Scribd Logo
Upload

Welcome to Scribd!

  • Framework Financial Market Development PDF

    Uploaded by

    Patricia Miñán Zaragoza
    4 views57 pages

    Original Title

    Framework-financial-market-development.pdf

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    4 views57 pages

    Framework Financial Market Development PDF

    Uploaded by

    Patricia Miñán Zaragoza

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 57
    WP/09/156 &m IMF Working Paper A Framework for Financial Market Development Ralph Chami, Connel Fullenkamp and Sunil Sharma INTERNATIONAL MONETARY FUND 1 2009 tenons Monetary Pd wrosss IMP Working Paper IMF Insite ‘A Framework for Financial Market Development Prepared by Raiph Cham, Connel Fullenkamp and S il Sharm July 2008 Abstract | This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Weking Paper are those of the author(s) and do noe necessarily epost those ofthe IMF or IMF policy Working Papers describe research in progses bythe thon.) and ate published to clict comments ant fre debate ‘The paper proposes framewcrk for examining the proces of financial market development. ‘The framework, consistent wit the functional view of financial system design is anchored in studying the incentives facing the key players i financial markets borrowers, lenders, liquidity providers, and regulsiors—whose actions determine whether and how markets or cual, Lindy (200) an Seige (200) make auch a aegamet fr the U.S. economy Ad athe ‘sy ea he Asan re pee anking iia the lal Hae eis of 207-2009 ste evidence that financial market development brings teal benefits tothe poorest members of society and reduces income inequality." Ths, rvently there has been considerable interest among policymakers to develop financial ‘markets—loun, bond, equity, asset-backed, and derivative markets. Thee practical questions are asked by policmakers: which new financial instruments are needed, how should they be introduced, and in what order should thedferent types of markets and related institutions be developed, Despite an abundance of research on financial market development, much less has been done ‘on examining the process of financial market development per se. This paper proposes a fiamework for anlyzing the proces of financial development and shovs how it can be ‘usefl for formulating responses to the tree questions raised above. Our methodology can be characterized us New Insititionalist (North 2008), Wiliamson (2000) and isn the sprit of the Fanetional and Swuctural Finance (FSF) approach ut forward by Merton and Bodie (2005) tht synthesizes neoclasial, new institutional, and behavioral perspectives to analyze the design of financial systems ‘The Merton-Radic analytical framework takes the functions ofthe financial system as conceptual anchor The key insight of the FSF framework is tha he functions performed by * onan (2000 bows ht nil eeening is mgt coated wit eadsout poverty Beck, ‘Demigby Kant end Lovie CUD} fd ht he cores of se nthe lowes! income qe a0 Ow {sn GDP in sot wh br devaape nc syste ° The resesh iterate docs provide insights int the determina of func met development. One sad of wsnih es owed on he uly of sins: For exile, LaPor, Lope-e Stes, Sei Vishny (197) reo th chee end uy of legal tons, paral with eget the ver tetany afr ae ea expesingcrosecomny fences in nace ‘evelopment, Galindo ua Moo (20) fea on cede ptetn and sow tt itis spies Inne. Avther rand ns th. depend of ep system, geographic endownets have bd @ ‘etc a sting imc on ial art development ee, for expe, Bek ea (200) Lesoas ‘Simei deelopmen cna leo fo stoi sai of nia mks and into. or ‘harp Bosie nt int (1997) pp he ols of ders inmce to weave Some of the ving forces {etn the emerge nd evo of bt corte ancl pate nd fucks between he TSthand 28 cetrics a ls (1398) prove god overview fhe eto the developmen of US. pl nce Theres lo iar compaing te srenghs eal weakness o banca and ke fete inane tems exemple by Alena Gale (200) and aj and Zines 201) at proves Fis no why bank based nace developed foe market-based nol se and Wht ‘esters foe bated system my poet obs the developmen of faunal aah. “te cre ction prom byte cn sytem eh lowing: () mseing resus tou ime tnt cos sce clearing antigay Gi) pooling mane an subg fi owes. {fe} ce ancy ma oe ination or dscns decom making (0) anya sk nd (2) (Sain with nce poems sein fro symm aro. Se, Cae etl (95), 5 financial markets are well defined and constant, while the instruments and institutions tht perform these functions change over ime, and are endogenously detenined by prevailing Conditions inching transactions costs, social factors, and behavioraleonsideations. Our proach is consistent with the FSF view of nancial system design ic thatthe specific ‘Mentos ofthe agents and institutions performing financial funetions may vary over ime, ‘Atthe same time, however, ur approach is based onthe belief hat development ultimately ‘depends on te presence snd actions of market participants, end can oxy be propedly Understood in terms of their incentives, constrains, and opportunities. Thus, our framework ia tbeed on analyzing four important players whose activities are essential for wel functioning financial markets, The ations taken by these four types of agents—orrowers, Tenders, igudity providers, and repulators—determine whether and bow markets develop in «particular environment tn our framework, financial contracts instruments) are the means through which the financial sysem cates otis functions. The nature ofthe contracts wed to perform the functions ofthe financial system depends onthe preferences of each agent as well s the fconomic legal, social, and technical constrains that prevail ata particular time, While ‘herent inci! instruments embody different concessions by borrowers and lenders, we focus on two Key compromises that determine the nature of many financial instrument: the traturity-collateral compromise and the seniority-control compromise. The process of Financial market development is sen as being embodied inthe eration, execution, and ‘eforcemen of contracts, This defines ase of interactions among the four players tht can be ‘eseribed and analyzed using the tools of economies. And ertcal interactions cat be texamined te se whether they advanee or retard market development. ‘Briefly, the view of financial market dynamics underlying ou framework can be expressed ie follows: fbortwers and lenders are willing and able to contrac, and liquidity provides find conditions conducive to trading te instruments that are created then financial markets ‘wll develop. The regulatory structure can suppor this process by removing obstacles that Thuke potential borzowers, lenders, and liquidity providers unwilingor unable to play their les, end by creating the right incentives fr each agent o full hi end ofthe bargain. ‘This view leads naturally tothe flowing process of analyzing finarcal market development and the design of polices. First the players must be identified. Who are or will be the tortovers, lenders, and traders for an instrument? What are the specific goals and objectives tt the varcus players? What i the narure and extent of regulation required and how i it to te provided bythe government andor the private sector? The next pis to decipher the ‘hatales that discourage or prevent the potential borrowers, lenders and liquidity providers fiom participating in the markets. Finally, policies that address the cbstacles must be proposed sa evaluated based on how wel they accommodate the needs ofthe players in the markets. “The pape is organized a follows, The next two sections present the framework, Section 2 ‘considers the four key players involved in the building of modern financial markets, including their ations, incentives, and constraint, Section 3 examines the fundamental ‘compromises among the players that influence the evolution of instruments and markets Section 4 uses the famiework to address sequencing isuesin financial market development. ‘Concluding remarks are presented in the last section, 1, “Tie FRAMEWORK: KEY PLAYERS AND THEIR INCENTIVES, Financial instruments are contracts between borrowers and lenders that govern the transfer, ‘se, and repayment of funds. And financial markets are the “arena” where potential ‘borrowers and lenders “meet” and agree on the terms ofthese contrat, This implies that the most fundamental building blocks of financial markets are the (Wo partes to the contract borrower and lender. As in most contracting stations, the two partes generally have ‘opposing goals and must necessarily make compromises in order to reach an agreement. Financial widening takes place when borrowers and lenders forge new types of compromises as embodied in new instruments, ad financial deepening when they increase the we of ‘existing instrament, Therefore, any analysis ofthe process of financial market development should start by discussing the goals of borrowers and lenders, and the difficulties they face in designing entering, and enforcing contracts.” A. Borrowers “The demand for funds can be motivated by one of three purposes: purchase of good, « service or an asst; funding an investment project (including the accumulation of financial, assets); or substituting a new financing arrangement for an existing one. Regardless of ‘purpose, most borrowers have a common set of preferences with respect othe ters oftheir borrowing. It goes without saying that borrowers prefer to pay the fowest cost forthe funds. In addition, borrowers want the freedom to pursue their interests in the best way they se fit, without outside interference—that is, they like control over the use of funds (choice of ‘project, sk-retur combination) with minimal conditions attached. They prefer nat to pledge collateral because it is costly to accumulate eligible asets, and because they dislike the possibilty of having to forfeit such assets. They also like maturities to be compatible with their needs and intermediate payment (of interest, for example) tobe infrequent, so thatthe projects have adequate ime to become successful. In ation, each borrower will have preferences and demands specific to her situation, and she must decide how to trade off * Cos ore ancl nsstons ollow the se gia ome ancl wansictions possibly with tonal ss sng om ewe of ferent eurences to aienal scares, We do aot eamine ‘hercy (rcp exchange) markets sane hese resell it ‘elopncm spe one develope of coumy'scommecel dei seco ands den foe servis and we 1 particular preferences asi cach lhe, nord to achieve the most favorable compromises possible Forexample, corporate ance theory has long focused onthe costs of borrowing 3 2 W890 ‘plan capital structure, te mixture of insiruments tht borrowers choose to finan ei ric The objective fo fund investment projects in such away a8 to maximize the we ern fim, given the mem offinncing alerstives—interal inane, debtor equity. One sito do this isto choose the last-cost combination of funding the frm. tn the highly tied worl ofthe Modilian-Miler theorem, where sere are no taxes, ansacton cont aaeration problem, the firm would be completly indifferent between te items on the sr ann But once transactional, informational and regulatory costs, 35 well 8s taxes, are rperndved, the fm hast rk te diferent fanding methods by their costs. This is he Tdamental idea bchied the so-called “Pocking Order” theory of capital structure ‘According to this theo, intemal finance is always the it choice ofthe firm, beause th ‘an has complete ox bilt in the use of these funds, and itincurs no explicit information or ieeuanee cone. There i an implieit opportunity cst, bu sch costs are more eppropristly erate wth the capital budgeting or iavestment decison rather than the financing ‘Gesion, Debt is more costly than internal fiance, because of the interest costs and the cots seetnted wrth issuing deb through an intermediary. However, in many counties debt is atpoved come tax rele inthe form of deductions fo interest payments. These deductions can ‘Mttentally reduce the effective interest cost of deb, and make it the next best financing ‘choice compared 1 intemally generated funds ‘Equity isa much more costly metho of financing the frm, First there is th cost of paying “Guidends and managing the frm ina way that assures investors about profitability inthe futore Since equity ithe mos risky ofthe three insrumens, investors wil demand the higheat expected retum, In adton to thi, shares are generally more costly than debt 1 rae A common commission rt in the US. fr share underwriting (on fim-commitment ‘ass is seven prcat ofthe value of the issue, But equity issuance is actually even more any, due to information costs. Because ofthe information asymmetry between the ‘Ranagors of he frm andthe investing pblic there san addional cost of equity. Basel, the managers ofthe fm know more about the tre oF ntinsic value of the fim than does the tvesting public. Ths the managers ay havea beter dca of when the shares ae overt tiled, reativeto the current market pice ofthe shares. The managers have the rons to issue new equity at precisely the times when the shares are overvalued in onde retake advantage of favorable market conditions. But the investors realize thatthe firm's ‘Panagers have this incentive, co that hey interpret a share issuance as signal fom the Trager thatthe firm's shares are overvalued. Ths, they sll shares and place downwant pressure on the firm's tock. Mikkelson and Path (1986) fo example, show ts he ln are price lends to aloss in vale ofthe overall rm equivalent on average o 30 peteet of the value ofthe issuance. This sin adltion to any decrease in value from gitution, which maccenscaa aa OODOAPRDIVIPPEPIAVIIDIDIIITIS SOS SSELSS spreads the earings over a greter number of shares, Ths, the total or all-in est of equity is ‘ite substantial especially relative to debt. is so costly, infact, tht mature firms tend to issue new equity only asa last resort “The Peeking Order theory is consistent with our framework in thai analyzes financial market outcomes by focsng onthe needs of one of the Key players. And the theory does ‘have implications forthe order in which financial instruments develop But tothe exten that ‘the theory assumes th menu of instruments already exists, and borrowers simply choose fiom this mena itis nota theory of financial development 1B. Lenders “The second building block of financial markets isthe lender. By defition, lenders are agents -who havean excess of funds over and above their immediate needs. Like borrowers, lenders, Ive refines aver risk-teturn combinations for the funds they oun. One way 1 Took at the lenders decision is that lenders compare the returns and risk fom lending with those fiom intemal investments, Thus, although its extemely unlikely tit a given lender's preferencss match a given borrower's preferences, there may be room for compromise over the termsof a loan that would make the lender beter off than would the next bes intemal investment. Inorder achieve» desired combination of rik and return, lenderstry to monitor the use of Toned finds with the purpose of meintaining some control over how te funds are deployed "They gonsally place specific covensnts in the lending contacts stating what the borower ‘may do with the funds, and requir the disclosure of information that will enable the lender to ‘verify thet the finds are being used properly. Short maturities are prefered, both in oder to Timi the rk ofthe lan 2s well as to provide a lever to contol the behavior ofthe borrower: the loans wll be rolled over only if the borower behaves according tothe terms ofthe contract, Finally, for insurance, the lender prefers thatthe loan be backed by a pledge of ‘collateral of some kind-—and the more stable the value of the pledget asset, the bet. ‘Based on this simple discussion of borrowers and lenders, we can already make several important observations about financial market development. The firsts that financial markets vill rise spontaneously whenever borrowers and lenders fr a particular instrument axe plentil and willing and able o contrat wit each other. Fe example, in Thailand from 1955-1988, the government limited the numberof banking licenses t granted, But because tere exited plenty of business opportunities, and households were willing to lend, nonbank finance companies arose to intermediate between borrowers and lenders. The finance companies sued interest-bearing promissory notes to obtain funding, and made fans to businesses and households, Infact, many banks in Thailand estblised finance companies in ‘order to evade the restrictions on their banking operations that prevented them from taking ‘advantage ofthese lending opportunities. Finance companies outnumbered banks and were @ Aeiving force in Thailand's Financial markets upto the 1997 exsis, er which they were closed, In general, when markets fal to develop, its because borrowers or knders ar not present, or they are not willing to contact The development ofthe commercial paper market inthe US. isan excellent eae in point. Although short-term, unsecured cerpoate debt known as ‘commercial paper had been in existence since the early 19th century, the market remained soll and unimportant until the 1970s, when issuance began to grow rapidly. Corporates Wishing to issue commercial paper were always plentiful, but until the 1970s there were few lenders for such an instrument. This shortage was resolved bythe eration of money-markst ‘mutual funds (MMF). These funds were themselves created in ord to avoid deposit intrest rate ceilings imposed on banks. MMs accept deposits from firms and households and invested them in high quality, short-term debt instruments. Commercial paper was a natural instrument forthe MMPs to hol, and they formed a critical link between household lenders and the money market—a matke that few households had been ableto participate in before ‘because ofthe minimum investment size. With the lenders i pace, the commercial paper ‘market grew rapily and now accounts for over St tlio in outstanding debt" The {evelopment ofthis market also facilitated the growth of US. nonbank Finance companies, institutions that funded themselves though issuance of commercial paper. ‘The above analysis suggests four major obstacles to developing finarcial markets. Fis, sulicient borrowers or lender fr an instrument may not be present. Second, the lenders and borrowers may have opposing goals in many dimensions, and ariving ata mutually ‘beneficial contract may be complicated. Tied, bortowers and lenders have to achieve their ‘goals in an environment characterized by a fundamental asymmetry in information: the leader always has less information than th borrower about the lates opportunities, actions ‘and intentions. Finally, continuous monitoring of the borrower may be expensive or simply not possible. These last vo obstacles mean that direct verification ard enforcement of contracts may be dificult if nt impossible, so that either more complex contracts have to be constructed, which can be demanding and expensive, or the contacting process wil fil ‘because of insuiicient assurance of performance. C. Liquidity Providers The provision of liquidity is essential for financial deepening, and liquidity in certain instruments can also catalyze the development of oer markets, There are many markets in ‘hich borrowers and lenders are preset, the instruments used ae agreeable to both parties, and yet the market hs litle atvity beyond primary issuance and redemption. For example, many of the nascent government bond markets around the world are simple “buy and hold” 0 markets, While such markets help achieve the fiscal policy goals ofthe government, they do not lead to Financial market deepening and its accompanying benefits. Ths is because there ‘sno trading inthe instruments, and in particular no agents making » secondary markt inthe “The nee for liquidity stems from the needs ofthe lender. In many cases, the lender's investment horizon willbe shorter than the maturity of the instrument she is considering for purchase, And there always exists the possibility thatthe Fender will havea sudden need for Tiqudity and will therefore wish to exchange the financial instrament fr eas If the lender cam be confident that she can sll he instrument at a fir price at any ime after purchasing it, then she will be more willing to purchase the instrument. Indeed, a key aspect of making ® financial instrument of ay kind atacive is to make sure that there i an ext strategy forthe Tender: an easy vay to exchange the instrament for cash Strictly speaking, itis not necesary to have a specialized agent supply liquidity, But because they do not face the same constants as borrowers o lenders inthe particular instrument, specialized liquidity providers who ae distinct from borrowers and lenders, can be useful in ‘many markets, These agents include brokers and dealers, [An obvious way to provide assurance othe lenders that they can exchange tht instruments for eash sto have dealers who are willing to buy and sll the instrument at posted prices ‘Therefore, a major step inthe development of most financial markets is the emergence of dealers, whose activities make the instrument significantly more attractive to lenders and borrowers. Ifa dealer accumulates an inventory ofa newly introduced instrument and stands willing to make a market, this serves s an indication to lenders tha the instrument is relatively quid. For example, in developed financial markets, when a financial institution tretes anew instrument, it has a strong incentive to serve asa dealer and even guarantee to epurchese th instrument from the buyers at predetermined prices for an introdvetory period. "The accumulation of inventory in & new and relatively unknown instrument may expose the firm to significant risks. ‘But the innovating institution has sufficient incentives to act asa dealer. The sucessful introduction of «new financial instrument by a private firm leads to temporary market power in the instrument. Before other fms mimic the security, the innovator i able to command 3 premium in erm ofboth underwriting fes and secondary market prices forthe instrument. ‘An exatmple ofthis was the sucessful introduction in the 1980s of synthetic Treasury strips, lor zero-coupon bons, These were special rst receipts issued by intermediaries, who purchased Treasury securities and effectively offered receipts representing claims aginst Individual cashflows fron the underiying Treasury bonds’. The fist dele to offer the >See gun (1990) for dei a product named ita “TIGR,” and soon the market ws fill with similar products, with ames such as “LIONS,” “CATS” and so on, White dates provide liquidity by seeking to profit from the bid-ask spreed on their inventory, traders who wish to profi from shor-ten fluctuations in financial market pices ako povide uit tothe market, These agents, who typically close out their positions ‘aily cr cary minimal inventor, provide a steady source of turnover for dealer inventories ind hence rovens forthe dealer, They effectively serve as counterparties who increase the thumber of agents with whom borrowers and lenders can contrat. But they are distin from pomovers and lender, in that their trades are motivated by views about ke relative values of changed arbitrarily. When taken together, these three elements serve to give borowers and lenders the ‘PRERRRRAPROKADOADRDRADDAAeRaAaeeaaanaaannnr-____. “4 confidence they need to modify exiting instruments and pussve te Fashioning of new and innovative financial conte, ‘Beyond establishing the rule of las, governments must also support market development through regulation and supervision, Asymmetries in information (and also expertise, resources and power) between market participants, and the externalities stemming from the failare of financial agents to live upto ther contractual obligations creat @ need for public regulation and supervision of marke and financial insiuins.® Based on these considerations, three reasons ae given for public regulation: (providing ret customers ‘with protection (i) ensuring systemic stability; and (i) proecting the taxpayer Who tilimately provides many ofthe formal and informal gusranees that shore up the financial system, ovsever, is important to realize tht regulation and supervision play a supplementary role in market development, Supervisors and regulators eannot develop the markets directly; only borrowers and lenders can do tis. This distinction is not always appreciated, and governments at times go too fri their effort to facilitate fancial market development. ‘This is apparent in the most common strategy for government-led financial market development, whichis the “Build Itand They Will Come” aproach in this approach, the ‘government introduces not only the legal infastucture but also particular instruments and exchange mechanisms inthe expectation that private playes will rush into the ready-made __ markets, The problem in many cases is that fw agents actully come to play and often there limited activity in these new markets Regulators typically need to play an active role in nancial market development, especially ‘when the conditions necesary fo trading certain contracts ae not present andthe conditions cannot be effectively created by borrowers and lenders themselves. In other words, it ‘generally takes two hands to develop financial markets: the invisible hand, anda “helping hha” The tasks performed by the helping hand isto remove obstacles, create the necessry support stricture for financial markets, and posibly coordinate market development. We consider each ofthese activities in tun, Removing obstacles includes correcting market failures and dealing with extemalities and distortions that prevent financial markes from developing. The payment system, for example, isa public god easential to financial market development tha usually requires government subsidy or provision. Accounting and disclosure standards can be thought of as is worth eenting onetinesRerween elon (ie ste of specials and behav an spervson osng tht erie re obeyed sd tat ell ouetpares conde hoses erin ‘Save way) Cals te costs demands, we wl we the er eo Wo emo both Fo mre ‘led conto te aol for egulia ed supervision of famacal makes, for example Good {a 98) and Llewann 199), Is public goods that may requir two types of regulator intervention ist, to ensure thatthe sardards embody te right incentives forall eoncerned; and second, to coordinate adoption of aich standards. Distortions caused by market power may also inhibit potential rowers andor lenders fom participating in certain segments ofthe financial system. ‘Qumoded or ill-conceived laws and regulations may present obstacles to financial activity Forexample, in many countries, only real assets—land and fixed stuctures—can be pledged ‘as cullateral. This estrcton may have heen intended to protect lenders by only allowing ‘immobile assets wit stable values and legally recognized titles to be pledged, but it constitutes fundamental barier to borrowing, particulary for small businesses whose main tnt arc durable equipment rather than land or structures, Another reaeston that regulators Sometimes place on capital markets isto prohibit the borowing and lending of securities. “These laws are often intended to prevent fraud and market manipulation, but end up reducing tiquity and imparting an upward bias to prices. Creating «supporting environment for financial market development, whichis the second task ofthe regulator, has many dimensions. Fis, polieymakers need to provide the necessary

    You might also like