Quarterly Bulletin
Corporate Sector Articles

Share prices and the value of workers (400k)
(by Eran Yashiv, Bank of England Houblon-Norman Fellow). Is the value of workers in a company reflected in its share price? Traditional approaches suggest not. This article proposes an alternative: the workforce of the company can be seen as a collection of matches between workers and jobs. The company decides on forming matches, as well as on investment in physical capital, on the basis of its expectations of future profits, which also determine the share price. So there is a link between investment and hiring on the one hand and share prices on the other. This approach has implications for the analysis of share price movements, employment and investment.

The determination of UK corporate capital gearing (440k)
(by Peter Brierley of the Bank’s Financial Stability area and Philip Bunn of the Bank’s MacroPrudential Risks Division). This article seeks to explain the high current level of UK corporate capital gearing. It also explores the empirical relationship between gearing and a range of financial characteristics. Analysis of aggregate data suggests that the sharp rise in gearing between 1999 and 2002 cannot all be explained by an increase in its long-run equilibrium level, according to a model where that equilibrium is determined by the trade-off between the tax benefits of debt and the risks of financial distress. There are a number of factors not captured by that model that could have contributed to a sustainable increase in gearing. But on balance it seems that gearing has been above a sustainable level, causing firms to adjust their balance sheets by paying lower dividends and issuing more equity and perhaps by investing less than they otherwise would have done. Analysis of company accounts data suggests that gearing levels are persistent, positively related to company size and negatively correlated with growth opportunities and the importance of intangible assets. In the past, highly profitable companies had low gearing, but this relationship has broken down since 1995 as more profitable firms have increased their debt.

Financial effects on corporate investment in UK business cycles (158k)
(By Simon Hall of the Bank's International Finance Division). The depth and persistence of the UK recession of the early 1990s surprised many economic forecasters, particularly the prolonged weakness of corporate investment growth. Views on the causes of sluggish investment in this period vary. However a number of analyses have suggested a potential role for financial factors, noting the coincidence of weaker corporate investment with a marked financial retrenchment by the sector.

This article focuses on the potential role of corporate financial health in investment behaviour in the early 1990s. It does so by examining whether the theoretical predictions of a macroeconomic model explicitly designed to allow for interactions between real and financial factors are consistent with features of observed behaviour. This 'financial accelerator model', which includes potential for financial effects, is used as a tool for analysing possible shifts over time in the strength of interactions between corporate financial conditions and investment. Model simulations suggest that financial effects may have been more important in the early 1990s recession than in the 1980s recession.

Clearly these simple experiments cannot hope to explain the complexities of investment behaviour in recent recessions: the article does not claim that financial accelerator effects were the single, or even the most important, determinant of corporate investment behaviour in the early 1990s recession. But the model-based results do illustrate that relationships between financial conditions and real behaviour can vary substantially over time. In this way, the exercise highlights the importance of monitoring interactions between corporate financial fragility, finance supply and investment spending.

The financing of technology-based small firms: a review of the literature (143k)
This review assesses the academic literature of recent years on the financing issues faced by technology-based small firms (TBSFs). It was produced as part of the latest report on these firms by the Bank's Domestic Finance Division, published last month. This report finds that, while there may still be market weaknesses in the provision of relatively small amounts of risk capital to TBSFs at the start-up and early stages, these appear to be less than four or five years ago, and to impact on TBSFs less than was the case then. Peter Brierley, Head of Domestic Finance Division, explains why the literature suggests that market imperfections in the provision of finance to small companies may apply with particular force to the start-up and early-stage financing of TBSFs, but concludes that there is little compelling evidence of a major market failure.

Technology-based small firms (TBSFs) are generally defined either as businesses whose products or services depend largely on the application of scientific or technological knowledge, or as businesses whose activities embrace a significant technology component as a major source of competitive advantage. These businesses are generally located in industries such as communications, IT, computing, biotechnology, electronics and medical/life sciences.

Earlier work at the Bank suggested that there might be some inefficiencies in the market for financing TBSFs, especially at the start-up and early stages of finance. Recent official enquiries in this area have focused in particular on possible barriers that high-tech companies in the United Kingdom might face in attracting finance. The profile of this work has been enhanced by the current Government's desire to encourage 'entrepreneurship', by growing interest in the 'new economy', and by the swings in investor sentiment towards high-tech stocks over the past two years.

These factors have motivated a new Bank report on the financing of TBSFs, which was published on 5 February. As background to this report, an extensive review of the economic literature on the financing of TBSFs has been undertaken, the results of which are summarised in this article.

The information in UK company profit warnings
(69k)
(by Andrew Clare of the Bank's Monetary Instruments and Markets Division). A wide range of indicators of UK economic activity is available. One relatively new indicator is a time series of 'profit warnings' issued by UK companies. These profit warnings are trading statements that have been reported in the press identifying an adverse outlook for a firm's future earnings and profitability. Bank staff recorded 88 UK company profit warnings in 2000 Q4, compared with 57 in 1999 Q4.

This article examines the information content of trading statements issued by UK companies between 1994 and 2000. The article summarises work undertaken at the Bank aimed at establishing: whether these statements contain genuine information; which types of statement are most informative; and whether the incidence of the statements can tell us anything about the state of the UK economy.

It appears that statements reporting an adverse outlook for the future prospects of the firm ('profit warnings') do contain market-relevant information, causing financial agents to revise expectations about future profitability dramatically. Statements reporting a positive outlook for future profits tend to have a much smaller (though still significant) impact upon prices—implying that the information content of these statements is lower. There is also some weak and preliminary evidence that the incidence of negative trading statements issued by FTSE 350 companies may be a leading indicator of UK economic activity.

Interpreting movements in high-yield corporate bond market spreads (162k)
(by Neil Cooper, Robert Hillman and Damien Lynch of the Bank's Monetary Instruments and Markets Division). Spreads of corporate bond yields over risk-free rates are often used as a leading indicator of macroeconomic conditions. The large widening of spreads within the US high-yield bond market during the second half of 2000 might be a precursor of a downturn in the US economy.

Credit spreads in the United States widened considerably during 2000, particularly in the high-yield bond market. Even indices of single-A and AA rated bonds widened in the last few months of the year. By contrast, with the exception of telecoms bonds, there was little evidence of widening in UK credit spreads. In this article we explain why US spreads widened, and assess the implications for the US macroeconomic outlook.

The financing of small firms in the United Kingdom
(66k)
(by Melanie Lund and Jane Wright of the Bank's Domestic Finance Division). Economists have often argued that imperfections in the financing of small firms arise because of information asymmetries: the small business owner generally has much better information than the bank on his firm's performance. This is fundamentally different from the situation with large companies. This article examines the developments over the past decade in the financing of small businesses in the United Kingdom. It notes the sector's reduced dependence on external funds and increased use of a range of financing products. The article also assesses the current risks faced by the small firms sector and its providers of finance, suggesting that this sector is now more resilient to a downturn in the economy than in the early 1990s, thus reducing the likelihood of a recurrence of the high levels of business failures experienced in that recession.

The article looks at the economic theory on the provision of finance in the small firms sector, indicating how market failures in the financing of small firms could arise from information asymmetries, leading to problems of adverse selection and moral hazard. Empirical evidence provides little conclusive support for the existence of such imperfections, but the theory highlights banks' problems in undertaking risk assessment of these firms.

The article examines how the patterns of small firms financing have changed over the past decade, making it less likely that the high levels of business failures and bank losses experienced in the previous recession will recur. It was noted that small businesses are now more appropriately financed than in the early 1990s. They are more dependent on internal sources of finance - with many of the smallest businesses being net creditors to the banking sector - and businesses that do require external finance now use a wider range of finance products. Traditional bank finance does, however, remain the most important source of external finance for small businesses.

Market competition in the provision of finance to small firms was identified as a means of facilitating and maintaining the momentum for improvement. The providers of bank finance to small businesses operate in a concentrated industry, but the degree of competition in this market is increasing, because of technological changes and new entrants.

One area where improvement in the provision of finance is less evident is in the supply of risk capital for technology-based small firms. Problems appear to arise at the start-up stage, where supplies of 'seedcorn' and early-stage equity finance are limited. Many formal venture capital firms tend not to invest in small enough amounts for these companies, and the informal venture capital market (business angels) is still underdeveloped compared with that in the United States.

The UK personal and corporate sectors during the 1980s and 1990s: a comparison of key financial indicators (243k)
(by Glenn Hoggarth of the Bank’s Financial Intermediaries Division and Alec Chrystal of the Bank’s Monetary Assessment and Strategy Division). This article draws together some key indicators of financial conditions in the personal and corporate sectors, which may provide interesting insights into aspects of the behaviour of the UK economy during the course of the two most recent business cycles. Although the main focus is retrospective, this analysis could also help to assess the likely future course of important components of aggregate demand.

There are both similarities and differences in the financial positions of the corporate and personal sectors in the 1980s and 1990s. The current level of income gearing in both sectors is similar to the comparable stage of the previous economic cycle (end 1986) - debt levels are currently higher, but nominal interest rates are lower. In the 1980s, there was little change in income gearing for either the corporate or personal sectors prior to the sharp tightening of monetary policy in 1988, but the marked rise afterwards preceded the 1990­92 recession. No comparable rise in income gearing has yet been evident in the 1990s recovery, though it has risen slightly following the interest rate rises since Spring 1997.

ICCs’ capital gearing has been above the level of the mid 1980s throughout the current recovery, but so far has shown no signs of the kind of deterioration that occurred after 1987. Similarly, the stock of personal sector debt began this recovery at a higher level than in the early 1980s but, unlike then, has grown no faster than incomes and slower than wealth so far during the 1990s.

There are other contrasts between the 1980s and 1990s recoveries. With regard to lending flows, in the 1980s boom, there was a channelling of funds to ICCs and personal housing loans. But in the current recovery, lending has been channelled more towards unsecured consumer credit and to OFIs. With regard to asset prices, in the 1980s, property and equity prices rose markedly in tandem. Although equity prices have again risen strongly in the 1990s, property prices have so far risen slowly in comparison.

During the 1980s, the spread of bank and building society mortgage rates over base rate fell only towards the end of the boom and only as a result of a delayed response to the increase in official rates. In contrast, since the early 1990s, lending spreads in the mortgage market have fallen, as they appear to have done in other main lending markets. This may have contributed to the growth in lending during this recovery, but does not necessarily imply an increase in financial risk, so long as the financial status of borrowers has improved.

The evolution of the financial position of the personal sector during the 1980s probably reflected a steady response to financial liberalisation from a starting position of sub-optimal debt levels - total personal debt rose much more rapidly than incomes, and at least in line with the rapid growth in personal wealth. Although consumer credit has increased at least as much relative to incomes during the current upswing as in the previous one, it now still accounts for only around one eighth of personal sector debt. As noted above, the relatively slow growth in lending for house purchase so far during this upswing has meant that the personal sector debt/income ratio has remained flat, while the debt/wealth ratio has fallen. This suggests that the upward adjustments in personal sector debt levels that followed the 1980s liberalisation may have been completed before the current recovery.

Company profitability and finance (69k)
(by Kieren Wright of the Structural Economic Analysis Division) assesses the evolution of firms' financial position over 1993 and 1994 Q1, comparing it with the 198284 recovery. Profitability has been markedly higher this time; ICCs' retained earnings were up by over a third in 1993. Firms have made unprecedented net repayments of bank debt, while increasing their use of capital markets. Investment has been higher as a share of GDP, but has not yet picked up as the recovery has progressed.

Investment appraisal criteria and the impact of low inflation (26k)
(by Andrew Wardlow of the Conjunctural Assessment and Projections Division) looks at the impact of a return to low inflation on corporate investment decision-making. It considers the different investment appraisal criteria used by firms - and the role they give them - and assesses the significance of firms' apparent slowness to adjust.