RDP 9216: The Evolution of Corporate Financial Structure: 1973–1990 5. Summary and Conclusions

The financial liberalisation of the 1980s eliminated the need for disequilibrium credit rationing in Australian financial markets. This permitted a wide range of firms to enjoy greater access to borrowed funds intermediated by the finance sector. In the newly liberalised and competitive financial markets, lending institutions competed aggressively for market share. This drive for market share was reflected in an enthusiasm to lend and a relaxation of credit control standards. The result was a rapid increase in aggregate credit extended by financial institutions. During the period from 1983 to 1990, credit increased at an average rate of 18 percent per annum^[17]. This rapid growth in credit was reflected in corporate balance sheets. During the 1980s the real size of corporate balance sheets increased at a considerably faster pace than in the 1970s and the proportion of total assets financed by debt increased markedly.

The results reported in Section 3 of this paper indicate that, through the 1970s, total debt accounted for an average of just over of 50 percent of total assets of the firms in our sample. By 1990, this share had increased to around 66 percent. The results also suggest that the increase in leverage was characteristic of a wide range of firms rather than being confined to a small number of firms. After 1987, while most firms reduced their leverage, average gearing continued to rise. This reflected the fact that, in the late 1980s, a number of firms that were already highly leveraged, further increased their debt-asset ratios.

Associated with the increased gearing of the 1980s was a significant decline in interest cover. During the 1982/83 recession, interest cover fell in line with the reduction in firm profits and the rise in interest rates. As the economy recovered from the recession, firms began to finance asset expansion primarily through debt. Thus, even though earnings increased and interest rates initially fell, interest cover did not return to the levels of the 1970s.

The paper also suggests that the constraints on the financial system, which were in place in the 1970s, led to firms becoming increasingly dependent upon trade credit as a source of finance. The liberalisation of financial markets over the 1980s has reduced the importance of this type of credit. However, given the lower transaction costs and the information advantage that suppliers of trade credit often hold over financial institutions, trade credit should remain an important funding source for many firms.

Section 4 of the paper indicated that the increase in leverage that occurred in the 1980s was characteristic of a range of different industry groups. The increase was relatively large in the manufacturing sector. Manufacturing is also the sector with the most cyclically sensitive output. The combination of cyclically-sensitive output and significant increases in leverage (and declines in interest cover) increased the probability that firms would be unable to meet current obligations out of current earnings following an adverse macro-economic shock. In a world characterised by full information and appropriate financial contracts, this would not necessarily imply an increased probability of financial distress or firm failure. However, we do not live in such a world. The increased probability of financial distress occasioned by higher leverage and an adverse shock to demand, is likely to have changed the incentives for management to undertake risky investment and for financial intermediaries to finance such investment. In turn, these changes are likely to have altered the evolution of the business cycle. This is a topic for further research.

Footnote

Based upon Table 3.2 in Occasional Paper No. 8 published by the Reserve Bank of Australia. [17]