Title: Financial Markets: International Context
1Financial Markets International Context
- Dr Richard Fairchild,
- mnsrf_at_bath.ac.uk
2Objectives of Course
- To give students an introduction to International
Financial Markets. - The purpose of Financial Markets.
- The issues involved.
- The Key Players.
- The regulatory Bodies.
- The impact of the emerging markets.
3In Summary
- Two main aims
- How Financial Markets work globally.
- To what extent should they be regulated, and by
whom?
4Recommended Textbook
- An Introduction to Global Financial Markets
- By Stephen Valdez
5Course Structure
- Raising Capital Debt and Equity.
- Banking/ The role of the Central Bank.
- Investment banks and Regulation.
- Bond Markets.
- Stock Exchanges and Regulation.
- International Trade and Markets.
- Investor Protection around the World.
- Hedge Funds, Private Equity, venture capital and
regulation. - Role of Regulatory Authorities (FSA)
- Derivatives.
- New Tiger Economies.
6Lecture 1Raising Capital Debt and
Equity(Valdez Ch 1)
- What is the purpose of the Financial Markets?
- Raising Capital matching lenders and borrowers.
- Intermediaries (eg Banks) Depositors gt
borrowers. - Stock Markets.
- gt Companies issue shares to investors.
- Shares freely bought and sold in the market.
7Who are the Borrowers?
- Individuals (eg bank loans, mortgages).
- Companies (for growth and expansion).
- Governments PSBR.
- Others (local authorities,municipalities,
counties, federal states)
8Who are the lenders?
- Individuals (eg savings in banks pension fund
contributions investors in equity/shares) - Companies (lending in short-term markets money
markets).
9Individuals Lending (investing) decision
- Portfolio analysis Individuals allocate their
wealth across equity and bonds. - We will examine this in more detail in later
courses!
10Companies Methods of Financing.
- Borrowing from Banks (Bank Loans).
- Issuing Bonds.
- Issuing Equity (shares).
- Primary Market.
- Secondary Market.
11Providers of capital to firms Expected returns
and Investor Rights.
- Banks and bondholders First claimants,
generally fixed returns required (interest). If
not paid, these holders have strong rights (eg
liquidation, bankruptcy). - Equity-holders Returns are risky! Very few
rights (but voting) Capital gains and dividends.
Shareholder is part-owner of the business.
12Financial Markets as a clearing mechanism
- Investors (lenders) decide how to allocate their
wealth across securities (financial instruments
such as shares and bonds). - Companies (borrowers) decide how to finance
expansion/growth/new projects by issuing shares
and bonds.
13Firms financing decision.
- Leverage The amount a firm borrows in relation
to equity. - In principal, nothing wrong with borrowing.
- Enables firm to invest and grow.
- However, too much borrowing gt problems? Credit
ratings. - Stock Market Analysts look at firms gearing
ratio.
14Risk and return (not in text book)
- The higher the risk, the more return
lenders/investors require as compensation. - Therefore, safe bonds have lower required return
(interest rate) than risky equity (volatile
capital gains and dividends).
15Firms financing mix.
Equity-holders required return
Equity-holders required return
Risky Debt
Lenders Required return on safe bonds
D/E
D/E
We will revisit these diagrams in later courses!
Downgraded Credit rating
16Market Failure/regulation.
- So, financial markets provide an efficient
mechanism for equating supply and demand of
financing? gt economy maximising growth
potential? gt fair allocation of wealth? gt
correct incentives for investors to provide
finance? - Not necessarily!
17Market failure.
- Moral Hazard problems.
- Adverse selection problems.
- Credit constraints.
- Credit cycles.
- Credit chains/contagion.
- Bank runs.
- Inefficient capital markets.
18Moral Hazard
- Managerial self-interest/diversion/stealing of
funds. - Shirking behaviour.
- Fraud (eg Enron, Parmalat etc).
- Role of regulatory authorities (eg FSA).
19Adverse Selection.
- Unobservable poor quality management/
Incompetence! - gt Credit constraints.
Rate if Bank can observe qualities.
Bank Lending Rate.
Pooling Rate
Increasing Risk of borrowers.
20Credit Cycles/chains/contagion
- Credit chains- macroeconomic cycles amplified!
- Contagion/ bank runs (Northern Rock?).
- Systemic risk.
B
C
A
D
21Bank Runs.
- Self-fulfilling!
- Mary Poppins syndrome!
22Inefficient capital markets
- Market values often different from fundamental
values. - gt Insider trading.
- gt very high volatility.
- FSA investigates abnormal share price movements
(eg Biffa recently).
23Increasing Globalisation of Financial Markets.
- Increases investors opportunities.
- Increases Firms financing scope (cross-listing).
- But increase in risks (systemic)/contagion/effect
of cycles? - Increased need for global regulation?
24Lecture 2Banking System
- Central Banks eg Federal Reserve in US
Bundesbank in Germany - Commercial Banks taking deposits/lending money.
- Investment Banks helping corporations find
money. - Savings Banks
- Cooperative Banks.
- .
- .
25Banks Balance Sheet
- Liabilities (Where the money comes from)
- Shareholders equity/retained profit
- Deposits (largest figure)
- Borrowings (eg a bond issue)
- Assets (how the money has been used)
- Notes/coins.
- Securities/ money market funds/ fixed assets
- Lending (largest figure) gt credit creation.
26Creation of Credit
- Banks have great ability to create credit.
- Banking depends on confidence.
- Governments and central banks will want to
control credit creation. Why? - Banks internal controls liquidity ratios.
- External control by bank supervisors capital
ratios.
27Money Supply
- M0, M3, M4.
- Interest rates, inflation, economic activity.
- Central Bank weapons mandatory reserves,
interest rates, open market operations.
28Liquidity Ratios
- Internal control method.
- Take all deposits and lend as 3 year personal
loans? NO!!! - LR percentage of deposits to be held as cash.
- Central bank can also impose this (eg Spain).
29Capital Ratio
- The external ratio imposed by bank supervisors.
- Major issue in banking
- Prudence.
- Banks lend money, some people default.
- Capital is a buffer against this.
- CR relationship between capital and lending.
30Capital Ratio (continued)
- Bank should not be excessively exposed to a few
key borrowers. - Eg Johnson Matthey Bank (UK) lent 115 of its
capital to 2 key borrowers. - 1987 Banking Act.
- Central Banks large exposure controls.
- Basel Committee gt uniform banking regulation gt
capital ratio. - Banks credit ratings.
31Increasing capital ratio
- Find more capital (rights issue, reducing
dividends, other forms of capital). - Reduce assets (selling off subsidiaries, selling
off loans to other banks, converting assets into
securities (securitisation).
32Central Bank Reporting
- All banks in a country must make detailed reports
to the Central Bank. - gt liquidity.
- Large exposures.
- FX exposure.
- Capital expenditure.
- Balance sheet.
- Profit and loss.
33Lecture 3 Role of the Central Bank/ Investment
Banks
- History 160 Central Banks in the World,
employing 352,000 people. - Consider 7 Major Central Banks China, France,
Germany, India, Japan, UK, US, European Central
Bank (ECB).
34Central Bank Activities
- Supervision of the Banking System.
- Advising the Government on Monetary Policy.
- Issuing Banknotes.
- Banker to other banks.
- Banker to the Government.
- Controlling the Nations currency reserves.
- Lender of last resort.
- Liaison with international bodies.
35Position of Central Bank.
- Last decade- a rise in power and influence.
- Central Banks have become independent gt ECB.
- Accountability?
- Inflation/growth/unemployment.
36Lender of Last Resort
- Guarantee of Rescue gt Moral Hazard (imprudent
behaviour by banks). - Walter Bagehots quote
- We will encounter moral hazard in many forms in
later finance courses!
37Other banks.
- Commercial Banks accept deposits/ make loans.
- gt retail banks
- gt wholesale banks.
- Investment Banks
38Key Retail Banking Issues
- Growing Competition (growing de-regulation)
- Cost Control
- Sales of Non-banking Products.
- Use of IT.
39Growing Competition
- Other Financial Institutions.
- Retailers.
- Insurance Companies.
- In-house Corporate Facilities.
40Bank Lending
- Uncommitted facilities gt
- Overdrafts.
- Lines of Credit.
- Bankers Acceptances.
- Committed Facilitiesgt
- Term Loans.
- Standby Credit.
- Revolving Credit.
- Project Finance (eg Eurotunnel).
- Syndicated Facilities.
41Investment Banks.
- Accepting
- Corporate Finance (new issues- equity/bonds,
rights issues, M and A, Research). - Securities Trading
- Investment Management
- Loan Arrangement
- Foreign Exchange
42Investment Banks-Corporate Finance Role
- New Issues Equity/bonds (pricing, selling to
investors, underwriting, general advice regarding
regulations). Close liaison with layers and
accountants. - Rights Issues Priced/underwritten.
- Mergers and Acquisitions (help bidders with
price, timing, tactics. Help target defend). - Research reputation important.
43Banking regulation.
- Commercial Banks risk depositors money if they
invest in stock market. - US Wall Street Crash 1929 Glass-Steagall Act
1933 deposit protection scheme gt Federal
Reserve Bank greater powers of supervision. - Separated commercial and investment banking.
- Glass-Steagall act repealed in November 1999.
- Research Question Role of the Treasury?
44Research Question.
- Discuss the dangers in Commercial Banks
undertaking securities trading. Should the
activities of commercial banks and investment
banks be separated?
45Lecture 4/5/6 Securities Markets.
- Money and Bond Markets.
- Stock Exchanges.
- Regulation of Stock markets.
- Cross-listing.
- Investor Protection around the World.
- Hedge Funds and Private Equity.
46Lecture 4 Money and Bond Markets.
- Rate of Interest price of money.
- Risk gt lender expects a greater reward for
higher risk. - OECD countries or US government
- gt lowest rate of interest applies to government
transactions (safest!). - Govt rate is benchmark for other rates.
- US corporate may borrow at Treasuries plus 1.
47Maturity and the yield curve
r
Time (months)
But may be downward-sloping! Expectations. Liquidi
ty. Supply and demand.
48Bond Yields
- Yield
- Par Values
- Coupon
- Gross redemption yield
- Accrued Interest.
- Volatility.
49Credit Ratings
- Creditworthiness gt Rate of Interest
- Credit-rating Agencies.
- AAA, AA, A, BBB, BB, B, CCC, CC, C, C1, D.
- Junk Bonds.
50Who Controls the Raters?
- Imperfect Information.
- Incentive for company to pay agency for full
rating to get a good one - March 1996 Moodys investigated by US justice
department - Reputations!
- Research Question Discuss the problems involved
in companies paying for credit rating?
51Domestic Money Markets
- Call money.
- Interbank Market (LIBOR).
- Money Market Securities.
- Treasury Bills.
- Etc
- Role of the Central Bank.
52Domestic Bond Markets.
53International Markets.
54Role of the Central Bank in Money Markets.
- Lender of Last Resort.
- Helping Commercial Banks with Liquidity Problems.
- Discount Rate, Lombard rate, open market
operations.
55Bond Markets.
- Government Bonds.
- Corporate Bonds
- Debentures/convertibles.
- Bond name of the bond, nominal or par value,
redemption value, rate of interest, redemption
rate. - Bond Maturity short, medium, long.
56Lecture 5 Stock Exchanges.
- What is the role of a Stock Exchange?
- How are Stock Markets regulated?
- Cross-listing.
- Investor Protection around the World.
57Role of the Stock Market.
- To provide the regulation of company listings.
- To provide a price formation mechanism.
- To supervise trading.
- Authorisation of members.
- Settlements of transactions.
- Publication of trade data and prices.
58Bonds versus equities in the market
- Equities have higher number of transactions.
- Bonds have higher value.
- Eg In UK, average domestic equity deal
50,000. - Average Government Bond Deal 3m.
- Which are the worlds biggest stock exchanges?
(Pg 162 Valdez table 7.1). - Market value? Turnover? Equity turnover?
59Indices
60Who Owns Shares?
- Small Investors Versus Institutions.
- Pension Funds.
- Equity Investments.
- Mutual Funds.
- Active Versus Passive Fund Mgt.
61Dealing Systems
- Order-Driven Systems.
- Quote-Driven Systems.
- Hybrid.
62International Equity
- 1980s, 1990s Cross-listing of MNCs.
- gt large expansion in primary issues and
secondary market trading in non-domestic
equities. - Eg German accounting rules not so strigent as
US - But Daimler-Benz listed in New York accepted
need for greater transparency. - French firm AXA listed on US stock exchange in
1996. - Research Question Why do countries cross-list?
63Sarbanes-Oxley (SOX)
- Following Enron SOX makes managers fully
responsible for maintaining adequate ICS and FR. - Rules for audit and accounting.
- Research question Will SOX work?
64Miscellanous features.
- Stock Borrowing (going short) and lending
- Bought Deals/block trades.
- Share buybacks.
- New issues.
- Rights issues.
- Scrip issues and splits.
- Scrip Dividends.
- Second Markets eg AIM (UK).
- Over the counter.
65EU Rules.
66Alternative Stock Markets.
- Tradepoint (UK).
- ECNs (US).
67Lecture 6 International Finance.
- Foreign Exchange (briefly!).
- International comparisons of investor
protection/corporate governance.
68International Trade.
- Foreign Exchange.
- Importers/exporters.
- Tourists.
- Government spending abroad (eg Troops)
- Speculators.
- Banks and Institutions.
- Looser Exchange controls gt Fund managers
investing in foreign equities and bonds gt
exchange rate risk.
69Drivers of exchange rate risk.
- PPP (Purchasing Power Parity).
- In theory, Basket of goods priced at 10 in UK
and 20 in US gt exchange rate 1 2. gt
stability of exchange rates - But Market imperfections/Barriers to
trade/tariffs/ERM. - Psychology of the market herd instinct.
- gt exchange rate volatility.
70Exchange rate Risk.
- Bretton Woods 1944.
- gt Exchange rate stability.
- IMF 1946
- The World Bank (IBRD).
- IFC.
- IDA.
- EEMU.
- Use of Options to reduce risk.
71Investor Protection around the World (not in
textbook)
- Civil Law versus Common Law Countries.
- Bank-dominated versus Capital Market-dominated
countries. - Developed V emerging markets.
- Dispersed or concentrated ownership structures.
- Effect on market development, capital structure,
dividend policy etc. - La Porta et al papers
72Research Question.
- Which type of market should lead to the best
stock market development? - Specific example share repurchases.
73Investor Protection and Corporate Governance (La
Porta et al).
- Large differences among countries in
- A) ownership concentration
- B) Breadth and Depth of Capital Markets
- C) Dividend Policies.
- D) Access of Firms to external finance.
74Investor Protection and Corporate Governance
(continued).
- Common explanation for differences gt
- Legal Approach How well investors (creditors
and shareholders) are protected by law from
expropriation by firms managers and controlling
shareholders. - Financial systems approach Bank-centred versus
Market-centred. - La Porta et al favour legal approach.
75- Legal protection of investors affects-
- Breadth and depth of capital markets.
- Pace of new security issues.
- Corporate ownership structures.
- Dividend policies.
- Efficiency of investment allocations.
- Different patterns across countries.
76- Why is investor protection important?
- Widespread expropriation of minority shareholders
and creditors by controlling shareholders
(insiders). - Corporate governance mechanisms for outside
investors to protect themselves.
77Managerial Expropriation
- Insiders steal the profits.
- Transfer pricing.
- Asset stripping.
- Investor dilution.
- Diversion of corporate opportunities form the
firm. - installing unqualified family members
- Overpaying top executives (Cadbury report).
78Legal Protection of investors
- Legal approach emphasises laws and enforcement.
- Strong legal system gt firms can raise more funds
in some countries than others. - Investors more vulnerable to expropriation than
employees or suppliers (why?)
79Cash flow rights versus control rights.
- Researchers recognise that securities give both
cash-flow rights and control rights. - Jensen and Meckling Managers incentives not to
expropriate increase with managerial equity
(cash-flow rights). - Grossman and Hart investor power Versus insiders
(control rights) - Both JM and GH well-defined contracts specifying
investor rights.
80Incomplete contracts
- But contracts incomplete.
- Therefore legal system becomes important.
- Concentration of ownership.
- Large managerial equity holing good incentives
due to cash-flow rights - But entrenchment bad (control rights).
81Investor protection.
- Equity-holder rights include
- Disclosure and accounting rules.
- Receive dividends on a pro-rate basis.
- Vote for directors
- Shareholder meetings.
- Subscribe to new issues on same terms as
insiders. - Sue directors.
- Call extraordinary meetings.
82Creditor Rights
- Bankruptcy and re-organisation procedures
- Repossess assets.
- Protect seniority of claims.
- Force reorganisation.
83Different sources of investor protection
- Company laws.
- Security laws.
- Bankruptcy laws.
- Takeover laws.
- Competition laws.
- Stock exchange regulations and accounting
standards.
84Enforcement of laws.
- In most countries, laws and regulations enforced
partly by - market regulators.
- Courts.
- Market participants themselves.
- Without effectively enforced rights, financing
mechanisms break down (why?)
85- Law and Economics approach to financial
contracting - Regulation of financial markets unnecessary.
Entrepreneurs will voluntarily commit to
contracts. - But contracts incomplete!!!
- So, law and regulation IS important.
86Law and Finance (La Porta et al)
- Legal rules, protection of investors, origin of
these rules, and quality of enforcement in 49
countries. - Common law countries have the strongest
protection of investors. - French civil law countries have the weakest
protection. - German and Scandinavian civil law countries in
the middle. Why? - See table 1.
87Common law versus civil law countries.
- Civil law gt greater government intervention in
economic activity/ lower investor protection.
88Consequences of investor protection
- Ownership structure of firms.
- Development of financial markets.
- Allocation of real resources.
89Investor protection and ownership structure of
firms.
- Low investor protection gt large ability to
expropriate gt control has enormous value. - gt leads to concentrated or dispersed ownership
of equity? - Some researchers poor investor protection gt
concentrated control. - Other researchers poor investor protection gt
dispersed control Consider why? - Empirically poor investor protection gt
concentrated control (substitutes V complements?)
90Investor protection in East Asia(Claessens et
al 2000)
- Apart from Japan (good investor protection)
- Bad investor protection gt large family/state
control. - Crony Capitalism
- Fundamental agency problem not between outside
investors and managers, - But between outside investors and controlling
shareholders.
91Corporate Ownership around the World (La Porta et
al)
92Investor Protection and Corporate valuation (La
Porta et al)
- Effect of legal system and ownership structures
on corporate valuation. - Theory and evidence.
- Higher valuation of firms in countries with
better investor protection. - Better legal protection of outside investors gt
willing to finance firms gt financial markets
broader and more valuable.
93Legal system/ownership structure
- Managers have cashflow rights (affects
incentives) and control rights gt expropriate
large private benefits. - Better legal protection gt managers are limited
in their expropriation abilities. - Concentrated ownership gt entrenchment
- But, higher cashflow rights gt less expropriation.
94Various tables from the paper.
95Lecture 7 Hedge Funds, Private Equity, and
venture capital.
- Hedge Funds Very controversial and much-debated.
- Collapse of Long Term Capital Management.
- Private Equity takeover of RJR Nabisco by KKR in
the late 1980s. - Barbarians at the Gate.
- Venture capital alternative funding mechanism
for start-ups
96Venture Capital
- New entrepreneurial start-ups Extreme
uncertainty/high risk - gt difficult to obtain finance from banks or the
general public. - Venture capitalists specialise in financing such
ventures gt potential large capital gains at IPO. - VCs active investors extreme agency problems gt
BVCA.
97Private Equity
- VCs early stage companies.
- MBOs highly leveraged.
- PE gt high ownership stake for management.
98Hedge Funds.
- Actively managed investment fund
- Seeks a high absolute return (whether markets go
up or down). - In contrast to an index tracker.
- Wide variety of complicated investment
strategies. - Not designed for retail investor, but for high
net worth individuals or institutions.
99Common hedge fund strategy
- Short-selling (selling a security we do not own
gt borrow the security). - Plus high leverage (why?)
- First hedge fund AW Jones and Co, in 1949.
- Other Hedge funds Warren Buffet 1950s.
- George Soros Quantum Fund 1974.
100Hedge Fund Strategies.
- Equity Hedge Funds.
- Global Asset Managers.
- Relative Value Arbitrage.
- Event-driven Investing.
- Short sellers.
101Should hedge funds be regulated?
- Investor protection?
- Destabilising the market?
- Systemic Risk?
- Inside information?
- See Paper by Noyer.
102Regulation of Hedge funds?
- Bank of England Seeks self-regulation (voluntary
code). - FSA update of regulation of hedge funds.
103Lecture 8 Regulatory authorities.
- Treasury.
- FSA.
- Research Question What is the FSAs role in
regulating financial markets?
104FSA
- CBA of regulation (paper by Alfon and Andrews).
- Market Cleanliness (paper by Monteiro, Zaman, and
Leitterstorf).
105CBA
- FSA has taken over the functions of 9 existing UK
financial regulators. - FSMB.
- gt CBA analysis of financial regulation.
- SIB established a CBA department in 1994 to
advise on costs and benefits of regulation of UK
investment business. - CBA gt more or less regulation?
106CBA in FSA (continued)
- CBA can improve firms compliance culture.
- Enhance regulatory agencies accountability.
107CBA in FSA (continued)
- Requirements of FSMB gt FSA has 4 statutory
objectives, and 6 other aims. - Are the benefits proportionate to their burden?
- Innovation.
- UKs competitive position.
- CBA useful tool for FSA trade-offs between
statutory objectives and economic matters.
108FSAs requirements
- FSA required to publish a CBA whenever impact of
regulation likely to be high. - FSA over-complies?
- CBA requires quantitative estimate of costs, but
not benefits. - Qualitative Benefits can be assessed
- gt Pragmatic approach to CBA.
109Economics of Regulation
- Regulation a monopoly good supplied at no
explicit charge. - Over-demanded? Not actually needed?
- Regulation can have significant impact on markets
and welfare. - Eg excessive regulation in the US gt Eurodollar
market ? (Investigate!)
110Economics of Regulation (continued)
- Non-use of CBA can lead to unintended bad
side-effects. - Eg a regulator reduces the freedom of banks in
order to reduce systemic risk. - But gt lack of bank innovation and investment.
- Option Comparison.
111CBA
- Theoretical and practical problems.
112FSAs analytical CBA Framework- six stage process
- Decide Scope and Depth of the analysis (how many
options to consider?) - Likely effects of each option.
- Qualitatively compare the effects of each option.
- Reject inferior options.
- Estimate Costs and assess benefits of remaining
options. - Provide an output to illustrate costs and
benefits of the options under consideration.
113Impact Analysis
- 6 impacts
- Direct Costs.
- Compliance Costs.
- Quantity of Good sold.
- Quality of goods offered.
- Variety of products offered.
- Efficiency of Competition.
114Assessing the costs of financial regulation.
- Direct costs.
- Compliance Costs
- Indirect costs (negative market impacts eg
reduced competition gt higher charges, costs of
imposed uniformity, moral hazard). - (Incremental Costs).
115Assessing the Economic Benefits of Financial
regulation
- Correction of Informational asymmetries between
buyers and sellers.
116Market Cleanliness
- FSA has a statutory objective to maintain
confidence in the Financial System. - Efficient, orderly and fair markets gt delivering
value to users and providers of financial
services. - FSAs main aim Reduction of market abuse in the
UK.
117Market Cleanliness
- Extent to which informed stock price movements
are observed ahead of significant price-sensitive
announcements. - gt price movements could indicate insider trading
- Eg BIFFA in January 2008?
118Market Cleanliness (continued)
- Insider trading is just one form of market abuse.
- Abuse in equity and non-equity markets?
- CBA of insider trading regulation?
- gt Financial markets built on trust. Insider
trading erodes trust.
119Market cleanliness (continued)
- FSMA (2001)
- gt Civil regime for prosecuting market abuse.
- Disclosure rules.
- FTSE350 listed companies no change in market
cleanliness after FSMA implemented?
120Lecture 9New Tiger Economies.