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Financial Markets: International Context

Dr Richard Fairchild,

mnsrf@bath.ac.uk

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Objectives 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.

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In Summary;

• Two main aims:

• How Financial Markets work globally.

• To what extent should they be regulated, and by whom?

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Recommended Textbook

• An Introduction to Global Financial Markets

• By Stephen Valdez

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Course 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.

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Lecture 1:Raising 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 => borrowers.

•Stock Markets.

•=> Companies issue shares to investors.

•Shares freely bought and sold in the market.

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Who are the Borrowers?

• Individuals (eg bank loans, mortgages).

• Companies (for growth and expansion).

• Governments: PSBR.

• Others (local authorities,municipalities, counties, federal states)

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Who are the lenders?

• Individuals (eg savings in banks; pension fund contributions; investors in equity/shares)

• Companies (lending in short-term markets: money markets).

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Individuals’ Lending (investing) decision

• Portfolio analysis; Individuals allocate their wealth across equity and bonds.

• We will examine this in more detail in later courses!

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Companies’ Methods of Financing.

• Borrowing from Banks (Bank Loans).

• Issuing Bonds.

• Issuing Equity (shares).

• Primary Market.

• Secondary Market.

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Providers 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.

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Financial 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.

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Firm’s 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 => problems? Credit ratings.

• Stock Market Analysts look at firm’s gearing ratio.

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Risk 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).

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Firm’s financing mix.

•

D/E D/E

We will revisit these diagrams in later courses!

Lender’s Required return on safe bonds

Equity-holders’ required return

Equity-holders’ required return

Risky Debt

Downgraded Credit rating

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Market Failure/regulation.

• So, financial markets provide an efficient mechanism for equating supply and demand of financing? => economy maximising growth potential? => fair allocation of wealth? => correct incentives for investors to provide finance?

• Not necessarily!

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Market failure.

• Moral Hazard problems.

• Adverse selection problems.

• Credit constraints.

• Credit cycles.

• Credit chains/contagion.

• Bank runs.

• Inefficient capital markets.

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Moral Hazard

• Managerial self-interest/diversion/stealing of funds.

• Shirking behaviour.

• Fraud (eg Enron, Parmalat etc).

• Role of regulatory authorities (eg FSA).

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Adverse Selection.

• Unobservable poor quality management/ Incompetence!

• => Credit constraints.

Increasing Risk of borrowers.

Bank Lending Rate.

Pooling Rate

Rate if Bank can observe qualities.

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Credit Cycles/chains/contagion

• Credit chains- macroeconomic cycles amplified!

• Contagion/ bank runs (Northern Rock?).• Systemic risk.

A

B

C

D

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Bank Runs.

• Self-fulfilling!

• “Mary Poppins” syndrome!

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Inefficient capital markets

• Market values often different from fundamental values.

• => Insider trading.

• => very high volatility.

• FSA investigates abnormal share price movements (eg Biffa recently).

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Increasing 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?

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Lecture 2:Banking 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.• .• .

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Bank’s 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) => credit creation.

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Creation 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.’

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Money Supply

• M0, M3, M4.

• Interest rates, inflation, economic activity.

• Central Bank weapons; mandatory reserves, interest rates, open market operations.

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Liquidity 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).

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Capital 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.

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Capital 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: => uniform banking

regulation => capital ratio.• Banks’ credit ratings.

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Increasing 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).

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Central Bank Reporting

• All banks in a country must make detailed reports to the Central Bank.

• => liquidity.• Large exposures.• FX exposure.• Capital expenditure.• Balance sheet.• Profit and loss.

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Lecture 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).

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Central 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 Nation’s currency reserves.• Lender of last resort.• Liaison with international bodies.

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Position of Central Bank.

• Last decade- a rise in power and influence.

• Central Banks have become independent => ECB.

• Accountability?

• Inflation/growth/unemployment.

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Lender of Last Resort

• Guarantee of Rescue => Moral Hazard (imprudent behaviour by banks).

• Walter Bagehot’s quote:

• We will encounter moral hazard in many forms in later finance courses!

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Other banks.

• Commercial Banks: accept deposits/ make loans.

• => retail banks

• => wholesale banks.

• Investment Banks

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Key Retail Banking Issues

• Growing Competition (growing de-regulation)

• Cost Control

• Sales of Non-banking Products.

• Use of IT.

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Growing Competition

• Other Financial Institutions.

• Retailers.

• Insurance Companies.

• In-house Corporate Facilities.

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Bank Lending

• Uncommitted facilities: =>• Overdrafts.• Lines of Credit.• Bankers’ Acceptances.• Committed Facilities=>• Term Loans.• Standby Credit.• Revolving Credit.• Project Finance (eg Eurotunnel).• Syndicated Facilities.

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Investment Banks.

• Accepting

• Corporate Finance (new issues- equity/bonds, rights issues, M and A, Research).

• Securities Trading

• Investment Management

• Loan Arrangement

• Foreign Exchange

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Investment 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.

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Banking regulation.

• Commercial Banks risk depositors’ money if they invest in stock market.

• US Wall Street Crash 1929: Glass-Steagall Act 1933: deposit protection scheme => 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?

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Research Question.

• Discuss the dangers in Commercial Banks undertaking securities trading. Should the activities of commercial banks and investment banks be separated?

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Lecture 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.

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Lecture 4: Money and Bond Markets.

• Rate of Interest = price of money.• Risk => lender expects a greater reward

for higher risk.• OECD countries or US government:• => lowest rate of interest applies to

government transactions (safest!).• Govt rate is benchmark for other rates.• US corporate may borrow at ‘Treasuries

plus 1%’.

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Maturity and the yield curve

• r

Time (months)

But may be downward-sloping!

Expectations.

Liquidity.

Supply and demand.

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Bond Yields

• Yield

• Par Values

• Coupon

• Gross redemption yield

• Accrued Interest.

• Volatility.

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Credit Ratings

• Creditworthiness => Rate of Interest

• Credit-rating Agencies.

• AAA, AA, A, BBB, BB, B, CCC, CC, C, C1, D.

• Junk Bonds.

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Who Controls the Raters?

• Imperfect Information.• Incentive for company to pay agency for

full rating to get a good one• March 1996: Moody’s investigated by US

justice department• Reputations!• Research Question: Discuss the problems

involved in companies paying for credit rating?

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Domestic Money Markets

• Call money.

• Interbank Market (LIBOR).

• Money Market Securities.

• Treasury Bills.

• Etc

• Role of the Central Bank.

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Domestic Bond Markets.

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International Markets.

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Role of the Central Bank in Money Markets.

• Lender of Last Resort.

• Helping Commercial Banks with Liquidity Problems.

• Discount Rate, Lombard rate, open market operations.

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Bond 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.

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Lecture 5: Stock Exchanges.

• What is the role of a Stock Exchange?

• How are Stock Markets regulated?

• Cross-listing.

• Investor Protection around the World.

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Role 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.

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Bonds 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 world’s biggest stock

exchanges? (Pg 162: Valdez: table 7.1).• Market value? Turnover? Equity turnover?

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Indices

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Who Owns Shares?

• Small Investors Versus Institutions.

• Pension Funds.

• Equity Investments.

• Mutual Funds.

• Active Versus Passive Fund Mgt.

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Dealing Systems

• Order-Driven Systems.

• Quote-Driven Systems.

• Hybrid.

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International Equity

• 1980s, 1990’s: Cross-listing of MNCs.• => 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?

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Sarbanes-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?

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Miscellanous 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.

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EU Rules.

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Alternative Stock Markets.

• Tradepoint (UK).

• ECNs (US).

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Lecture 6: International Finance.

• Foreign Exchange (briefly!).

• International comparisons of investor protection/corporate governance.

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International Trade.

• Foreign Exchange.• Importers/exporters.• Tourists.• Government spending abroad (eg Troops)• Speculators.• Banks and Institutions.• Looser Exchange controls => Fund managers

investing in foreign equities and bonds => exchange rate risk.

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Drivers of exchange rate risk.

• PPP (Purchasing Power Parity).

• In theory, Basket of goods priced at £10 in UK and $20 in US => exchange rate £1 = $2. => stability of exchange rates

• But: Market imperfections/Barriers to trade/tariffs/ERM.

• Psychology of the market: herd instinct.

• => exchange rate volatility.

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Exchange rate Risk.

• Bretton Woods 1944.• => Exchange rate stability.• IMF 1946• The World Bank (IBRD).• IFC.• IDA.• EEMU.• Use of Options to reduce risk.

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Investor 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

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Research Question.

• Which type of market should lead to the best stock market development?

• Specific example: share repurchases.

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Investor 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.

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Investor Protection and Corporate Governance (continued).

• Common explanation for differences =>

• 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.

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• 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.

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• 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.

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Managerial 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).

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Legal Protection of investors

• Legal approach emphasises laws and enforcement.

• Strong legal system => firms can raise more funds in some countries than others.

• Investors more vulnerable to expropriation than employees or suppliers (why?)

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Cash flow rights versus control rights.

• Researchers recognise that securities give both cash-flow rights and control rights.

• Jensen and Meckling: Manager’s 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.

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Incomplete 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).

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Investor 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.

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Creditor Rights

• Bankruptcy and re-organisation procedures

• Repossess assets.

• Protect seniority of claims.

• Force reorganisation.

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Different sources of investor protection

• Company laws.

• Security laws.

• Bankruptcy laws.

• Takeover laws.

• Competition laws.

• Stock exchange regulations and accounting standards.

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Enforcement 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?)

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• “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.

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Law 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.

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Common law versus civil law countries.

• Civil law => greater government intervention in economic activity/ lower investor protection.

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Consequences of investor protection

• Ownership structure of firms.

• Development of financial markets.

• Allocation of real resources.

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Investor protection and ownership structure of firms.

• Low investor protection => large ability to expropriate => control has enormous value.

• => leads to concentrated or dispersed ownership of equity?

• Some researchers: poor investor protection => concentrated control.

• Other researchers: poor investor protection => dispersed control: Consider why?

• Empirically: poor investor protection => concentrated control (substitutes V complements?)

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Investor protection in East Asia:(Claessens et al 2000)

• Apart from Japan (good investor protection):

• Bad investor protection => large family/state control.

• “Crony Capitalism”: • Fundamental agency problem not between

outside investors and managers,• But between outside investors and

controlling shareholders.

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Corporate Ownership around the World (La Porta et al)

• See paper.

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Investor 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 => willing to finance firms => financial markets broader and more valuable.

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Legal system/ownership structure

• Managers have cashflow rights (affects incentives) and control rights => expropriate large private benefits.

• Better legal protection => managers are limited in their expropriation abilities.

• Concentrated ownership => entrenchment

• But, higher cashflow rights => less expropriation.

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Various tables from the paper.

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Lecture 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

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Venture Capital

• New entrepreneurial start-ups: Extreme uncertainty/high risk

• => difficult to obtain finance from banks or the general public.

• Venture capitalists specialise in financing such ventures => potential large capital gains at IPO.

• VCs active investors: extreme agency problems => BVCA.

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Private Equity

• VCs – early stage companies.

• MBOs – highly leveraged.

• PE => high ownership stake for management.

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Hedge 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.

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Common hedge fund strategy:

• Short-selling (selling a security we do not own => 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.

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Hedge Fund Strategies.

• Equity Hedge Funds.

• Global Asset Managers.

• Relative Value Arbitrage.

• Event-driven Investing.

• Short sellers.

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Should hedge funds be regulated?

• Investor protection?

• Destabilising the market?

• Systemic Risk?

• Inside information?

• See Paper by Noyer.

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Regulation of Hedge funds?

• Bank of England Seeks self-regulation (voluntary code).

• FSA update of regulation of hedge funds.

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Lecture 8: Regulatory authorities.

• Treasury.

• FSA.

• Research Question: What is the FSA’s role in regulating financial markets?

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FSA

• CBA of regulation (paper by Alfon and Andrews).

• Market Cleanliness (paper by Monteiro, Zaman, and Leitterstorf).

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CBA

• FSA has taken over the functions of 9 existing UK financial regulators.

• FSMB.

• => 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 => more or less regulation?

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CBA in FSA (continued)

• CBA can improve firms’ compliance culture.

• Enhance regulatory agencies’ accountability.

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CBA in FSA (continued)

• Requirements of FSMB => FSA has 4 statutory objectives, and 6 other aims.

• Are the benefits proportionate to their burden?

• Innovation.• UK’s competitive position.• CBA useful tool for FSA: trade-offs

between statutory objectives and economic matters.

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FSA’s 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

• => Pragmatic approach to CBA.

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Economics 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 => Eurodollar market ? (Investigate!)

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Economics 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 => lack of bank innovation and investment.

• Option Comparison.

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CBA

• Theoretical and practical problems.

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FSA’s 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.

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Impact Analysis

• 6 impacts:

• Direct Costs.

• Compliance Costs.

• Quantity of Good sold.

• Quality of goods offered.

• Variety of products offered.

• Efficiency of Competition.

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Assessing the costs of financial regulation.

• Direct costs.• Compliance Costs• Indirect costs (negative market impacts:

eg reduced competition => higher charges, costs of imposed uniformity, moral hazard).

• (Incremental Costs).

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Assessing the Economic Benefits of Financial regulation

• Correction of Informational asymmetries between buyers and sellers.

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Market Cleanliness

• FSA has a statutory objective to maintain confidence in the Financial System.

• Efficient, orderly and fair markets => delivering value to users and providers of financial services.

• FSA’s main aim: Reduction of market abuse in the UK.

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Market Cleanliness

• Extent to which informed stock price movements are observed ahead of significant price-sensitive announcements.

• => price movements could indicate insider trading

• Eg BIFFA in January 2008?

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Market Cleanliness (continued)

• Insider trading is just one form of market abuse.

• Abuse in equity and non-equity markets?

• CBA of insider trading regulation?

• => Financial markets built on trust. Insider trading erodes trust.

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Market cleanliness (continued)

• FSMA (2001)

• => Civil regime for prosecuting market abuse.

• Disclosure rules.

• FTSE350 listed companies: no change in market cleanliness after FSMA implemented?

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Lecture 9:New Tiger Economies.