Article

Privatization and the Development of Financial Markets in Italy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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Italy’s relatively underdeveloped capital markets and fragmented banking industry, compared with those of other large industrial countries, as well as its structure of corporate ownership and pattern of corporate finance, have limited the role of financial markets in corporate activity. These features of the economy have posed considerable difficulties for the large-scale privatization program initiated in 1992 to reduce the state’s share of economic- activity. Several public banks, insurance companies, industrial firms, and major public utilities were earmarked for privatization. Most of the early privatizations were carried out through private placements, primarily because of the small size of Italy’s equity market (although in some cases the specific-characteristics of the firm being privatized may have made this appropriate). Although recent privatizations carried out through public offerings—mainly those of state-owned banks—have generated considerable interest among small shareholders, structural weaknesses in financial markets, including a lack of transparency of corporate ownership and control, have continued to hinder the broadening of share ownership.

Since June 1993, total proceeds from privatization have amounted to over 15 trillion lire (about $9.4 billion), of which the stock market has effectively financed about Lit 11 trillion, representing about 5 percent of stock market capitalization. Forthcoming privatizations will involve significantly larger amounts than have been raised in recent years. The Government’s 1996-98 fiscal program contains projections for privatization proceeds of roughly Lit 10 trillion per year. By contrast, since 1988, new capital raised on the Milan Stock Exchange—the largest of the ten Italian stock exchanges, accounting for more than 90 percent of all equity trading—has averaged about Lit 6 trillion a year.

The Government’s need to sell large volumes of shares generated by the privatization program is having the beneficial effect of providing an impetus for reforms to enhance the efficiency of financial markets. For instance, reforms of takeover legislation and new regulations concerning representation of minority stockholders in privatized companies have been designed to improve the system of corporate governance and to encourage wider share ownership. There have also been important changes in other areas, such as improvements in the liquidity and transparency of equity markets and a move toward establishing a universal banking system.

Financial markets

Bond market. Italy’s bond market is one of the largest in the world and the second largest in Europe; its government bond market is the largest in Europe and the third largest in the world. Large public sector deficits have led to dramatic growth in the bond market, and government debt now accounts for over 85 percent of the total value of debt instruments traded. The market’s size and the broad range of debt instruments traded there, particularly the relatively large floating-rate market, have attracted significant interest from foreign investors. The introduction of an active secondary market, improvements in the settlement process, and withholding tax reforms have also increased the international attractiveness of Italian bonds.

Mahmood Pradhana UK national, is an Economist in the World Economic Studies Division of the IMF’s Research Department.

European stock markets: indicators of size and turnover in 1994(million dollars)
Market capitalization 1Market capitalization as percentage of GDPAverage company size 2Turnover ratio (percent) 3
United Kingdom1,210,245118.158578.1
Germany470,51923.01,12897.8
France451,26334.0983133.9
Switzerland284,092108.91,19980.1
Netherlands283,25185.989473.5
Italy180,13517.780872.3
Spain154,85832.140944.1
Sweden130,93966.61,14970.5
Belgium84,10336.954315.6
Sources: International Finance Corporation, Emerging Stock Markets Factbook, 1995: and IMF, World Economic Outlook data base.

Total market value of all listed domestic companies at the end of 1994.

The ratio, as of end 1994, of market capitalization to the number of listed domestic companies, in millions of dollars.

The total value of shares traded during the period divided by the average market capitalization for the period.

Sources: International Finance Corporation, Emerging Stock Markets Factbook, 1995: and IMF, World Economic Outlook data base.

Total market value of all listed domestic companies at the end of 1994.

The ratio, as of end 1994, of market capitalization to the number of listed domestic companies, in millions of dollars.

The total value of shares traded during the period divided by the average market capitalization for the period.

A particularly striking feature of the Italian bond market is the small amount of corporate debt issued and traded there. In 1993, new debt issues by nonfinancial corporations accounted for less than 2 percent of the market. In the past, regulatory constraints limited the growth of this market, and the absence of rating agencies hindered the development of an active secondary market. The new Banking Law that came into effect in early 1994 virtually eliminated stamp duty on corporate debt transactions, and firms that could provide a good record of profitability and a bank guarantee were permitted to issue short-term commercial paper and investment certificates. These reforms did not result in an immediate flourishing of private bond markets, however, since they coincided with a period of relatively high interest rates that limited new issues by private sector borrowers.

Equity market. In contrast to the bond market, the equity market in Italy is relatively underdeveloped, with a market capitalization, measured as a percentage of GDP, that is among the smallest in Europe (see table). Although recent privatization issues have attracted a large number of small shareholders, household sector savings have traditionally been channeled mainly through banks, and the total amount of equities held by the domestic household sector remains relatively low.

Institutional investors are also underrepresented, compared with other European countries. This partly reflects the absence, until recently, of a legal framework encouraging the emergence of several key types of institutional investor. New investment funds have been permitted only since 1992, and closed-end funds and private pension funds since 1993. Banks have only recently been allowed to own equity stakes in nonfinancial enterprises. Most important, however, the limited involvement of institutional investors reflects the structure of corporate ownership, which consists of a small number of large business groups with extensive cross-holdings (accounting for roughly 80 percent of the market capitalization on the Milan Stock Exchange) and a large number of small and medium-sized firms that are mainly family-owned.

Transactions costs in the Italian equity market, as in other European equity markets, have fallen significantly over the past decade, largely because of dramatic technological advances in information dissemination and trading systems but also, to a lesser extent, because of extensive regulatory reforms. The latter have included liberalization of access to membership of stock exchanges, reductions in transaction taxes, and liberalization of brokerage commissions. Underlying these reforms has mainly been the recognition by many countries of the increased competition between national stock markets resulting from the liberalization of capital flows in Europe.

Reforms in Italy were implemented beginning in the early 1990s, which was relatively late compared with those in France, Germany, Spain, and the United Kingdom. However, after the January 1991 law that set up single- capacity stock exchange firms, Società di Intermediazione Mobiliare (SIMs); the introduction of block trading in November 1991; and, more recently, the New Banking Law (September 1993), which relaxed constraints on banks’ ownership of stock exchange member firms, the Italian stock market has largely caught up with competing markets in Europe.

To improve the transparency of trading volumes and the information content of transactions prices, the 1991 SIM law made it mandatory for all trades to be conducted on the stock exchange. Before the November 1991 reforms, Italian banks had for some time acted effectively as market makers by offering to match block trades. An important incentive for banks to offer this service was the fixed commissions that existed up to that time. Such off-exchange trading had often provided scope for insider trading, especially for large traders who could artificially affect prices on the exchange prior to their own off- exchange trades.

Competition from other European stock markets has also led to the development of markets in derivative securities. In September 1992, a futures contract on ten-year government bonds was introduced on the Milan Stock Exchange. More recently, there has been increasing interest in derivative instruments in equities, particularly since the introduction of trading in futures contracts based on the equity price index, Indice della Borsa di Milano (MIB30), on the Italian Futures Market (MIF) in November 1994.

Corporate control and finance

Systems of corporate control differ considerably among industrial countries. In stock- market-based systems, such as the United Kingdom and the United States, control is exercised by institutional investors via large and active equity markets. By contrast, in many countries in continental Europe, control and finance are institution-based; banks and other financial institutions are major shareholders in nonfinancial corporations and perform an active role in supervising and managing them. In stock-market-based systems, investor protection—that is, taking steps to ensure adequate performance and an equitable distribution of corporate profits—is provided largely through potential and actual takeovers. Typically, there are few takeovers in institution-based systems, and investors are protected largely by the active involvement of equity-holding financial institutions.

Corporate control. In Italy, neither of these systems of corporate control has been effective: control is concentrated in the hands of a few large business groups; there are few hostile takeovers; and, until recently, banks were impeded by regulations from taking an active role in corporate governance. Although the greater concentration of ownership in Italy does not necessarily imply weaker performance of its corporate sector—since majority stockholders have greater incentives than minority stockholders to actively monitor performance of corporations—the absence of both external monitoring and the threat of hostile takeovers has resulted in less effective protection of minority shareholders.

The corporate sector in Italy consists of a small number of large business groups with widespread intergroup shareholdings and a large number of small and medium-sized firms that are either family-owned or have one majority owner. Shareholdings of the nonfi- nancial corporate sector account for almost 80 percent of the capitalization of firms listed on stock markets, with most of the remainder being held by financial institutions. Furthermore, companies where a single entity owns a majority stake account for 60 percent of stock market capitalization. By comparison, in the United Kingdom, less than 4 percent of market capitalization is held by the nonfinancial corporate sector, and of the largest 200 companies, more than two thirds have no single shareholder with more than 10 percent of the equity. Ownership is more concentrated in Germany, where 90 percent of the largest 200 companies have at least one shareholder with more than 25 percent of the equity. In both Germany and the United Kingdom, however, minority shareholdings are more significant than in Italy.

These differences have important implications for the Italian Government’s privatization program. The efficiency of privatized industries will depend largely on effective monitoring and supervision of corporate performance, especially in sectors where existing public enterprises may be transformed, at least in part, into private monopolies. Reducing the concentration of ownership will require particular attention to the rights of minority shareholders, especially where privatization is intended to lead to wider share ownership.

Large business groups in Italy are typically characterized by extensive cross-holdings of equity stakes, both within and outside the group. The hierarchical nature of business groups distinguishes the Italian system of cross-holdings from those of other countries where cross-holdings are also extensive, such as France, Germany, and Japan. In Italy, “parent” companies—those at the top of a pyramidal structure—have stakes in smaller firms lower down the hierarchy, but these subsidiaries rarely hold equity in parent firms. Such business group interests are extensive in the manufacturing sector, where they account for 75 percent of total employment. For parent firms, control of firms lower down the hierarchy can often be exercised with a minority holding. The controlling group can gain at the expense of other shareholders through transactions among subsidiaries that are designed to transfer profits to subsidiaries in which the controlling group has a larger share. This makes the protection of minority investors a particularly important issue in Italy: without adequate protection, there is little incentive for investors to hold noncontrolling stakes.

Corporate finance. In comparison with other major industrial countries, debt finance in Italy differs significantly in terms of maturity and source; most such debt consists of short-term bank loans. Equity finance is both small and restricted mainly to large firms: for example, the five largest business groups account for 70 percent of the market capitalization of the Milan Stock Exchange. This pattern of corporate finance is attributable primarily to relatively high corporate income tax rates, favorable tax treatment of interest payments on debt, and regulatory constraints on the amount of long-term lending by banks.

Few Italian banks have well-established procedures for analyzing the risk exposures entailed in longer-term lending. The market in wholesale corporate banking is dominated by Mediobanca, which is owned mainly by large industrial groups. It is the only institution active in mergers and acquisitions and has a dominant position in managing equity issues for large industrial enterprises and has, therefore, been extensively involved in the Government’s privatization program.

The regulation of Italy’s banking industry- has recently been relaxed, however, and banks will consequently be able to play a greater role in both corporate finance and the Government’s privatization program. The banking system is moving toward the universal bank model, although some restrictions on banks’ activities have been retained: they are still not permitted to operate directly in insurance, mutual funds, or stockbroking. Under the European Union directive on financial services, however, banks will be allowed to offer stockbroking services by 1996.

The Italian equity market is widely perceived to favor insiders. Small stockholders who do not have controlling interests, especially those who hold nonvoting shares, are often placed at a disadvantage, because they do not benefit from the transfer of firm ownership. Legislation approved in 1974 enabled Italian companies to issue savings shares (azioni di risparmio) that do not have voting rights; holders of these nonvoting shares are entitled to the same dividend paid on voting shares plus an additional 2 percent in years when dividends are paid to other shareholders, with a minimum dividend of 5 percent of the par value in years when no dividends are paid to holders of voting shares. Although the number of companies issuing both voting and nonvoting shares in Italy—about 50 percent—is not unusually high, nonvoting shares accounted for 57 percent of the market capitalization of the Milan Stock Exchange in 1990.

Further, the premium on voting shares is significantly higher in Italy than in most other countries. Between 1987 and 1990, the average premium on voting shares, compared with nonvoting shares, was over 80 percent. In contrast, in the United Kingdom, voting shares traded at a premium of just over 10 percent; in Canada, of just over 20 percent; and in Sweden, where voting and nonvoting shares are extensively issued, the premium was only about 6 percent. For companies with a majority holder, the premium was significantly lower than for companies that had a number of large holders but no majority holder—suggesting that the premium reflects the private benefits of control, even though these benefits cannot be observed directly.

Reforms of takeover legislation

The primary aim of recent takeover legislation in Italy has been to ensure that when one party, or a group of shareholders acting in concert, acquires a controlling interest in a firm, the effective takeover is transparent and that minority stockholders are offered the same terms for their holdings as those who sell out to the bidder. In 1992, the new law relating to takeover bids (offerte pubbliche d’acquisto (OPA)) made it compulsory for those intending to acquire control of a listed company to make a public tender offer, which must cover enough capital (a minimum of 10 percent) to enable them to achieve control. It is, however, intrinsically difficult to detect informal agreements or voting trusts among investors. Moreover, although the regulatory authority, in principle, has to be notified of any such trusts, it is not in general obliged to make public any information it obtains on formal or informal voting trusts.

The widespread existence of informal agreements among investors has raised some concerns in the context of the privatization program, particularly with regard to the potential for core groups to acquire control without the knowledge of minority holders. In response to such concerns, the OPA law of 1992 was revised and strengthened by the March 1994 law, which requires public notification of agreements among investors bidding for firms being privatized. The new law, however, applies only to takeover bids for such companies; the more general problem of defining and identifying informal agreements remains. These recent reforms of takeover legislation may, in the long run, act to reduce concentration in corporate ownership to the extent that acquiring control of enterprises will be more costly. Takeover activity should also, in principle, become more efficient, in that transfers of ownership will be more transparent.

Promoting equity finance

The authorities have sought to strengthen the protection of minority shareholders by establishing the relevant legal and supervisory structures. A law prohibiting insider trading and other related insider activity was passed in October 1991. Other measures to protect the rights of “outsiders” include rules for the selection of outside directors and rules mandating postal voting in privatized companies. In the recent privatization of the state-owned insurance company Istituto Nazionale delle Assicurazioni (INA), for example, three seats on the management board were reser-ved for directors nominated by minority shareholders. Also, effective February 1995, privatized companies have been obliged to introduce postal voting at shareholder assemblies.

The Government has also introduced a number of measures designed to encourage small investors. In June 1994, it issued a decree that would harmonize the withholding tax on shares at 12.5 percent, the same rate applied to withholding tax on bond interest payments, and shareholdings of up to Lit 100 million were exempted from inheritance tax.

Conclusion

In embarking on a large-scale privatization program, the Italian Government has needed to address many distortions in domestic capital markets. For a long time, the relative lack of transparency of corporate ownership and control in Italy have acted to discourage share ownership. Many of the recent reforms of takeover legislation and regulations relating to minority representation on corporate boards should, over time, lead to improved confidence in the system of corporate governance. To the extent that legislation was required, many of the necessary reforms are in place. There is, however, a different kind of problem that may not be resolved by legislation. The practice of exercising control via informal coalitions (voting trusts) among shareholders has been extensive in Italy, in large part because of the concentration in the structure of corporate ownership. The privatization program represents an important opportunity for the authorities to reduce the extent of concentration by ensuring a wider dispersion of shareholding and increasing the transparency of ownership and control.

This paper is based on a more detailed study of privatization and the financial markets that is included in “Italy: Background Economic Developments and Issues,” Staff Country Report No. 95/36 (Washington, IMF, 1995).

Suggestions for further reading: Colin Mayer, “Financial Systems, Corporate Finance and Economic Development,” in G. Hubbard (editor.), Asymmetric Information, Corporate Finance and Investment (Cambridge, Massachusetts: National Bureau of Economic Research, 1990); C. Robinson and A. White, “The Value of a Vote in the Market for Corporate Control,” (unpublished, York University, Toronto, Ontario, 1990); and Luigi Zingales, “The Value of the Voting Right: A Study of the Milan Stock Exchange Experience,” Review of Financial Studies, Vol. 7 (Spring 1994), pp. 125-48.

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