A comparative institutional analysis: why a European perspective is key

Countries differ greatly in their forms of institutional governance of the relation between financial institutions and the corporate sector – in their different reliance on retained profits, bank loans, equity and venture capital in the finance of investment and innovation. What is the impact of such variety of institutional arrangements (i.e. the “variety of capitalism”, discussed in e.g. Hall and Soskice (2001) and Aoki (1990)) on information and incentive properties and, through that, ultimately on rates of innovation and growth? It is in relation to these fundamental issues that the study aims to make its theoretical and empirical marks.

The FINNOV project also progresses the state of the art by adopting an explicit focus on the Europeanisation of parts (but only parts) of the financial sector and their local and regional impacts on patterns of innovation and society more generally. Typically, the treatment of these relationships has been very abstract and has not taken account of national differences. Where national characteristics have been taken into account, the dominance of American studies in this area has led to a focus on the US, with the rest of the world either ignored, or treated as an embryonic form of US patterns. For example, Gompers and Lerner's (2001) review of the venture capital literature highlights how most analysis is based purely on US experience. Our study will instead start from the assumption that rather than being a weak form of the US, Europe is in fact simply different and has its own patterns of governance, innovation and distribution that are themselves not only worthy of further study, but that may also result in superior economic outcomes. At least since the Enron case, it is not at all clear that US patterns of corporate governance are 'the best' (Bebchuk and Walker 2002). Moreover, it is not clear how appropriate US models are outside the US or even outside the very specific sectors where they have been successful (see Dushnitsky and Lenox, 2006 who question VC's value for biotech). In this study we wish to understand the particular strengths and weaknesses that diverse forms of financing have.

Rather than being a poor copy of the US, instead we suggest that Europe has a distinct pattern of financial services and a distinct position in relation to both local and global financial provision.

The emergence and success of the European financial services sector (in which we include Switzerland) can be seen in European leadership in insurance (London is the world's leading market with premium income of £167bn in 2005), IPOs, and the fact that a third of foreign exchange turnover ($1,109bn each day) and 43% of the world OTC derivatives trade ($643bn/day) are in London. An increasing number of European high tech firms are seeking funding on AIM in London. Baden-Fuller et al (2006) highlight how the US model of VC funding plays a limited role in European high-tech firms that draw on specific EU financial institutions and build capabilities in technology and management in distinct ways

This Europeanisation is important, as it offers the potential for European firms to exploit European diversity and through transnational patterns of service provision address weaknesses in national patterns. For example, German high-tech firms might exploit London during their early stages, but then as they develop, exploit local commercial banking to support longer term R&D projects. This example is hypothetical, but it does suggest that Europeanisation of financial services is an important and interesting feature of the links between finance and innovation. However, in order for industry to exploit this potential, and for government policy makers at the national and EU level to support it, we need to better understand the strengths and weaknesses of different institutional settings linking finance, innovation and corporate governance.

Moreover, the very different patterns of the distribution of income in the US and Europe are poorly understood in terms of aggregate 'rankings'. Between 1980 and 2004 US real wages in manufacturing decreased by 1%, while the richest 1% of the population saw their incomes increase by 135% (this corresponds to families with over $272,000 in 2004). A recent review of the evidence on US corporate governance came to the conclusion that US governance measures are extremely ineffective and that they should be understood in terms of managerial power and rent extraction (Bebchuk and Walker 2002). This suggests there is a need for further comparative evidence on the impact of different modes of corporate governance on income distribution, to better understand whether inequality has sharply widened due to unbalanced increase in the share of corporate income absorbed by managers' and shareholders' compensation.

Relatedly, it is crucial to understand the relative role of the different modes whereby financial markets exert influence on corporate governance, identifying the relative balance between market vis-à-vis non-market forms of discipline in different countries, in terms of “exit” vs. “voice” pressure (Hirschman, 1970), on the part of shareholders, and their effects on corporate performance and income distribution.