What is the “Market Overview of US vs. EU”?
The term “Market Overview” typically refers to a snapshot of financial systems or a specific part of the market. We can look at this in more detail and compare the EU and US markets. In the US public and private debt securities instruments represent a significant share of funding sources for borrowers. Globally, the US is the largest debt market in the world. It represents around 1/3 of the total US$ value of all outstanding bonds and credit. While in the EU bank loans are still the dominant source of funding. Historically and currently, the volume of credit intermediation by banks (as % of GDP) is larger in the EU than in the US.
The US can be termed as a relatively market-based financial system, while the EU a relatively bank-based financial system. Japan has the second largest debt market in the world. However, it is also a relatively bank-based financial system.
Key Learning Points
- Market Overview is typically a snapshot of a particular market or markets
- The US is the largest debt market in the world and is termed a market-based financial system
- In the EU, a much larger proportion of the total credit is accounted for by bank credit i.e. it has a relatively bank-based financial system.
- Systemic risk may be larger in bank-based structures than in market-based financial structures
Market Overview – the US vs. the EU
There is a huge difference in traditions with reference to credit markets between the US and the EU i.e. there are substantial differences pertaining to the distributions between public and private debt securities, stock market capitalization and bank credit (as a % of GDP).
In contrast to the US, in the EU, a much larger proportion of the total credit is bank credit, while a very small proportion of total credit is public and private debt securities that are trading in the markets. On the other hand, In the US, public and private debt securities make up for about as much as the total bank credits (US companies source approximately equal amounts of finance from the debt securities markets and bank loans – i.e. roughly the same amount of debt outstanding is traded in the securities markets as the total outstanding value of bank loans in the US). Further, US companies source a larger proportion of finance from the debt markets compared to European companies.
Traditionally, Europeans have been inclined to save money in banks. Saving money in these institutions or depositing money with banks have enabled these institutions in the EU to have more capital on their balance sheets. Consequently, they have been able to make more loans to corporations and individuals. There are signs that this is changing in Europe now and that more debt is securitized and traded in their markets.
The outstanding US bond market debt comprises mostly of treasury bonds (largest segment), mortgage-related bonds (second-largest), corporate debt (third-largest), municipal bonds, federal agency securities, asset-backed securities, and money markets. The first three types of bonds make up nearly 80% of the outstanding US bond market debt.
Next, systemic risk may be larger in bank-based systems (as in the EU) as banks tend to be highly leveraged. Quite often interconnected institutions with mismatches vis-à-vis maturity can be significant on their balance sheets. In the US (which is a relatively market-based system), the systemic risk may be lower as markets channel finance directly from savers to borrowers. Consequently, such systems are not as dependent on intermediation via large balance-sheet mismatches.
Loan vs. Equity Financing – Example
Given below is an example, where a small unlisted company needs money to expand operations. Its financing requirement is US$60,000. It can either go to a bank and take a loan of US$60,000 at an interest rate of 10% (i.e. interest expense of US$6,000), or the firm has the option to sell a 25% stake in its business to someone for US$60,000.
Assume that the company earns a profit of US$30,000 during the next year and opted for taking the bank loan. In this scenario, the company will make a profit of US$24,000 – after deducting the interest expense.
However, if this company opted to sell a stake (25%) to someone at US$60,000, there would be no interest costs to pay. However, the disadvantage is that this company can keep only 75% of the profit (i.e. US$ 22,500) – which is lower than in the case of debt financing (US$24,000) and 25% of the profit (US$ 7,500) goes to the person who has bought a 25% stake in the company.
In effect, usually, debt financing has a lower effective cost than equity financing, if the company is expected to generate enough cash and perform well.