In the aftermath of the Great Financial Crisis, debt has taken center stage. When borrowing is either high or growing quickly, people see it as a danger sign. When individuals, firms or governments are heavily indebted, they have less flexibility in responding to unfortunate events. And, when borrowers default, lenders suffer as well. We should, therefore, anticipate that high debt can be a drag on growth.
So, it ought not be surprising that borrowing can be difficult. In good times, households usually can obtain financing to purchase a house or car. But these loans are secured with collateral that is easy to resell. Even so, some measures suggest that it is currently more difficult than under “normal” conditions to obtain mortgage finance (see the Urban Institute’s Housing Credit Availability Index on page 16).
With firms, credit has been rising significantly in recent years—across advanced and emerging economies alike (see the BIS measures through 2017 here). Yet, commercial borrowers, especially small and medium-sized enterprises, complain loudly when they feel that their ability to succeed is being hampered by overly cautious lenders. And, since lenders often find it difficult to both assess a business’s prospects and to monitor effort once a loan is made, aside from periods of euphoria, borrowing can be quite difficult.
As we discuss in our primers on adverse selection and moral hazard, information asymmetries make external funding—either through equity or debt—expensive. And, while the entire financial system is designed to reduce these costs, they are still quite high. Importantly, as business prospects improve (along with firms’ net worth), creditworthiness rises, reducing the external finance premium and lowering the cost of borrowing. As a result, investment financed externally, either directly in financial markets or from banks, tends to be procyclical. (This gives rise to what is commonly known as the financial accelerator effect.)
Reflecting the average size of this external financing premium, nonfinancial firms seeking to fund new investment typically rely on retained earnings, rather than on issuing new equity or on borrowing. For example, the following plot depicts the sources of investment finance in the U.S. nonfinancial business sector in the United States. The blue bars are market-based finance—comprised of bond and equity issuance, and foreign direct investment (from foreign sources); the red bars are intermediated finance—including bank lending and net trade credit; and the black bars show retained earnings. What jumps out immediately is that the vast majority―an average of nearly 80 percent since 1990―of investment finance comes from internal sources. That is, financial markets and banks appear to play only a supporting role in financing investment.
Sources of investment finance (Percent of total investment), 1980-2017
Source: All data are for the nonfinancial business sector. Data from Table F.102, Financial Accounts of the United States, Board of Governors of the Federal Reserve System are adjusted for reinvestment of earnings without current-cost adjustment using Foreign Direct Investment in the U.S., Bureau of Economic Analysis. Retained earnings is computed as the difference between gross investment, including direct investment abroad, less the sum of market financing and bank borrowing.
Looking more closely at the chart, we can see that both market-based and intermediated finance go through periods when they are negative. In the case of banks (the red bars), this happens during economic downturns. Predictably, when the economy is contracting, the total amount of debt shrinks: hence, the negative contribution to investment finance. Perhaps more unexpected is the pattern of market-based finance. Notice that the blue bars show a negative contribution from 2004 to 2007, the years leading up to the financial crisis.
Net equity issuance (Billions of dollars), 1980-2017
Source: Data are for the nonfinancial business sector, line 38 of Table F.102, Financial Accounts of the United States, Board of Governors of the Federal Reserve System.
To understand where firms obtain resources for investment, we can look at one component of market-based finance: equity issuance. Remarkably, as the above chart shows, since 1994 annual net equity issuance has been negative. This is all consistent with the fact that the number of publicly traded companies has been falling over the past several decades (see here and here). And, reflecting this year’s cut in the corporate tax rate, 2018 buybacks appear poised to set a record—despite high equity valuations.
Before continuing, we should note that the financing pattern for financial firms―banks, finance companies, insurers, pension funds, real estate investment trusts, and the like―is quite different from that of nonfinancial firms. Not only has net equity issuance been positive since 2005, it has been large. For example, in 2017 the financial sector issued $791 billion of net equity. (Unfortunately, because of the way the data are constructed, we are not able to include the liabilities of private equity and venture capital firms.)
Returning to where we started, if nonfinancial businesses self-finance the bulk of investment using retained earnings, why do commercial borrowers, especially small and medium sized enterprises, complain when they feel that their ability to succeed is being hampered by overly cautious lenders? The answer is straightforward. While the bulk of investment may be financed internally, bank borrowing and bond issuance are sources of funds on the margin. They also are important drivers of aggregate fluctuations. To see this, consider what would happen if 20 percent of investment finance were suddenly to disappear. Since investment is between 16 and 20 percent of GDP, a decline of one-fifth would lower GDP by between 3 and 4 percent! That is, if all of external finance were to evaporate, the resulting recession would be similar in magnitude to the Great Recession of 2007-09 when real output fell by 4 percent― its largest decline in 75 years.
Put another way, 1947 was the last year that GDP excluding investment fell. So, investment is the primary driving force behind recessions, and the supply of external finance is a key influence on investment. When lenders are willing to lend, either through markets or banks, firms can borrow and invest. When lending evaporates, investment collapses.
This pattern, where firms rely on internal funds to finance their investments, has been around for a long time and is likely to persist. But, if it were to change, what might be the catalyst? We see two mechanisms that could lead to an increase in reliance on external finance: the changing means of financing intangible investment and the decline of information costs. As we discussed in an earlier post, over the last quarter century the composition of investment has been slowly shifting from buildings and machines, to software, patents and other forms of intellectual property. We see the increase in private equity, where financiers have intimate knowledge of a firm’s investment opportunities, as an effective response to this. So, as the shift to intangibles continues, we can envision a further move away from the combination of internal funding, bank borrowing and market-based finance to private funding (both equity and debt).
Similarly, insofar as technology reduces information costs, lenders will find it easier and cheaper to screen and monitor borrowers. That is, the traditional rationale for external finance to be so costly may fall by the wayside. To the extent that this happens, external finance will become cheaper and more readily available.
The rash of financial innovation underway is producing many tantalizing developments in this area (see, for example, the recent Treasury report). We remain skeptical that nonbank tech firms will out-compete traditional credit-card suppliers in supplying funds to the bulk of consumer borrowers. At the same time, it would be especially welcome were financial innovators to lower the cost of funding to startups and small, but rapidly expanding firms, as well as to those consumers who (for lack of alternatives) currently pay the exorbitant fees of payday lenders.