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HANDBOOKOFTHEECONOMICSOFFINANCEVOLUME1AHANDBOOKSINECONOMICS21SeriesEditorsKENNETHJ. ARROWMICHAELD. INTRILIGATORAmsterdam Boston Heidelberg London New York OxfordParis San Diego San Francisco Singapore Sydney TokyoHANDBOOKOFTHE ECONOMICS OFFINANCEVOLUME1ACORPORATEFINANCEEditedbyGEORGEM. CONSTANTINIDESUniversityof ChicagoMILTONHARRISUniversityof ChicagoandRENEM. STULZOhioStateUniversity2003Amsterdam Boston Heidelberg London New York OxfordParis San Diego San Francisco Singapore Sydney TokyoELSEVIER B.V.Sara Burgerhartstraat 25P.O. Box 211, 1000 AE Amsterdam, The Netherlands 2003 Elsevier B.V. All rights reserved.This work is protected under copyright by Elsevier, and the following terms and conditions apply to its use:PhotocopyingSingle photocopies of single chapters may be made for personal use as allowed by national copyright laws. 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Because of rapid advances in the medical sciences, in particular, independent verication ofdiagnoses and drug dosages should be made.First edition 2003Library of Congress Cataloging-in-Publication DataA catalog record from the Library of Congress has been applied for.British Library Cataloguing in Publication DataA catalogue record from the British Library has been applied for.ISBN: 0-444-50298-X (set, comprising vols. 1A & 1B)ISBN: 0-444-51362-0 (vol. 1A)ISBN: 0-444-51363-9 (vol. 1B)ISSN: 0169-7218 (Handbooks in Economics Series) The paper used in this publication meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper).Printed in The Netherlands.INTRODUCTION TO THE SERIESThe aim of the Handbooks in Economics series is to produce Handbooks for variousbranches of economics, each of which is a denitive source, reference, and teachingsupplement for use by professional researchers and advanced graduate students. EachHandbook provides self-contained surveys of the current state of a branch of economicsin the form of chapters prepared by leading specialists on various aspects of thisbranch of economics. These surveys summarize not only received results but alsonewer developments, from recent journal articles and discussion papers. Some originalmaterial is also included, but the main goal is to provide comprehensive and accessiblesurveys. The Handbooks are intended to provide not only useful reference volumes forprofessional collections but also possible supplementary readings for advanced coursesfor graduate students in economics.KENNETH J. ARROW and MICHAEL D. INTRILIGATORPUBLISHERS NOTEFor a complete overview of the Handbooks in Economics Series, please refer to thelisting at the end of this volume.ThisPage Intentionally LeftBlankCONTENTS OF THE HANDBOOKVOLUME 1ACORPORATE FINANCEChapter 1Corporate Governance and ControlMARCO BECHT, PATRICK BOLTON and AILSA ROELLChapter 2Agency, Information and Corporate InvestmentJEREMY C. STEINChapter 3Corporate Investment PolicyMICHAEL J. BRENNANChapter 4Financing of CorporationsSTEWART C. MYERSChapter 5Investment Banking and Security IssuanceJAY R. RITTERChapter 6Financial InnovationPETER TUFANOChapter 7Payout PolicyFRANKLIN ALLEN and RONI MICHAELYChapter 8Financial IntermediationGARY GORTON and ANDREW WINTONChapter 9Market MicrostructureHANS R. STOLLviii Contents of the HandbookVOLUME 1BFINANCIAL MARKETS AND ASSET PRICINGChapter 10Arbitrage, State Prices and Portfolio TheoryPHILIP H. DYBVIG and STEPHEN A. ROSSChapter 11Intertemporal Asset-Pricing TheoryDARRELL DUFFIEChapter 12Tests of Multi-Factor Pricing Models, Volatility, and Portfolio PerformanceWAYNE E. FERSONChapter 13Consumption-Based Asset PricingJOHN Y. CAMPBELLChapter 14The Equity Premium in RetrospectRAJNISH MEHRA and EDWARD C. PRESCOTTChapter 15Anomalies and Market EfciencyG. WILLIAM SCHWERTChapter 16Are Financial Assets Priced Locally or Globally?G. ANDREW KAROLYI and RENE M. STULZChapter 17Microstructure and Asset PricingDAVID EASLEY and MAUREEN OHARAChapter 18A Survey of Behavioral FinanceNICHOLAS C. BARBERIS and RICHARD H. THALERFinance Optimization, and the Irreducibly Irrational Component of Human BehaviorROBERT J. SHILLERChapter 19DerivativesROBERT E. WHALEYChapter 20Fixed Income PricingQIANG DAI and KENNETH J. SINGLETONPREFACEFinancial economics applies the techniques of economic analysis to understand thesavings and investment decisions by individuals, the investment, nancing and payoutdecisions by rms, the level and properties of interest rates and prices of nancialassets and derivatives, and the economic role of nancial intermediaries. Until the1950s, nance was viewed primarily as the study of nancial institutional detail andwas hardly accorded the status of a mainstream eld of economics. This perceptionwas epitomized by the difculty Harry Markowitz had in receiving a PhD degree inthe economics department at the University of Chicago for work that eventually wouldearn him a Nobel prize in economic science. This state of affairs changed in the secondhalf of the 20th century with a revolution that took place from the 1950s to the early1970s. At that time, key progress was made in understanding the nancial decisionsof individuals and rms and their implications for the pricing of common stocks, debt,and interest rates.Harry Markowitz, William Sharpe, James Tobin, and others showed how individualsconcerned about their expected future wealth and its variance make investmentdecisions. Their key results showing the benets of diversication, that wealth isoptimally allocated across funds that are common across individuals, and that investorsare rewarded for bearing risks that are not diversiable, are now the basis for much ofthe investment industry. Merton Miller and Franco Modigliani showed that the conceptof arbitrage is a powerful tool to understand the implications of rm capital structuresfor rm value. In a world without frictions, they showed that a rms value is unrelatedto its capital structure. Eugene Fama put forth the efcient markets hypothesis and ledthe way in its empirical investigation. Finally, Fischer Black, Robert Merton and MyronScholes provided one of the most elegant theories in all of economics: the theory ofhow to price nancial derivatives in markets without frictions.Following the revolution brought about by these fathers of modern nance, the eldof nance has experienced tremendous progress. Along the way, it inuenced publicpolicy throughout the world in a major way, played a crucial role in the growth ofa new $100 trillion dollar derivatives industry, and affected how rms are managedeverywhere. However, nance also evolved from being at best a junior partner ineconomics to being often a leader. Key concepts and theories rst developed in nanceled to progress in other elds of economics. It is now common among economiststo use theories of arbitrage, rational expectations, equilibrium, agency relations, andinformation asymmetries that were rst developed in nance. The committee for thex PrefaceAlfred Nobel Memorial Prize in economic science eventually recognized this state ofaffairs. Markowitz, Merton, Miller, Modigliani, Scholes, Sharpe, and Tobin receivedNobel prizes for contributions in nancial economics.This Handbook presents the state of the eld of nance fty years after thisrevolution in modern nance started. The surveys are written by leaders in nancialeconomics. They provide a comprehensive report on developments in both theoryand empirical testing in nance at a level that, while rigorous, is neverthelessaccessible to researchers not intimate with the eld and doctoral students in economics,nance and related elds. By summarizing the state of the art and pointing outas-yet unresolved questions, this Handbook should prove an invaluable resource toresearchers planning to contribute to the eld and an excellent pedagogical tool forteaching doctoral students. The book is divided into two Volumes, corresponding tothe traditional taxonomy of nance: corporate nance (1A) and nancial markets andasset pricing (1B).1. Corporate nanceCorporate nance is concerned with how businesses work, in particular, how theyallocate capital (traditionally, the capital budgeting decision) and how they obtaincapital (the nancing decision). Though managers play no independent role in thework of Miller and Modigliani, major contributions in nance since then have shownthat managers maximize their own objectives. To understand the rms decisions, itis therefore necessary to understand the forces that lead managers to maximize thewealth of shareholders. For example, a number of researchers have emphasized thepositive and negative roles of large shareholders in aligning incentives of managersand shareholders. The part of the Handbook devoted to corporate nance starts with anoverview, entitled Corporate Governance and Control, by Marco Becht, Patrick Bolton,and Ailsa R oell (Chapter 1) of the framework in which managerial activities take place.Their broad survey covers everything about corporate governance, from its history andimportance to theories and empirical evidence to cross-country comparisons.Following the survey of corporate governance in Chapter 1, two complementaryessays discuss the investment decision. In Agency, Information and CorporateInvestment, Jeremy Stein (Chapter 2) focuses on the effects of agency problems andasymmetric information on the allocation of capital, both across rms and within rms.This survey does not address the issue of how to value a proposed investment project,given information about the project. That topic is considered in Corporate InvestmentPolicy by Michael Brennan in Chapter 3. Brennan draws out the implications ofrecent developments in asset pricing, including option pricing techniques and taxconsiderations, for evaluating investment projects.In Chapter 4, Financing of Corporations, the focus moves to the nancing decision.Stewart Myers provides an overview of the research that seeks to explain rms capitalstructure, that is, the types and proportions of securities rms use to nance theirPreface xiinvestments. Myers covers the traditional theories that attempt to explain proportionsof debt and equity nancing as well as more recent theories that attempt to explainthe characteristics of the securities issued. In assessing the different capital structuretheories, he concludes that he does not expect that there will ever be one capitalstructure theory that applies to all rms. Rather, he believes that we will always usedifferent theories to explain the behavior of different types of rms. In Chapter 5,Investment BankingandSecurityIssuance, Jay Ritter is concerned with how rmsraise equity and the role of investment banks in that process. He examines both initialpublic offerings and seasoned equity offerings. A striking result discovered rst byRitter is that rms that issue equity experience poor long-term stock returns afterwards.This result has led to a number of vigorous controversies that Ritter reviews in thischapter.Firms may also obtain capital by issuing securities other than equity and debt.A hallmark of the last thirty years has been the tremendous amount of nancialinnovation that has taken place. Though some of the innovations zzled and othersprovided fodder to crooks, nancial innovation can enable rms to undertake protableprojects that otherwise they would not be able to undertake. In Chapter 6,FinancialInnovation, Peter Tufano delves deeper into the issues of security design and nancialinnovation. He reviews the process of nancial innovation and explanations of thequantity of innovation.Investors do not purchase equity without expecting a return from their investment.In one of their classic papers, Miller and Modigliani show that, in the absence offrictions, dividend policy is irrelevant for rm value. Since then, a large literature hasdeveloped that identies when dividend policy matters and when it does not. FranklinAllen and Roni Michaely (Chapter 7) survey this literature in their essay entitledPayout Policy. Allen and Michaely consider the roles of taxes, asymmetric information,incomplete contracting and transaction costs in determining payouts to equity holders,both dividends and share repurchases.Chapter 8, Financial Intermediation, focuses more directly on the role nancialintermediaries play. Although some investment is funded directly through capitalmarkets, according to Gary Gorton and Andrew Winton, the vast majority of externalinvestment ows through nancial intermediaries. In Chapter 8, Gorton and Wintonsurvey the literature on nancial intermediation with emphasis on banking. Theyexplore why intermediaries exist, discuss banking crises, and examine why and howthey are regulated. Exchanges on which securities are traded play a crucial role inintermediating between individuals who want to buy securities and others who wantto sell them. In many ways, they are special types of corporations whose workingsaffect the value of nancial securities as well as the size of nancial markets.The Handbook contains two chapters that deal with the issues of how securities aretraded. Market Microstructure, by Hans Stoll (Chapter 9), focuses on how exchangesperform their functions as nancial intermediaries and therefore is included in thispart. Stoll examines explanations of the bid-ask spread, the empirical evidence for theseexplanations, and the implications for market design. Microstructure and Asset Pricing,xii Prefaceby Maureen OHara and David Easley (Chapter 17), examines the implications of howsecurities trade for the properties of securities returns and is included in Volume 1Bon Financial Markets and Asset Pricing.2. Financial markets and asset pricingA central theme in nance and economics is the pursuit of an understanding of howthe prices of nancial securities are determined in nancial markets. Currently, thereis immense interest among academics, policy makers, and practitioners in whetherthese markets get prices right, fueled in part by the large daily volatility in prices andby the large increase in stock prices over most of the 1990s, followed by the sharpdecrease in prices at the turn of the century. Our understanding of how securities arepriced is far from complete. In the early 1960s, Eugene Fama from the Universityof Chicago established the foundations for the efcient markets view that nancialmarkets are highly effective in incorporating information into asset prices. This viewled to a large body of empirical and theoretical work. Some of the chapters in this partof the Handbook review that body of work, but the efcient markets view has beenchallenged by the emergence of a new, controversial eld, behavioral nance, whichseeks to show that psychological biases of individuals affect the pricing of securities.There is therefore divergence of opinion and critical reexamination of given doctrine.This is fertile ground for creative thinking and innovation.In Volume 1B of the Handbook, we invite the reader to partake in this intellectualodyssey. We present eleven original essays on the economics of nancial markets.The divergence of opinion and puzzles presented in these essays belies the incredibleprogress made by nancial economists over the second half of the 20th century thatlay the foundations for future research.The modern quantitative approach to nance has its origins in neoclassicaleconomics. In the opening essay titledArbitrage, StatePricesandPortfolioTheory(Chapter 10), Philip Dybvig and Stephen Ross illustrate a surprisingly large amountof the intuition and intellectual content of modern nance in the context of a single-period, perfect-markets neoclassical model. They discuss the fundamental theoremsof asset pricing the consequences of the absence of arbitrage, optimal portfoliochoice, the properties of efcient portfolios, aggregation, the capital asset-pricingmodel (CAPM), mutual fund separation, and the arbitrage pricing theory (APT).A number of these notions may be traced to the original contributions of StephenRoss.In his essay titled Intertemporal Asset Pricing Theory (Chapter 11), Darrell Dufeprovides a systematic development of the theory of intertemporal asset pricing, rstin a discrete-time setting and then in a continuous-time setting. As applications of thebasic theory, Dufe also presents comprehensive treatments of the term structure ofinterest rates and xed-income pricing, derivative pricing, and the pricing of corporatesecurities with default modeled both as an endogenous and an exogenous process.Preface xiiiThese applications are discussed in further detail in some of the subsequent essays.Dufes essay is comprehensive and authoritative and may serve as the basis of anentire 2nd-year PhD-level course on asset pricing.Historically, the empirically testable implications of asset-pricing theory have beencouched in terms of the mean-variance efciency of a given portfolio, the validityof a multifactor pricing model with given factors, or the validity of a given stochasticdiscount factor. Furthermore, different methodologies have been developed and appliedin the testing of these implications. In Tests of Multi-Factor Pricing Models, Volatility,and Portfolio Performance (Chapter 12), Wayne Ferson discusses the empiricalmethodologies applied in testing asset-pricing models. He points out that these threestatements of the empirically testable implications are essentially equivalentand thatthe seemingly different empirical methodologies are equivalent as well.In his essay titledConsumption-BasedAssetPricing (Chapter 13), John Campbellbegins by reviewing the salient features of the joint behavior of equity returns,aggregate dividends, the interest rate, and aggregate consumption in the USA. Featuresthat challenge existing asset-pricing theory include, but are not limited to, the equitypremium puzzle: the nding that the low covariance of the growth rate of aggregateconsumption with equity returns is a major stumbling block in explaining the meanaggregate equity premium and the cross-section of asset returns, in the context of therepresentative-consumer, time-separable-preferences models examined by Grossmanand Shiller (1981), Hansen and Singleton (1983), and Mehra and Prescott (1985).Campbell also examines data from other countries to see which features of the USAdata are pervasive. He then proceeds to relate these ndings to recent developmentsin asset-pricing theory that relax various assumptions of the standard asset-pricingmodel.In a closely related essay titledTheEquityPremiuminRetrospect (Chapter 14),Rajnish Mehra and Edward Prescott the researchers who coined the term criticallyreexamine the data sources used to document the equity premium puzzle in the USAand other major industrial countries. They then proceed to relate these ndings torecent developments in asset-pricing theory by employing the methodological tool ofcalibration, as opposed to the standard empirical estimation of model parameters andthe testing of over-identifying restrictions. Mehra and Prescott have different viewsthan Campbell as to which assumptions of the standard asset-pricing model need tobe relaxed in order to address the stylized empirical ndings.Why are these questions important? First and foremost, nancial markets play acentral role in the allocation of investment capital and in the sharing of risk. Failure toanswer these questions suggests that our understanding of the fundamental process ofcapital allocation is highly imperfect. Second, the basic economic paradigm employedin analyzing nancial markets is closely related to the paradigm employed in the studyof business cycles and growth. Failure to explain the stylized facts of nancial marketscalls into question the appropriateness of the related paradigms for the study of macro-economic issues. The above two essays convey correctly the status quo that the puzzlexiv Prefaceis at the forefront of academic interest and that views regarding its resolution aredivergent.Several goals are accomplished in William Schwerts comprehensive and incisiveessay titledAnomaliesandMarket Efciency (Chapter 15). First, Schwert discussescross-sectional and time-series regularities in asset returns, both at the aggregate anddisaggregate level. These include the size, book-to-market, momentum, and dividendyield effects. Second, Schwert discusses differences in returns realized by differenttypes of investors, including individual and institutional investors. Third, he evaluatesthe role of measurement issues in many of the papers that study anomalies, includingthe difcult issues associated with long-horizon return performance. Finally, Schwertdiscusses the implications of the anomalies literature for asset-pricing and corporatenance theories. In discussing the informational efciency of the market, Schwertpoints out that tests of market efciency are also joint tests of market efciency anda particular equilibrium asset-pricing model.In the essay titledAreFinancialAssetsPricedLocallyorGlobally? (Chapter 16),Andrew Karolyi and Ren e Stulz discuss the theoretical implications of and empiricalevidence concerning asset-pricing theory as it applies to international equities markets.They explain that country-risk premia are determined internationally, but the evidenceis weak on whether international factors affect the cross-section of expected returns.A long-standing puzzle in international nance is that investors invest more heavily indomestic equities than predicted by the theory. Karolyi and Stulz argue that barriersto international investment only partly resolve the home-bias puzzle. They concludethat contagion the linkage of international markets may be far less prevalent thancommonly assumed.At frequencies lower than the daily frequency, asset-pricing theory generally ignoresthe role of the microstructure of nancial markets. In their essay titled Microstructureand Asset Pricing (Chapter 17), David Easley and Maureen OHara survey thetheoretical and empirical literature linking microstructure factors to long-run returns,and focus on why stock prices might be expected to reect premia related to liquidityor informational asymmetries. They show that asset-pricing dynamics may be betterunderstood by recognizing the role played by microstructure factors and the linkagesof microstructure and fundamental economic variables.All the models that are discussed in the essays by Campbell, Mehra and Prescott,Schwert, Karolyi and Stulz, and Easley and OHara are variations of the neoclassicalasset-pricing model. The model is rational, in that investors process informationrationally and have unambiguously dened preferences over consumption. Naturally,the model allows for market incompleteness, market imperfections, informationalasymmetries, and learning. The model also allows for differences among assets forliquidity, transaction costs, tax status, and other institutional factors. Many of thesevariations are explored in the above essays.In their essay titled A Survey of Behavioral Finance (Chapter 18), NicholasBarberis and Richard Thaler provide a counterpoint to the rational model by providingexplanations of the cross-sectional and time-series regularities in asset returns byPreface xvrelying on economic models that are less than fully rational. These include culturaland psychological factors and tap into the rich and burgeoning literature on behavioraleconomics and nance. Robert Shiller, who is, along with Richard Thaler, one of thefounders of behavioral nance, provides his personal perspective on behavioral nancein his statement titled Finance, Optimization and the Irreducibly Irrational Componentof Human Behavior.One of the towering achievements in nance in the second half of the 20th century isthe celebrated option-pricing theory of Black and Scholes (1973) and Merton (1973).The model has had a profound inuence on the course of economic thought. Inhis essay titledDerivatives (Chapter 19), Robert Whaley provides comprehensivecoverage of the topic. Following a historical overview of futures and options, heproceeds to derive the implications of the law of one price and then the BlackScholesMerton theory. He concludes with a systematic coverage of the empirical evidenceand a discussion of the social costs and benets associated with the introductionof derivatives. Whaleys thorough and insightful essay provides an easy entry to animportant topic that many economists nd intimidating.In their essay titled Fixed-Income Pricing (Chapter 20), Qiang Dai and KenSingleton survey the literature on xed-income pricing models, including termstructure models, xed-income derivatives, and models of defaultable securities.They point out that this literature is vast, with both the academic and practitionercommunities having proposed a wide variety of models. In guiding the reader throughthese models, they explain that different applications call for different models based onthe trade-offs of complexity, exibility, tractability, and data availability the art ofmodeling. The Dai and Singleton essay, combined with Dufes earlier essay, providesan insightful and authoritative introduction to the world of xed-income pricing modelsat the advanced MBA and PhD levels.We hope that the contributions represented by these essays communicate theexcitement of nancial economics to beginners and specialists alike and stimulatefurther research.We thank Rodolfo Martell for his help in processing the papers for publication.GEORGE M. CONSTANTINIDESUniversity of Chicago, ChicagoMILTON HARRISUniversity of Chicago, ChicagoRENE STULZOhio State University, ColumbusReferencesBlack, F., and M.S. Scholes (1973), The pricing of options and corporate liabilities, Journal of PoliticalEconomy 81:637654.xvi PrefaceGrossman, S.J., and R.J. Shiller (1981), The determinants of the variability of stock market prices,American Economic Review Papers and Proceedings 71:222227.Hansen, L.P., and K.J. Singleton (1982), Generalized instrumental variables estimation of nonlinearrational expectations models, Econometrica 50:12691288.Mehra, R., and E.C. Prescott (1985), The equity premium: a puzzle, Journal of Monetary Economics15:145161.Merton, R.C. (1973), Theory of rational option pricing, Bell Journal of Economics and ManagementScience 4:141183.CONTENTS OF VOLUME 1AIntroduction to the Series vContents of the Handbook viiPreface ixCORPORATE FINANCEChapter 1Corporate Governance and ControlMARCO BECHT, PATRICK BOLTON and AILSA ROELL 1Abstract 3Keywords 31. Introduction 42. Historical origins: a brief sketch 52.1. How representative is corporate government? 52.2. Whom should corporate government represent? 73. Why corporate governance is currently such a prominent issue 73.1. The world-wide privatization wave 83.2. Pension funds and active investors 93.3. Mergers and takeovers 123.4. Deregulation and capital market integration 123.5. The 1998 Russia/East Asia/Brazil crisis 123.6. Scandals and failures at major USA corporations 134. Conceptual framework 134.1. Agency and contracting 134.2. Ex-ante and ex-post efciency 134.3. Shareholder value 144.4. Incomplete contracts and multiple constituencies 144.5. Why do we need regulation? 164.6. Dispersed ownership 174.7. Summary and conclusion 175. Models 195.1. Takeover models 195.2. Blockholder models 245.3. Delegated monitoring and large creditors 29xviii Contents of Volume 1A5.4. Board models 315.5. Executive compensation models 335.6. Multi-constituency models 356. Comparative perspectives and debates 416.1. Comparative systems 426.2. Views expressed in corporate governance principles and codes 476.3. Other views 497. Empirical evidence and practice 497.1. Takeovers 507.2. Large investors 597.3. Minority shareholder action 677.4. Boards 717.5. Executive compensation and careers 737.6. Multiple constituencies 808. Conclusion 82References 86Chapter 2Agency, Information and Corporate InvestmentJEREMY C. STEIN 111Abstract 113Keywords 1131. Introduction 1141.1. Scope of the essay: whats covered and whats left out 1151.2. Organization 116Part A. Investment at the rm level 1162. Theoretical building blocks: investment at the rm level 1162.1. Models of costly external nance 1162.2. The agency conict between managers and outside stockholders 1202.3. Investment decisions when stock prices deviate from fundamentals 1263. Evidence on investment at the rm level 1273.1. Financial slack and investment 1273.2. Direct evidence of agency-related overinvestment 1303.3. Evidence on reputational models of investment 1314. Macroeconomic implications 1334.1. The nancial accelerator 1334.2. When banks face nancing frictions 1344.3. Cross-country differences in nancial development, investment and growth 135Part B. Investment inside rms 1365. Theoretical work on internal capital allocation 1365.1. Fundamental differences between internal and external capital markets 1375.2. Implications for the efciency of capital allocation 1405.3. How information and agency problems shape rms capital budgeting practices 145Contents of Volume 1A xix6. Empirical work on internal capital allocation 1456.1. The value consequences of diversication 1456.2. Evidence on investment at the divisional and plant level 1477. Conclusions: implications for the boundaries of the rm 152References 155Chapter 3Corporate Investment PolicyMICHAEL J. BRENNAN 167Abstract 168Keywords 1681. Introduction 1692. The objective of the rm and the net-present-value rule 1713. Valuation by discounting 1753.1. Multi-factor asset pricing models 1783.2. The capital asset pricing model 1794. Practical approaches to estimating discount rates 1804.1. Estimating equity discount rates in practice 1804.2. From rm cost of equity to rm cost of capital 1884.3. Performance of CAPM-based valuations 1914.4. From rm cost of capital to project cost of capital 1925. The certainty equivalent approach to valuation 1945.1. The basic theory of martingale pricing 1965.2. Estimating risk-adjusted drifts 1975.3. Some real options 2036. Summary 208References 209Chapter 4Financing of CorporationsSTEWART C. MYERS 215Abstract 216Keywords 2161. Introduction 2171.1. Theories of optimal nancing 2172. The ModiglianiMiller value-irrelevance propositions 2183. The trade-off theory 2213.1. Taxes 2223.2. Direct costs of nancial distress 2263.3. Indirect costs of nancial distress conicts between creditors and stockholders 2263.4. Other indirect costs of nancial distress 2283.5. Evidence on costs of nancial distress 2293.6. Leverage and product markets 2293.7. Evidence for the trade-off theory 230xx Contents of Volume 1A3.8. Target-adjustment models 2313.9. Computational models 2324. The pecking-order theory 2334.1. Debt vs. equity in the pecking order 2344.2. Whats wrong with the pecking order as theory? 2364.3. Pecking order vs. the trade-off theory time-series tests 2374.4. Further tests of the trade-off and pecking-order theories 2385. Agency theories of capital structure 2395.1. Jensen and Mecklings pecking order 2405.2. Free cash ow, leveraged buyouts and restructurings 2425.3. Is there a general free-cash-ow theory of capital structure? 2436. What next? 2436.1. Compensation and incentives 2446.2. Human capital and nancing 2456.3. Exporting capital-structure theory 246References 247Chapter 5Investment Banking and Securities IssuanceJAY R. RITTER 255Abstract 256Keywords 2561. Introduction 2571.1. Overview 2571.2. A brief history of investment banking and securities regulation 2591.3. The information conveyed by investment and nancing activities 2612. Seasoned equity offerings (SEOs) 2632.1. Announcement effects 2632.2. Evidence on long-run performance 2652.3. Reasons for underperformance 2713. Short-run and long-run reactions to corporate nancing activities 2744. Initial public offerings (IPOs) 2794.1. Overview 2794.2. Short-run underpricing of IPOs 2814.3. Alternative mechanisms for pricing and allocating securities 2814.4. Explanations of underpricing 2864.5. Underwriter compensation 2914.6. Stabilization activities 2924.7. Hot-issue markets 2934.8. Market activity across countries 2944.9. Long-run performance 2955. Summary 299References 300Contents of Volume 1A xxiChapter 6Financial InnovationPETER TUFANO 307Abstract 308Keywords 3081. Introduction 3092. What is nancial innovation? 3103. Why do nancial innovations arise? What functions do they serve? 3133.1. Inherently incomplete markets stimulate innovation 3143.2. Inherent agency concerns and information asymmetries stimulate innovation 3153.3. Transaction, search or marketing costs stimulate innovation 3173.4. Taxes and regulation stimulate innovation 3183.5. Increasing globalization and perceptions of risk stimulate innovation 3203.6. Technological shocks stimulate innovation 3214. Who innovates? The identities of and private returns to innovators 3245. The impact of nancial innovation on society 3276. Issues on the horizon: patenting and intellectual property 3297. Summary 331References 331Chapter 7Payout PolicyFRANKLIN ALLEN and RONI MICHAELY 337Abstract 339Keywords 3391. Introduction 3402. Some empirical observations on payout policies 3423. The MillerModigliani dividend irrelevance proposition 3514. How should we measure payout? 3545. Taxes 3585.1. Static models 3595.2. Dynamic models 3685.3. Dividends and taxes conclusions 3766. Asymmetric information and incomplete contracts theory 3776.1. Signaling and adverse selection models 3776.2. Incomplete contracts agency models 3837. Empirical evidence 3867.1. Asymmetric information and signaling models 3867.2. Agency models 3968. Transaction costs and other explanations 3999. Repurchases 4049.1. The mechanics and some stylized facts 4049.2. Theories of repurchases 407xxii Contents of Volume 1A9.3. Repurchases compared to dividends 4089.4. Empirical evidence 4109.5. Summary 41910. Concluding remarks 420References 422Chapter 8Financial IntermediationGARY GORTON and ANDREW WINTON 431Abstract 432Keywords 4321. Introduction 4332. The existence of nancial intermediaries 4372.1. Empirical evidence on bank uniqueness 4372.2. Banks as delegated monitors 4402.3. Banks as information producers 4442.4. Banks as consumption smoothers 4482.5. Banks as liquidity providers 4532.6. Banks as commitment mechanisms 4562.7. Empirical tests of bank-existence theories 4582.8. Bonds versus loans 4592.9. Banks versus stock markets 4613. Interactions between banks and borrowers 4623.1. Dynamic relationships and the pros and cons of bank monitoring 4633.2. Monitoring and loan structure 4693.3. Beyond lending: equity stakes, board seats, and monitoring 4743.4. Banking sector structure and lending 4793.5. Credit cycles and the effect of bank funding on lending 4904. Banking panics and the stability of banking systems 4944.1. Denitions of banking panics and the relation of panics to the business cycle 4954.2. Panics and the industrial organization of the banking industry 4994.3. Private bank coalitions 5014.4. Are banks inherently awed institutions? 5034.5. Information-based theories of panics 5054.6. Other panic theories 5074.7. Tests of panic theories 5084.8. The banking crises during the Great Depression 5114.9. Contagion 5165. Bank regulation, deposit insurance, capital requirements 5185.1. The origins of government bank regulation and government deposit insurance 5195.2. Deposit insurance and moral hazard 5205.3. Corporate governance in banks and the moral hazard argument 5265.4. Bank capital requirements 529Contents of Volume 1A xxiii5.5. Other issues 5326. Conclusion 532References 534Chapter 9Market MicrostructureHANS R. STOLL 553Abstract 555Keywords 5551. Introduction 5562. Markets, traders and the trading process 5572.1. Types of markets 5572.2. Types of orders 5582.3. Types of traders 5592.4. Rules of precedence 5602.5. The trading process 5613. Microstructure theory determinants of the bidask spread 5623.1. Inventory risk 5633.2. Free-trading option 5663.3. Adverse selection 5664. Short-run price behavior and market microstructure 5674.1. A model of short-term price behavior 5684.2. The realized spread 5694.3. Serial covariance of price changes 5705. Evidence on the bidask spread and its sources 5725.1. The spread and its components 5725.2. Cross-section evidence 5756. Price effects of trading 5776.1. Block trading 5776.2. Herding 5786.3. Other studies of the effects of trading 5797. Market design 5797.1. Call-auction markets 5807.2. Dealer versus auction markets: the Nasdaq controversy 5837.3. Other issues in market design 5868. The market for markets: centralization versus fragmentation of trading 5898.1. Evolution of equities markets in the USA 5898.2. Global markets 5928.3. Economic forces of centralization and fragmentation 5938.4. The future structure of markets 5959. Other markets 5959.1. Bond market 5969.2. Currency market 596xxiv Contents of Volume 1A9.3. Futures markets 5979.4. Options markets 59710. Asset pricing and market microstructure 59811. Conclusions 598References 600Subject Index I-1Chapter 1CORPORATE GOVERNANCE AND CONTROLMARCO BECHTECARES, Universit e Libre de Bruxelles and European Corporate Governance Institute (ECGI)PATRICK BOLTONBendheim Center for Finance at Princeton University, NBER, CEPR and ECGIAILSA ROELLBendheim Center for Finance at Princeton University, CEPR and ECGIContentsAbstract 3Keywords 31. Introduction 42. Historical origins: a brief sketch 52.1. How representative is corporate government? 52.2. Whom should corporate government represent? 73. Why corporate governance is currently such a prominent issue 73.1. The world-wide privatization wave 83.2. Pension funds and active investors 93.3. Mergers and takeovers 123.4. Deregulation and capital market integration 123.5. The 1998 Russia/East Asia/Brazil crisis 123.6. Scandals and failures at major USA corporations 134. Conceptual framework 134.1. Agency and contracting 134.2. Ex-ante and ex-post efciency 134.3. Shareholder value 144.4. Incomplete contracts and multiple constituencies 144.5. Why do we need regulation? 164.6. Dispersed ownership 174.7. Summary and conclusion 17We are grateful to Bernardo Bortolotti, Mathias Dewatripont, Richard Frederick, Stu Gillan, PeterGourevitch, Milton Harris, Gerard Hertig, Takeo Hoshi, Steve Kaplan, Roberta Romano, ChristianRydqvist and Scott Verges for helpful input and comments.Handbook of the Economics of Finance, Edited by G.M. Constantinides, M. Harris and R. Stulz 2003 Elsevier B.V. All rights reserved2 M. Becht et al.5. Models 195.1. Takeover models 195.2. Blockholder models 245.3. Delegated monitoring and large creditors 295.4. Board models 315.5. Executive compensation models 335.6. Multi-constituency models 355.6.1. Sharing control with creditors 355.6.2. Sharing control with employees 376. Comparative perspectives and debates 416.1. Comparative systems 426.2. Views expressed in corporate governance principles and codes 476.3. Other views 497. Empirical evidence and practice 497.1. Takeovers 507.1.1. Incidence of hostile takeovers 507.1.2. Correction of inefciencies 537.1.3. Redistribution 547.1.4. Takeover defenses 547.1.5. One-shareone-vote 557.1.6. Hostile stakes and block sales 587.1.7. Conclusion and unresolved issues 587.2. Large investors 597.2.1. Ownership dispersion and voting control 607.2.2. Ownership, voting control and corporate performance 637.2.3. Share blocks and stock market liquidity 647.2.4. Banks 657.3. Minority shareholder action 677.3.1. Proxy ghts 677.3.2. Shareholder activism 687.3.3. Shareholder suits 697.4. Boards 717.4.1. Institutional differences 717.4.2. Board independence 727.4.3. Board composition 727.4.4. Working of boards 727.4.5. International evidence 737.5. Executive compensation and careers 737.5.1. Background and descriptive statistics 737.5.2. Payperformance sensitivity 757.5.3. Are compensation packages well-designed? 767.5.4. Are managers paying themselves too much? 777.5.5. Implicit incentives 78Ch. 1: Corporate Governance and Control 37.5.6. Conclusion 797.6. Multiple constituencies 807.6.1. Debtholders 807.6.2. Employees 818. Conclusion 82References 86AbstractCorporate governance is concerned with the resolution of collective action problemsamong dispersed investors and the reconciliation of conicts of interest betweenvarious corporate claimholders. In this survey we review the theoretical and empiricalresearch on the main mechanisms of corporate control, discuss the main legal andregulatory institutions in different countries, and examine the comparative corporategovernance literature. A fundamental dilemma of corporate governance emergesfrom this overview: regulation of large shareholder intervention may provide betterprotection to small shareholders; but such regulations may increase managerialdiscretion and scope for abuse.Keywordscorporate governance, ownership, takeovers, block holders, boardsJEL classication: G32, G344 M. Becht et al.1. IntroductionAt the most basic level a corporate governance problem arises whenever an outsideinvestor wishes to exercise control differently from the manager in charge of therm. Dispersed ownership magnies the problem by giving rise to conicts of interestbetween the various corporate claimholders and by creating a collective action problemamong investors.1Most research on corporate governance has been concerned with the resolution ofthis collective action problem. Five alternative mechanisms may mitigate it: i) partialconcentration of ownership and control in the hands of one or a few large investors;ii) hostile takeovers and proxy voting contests, which concentrate ownership and/orvoting power temporarily when needed; iii) delegation and concentration of controlin the board of directors; iv) alignment of managerial interests with investors throughexecutive compensation contracts; and v) clearly dened duciary duties for CEOstogether with class-action suits that either block corporate decisions that go againstinvestors interests, or seek compensation for past actions that have harmed theirinterests.In this survey we review the theoretical and empirical research on these vemain mechanisms and discuss the main legal and regulatory institutions of corporategovernance in different countries. We discuss how different classes of investors andother constituencies can or ought to participate in corporate governance. We alsoreview the comparative corporate governance literature.2The favored mechanism for resolving collective action problems among shareholdersin most countries appears to be partial ownership and control concentration in thehands of large shareholders.3Two important costs of this form of governance havebeen emphasized: i) the potential collusion of large shareholders with managementagainst smaller investors; and ii) the reduced liquidity of secondary markets.In an attempt to boost stock market liquidity and limit the potential abuse ofminority shareholders some countries corporate law drastically curbs the power oflarge shareholders.4These countries rely on the board of directors as the mainmechanism for co-ordinating shareholder actions. But boards are widely perceivedto be ineffective.5Thus, while minority shareholders get better protection in thesecountries, managers may also have greater discretion.1See Zingales (1998) for a similar denition.2We do not cover the extensive strategy and management literature; see Pettigrew, Thomas andWhittington (2002) for an overview, in particular Davis and Useem (2002).3See ECGN (1997), La Porta et al. (1999), Claessens et al. (2000) and Barca and Becht (2001) forevidence on control concentration in different countries.4Black (1990) provides a detailed description of the various legal and regulatory limits on the exerciseof power by large shareholders in the USA. Wymeersch (2003) discusses legal impediments to largeshareholder actions outside the USA.5Gilson and Kraakman (1991) provide analysis and an agenda for board reform in the USA againstthe background of a declining market for corporate control and scattered institutional investor votes.Ch. 1: Corporate Governance and Control 5In a nutshell, the fundamental issue concerning governance by shareholders todayseems to be how to regulate large or active shareholders so as to obtain the right balancebetween managerial discretion and small shareholder protection. Before exploring ingreater detail the different facets of this issue and the ve basic mechanisms describedabove, it is instructive to begin with a brief overview of historical origins and earlywritings on the subject.2. Historical origins: a brief sketchThe term corporate governance derives from an analogy between the governmentof cities, nations or states and the governance of corporations.6The early corporatenance textbooks saw representative government [Mead (1928, p. 31)] as animportant advantage of the corporation over partnerships but there has been and stillis little agreement on how representative corporate governance really is, or whom itshould represent.2.1. How representative is corporate government?The institutional arrangements surrounding corporate elections and the role andduciary duties of the board have been the central themes in the corporate governanceliterature from its inception. The dilemma of how to balance limits on managerialdiscretion and small investor protection is ever present. Should one limit the powerof corporate plutocrats (large shareholders or voting trusts) or should one tolerateconcentrated voting power as a way of limiting managerial discretion?The concern of early writers of corporate charters was the establishment ofcorporate suffrage, where each member (shareholder) had one vote [Dunlavy(1998)]. The aim was to establish democracy by eliminating special privileges ofsome members and by limiting the number of votes each shareholder could cast,irrespective of the number of shares held.7However, just as corporate democracywas being established it was already being transformed into plutocracy by movingtowards one-shareone-vote and thus allowing for concentrated ownership andcontrol [Dunlavy (1998)].8In the USA this was followed by two distinct systems of corporate feudalism:6The analogy between corporate and political voting was explicit in early corporate charters andwritings, dating back to the revolutionary origins of the American corporation and the rst railwaycorporations in Germany [Dunlavy (1998)]. The precise term corporate governance itself seems tohave been used rst by [Richard Eells (1960, p. 108)], to denote the structure and functioning of thecorporate polity.7Frequently voting scales were used to achieve this aim. For example, under the voting scale imposedby a Virginia law of 1836 shareholders of manufacturing corporations cast one vote for each share upto 15, one vote for every ve shares from 15 to 100, and one vote for each increment of 20 shares above100 shares [Dunlavy (1998, p. 18)].8Voting right restrictions survived until very recently in Germany [Franks and Mayer (2001)]. Theyare still in use in Denmark, France, Spain and other European countries [Becht and Mayer (2001)].6 M. Becht et al.rst, to the voting trusts9and holding companies10[Cushing (1915), Mead (1903),Liefmann (1909, 1920] originating in the Gilded Age [Twain and Warner (1873)]11and later to the managerial corporation.12The captains of industry in the trustsand hierarchical groups controlled the majority of votes in vast corporate empireswith relatively small(er) amounts of capital, allowing them to exert product marketpower and leaving ample room for self-dealing.13In contrast, the later managerialcorporations were controlled mainly by professional managers and most of theirshareholders were too small and numerous to have a say. In these rms control waseffectively separated from ownership.14Today corporate feudalism of the managerial variety in the USA and the captainof industry kind elsewhere is challenged by calls for more shareholder democracy,a global movement that nds its roots with the corporate Jacksonians of the 1960sin the USA.159Under a typical voting trust agreement shareholders transfer their shares to a trust and receivecerticates in return. The certicate holders elect a group of trustees who vote the deposited shares.Voting trusts were an improvement over pooling agreements and designed to restrict product marketcompetition. They offered two principal advantages: putting the stock of several companies into thevoting trust ensured that the trustees had permanent control over the management of the various operatingcompanies, allowing them to enforce a common policy on output and prices; the certicates issued bythe voting trust could be widely placed and traded on a stock exchange.10Holding companies have the purpose of owning and voting shares in other companies. After thepassage of the Sherman Antitrust Act in 1890 many of the voting trusts converted themselves intoNew Jersey registered holding companies (industrial combinations) that were identical in function,but escaped the initial round of antitrust legislation, for example the Sugar Trust in 1891 [Mead (1903,p. 44)] and Rockefellers Standard Oil in 1892 [Mead (1903, p. 35)].11The captains of industry of this era, also referred to as the Robber Barons [Josephson (1934),DeLong (1998)], were the target of an early anti-trust movement that culminated in the election ofWoodrow Wilson as USA President in 1912. Standard Oil was broken up even before (in 1911) underthe Sherman Act of 1890 and converted from a corporation that was tightly controlled by the Rockefellerclan to a managerial corporation. Trust nance disappeared from the early corporate nance textbooks[for example Mead (1912) vs. Mead (1928)]. In 1929 Rockefeller Jr. (14.9%) ousted the scandal riddenChairman of Standard Oil of Indiana, who enjoyed the full support of his board, only by small margin,an example that was widely used for illustrating how much the balance of power had swung fromthe Robber Barons to management [Berle and Means (1932, pp. 8283), cited in Galbraith (1967)],another type of feudal lord.12For Berle and Means (1930): [the] publicly owned stock corporation in America. . . constitutesan institution analogous to the feudal system in the Middle Ages.13They also laid the foundations for some of the Worlds nest arts collections, philanthropic foundationsand university endowments.14This separation of ownership and control triggered a huge public and academic debate of thecorporate problem; see, for example, the Berle and Means symposia in theColumbiaLawReview(1964) and theJournalofLawandEconomics (1983). Before Means (1931a,b) and Berle and Means(1930, 1932) the point was argued in Lippmann (1914), Veblen (1923), Carver (1925), Ripley (1927)and Wormser (1931); see Hessen (1983).15Non-Americans often consider shareholder activism as a free-market movement and associated callsfor more small shareholder power as a part of the conservative agenda. They are puzzled when theyCh. 1: Corporate Governance and Control 7As an alternative to shareholder activism some commentators in the 1960sproposed for the rst time that hostile takeovers might be a more effective way ofdisciplining management. Thus, Rostow (1959, p. 47) argued, the raider persuades thestockholders for once to act as if they really were stockholders, in the black-letter senseof the term, each with the voice of partial ownership and a partial owners responsibilityfor the election of directors. Similarly, Manne (1964, p. 1445) wrote, vote selling[. . . ] negatives many of the criticisms often levelled at the public corporation. As weshall see, the abstract market for corporate control has remained a central theme inthe corporate governance literature.2.2. Whom should corporate government represent?The debate on whether management should run the corporation solely in the interestsof shareholders or whether it should take account of other constituencies is almostas old as the rst writings on corporate governance. Berle (1931) held the view thatcorporate powers are powers in trust for shareholders and nobody else.16But, Dodd(1932, p. 1162) argued that: [business] is private property only in the qualied sense,and society may properly demand that it be carried on in such a way as to safeguardthe interests of those who deal with it either as employees or consumers even if theproprietary rights of its owners are thereby curtailed. Berle (1932) disagreed on thegrounds that responsibility to multiple parties would exacerbate the separation of own-ership and control and make management even less accountable to shareholders.17There is nowadays a voluminous literature on corporate governance. On manykey issues our understanding has improved enormously since the 1930s. Remarkablythough, some of the main issues over which the early writers have been debating remaincentral today.3. Why corporate governance is currently such a prominent issueWhy has corporate governance become such a prominent topic in the past two decadesor so and not before? We have identied, in no particular order, the following reasons:learn that shareholder activism today has its roots in part of the anti-Vietnam War, anti-apartheid andanti-tobacco movements and has close links with the unions. In terms of government (of corporations)there is no contradiction. The corporate Jacksonians, as a prominent critic called them [Manning(1958, p. 1489)], are named after the 7th President of the USA (182937) who introduced universalmale suffrage and organised the Democratic Party that has historically represented minorities, labourand progressive reformers (Encyclopaedia Britannica: Jackson, Andrew; Democratic Party).16Consequently all powers granted to a corporation or to the management of a corporation, or to anygroup within the corporation, whether derived from statute or charter or both, are necessarily and atall times exercisable only for the ratable benet of all the shareholders as their interest appears, Berle(1931).17He seems to have changed his mind some twenty years later as he wrote that he was squarelyin favour of Professor Dodds contention[Berle (1954)]. For a comprehensive account of the BerleDodd dialogue see Weiner (1964) and for additional papers arguing both points of view Mason (1959).Galbraith (1967) in his inuential The New Industrial State took Dodds position.8 M. Becht et al.i) the world-wide wave of privatization of the past two decades; ii) pension fund reformand the growth of private savings; iii) the takeover wave of the 1980s; iv) deregulationand the integration of capital markets; v) the 1998 East Asia crisis, which has put thespotlight on corporate governance in emerging markets; vi) a series of recent USAscandals and corporate failures that built up but did not surface during the bull marketof the late 1990s.3.1. The world-wide privatization wavePrivatization has been an important phenomenon in Latin America, Western Europe,Asia and (obviously) the former Soviet block, but not in the USA where stateownership of enterprises has always been very small (see Figure 1). On average, since1990 OECD privatization programmes have generated proceeds equivalent to 2.7%of total GDP, and in some cases up to 27% of country GDP. The privatization wavestarted in the UK, which was responsible for 58% of OECD and 90% of EuropeanCommunity privatization proceeds in 1991. Since 1995 Australia, Italy, France, Japanand Spain alone have generated 60% of total privatization revenues.WesternEuropeAsia LatinAmericaOceania CEECand formerSoviet UnionNorthAmericaand theCaribbeansNorthAfrica andMiddle-EastSub-SaharanAfricaPO PS050100150200250300350400Revenues(currentUS$bn)Fig. 1. Privatization revenues by region 197797. Source: Bortolotti, Fantini and Siniscalco (2000).PO, public offerings; PS, private sales.Inevitably, the privatization wave has raized the issue of how the newly privatizedcorporations should be owned and controlled. In some countries, most notably the UK,part of the agenda behind the massive privatization program was to attempt to recreatea form of shareholder democracy18[see Biais and Perotti (2002)]. In other countries18A state-owned and -controlled company is indirectly owned by the citizens via the state, which has asay in the affairs of the company. In a shareholder democracy each citizen holds a small share in thewidely held company, having a direct interest and theoretically say in the affairs of the company.Ch. 1: Corporate Governance and Control 9great care was given to ensure the transfer of control to large shareholders. Theissues surrounding the choice of privatization method rekindled interest in governanceissues; indeed Shinn (2001) nds that the states new role as a public shareholderin privatized corporations has been an important source of impetus for changes incorporate governance practices worldwide. In general, privatizations have boosted therole of stock markets as most OECD sales have been conducted via public offerings,and this has also focused attention on the protection of small shareholders.3.2. Pension funds and active investorsThe growth in dened contribution pension plans has channelled an increasing fractionof household savings through mutual and pension funds and has created a constituencyof investors that is large and powerful enough to be able to inuence corporate gover-nance. Table 1 illustrates how the share of nancial assets controlled by institutional in-vestors has steadily grown over the 1990s in OECD countries. It also highlights the dis-proportionately large institutional holdings in small countries with large nancial cen-tres, like Switzerland, the Netherlands and Luxembourg. Institutional investors in theUSA alone command slightly more than 50% of the total assets under management and59.7% of total equity investment in the OECD, rising to 60.1% and 76.3%, respectively,when UK institutions are added. A signicant proportion is held by pension funds (forUSA and UK based funds, 35.1% and 40.1% of total assets, respectively). These fundsare playing an increasingly active role in global corporate governance. In the USAERISA19regulations oblige pension funds to cast the votes in their portfolio responsi-bly. This has led to the emergence of a service industry that makes voting recommenda-tions and exercises votes for clients. The largest providers now offer global services.Japanese institutional investors command 13.7% of total institutional investor assetsin the OECD but just 8.3% of the equities. These investors are becoming moredemanding and they are one of the forces behind the rapid transformation of theJapanese corporate governance system. As a percentage of GDP, the holdings of Italianand German institutional investors are small (39.9% and 49.9% in 1996) and wellbelow the OECD average of 83.8%. The ongoing reform of the pension systems inboth countries and changing savings patterns, however, are likely to change this picturein the near future.2019ERISA stands for the Employee Retirement Income Security Act of 1974.20One note of caution. The gures for Luxemburg and Switzerland illustrate that gures are compiledon the basis of the geographical location of the fund managers, not the origin of the funds undermanagement. Judging from the GDP gures, it is very likely that a substantial proportion of the fundsadministered in the UK, the USA, Switzerland and the Netherlands belong to citizens of other countries.For governance the location of the fund managers matters. They make the investment decisions and havethe power to vote the equity in their portfolios and the sheer size of the numbers suggests that fundgovernance is a topic in its own right.10M.Bechtetal.Table 1Financial assets of institutional investors in OECD countriesaValueassets (billion US $)1990 1996Assetgrowth199096% TotalOECDassetsAssets as % GDP1990 1996Pensionfunds1996 (%)Insurancecomp.1996 (%)Invest.comp.1996 (%)Assetsin equity1996 (%)OECDequity1996 (%)Australia 145.6 331.1 127.4 1.3 49.3 83.8 36.3 46.0 14.1 52 1.9Austria 38.8 90.1 132.2 0.3 24.3 39.4 3.0 53.3 43.7 8 0.1Belgium 87.0 169.1 94.4 0.7 44.4 63 6.5 49.0 41.0 23 0.4Canada 332.8 560.5 68.4 2.2 58.1 94.6 43.0 31.4 25.7 9 0.6Czech Republic 7.3b