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Students Zone - Answers to End of Chapter Questions

CHAPTER 8: INTERNATIONAL AND EUROPEAN CAPITAL MARKETS

1. What do you think are the main advantages and disadvantages involved in organising the financial system around either markets or institutions? Can you think of any reasons that the United Kingdom has tended to use markets more than continental Europe? Why do you think Gerschenkron argued that markets would become more important than institutions over time?

Answer

With regard to the advantages and disadvantages of the systems, market-based systems have generally been thought to be advantageous in terms of mobilising large amounts of funds from dispersed savers and in terms of spreading risk and allowing for diversification. They are often regarded as being more flexible and adaptable than institution-based systems. The advantage of institution-based systems is in their ability to build close relationships between borrowers and lenders which can avoid some of the potential `short-termism’ of the market. However, this can also be a disadvantage if the links get too close and lenders cease to ensure that borrowers are spending money wisely. As well as short-termism another potential disadvantage of market-based systems is instability – if markets become vulnerable to speculative bubbles then there can be rapid rises and falls in asset prices which can destabilise the system.

There are two main reasons that have been put forward for the UK using markets more than Continental Europe. Firstly, it may result from a general preference towards markets in Britain as a way of organising economic activity and a scepticism about state involvement and large companies (in a number of the European countries – notably France – there has been heavy government involvement in the institution based financial system). The second possibility, which is basically Gerschenkron’s argument, is that since the UK industrialised earlier than Continental Europe it was not faced with the same need to acquire centralised funds for very rapid investment projects in order to `catch up’ in its industrialisation process. The European countries, which did need to do this, relied on financial institutions to help them in this task.

Gerschenkron essentially argued that the role of institutions was closely related to this catching up process and that once industrialisation had taken place and countries could compete on a level playing field with one another the role of institutions would become less. It is also the case that both savers and borrowers may well move away from institutions as they become richer and more sophisticated. Neither wants to be tied to a particular intermediary and both may be attracted by the wider range of financial possibilities offered by markets.

2. Which of the three eras in the international financial system, as identified by Eichengreen and Fishlow, namely the eras of bond finance, bank finance and equity finance, was most desirable from the point of view of (a) the availability of funds for individual countries and firms, and (b) the stability of the overall system?

Answer

There is no definite right or wrong answer to this question but looking back to the advantages and disadvantages of market and institutional systems, as discussed in the answer to the previous question, we can suggest that bond and equity finance were able to offer access to a wider pool of funds than bank finance and that perhaps the popularity of bank finance in the 1970s resulted from the temporary weakness of financial markets rather than from the attractiveness of this form of finance in itself.

With regard to stability many would argue that equity finance is more stable than debt finance (either provided by banks or bonds). This is because if times get hard returns to equity holders are more inherently flexible than returns to debt holders (which have to be paid each year as interest) and so there is less possibility of defaults or bankruptcies spreading through the system. This may be one reason why there has not yet been an international financial crisis in the era of equity finance to rival those of the 1930s or the 1980s. However, one disadvantage of equity finance, to set against its benefits in terms of stability or flexibility, is the way that control over assets passes to overseas investors.

3. Why do you think the Eurocurrency market grew so fast? Which kinds of businesses do you think particularly benefited from the growth of this market? Were any problems associated with this growth?

Answer

The main reasons for the fast growth of the Eurocurrency market were (a) the ready availability of funds as a result of the rise in oil prices and (b) the lack of regulation which allowed banks both to cut costs generally and to offer competitive deals which might have been excluded for regulatory reasons elsewhere.

Apart from sovereign borrowers the main beneficiaries of the market were multinational companies who needed to step up their foreign currency borrowing in order to fund their international activities.

Two main problems have been raised with the growth of the market. Firstly, it was argued that it led to uncontrolled credit growth which might fuel global inflation. There has been considerable controversy amongst monetary economists about whether this is actually a real threat and it has been somewhat superseded anyway by the general fall in international inflation rates. Secondly, the growth in unregulated lending raises the possibility of financial turmoil which might threaten the stability of the international system. This could in theory have happened either through corporate or sovereign lending – in fact it was sovereign (government) borrowers who defaulted from 1982 onwards.

4. Many people have argued that asymmetric information and systemic risk justify government regulation of financial institutions and markets. Can you think of any ways in which such institutions and markets have been able to limit these problems on their own account, without having to rely on outside regulators? Are such alternative approaches to dealing with these problems preferable to regulation from the point of view of the businesses who are customers of these institutions and who deal in these markets?

Answer

There are two main ways in which it has been argued that the financial system could regulate itself without relying on government involvement. The first is to move much more radically towards a market-based system, with banks competing not just in terms of banking services but also in terms of issuing different kinds of money. The argument is that the money which is most reliable (because it is backed up by the most reliable bank) will win out in the competitive process and there will be no need for governments to intervene. So-called `free banking’ in the UK before the Bank Charter Act of 1844 and in the USA before the Civil War is an inspiration for this school of thought.

The second approach is to rely much more heavily on informal methods of ensuring stability, focusing on long-term links between lenders and borrowers, which lessen the problem of asymmetric information. The Japanese financial system (and to some extent the German system) has been seen as a possible way forward here.

Neither of these alternatives seems very satisfactory. The main problem with relying on informal networks, as in Japan, is the possibility of relationships between borrowers and lenders becoming too close, as appears to have happened in the 1980s, with a consequent build-up of bad debt. Such networks can also lead to unaccountable concentrations of economic power. In many ways the current international economic system, with no international central bank and with a multiplicity of currencies, provides something of a test of what a free banking system might be like nationally. It does not seem to have avoided financial instability over the last decade – rather the reverse (consider the crises in Mexico in 1994, Asia in 1997, Russia in 1998, Turkey and Argentina in 2001).

At present there seems no real alternative to a system of financial regulation. However, this does present the challenge of ensuring that such a system does not lead to moral hazard – with users and providers of funds simply scaling down their efforts to monitor the correct use of money in the light of a belief that the authorities will bale them out if times get hard.

5. The proposals for an international lender of last resort and an international bankruptcy court, which are outlined in the chapter, have been criticised because it is thought they might lead to moral hazard. Can you think of any ways in which these proposals might be modified in order to avoid this happening?

Answer

One way of approaching this is to look at the ways these institutions have been set up on a national basis in order to avoid problems of moral hazard. With regard to lenders of last resort the main way of ensuring that such lending does not lead to irresponsible behaviour is to charge a very high interest rate (often referred to as a `penal’ rate). Another approach is to make such lending conditional on changes in the management of institutions.

The situation with regard to bankruptcy is slightly more difficult, particularly as any bankruptcy procedure for sovereign borrowers would have to involve refinancing them in order to allow them to continue as independent countries. The most obvious way of avoiding moral hazard would be to make any declaration of bankruptcy involve some kind of transfer of ownership of national assets to those who had previously provided funds. However, this might be seen as resulting in too great a sacrifice of national independence to be acceptable.

6. What are the main problems involved in relying on capital adequacy ratios as a means of regulating the financial systems? Can you think of any ways in which the use of these ratios might be altered in order to avoid such problems? What changes do you think the introduction of such ratios might make to the strategies adopted by banks to obtain competitive advantage?

Answer

The main problems involved in capital adequacy ratios are those mentioned in the text: firstly that they can be destabilising and secondly that they are undiscriminating in their assessment of risk. In order to avoid the first problem one approach might be to have some kind of temporary allowance whereby in the event of adverse economic circumstances banks might be allowed to exceed the `normal’ ratio for a specified time period rather than calling in loans (this is in some ways analogous to some of the proposals for reform of the stability and growth pact associated with European monetary union). Alternatively there might be some kind of government owned or financed lender who would provide emergency finance to corporate or household borrowers in such circumstances.

Most of the proposals for reform of capital adequacy ratios have concentrated on the second problem and have tried to use a variety of credit scoring techniques in order to assess the risk of various loans more appropriately. Another approach here might be to weight the riskiness of loans more heavily if they are concentrated heavily in a particular sector.

The main change which the introduction of capital adequacy ratios is believed to have made to the competitive strategies of banks is to encourage merger and takeover activity in the sector as institutions try to boost their capital by taking over other well-capitalised banks. This can cause problems in terms of maintaining effective competition in the sector.

7. What are the main arguments for and against having a single European financial regulator? Do you think it would be a good idea to introduce such a regulator?

Answer

The main arguments for having a single regulator are ensuring consistency of treatment across Europe, resolving potential conflicts or ambiguous situations where it is not clear whether home or host countries have responsibilities for a particular institution (or where they each have responsibility for some of the actions of the institution), and avoiding a situation where the level of regulation is bid down by competitive pressures to too low a level.

The problems with having such a regulator are partly those resulting from the fact that we do not really yet know the optimum structure of financial regulation and in such circumstances it might be better to have a variety of different regulators trying different approaches in order to see which one works best. Having a single regulator also raises questions about who that regulator should be accountable to and about how personnel should be selected.

8. What are the main advantages and disadvantages of the approach to financial regulation proposed by the Lamfalussy Commission? Do you think that companies in the financial and non-financial sectors might differ regarding the desirability of this approach, and if so, why?

Answer

The main advantages have been regarded as being flexibility and speed in adapting to changing circumstances in the fast moving financial markets. The main problems with this approach concern a possible lack of democratic accountability and the difficulties involved in determining which of the four levels a particular issue should fall under.

With regard to different kinds of companies there may be a potential disagreement between financial and non-financial companies in that financial companies will generally want as light a regulatory structure as possible whereas non-financial companies will be more interested in the security provided by regulation (though they will not want regulations to be so extensive that they raise the cost of capital). Also, non-financial companies may well also value their links to national governments and the possibility of lobbying which this gives rise to, so they may not be so keen on taking financial regulation up to the pan European level and removing it from political influence, particularly if this means that national governments are less able to provide cheap funds to favoured companies.

9. What do you think are the main obstacles remaining to the creation of a single European financial market? Would such a single market provide significant benefits for European businesses?

Answer

There is no single right or wrong answer to this question. There is however a vigorous debate going on amongst academic observers of European finance which basically has led to two main positions. The first argues that the main obstacles to a single market lie in political or business obstruction to financial integration (for example the reluctance of banking regulators to facilitate cross-border mergers, the unwillingness of banks to adopt a structure based on branches rather than subsidiaries) and that the key issue for the future is breaking down this obstruction through appropriate legislative changes. The second argues that there are inherent characteristics of the financial markets which make integration difficult (for example the need for liquidity which has led to national specialisation in the issuance of government bonds and the way in which asymmetric information problems lead to the prevalence of relationship banking). In this case legislative changes on their own will not lead to integration, and something else is required. This might be some kind of innovation in terms of products or market structure. There seems to be some truth in both positions and the relative merits of each is a matter for continuing debate.

A further obstacle to creating a single financial market is likely to be the question of integrating into that market the countries of Central and Eastern Europe as they eventually adopt the euro.

While the proposed benefits of a single market put forward in the Cecchini report were probably over-optimistic the general consensus amongst growth theorists in recent years has been that large integrated financial markets do significantly aid business and economic development.

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