Financial Systems, Markets and Institutional Changes

T. Lindblom, S. Sjögren, M. Willesson, T. Lindblom, S. Sjögren, M. Willesson

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137413598
• Topic: Business
• Subtopic: Servizi finanziari
• Index: Business

This book analyses how the financial system adjusts to institutional changes such as new technology, political tendencies, cultural differences, new business models, and government interactions. It emphasises how different institutional settings affect firms' borrowing and increases our understanding of how efficient financial markets are formed.

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Institutional Change and the Design of Financial Systems

Ted Lindblom, Stefan Sjögren and Magnus Willesson

Financial Systems, Markets and Institutional Changes includes contemporary studies on different institutional settings and how these affect firms’ ability to borrow money, as well as how the latest financial crisis has affected the relationship between firms that borrow and banks that lend. The book also addresses issues related to the globalization of the financial market. One such issue concerns the imbalances between different regions in the EMU, which raises the question of whether this is as an optimal currency union and also puts new requirements on an international lender of last resort (ILLR). Recent technology development, along with high-frequency trading, and the growth of Islamic banking, are two other examples of institutional changes that forms new actors and new markets. We will in this introductory chapter take the opportunity to discuss each contribution from another perspective, perhaps different from the original purpose of the author(s) in their specific chapter. We have observed that the chapters all have similarities in that they describe, analyse and exemplify how the financial system endogenously adjusts to institutional changes.

The analytical framework used in this introductory text rests on the ideas described and elaborated upon by Merton and Bodie (2005). In their conceptual work, Merton and Bodie lay the foundation for what they refer to as ‘functional and structural finance’ (FSF) in which they try to synthesize three different theoretical foundations or theories. The authors propose a new way to integrate the three broad and, to a greater or lesser extent, conflicting perspectives of the neo-classical, the neo-institutional and the behavioural theories. Instead of viewing these perspectives as competing abstractions of the complex reality, the FSF paradigm aims at integrating the core understanding from each perspective. Broadly described it is an attempt to adopt an analytical framework that views institutions as endogenously shaped and formed as a response to exogenously given functions. A particular institution exists, when exchanging goods and capital, as a response to existing transaction costs and behavioural distortions.

The basic neo-classical theory, with atomistic actors acting on a perfect market, has been criticized for not providing an adequate model for identifying inefficient structures and therefore delivers only limited guidance to decision-makers. However, behavioural theories emphasizing the human factor as important when analysing market failures have offered some answers, albeit not without criticism. The most recent financial crisis is said to constitute an example of how aspiration, overconfidence and perceptions affect mortgage markets. This is, however, not a new phenomenon: Keynes (1936) argued that booms and busts are a result of sentiment, pessimism and other psychological factors.

The neo-institutional theory advocates that organizations are ‘caged’ by institutional isomorphism (DiMaggio and Powell, 1983). Organizations can sanction or even actively support the current institutional structure. One example is again related to the mortgage market where organizations, such as too-big-to-fail banks (TBFBs), involved in the issuance, securitization and rating of assets, gave authorization to the existing regulatory regime and a cultural acceptance of, as it turned out, excessive borrowing.

The FSF paradigm can be viewed as an attempt to enrich the neo-classical theory by including behavioural distortions and institutional theories to allow for better understanding of how organizations, and not atomistic players, are endogenously formed in order to minimize market distortion.

How about regulation? If organizations can reform, or if the construction of a new organization is a result of a ‘invisible hand’, which minimizes the costs of behavioural distortions or transactions, the neo-classical market solution should be a reasonable approximation of the second-best outcome. However, the recent financial crisis has called for a lot of regulatory changes. Many blame the deregulation of the financial services markets in the US about a decade ago. In 1999 the Congress enacted the Gramm–Leach–Bliley Act (also referred to as the Financial Services Modernization Act), which allowed commercial banks to engage in investment banking. What followed were ever-increasing, larger banks, which eventually ended up as TBTF banks. Today, we can hear voices advocating a much tougher regulation of the financial markets. This has many similarities with what happened after the financial crisis in the late 1920s, which finally lead to implementation of the Glass–Steagall Act of 1932.

The functional and structural finance theory of Merton and Bodie (2005) has the neo-classical perspective as a point of departure. If market failures, which violate the idea of an invisible hand, occur the reasons for these failures can be argued to be institutional rigidities, technological inadequacies, or dysfunctional behavioural patterns. However, as technology progresses and institutions strive for reduced transaction costs, the neo-classical theory can still produce a fair prediction of the future. Even individual irrationality can be offset by institutions. As an example, the authors use the market for life insurance to explain that the long-run market equilibrium will not reflect individuals’ underestimation of their life expectancy whenever competing insurance firms enter the market. In this book we can provide the reader with eight other examples.

The rest of the text in this introductory chapter consists of brief summaries of each contribution. These summaries are to some extent based on the chapter abstracts and, thus, ‘co-authored’ with the contributors to this book. Our aim is to describe the content of the chapters and, at the same time, highlight the importance of the research carried out by the different contributors by placing them in the context of a functional and structural finance theory, of which the ambition and overall purpose is to synthesize the three different perspectives of neo-classical, neo-institutional and behavioural theories.

The neo-classical theory constitutes the basic foundation for many areas. One such area is the theory of optimal currency unions. In Chapter 2, René W. H. van der Linden discusses the EMU as an optimal currency union and describes how one of the key sources of stress within the EMU is the divergence of competitiveness and external imbalances between its ‘core’ and ‘periphery’ members, whereby the single monetary policy as ‘one size fits all’ has proved to be an illusion or ‘one size fits none’ problem. On one hand the euro has boosted trade, credit flows and foreign direct investments (FDIs) within the EU. On the other hand, the single currency has also become an economic trap and the resulting recession has created a disaffection in several EMU members, which has enhanced the different views of both its advocates and critics. The author concludes that the architects of the EMU definitely hoped that the emergence of a single currency would create the conditions for an optimal currency area (OCA). However, the EMU has created externalities that require fiscal transfers between member countries to compensate for a lack of exchange-rate adjustments and to offset regional divergences and temporary imbalances. The interconnectedness between banks and governments shows that the central bank should broaden its mandate without interfering with its monetary policy aims. Although the OCA theory does not explicitly refer to a banking union, it is obvious that a major role has been reserved for the ECB as the lender of last resort for suffering states. Other building blocks for a more viable monetary union include the structural reforms to improve the foundations of growth, a permanent transfer union and, ultimately, a fiscal union. EMU members that form a currency area need to accept the costs in the name of a common destiny. This requires more solidity of fiscal policy, but also more solidarity or willingness to share each other’s risks in order to make the EMU a more optimal currency region. This chapter presents a good example of where the markets are highly influenced by both institutional settings and behavioural aspects challenging the rational neo-classical theory.

In Chapter 3, Pierluigi Morelli, Giovanni B. Pittaluga and Elena Seghezza give us a new perspective on the international lender of last resort (ILOLR). New challenges give rise both to new instruments and institutional changes. The dollar shortage suffered by the European banking systems in 2007–2008 was overcome thanks to the swap lines operated by the US central bank and granted to the European banking systems in order to overcome the dollar shortage and reduce the risk of default. Emerging countries dealt with the dollar shortage by turning to the ample currency reserves they had at their disposal. What happened reopened the debate about the ILOLR. On the one hand, contrary to what has been shown by a vast amount of literature, the recent crisis has demonstrated that the IMF lacks a fundamental requisite for being an ILOLR – it does not have the capacity to create money. On the other hand, various emerging countries are unwilling to accept the drawbacks connected to the FED performing the function of an ILOLR. However, the authors argue that the FED plays the role of an ILOLR taking into consideration the protection of the interests of its country. Therefore, they recommend that other countries escape the state of dependency on the FED, and the uncertainty of its behaviour, by introducing new regulations to reduce the foreign currency liquidity risk.

Chapter 4 by Eleuterio Vallelado, Paolo Saona and Pablo San Martín, offers clear evidence on how the institutional setting of a country can play a role in forming different organizational outcomes. Ever since the LLSV (La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1998) research was first submitted, our understanding of how different legal structures affect investor choice has increased. The LLSV approach fits well into the FSF paradigm as it shows how legal protection (i.e. different transaction costs for different types of financing), will affect capital structure decisions at a firm level. The goal of this chapter is to describe how decisions on the maturity of bank borrowing are conditioned by firm-based variables and the characteristics of the regulatory and the institutional setting within which the firms operate. The sample includes observations from Australia, Belgium, Canada, Denmark, France, Germany, Italy, Spain, the United Kingdom, and the United States over the period from 1996 to 2008. As a result, the authors observe that the funding of investments depends on the extent to which the financial system is either market-oriented or banking-oriented. Furthermore, the new regulation on transparency has modified the role of bank debt maturity in common-law countries as a disciplining device and reinforced its corporate governance role in civil-law countries. The relationship between the external funds needed and the ownership structure, and bank debt maturity is affected by corporate governance regulation and by a country’s legal tradition.

In Chapter 5 by Elisabetta Gualandri and Valeria Venturelli, the aim is to analyse how the credit crunch has modified the traditional bank–firm relationship, with particular attention to the Italian situation. Their analysis reinforces the finding that in Italy, the credit available to the real economy is insufficient not only in terms of quantity but also in terms of quality. The next step is to identify and discuss possible exit strategies for eliminating the effects of the credit crunch and then to overcome serious intrinsic shortcomings in terms of alternative instruments, markets and intermediaries. On one hand, the crisis has revealed the underdevelopment of the Italian financial market, the insufficient role of institutional investors, the embryonic state of the corporate bond markets and the virtual non-existence of commercial paper markets. On the other hand, this could finally provide the opportunity for the development of these channels. The changing role of banks in the new scenario is also analysed as well as the characteristics that firms will require in order to benefit from it.

Even if there is more than one way of best providing financial functions, which is the central lesson of the FSF paradigm put forward by Merton and Bodie, the Italian case shows that in times after crises, inefficiencies are revealed and institutional change is a natural outcome. Together with the other, richly described examples in this book, this chapter teaches us that the irrelevance proposition of financing decisions, as put forward in the neo-classical theory, does not hold.

In Chapter 6, Elisa Giaretta and Giusy Chesini provide us with further insight into the Italian financial markets. They investigate the Italian private equity industry and ask if a team manager does ‘earn more than his coached players’, offering an analysis of the earnings of Italian asset management companies and their portfolio companies in the field of private equity. Asset management companies (AMCs) collect investors’ pooled savings into funds and manage these funds to match their declared financial objectives. There are some AMCs that specialize in private equity investments and use funds only to buy unlisted companies. These companies earn profits by charging their clients carried interest on the capital gain obtained by the sales of the portfolio companies and a percentage of the funds managed. This chapter analyses and measures the earnings of Italian AMCs (‘the team manager’) that invest in private equity with a comparison between their portfolio companies (‘the coached players’). They find that Italian AMCs investing in private equity earn more than their portfolio companies – the team managers earn more than the trained players. This study also explores the characteristics of the portfolio companies that help to provide higher earnings for Italian AMCs. The results show that the AMCs that invest more per portfolio-company exhibit a better performance than others.

Chapter 7 presents a good example of a synthesis of public and private investments creating different potential solutions to existing needs. In this chapter, Andrea Paltrinieri, Flavio Pichler and Stefano Miani examine the Korea Investment Corporation’s (KIC) investment strategies over the years 2005–2012, in order to evaluate whether the corporation shows a ‘political bias’. The FSF paradigm put forward by Merton and Bodie has no ideological bias in suggesting which type of institutions should perform financial functions. They use the retirement system as an example of where the same financial engineering can be used, regardless of ownership. Merton and Bodie also emphasize both the role institutional settings, demographics and social structure have in producing the best organizational outcome and the fact that that this can lead to different efficient systems between countries.

The results of the case study presented in Chapter 7 suggest that the KIC aims to maximize the portfolio risk/return relationship, while it manages foreign excess reserves. The authors argue that a form of ‘internal political bias’ affects the investment process, as most of the financial resources are managed in-house. Overall, the authors lend support to the hypothesis that KIC’s investment strategies reflect both financial and political objectives. This chapter also exemplifies the importance of studying cases as a methodology for reaching a deeper understanding of real-world phenomena. The motivation of doing a case study on KIC in South Korea is that it is one of the most important economies among the so called ‘emerging markets’. The Economist magazine (2011) stated that South Korea is an even better model of growth than China, Taiwan, Singapore or Hong Kong. KIC was also among the first SWFs to re-entrust financial resources to external managers, with important implications in terms of corporate governance and geographical asset allocation. The study makes an important contribution to the emerging body of literature dealing with case studies, by examining the KIC’s investment process, asset allocation and portfolios. The study is also useful to policymakers, as it offers a definition of a regulatory framework that can regulate SWFs in a similar way to other institutional investors or, alternatively, introduce tighter regulation.

The FSF paradigm takes the neo-classical theorem as point of departure where rational agents operate opportunistically on a frictionless market. If the existing prices and allocation of resources is not in conformity with the neo-classical theory, the most plausible explanations, according to Merton and Bodie, are: 1) institutional rigidity 2) technological inadequacies 3) dysfunctional behaviour which cannot be offset by institutional changes.

In Chapter 8, Giusy Chesini and Elisa Giaretta examine high-frequency trading (HFT) in European, U.S. and Australian equity markets with a particular focus on the technological inadequacies of new computerized products, which, they argue, increase market efficiency. Merton and Bodie use the term ‘the financial innovation spiral’, in which the competition between intermediaries on the market is sometimes irrupted by new complements or products. However, the innovation described by the authors of this chapter is perhaps one of the largest technological shifts that the financial markets are facing. The detailed discussion in this chapter also includes issues, which, viewed from a FSF paradigm, relate to institutional rigidity. HFT, which involves the use of computer-driven techniques to trade on exchanges and other trading venues in fractions of a second, has become one of the financial industry’s greatest concerns, mainly because it supposedly allows for profits to be made at the expense of traditional investors and causes outages and glitches on trading platforms. In contrast, some studies have found that HFT did level-out price differences between trading venues and provides valuable liquidity to markets; moreover, the activities of HFT firms have been credited with reduced bid-ask spreads, thereby making markets more efficient for all involved. Despite all the academic research, HFT seems to have an ambiguous impact on market integrity because of the increasing number of trading flash-crashes and outages. As a result, the impact of HFT o...

Table of contents

• Cover
• Title
• 1  Institutional Change and the Design of Financial Systems
• 2  The Road to a Viable Euro Zone and the Preconditions for Becoming a More Optimal Currency Region
• 3  Gross Imbalances, Liquidity Shortage and the Role of the Federal Reserve
• 4  Firm-based and Institutional-based Determinants of the Bank Debt Maturity: New Evidence for Developed Countries
• 5  The Financing of Italian Firms and the Credit Crunch: Findings and Exit Strategies
• 6  Does the Team Manager Earn More than His Coached Players? Analysis of the Earnings of Italian Asset Management Companies, and their Portfolio Companies, in the Field of Private Equity
• 7  Does ‘Political Bias’ Undermine the Korea Investment Corporation?
• 8  Regulating High-frequency Trading: An Examination of European, US and Australian Equity Market Structures
• 9  Islamic and Conventional Exchanges: A Performance Analysis and Governance Perspectives
• Index