External and Internal Financial Structures in Europe: a Corporate Finance Perspective

The comparative performance of different systems of corporate governance, in turn, has been at the core of recent debates on how to reform financial market institutions. So far, the literature has treated the discussion of internal and external financial structures largely in isolation. However, few attempts have been made so far to combine these two strands of the literature and to analyze the interaction between internal and external financial structures. In this paper we argue that these linkages are important with the support of a stylized model featuring ex post asymmetries between domestic and foreign investors in the credit market. This simple model is able to generate an equity bias in capital imports relative to the internal financing structure. The intuition is that competition from the equity market drives the contractual interest rate in the credit market down to a level where foreign creditors can no longer cover their cost of collecting on defaulting loans. Thus, only domestic creditors, who do not face such a cost, can compete with equity in equilibrium. Foreign creditors get crowded out. As a result, the overall financing structure of the economy reflects the indifference of firms between the two sources of financing in equilibrium, but capital imports consist only of equity.