Does bank affiliation mitigate liquidity constraints? Evidence from Germany's Universal Banks in the pre-World War I period.

• Author: Becht, Marco

1. Introduction

   Theoretical and empirical literature on imperfect capital markets has established that asymmetric information and moral hazard problems increase the cost of raising external funds for corporations. As the degree of such problems increases, so does the cost of obtaining external funds. In particular, when financial markets are not well developed, these information problems can be quite severe and, as a result, can effectively make external financing prohibitively expensive. One way in which firms can (and in fact do) partially overcome these problems is by developing affiliations with financial intermediaries. Such an affiliation mitigates information problems and reduces monitoring costs, making it easier for the firm to obtain external financing. (1)

   A sizable amount of work has formalized and tested these arguments. At the theoretical level, stylized models such as those of Stiglitz and Weiss (1981), Diamond (1984, 1991), Rajah (1992), and Webb (1991) have shown in one way or another that establishing a link with a financial intermediary can potentially reduce the borrowing cost for long-term investment. Empirically, Fazzari, Hubbard, and Petersen (1988) and Gilchrist and Himmelberg (1995), (1998), using recent U.S. data, Ramirez (1995, 1999) and Calomiris and Hubbard (1995), using historical U.S. data, and Hoshi, Kashyap, and Scharfstein (1990, 1991), using data for Japan, have examined the effect of liquidity on corporate investment. These researchers found that firms that would appear to face the greatest problems raising capital externally tend to cut investment spending in response to cash flow shortfalls. (2) In this paper we follow these theoretical and empirical arguments and use them to examine the effects of German banks on corporate investment spending behavior. With a sample of mining and steel industry firms, we investigate whether firms that had close ties to one or more of the Universal Banks depended less on their own funds to finance investment spending. Our empirical findings suggest that Universal Banks did facilitate liquidity for their client firms--firms with close ties to the banks displayed very low sensitivities of investment spending to measures of internal finance. By contrast, the investment spending of firms with weak or no ties to the banks tended to be very responsive to the same measures of internal finance. (3)

   These empirical results confirm what many researchers suspect to be one of the more important contributions of the German Universal Banks--facilitating credit and liquidity to their client corporations. Many economic historians see the institutional organization of Universal Banks as a catalyst of Germany's impressive takeoff in industrial growth from around 1880 to the decade before War World I. For example, Gershenkron (1962), Landes (1969), Tilly (1967, 1978, 1986), Kocka (1978), Cable (1985), and Calomiris (1995), have argued that the so-called Universal Banks, or Groflbanken, had a strong influence on the corporate governance of their clients and may have facilitated the channelling of funds for improvements and expansions. Contemporaries such as Riesser (1911) saw this institutional organization as, on balance, beneficial to both the banks and German industries. (4) There is, however, some disagreement as to the overall contributions of Universal Banks to the German economy. Neuberger and Stokes (1974), for example, and more recently Edwards and Fischer (1994), Edwards and Ogilvie (1995), and Fohlin (1999) argue that the Universal Banks contributed very little to industrial growth and in many cases may have actually hampered it.

   This paper contributes to this debate by studying how German banks facilitated credit and investment financing for a sample of mining and steel corporations during the decade before World War I. We chose to study the mining and steel industry because of its importance in understanding industrialization and economic development in Imperial Germany. It would not be appropriate, however, to try to draw broader conclusions about the overall benefits of the Universal Banks to German economic development and growth with the evidence presented here. Such a conclusion would require a general equilibrium model capable of, at the very least, modelling how aggregate savings were being channelled to borrowers through the financial system.

   The rest of this paper is organized as follows: Section 2 gives a brief outline of what was special about the Universal Banks--their business strategy and their development. Section 3 reviews the main components of German corporate structure as set out in the reform to the Handelsgesetzbuch (HGB), the German wade law of 1884. This is important because corporate control in Germany takes a somewhat different form from that in the United States or Japan and played an important part in the evolving relationship between the Universal Banks and industry. In addition, the HGB set out minimum reporting standards that had to be respected by all corporations and thus provided the basis for the balance sheet data underlying the analysis. Section 4 investigates the nature of the affiliations between the Universal Banks and industry. It argues that the strongest form of the relationship was established when members of the Universal Banks' management or boards of governors were placed on the boards of industrial customers. We call this a board of governors, or Aufsichtsrat, link. In section 5 we use the Aufsichtsrat link to derive a quantitative measure of the degree of affiliation between industrial enterprises and several banking groups. Section 6 presents our main empirical results and a brief discussion of their implications. Section 7 concludes. In the Appendix, we include a detailed description of the data used from the balance sheets and also report descriptive statistics for the sample of firms.

2. The German Universal Banks

   German bankers' influence on industrial finance began in the railroad industry during the 1850s. According to Tilly (1986), the financing and reorganization of railroads was a big and profitable business during that period. As early as the 1830s, private bankers were represented on railroad management committees:

   Bankers not only underwrote the issue of railroad securities but also managed the companies' current accounts; and to insure their investments they occupied key positions in the management ... (Tilly 1986, p. 119) Although railroad financing served as a stepping-stone for the development of finance capitalism in Germany, it was the rise of big industrial businesses and organized capitalism in the 1870s that firmly established the role of the Universal Banks in the financing and management of industrial corporations. The liberal laws of 1870 allowed flexible rules regarding the issue of new securities, in particular of share capital. The establishment of joint-stock companies was an important way in which banks could influence their client enterprises. The Panic of 1873 reinforced this trend of increasing banking influence over corporations because after the panic and the subsequent economic downturn, investors became more cautious about securities and banks served as guardians of their corporate clients' share capital.

   However, after the Panic of 1873, legal restraints were imposed on the liberal laws of 1870. The series of restraints eventually culminated in the Corporate Law of 1884. This law marked a significant change in the evolution of the German corporation and, Tilly (1986) maintains, even increased the Universal Banks' influence over industrial corporations. By increasing the minimum number of shares that corporations had to issue, the law compelled companies to seek out powerful banks that had the capability of floating security issues. In addition, it increased the time lag between the establishment of a company and its first listing in the stock exchange in order to weed out weak companies before they were actually listed. Furthermore, the law strengthened the influence of the Aufsichtsrat over the management of the corporation. Since bank executives were members of this board, this meant that the banks had a greater influence over internal decisions of the company.

3. Corporate Control in Imperial Germany

   The German corporation as defined in the HGB of 1884 had three main agents at the decision-making level: executives or management (Vorstand),

   the board of supervisors (Aufsichtsrat), and the general meeting of shareholders (Akttonare, Generalversammlung). The law of 1884 stipulated in separate sections the privileges and duties of each of these three groups, thereby regulating the relationships that existed among them. (5) The main regulations for each group are summarized in Table 1. (6)

   The legislators intended the shareholders, through the annual general meeting, to be the most powerful institution inside the corporation. As the ultimate owners of the corporation, shareholders were thought to deserve ultimate control. The institution of the Aufsichtsrat was intended to look after the shareholders' interests and provide professional supervision of management on behalf of the shareholders. In practice, however, the law of 1884 gave the Aufsichtsrat more de facto power than the legislators intended. In Staub's authoritative commentary on the HGB (reprinted in Konige, Stranz, and Pinner 1906), it was argued that the Aufsichtsrat, provided it could find the necessary three-quarters majority in the annual general meeting, could alter the corporation's constitution to its own benefit. (7) The position of the Aufsichtsrat was further strengthened by the lack of attendance by shareholders.

   In effect, the law of 1884 essentially increased the relative power of the Aufsichtsrat institution in the German corporation. Hence, bankers who sat on these supervisory boards enjoyed wide latitude in involving themselves in the internal affairs and decision making of...