While the globalization of financial markets provides access to capital for some small segment of firms in emerging market economies, either through listing abroad or through foreign direct investment in the local banking sector, this access cannot replace domestic financial institutions for the majority of firms.

A recent conference, co-sponsored by the William Davidson Institute, Amsterdam Center for International Finance Research, the Tinbergen Institute, and the International Review of Finance highlighted several aspects of development of the financial sector in transition and emerging markets.

Banking Crises

The first issue, discussed in two papers, is the optimal policy for avoiding bank crises in the context of a troubled banking sector. Both papers challenge commonly held views of how to deal with banking crises in transition economies. Jenny Corbett (Oxford University and Centre for Economic Policy Research) and Janet Mitchell (Facultes universitaires Saint-Louis, European Center for Advanced Research in Economics and Statistics, Centre for Economic Policy Research, and William Davidson Institute), in a paper titled "Banking Crises and Bank Rescues: The Effect of Reputation," present a theoretical model that analyzes bank rescue packages and bank responses to offers of rescue made during a banking crisis. By taking into account bank managers’ reputational concerns, they show that banks may reject recapitalization even when associated conditions are not very strict.

Jean Paul Azam, Bruno Biais, and Magueye Dia (Toulouse University), in a paper titled "Privatization versus Regulation in Developing Economies: The Case of West African Banks," discuss the restructuring of the West African banking sector following a severe crisis in 1987 and 1988. Using stylized facts from the West African case, they argue that foreign ownership of the banking sector may be destabilizing in the absence of a strong regulatory commission. This analysis is based on the assumption that foreign investors will choose a high-risk high-return strategy as long as Western African risks are idiosyncratic and not correlated with global risk.

The Creation of Equity Markets

The second issue is the design and performance of fledgling equity markets in transition and emerging economies. The first two papers relate to the challenge of creating equity markets in economies where market reforms are only beginning to take hold. The second two papers extend this discussion by providing evidence that emerging equity markets have a long way to go before they can catch up with developed equity markets.

Utpal Bhattacharya (Indiana University) is concerned with preconditions for the proper functioning of equity markets, in his paper titled "On the Possibility of Ponzi Schemes in Transition Economies." He argues that transition economies are the ideal breeding grounds for Ponzi, or pyramid, schemes, in which a self-interested promoter persuades people to invest their funds in a pseudo investment company with the promise of high returns. Returns to early investors are paid from deposits by later investors, rather than from actual earnings. The conditions that allow Ponzi schemes to arise, and the resulting loss of faith in "investment companies" and other financial institutions, make the subsequent creation of equity markets extremelydifficult. (Excerpts from this paper are included below).

Wolfgang Aussenegg (Vienna University of Technology), in a paper titled "Going Public in Poland," links the privatization of Polish firms with the development of the stock market. Looking at the performance of three types of listings on the Warsaw Stock Exchange (including private sector initial public offers, or IPOs, individual privatizations, and listings through the mass privatization program), he argues that the Polish government used the stock market to build up a reputation for its privatization policy by underpricing IPOs. (The government sets a starting price for an enterprise it is privatizing, and if the price is low, it generates a lot of activity in the stock market.)

Bernardo Bortolotti, Marcella Fantini, and Carlo Scarpa (Fondazione Eni Enrico Mattei, Milan), in "Why Do Governments List Privatized Companies Abroad?", examine factors that lead governments to let privatizing companies list on international as well as domestic capital markets. They find that in emerging markets, lower stock market liquidity is correlated with listing abroad, while in advanced market economies the reverse is true.

Ian Domowitz (Pennsylvania State University), Jack Glen (International Finance Corporation), and Ananth Madhavan (University of Southern California) also compare equity markets in emerging and developed market economies, analyzing differences in trading costs. In their paper, titled "Liquidity, Volatility, and Equity Trading Costs Across Countries and Over Time," they find that there is a wide variation in one-way equity trading costs across countries, and the transactions costs are higher in emerging markets. The implication is that firms in emerging markets can reduce their cost of capital by listing on developed country markets.

Ownership and Governance

The third issue relates equity markets to firm ownership and corporate governance. The first three papers evaluate ownership forms that are more common in emerging than in developed markets, namely business groups and family-controlled firms. The last paper steps back to analyze the effect of these alternate governance structures on vulnerability to global financial instability.

Raja Kali (University of Arkansas), in "Business Groups, the Financial Market and Economic Development," argues that diversified business groups may facilitate economic development by allowing for some risk sharing among owners in the absence of well-functioning stock markets.

Two papers test the relationship between ownership structure and stock market valuation of the firm. Yupana Wiwattanakantang (Hitotsubashi University, Japan), in "The Effects of Ownership Structure and Corporate Governance on the Performance of Thai Firms," investigates whether, in Thai firms, of which 80 percent are family controlled, controlling shareholders expropriate corporate benefits in a way that has a negative effect on the firms’ value. Family controlled firms are shown to perform similarly to those with no controlling shareholder, while foreign controlled firms perform better than either. Stijn Claessens (World Bank), Simeon Djankov (World Bank and Centre for Economic Policy Research), Joseph Fan (Hong Kong University of Science and Technology), and Larry Lang (Chinese University of Hong Kong) examine a similar issue for nine East Asian economies in "The Rationale for Groups: Evidence from East Asia." Taking into account both the benefits of diversification and the costs of expropriation by controlling shareholders, they find that, on balance, group affiliation is associated with lower firm valuation.

Simon Johnson (Massachusetts Institute of Technology and William Davidson Institute), Peter Boone (Brunswick Warburg), Alasdair Breach (Russian European Centre for Economic Policy), and Eric Friedman (Rutgers University) link weak legal institutions for corporate governance to the extent of stock market declines in the Asian crisis of 1997–98, with a particular emphasis on the legal mechanisms that prevent managers from expropriating minority shareholders. (Excerpts from this paper are included below).

Anna Meyendorff is a Faculty Associate at the William Davidson Institute.