Financial Markets and Institutions (2-downloads)

Is China a Counter-Example to the

Importance of Financial Development?

Although China appears to be on its way to becoming an economic powerhouse, its

financial development remains in the early stages. The country’s legal system is weak

so that financial contracts are difficult to enforce, while accounting standards are lax,

so that high-quality information about creditors is hard to find. Regulation of the

banking system is still in its formative stages, and the banking sector is dominated by

large state-owned banks. Yet the Chinese economy has enjoyed one of the highest

growth rates in the world over the last 20 years. How has China been able to grow

so rapidly given its low level of financial development?

As noted above, China is in an early state of development, with a per capita

income that is still less than $5,000, one-eighth of the per capita income in the United

States. With an extremely high savings rate, averaging around 40% over the last

two decades, the country has been able to rapidly build up its capital stock and shift

a massive pool of underutilized labor from the subsistence-agriculture sector into

higher-productivity activities that use capital. Even though available savings have not

been allocated to their most productive uses, the huge increase in capital combined

with the gains in productivity from moving labor out of low-productivity, subsis-

tence agriculture have been enough to produce high growth.

As China gets richer, however, this strategy is unlikely to continue to work. The

Soviet Union provides a graphic example. In the 1950s and 1960s, the Soviet Union

shared many characteristics with modern-day China: high growth fueled by a high

savings rate, a massive buildup of capital, and shifts of a large pool of underutilized labor

from subsistence agriculture to manufacturing. During this high-growth phase, how-

ever, the Soviet Union was unable to develop the institutions needed to allocate capi-

tal efficiently. As a result, once the pool of subsistence laborers was used up, the Soviet

Union’s growth slowed dramatically and it was unable to keep up with the Western

economies. Today no one considers the Soviet Union to have been an economic suc-

cess story, and its inability to develop the institutions necessary to sustain financial

development and growth was an important reason for the demise of this superpower.

To move into the next stage of development, China will need to allocate its cap-

ital more efficiently, which requires that it must improve its financial system. The

Chinese leadership is well aware of this challenge: The government has announced

that state-owned banks are being put on the path to privatization. In addition, the

government is engaged in legal reform to make financial contracts more enforce-

able. New bankruptcy law is being developed so that lenders have the ability to take

over the assets of firms that default on their loan contracts. Whether the Chinese gov-

ernment will succeed in developing a first-rate financial system, thereby enabling

China to join the ranks of developed countries, is a big question mark.

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Chapter 7 Why Do Financial Institutions Exist?

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this information, financial institutions can use the information over and over again

in as many ways as they would like, thereby realizing economies of scale. By pro-

viding multiple financial services to their customers, such as offering them bank

loans or selling their bonds for them, they can also achieve economies of scope;

that is, they can lower the cost of information production for each service by apply-

ing one information resource to many different services. A bank, for example, can

evaluate how good a credit risk a corporation is when making a loan to the firm,

which then helps the bank decide whether it would be easy to sell the bonds of

this corporation to the public. Additionally, by providing multiple financial services

to their customers, financial institutions develop broader and longer-term relation-

ships with firms. These relationships both reduce the cost of producing informa-

tion and increase economies of scope.

What Are Conflicts of Interest and Why Do

We Care?

Although the presence of economies of scope may substantially benefit financial

institutions, it also creates potential costs in terms of conflicts of interest.

Conflicts of interest are a type of moral hazard problem that arise when a person

or institution has multiple objectives (interests) and, as a result, has conflicts

between those objectives. Conflicts of interest are especially likely to occur when

a financial institution provides multiple services. The potentially competing inter-

ests of those services may lead an individual or firm to conceal information or dis-

seminate misleading information. Here we use the analysis of asymmetric

information problems to understand why conflicts of interest are important, why

they arise, and what can be done about them.

We care about conflicts of interest because a substantial reduction in the qual-

ity of information in financial markets increases asymmetric information problems

and prevents financial markets from channeling funds into the most productive

investment opportunities. Consequently, the financial markets and the economy

become less efficient.

Why Do Conflicts of Interest Arise?

Three types of financial service activities have led to prominent conflicts-of-

interest problems in financial markets in recent years: underwriting and research

in investment banks, auditing and consulting in accounting firms, and credit assess-

ment and consulting in credit rating agencies. Why do combinations of these activi-

ties so often produce conflicts of interest?

Underwriting and Research in Investment Banking

Investment banks perform

two tasks: They research companies issuing securities, and they underwrite these

securities by selling them to the public on behalf of the issuing corporations.

Investment banks often combine these distinct financial services because infor-

mation synergies are possible: That is, information produced for one task may also

be useful in the other task. A conflict of interest arises between the brokerage

and underwriting services because the banks are attempting to simultaneously

serve two client groups—the security-issuing firms and the security-buying

investors. These client groups have different information needs. Issuers benefit

from optimistic research, whereas investors desire unbiased research. However, the

same information will be produced for both groups to take advantages of economies

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Part 3 Fundamentals of Financial Institutions

of scope. When the potential revenues from underwriting greatly exceed the bro-

kerage commissions from selling, the bank will have a strong incentive to alter

the information provided to investors to favor the issuing firm’s needs or else risk

losing the firm’s business to competing investment banks. For example, an inter-

nal Morgan Stanley memo excerpted in the Wall Street Journal on July 14, 1992,

stated, “Our objective . . . is to adopt a policy, fully understood by the entire firm,

including the Research Department, that we do not make negative or controver-

sial comments about our clients as a matter of sound business practice.”

Because of directives like this one, analysts in investment banks might distort

their research to please issuers, and indeed this seems to have happened during

the stock market tech boom of the 1990s. Such actions undermine the reliability of

the information that investors use to make their financial decisions and, as a result,

diminish the efficiency of securities markets.

Another common practice that exploits conflicts of interest is spinning.

Spinning occurs when an investment bank allocates hot, but underpriced, initial