Sources of Capital and Economic Growth: Interconnected and Diverse Markets Driving U.S. Competitiveness

By: Anjan V. Thakor, John E. Simon Professor of Finance and Director of the PhD Program, Washington University, St. Louis, MO, and European Corporate Governance Institute.

Executive Summary:
This paper provides a broad overview of the U.S. financial system. It describes the variety of financing sources available to both individual consumers and businesses, and the considerations that lead a consumer or a business to choose a specific financing source. It then discusses how this variety of financing sources provides benefits to the economy. Five main conclusions emerge from this analysis.

First, a robust, efficient, and diverse financial system facilitates economic growth. Research has shown that the level of financial development is a strong predictor of economic growth. This research is based on a study of a large number of countries. Even with the unprecedented economic crisis, the growth in the U.S. financial services industry has been accompanied by a robust growth in our economy, as measured by growth in gross domestic product (GDP).

The financial system facilitates economic growth by providing four basic services:

• facilitating trade;
• facilitating risk management for various individuals and businesses;
• mobilizing resources; and
• obtaining information, evaluating businesses and individuals based on this information, and allocating capital.

It is through the provision of these services that the financial system ensures that investment capital is channeled most efficiently from the providers of capital to the users of capital, so that both the economy and employment grow.

Second, in terms of their financing choices, individuals are largely limited to debt financing for raising capital. For individuals, these sources include family and friends, credit cards, home equity loans, and other types of bank loans. Consumer credit provided through these diverse sources is a large segment of our economy. The major providers of consumer credit—commercial banks, finance companies, credit unions, the federal government, savings institutions, and nonfinancial businesses—provided over $2.4 trillion of consumer credit as of year-end 2010. The efficient availability of this credit is critical in an economy so dependent on domestic consumption. It is important to note that for many smaller businesses, especially start-ups, these consumer credit products are often the only available sources of new or even working capital. Entrepreneurs often rely on access to personal credit, including credit cards and home equity loans, to launch their new businesses.

Third, as businesses grow they can access both debt and equity financing, and the mix of these two, called the “capital structure” decision, is an important choice every business makes. Three broad categories of financing sources are available to businesses for either debt or equity capital. One source of capital involves raising funds without using any intermediaries like banks or going to the public capital market. Included in this category are family and friends, employee ownership, retained earnings generated by the operating profits of the business, customers and suppliers, and angel investors. A second category is intermediated finance that does not involve going to the capital market. Included in this are loans from intermediaries like banks and insurance companies, funding by private-equity firms and venture capitalists, small business investment companies that provide Small-Business-Administration-sponsored financing, and factoring companies that provide financing against receivables. While all these financing sources are important, venture capital has played an especially vital role in helping launch new businesses: venture capital financing accounts for 21% of GDP. Many famous companies like Apple were financed in their infancy by venture capital. For more mature business, bank loans are an essential source of finance. In 2009, U.S. banks made more than $7 trillion in loans. The third category of financing available to businesses is direct capital market access, whereby the firm uses an investment bank and sells debt or equity claims directly to capital-market investors. These include commercial paper, initial public offerings (IPOs), bond sales, and secondary equity offerings.

Fourth, a rich diversity of financing sources is provided by the U.S. financial system. This diversity helps U.S. consumers and businesses to better manage their risks and lowers their cost of capital. Diversity enables consumers and businesses to effectively match their financing needs to the financing sources, with each financing source providing a different set of services. Since the needs of those seeking financing differ, it is beneficial to have specialized financiers catering to different needs. The result is better risk management and higher investment in the economy, leading to an increase in GDP and employment.

Fifth, the U.S. financial system is highly interconnected. What happens to one financing source typically affects a host of other financing sources as well as those seeking financing. These spillover effects cause any change in the part of the system to be propagated through the entire system, often in ways that are difficult to predict. For example, if our public equity markets were to diminish in the future—say due to excessively onerous regulation—it is very likely that the supply of private equity and venture capital financing would decline as well. Hence, assessing the risks associated with regulatory changes in the financial system is a notoriously difficult task. This often leads to unintended consequences when changes are introduced in some part of the financial system. Disturbing examples of this can be found in the impact of the Sarbanes-Oxley Act and the litigation environment faced by U.S. companies. These changes have contributed to a slowdown of the rate at which new public companies are formed and an increase in the rate at which existing public companies are leaving the market, leading to a substantial decline in the number of publicly listed U.S. companies.

A well-developed financial system goes hand-in-hand with robust economic growth and increased employment. The better the financial system functions, the more new companies are launched, the larger the number of publicly listed companies, the better the overall management of risk, the greater the availability of consumer credit, and the higher aggregate investment.