IT innovations and financing patterns: implications for the financial system

February 2002

Executive summary

Innovation in information technology (IT) has changed the way economic activity is carried out and organised. The eventual macroeconomic outcome of these changes and the macroeconomic profile of an IT-based economy are still uncertain. The major global correction in equity prices of IT companies, the dramatic cutbacks in IT investment and the abrupt deterioration in business conditions in the United States and elsewhere have all contributed to the sense that the structural changes in the economy may well be smaller and less beneficial than some of the most enthusiastic proponents of the "new economy" had argued. Since the contribution of the most recent wave of IT development has not been observed over a full business cycle, the outcome remains uncertain. But evidence of structural changes in different countries is abundantly available at the microeconomic level, with implications for firms' financial structure and the character of financial intermediation.

By improving the availability and dissemination of information, IT has the potential to act as a catalyst for fundamental changes in production processes and in the competitive environment within and outside the IT sector. IT facilitates more customised production based on flexible work processes. This involves firm reorganisation that allows IT and human capital to be combined in an efficient way. As a consequence of these skill-biased production changes, intangible and non-marketable assets such as intellectual property rights and firm-specific knowledge gain in importance. In addition, incorporating performance-based incentives into compensation schemes becomes more prevalent. This fundamental transformation of the firm is mirrored by changes in the household sector. Households tend to assume more business risk both through the provision of capital and, in tendency, also through labour income.

These trends have implications for the financing needs of firms and the confidence with which firms' performance can be assessed and foreseen. Firm reorganisation towards "soft" and customised production tends to increase idiosyncratic risks. And simultaneous changes in the competitive environment and in business models may alter the risk-reward profile of firms quickly and in an unpredictable way. In tendency, the need increases for capital that bears business risk and for corporate governance structures that create incentives to adapt to new ways of production. This suggests a greater role for equity and for financial contracts that incorporate equity characteristics.

Corporate financing patterns support the notion of an increasing role for equity and equity-like instruments in the financing of both new and established firms. Venture capital has offered a way to combine funding of high-risk projects and managerial support in a flexible way for new and innovative firms, which typically lack collateral, track record and managerial experience. Established firms in the IT sector, but also in other industries, have increasingly relied on public equity and on debt instruments incorporating equity characteristics such as convertible bonds, issuance in the high-yield segment of the bond market, coupon step-up clauses or bank loans with terms contingent on the borrower's performance. The boom and bust in the IT segment of equity markets has clearly influenced external funding, but factors like the establishment of new instruments and markets for equities or related instruments suggest that there will be lasting effects.

Generally, the character and the role of different financial arrangements can be expected to change according to the altering risk-return profile and financing preferences of firms. In addition to modifications in the design of financial contracts, this would include adjustments in the valuation techniques applied by financial intermediaries and in the management of risks and exposures. One example is an increasing specialisation of intermediaries in financing firms in different stages of the corporate life cycle. Another may be greater reliance on credit risk transfer in order to achieve the desired diversification of portfolios. The boom and bust of IT equities and their impact on the financial system highlight several important issues raised in this study.

First, on the positive side the huge loss in equity wealth has not triggered any major default among financial intermediaries. This suggests that the shift of risk from financial intermediaries to investors in financial markets through increasing reliance of firms on market-based financing has provided for a better, more dispersed allocation of risks across sectors that have been able to bear them. This possibly includes the diffusion of IT-related credit exposures through credit risk transfer markets. Overall, business-related risks seem to have been distributed more broadly across the economy.

Second, valuation problems have been substantial and were probably exacerbated by market practices - eg with respect to IPOs - that might not have dealt appropriately with the specific information and valuation problems that characterise new and innovative firms. Looking ahead, greater relevance of firm-specific risks and difficulties in evaluating them is likely to affect volatility clusters in financial markets and in particular in equity markets. While overall market volatility need not necessarily be higher, heightened price volatility of individual stocks could become a persistent phenomenon. With rising idiosyncratic risk, diversification may require larger portfolios and more widely ranged exposures than before to generate desired levels of risk.

Third, equity market conditions had considerable knock-on effects for other segments of the financial system. The decline of IT equity prices impacted adversely on the provision of venture capital and private equity to high-tech firms. The drop in equity market capitalisation also reduced the willingness of banks and other financial institutions to provide new finance to these sectors, as the validity of earlier assumptions about the ease of refinancing existing debt finance through equity markets was undermined. As equity market valuation is likely to become more central, fluctuations in equity prices would be easily transmitted to other markets. One transmission channel that may involve risk is the reliance on the equity market capitalisation of a firm as an indicator of its future earning capacity and hence its ability to service debt.

Fourth, the difficulties associated with the assessment of credit risk involved in financing innovative activities became apparent. A case in point is the telecoms sector. The quality of telecoms debt declined rapidly and the inability of some telecoms companies to arrange equity market take-outs of bank debt and rising defaults left banks with unanticipated exposures. More generally, in a climate of rapid technological change and intense competition, banks may face a rapidly evolving credit risk environment. Correlation of risk factors among sectors will change when industries expand into new markets. As a consequence, issues related to sectoral exposures or an increasing reliance on credit risk transfer tools would become increasingly relevant. And technological change challenges the reliability of backward-looking indicators (such as default histories) for credit risk assessment.

In a longer-term perspective, these experiences can be seen as part of a learning process for all participants, which may have led to significant improvements in risk management and valuation capability. However, the tentative nature of these arguments should be recognised, as it is still too early to draw final conclusions about the implications of the IT sector boom, its subsequent bust and its future course. Reconsidering and reassessing these implications should be the subject of future investigations.

The general issue for public policy in the face of a technological shock is to strike the right balance between exploiting potential gains and avoiding risks that could threaten the overall system. Financing plays a role in supporting the reorganisation of the corporate sector and in allocating the risks associated with this process. And this role is likely to increase as market-based incentive mechanisms gain in importance and the management of financial risks becomes more complex.

Main risks involved in the financing of new technologies are large-scale failures of investment projects that may damage the financial institutions providing funding and excessive price movements in financial markets resulting from unrealistic expectations. Against this background, the task of financial policy is to set a framework of standards and guidelines that allows for market-driven adjustment of financing mechanisms and encourages ongoing improvement in risk management techniques.

Central banks can play an active role in this process. One aspect of this role is employing the research capabilities and the knowledge of the financial system combined in central banks to improve the understanding of the financial impact of technological change. The other aspect is active monitoring of the financial system. Changing linkages between the real and the financial sphere and across the different segments of the financial system, and in particular the reallocation of risks across the financial system, underline the need for systemic monitoring.