Ebook Financial Market Development and The Rise in Firm Level Uncertainty
This paper argues that financial market development is one of the driving forces behind the rise in firm level uncertainty. Theoretically, we focus on the role of risk sharing among investors. Financial globalization and stockmarket development, by broadening the pool of potential investors, promote risk sharing; this enables firms listed on the stock exchange to adopt more profitable and riskier strategies. But in equilibrium, all firms compete on the labor and product markets. In order to maintain their market shares in front of more aggressive listed firms, non listed firms are induced to bear more risk as well. The overall result is a pervasive increase in sales volatility and labor market reallocations, amplified by the extent of product market competition. We then find supportive empirical evidence for our theory by looking at French data, using the 1984-1990 stock market reforms as an experiment. Focusing on the French experience is useful for two main reasons: first, this event is sufficiently concentrated in time to provide us with a clear break in ownership structure. Secondly, French data give access to a large set of privately held firms, of size comparable to listed ones: we will use them as a control group to filter out contemporaneous shocks to the French economy that have nothing to do with finance. Our evidence holds in front of various robustness checks: in particular, we seek to control for the degree of information technology diffusion, which may have affected publicly and privately held firms differently.
Since the 1970s, most developed economies experienced dramatic developments of their financial markets (see figure 1 for the US, the UK and France). In financial markets, the past three decades have been years of intense financial and technical innovations, unleashed international capital flows and stockmarket reforms. As financial markets became more global, fluid and efficient, a mix of socio demographic changes in some advanced economies channeled more and more savings to them. As a result of these mutations, the average investor changed from a passive, unexperienced, underdiversified household into an active, sophisticated and potentially foreign fund manager, well aware of notions such as risk, return and portfolio management. While the broad outlook is the same across all developed economies, the details of the picture vary from one place to the other. In the US, the dominant post war trend has indeed been one of rising institutionalization of equity ownership (Friedman [1996]): the share of outstanding equity directly held by households has declined from over 90% in 1950 to about 50% in the mid 1990s, and pension and mutual funds have progressively replaced households as the real owners of corporate America. In France the stockmarket was deeply reformed by the government in the late 1980s. Within a few years, capital controls were lifted, the Paris stock brokers’ monopoly was dismantled, tax incentives were provided to equity investors and stock issues were made simpler. This prompted a massive increase in the number of shareholders and in the rising involvement of domestic and foreign financial institutions.
Our theory relates these developments on financial markets to the rise in firm level uncertainty which took place over the past thirty years. This rise in uncertainty is now documented by several empirical studies, mostly on US data, but also for the UK and France. Two stylized facts have been established. Regarding the product market, firms sales have become more volatile among US listed firms (see Comìn [2000] and Philippon [2003]) and UK firms (see Higson et al. [2001]). Regarding the labor market, this literature suggests that the increase in wage inequality is in great part due to an increased dispersion of the transitory component of wages during the 80s and 90s (see for example Gottshalk and Moffit [1994], Haider [1999] for the US, Blundell and Preston [1998], and Dickens [2000] for the UK). In continental Europe this phenomenon translated into a rising job insecurity instead of wage uncertainty (Givord and Maurin [2004] for France during the 90s). Consistently with this, workers now perceive their positions as more insecure than ever (OECD [1997]).
Our theoretical analysis highlight here a new form of interaction between financial, labor and product markets. For this purpose we build a framework where those three markets clear. There are risk averse entrepreneurs who operate on the product market under monopolistic competition. These entrepreneurs may increase their market shares and profits by choosing a larger degree of risk for their technological/marketing/organizational strategies. Hence product market success goes with more risk. On the other hand, equity trading on the financial market allows the entrepreneurs to share part of their risk by selling their firm to a pool of diversified investors. We show that a larger pool of investors encourages the adoption by listed firms of riskier business strategies but whose profits are larger on average. This direct effect comes, however, with an indirect effect that appears in general equilibrium and affects both listed and non listed firms. By adopting more ambitious strategies, listed firms gain market shares from each other and from privately held firms. To recover their profits, all firms choose to increase the profitability of their project, at the expense of more risk taking. Hence, the rise in firm level uncertainty is pervasive and goes beyond those firms directly involved in risk sharing (ie. listed firms). Moreover we show that a larger degree of competition on the product market enhances this diffusion effect.
Two of the predictions of our model are put to the test: (1) compared to privately held firms, the uncertainty borne by listed firms should increase more following financial development; (2) this effect should be stronger when product market competition is tougher. We use the 1980s French stockmarket reforms as a background to test these predictions on a panel of large firms over the 1984-1999 period which we break down into listed and non listed firms. In order to sort out the pure effect of financial development from other changes that took place in the French economy within the period, we use non listed firms as a control group. We then look at two measures of uncertainty at the firm level: the volatility of firm’s sales growth and the elasticity of firm’s own sales to industry sales shocks. In both cases our estimates show that uncertainty increases for listed firms after stockmarket reforms, much more so than for privately held firms. These results are robust to various controls, such as firm or industry level measures of adoption of new technologies and exposure to international competition. Last, we show that most of the effect occurs in industry where traditional measures of product market competition are high.
We view this paper as a contribution to both finance and labor literatures. According to the existing literature in macro/labor, the rise in labor market insecurity could be fully accounted by technological causes and by globalization of trade flows. In this paper we highlight a different, complementary, channel where finance is put at the forefront: new, diversified, investors value more volatile returns, and this explains the rise in real, firm level, uncertainty. Hence, technical change and globalization of trade flows might not be the sole driving forces behind the past rise in firm level uncertainty and wage inequality (in English speaking countries) or unemployment (in continental Europe).
To be fair, some existing papers have been investigating the impact of financial development on the labor market; those papers have however mostly argued that the balance of power may have shifted in recent decades away from workers toward capitalists. However, any macroeconomic interpretation of recent trends in light of this literature requires to explain why labor’s share in GDP has been fully stable in most OECD countries. Our paper takes another route: better financial systems do not affect the sharing rule between capital and labor, but improve risk sharing among investors.
Last, our analysis may shed light on a famous recent result from the finance literature. Campbell, Lettau, Malkiel and Xu (2000) have shown that the idiosyncratic volatility of stock returns has sharply increased over the past decades. This could partly reflect the fact that listing costs decreased over the period allowing younger but more risky firms to list on stockmarkets ( the NASDAQ was created in 1971). But as shown by Pastor and Veronesi [2002] and Malkiel and Xu [2001], this line of explanation cannot fully account for rise in idiosyncratic volatility . In contrast to this “pure finance” view, some very recent contributions suggest that the rise in stock returns volatility is in fact driven by real effects since firms’ real profits have also become more uncertain. Our explanation for the rise in stock return sphere.
The next section lays out the model, section 3 solves it and section 4 draws the main predictions. Section 5 presents our data and some facts. Section 6 brings some of the theoretical predictions to the test. Various robustness checks are performed in section 7 and section 8 concludes.
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