Stock Market and Bank Regulation

QUESTION: Compare and contrast how the stock market and banks promote economic growth; and provide a critique of their functions in the development of the economy

INTRODUCTION The main aim of the paper is to compare and contrast how the stock market and the Banks promote economic growth and it provides a critique of their functions in transitional economies. Every country depends on its economy for its growth. For a country to be stable, its economy has to be stable. Banks and stock market contribute to a great extent to the economic growth of every country where it provides firms with opportunity to get funds thus encouraging more investment from the firms. At the same time they give information on the ways resources should be allocated. The development of a financially sound, market-oriented banking system is always considered to be fundamental to a flourishing transition. Arguably, it is important to macroeconomic stability and to positive long-term growth prospects. As documented, bank intermediation in transition economies continues to be stunted after a decade or addition of reform, mainly where advancement in banking reforms is inadequate. The banking system profitability still stands to be unimpressive, after the effect of inflation on valid profitability is taken into account.

When we consider the balance between return and risk provided by the stock markets in transition economies, the developing countries and industrialized market economies have provided a higher favorable balance between risk and return during the earlier four years than the transition economies as a group. The price-to-book-value ratios are lesser in the transition group as compared to developing countries. It is obvious that firms that are flourishing in investing their capital together with their borrowings will likely have sturdy prospects for earning growth and will get reduced discount rates used in their future earnings.

Considering the modern economy, banks and stock markets represent a key component of the financial system. Even though they may execute dissimilar functions in the economic development process, their distinctiveness is barely emphasized within the framework of economic growth. The analysis by King and Levine (1993) cannot differentiate between the functions of stock markets and banks. As per the physical accumulation, banks and stock markets offer sources of external financing for firms. In terms of the role of resource allocation, stock markets and banks generate information to direct the allocation of resources. They vary only by means of transmitting information. Stock markets information is enclosed in equity prices, while loan managers collect that in banks.

Dow and Gorton (1995) conveyed a model analysis that if the major function of the stock market is to signal information for monitoring, evaluation and financing, banks may be similarly efficient at proficient resource allocation. Even though some papers had analyzed the effect of stock market on social welfare (Bresnahrah, Milgrom, and Paul (1992), has connected empirically stock markets and economic growth on volume or investment productivity.

Another perception on the connection involving financial development and economic growth is based on savings, investments, financial markets and growth. The analysis is that financial markets will increase savings, investment and hence the growth rates. The stock market is considered to promote savings by offering households with an extra instrument which may meet their liquidity need and risk preferences. Considering the well-developed capital market, share ownership gives individuals fairly liquid ways of sharing risk in investment projects. There is also substantial proof on the level to which these markets are playing a function in distributing capital to the corporate sector and the useful effects for the rest of the economy. Though the structure of corporate finance differs broadly between the developing countries, the corporate sector used equity finance which is significant.

Share of net investment expenditures, equity funds became more than debt finance, or internally generated funds in 1980s within the countries like Korea, and Thailand (Singh and Hamid 1993). This was extremely different with the corporate finance pattern in industrial countries, which is broadly dependent heavily on funds generated internally. The evidence shows that the stock market is not performing this savings role well. Thus, more current research on the functions of the stock market in an economy has stressed on the function of a developed stock market, which boost the effectiveness of investment, in turn leading to higher economic growth. Consequently, stock markets can improve economic growth by investment productivity as compared to savings function.

Stock market liquidity and banking development predict growth, productivity improvement and capital accumulation, when entered collectively in regressions, even after controlling political and economic factors. The consequences are constant with the opinion that financial markets offer significant services for growth, whereas stock markets offer different services from banks. Stock market size, integration and volatility, with world markets are never robustly connected with growth, and that no financial indicator is very much associated with private saving rates. Substantial debate exists on the relationships involving economic growth and the financial system. Historically, economists have concentrated on banks. Walter Bagehot (1873) and Joseph Schumpeter (1912) put emphasis on the critical significance of the banking system in economic growth and underscore conditions when banks can actively spur innovation and future growth by determining and funding productive investments.

In contrast, Robert E. Lucas (1988) highlights that economists put a lot of emphasis on the function of the financial system, and Joan Robinson (1952) analyzed that banks respond passively to economic growth. Empirically, Robert G. King and Ross Levine (1993a) indicate that the extent of financial intermediation is a fine predictor of long-run rates of economic growth, productivity improvements and capital accumulation. There is an increasing theoretical literature on the relations between stock markets and long-run growth, with very diminutive empirical evidence. Levine (1991) and Ross M. Starr (1995) base their models where additional liquid stock markets (markets where it is not so much expensive in trading equities ) decrease the disincentives to investing projects which takes a long time since investors can easily sell their stake in the project if they want their savings before the project matures. Improved liquidity, hence, facilitates investment in higher-return projects on long-run that boost productivity growth. Similarly, Michael B. Devereux and W. Smith (1994) and Maurice Obstfeld (1994) indicate that higher international risk which is shared through internationally integrated stock markets bring on a portfolio shift from safe, low-return investments to high-return investments, thus speeding up productivity growth.

These risk models and liquidity, nevertheless, also mean that international capital market integration and higher liquidity vaguely influence saving rates. Better risk-sharing and higher return may influence saving rates to come down such that general growth slows with additional liquid and internationally integrated financial markets. Furthermore, theoretical debate exists about whether greater stock market liquidity supports a shift to higher-return projects that motivate productivity growth. Given that additional liquidity formulates it to be easier to sell shares, a number of them argue that more liquidity decreases the incentives of shareholders to carry out the expensive role of monitoring managers (Andrei Shleifer and Robert W. Vishny 1986; and Amar Bhide 1993). In turn, corporate governance which is weak impedes effective slow productivity growth and resource allotment. Thus, theoretical debate continues over the relation involving economic growth and the functioning of stock markets.

Stock market liquidity as measured by the value of trading relative to the size of the economy and the value of stock trading relative to the size of the market is significantly and absolutely correlated with the present and future rates of economic growth, productivity growth and capital accumulation. Stock market liquidity tends to be a robust predictor of physical capital, real per capital GDP growth and productivity growth once controlling for fiscal policy, openness to trade, initial income, and initial investment in education, political stability, macroeconomic stability, and the forward looking nature of stock prices. Besides, the banking development level as measured by loans from the bank for the private enterprises divided by GDP too enters significantly to these regressions.

Stock market liquidity and banking development are good predictors of economic growth. The additional stock market indicators do not possess a robust link with long-run growth. Volatility is unimportantly connected with growth in the majority of specifications. Likewise, international integration and market size are never robustly related with growth, and none of the financial indicators is strongly linked to private saving rates. The outcome have proposition for a diversity of theoretical models. The strong, positive links involving stock market liquidity and capital accumulation confirm productivity improvements and faster rates of growth, Levine 's (1991) and Starr’s (1995) theoretical predictions.

Banks offer different services compared to those of stock markets. Banking development and stock market liquidity measures enter significantly to the growth regression. Stock market liquidity and banking development are positively and strongly connected with present and future rates of economic growth even once controlling for various other factors related with economic growth. Stock market liquidity and banking development foretell long term growth. Though this investigation does not establish the direction of causality between financial sector development and growth, the results show that the strong link between financial development and growth does not just reveal contemporaneous shocks to both, that stock market and banking development do not merely follow economic growth, and that the financial development indicators content predictive does not just signify the forward looking nature of stock prices. This result of the paper are certainly reliable with the opinion that the services offered by financial institutions and markets are significant for long-run growth.

Asli Demirguc-Kunt and Vojislav Maksimovic (1996) illustrate those firms in
Countries with improved functioning banks and equity markets grow at a high rate than predicted by individual firm characteristics. Industries that rely more on external finance prosper more in countries with better developed financial markets. Raymond Atje and Boyan Jovanovic (1993) show a cross-country study of stock markets and economic growth. They find an important association between growth over the period 1980-1988 and the stock market trading value divided by Gross Domestic Product (GDP) for 40 countries. Apart from added number of countries by 20 percent and approximately doubling the number of years in the sample, extra measures of stock market liquidity, a measure of stock put it back to volatility, and two of stock market integration measures in world capital markets and integrate these measures into our study of banks, stock markets and economic growth. In addition, we control for economic and political factors that may affect growth to determine the sensitivity of the outcome in the conditioning information changes set.

Furthermore, the functioning of stock markets and banks is fixed to performance of the economy, not in any case agents expect faster growth. Moreover, Robert J. Barro (1991) standard cross-country growth regression framework creates comparison with other work easier, methodically test for the significance of correct heteroskedasticity and influential observations.

FUNCTION OF BANK AND STOCK MARKET IN TRANSITIONAL ECONOMIES

The function of the financial sector in every country is of supreme value. Intermediation agents between savings and investment are banks. Only solid institutions are capable of attracting deposits and to direct them in a professional means towards productive opportunities. The effectiveness of the banking sector and of the financial markets is a well known aspect of lasting growth. Capital flow freedom is now a common feature in nearly all countries. Shared with deregulation and a more integrated international financial system, this freedom is bringing a lot of opportunities for rising economies where net financial flows to rising countries have extremely amplified over the precedent years and have enhanced the economic growth; however it is also causing more vulnerability.

Definitely, short term capital is volatile and, as South East Asian experience has exposed, not having a robust banking system which are well capitalized and properly managed and monitored can be a chief source of weakness when sentiments of investors change and when capital movements begin to shift. The weak performance of banks in transition economies is in several ways unsurprising. Similar to industrial firms, socialist banks were on their own enterprises that regularly required restructuring at the outset of transition. From then, banks became in use to channel funds mostly, giving credits to enterprises of state for investment projects permitted under central planning. The distribution of finance was not identified by the funds opportunity cost and the likely capability to repay; instead, if these factors ever affected investment decisions, it existed at the level of planning and not at the banking system level. As a result, banks have been forced to restructure their own activities and be taught from scratch a lot of the trade of their partners in market economies.

Exact features of the banking industry as well, make restructuring particularly hard to achieve. The circumstances that are highly favorable to the restructuring of industrial enterprises are efficient competition in the product market, the imposition of hard budget constraints and efficient mechanism of corporate control Carlin, Fries, Schaffer and Seabright, (2001). Yet these are less probable to get in the case of banks as compared to mainly ordinary firms. When we consider competition on product market, when central, commercial and banking roles were divided early in the transition, the “monobank” derived from central planning was nearly invariably split into an extremely less number of independent entities. Furthermore, the process of entry into the banking sector was often poorly regulated, with many newly established private banks not having the basic capital and skills to compete successfully with the dominant state-owned and privatized banks. It has hard budget constraints, though, the major complexity arises. Since then banks are subjected to run and that failure of the bank can rash a financial crisis, banks nearly perpetuate advantage from some form of state guarantee which can be explicit deposit insurance either through an implicit bailout commitment by the central bank. A simple hard budget constraint is not suitable for banks even in mature market economies, so it is probable that bank restructuring will experience further difficulties in transition than the restructuring of enterprises where uncompromising bankruptcy rules make extra sense.

The development and regulation of stock markets play major functions in the financial system architecture in transition economies. During communist era stock markets did not exist. These days a fast growth of the stock markets is taken to be a vital element of the development of the financial sector of these economies. Stock market developments together with other forms of financial market development happen concurrently and complement each other (Demirguc-Kunt and Levine, 1996). An important question is that to what level and under which conditions development of stock market may take part to a process of long-term economic growth.

Authors emphasize the significance of stock market development, liquid stock markets are essential in influencing industrialization. In addition to bank finance, share issues give possibilities for getting external funds. Significantly, stock markets may have a crucial function in improving economic growth by distributing resources to investment projects that offer the highest returns. If there is no existence of well-functioning financial markets, agents may have a hard time in defending themselves from liquidity shocks, which give them no other choice but to invest in liquid assets that can be transformed very easily in a medium of exchange.

Stock markets offer liquidity insurance because shareholders in need of liquidity are able to sell their shares which they claim and get profits of an illiquid production technology whereas firms can permanently utilize the funds invested by the initial shareholders. Therefore, stock markets facilitate additional productive long-duration investments (e.g., Levine, 1991; Bencivenga et al., 1995). Commercial banks too may offer liquidity insurance. Nonetheless, because commercial banks are subject to bank runs, which impose banks to liquidate long-term projects, stock markets most likely have a more significant task in stimulating productive investment. Stock markets may assist to solve the problems of asymmetric information when countries begin to liberalize their financial sector while not possessing a well functioning equity market (Cho, 1986). The explanation is that, in contrast to banks, equity markets do not suffer from moral hazard and adverse selection. A final theoretical issue which can be mentioned here is that stock markets may lower agency problems between the managers of the firm and the owner in any case the compensation of managers is fixed to stock. This may also better productivity of the firm.

Generally empirical studies are also rather positive regarding the function of stock market development in improving economic growth. An example is the study by Atje and Jovanovic (1993) who provided their conclusion that stock market trading and economic growth are strongly associated for a group of 40 countries in the 1980s. With the Atje Jovanovic framework, Murinde (1996) come across the May 1996 issue of the World Bank Economic Review for a general discussion. N. Hermes, R. Lensink / Journal of Banking & Finance (2000) confirm the stock market developments’ positive effects of the Pacific Basin countries’ growth rates.

Currently a study provided a comprehensive empirical on the importance of stock markets. Their study robustly proposes that stock markets take part positively in economic growth. In addition, they never get any sign for a negative effect of capital market integration or stock price volatility on economic growth. Some practical studies clearly deal with financing of firms’ investments and stock market development.

These studies recommend that financial systems which are well developed, and having good functioning stock markets, have positive effects on performance of the firm. Associated issues of substantial significance for countries in transition are about the effects of capital control liberalization. In most transition economies capital controls is present. Frequently, equity markets are managed by restricting part of the shares to be apprehended by domestic investors only, while the rest of the shares can be in custody of domestic and foreign investors. A good example can be seen in China, where a division is put between so-called A and B shares. Levine and Zervos (1998) study propose that capital control liberalization may assist in promoting stock market development. As per their study these liberalization contributes to larger stock markets, more liquid and more volatile. Besides, they indicate that larger and more liquid stock markets are positively connected to long-term economic growth, thus giving a reason for being in favor of abolishing capital controls. However, the function the stock markets take part in stimulating economic growth is acknowledged.

Stein (1989), for example, argues that stock markets encourage investments in short-term projects because stock markets endlessly assess the managers. Sometimes it might be that additional liquid stock markets, with a considerable total of small shareholders and thus diffuse ownership, reduce incentives to check the investors carefully. Liquid equity markets may contribute to hostile takeovers, which lowers the competence of resource allotment. Some authors argue that stock markets do not have an essential function because only a small fraction of corporate investments is financed by ways of equity. Stock markets may experience a negative effect for they are simply `casinos '.

Singh (1997) is recognized due to his disagreement of the view that stock markets are vital for a process of long-run economic growth. He criticizes the applied methodology in the majority of current studies on economic growth and stock market development. A number of studies carry out Barro-type condensed form growth regressions, which do not give any insights in the manner by which stock markets influence economic growth. Singh states that stock markets, whether in developed economies, do not execute the monitoring, screening and disciplinary function quite well.

In rising markets, together with the transition economies, it is worse because the regulatory infrastructure is poorly developed. In the majority of transition economies the stock markets are incredibly lean. This may result to extremely volatile share prices. According to Singh (1997), stock price volatility may badly hinder economic development. Current developments in the Asian Financial markets appear to verify this. He again indicates, in contrast that stock markets experience more problems with asymmetric information as compared to banks. The explanation is that stock markets frequently offer investors with short-term finance, whereas banks,
Particularly group-banks have long-run relations with firms. It can also be said that stock markets may suffer from short-termism. Finally, long-term growth may be hindered where there is a negative economic shock as a result of close connections between the stock and currency markets.

This discussion on the functions of stock markets in the process of economic development robustly views that, in principle, stock markets may fulfill an essential function in inducing growth. Conversely, a prerequisite tends to be that the regulatory infrastructure is developed well and that precautions are taken to decrease excessive volatility of stock prices. However, there are less empirical studies existing that clearly deal with regulatory issues regarding stock markets. This is mainly true for transition economies.

CONCLUSION

Though, this study indicates that stock market development promote economic growth by its effect on investment productivity in the long run. The outcome also is reliable with the fact that well-functioning stock market which can carry out its allocated roles by the pricing of shares. An efficient pricing process will reward the profitable and well-managed firms and by valuing their shares highly as compared to unsuccessful and unprofitable firms. This mechanism reduces the cost of capital and therefore confirms a larger allocation of new investment resources and in combination will improve economic growth. Thus, a broad conclusion of this study might be that a well functioning stock market is an essential in promoting economic growth. Banks contribute a lot to the economic growth of a country where it provides firms with foreign finance and it allocates resources to different places as required. Banks provide information which is necessary for the allocation of resources.

Development of Financial Sector continues to be an essential part of the reforms even to the highly advanced of the transition economies. The development of efficient banks and equity market that offers capital for domestic firms is a prerequisite for long-term and sustainable economic growth. At the same time finance market globalization offers access to capital for some small segment of firms in emerging market economies, either by foreign direct investment or by listing abroad in the local banking sector, though this access cannot take the place for domestic financial institutions for the majority of firms. The economic growth depends on the investment, savings and financial growth as provided by financial market. Stock market liquidity and banking also predict the growth, productivity improvement and capital accumulation which are a source of growth.

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