ANTI-COMPETITIVE FINANCIAL CONTRACTING: THE DESIGN OF FINANCIAL CLAIMS.



ism in the United States (Segliman 1982). The extension of monopoly power by
banks into industry requires the double coincidence of imperfect competition
in the banking industry and bank equity-holding.20

A major policy debate is now in course as to whether this restrictive legis-
lation should be relaxed. In his overview of the costs and benefits of such a re-
form, Saunders (1994, pp.239-40) expresses concern that, ”
A bank may restrict
the supply of credit to the competitors of its commercial firm affiliate...while
showing preferential credit treatment towards its affiliated firm... This issue
is important given the widely held public policy view that banks are ’special’
in their provision of loans or credit finance to corporations.
The Economist
(Feb 1st 1997) also asks whether pressure to reform the Glass-Steagall Act
”might not ...recreate the cartels of [J.P.] Morgan’s day?” Our model suggests
that these fears would indeed be rationally grounded, if US financial markets
were today as uncompetitive as 70 years ago.2
1 But given the competitiveness
of sources for funding in the US, a relaxation of the rules will probably have
little impact.

In countries where funding opportunities are more scarce, however, equity
holding by banks may give more cause for concern. For example, entrant firms
in Eastern Europe face severe funding shortages because there is little com-
petition in the banking industry, and little opportunity for outside funding
(Pissarides 1998). Moreover, existing banks tend to be biased towards fund-
ing only incumbent firms (Gordon 1994, p59, Frydman et al 1993). In these
circumstances it might be advisable for these countries to avoid bank equity
holding, rather than encouraging bank debt-equity swaps in the old state in-
dustries, as has sometimes been the case (for a description of events in Poland,
Hungary and Slovenia, see for example van Wijnbergen 1998).

This analysis assumes of course that competition is beneficial (see section
5.1 above). However, there may be instances where it is desirable to hold
off competition in order to stimulate growth. The situation in Eastern Eu-
rope probably does not correspond to such an instance, since it is the new
entrant firms - currently starved of funding - which are most likely to generate
new growth, rather than the larger former state-owned incumbent enterprises
(Pissarides 1998). But economists such as Schumpeter and Gershenkron have

20For an alternative view of the impact of bank equity-holding, see Arping (1999). In
the context of a perfectly competitive financial market he shows that if entrant firms face a
soft budget constraint, limited ownership of established firms by banks can make it easier
for young firms to obtain debt financing. As in our model, he shows that equity-holding
makes banks act toughly towards entrants. But when the latter cannot otherwise commit
to repay, bank toughness improves their ex post incentives, and thus their ex ante prospects
of finance.

21De Long (1990) raises the interesting possibility that financial capitalism and lack of
concentration in investment banking may be intimately linked, since it is difficult for banks
with small market shares to maintain reputations.

20



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