The Decline of the Financial Markets

In 1309 the Venetian Republic auctioned its first bonds to the public, close to the Rialto bridge, in order to finance its wars. This was the first time that the markets had taken on a sovereign finance role. Until then, states had been financed by the banks. The markets performed this service for the next few centuries, although it has become less and less prevalent over time. France was mainly financed by the banks during the Napoleonic wars, while England turned to bond financing. Given that bonds offer greater diversification, England suffered fewer financial losses than Napoleon, giving it a crucial competitive advantage, which went some way to explaining its victory. From then on, the markets have been the main source of sovereign lending. Nonetheless, the important role of central banks in sovereign bond purchasing has reduced the liquidity of these markets, which is breeding potential future financial instability.

The first stock exchanges were set up in Holland and England in the 17th century, and enabled savings to be channelled towards the shareholder equity of companies offering the best growth forecasts, thereby firmly strengthening capitalism. The stock markets played a key role in financing the innovations associated with industrial revolutions. In this context, innovative and growing companies, which were essential to the fourth Industrial Revolution, did not hesitate to use the Stock Exchange to fund their expansion in the early stages.

At the same time, and mainly since the 19th century, major companies issued bonds in order to diversify their bank financing, following the example that states had previously set for financing their debt. Since 1979, the markets have also financed the debt of more risky companies through high yield bond markets.

The excesses of the dotcom bubble at the end of the 1990s led to burdensome regulations which affected the financial markets and also translated into excessive regulatory intervention. As a result, fewer and fewer companies used the Stock markets to finance their businesses, while at the same time private equity industries started to flourish, in order to meet this need. These were either innovative industries (financed by venture capital) or established ones (financed by private equity). While Amazon first traded publicly on the stock market in 1997 with a market capitalisation of only 600 million (today it is worth almost 2 trillion), and a prospectus of no more than 80 pages, Uber chose not to go public until it reached a valuation of 80 billion dollars, and when it did eventually list on the Stock Exchange, its prospectus was nearly 300 pages long, which later entailed considerable regulatory costs. Moreover, the reforms aimed at overhauling securities market analysis have sped up the decline of the stock markets, particularly among mid-level securities, another regulatory own goal. It therefore comes as no surprise that over the last twenty years the number of listed companies in the United States has fallen by almost half. The OECD has calculated that the number of listed companies has gone down by 15,000 since 2005 in the United States and Europe, and has barely been offset by the small number of new listings on the Stock markets. It is estimated that the global private equity industry, which was created in the 1980s, is probably handling some 8 trillion dollars, or possibly 16 trillion if we take into account the indebtedness it uses to acquire companies. This figure is higher than Chinese GDP and just below US GDP. All the stock exchanges worldwide are handling a combined value of around 100 trillion dollars.

Private Finance

Although the corporate bond markets coexisted alongside the banks in the past in order to finance company debt, private finance has also been making its mark for a number of years. Direct lending allows money from investment funds to be loaned directly to companies. Worldwide, direct lending is probably handling some 2 trillion dollars, which is not to be sniffed at, especially when we know that global corporate bond markets are worth around 30 trillion and direct lending growth is accelerating. After all, this industry scarcely existed a few years ago.

Although it is always a good idea to diversify your sources of financing, the decline of the financial markets should alarm us all. The sovereign bond markets are more illiquid and more volatile. The Stock markets have tended towards large-cap value stocks, and they have increasingly failed to serve their role of financing successful medium-sized companies. The corporate bond markets are having to cope with the rise of direct financing. And on top of that, the eurozone divides up the poor liquidity of its financial markets into 27 different markets, which makes it harder to compare them and leads to the outflow of resources (250 trillion euros a year, according to the latest Letta report) to other more efficient and liquid markets such as the US market.

Vast investment is needed in the next few years for the climate transition, infrastructure and defence. Only a profound and highly sophisticated revamping of the financial markets will help us to tackle this challenge effectively.

Ignacio de la Torre

Chief Economist at Arcano Partners

Published in Expansión