Development Finance:

Debates, Dogmas and New Directions

Chapter One
An Introduction to the Financial System in Theory
and in Practice

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
• Debate:
- the development of an effective financial system has been seen as an essential
prerequisite for growth at some points,
- And an unproductive parasite on the real economy at others.

• Theoretical positions have evolved , changed direction, gone up blind alleys and
been informed by real-world experience for at least a hundred years.

• It is from this real-world experience that we have, perhaps , the most to learn: we
have seen what has worked and what has not, though we may not always know
exactly why these outcomes have occurred.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
• What is the financial system actually for?

- ‘It is an organisation of credit, by which the capital of A, who

does not want it, is transferred to B, who does want it’ (Bagehot,
1978: 422).

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
 Function of the financial system

a) To mobilise savings and allocate credit

- channelling resources indirectly from the capital-rich to the
capital-poor through third-party financial intermediaries, such as banks.

b) It enables individuals to directly provide surplus resources through

the capital markets
-through providing debt financing to companies by purchasing
corporate bonds, or by providing equity finance to companies through
the purchase of shares.
-organises and implements various aspects of the ‘plumbing’ of the
national economic system.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
c) The provision of clearing and settlement services

- Businesses and individuals are able to settle financial balances, whether they be
cheques or credit and debit cards for smaller balances usually associated with
individuals or small businesses or large value payments between financial
institutions, which are generally settled centrally within the national central
bank.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
 As well as providing these vital functions for the private sector, the financial
system is both overseen and used by national governments in a variety of
ways:

d) Governments regulate the activities of the financial system

e) Governments also borrow from the financial system
-Via sovereign bonds
-To provide the funds needed to finance government expenditure (i.e. to
finance fiscal deficits)
f) Governments may also take a more direct role in the financial system
-intervene directly in the functioning of domestic financial systems (such as
directing the allocation of credit through development banks and/or directly
owning or controlling a section of the commercial banking sector)

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
 Key features of the financial system

1. Capital markets

(a) Bond markets (or ‘fixed income’ markets)

- enable corporations and governments to borrow directly from investors in the
capital markets through the issuance of bonds.
- Bonds are issued in the ‘primary market’, and then traded in the ‘secondary market’.
- level of interest attached with (i) the creditworthiness of the issuer (ii) specific
features of the bond

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
(b) Equity markets
- ‘public equity markets’ (share markets/stock exchanges) are where
companies ‘list’ their shares for trading purposes, with the total value of the
company’s outstanding shares termed ‘market capitalisation’.

- Investors that purchase a company’s shares are entitled to a share of the

company’s profits in proportion to their stake in the form of ‘dividends’,
which are usually paid annually.

- Although in many markets – particularly developed ones – anyone can invest

in public equity markets, in practice major institutional investors play a
dominant role.
- The second form of equity market is ‘private equity’, where shares are not
listed on a public market, but are sold directly to investors.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
2. Other financial markets

(a) Money markets:

- a market for short-term debt securities, such as bankers’ acceptances,
commercial paper and government bills with short maturities.

- Money market securities are generally used to provide liquidity to

companies and banks – including overnight loans to meet their reserve
requirements as usually determined by the central bank.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
(b) Derivatives markets

- provide instruments for the handling of financial risks, where participants in the
derivatives markets purchase instruments that enable themselves to ‘hedge’ themselves
against future movements in asset prices.

(c) FX markets
- trade currencies internationally.
- - Foreign exchange markets are actually made up of many different markets,
because the trade between individual currencies—say, the euro and the U.S. 
dollar—each constitutes a market. 
- The currency markets are the largest and most liquid of all the financial markets

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
3. Commercial financial institutions

a) Commercial banks
b) Investment banks/merchant
- assist businesses in finding and structuring various forms of finance,
including the issuance of corporate bonds and the ‘underwriting’ these
issues (i.e. they agree to purchase any unsold bonds).
- Investment banks also arrange mergers and acquisitions (M&A) and may
invest their own capital by taking equity positions (public or private) in
selected businesses.
c) Universal banks
- perform all the functions of commercial banks, combined with the
services offered by investment banks.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
d) Mortgage banks/building societies
- providing finance for the purchase of property, both residential and commercial.

e) Contractual savings’ institutions

- pension funds and insurance companies pool and invest the savings of their members to
generate sufficient funds to meet their liabilities (i.e. pension liabilities and paying
insurance claims).
f) Asset management companies
- provide ‘portfolio management’ services for retail and institutional investors (including
pension funds) by accessing the public (and private) financial markets described above.
g) Venture capitalists/private equity companies
- provide seed (or growth)
capital for new (or expanding) businesses.
h) Finance companies
- less clearly defined activities than banks, and are frequently established to circumvent
restrictive regulation. They are generally regulated far less stringently than commercial banks
in particular, as they do not take deposits from the general public.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
4. Quasi-commercial financial institutions

(a)State development banks

- directly owned by governments (either wholly or partially) and are used
to direct credit to those sectors of the economy identified by
government as priorities.

(b) Mutual /cooperative banks

- collectively owned by their members and operate on a basis that is not
strictly commercial but is designed to maximise the benefits to these
members.
- They are therefore often able to pay higher rates of interest to savers and
charge borrowers lower rates of interest than purely commercial banks.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
(c) Post office savings banks
- provide basic financial services, often to those on low incomes.

(d) Credit unions/friendly societies

- owned by their members, where savings are pooled and credit granted
to members on low incomes.

(e) Microfinance institutions

- may be organised as a bank, cooperative, credit union etc. Aims vary, but
providing the poor with access to financial services is a core feature.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
5. Governmental financial institutions

Central banks
- Provide liquidity on a day-to-day basis, which is often used to control the
money supply.

- Act as the lender-of-last resort (LOLR) to the domestic banking system,

thereby providing sufficient confidence to prevent bank runs.

- Own or oversee national payment and settlement systems

- Provide prudential regulation/supervision of the banking (and broader

financial) sector.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
- Provide (or require banks to provide) deposit insurance, which, as the
name suggests, insures depositors’ money held in banks. The purpose
of deposit insurance is broadly similar to that of the LOLR function
described above: by guaranteeing individuals’ money held in banks,
deposit insurance schemes may prevent the onset of bank runs.

- Determine and/or execute monetary policy. The past decade has seen
increasing moves towards independence of central banks with regard
to executing monetary policy.

- Determine and/or execute exchange rate policy.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
How do financial markets differ from other markets?

1. Fundamentally, financial markets differ from other markets in that they

generally involve delivery in the future as opposed to the present.

2. Financial markets also allow transfers across time.

3. Financial markets also transfer and manage risk by channelling funds

from risk-averse savers to risk-taking investors.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Financial theory and the major schools of thought in historical perspective

Efficient Market Hypothesis (EMH)

The hypothesis postulates that capital markets will be optimal in terms of allocative
efficiency if prices fully and accurately reflect all the relevant information, thereby
ensuring that price signals correctly direct equilibria.

• ‘weak form’ of the EMH:

- requires prices to fully reflect historical performance and volatility
• ‘semi-strong form’ of the EMH:
- requires prices to reflect all the information contained in the weak form as well as all
currently available information

• ‘strong form’ of the EMH:

- requires all the information which is known to any market actor to be fully reflected in
the price
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
If there is truly some area of pricing inefficiency that
can be discovered by the market and dependably
exploited, then profit-maximising traders and
investors will eventually through their purchases and
sales bring market prices in line so as to eliminate the
possibility of extraordinary return.
(Malkeil, 1987: 122)

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Challenges
Tobin (1984) is highly sceptical on the efficiency of the financial markets. He
distinguishes four efficiency tests that can be levelled at the financial markets:
1. Information-Arbitrage Efficiency
- asks whether all publicly available information is reflected in market
prices: in this sense Tobin agrees that financial markets are indeed highly
efficient.
2. Fundamental-Valuation Efficiency
- asks whether prices fully reflect future expected earnings: he concludes
that, in this sense, the financial markets are not efficient as they fluctuate
far more than can be justified by changes in fundamentals.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
3. Full-Insurance Efficiency
- assesses whether market actors are able to fully insure for themselves the delivery
of goods and
services in all future contingencies: again, Tobin concludes that financial markets in
this sense are not efficient.

4. Functional Efficiency
- asks whether markets perform their functions efficiently: Tobin asserts that, in
contrast to the ostensible purpose of the financial markets – as described by
Bagehot – ‘very little of the work done by the securities industry, as gauged by the
volume of market activity, has to do with the financing of real investment in any
direct way’ (p. 11).

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Tobin (1984) ultimately concludes that: ‘we are throwing
more and more of our resources, including the cream of
our youth, into financial activities remote from the
production of goods and services, into activities that
generate high private rewards disproportionate to their
social productivity’ (p. 14)

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
 For supporters of the EMH, therefore, the international financial system could
function in an optimal manner if allowed to develop without distorting interventions.

price mechanism

illusion

economic fundamentals – of companies or countries – do not

change to anything like the extent that market prices do

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
A belief in the inherent superiority and efficiency of the market
mechanism suggests that government should:
(a)concentrate on establishing the ‘rule of the game’ in terms of a level
playing field for market participants,
(b)ensure obstacles to financial and private sector development are
removed, and
(c)avoid further interventions in the economic or financial sectors, which
by definition will be sub-optimal when compared with the ‘invisible
hand’ of efficient markets.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
 Some History

(a) John Maynard Keynes

- Keynes (1936) argued that imperfections are inherent in markets and
that there is no innate tendency towards the production of optimal
outcomes – aggregate demand is just as likely to be such as to produce a
low-growth, high-unemployment equilibrium than any other. Therefore, to
ensure the desirable outcomes of high levels of growth and employment, it
is necessary for governments to intervene in the economy.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
- For Keynes, changes in market structure and the nature of economic
activity had created a highly precarious environment (such as divorce
between ownership and control and the emergence of stock markets
altered this situation radically).
- Stock market valuations offer the investor the opportunity to
reappraise her investments on a daily basis as prices fluctuate both
absolutely and relative to each other. This introduced liquidity into the
economic system, enabling investors to withdraw their investments at
any stage
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
For Keynes, these developments had a number of significant consequences:
• Firstly, the quantity of real knowledge of the businesses concerned – in terms of their genuine
long-term prospects – is inevitably reduced
• Secondly, and as a result of the first consequence, day-to-day fluctuations in profits have an
unwarranted impact on the share price.
• Thirdly, ‘a conventional valuation which is established as the outcome of the mass psychology of
a large number of ignorant individuals is liable to change violently as the result of a sudden
fluctuation of opinion due to factors which do not really make much difference to the prospective
yield’ (p. 154).
• Fourthly, Keynes argues that although one would expect these destabilising forces to be offset by
the activities of professional and knowledgeable investors, this does not occur because investors:
‘are concerned, not with what an investment is really worth to a man who buys it for keeps, but
with what the market will value it at, under the influence of mass psychology, three months or a
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
year hence’ (p. 155). University of Dhaka
(b) Irving Fischer, the Great Depression, Bretton Woods and the Keynesian
consensus
- Observable real-world impacts of the Great Depression: The approach viewed
financial crises as an integral part of the business cycle – not anomalies or a
rational response to deteriorating economic circumstances as had previously been
assumed.
- Fisher (1933) attempted to determine the root cause of the length and depth of the
Great Depression, where he saw the crucial factor as the level of debt in the
economy. Fisher argued that upswings in the economy, instigated by some
exogenous event, encouraged increasing levels of indebtedness as greater
investment opportunities emerged.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
- The Debt-Deflation Theory of Great Depressions: recessions and depressions are due to the
overall level of debt rising in real value because of deflation, causing people to default on
their consumer loans and mortgages. Bank assets fall because of the defaults and because
the value of their collateral falls, leading to a surge in bank insolvencies, a reduction in
lending and by extension, a reduction in spending.
- - The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the
ensuing Great Depression.
- Higher levels of investment are then financed through higher levels of debt, which also
funds the growth of speculation in asset markets with the aim of obtaining capital gains
through rising asset prices. The increase in borrowing raises the money supply and
therefore the rate of inflation. This rise in prices reduces the value of the debt, which
encourages ever more borrowing.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
- At a crucial point a crisis is provoked when the level of debt becomes
‘overindebtedness’ and borrowers are no longer able to meet their liabilities.
- To overcome this problem ‘distress selling’ occurs where borrowers liquidate their
assets in an attempt to meet the demands of creditors.
- If selling of this kind is widespread enough, the previous inflation becomes
deflation and the cycle reverses itself. Falling prices then cause the level of
outstanding debt to increase and, as the value of collateral falls with the price
level, creditors call in loans and fears of bank insolvencies trigger off bank runs.
- This process continues, economic activity declines and unemployment rises.
Ultimately, bankruptcies rectify the excessive levels of debt and recovery can
begin. Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
- many commentators believed that the international financial and economic
effects of this event led directly to the onset of the Second World War.
- Consequently, when representatives of forty-four countries gathered at Bretton
Woods in New Hampshire in 1944, the aim was to construct an international
economic system that would reduce the instability of the financial system.
- Unlike what had preceded it – and the situation today – the time was one of
faith in the power of the state to achieve desirable goals that the market, left to
itself, was now seen as incapable of producing: the goal was stability and the
establishment of confidence in future events.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
The reforms instituted at Bretton Woods ushered in a long period of
stability:
- with currencies holding to their pegs (other than infrequent realignments) for
the better part of thirty years.
- International movement of capital was greatly restricted in relation to what had
existed previously. Indeed, at Bretton Woods Keynes had argued that the
imposition of stringent capital controls should be obligatory on all countries,
not least because of the damage he thought that unfettered capital flows could
do.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
(c) Structuralism
- In Latin America the structuralist school of thought began to develop within the Economic
Commission for Latin America (ECLAC) from its launch in 1947, and under the leadership of its first
executive secretary, Raul Prebisch.
- In a radical departure from classical trade theory, structuralists did not view developing countries
that focused on primary commodity exports as rationally exploiting their comparative advantage in
these sectors.
- the global recession of the 1930s greatly reduced export markets, and led to a questioning of this
approach.
- The structuralists argued that the industrial revolution in the ‘centre’ had dramatically increased the
productivity of the factors of production (land, labour, capital) in these economies. In contrast, the
industrial sector in the periphery was tiny and was reliant on the import of capital goods from the
centre.
- developing countries had to export more and more commodities simply to be able to import the
same quantity of capital goods. Wages in the periphery were kept low by a large pool of surplus
labour in agriculture and the lack of unionisation, whilst wages in the centre were driven up by
unionisation and productivity improvements.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
- the periphery was trapped in commodity production and export to serve the centre and had no prospect of developing the
vibrant industrial sector needed to get out of this situation.
- To address this, the structuralists proposed ‘import-substitution industrialisation’ (ISI) where high tariffs were placed on
industrial imports, except for the essential hi-tech capital goods needed to drive the industrialisation process. The aim was
to move the economy onto a virtuous circle of industrialisation, rising productivity, wages and employment.
- However, as the fruits of the ISI process failed to develop, the structuralist position came in for strong criticism in the
1960s, not least from within its own ranks. T

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
 Monetarism and the return of faith in markets

Kindleberger (1978) distinguishes two distinct schools of thought in financial

theory:
To maintain the
credibility, and
therefore
i. Currency School (monetarism) : desire to control the money supply functionality of
ii. Banking School (Keynesianism) : desire to expand money supply the stock of
money, and the
expansion of
credit to foster
higher levels of
economic
growth.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Currency School (monetarist)
• Monetarists see the money supply (M) as exogenous to real income (Y), prices (P)
and interest rates (R) so that an increase in M will result in an increase in P but Y
cannot change (too much money chasing too few goods).
• Keynesians also subscribed to this ‘quantity theory of money’ in principle.
However, they argued that increasing M could increase Y, since the economy may
spend long periods below full employment equilibrium and Y can be increased up
to this level.
• From a structuralist or post-Keynesian perspective, however, M is endogenous to
the economy: i.e. it responds to the credit needs of the economy. Artificially
restricting the money supply therefore only serves to artificially restrict the growth
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
of the economy. University of Dhaka
 This debate has witnessed the dominance of one school or the other at different
times: the post-war adoption of expansionary demand-management policies by
many countries was a significant victory for the intellectual offspring of the Banking
School, for example. From a monetarist perspective the expansion of the money
supply through government borrowing, ostensibly to raise effective demand during
economic downturns, was a recipe for disaster. They argued that the long-run
impact of this approach would inevitably lead to an inflationary spiral, an argument
that ultimately proved to be correct.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
The United States economy completed its recovery from the Great Depression in
1942, restoring full-employment output in that year after 12 years of below-full-
employment performance. Fiscal policies were not the most important factor in
the 1933 through 1940 phase of the recovery, but they became the most
important factor after 1940, when the recovery was less than half-complete.
World War II fiscal policies were, then, instrumental in the overall restoration of
full-employment performance.

Reference: Vernon J. R. (1994), Policies and the End of the Great Depression, Journal of Economic History,
Vol. 54, No. 4, pp. 850-868.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Crudely, monetarists placed greater faith:
i. in the ability of free markets in general
ii. the price mechanism in particular, to produce optimal outcomes.
In contrast, they had little faith in the state’s ability to successfully
take on this role.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
The monetarist revival gathered pace throughout the 1960s and was therefore well
positioned to offer an alternative explanation of the events that were
to unfold in the 1970s.

This decade (1960 – 1970) saw the collapse of the system of fixed exchange rates, the
demise of Keynesianism as the dominant, global economic ideology, and the return to
the instability that the optimists at Bretton Woods thirty years earlier had hoped to
eradicate. These huge changes in the economic landscape moved the parameters
within which theory had been operating and led to the emergence of new schools of
thought, as well as the evolution of older ones.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Why Bretton-Woods system collapsed?

 The Bretton-Woods system of fixed exchange rates supported by extensive capital

controls offered few opportunities for profit in international financial markets.

 However, capital controls began to be loosened from 1958 and the consequence
was a steady rise in the scale and complexity of international flows of capital.

 These increases put rising pressure on the parities of international currencies and
were a significant factor in the eventual collapse of the system.

 In 1971 the Nixon administration in the US, no longer able to maintain the fixed
rate between the dollar and gold, unilaterally severed the link and thus removed
the foundation of the international system of fixed exchange rates.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Neo-liberalism

Neo-liberalism is primarily associated with the Chicago School of Economics, which

also emphasised the efficiency of markets and free competition, and stressed the
primary role of individuals in determining optimal economic outcomes.

In contrast, government interventions in markets were viewed with suspicion, being

largely seen as distorting markets and preventing these optimal outcomes from
occurring.

Neo-liberals argued that there was no need for government to intervene in the
economy to ensure full employment, for example, since in a free market situation prices
will adjust to ensure adequate supply and to ensure that all the factors of production
are employed – that is, markets automatically adjust to full employment and attempts
to use monetary or fiscal policy to achieve these ends merely create inflation.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
In domestic terms, the agenda has been dominated by proposals to mimic the
‘Anglo-Saxon’ model. Relevant domestic policy proposals in this regard include:

• the deregulation of domestic financial markets

• Privatisation
• reductions in the power of trade unions
• smaller government
• lower tax rates
• opening of international goods and capital markets

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Internationally, the 1990s saw the birth and rise of the ‘Washington
Consensus’, which in turn advocated:
• privatisation;
• free trade;
• export-led growth;
• financial capital mobility;
• deregulated labour markets;
• macroeconomic prudence.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
(f) Financial fragility, uncertainty and asymmetric information

In an analysis of the nature of business cycles and financial crises, Kindleberger (1978)
distinguished between upswings and downturns, with the former characterised by
behaviour resembling a ‘mania’ and the latter by behaviour resembling a ‘panic’.

- The mania stage is triggered by what Kindleberger calls a ‘displacement’, which is

an exogenous event that produces a change in the perception of economic
prospects – the dotcom boom is a clear recent example of this.

- The demand for credit increases > rise in bank loans fuels the expansion> Asset
prices rise> further enhancing the feeling of increased wealth> encouraging ever
more borrowing> Investors switch out of cash, ‘get on the bandwagon’> fuelling the
rise in asset prices> feelings of mania > the bubble expands> sucking in more and
more investors.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
At this stage Kindleberger distinguishes between ‘insiders’ and ‘outsiders’:
- the insiders, who are aware of the situation, sell out at the top of the market to
the outsiders attracted by the mania to get in on the act – the dotcom boom of
the late 1990s comes to mind.
- The bubble can only continue to expand if outsiders (buyers) outnumber insiders
(sellers).
- At some point a period of ‘distress’ emerges where the nature of the bubble is
recognised and the influx of outsiders ceases. An uneasy period ensues until some
trigger sets off a panic as investors rush to withdraw their funds.
- Investors have a strong incentive to be first in the queue to withdraw their funds
since all know that not every investor will be able to liquidate without loss, not
unlike a bank run.
- This process is described by Kindleberger as a ‘fallacy of composition’, wherein
individual investors acting in a rational way – attempting to withdraw their funds
before a crash – ensure that the opposite occurs.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
- A very important strand of theory that emerged in the 1980s was that of
‘asymmetric information’, which owed much to the work of Joseph Stiglitz, who won
the Nobel Prize for Economics for his work in this area.

- The asymmetric information problem identifies the fact that lenders and borrowers
do not have access to equal information as to the credit-worthiness of a potential
borrower. Asymmetric information is considered a particular problem in financial
markets, which as we have seen are concerned with uncertain future events.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Mishkin (1996) draws on the pioneering work of Stiglitz and identifies two key
problems of asymmetric information that afflict the financial system.
i. ‘adverse selection’: in debt and equity markets, lenders have no way of
distinguishing good borrowers from bad. Therefore, the price that they are
prepared to pay, rather than being a reflection of the genuine risks involved,
represents the average quality of firms in the market.
ii. ‘moral hazard’: Here, the borrower has an incentive to engage in high-risk
strategies since, if they come off, the borrower wins but, if they fail, the
lender shoulders the burden. The consequence is that some lenders will not
make loans and lending therefore remains at sub-optimal levels.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
(g) The return of psychology and behavioural finance
- The foundation stone of orthodox financial theory is the assumption of rational,
utility-maximising agents.

- Early classical economists such as Marshall, Fisher and, particularly, Keynes

recognised the importance of psychology and analysed the nature of economic
decision-making in this context.

- However, the psychological content of mainstream economics began to diminish in

the 1940/50s as new quantitative techniques were brought to bear in support of the
rationality hypothesis.

- Early pioneers in what would become behavioural economics were Amos Tversky and
Daniel Kahneman, whose article ‘Judgement under Uncertainty: Heuristics and
Biases’ appeared in a 1974 edition of Science.
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
- Tversky and Kahneman demonstrated that actual behaviour systematically
violates the precepts of rational, optimising behaviour.

- Crucially, they also showed that these ‘anomalies’ could be predicted.

- The fact that the ‘anomalies’ described are systematic and therefore
predictable is important because supporters of the market efficiency position
argue that deviations from rational behaviour are random and uncorrelated:
consequently, this is just ‘white noise’ that effectively cancels itself out, and
therefore cannot move markets away from the equilibrium implied by
rational behaviour.
- it is argued that, in practice, individuals often do not make decisions in this
way, but rely on a limited number of ‘heuristic principals’ that serve to
simplify complex probability judgements.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
• The work of Tversky and Kahneman provides the foundation for the school of
thought known as ‘behavioural finance’.

• From this perspective, markets are not always driven by rational, utility-
maximising individuals, but often by people employing psychological short-
cuts in their decision-making.

• Consequently, many of the ‘anomalies’ we see in the workings of markets are

not anomalies at all, but
• the consequence of this consistent and predictable behaviour.

Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,

University of Dhaka
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka
Dr Sheikh Tanzila Deepty, Associate Professor, Dept. Of Finance,
University of Dhaka