than for firms that did not. To measure this relationship, they evaluated the degree of correlation between investment and cash flow for firms affiliated regularly with a bank, and for independent firms. Formally, they prove the following: that firms that have close banking ties appear to invest more and perform better than firms that do not have such ties. This proposition is crucial for the work presented here. In the next chapter, which is devoted to the empirical study of the Crédit Mobilier, the validity of this hypothesis will be investigated: as this bank went bankrupt in 1867, if the above affirmation were valid, the share prices of the companies with which the Crédit Mobilier was involved should have fallen relative to other firms; surprisingly, a formal test presented in the next chapter does not support this hypothesis. The question we should ask now is, to what extent should a system of corporate finance based on intermediation through a ‘main bank’ be regarded as internally stable? Mayer seems to believe that the superior performance of such a system is a guarantee of its persistence over time. In

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contrast, Gerschenkron (1962) regarded it as being transitory, with firms depending on outside finance through banks only until they have enough inside finance available. The empirical research reported below will test these assertions in order to clarify the financial role played by the Crédit Mobilier in French industrialisation. Similar patterns can also be observed in other countries. Thus Hoshi et al. report that in Japan, too, the larger, more profitable companies availed themselves of the newly developing organised markets to become more independent of their banks. In the long term, there is a certain tendency for firms to emancipate themselves from such a relationship, using markets, competition amongst banks and, above all, reliance on internal rather than external finance. The emancipation of firms from close banking relationships is certainly not costless. Recall the observation of Hoshi et al. that the costs of financial distress in Japan are significantly larger for firms without close banking relations than for firms with close banking relations. For firms that are not in financial distress, Hoshi et al. report a similar observation: hence the emancipation of a firm from a ‘main bank’ relationship is accompanied by a significant increase in the sensitivity of current investment to fluctuations in current earnings and liquidity. Bank loans are less used and/or available to smooth over fluctuations in earnings. From the perspective of Jensen and Meckling (1976) one might argue that internal finance has priority because the agency costs of internal finance are lower than the agency costs of external bank or market finance. This is also the explanation given by Myers and Majluf (1984) in the context of a model of asymmetric information and signalling. Internal finance is taken to have no agency costs (signalling costs, simple inefficiencies) because it represents the use of funds available to the firm itself. External finance has no agency costs because information asymmetries and externalities preclude the attainment of a first-best allocation in the arrangement between the firm and its outside financiers. From this perspective, the Hoshi et al. observation of investment sensitivity to current earnings should be seen as evidence of the agency costs of outside finance: investment projects that might be expected to be profitable under internal finance are deemed to be unprofitable under outside finance when the agency costs of outside finance are added to the mere opportunity costs of funds. The inefficiency in the allocation of funds across the firms that results when investment opportunities are less than perfectly correlated with earnings is nothing but an element in the overall agency cost of outside finance. 1.4 GENERAL CONCLUSION This first analysis describes the relationships that exist between the manager of a firm, its shareholders and the bank which finances the investment

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project, in the context of asymmetric information. As we have shown in the first section, each partner wants to define the debt contract according to his own interest. The manager is willing to find the amount of funds he thinks acceptable to undertake his investment project. For the shareholders and the bank, this commitment is a way to realise profit. However, the latter actors bear different costs. The shareholders give the manager a financial compensation for his work, while the banker supports the interest cost for granting the credit.15 As there is asymmetric information between the economic agents, we must determine which actor(s) is (are) able to control the manager and if necessary punish him when he does not truthfully reveal the necessary information about the productive project. There are two possible candidates: the shareholders of the firm, or the bank which finances the projects. Let us consider first the shareholders. In order to exert this control effectively, the shareholders have to agree unanimously, or at least on a majority basis. On the other side, the bank disposes of a number of tools to control its affiliated companies more efficiently. Our analysis shows the power of banks in screening the investment projects of firms with which they are involved. As pointed out in the survey of the literature, some authors carried out empirical studies of the efficiency of certain financial systems. More precisely, Gerschenkron for the nineteenth century and Hoshi et al. for the recent period have analysed the power of banks. They have stressed the importance of banks in controlling the investment policy of their affiliated companies. My aim is now to apply their methodology to the French case. As I have chosen the same period (1852– 1914), I intend to compare my results to those obtained for Germany and Japan. In particular, I shall investigate whether the power of banks in the French financial system was as strong as in Germany.

25

2 THE CRÉDIT MOBILIER AND THE FRENCH STOCK EXCHANGE 1853–1914 An empirical perspective The fate of the Crédit Mobilier is characteristic not only of the rivalry between financial groups, and of the dangers of speculation on the stock exchange: it highlights an ever present problem of industrial involvement.1 Bouvier (1988:109)

2.1 INTRODUCTION The aim of this work is to gain, through empirical research, an insight into the role of banks in the financing of enterprises during the period 1850– 1913 in France. Some authors (e.g. de Long (1989) and Ramirez (1992)) have already applied this analysis in the United States. The credit which a bank gives to a company enables it to exert an influence over the company. 2 J.Bradford de Long has illustrated the role of investment bankers in his article ‘Did J.P.Morgan’s men add value? A historical perspective on financial capitalism’. In the period of which he writes, financiers possessed strong voices in corporate management. The author illustrates his point of view by focusing on the J.P.Morgan Company. J.P.Morgan and his partners saw themselves, as did other participants in the pre-WWI securities industry, as fulfilling a crucial monitoring and signalling intermediary role between firms and investors, in a world where information about the underlying values of firms and the quality of management was scarce. De Long stresses that investment bankers played an important role, in that they took great care to make sure that the firms they watched had the right managers. This analysis fits our hypothesis that the bank can control the management of a firm and motivate it to reveal truthfully the information about the project it proposes to undertake. Another line of research has been made in the German context. The roles of four banks—the Deutsche, the Diskonte Gesellschaft, the Dresdner, and the Darmstädter—have been studied, producing the same

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

conclusion. Bradford de Long and Marco Becht (1992) have used price and dividends series to test the volatility of the German stock market. In particular, they examined whether the role played by the German Großbanken in the pre-WWI stock market might have been the cause of the low comparative volatility of the German stock indices before 1914. These ‘Great Banks’ were founded in deliberate imitation of the French Crédit Mobilier. There has been much discussion about the origin of the early German credit banks, and especially to what extent the Crédit Mobilier served as a model. The first significant joint-stock bank was created in 1848: the Schaaffhausen’schen Bankverein. During the crisis of the 1860s’ recession it faced a liquidity problem. Because of the bank’s importance and the strained atmosphere of the times, normal liquidation procedures did not occur. The Darmstädter was a direct result of the French Crédit Mobilier. It counted among its founders Abraham Oppenheim, who had been co-founder of the Crédit Mobilier. Much of the initial capital of the bank was supplied by the Péreire brothers. These banks had access to considerable capital with which to provide finance to corporate enterprises. They contributed to the intensity of the boom of the 1850s. Despite the crash in 1857 and the depression of the 1860s, most of the banks survived. The early German banks remained permanently tied in with the companies which they promoted, through representation on boards of directors and direct participation in ownership. How this cautious approach can be reconciled, at least in theory, with the role the banks wished to play in the development of industry, is clear from the Schaaffhausen’schen Bankverein for 1852 The management has proceeded from the principle that it is the function of a great banking institution not so much to call great new branches of industry into existence through large scale participation on its own account as to induce the capitalists of the country by the authority of its recommendations, based on thorough investigations, to apply their idle capital to undertakings which, properly planned, corresponding to real needs, and equipped with expert management, offer prospects of reasonable profits. 3 The case of the Crédit Mobilier will be analysed to see if, as in the American and German contexts, bankers possessed strong voices in corporate management. From 1853 to 1913 this bank took part in the financing of firms. In fact, two ‘Crédit Mobiliers’ existed. The first, founded by the Péreires, went bankrupt in 1867. After its bankruptcy it was reorganised, but it went bankrupt again in 1900. It reappeared in 1903 as the

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THE ROLE OF BANKS IN MONITORING FIRMS

Crédit Mobilier Français. In 1932 it merged with the Banque de l’Union Parisienne. The most interesting banking model was, of course, the first Crédit Mobilier, because of its innovative characteristics and because of the power it had reached in financial markets and among banks. That was certainly one reason why the Péreires faced a certain amount of criticism. The first criticisms arose when they envisaged the possibility of founding a bank capable of issuing money. The Banque de France refused categorically to allow this. Their commitments in various risky sectors (for instance, the property business with the Compagnie Immobilière) contributed to their failure. However, they tried new banking techniques for financing industries. The advances they granted to the companies with which they were involved could be considered as innovative, matching the ideas the Péreires had on finance. To the Crédit Mobilier, the role of a merchant bank was to provide the necessary funds in order to contribute as fully as possible to the industrial development. This idea was new and sometimes unrealistic. The aim of this chapter is to verify whether, as de Long (1989) suggests, a close relationship with a bank is always beneficial for firms, increasing the market value of their shares. In that respect, the place of the Crédit Mobilier in the banking sector will be analysed. De Long maintains that an association with J.P.Morgan facilitated the assessment of company managers’ performance and the careful evaluation of projects. Having J.P. Morgan act as an intermediary partially resolved the principal-agent problem between shareholders and managers. A similar question will be asked about the Crédit Mobilier for the period 1853–1914; namely, ‘did the Crédit Mobilier increase the ratio of market value to book value?’ Attention will then turn to the private participation of the Péreire brothers in the financing of firms. In particular, we will investigate how the Crédit Mobilier may have increased the value of shares by providing liquidity. This question will be of interest at the point when the Crédit Mobilier went bankrupt. Bradford de Long maintains that investment banker representation on boards allowed bankers to monitor the performance of firms’ managers, quickly replace managers whose performance was unsatisfactory, and signal to ultimate investors that a company was well managed and fundamentally sound. If this argument is to be followed, the companies where the Crédit Mobilier was personally involved should have experienced difficulties in 1867, the year of its bankruptcy. In the second section of the chapter I will study the fluctuations of the share prices of the companies involved with the Crédit Mobilier between 1866 and 1868. According to de Long’s argument, these prices should

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

have fallen. A formal test will be presented to analyse the validity of this proposition for a sample including affiliated companies and nonaffiliated companies. The last section of this chapter will present the results obtained for a pooled panel including both affiliated and nonaffiliated firms. A comparison between France and Germany will be made. Differences and the analogies will be identified. As the German Großbanken were founded after the bankruptcy of the Crédit Mobilier, their success can be interpreted as a learning effect from the mistakes made by the Péreires. The Germans were more careful to screen projects according to their risk level, to avoid situations similar to that of the Compagnie Immobilière. 2.2 FINANCIAL CAPITALISM AND DATA ON THE CRÉDIT MOBILIER IN FRANCE, 1853–1914 (a) Some historical background about the Crédit Mobilier, the banking system and French industry The interpenetration of finance and industry was intensified by the countermovement of industrialists-turned-bankers. André Koechlin, a scion of the notable Alsacian family, head of Dollfus Mieg et Cie, and founder of the machine shops that produced the first French locomotives, became one of the most daring and successful promoters and investment bankers of the second Empire, both in France and abroad. Emile and Isaac Péreire went from railways to the Crédit Mobilier, and one of their principal associates, Baron Seillière, from a Vosges textile family, also helped to finance several large metallurgical establishments, including Le Creusot and Wendel in France and Krupp in Germany. In part, for a relatively small section of its total operations, the Crédit Mobilier functioned as an ordinary banking enterprise—that is, it accepted deposits, discounted commercial paper and made loans and advances on security. The Crédit Mobilier’s principal function consisted of lending to merchants and industrialists on ‘two-signature papers’ for a period of up to two years. (The Bank of France discounted only three-signature paper with maturities not longer than ninety days.) In an effort to obtain the sources for such loans, the bank proposed that it should be allowed to issue what would have been, in effect, interest-bearing bank notes (bearer bonds, interest bonds). The provision for interest (at 3.65 per cent per year—one centime per 100 francs per day) would have ensured circulation of bonds and if they were made receivable in payment of taxes, as the Péreires proposed, they would have acquired virtual legal tender status. (In some respects the proposal resembled a vast paper money scheme, in as much as the loans granted by the bank as well as their repayment might be in bonds.) To

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THE ROLE OF BANKS IN MONITORING FIRMS

enhance confidence in the institution and in its attractiveness to potential investors and bondholders, the Péreires also proposed that the French government should guarantee it against losses up to twenty five million francs. In the Péreires’ own words, ‘The new establishment should be considered as a lending and borrowing office [“bureau de prêt et d’emprunts”] where industry will borrow from all capitalists on the most favourable terms through the intermediary of the richest bankers acting as guarantors, because the holders of the bonds, who are the true stockholders of the association, will find an easier and safer investment for their capital without the hazards of individual loans.’4 In the spring of 1853, soon after the Crédit Mobilier began to function, the Péreires and Fould requested an agreement for a ‘Caisse Générale des Sociétés de Crédit Mutuel’, intended as the nucleus of a network of mutual credit societies in various localities and different lines of industry. The Caisse Générale was intended to perform the same or similar functions for small firms and handicrafts that the Crédit Mobilier did for large-scale industry; thus the four-fold programme implicit in their abortive Saint Simonian scheme of 1830 would be complete: commercial credit (Comptoir d’Escompte), industrial credit (Crédit Mobilier), mortgage credit (Crédit Foncier), and mutual credit for small entrepreneurs. However, the Conseil d’Etat, reasserting its prerogatives in such matters, quietly shelved the project. Shortly afterwards, the Corps Legislatif passed a law to permit departments and communes to convert and consolidate their floating debts. The Crédit Mobilier requested permission to exchange its own bonds for the debts of these local government bodies, to have them stamped by an official of the government, made payable through the receivers-general of taxes, and accepted for purchase by the Caisse des Depots et de Consignations (the official government loan office). Such measures would, in effect, have advanced the Mobilier’s bonds to the status of fiduciary money. This was never realised in practice. The power of the Crédit Mobilier had an important effect on financial institutions at that time (P.Dupont Ferrier (1925)). Jean Bouvier, François Furet and Marcel Gillet (1965)5 drew up a balance sheet of the Crédit Mobilier from its foundation until its fall, with the average profit calculated over five years (see Appendix A), which supports this argument.

(b) The financing of enterprises during the period During the period the number of financial intermediaries providing shortterm credit6 varied. Probably there were around 400 institutions on average. It is difficult to gauge the extent of their activity, as only a limited number published their balance sheets. Only the report by the General Assembly together with the balance sheets of those companies with which the banks had relations provide evidence of the amount of credit devoted to the financing of production.

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

Statistics on the issue of shares and the interest rate on the financial market give an idea of the fluctuations on an aggregate level. 7 These statistics serve as a reference point for the analysis of the relations between the Crédit Mobilier and the companies with which it was in contact. Nevertheless, operating only with its own capital and deposits, the Crédit Mobilier performed prodigious feats of industrial promotion and financial manipulation. In its first major operation, it subscribed to 40 million francs in the Crédit Foncier’s bonds, with which it maintained close ties in the early years. In its first full year of operation the Crédit Mobilier financed, by making advances and underwriting bond issues, the Midi railway as well as the newly chartered Grand Central and the French Eastern, Mulhousen and Strasburg-Basle railways. The Crédit Mobilier also secured the merger of three short railways in the Loire coal basin with the Grand Central, reorganised the Loire coal industry and promoted the Darmstädter Bank. It played a leading role in the mergers which took place in 1855 in the French Western (railway), and promoted or financed the railways of the Pyrenees, Dauphine, the Ardennes and several shorter lines. It created, with generous government subsidies, the Compagnie Générale Transatlantique (French Line), the Compagnie Générale des Omnibus (Paris), and the Société de l’Hôtel et des Immeubles de la Rue de Rivoli (subsequently the Compagnie Immobilière). The Crédit Mobilier founded by the Péreires played a great role in French industrialisation. In every company financed by this bank, a member of the Crédit Mobilier’s board of directors was represented in the shareholders’ assembly. The annual report of April 1860 is very explicit on this subject: Our company has always considered as a principle of its high commercial morality never to open a subscription, nor recommend a firm, without first having a large proportion of interest in it and its administrators having become associated with it.8 A representative from the Crédit Mobilier was present on the board of directors of each of the companies asking for funds. Table 2.1 gives details of the ownership of the shares of the Immeubles de la Rue de Rivoli in 1854 (subsequently the Compagnie Immobilière) (Aycard, 1867). The par value of capital of the company was 24 million francs, divided in 240,000 shares. The three latter members of this list were subscribers of the Crédit Mobilier. Table 2.1 shows clearly that the affiliated companies belonged to the Crédit Mobilier, unlike the German case or J.P.Morgan company. Let us refer to the question J.Bradford de Long and Marco Becht (1992) have asked in their paper: ‘Did association with the Crédit Mobilier reduce

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THE ROLE OF BANKS IN MONITORING FIRMS

Table 2.1 Ownership of the shares of the Immeubles de la Rue de Rivoli

Sources: Archives d’Entreprises Privées (General shareholders’ assembly and newspapers) of the Société Immobilière or Immeubles de la Rue de Rivoli, 1857–67

Table 2.2 Advances to companies, 1856–66

the variance of the ratio price to dividends?’ This question is an important one for the Crédit Mobilier. To be more precise in answering it, let us analyse how the Crédit Mobilier used to loan companies money. The Crédit Mobilier granted credit to the companies with which it was involved. Most of the time it gave advances to enable them to undertake their investment. Table 2.2 shows the aggregate advances made to companies between 1856 and 1866.9 Examples of advances being made without any special guarantee include the following: • • • •

In 1856 and 1857, 6 million fr, to the Compagnie Parisienne du Gaz. In 1857, 13 million fr. to the Compagnie Transatlantique. In 1855, 1856 and 1857, 29 million fr. to the Compagnie des Chemins de Fer du Midi. In 1865, out of 53,971,339 francs advanced, 52,080,709 francs went to the Compagnie Immobilière.

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

If we refer precisely to the balance sheet figures (see Appendix A), we observe that the advances are part of the investment account. These advances represent at least one third and sometimes half of the total amount of the account. This demonstrates the risky behaviour of the bank, since it did not ask for collateral. Collateral can be useful in dealing with the problem of adverse selection, as discussed in the preceding chapter. As mentioned earlier, the collateral in the debt contract has a dual role: in addition to providing financial cover in the event of bankruptcy of the firm, it acts as a signal transmitted between the parties.10 Any manager is ready to offer collateral if he thinks that the probability of bankruptcy is low. The Crédit Mobilier did not benefit from this information because it never asked for guarantees from its affiliated companies. Several hypotheses can be formulated to explain this practice. The first is that the Crédit Mobilier wanted to attract clients by offering them optimal conditions to finance their projects. Another argument refers to the situation of French industry over the period. Large numbers of companies were new. Many of the firms involved with the bank were in heavy industry (the railways, for example). They needed huge amounts of credit. The Crédit Mobilier had made the choice to invest in these sectors, thinking it could be profitable in the long term. In any case, if the French credit policy is compared to the German policy over the same period, we can see that German banks used similar practice as regards the financing of the productive projects of their companies. As the Crédit Mobilier often owned part of the companies’ equity with which it was involved, the bank was not only an intermediary but an active partner. The question is: did the Crédit Mobilier reliably screen and supervise companies? In other words, as the Crédit Mobilier took a great part in the enterprises where they granted credit, was it possible for the bank to correctly evaluate the risk of its investment? As the Crédit Mobilier gave credit without asking for any collateral, it increased the risk of bankruptcy (see the next section, concerning the fall of the Crédit Mobilier). It could be thought that, for affiliated companies, an association with the Crédit Mobilier did not always reduce the variance of share price towards dividends.11 The scale of the advances to companies emphasises the power of the Crédit Mobilier. This power was important among banks until 1865 (see Appendix A). After this date, the ‘Banque de Savoie affair’ provoked hostility among financial circles and at the Banque de France. Prominent investors such as the Rothschilds wanted to force the Crédit Mobilier out of the banking sector. However, it was the Crédit Mobilier’s position on the financial market and the Péreires’ investments in risky sectors (e.g. the Compagnie Immobilière) that eventually brought about the failure of the establishment. Before 1864 the

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THE ROLE OF BANKS IN MONITORING FIRMS

Table 2.3 Fluctuations of share prices for affiliated companies between 1855 and 1856

Sources: Archives d’Entreprises Privées (General shareholders’ assembly and newspapers)

Crédit Mobilier had been a victim of strong speculative movements: for investors, the profit realised by the institution made investors believe in its stability. To illustrate this effect, Table 2.3 sets out the values of the shares of some companies involved with the Crédit Mobilier in 1856. These last remarks lead us to ask the same question as de Long and Becht: Did association with the Crédit Mobilier stabilise the share price compared to book value? The speculative movements indicated here cast doubt on this. In the next sections of this chapter, a formal test will be presented to analyse the impact of the Crédit Mobilier bankruptcy on the stability of assets of the companies with which it was involved. The aim is to see if the Crédit Mobilier ever managed to supervise firms properly and thus to stabilise share prices. Table 2.3 suggests that the bank never really achieved this.

(c) The fall of the Crédit Mobilier The fall of the Crédit Mobilier was essentially caused by the attempt to salvage the Société Immobilière. This company’s eagerness to participate fully in the extension of Paris led its managers to undertake huge investments with poor potential. From 1864–5 the Crédit Mobilier had to confront serious difficulties arising from the Banque de France’s decision to increase interest rates. The Crédit Mobilier decided to double its capital, to support advances for the Compagnie Immobilère. But in June 1866 its situation became worst and the fall of the share prices seemed to be the consequences of the depreciation of its portofolio. The Péreires redoubled their efforts to obtain cash. It was said at the time that a loan would be granted to the Crédit Mobilier by the city of Paris, but the deal was never realised. By the end of 1866, the Péreires were contemplating the possibility of a merger between the Mobilier, the Mobiliario Espanol and the Immobilière, with a loan from the Caisse des Consignations (an agency of the government), but they did not succeed. In addition to these difficulties, the Péreires faced a stockholders’ dispute

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

concerning the increase of the bank’s capital. The Crédit Mobilier’s true situation could no longer be concealed. In March 1867, for the first time in its existence, the prices of its shares fell below par. The Péreires were forced to resign from both the Crédit Mobilier and the Immobilière. Between 1867 and 1870, little information was available. The Crédit Mobilier went bankrupt, Emperor Napoleon III, who had supported the Péreires, fell and France had to face a war with Germany. In 1871, Baron Haussmann made a deal with the bank for the repayment of its debt. This involved formally dissolving the old company, and immediately forming a new one. The new bank, called the Société de Crédit Mobilier Français, was to take over the assets of the old Crédit Mobilier.12 The impact of this new bank on the financing of French industry was so small that it disappeared from the economic literature. The bankruptcy and loss of resources meant it played only a secondary role.

(d) The reconstitution of the Crédit Mobilier and its final bankruptcy After the fall of the Péreires in 1871, Baron Haussmann, an old member of the board of directors, became President of the new Crédit Mobilier. However, as mentioned previously, the bank had lost its earlier pre-eminent role in the financing of French industry. The first aim of the new bank was to solve the difficulties of the Compagnie Immobilière. The capital of the company was divided in two parts, between Paris and Marseille. Part of this credit came from the Crédit Foncier, which had contributed to the financing of the Compagnie Immobilière: 55 million francs came from the credit of the Paris division and 32 million from Marseille. Floating assets were liquidated. The Crédit Mobilier reduced its holdings of the Compagnie Immobilière’s debt to 51 million francs by selling part of its bonds and issued new assets for an amount of 76 million francs. Half of these assets were bonds with fixed revenue (5 per cent) and half were bonds with variable revenue to the amount of 5 per cent of the capital. The liquidity problems of the Compagnie Immobilière were solved by the partial liquidation of its debt. The Crédit Mobilier became a firm with a par value of only 40 millions francs, undertaking more projects abroad than in France. In 1875, Emile d’Erlanger, another member of the old board of directors (of the first Crédit Mobilier) became President. During this period the bank had relations with the Bank of Brussels and the Spanish government. No balance sheet was published in the reports to the shareholders’ assembly, despite the fact that they had been specifically requested by the shareholders. In August 1876, Baron Emile d’Erlanger submitted his resignation and Charles Wallut, the bank’s Vice-President, became President. The Crédit

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Mobilier continued to start new ventures with foreign companies, but little information was published relating to its activities within France. The bank participated in the Italian Ice House Society, as well as contributing to an Algerian government loan. In June 1881, Eugène Péreire, founder of the first Crédit Mobilier, was nominated Administrator of the bank. He proposed to add a bank service to the Compagnie Transatlantique. The Banque Transatlantique was founded with a capital of 50–60 million francs, of which one quarter was to be given immediately to the Company Transatlantique. Twenty thousand Comptoirs Maritimes shares were absorbed by the new bank. The Crédit Mobilier took 10,000 shares in this new society. In August 1881, M.Péreire was appointed to represent the Crédit Mobilier on the syndicate which was formed to issue the Banque Transatlantique shares. The Crédit Mobilier, with the Romanian government, undertook the constitution of a Romanian Crédit Mobilier. Economic relations were developed with the United States and Spain for railway construction. On 4 November 1882, M.Péreire raised the issue of the participation of the Crédit Mobilier in the profits of the Compagnie Transatlantique. He thought that the idea of a combination of capitalisation or repurchase of the right to the profit sharing should be examined. On 3 February 1883, Péreire submitted his resignation. This was followed, on 29 June that year, by the Crédit Mobilier asserting its rights to the benefits of the Compagnie Transatlantique. It was believed that the Crédit Mobilier should have 25 per cent of these profits and the shareholders 8 per cent. Subsequent court proceedings resulted in the Compagnie Immobilière being ordered to pay 367,000 francs to the Crédit Mobilier for 1881 and 1882. In 1886, the Crédit Mobilier was a company with 30 million francs of Table 2.4 Crédit Mobilier’s liquidation account in 1901

Sources: Crédit Mobilier: Procès Verbaux des Assemblées Générales; Procès Verbaux du Conseil d’Administration

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

capital. Its financial situation got worse and worse, until it became completely bankrupt in 1902. One consequence was that, in 1898, funds were cut to two main borrowers, causing the Puerto Rican railway to stop and the Rhone railway line to be liquidated. In 1901 the Crédit Mobilier’s liquidation account was as shown in Table 2.4.

(e) The new Crédit Mobilier After the first Crédit Mobilier’s bankruptcy and subsequent reorganisation, the Crédit Mobilier Français had to confront the scepticism of its clients. The strategy that was adopted was ‘to make the Crédit Mobilier Français become an intermediary between the mediumsized business and the public’ (Rapport sur l’exercice, 1903–4). Its capital of 7,525,000 francs was constituted of subscriptions in cash, all the capital of the Office des Rentiers, together with all the Crédit Mobilier capital, namely: • • • •

rights to the Compagnie Generale Transatlantique; the Société Publique Financière capital; the Société Civile Franco-Mexicaine capital; the Puerto Rico business.13

The Crédit Mobilier was anxious to prove that its portfolio was performing and it took part in business which was small and easy to realise. Between 1903 and 1904 the Crédit Mobilier began to develop: its capital reached 10 million francs and, the year after, 25 million francs. During this period the bank had business relations with the large financial house of Thalmann and Co. and had just concluded a South American business deal. The bank was then capable of entering, either alone or with the participation of other companies, more suitable financial operations (e.g. the Serbian national debt). The Crédit Mobilier maintained relationships with provincial banks to guarantee full realisation of share transactions. The report of 1911 states: We have sent more correspondents abroad and the portfolio fluctuation has increased. In this aim we have taken interest in the banks’ institutions…If this policy has your approval, we propose to improve our effort in this direction and to create a greater base of operations.14 From 2 million francs in 1909, the discount portfolio reached 20 million francs in 1910 and 39 million francs the year after. Financial advances to industry reached 12 million francs in 1910. At this point, the Crédit Mobilier succeeded in concluding a contract with the Banque de Paris and

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entered the bank consortium. By 1910, after an increase in capital to 60 million francs, the Crédit Mobilier had become a great financial establishment. In 1921 its capital was 100 million francs. The balance sheet, now officially audited, shows the first important variations: few elements of comparison exist between the preceding system and the new one. To illustrate this idea, let us analyse the balance sheet of the new Crédit Mobilier (see Appendix A). The credit side is constituted by monetary funds available in cash and funds resulting from liquidation on the stock exchange. Their use corresponds to financial operations such as bills in portfolio, reports and advances. The deficit account of investment banks consists, in the major part, of lending to companies in a direct relationship with the Crédit Mobilier, in order to guarantee their development. Credit for the assetsportfolio and financial participation during the period 1900–13 amounted to a maximum of 43.4% and a minimum of 10.3%, with the average value 24.6%. For the liabilities, with the exception of the reserves which have already been discussed, the most interesting aspect is the deficit current accounts. The Crédit Mobilier made a distinction between the debit accounts and the deposit account, but this distinction is not very useful from the eligibility point of view. The merchant banks had expanded considerably and as a consequence they experienced an increase in their balance sheets. The Crédit Mobilier’s balance sheet totalled 248 million francs in 1913 against 40 million francs in 1903. The average profit over the period 1904 to 1908 was about 5.3 per cent, and between 1909 to 1913 approximately 12.3 per cent. The distribution of the dividends was stable and from 1910–13 represented 7 per cent. This survey of the Crédit Mobilier demonstrates that the three different establishments of that name were not at all comparable. If we consider the first Crédit Mobilier and the second one, few points of comparison exist, except the fact the formal organisation of the firm was identical and a large number of the shareholders in the Péreires’ bank maintained their participation in the financing of firm’s projects, despite the bankruptcy of 1867. Concerning the relationship between the second Crédit Mobilier and the third the differences are much stronger as the beginning of the twentieth century heralded a new role for the merchant banks which was implied by the new role of the Banque de France. This latter exerted an increasing monitoring role over banks. However, in regard to the bankruptcy of the Crédit Mobilier, we can ask whether the central bank in France really fulfilled its interventionist role as the lender of last resort. Henry Thornton (1802) and Walter Bagehot (1873) developed the key elements of the classical doctrine of the lender of last resort in England.

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They argued that the central bank should intervene for illiquid but solvent banks. Otherwise supporting failed companies would damage healthy competitors and weaken the discipline of a market economy.15 For Thornton, the Central bank’s responsibility in times of panic was to act as lender of last resort, providing liquidity to the market and discounting freely the paper of all solvent banks, but denying aid to insolvent banks no matter how large or important (Humphrey 1975, 1989). In other words, the lender of last resort must prevent illiquid but solvent banks from failing. 16 At the other extreme, Charles Goodhart (1985, 1987) advocates temporary central bank assistance to insolvent banks. He argues that the distinction between illiquidity and insolvency is a myth, since banks requiring lender of last resort support because of ‘illiquidity will in most cases already be under suspicion about…solvency.’ Furthermore ‘because of the difficulty of valuing [the distressed bank’s] assets, a Central Bank will usually have to take a decision on last resort support to meet an immediate liquidity problem when it knows that there is a doubt about solvency, but does not know just how bad the latter position actually is’ (1985:35). Solow (1982) is also sympathetic to assisting insolvent banks. He argues that any bank failure, especially a large one, reduces confidence in the whole system. To prevent a loss of confidence caused by a major bank failure from spreading to the rest of the banking system, the central bank should provide assistance to insolvent banks. However, such a policy creates a moral hazard, as banks respond with greater risk-taking and the public loses its incentive to monitor them. In the event, the Banque de France did not rescue the Crédit Mobilier. Its reasoning followed Thornton’s argument, according to which: It is by no means intended to imply that it would become the Bank of England to relieve every distress which the rashness of country banks may bring upon them: the bank, by doing this, might encourage their improvidence. There seems to be a medium at which a public bank should aim in granting aid to inferior establishments, and which it must often find it difficult to be observed. The relief should neither be so prompt and liberal as to exempt those who misconduct their business from all the natural consequences of their fault, nor as scanty and slow as deeply to involve the general interests. These interests, nevertheless, are sure to be pleaded by every distressed person whose affairs are large, however indifferent or even ruinous may be their state. (Thornton 1802:50)

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Hence the non-intervention of the Banque de France was profitable for the whole system, because an insolvent bank disappeared. From an historical and human point of view, a simple study of the main shareholders of the Banque de France sheds further light on this nonintervention. During the period, the Rothschild family, who disliked the Péreires for both personal and professional reasons (and may have been jealous of the power the Crédit Mobilier had obtained in the financial market) had contributed to the decision of the ‘Banque de France’ not to salvage the Crédit Mobilier. The only intervention that had occurred was to prevent a too sudden and huge fall of share prices on the stock market, which would have provoked a financial crisis for the whole economy. As regards this argument, it will be interesting to analyse the impact of the Crédit Mobilier’s bankruptcy on the share prices for both affiliated and nonaffiliated companies. 2.3 DATA AVAILABLE OVER THE PERIOD OF THE TWO CRÉDIT MOBILIERS: COMPANIES INVOLVED AND PRELIMINARY ANALYSIS OF THE DATA This section presents and discusses all the data sets that will be used in the empirical tests explained below. Three points are developed: the first aims to elicit the general context of the French economy and to analyse in more detail the situation of the financial markets; this will constitute the basis of our excess volatility test. The second and third parts describe the data available for companies that were affiliated with the Crédit Mobilier and independent ones; this will support our statistical research relative to the examination of the impact of the Crédit Mobilier’s bankruptcy for both sub-samples and for the whole sample.

(a) General context of the French economy during the period As Bradford de Long and Marco Becht (1992) did for the United States and Germany, I intend to analyse the excess volatility of the French stock market from 1852 until 1914. In this respect some general ideas about the French economy from 1853 to 1914 are given. 17 More specifically, general figures on share prices, market prices, interest rate and dividend are provided. The aggregate data are relatively simple. The money stock was stable. The huge saving rate compared to a reasonable demand maintained interest rates at a moderate level over the period: between 3 per cent and

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

4.5 per cent (Loutchitch 1930). The rate of discounting assets with fixed revenue varied between a minimum of 3.22 per cent in 1897 and 1898 and a maximum of 3.73 per cent in 1913. The official discount rate decreased to 2 per cent in 1896 and 1897. Its value was around 3 per cent from 1900 to 1910. This low return on credit gave the banks an incentive to invest abroad. Some explanations are required to explain how the indices are calculated. To construct the industrial, transport and trade series, fifty four separate assets have been taken into consideration for the years 1895 to 1913 and twenty four assets for the years 1870 to 1895. Amongst these were some issued by companies involved with the Crédit Mobilier. From 1895 to 1913 these were: • • • •

Electrometallurgie de Dives; Chemin de Fer PLM, Nord, Orleans, Midi; Compagnie Générale Transatlantique; Société Parisienne d’Eclairage.

From 1870 to 1895 they were: • • •

Chemin de Fer PLM, Nord; Compagnie Générale Transatlantique; Compagnie d’Eclairage par le Gaz.

From this series, the impact of the Crédit Mobilier’s bankruptcy on the level of production can be analysed. If the Crédit Mobilier had been a ‘Great Bank’, the impact of its bankruptcy on affiliated companies could have induced a relative effect for the sectors to which these firms belonged. As, for a large number of sectors (e.g. the railways), the Crédit Mobilier was an active partner in the financing of companies, it will be interesting to present some figures to support the argument. Table 2.5 compares market product prices by sector on an aggregate level. The sectors I have chosen are those in which the Crédit Mobilier Table 2.5 Market product prices by sector

Source: Lenoir (1919:87–8) basis average of the market prices for 1901–10

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THE ROLE OF BANKS IN MONITORING FIRMS

was interested, such as railways and mining. A simple examination of these figures shows that the situation was very stable between 1867 and 1870. No big change can be observed when the Crédit Mobilier went bankrupt. The bank’s failure does not seem to have had a great impact on the companies. As regards the financial point of view, some general comments on these series can be made. From 1870 to 1872 wars (the Franco-Prussian, the Commune of Paris and a civil war) led to an increase in the interest rate. The rate of 3 per cent increased from 4.17 per cent in 1869 to 5.51 per cent in 1871 and 5.47 per cent in 1872. The yield on bonds went from 4.73 per cent to 5.72 per cent between 1869 and 1872. The dividend yield on stock passed from 5.07 per cent in 1870 to 7.28 per cent in 1872. Prices followed this trend between 1869 and 1872. The year 1873 was one of general crisis, particularly in Germany, Great Britain, and in the United States. France experienced economic difficulties until approximately 1879. Between 1882 and 1884, the interest rate increased, but a new crisis in 1890 led to a remarkable trend towards a reduced discount rate proposed by banks (see Appendix B: 2.18 per cent in 1878, 3 per cent in 1883, 2 per cent in 1896). During this period, the dividend yield decreased regularly, remaining one point below the interest rate on long-term bonds. A slow and almost regular increase of the interest rate characterised the period from 1897 to 1913. Shares did not experience any general marked movement. Goods price fluctuations were small,18 where the author studies the evolution of the general price level between 1809 and 1925 (see Appendix B).

(b) List of the companies affiliated to the Crédit Mobilier Here an analysis similar to that of Bradford de Long and Marco Becht (1992) will be employed. Companies affiliated and not affiliated to the Crédit Mobilier must be taken into consideration in order to answer the two following questions: • •

Did the Crédit Mobilier stabilise the ratio of market value to dividends of affiliated firms? Did the Crédit Mobilier increase the market value compared to book value of affiliated firms?

In addition, I want to study the power of the Crédit Mobilier among the banking sector, its policy towards investment and the importance of an affiliation with the bank as regards credit policy. P.Dupont Ferrier in his book Le Marché Financier sous le Second Empire provides a list of the societies founded by the Péreires between 1853 and 1867. These enterprises were:

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

• • • •

• •

The railway enterprises: Compagnie de l’Est, PLM, Compagnie du Midi, Compagnie d’Orleans and Compagnie de l’Ouest. Insurance companies: l’Union. La Compagnie Transatlantique. La Compagnie Immobilière de Paris. This company was very important for the Crédit Mobilier, Appendix C gives an indication of its financial situation in 1867, the year of the bankruptcy of the bank, and describes the market price of shares and dividends of the Compagnie Immobilière between 1855 and 1866. La Compagnie des Omnibus. La Société Parisienne d’Éclairage et de Chauffage par le Gaz.

The bonds issued by the firm were guaranteed by its capital. The received capital during the year could not be greater than the capital realised (Cameron 1991:142). Plenge (1903) gives the data on the Crédit Mobilier’s shares throughout its existence, their value in 1867 (the year when it went bankrupt) and the distribution of dividends (see Appendix A). The new Crédit Mobilier (1903–14) was initially involved with the Société métallurgique de Montbard-Aulnaye, in which the bank was largely represented, and with the Société d’Electro-métallurgie de Dives. The Crédit Mobilier also founded the Société Française des MachinesOutils. In varying degrees, the Crédit Mobilier participated in the Compagnie Parisienne de Distribution d’Électricité and in the reorganisation of the Compagnie Générale des Omnibus de Paris. It contributed to the development of the Société de Raffineries Say and to the expansion of the Société de l’Éclairage Électrique. The bank also concluded contracts abroad. In 1909–10 it participated in an Argentinian government loan whose interest rate was 4.5 per cent and in the Santa Fe business affair (interest rate 6 per cent). In summary, the firms in which the Péreires were interested were the railway companies, l’Union, the Compagnie Transatlantique and the Compagnie Immobilière de Paris. Two societies were involved with both the Péreires and with the Crédit Mobilier Français: the Société des Omnibus de Paris and the Compagnie d’Eclairage et de Chauffage par le Gaz. Firms involved with the new Crédit Mobilier included the Société des Machines Outils, the Société Montbard-Aulnoye, the Electro-metallurgie de Dives and the Raffineries Say. In contrast to the first Crédit Mobilier founded by the Péreires, the second one was not always represented on the boards of firms with which it was involved. In the Raffineries Say, however, the Crédit Mobilier was a financial partner of the company, while with the Société des Machines Outils, the Société Montbard-Aulnoye and the Electro-Metallurgie de Dives the Crédit Mobilier was strongly represented on the boards of

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THE ROLE OF BANKS IN MONITORING FIRMS

directors, and sometimes also the principal shareholder, as with the Société des Machines Outils. However, the new Crédit Mobilier’s functioning was not very different from that of the Péreires, particularly when it was well represented on boards of directors. The close relations that the Crédit Mobilier maintained with the societies with which it was involved enabled it to be not only a financing establishment but also an active partner in the realisation of projects. As advances were granted to the societies where the Crédit Mobilier was officially represented, the risk of bankruptcy was increased. In this case we can ask the following questions: • • •

Did association with the Crédit Mobilier increase the value of shares compared to book value? Did association with the Crédit Mobilier reduce the variance of the price dividend ratios? Did association with the Crédit Mobilier always facilitate loans and advances to the companies? If so, in what measure?

More specifically, it will be interesting to study share fluctuations when the Crédit Mobilier went bankrupt. As in de Long (1989) I would like to extend this analysis to companies that were not affiliated to the Crédit Mobilier.

(c) List of companies not affiliated to the Crédit Mobilier This data set supports the hypothesis that companies not affiliated to a bank tend to be liquidity constrained (and face a larger gap between external and internal costs of funds) than those which are. Bertrand Gille (1968) provides us with a list of companies which were affiliated with the Crédit Lyonnais for the financing of their projects. These companies were • • • • • • • • • • • •

Alais; Schneider; Marine; L’home; Terrenoire; Denain; Fourchambault; Maubeuge; Givors; Firminy; Franche Comté; Chatillon.

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

Lenoir (1919) enables us to complete this list by considering the case of the Houillères du Nord and the textile sector, which was not affiliated to the Crédit Mobilier on the period. Appendix D presents the data available for these companies. The comparison of the results of the test for the two groups of companies will allow us to evaluate the effectiveness of an association with the Crédit Mobilier as opposed to an association with the Crédit Lyonnais (some of the firms, e.g. Marine, Fourchambourg, Firminy and Chatillon, were involved with the bank). Unfortunately, no data were available on firms which were affiliated with neither bank. From the historical data collected here, a test can be constructed to show if: • •

association with the Crédit Mobilier increased the value of shares compared to book value; association with the Crédit Mobilier always facilitated loans and advances to the companies. As advances (without collateral) were granted to the societies where the Crédit Mobilier was officially represented, the risk of bankruptcy increased. 2.4 EXCESS VOLATILITY TESTS

As in de Long and Becht’s paper, an analysis can be undertaken to test for excess volatility. More specifically, we can evaluate volatility of the prices relative to trend. Let us recall the idea of such of a test. Shiller’s19 first key insight was that the level of the stock market should be a forecast of the ex post perfect foresight fundamental. An investor who buys and holds, and pays less than the ex post fundamental, receives a supernormal return. Arbitrage, therefore, should push prices to an efficient forecast of the perfect foresight fundamental. If prices are too volatile to trend, investors can make better forecasts of ex post fundamentals by taking as their forecast some linear combination of the market price and the trend, and betting that returns will be low whenever the market price is above the trend. How can such a test be expressed more formally?

(a) Presentation of the test Following de Long and Becht’s argument, let us call p* the fundamental price, which can be expressed as: where p is the stock index divided by the (2.1)

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THE ROLE OF BANKS IN MONITORING FIRMS

Figure 2.1 Prices, dividends, and perfect-foresight fundamental sample 1870–1914 Legend Lnrp* represents the natural log of the perfect foresight fundamental, Lnrp is the log of the real stock price and Lnrd for the real dividend

price level, d represents the dividends divided by the price level and r is chosen to represent either the an arbitrary real required rate of return or a risk premium paid on assets plus the risk-free rate minus the inflation rate. Here r is similar to the value taken by Becht and de Long (8 per cent) to facilitate the interpretation of the result. Other values for r between 5 per cent and 10 per cent would not have changed the shape of the graph in Figure 2.1. In the French case I have calculated the fundamental price using Dessirier’s series for the share prices and the dividend and Lenoir’s series for the general level of prices. All the series constructed are deflated by the GNP deflator from Lenoir. The same methodology used by Bradford de Long and Becht (1992) will be followed. As the general price series, the share price series and the dividends series do not refer to the basic year in the construction of the indices, normalisation of all these prices is necessary to avoid any bias problems in the test. Moreover, the dividend series presented in Dessirier’s paper was not used as such. We evaluated the ratio as dividend.100/share price. This series corresponds to a constant term times the ratio of dividend index to price index. After having normalised the dividend, a calculation of the volatility ratio, that is the price dividend ratio, is made in order to construct the test. Figure 2.1 provides individual surveys of the behaviour of prices, dividends, and perfect foresight fundamentals which are obtained by computing equation

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

(2.1). They plot for the period the logs levels of prices and the log ex post perfect-foresight fundamental. Shiller’s test says that: pt = E(p*t | It)

(2.2)

var pt < var p*t.

(2.3)

This formulation was the subject of much controversy because the definition of p* is said to be impossible. If so, investors will take t advantage of this to buy when the price is low, and sell when it is high. The basic idea of solving this problem is to consider a naive forecast noted p equal to a constant times dividends. The problem can be N reformulated and expressed by: var (ln pt – ln pN) < var (ln p*t – ln pN)

(2.4)

where pN=αd and α is a constant. Dessirier’s series and Levy-Leboyer’s series enable us to construct such a test. The question is then: are the conclusions obtained for Germany comparable with those we will obtain for France? To answer this question, let us consider the result represented by Figure 2.1 and that of de Long and Becht.20 Before discussing the similarities and the differences between these two graphs some explanations about the underlined data are worth making. The share prices series is taken from Dessirier (1928b) and presents some odd elements. The first remark is that the figures reported in the article are flat and the financial terms used to explain the data are confusing. For example, the values in column 2 of the share prices series retrace the dividend for assets with variable revenue. The French term used by Dessirier is ‘revenue des actifs à revenu variable’. For the description given in text it is clear that the two terms (‘revenu des actifs à revenu variable’ and ‘dividend’) reflect the same parameters. What is more ambiguous is on what basis the author built this series. Therefore the interpretation of the whole test is relative to the underlying data. The second argument is related to the figures themselves. When reading Dessirier’s data the symbol ‘is found in place of numbers. The problem is whether this a representation of unavailable data, or did the author choose not to report it as it was identical to the preceding value? Dessirier wrote four papers in three years and proceeded the same way each time. When a number was non available, he clearly stated this and when, for two subsequent years, numbers were identical, he always used the same symbol’. This clarification being made, arguments can be advanced to explain the existence or the absence of volatility in France over the period.

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THE ROLE OF BANKS IN MONITORING FIRMS

As in the German case the fundamentals follow a trend. From 1890 to 1913 the German and the French results are quite comparable: dividends, prices and perfect foresight fundamentals follow a similar increase. Hence a test on excess volatility in this period would probably give similar results to those obtained by de Long and Becht. The second remark about the graph is that for France, between 1870 and 1890, the price/dividend ratio was increasing. How can we explain these differences? In 1882 France suffered a banking crash due to the failure of the Banque de l’Union Générale. All industrial activity decreased between 1881–4 and 1885–6, with some variations according to the sectors and the firms. There was then a slight increase, which was interrupted during 1887–9 due to the bankruptcies of the Compagnie du Canal de Panama and the Comptoir de l’Escompte. What is more interesting to analyse is the behaviour of the Banque de l’Union Parisienne just before the crash, that is at the end of the summer of 1881 and afterwards. Prior to this date, a revision of all their policy towards industry took place. They suspended part of their participation in the creation of enterprises. They decreased the supply of credit in the short and medium term. The crisis, which the bank anticipated, resulted in a decrease in their profit, which was at the origin of their defensive attitude. This situation became more pronounced during the second quarter of 1881. The price of money increased and most of the important investors and lenders followed a deflationary policy. According to Bertrand Gille in La Banque et le Crédit en France de 1815 à 1848, the disparity that was essentially responsible for the crises was an ‘excess of investment’21 inducing a relative gap in the ‘circulating capital’22 and hence the capital of firms. ‘The investment chains provoke the excess and the break in the equilibrium’.23 The crisis happens when ‘the investment ceases’ and this issue is unavoidable: The investments cease because the accumulation of capital is destroyed and there is no longer any liquidity; they cease because the scarcity of circulating money may increase its rate of interest; because certain projects are revealed to be bad or speculative.24 Certain bankers of the first half of the nineteenth century (and more later also such as Laffite, or, more importantly, the Péreires) thought and said that the progress in the banking system, in feeding payment and credit, enabled growth and avoided ‘commercial crises’. The facts contradicted their optimism. The promotion of banking and the modern form of credit did not prevent cycles. They furnished, on the contrary, a source of new turmoil: the rise of credit expansion and the confirmation of depression due to the increase of banking operations.

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

The Großbanken and the Crédit Mobilier were different. Several arguments can be adduced to explain these differences: •

•

•

The first one concerns the effective power of each bank. In particular the Crédit Mobilier and the Großbanken did not have similar powers with regard to screening companies’ projects. The German Great Banks were more cautious and evaluated the level of risk for any potential investment project. The second deals with the ability of the Crédit Mobilier to supervise the managers of the firms which whom it was involved. The differences described in the text between 1870–95 on the one side and 1895–1914 on the other side give a hint of the different policy which had been exerted by the German banks and the French Crédit Mobilier. The third refers to the economic situation in France during the period and, more specifically, the difficulties faced by the banking system because of its innovative character as evidenced by Saint Simon’s theory.

(b) Volatility ratios Presentation of the results Table 2.6 presents summary statistics on the volatility of the French stock market. For comparative purposes, it also reports similar statistics for the United States and Germany. If actual prices were rational estimates of fundamentals, they should exhibit less volatility relative to some ‘naive’ forecast than do the ex post perfect. As the values are Table 2.6 Volatility tests for the French, German and American stock markets between 1870 and 1914

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THE ROLE OF BANKS IN MONITORING FIRMS

extremely flat before 1895 (some values are identical for subsequent years) and reported yearly after 1895, the ratios are evaluated for the whole sample and for 1895–1914. The first line of Table 2.6 shows the volatility of log prices (p) around the log of the perfect foresight fundamental (p*–p) calculated using an 8 per cent per year real discount. The second line shows the volatility of the log price-dividend ratio (p–d). The third line shows the volatility of the log ex post perfect foresight fundamental to dividend ratio (p*–d). If prices are more volatile relative to ‘naive’ forecasts than perfect foresight fundamentals are, relative to the naive forecast, investors could and should have constructed a better forecast: a weighted average of the market price and the naive forecast would have generated smaller forecast errors. Thus the values in the second line of the table, the volatility of the price-dividend ratio, should under the efficient market hypothesis be smaller than the values in the third line, the volatility of ex post perfect foresight fundamental. For France it is true after 1895 as for Germany. Between 1870 and 1914 the situation is more similar to the United States. Line four reports this volatility ratio. Line five of the table calculates another volatility ratio. The volatility of the perfect foresight fundamental about the actual price should be less than the volatility of the perfect foresight fundamental about the naive forecast. For both periods the price and the dividend are almost exactly equally good forecasts of the perfect foresight fundamentals. A final implication of the efficient markets hypothesis is that the two ratios of lines four and five—the sum reported in line six—should add up to one. If not (as is the case of France for the whole sample, and the United States) the log difference between price and the perfect foresight fundamental (p–p*) is correlated with the log price-dividend ratio (p–d). Profits could have been earned by trading on this correlation of the price-dividend ratio and value relative to price. Surprisingly, between 1895 and 1914 the situation of France is similar to that of Germany. The analysis of the results obtained for France leads us to the following conclusions: 1

Prices are volatile relative to dividend over the period 1870–1914. Prices are much more volatile than perfect foresight fundamentals relative to the naive forecast. Thus, tests based on market volatility ratios shows traces of excess volatility in the French stock market before the First World War. However, between 1895 and 1914 volatility tests present strong similarities between France and Germany 2 The situation described by the French stock market is much more similar to that of the United States for the whole sample than that of Germany. The symbol ‘ used in Dessirier’s data should lead to a bias which gives opposite results for the whole sample and the period 1895–1914.

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

Interpretation of the results How can we explain the similarity and the differences between France, Germany and the United States? We propose to give an interpretation of these results by explicating the monitoring role played by the banks and their relations with the stock market. The monitoring role of banks in France, Germany and the United States According to Becht and de Long, ‘the key position of the Großbanken in the German economy is linked to the absence of excess volatility. The Großbanken dominated pre-World War I financial markets in Germany.’25 The system involved well-developed analytical abilities, strong views regarding the proper levels of stock prices and an incentive to moderate fluctuations away from fundamentals. Vincent P.Carosso and Richard Sylla, when examining the role of J.P.Morgan said: Bankers generally undertook non financial responsibilities out of necessity—to protect their own interest and those of the investors to whom they sold the companies’ securities.26 Their role in the affairs of the corporations they sponsored sometimes required them to assume entrepreneurial responsibilities they generally would have preferred to avoid. The fact that they were capable and stood ready to undertake these tasks when the occasion demanded it gave the private bankers immense influence far beyond the sums of money they themselves commanded. In the United States these private bankers were largely responsible for facilitating the rise of giant enterprises, the consolidation of industries and the organisation of the earliest multinational companies, but did not monitor as thoroughly as the Großbanken. This strong monitoring role in the case of Germany explains the absence of volatility on the German stock market: the fluctuations of share price were reduced over the period. However, the stock market price seems to imply that this role was less efficient in the French case from 1870–95. The failure of the Crédit Mobilier and the bankruptcy of the Banque de l’Union Parisienne in 1880 can partly explain the high volatility ratios over the period. The banks and the Stock Market According to Becht and de Long, the Großbanken, as well as trying to create value for the investors to whom they sold newly issued securities,

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THE ROLE OF BANKS IN MONITORING FIRMS

sought also to support the prices of the securities they issued. For Riesser, this support was not an attempt to produce an artificial market or to swindle the public. These authors wonder if the Großbanken had sufficient resources to keep asset prices close to their own internal estimates of fundamentals. As the Großbanken were by far the largest actors in the German economy, an affirmative answer can be given to this question. In the United States the situation was similar to that in Germany: the banks occupied a powerful position. To illustrate this argument, let us just quote Karl Erich Born (1983:93): What probably explains their success is that they had collaborated in the formation of big trusts at the end of 19th and the beginning of the 20th century thereby not only gaining opportunities for control and influence in industry and transport but also making considerable profit. Vincent P.Carosso and Richard Sylla (1991) added: Their chief contribution in the industrial development which was the ultimate basis of their strength and influence, was their access to the world’s principal source of capital. In France such a situation did not exist except for the ‘Haute Banque’ and more specifically the Rothschilds, whose aims was to fight the Péreires. The Rothschilds found the Péreires’ investment policy too risky to consider them as real bankers. On the other hand, they saw them as competitors they had to force out of the market. Evidence of this lack of supervision will be provided in the following section by analysing the impact of the Crédit Mobilier’s bankruptcy on the financial market.

(c) Conclusion It appears that the Crédit Mobilier benefited from a powerful position up until 1862–3. Even before the bankruptcy, however, it faced liquidity difficulties. Its place on the financial market was delicate, as most of the bankers of the period were hostile to the Péreires. The Péreires wanted to be innovative as regards credit policy: in particular they presented themselves as promotors of firms, whose principal aim was to provide liquidity to industry. But the control they exerted on firms was limited. When comparing the Crédit Mobilier with the German Großbanken, Engberg (1981:35) states that: The Crédit Mobilier never became a ‘universal’ bank as did the German banks soon after their organisation. The Crédit Mobilier

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

represented a bold and imaginative idea; it was designed to effect revolutionary changes on a grand scale of entire railway, industrial and credit systems. The German credit banks were called into existence to meet new and enormous demands for ‘finance’ in general. The Crédit Mobilier was created to implement change; the early German credit banks were created in response to changes of the society that were taking place. 2.5 THE EFFECT OF THE BANKRUPTCY OF THE CRÉDIT MOBILIER ON THE COMPANIES WITH WHICH IT WAS INVOLVED E.Nouette-Delorme (1865) pointed out the evolution of the prices of shares and bonds of these societies just before the bankruptcy of the bank. I have chosen to add to this analysis the evolution of the share prices in the year immediately following the fall of the Crédit Mobilier to answer the following question: what happened to the companies with which the Crédit Mobilier was involved between 1867 and 1869? Because of the bankruptcy of the Crédit Mobilier, the share prices of these companies should have fallen relatively to the share prices of other firms. Table 2.7, however, which reproduces the average asset prices for affiliated firms, shows the opposite. Table 2.7 suggests that the railways suffered least from the crisis of the Crédit Mobilier. The Rothschilds were a partner of one of the railway companies and came to the assistance of the railway companies during this difficult period. The importance of railways in the French economy, and the low level of competition that existed between the companies in the period, probably provided stability for these companies. Moreover, monthly share prices for affiliated companies between 1866 and 1868 show that the companies did not underperform in the market. In what follows, the impact of the bankruptcy will be analysed in three ways: 1 2 3

the effect of price level and dividend on share prices for the Crédit Mobilier’s firms; the correlation between the failure of the bank and the fluctuation of share prices for the affiliated companies; an evaluation of the association with the Crédit Mobilier between 1866 and 1868.

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THE ROLE OF BANKS IN MONITORING FIRMS

Table 2.7 Average asset prices for affiliated firms

Sources: Archives d’Entreprises Privées (General shareholders’ assembly and newspapers); Société Immobilière or Immeubles de la Rue de Rivoli, 1857–67; Compagnie Générale Transatlantique, 1854–67; Compagnie Générale des Omnibus de Paris 1855–1914; Compagnie Parisienne d’Eclairage et de Chauffage par le Gaz, 1855– 1914. Notes a When the share price increased this is indicated by a minus sign (i.e. negative loss). * This must be considered as the loss per share before the reorganisation of the Crédit Mobilier and the issue of the new shares. After the fall of the Crédit Mobilier the Cie Immobilière went bankrupt: so the same comments as those made for the Crédit Mobilier apply in that context. ** After the bankruptcy of the Crédit Mobilier the Compagnie Transatlantique chose to reduce its partnership with this bank. For example, in 1864, the amount due to the Crédit Mobilier was 10,126,461.08 francs. The company was supposed to give 25 francs of dividends deductable from a reserve fund in case of insufficient profit over the year. In 1867 the dividend was only 15 francs per share and the Crédit Mobilier became a debtor of the company for an amount of 4,514,610.78 francs. In 1868, M.Dollfuss became President of the Compagnie Transatlantique; M.Péreire had to resign.

(a) The general influence of the Crédit Mobilier’s bankruptcy The aim of this section is to see if there was any marked effect on price level and dividends due to the bank’s failure. This effect will be examined by measuring changes in share prices for affiliated companies, correlated with price level and dividend. The ordinary least square regression is expressed by: ln(pt / pt–1) = constant + α ln(pyt / pyt–1) + β (divt / divt–1) 54

THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

Table 2.8 Relative impact of the bankruptcy of the Crédit Mobilier

where py stands for the general level of prices for the whole economy, divt stands for general dividend series and pt represents the share prices for each of the affiliated companies. The sample considered is 1861–75. Table 2.8 does not reveal any significant figures regarding any influence of the failure that are distinct from the effects of price level or dividends. Dummy variables are introduced to concentrate the analysis on this specific aspect. The table provides us with very low coefficients for both the GNP deflator and dividends. If the figures produces by the second regression are much higher, they remain insignificant as most of them are close to 0. The regression equations which are going to be considered are: ln(pt / pt–1) = constant + α ln(pyt / pyt–1) + β ln(divt / divt–1) + γd18

67

where d1867=1 in 1867 and 0 otherwise. This test is carried out for each of the companies separately and over the same sample, that is 1861–75. The results are given in Table 2.9 (standard errors are in brackets). The statistical shown in Table 2.9 provide no more explanatory power than the preceding ones, which is quite surprising as the focus of the regression is the bankruptcy. The coefficients are not significant except for two companies: the Compagnie Immobilière and the Compagnie Transatlantique. Both these firms were confronted with financial difficulties, for different reasons. For the former, its simultaneous failure with that of the Crédit Mobilier (and causing it) explains the correlation between the different parameters. In the Compagnie Transatlantique’s case, the reason behind the failure is found in the struggle between the Compagnie, which wanted to sever all relations with the bank, and the Péreires, who wanted to maintain their position on the board of directors.

55

Table 2.9 Relative impact of the bankruptcy of the Crédit Mobilier including a dummy variable d1867

Table 2.10 Relative impact of the bankruptcy of the Crédit Mobilier including a dummy variable d1867/68

THE ROLE OF BANKS IN MONITORING FIRMS

To complete the argument the same regression can be carried out for d1867/ considering that d1867/68=1 in 1867 and 1868, 0 otherwise. The results are given in Table 2.10. Table 2.10 confirms the results obtained in the preceding test. Except for a relatively small number of firms such as the Compagnie Immobilière and the Compagnie Transatlantique, the bankruptcy did not lead to any great perturbation that could not be explained by the price level (e.g. the GNP deflator coefficient) or the financial market (e.g. the dividend coefficient). In what follows, these two parameters will be avoided: we concentrate on the correlation between the fluctuations of the share prices for affiliated companies and the bankruptcy, and we evaluate the validity of an association with the Crédit Mobilier. 68

(b) The impact on shares for affiliated companies To analyse the magnitude of the fluctuations of the share prices, we analyse two sub-samples: the first includes the railways companies, which suffered less from the failure (in total six companies); the second includes all other firms which were confronted with financial problems because of the policy of the Crédit Mobilier toward credit. Let us consider the six railway companies. An ordinary least square regression can be run by calculating ln(p /p ) for each of the companies t t–1 between 1862 and 1867. The equation of the regression will be then: ln (pt / pt–1) = c + βd1867 where d1867=1 in 1867 and 0 otherwise. The same regression can be done for d considering that d =1 in 1867/68 1867/68 1867 and 1868, 0 otherwise. The dependent variables are the share prices of the Compagnie de l’Est. Table 2.11 Regression for d1867

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THE CRÉDIT MOBILIER AND THE STOCK EXCHANGE

Table 2.12 Regression for d1867/68

The aim of the test is to analyse the impact of the bankruptcy of the Crédit Mobilier on the share fluctuations. Specifically we intend to test the null hypothesis: H0 β=0: ‘The bankruptcy of the Crédit Mobilier has no influence on the share prices’ against H1 β