Are Euro-area Corporate Bond Markets Irrelevant?
In a recently published paper, we find that access to corporate bond markets affects investment in the US, but not in the euro-area. Euro-area bond markets seem to be irrelevant because firms receive sufficient financing from banks.
Several research papers argue that developed capital markets improve economic growth as they allow firms to finance investment. While there is much more media coverage on equity markets, US firms actually raise more funds via corporate bond issuance than via equity issuance. For example, in 2015, US non-financial firms had a net issuance of bonds worth $400 billion, which was more than double their issuance of equity ($174 billion).
Compared to the US, corporate bond markets have a much lower importance in the euro area. Hoping to promote economic growth, recent policy initiatives in Europe have been designed to increase the importance of the corporate bond market. For example, the European Commission proclaimed the goal to create a Capital Markets Union, which it defines as ‘a true single market for capital’ within the 28 Member States of the European Union. In addition, the decision of the European Central Bank (‘ECB’) to purchase corporate bonds as part of its quantitative easing program may raise the importance of the euro-area corporate bond market.
But, would a larger bond market in the euro area really allow firms to invest more? How much would firm investment increase if the euro-area corporate bond market had the same size as its counterpart in the US?
We address these questions in our paper, ‘Are euro-area corporate bond markets irrelevant? The effect of bond market access on investment’. We use the fact that firms without a bond rating generally cannot access bond markets. Therefore, we compare how investment and leverage differs between firms with and without a bond rating in the US and the euro area. Our main finding is that having a bond rating affects investment and capital structure in the US, but not in the euro area.
How do we explain these surprising differences between the US and the euro area? We propose two potential explanations: the weak bond market hypothesis and the strong banking hypothesis. The weak bond market hypothesis suggests that bond market access is less important in the euro area because bond markets in the euro area are underdeveloped and cannot supply sufficient financing. Thus, even euro-area firms with bond market access are financially constrained and would like to access a stronger bond market. In contrast, the strong banking hypothesis argues that good access to bank financing in the more bank-based euro area makes bond market access redundant. This hypothesis assumes that all euro-area firms have good access to financing through their banks, and thus do not need access to bond markets.
If the weak bond market hypothesis were true, we would expect euro-area firms with a bond rating to expand investment to the levels of their US peers if the euro-area bond market was able to grow to the size of the its U.S. counterpart. We estimate this increase in investment to be $100 billion or approximately 0.8 percent of euro-area GDP. However, we would not expect these benefits to materialize under the strong banking hypothesis.
We try to distinguish between these two hypotheses by focusing on a time when bank lending was severely constrained: the financial crisis of 2008. Consistent with the strong banking hypothesis, we find that bond ratings become more important for investment in the euro area after the financial crisis.
To summarize, our findings suggest that euro-area bond markets are irrelevant for investment, implying that there may be potential to boost investment by creating stronger capital markets in the euro area. However, this conclusion is limited by our evidence in favor of the strong banking hypothesis, which implies that bond market access may have been irrelevant before the financial crisis, because firms had access to sufficient bank financing. If bank financing is sufficient, one would not expect improved bond market financing to lead to an increase in investment.
Bastian von Beschwitz and Conor Howells are both economists at the Board of Governors of the Federal Reserve System and guest contributors to the Oxford Business Law Blog.