Dubai Project Financia Crisis Senbet Final 09

8/13/2019 Dubai Project Financia Crisis Senbet Final 09

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Financial Crisis and Stock Markets: Issues, Impact, and Policies*

by

Lemma W. SenbetUniversity of Maryland

Amar GandeSouthern Methodist University

Abstract

The financial crisis stemming from the burst of the housing and credit bubble lead to ashutdown of the credit markets and spread around the globe, with the resultant massivedestruction of equity and real estate wealth. The drastic crisis of investor confidencetriggered massive selloffs in the stock markets around the world. The adverseconsequences of the crisis have been transmitted both through the financial and realsectors, and even those which are not integrated into the global financial economy have

been affected due to real sector transmission. In fact, the global financial crisis hasengendered collateral damage to several countries without fault of their own. This policy-oriented piece focuses on the stock markets from various regions and assesses the impactof the crisis broadly and, in more specific terms, the macro and country factorscontributing to the impact. In particular, we examine the comparative stock market

performance across countries during the pre-crisis and post-crisis period both in absoluteand risk-adjusted terms. These performance metrics are then related to a variety offactors, such as institutional investor ratings, sectoral concentration, market depth andliquidity. We will then draw lessons from the crisis to come up with long term policyreforms which are also partly guided by the root causes as detailed in the beginningsection of the paper.

*Preliminary: Not for Quotation

* Prepared for, and presented at, the annual conference of the Dubai EconomicCouncil Financial Crisis, Its Causes, Implications, and Policy Responses, Dubai,October 2009.


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I. Introduction

The financial crisis stemming from the burst of the housing and credit bubble lead to ashutdown of the credit markets and spread around the globe, with the resultant massivedestruction of equity and real estate wealth. The drastic crisis of investor confidencetriggered massive selloffs in the stock markets around the world. The markets, whichwere integrated into the global financial economy, got hit first. However, even thosewhich were weakly integrated got adversely affected due to transmission of the crisisthrough the real sectors.

The real sector transmission of the crisis has manifested itself in the plunge of exportsand commodity prices due to the slump in global demand, shrinkage in foreign directinvestments and portfolio flows. On the financing side, the global crisis of confidencelead to a sharp rise in cost of borrowing in the credit markets, with a rationing ofemerging and pre-emerging economies out of the credit markets altogether.

The global crisis is unlike anything we have witnessed since the Great Depression, andevery region of the globe has been hit. The global slump in demand and plunging globaltrade has hurt countries in East Asia and Latin America. Eastern and Central Europeancountries, such as Hungary, the Czech Republic, and Poland got hit even harder as aresult of diminishing exports to Western Europe. They also got caught up caught up inthe misfortunes of major European banks which themselves had experienced huge lossesdue to exposures to the mortgage backed securities in the United States.

What is particularly stunning was the impact of the global crisis on the private capitalflows to emerging markets. These flows were $928 billion in 2007 but dropped to $466

billion in 2008 almost a 50% drop. 1 Correspondingly, foreign holdings of US T-billsrose by $456 billion in 2008, almost to the same magnitude as the decline in privatecapital flows to emerging economies. Ironically, the US Treasury securities benefittedfrom the US being the epicenter of the global financial crisis. At the global aggregatelevel, the IMF and the World Bank figures indicate that the world economic growthmoving into a negative territory, the worst economic performance of generations.Moreover, according to the newly released World Bank report, the global economywould shrink in 2009. 2

The dramatic global crisis has resulted in dramatic responses by the governments aroundthe world, particularly of the G-20 countries. In particular, the more advanced countrieshave committed staggering resources to the tune of trillions of US dollars in the form offiscal stimulus to jump start their economies and for bailing out large failing institutions(e.g., AIG) and entities (e.g., GM) that are deemed too big to fail.

1 Report of the Institute of International Finance (2009).2 World Bank Global Economic Prospects (2009).


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In the stock equity sector, the selloffs and plunging stock prices have resulted in massivedestruction of equity wealth around the globe. This paper will focus on the stock marketsand assesses the damage and the macro and specific country factors contributing to thisimpact. In particular, we examine the comparative stock market performance acrosscountries during the pre-crisis and crisis period both in absolute and risk-adjusted terms.

These performance metrics are then related to a variety of factors, such as institutionalinvestor ratings, sectoral concentration, market depth and liquidity. We will then drawlessons from the crisis to come up with long term policy responses.

To guide the policy prescriptions for building capacity of the stock markets, we motivateour analysis based on the available evidence that provides a positive linkage betweenstock market development and economic development. It turns out that multiple functionsthat stock markets perform provide a channel for this linkage; beyond savingsmobilization, the stock markets are avenues for risk sharing, price discovery, promotionof quality governance, and promotion of financial globalization. The stock market

performance results, as well as their multiple functions, are used as an anchor for a

proposal and discussion of a menu of policy guides to build capacity of the stock marketsand help reduce the frequency and severity of financial crisis in the future. At the heartof these guides are risk management capacity, best practices in corporate governance,design features of executive compensation, market-based privatizations, stock marketconsolidations (where they are thin) through regional cooperation, financial literacy in

private and regulatory circles, etc.

Moreover, based on the argument for complementarity between stock marketdevelopment and a well-functioning banking system, policy guides include reforms incapital regulation and systemic regulation as inspired by the current crisis. The globalcrisis has revealed serious gaps in oversight of systemically critical institutions, such asAIG in the US, which built up excessively high, yet non-transparent (e.g., credit defaultswaps) risks, since a system of distorted incentives provided exorbitant rewards in the

boom era but the resultant costs to society in the bust era that we are now going through..Moreover, this era saw an emergence of shadow banks or bank-like institutions whichwere outside the traditional regulatory structure, but they grew to a point where theirfailure brought down the financial system, with a staggering damage to the entire globe.Thus, the current crisis brings home that failure or absence of systemic regulation in onelarge country can adversely affect other regions, calling for an era of globalized reformsof the financial systems, including stock markets.

The paper is organized as follows. Section II provides an overview of the root causes ofthe global crisis, focusing on those directly or indirectly related to the stock markets.Understanding the causes help us understand the long term reforms toward the preventionof crises and mitigation of costs of such crises if they arise in the future. Section III

provides a conceptual framework that rationalizes the economic significance of the stockmarket economy. A particular attention is on the linkage between stock marketdevelopment and economic development. Section IV provides an analysis of the stockmarket performance pre crisis and during the crisis across a sample of countries.Moreover, we perform simple tests to identify specific factors that are significant in terms


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of stock market sensitivity to the crisis. Section V catalogues a series of long-termreforms to develop and build capacity of stock markets in mitigating the severity andfrequency of future crises.

II. What Caused the Global Financial Crisis?: An Overview

The root causes of the global crisis are still being debated. However, some key factorshave emerged that have contributed to the build-up of the excesses that devolved into thelargest financial crisis in recent memory. The collapse of the venerable financialinstitution, Lehman Brothers, and its filing for bankruptcy on September 15, 2008sparked a massive loss of confidence in the credit and stock markets. In fact, this lead toa complete shutdown of the credit markets. Many have argued that the sudden reversal offortunes in the financial markets in September 2008 was rooted in the unsustainablehousing bubble that began bursting in 2006. However, the housing bubble was notaccidental, and it was accompanied by a credit (mortgage boom), excessive leverage inthe financial sector, an era of low interest rates and easy money, complex securitizationof mortgage backed securities fueled by credit ratings boom, and other derivative factors.

The crisis, although it was rooted in the US, has spread around the globe. The globaldimension of the crisis is astounding. In part, it is related to the exposure of the rest ofthe world to the US housing market through holdings of mortgage backed securities.These mortgage backed securities (MBS) derive value from the underlying mortgagesand were sold around the world. Thus, through this vehicle, the US housing market gotglobalized, since financial institutions and investors around the globe had exposure to the

booming market through holdings of mortgage backed securities.

The crisis had an immediate destructive effect on financial and real estate wealth, withthe collapse of the stock markets resulting in massive loss of equity wealth. The damagespread quickly to those stock markets which are integrated into the global financialeconomy, but in a short span of time, through transmission through the real sectors, it gotto those countries which were not even that integrated globally. In this section we willattempt to sort things out to make a better sense of what precipitated a crisis of this

proportion unseen since the Great Depression.

A. Housing boom and a parallel mortgage boom

As reflected in the Case-Shiller index (see Figure 1), the US housing prices reached all-time high in 2006. Over a ten-year period ending in 2006, a typical house had increasedabout 125%. The housing boom was accompanied and supported by a parallel mortgage

boom. Mortage-related debt accounted for 80% of housing debt which had doubled since2000 to about US $15 trillion.


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Figure 1: House Bubble and Bust

An important component of the mortgage credit was in the form of sub-prime lendingtargeted to borrowers providing little or no down payment, and with those questionableand troubled credit histories, and minimal income requirement for loan origination. In2006, the booming sub-prime market reached 25% of all mortgages. Subprimes weretypically adjustable rate mortgages with low initial teaser rates but can be reset to higherinterest rates over time due to rising interest rates or expiring teaser periods. . Asmonthly repayments go up, more mortgages could go into default. Further, financialinstitutions pool both prime and subprime mortgages and issue securities backed by thesemortgage pools, with the advent of complex securitization (see below for further details).

When the housing prices got flat, or even began declining, in 2006 (see Figure 1), the

subprime borrowers had difficulty making their mortgage payments or refinancing themortgages. At the beginning of the burst of the bubble, about 25% of the subprimemortgages were in delinquency, and the estimate was that 12 million borrowers hadnegative net worth. The crisis in the subprime market came in the open when manysubprime mortgage lenders began declaring bankruptcy around March 2007.Foreclosures also shot up. Even prime mortgages were being downgraded. However,

policy makers were not aware that the subprime crisis would eventually lead to thismassive global crisis. As we know now from September 2008 (Black September), the


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mortgage market collapsed altogether with most of the values of the MBS backed bysubprime evaporating, with increasing crisis of confidence in the credit market. . Spreadsrelative to LIBOR skyrocketed. Even the LIBOR itself shot up. The credit marketeffectively froze!

B. Excessive leverage and too big to failWhen major financial institutions and banks began reporting huge losses resulting mainlyfrom mortgage backed securities, the global panic ensued with a flight to safety fromeven traditionally safe assets, such as commercial paper and money market funds.Private capital dwindled with a loss of confidence in the quality of assets held byfinancial institutions, with a build-up of what has come to be known as toxic assets.September 2008, which came to be known as Black September, saw massive andsimultaneous collapse of Wall Street institutions (see Table 1). This triggered staggeringgovernment intervention unseen for generations.

[Table 1 (Black September) goes here ]

Table 1 lists financial institutions characterizing massive failures, and these institutionswere deemed too big to fail or systemically critical. As the table shows, they were alsohugely levered. Take the case of two giants - Fannie Mae and AIG. Fannie is a massivegovernment sponsored agency (GSE) which is at the center of the mortgage pooling andsecuritization. It operated with implicit government guarantees but outside the formalregulatory scheme. AIG is the largest insurance company in the world and completely

private prior to government bailout. What are the commonalities between these twogiants? At the onset of the crisis, both companies were huge in terms of their asset size(see Table 1). The government sponsored agencies (GSEs) accounted for $5 trillion ofthe $11 trillion mortgages outstanding when the trouble got uncovered in September2008. A lions share of the volume was attributable to Fannie Mae.

AIG started out as a regular insurance company selling insurance to individuals and businesses, but got into derivatives in a big way with a creation of the financial productsdivision. It also became huge with about $1 trillion assets in 2008. Its financial productsdivision sold credit default swaps (CDS) to insure debt holders against defaults,focusing on corporate and mortgage insurance. AIG emerged as a central player of theCDS market which is huge with trillions of dollars in notional values. In fact, at theheight of the boom, it was estimated that the AIG credit default swap portfolio reachedover $400 billion, which then brought down the company when the mortgage marketcollapsed.

Thus, as Table 1 shows not only are these troubled institutions deemed too big to fail orsystemically critical, but they were excessively leveraged. Fannie Mae had only $55

billion of equity to support some $3 trillion of assets held and securitized, and AIG hadonly $80 billion of equity to support $1 trillion of assets. The government intervenedwhen both Fannie Mae and AIG were on the verge of collapse. The government rescueof Fannie Mae was triggered by systemic implications of the collapse, leading to potentialcollapse of small financial institutions and banks which are holders of mortgage backed


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TABLE 1 Black September

( As of September 29, 2008)

Institution Equity($billion)

Assets($billion)

Source

Fannie Mae 55.00 3,000.00 MortgagesAIG 80.00 1,000.00 Insurance,

Credit defaultswaps,

Bear Stearns 18.00 400.00 Sub-primecrisis; run/panicLehman 28.00 639.00 Mortgages

Merril Lynch 35.00 1,000.00 MortgagesLehman 28.00 639.00 MortgagesWAMU 26.00 310.00 MortgagesIndymac 1.00 32.00 Mortgages

Wachovia 75.00 812.00 Mortgages


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securities issued by Fannie Mae, further credit crunch in the housing market, and furtherdecline in housing prices. Similarly, there was a concern that the counterparts to AIGwould have collapsed if AIG was let go, since it lost so big on credit default swaps. Thus,

both AIG and Fannie Mae were bailed out to avert systemic damage to the financialeconomy, and ultimately the real economy. .

The government has retained claims on the bailed out institutions and companies.Typically a bailout package involved a line of credit to the failing firms, but in exchangethe government took positions through holdings of warrants and/preferred stock in thecompanies. This is, of course, tantamount to partial nationalization. In the case ofFannie Mae, the entity effectively got transformed from being a government sponsoredagency (GSE), with implicit government guarantee, into a government ownedenterprise (GOE) with explicit guarantee. AIG also got partially nationalized, and at thetime of the bailout the governments position amounted to 80% ownership interest in thefirm.

C. Distorted incentives and excessive risk-taking

As we saw in Table 1 above, during the pre-crisis era, excessive leverage was undertaken by banks and other financial institutions. Excessive leverage induces wrong incentives inthe form of excessive risk-taking by the institutions whose interests are not aligned withsociety when there are explicit or implicit guarantees (e.g., Fannie Mae). Depositoryinstitutions have typically explicit deposit insurance, but other institutions (e.g., WallStreet firms) may grow to be too big to fail or become interconnected. The latter fallsunder the category of implicit guarantee. Whether explicit or implicit, the guaranteesincrease incentives to take excessively risky assets relative to what is socially desirable.

Weak corporate governance and flawed executive compensation contracts can furtherexacerbate the distorted incentives, allowing executive to be amply rewarded on theupside but escaping the downside.

In fact, the current global crisis has drawn ample attention to the possibility that flawedcompensation plans might have been among the causes of the global financial crisis byfostering a business environment of greed and excessive risk-taking. This concern wasalso expressed in the wake of the corporate scandals associated with the informationtechnology bubble of the 1990s. There was a dramatic rise in executive pay in the US,leading up to the burst of the bubble (see Figure 2), both in absolute and in relative terms.The average CEO pay grew from $3.5 million in 1992 to about $15 million in 2000 forthe companies comprising the S&P 500 index. This amounted to about 500 times that ofthe average worker compensation. To see how dramatic the rise in executive pay is,consider that back in 1980, the ratio was only about 40 times! 3 The lions share of theincrease in CEO pay came from the dramatic use of stock option grants during the 1990s.Overly generous compensation packages and the widespread use of stock option grantsmay have created incentives for aggressive risk behavior which is now being partly

blamed for the current crisis.

3 Business Week ( September 11, 2000).


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Figure 2: Distorted Incentives and Poor Corporate Governance: Dramatic Rise of CEO Pay

D. Grade inflation

With increasing complexity in financial innovation and mortgage backed securities, manyhave suggested that there was on an overreliance on credit rating agencies. The complexinstruments were granted a blessing by these raters, but as it turns out they grosslyunderestimated the risks, with low risk securities receiving a seal of approval for AAA

rating. These safe securities were purchased by investors around the world, includinginstitutional investors, such as pension funds, mutual funds, and banks. The riskiersecurities were channeled to the hedge funds. Moreover, money funds are required byregulation to hold only securities with high ratings (e.g., AAA.), while others (e.g.,insurance companies), may choose to do so.

Thus, the pre-crisis era was a period of grade inflation by rating agencies, which fosteredabsorption of enormous volume of securities. The sad story is that the ratings totally

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6 7 8 9 1 0

1970 1980 1990 2000 2010Year

Murphy_index Frydman_index

normalized to 1 in 1980 Average Executive Compensation of Top Firms


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missed the exact quality of securities being rated, with the AAA seal, for instance,having no normal relation to default risks associated with mortgage backed securities.Therefore, investors bought securities with inflated ratings at inflated prices. There are atleast two reasons for grade inflation: (a) the incentive structure facing the rating agenciesand (b) the complexity/opacity of the securities being rated. The fact that the rating

agencies were being compensated by the rated would create misalignment of incentives between raters and investors. From the standpoint of complexity, extensive securitizationand financial innovation produced complex securities which were too hard and opaque torate (see below).

D. Complex and non-transparent financial innovation

The 1990s saw financial innovation characterized by complex instruments, such ascollateral debt obligations, credit default swaps, with the primary goal of transferring riskfrom loan originators, particularly those originating mortgages, to other parties. On the

positive, securitization is an exciting financial vehicle. It allowed wider sharing of risks

embedded in the original loans and promoted increased liquidity in the market. However,as it turned out, these securitized instruments were characterized by lack of clarity andtransparency, since investors did not fully understand them. They also contributed to a

build-up of system-wide risks in the financial systems across the globe, since they weresold around the world.

Under mortgage securitization, individual mortgages were put into pools of assets out ofwhich mortgage backed securities (MBS) are created. The pools are sold to special

purpose vehicles (SPVs) which then finance them through complex securities involvingmultiple tranches. The payoffs to a tranche are derived from the principal and interestrepayments, prepayments, and default risks of the underlying mortgages, but in a

complex fashion. Tranche instruments were produced in a wide variety of forms butsubject to few disclosure requirements. They became opaque and illiquid. That is whywhen the crisis surfaced; the market participants had no idea what these securities werereally worth. Thus, the opacity and illiquidity created from complex securitizationcontributed to the freezing of the credit markets and a dramatic loss of investorconfidence in the system.

E. Easy money and global imbalance

During the boom period, the Federal Reserve Board maintained short interest rates lowdespite the asset market bubble. These rates were sustained by global macroeconomicimbalances in trade and capital flows, with huge savings from export-led Asianeconomies that were being channeled to the US. The imbalances reflected excessivesavings in many emerging economies, particularly East Asian economies, while the USsaw shortage of savings, relative to investments. This imbalance was consequential. TheUS and some advanced economies saw massive capital inflows for about a decadedespite low short and long-term interest rates.


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III. Stock Markets: Finance Matters

In the wake of the collapse of Lehman Brothers, the stock market reacted brutally aroundthe globe. In the US, the equity wealth had declined 40% during January October 2008,from $20 trillion to $12 trillion. Thus, $8 trillion of equity wealth got wiped out in such a

short span of time!

The sobering experience from the current crisis has an important revelation to policymakers and economists. Finance matters. Paradigms in economics do not pay muchattention to the central role that the financial sector, inclusive of banks and stock markets,

plays in an economy. However, it was the financial institutions that fomented the currentcrisis, by creating risky products, encouraging excessive borrowing among consumersand engaging in high-risk behavior themselves, like amassing huge positions inmortgage-backed securities. The crisis has revealed their dark side. Since they also havegood side, we cannot live without them. It would be useful to point out the positivedimension, particularly of the stock markets, before we discuss their vulnerability to

outside shocks. Moving forward, we need to understand better the workings of theincreasingly interconnected global financial system its good side and dark side.

A. Stock market development and economic development

There is substantial scholarly literature documenting the link between the level of stockmarket development and economic growth of countries. The available empiricalevidence is that well-functioning stock markets, along with well-designed institutions andregulatory systems, foster economic growth. The evidence is particularly encouraging tothose countries which have already established the stock markets or to those which arecontemplating to do so, since it supports a vital link between stock market development

and poverty alleviation, as well as employment creation.4

This linkage is attributed in part to the role of a well-functioning stock market system inlowering the costs of mobilizing financial resources and in ensuring that these resourcesare allocated efficiently in the sense of being channeled to their highly valued use. Thevalue creation from optimal resource allocation contributes to economic growth. One can

begin with a broad observation linking stock market development with economicdevelopment. Broadly speaking, the available evidence is consistent with countries with

better developed and deeper stock markets experiencing faster economic growth. In theseventies and eighties, for instance, most East Asian countries experienced higheconomic growth while most Latin American countries saw low growth. It was alsoobserved, during the same period, that stock market capitalizations were higher in EastAsia than in Latin America.

4 There is little research on this issue in the context of financial markets in the Middle East, although thisregion comprises some of the wealthiest and resource-abundant countries in the world. Billmer and Massa(2007) provide evidence for linkage between market capitalization and oil prices in the resource-richcountries.


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B. Channels for linkage between stock market development and economicdevelopment

The principal channel for the linkage between stock market development and economic performance is liquidity provision of the market. A liquid stock market, which is

characterized by active trading among a large number of investors and firms, provides anexit strategy both for investors and issuing firms. Thus, liquidity is a crucial feature ofstock market development. It also provides a channel for more efficient corporategovernance and resource allocation, whereby resources are allocated to the most

productive and innovative firms. The existing empirical evidence supports a positivelinkage between stock market liquidity and economic growth; countries with more liquidmarkets experience faster rates of capital accumulation and subsequently greater

productivity (e.g. Levine 1997, Levine and Zervos, 1998).

The value of stock markets to an economy can be appreciated by understanding themultiple functions that they perform. In particular, in an environment characterized by

uncertainty, stock markets provide functions beyond capital/savings mobilization.First , stock markets promote savings through provision of an alternative financial vehiclefor individuals to better meet their risk preferences and liquidity needs, potentiallyincreasing the savings rate in the economy. Second , stock markets promote growth at thefirm level, since the listed firm is now able to mobilize capital at a lower cost of capital asrisk is shared widely in the market place. This leads to value creation, as positive net

present value projects, which might have been rationed out, can be adopted. As value iscreated by many such firms, the aggregate economy also benefits and grows. Third,through liquidity provision, stock markets help promote adoption of illiquid long-term

projects, since investors in the firm should be able to meet their desired liquidity needs byselling their stock positions through the market.

Fourth, stock markets can serve a vital governance function by exerting external pressureand discipline on management in an environment with imperfect information andincentive conflicts between corporate decision-makers and suppliers of capital. The pricediscovery function of the stock market is the key in this regard, since the market providesa signal for the quality of managerial performance. Moreover, the market price andinformation disclosure allows investors to uncover target firms for potential takeover byvirtue of active trading of target shares. Once control is transferred, inefficientmanagement may be removed and replaced by an alternative management team thatresponds to the interests of capital owners. What is even equally powerful is the threat oftakeover which has a disciplining effect on management so as not be vulnerable to actualtakeover. .

C. Observed characteristics of stock markets

The foregoing discussion has provided an economic rationale as to why stock marketsmatter. It is not their existence per se that matters, but the extent to which they providemultiple functions, such as capital mobilization, risk sharing, liquidity, and governance.Given that these functional characteristics are a channel for the linkage of stock market


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and economic development, it would be useful to examine the observed characteristics ofmarkets around various regions of the world. We will use indicators of these functions tocharacterize the stock markets (e.g., market capitalization, turnover, etc.).

For our empirical analysis, we create a sample of 63 countries, which includes the entire

set of countries covered in the S&P Emerging Markets Database (EMDB), which isfurther augmented by G-20 countries, and select countries from the Dubai and MiddleEastern region. Table 2 presents the entire list of our sample countries.

[Table 2 (Sample Countries) goes here ]

An important variable that we use in our empirical analysis is the Institutional Investor(II) Country Credit Ratings. Table 3 presents the change in the II credit ratings during thecrisis period. Some of the changes in these ratings are impressive. For example,Argentina saw its II credit rating more than halved during the crisis period. Interestingly,the US only saw a 6.93% drop in the II credit rating during this period.

[Table 3 (Institutional Investor Country Credit Ratings) goes here ]

Table 4 presents data for the characteristics of the stock markets for the sample countriesaround the world. In particular, we present data on (a) the extent of stock market depthand development, proxied by the market capitalization, measured as a percentage ofGDP, (b) the stock market liquidity measured by turnover (i.e., stock market value tradedas a percentage of market capitalization), and (c) the number of listed companies in eachof the sample countries.

[Table 4 (Stock Market Characteristics) goes here ]

Several patterns emerge from Table 4. We find, on average, the market capitalization, asa percentage of GDP more than halved after the crisis from the pre-crisis (2007) levels.This is mostly reflective of a dramatic decline in equity wealth resulting from the crisis.Interestingly, the stock market turnover has increased relative to the pre-crisis levels.However, we did not notice any perceptible change in the number of listed companies onaverage across our sample countries from the pre-crisis levels.

IV. Performance Effects of Crisis on Stock Markets

A. Pre-crisis performance

The US stock market went up by a factor of almost eighteen over the 25 year period (pre-crisis) since it bottomed in 1982 with the Dow Jones index then at 800. Other assetclasses, including housing, did exceedingly well during that same period. Such

prolonged asset boom periods clouded risk perception with an illusion that things wouldcontinue to move up. As it turned out, all asset classes fell when the reality set it in.


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TABLE 2 Sample Countries

This table presents the list of 63 sample countries, which includes the entire set of countriescovered in the S&P Emerging Markets Database (EMDB), which is further augmented by G-20 countries, and select countries from the Dubai and middle east region.

Country Name of the country Code ContinentArgentina ARG South AmericaAustralia AUS AustraliaBahrain BHR AsiaBangladesh BGD AsiaBulgaria BGR EuropeBotswana BWA AfricaBrazil BRA South AmericaCanada CAN North AmericaChile CHL South AmericaChina CHN AsiaColombia COL South AmericaCte dIvoire CIV AfricaCroatia HRV Europe

Czech Republic CZE EuropeEgypt EGY AfricaEcuador ECU South AmericaEstonia EST EuropeFrance FRA EuropeGermany DEU EuropeGhana GHA AfricaHungary HUN EuropeIndia IND AsiaIndonesia IDN AsiaItaly ITA EuropeIsrael ISR AsiaJamaica JAM South AmericaJapan JPN AsiaJordan JOR Asia


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TABLE 2 (Continued) Sample Countries

Country Name of the country Code ContinentKuwait KWT AsiaKenya KEN AfricaLatvia LVA EuropeKorea KOR AsiaLebanon LBN AsiaLithuania LTU EuropeMalaysia MYS AsiaMauritius MUS Africa

Mexico MEX South AmericaMorocco MAR Africa Namibia NAM Africa Nigeria NGA AfricaOman OMN AsiaPakistan PAK AsiaPeru PER South AmericaPhilippines PHL AsiaPoland POL EuropeRomania ROU EuropeRussia RUS Asia

Saudi Arabia SAU AsiaSlovak Republic SVK EuropeSlovenia SVN EuropeSouth Africa ZAF AfricaSri Lanka LKA AsiaTaiwan Province of China TWN AsiaThailand THA AsiaTrinidad and Tobago TTO South AmericaTunisia TUN AfricaUkraine UKR EuropeTurkey TUR EuropeUnited Arab Emirates ARE AsiaUnited Kingdom GBR EuropeUnited States USA North AmericaVenezuela VEN South AmericaZimbabwe ZWE Africa


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TABLE 3 Institutional Investor Country Credit Ratings (Scale of 0-100)

This table presents the country credit ratings (on a scale of 0 to 100 where a highernumber indicates a lower level of country risk) from the Institutional Investor Magazineas of September 2007 and March 2009 that span the global financial crisis. The lastcolumn shows the change in the country credit rating during this period.

Sept March Change Name of the country 2007 2009 (%)Argentina 44.40 28.30 -56.89Australia 90.20 86.70 -4.04Bahrain 69.30 68.20 -1.61Bangladesh 27.80 25.10 -10.76Bulgaria 61.20 54.10 -13.12Botswana 66.40 66.90 0.75Brazil 61.20 62.50 2.08Canada 94.40 91.60 -3.06Chile 77.60 76.70 -1.17China 75.90 74.10 -2.43Colombia 56.60 55.30 -2.35Cte dIvoire 20.10 19.40 -3.61Croatia 60.60 57.60 -5.21

Czech Republic 74.40 74.70 0.40Egypt 51.40 49.90 -3.01Ecuador 33.00 25.60 -28.91Estonia 71.40 61.00 -17.05France 94.00 91.50 -2.73Germany 94.80 92.60 -2.38Ghana 37.60 34.40 -9.30Hungary 66.00 59.20 -11.49India 62.30 59.90 -4.01Indonesia 50.20 47.50 -5.68Italy 85.40 79.40 -7.56Israel 68.30 67.80 -0.74Jamaica 36.20 32.80 -10.37Japan 89.80 85.70 -4.78Jordan 44.80 43.80 -2.28Kuwait 74.90 74.40 -0.67Kenya 30.60 26.80 -14.18


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TABLE 3 (Continued) Institutional Investor Country Credit Ratings (Scale of 0-100)

Sept March Change Name of the country 2007 2009 (%) Latvia 65.00 55.20 -17.75 Korea 79.40 72.60 -9.37 Lebanon 28.70 26.10 -9.96 Lithuania 67.90 59.80 -13.55 Malaysia 72.80 70.30 -3.56 Mauritius 56.20 55.40 -1.44 Mexico 70.00 65.70 -6.54 Morocco 54.20 53.70 -0.93

Namibia 50.20 49.70 -1.01 Nigeria 40.00 35.50 -12.68 Oman 69.10 69.80 1.00 Pakistan 40.20 21.90 -83.56 Peru 58.20 58.80 1.02 Philippines 52.20 47.10 -10.83 Poland 71.20 71.50 0.42 Romania 59.30 52.50 -12.95 Russia 67.50 64.60 -4.49 Saudi Arabia 69.60 72.40 3.87 Slovak Republic 70.90 73.60 3.67 Slovenia 81.60 81.50 -0.12 South Africa 66.70 61.10 -9.17 Sri Lanka 33.50 30.80 -8.77 Taiwan Province of China 81.30 78.80 -3.17 Thailand 64.10 59.60 -7.55 Trinidad and Tobago 65.20 65.20 0.00 Tunisia 60.70 58.70 -3.41 Ukraine 47.90 35.60 -34.55 Turkey 51.70 49.00 -5.51 United Arab Emirates 76.80 76.00 -1.05 United Kingdom 94.40 88.50 -6.67 United States 94.10 88.00 -6.93 Venezuela 45.10 40.70 -10.81 Zimbabwe 8.00 4.60 -73.91Average 61.66 58.22 -5.91 Median 65.00 59.80 -8.70


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TABLE 4 Stock Market Characteristics

This table presents stock market characteristics, such as (a) the market capitalization,measured as a percentage of GDP, (b) the stock market turnover, i.e., stock market valuetraded, measured as a percentage of market capitalization, and (c) the number of listedcompanies. We obtain this data from the World Development Indicators (WDI) database.We present this data for 2007 and 2008 to span the global financial crisis.

Mkt Cap/GDP Turnover Listed Cos. Name of the country 2007 2008 2007 2008 2007 2008Argentina 33.03 15.93 9.90 19.31 107 107Australia 158.16 66.55 110.50 103.06 1,913 1,924Bahrain NA NA 6.60 12.00 43 45Bangladesh 9.93 8.44 92.30 137.26 278 290Bulgaria 55.10 17.75 34.20 10.77 369 334Botswana 47.77 27.42 2.20 3.05 18 19Brazil 102.78 36.55 56.20 74.27 442 432Canada 164.42 71.58 84.70 123.72 3,881 3,755Chile 129.92 78.15 23.00 21.17 238 235China 197.31 72.37 180.10 121.30 1,530 1,604Colombia 49.07 35.92 13.10 13.21 96 96Cte dIvoire 42.20 30.20 2.50 4.08 38 38

Croatia 112.67 38.64 8.60 7.42 353 376Czech Republic 42.21 22.57 68.70 70.39 32 28Egypt 106.75 52.75 45.60 61.85 435 373Ecuador 9.32 8.68 7.00 3.55 35 38Estonia 28.81 8.45 34.90 25.40 18 18France 107.00 52.31 131.50 152.45 707 966Germany 63.47 30.33 179.70 191.54 658 638Ghana 15.88 21.05 3.90 5.19 32 35Hungary 34.34 12.01 106.00 93.01 41 41India 154.57 53.02 84.00 85.19 4,887 4,921Indonesia 49.01 19.20 64.40 71.30 383 396Italy 51.04 22.71 220.40 284.24 301 294Israel 144.16 67.40 55.40 58.87 654 630Jamaica 94.37 49.86 2.90 3.65 41 39Japan 101.58 65.60 141.60 153.23 3,844 3,299Jordan 249.31 179.11 49.10 72.69 245 262Kuwait 167.72 NA 76.20 83.16 181 202Kenya 49.67 31.64 10.60 11.83 51 53


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TABLE 4 (Continued) Stock Market Characteristics

Mkt Cap/GDP Turnover Listed Cos. Name of the country 2007 2008 2007 2008 2007 2008 Latvia 10.82 4.76 4.80 1.79 41 35 Korea 107.09 53.24 201.60 181.18 1,767 1,798 Lebanon 43.90 33.64 10.40 6.88 11 11 Lithuania 26.06 7.66 10.10 59.86 40 41 Malaysia 174.41 95.97 53.50 33.24 1,036 977 Mauritius 83.48 39.79 8.00 8.85 90 41 Mexico 38.89 21.42 31.00 34.33 125 125 Morocco 100.50 76.16 42.10 31.05 74 77

Namibia 8.05 7.22 3.70 2.84 9 7 Nigeria 52.04 23.48 28.20 29.30 212 213 Oman NA NA 27.70 44.24 125 127 Pakistan 49.17 13.96 173.50 115.96 654 653 Peru 98.76 43.65 8.80 6.33 190 199 Philippines 71.66 31.22 34.10 22.16 242 244 Poland 48.81 17.12 47.50 45.68 328 349 Russia 116.51 82.21 58.90 75.02 328 314 Saudi Arabia 134.29 52.68 161.50 137.82 111 127 Slovak Republic 9.30 5.35 0.50 0.37 153 120 Slovenia 61.39 21.55 12.30 6.91 87 84 South Africa 293.77 177.51 55.00 60.61 422 425 Sri Lanka 23.34 10.62 12.40 17.21 235 234 Thailand 82.85 39.35 64.20 78.20 475 476 Trinidad and Tobago 74.75 50.87 2.30 2.55 37 37 Tunisia 15.29 15.86 13.30 25.48 50 49 Ukraine 78.31 13.51 2.60 3.73 276 251 Turkey 43.69 14.85 134.70 118.52 319 284 United Arab Emirates NA NA 82.80 89.85 90 96 United Kingdom 139.19 70.00 270.10 226.85 2,588 2,415 United States 145.06 82.63 216.50 232.26 5,130 5,603 Venezuela NA NA 1.34 NA 60 60 Zimbabwe NA NA 5.10 NA 82 81 Average 83.98 41.86 60.40 64.02 610 607 Median 67.57 31.64 34.90 44.24 212 213


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Table 5 presents the stock market performance during the pre-crisis period. We chooseSeptember 2005 thru December 2006 (16 months) as the pre-crisis period to facilitatecomparison with return performance during the crisis period, characterized by a 16-month period spanning November 2007 thru February 2009.

[Table 5 (Stock Market Performance) goes here ]

We find that, on average, our sample countries experienced a positive 38.25% during the pre-crisis period. While the US registered a modest 16.40% during this period, the BRICcountries (i.e., Brazil, Russia, India and China) each experienced more than 50% increaseduring this period.

B. Stock markets hit by the global crisis

The crisis resulted in dramatic reversals of fortunes for stock markets around the globe.The decline in equity wealth around the world is staggering, and in trillions of dollars justin the US alone. The stock markets declines in 2008 were 37% in the US, 38% in LatinAmerica, 43% in Japan, and 51% in China. European stocks declined 38.5%. 5

During the pre-crisis period, emerging markets turned in a remarkable growth performance, triggering a new conventional wisdom that these markets had becomedecoupled from the cycles of the more advanced countries. In fact, initially it appearedthat they were unaffected by initial 2007 sub-prime crisis, fueling the conventionalwisdom. However, they too got hit eventually by the global crisis. Even the oil-rich GulfStates and Russia, which were thought of being immune to the crises in the US and theadvanced countries, suffered a dramatic crisis of confidence.

The right panel of Table 5 presents the stock market performance of our sample countriesduring the crisis period. This presents an interesting contrast to the performance in the

pre-crisis period (left panel). Overall, we find that our sample countries dropped by morethan 50% during the crisis period. Each of the BRIC countries dropped much more than50% during the crisis period, giving up a large part of the gains they made during the pre-crisis period.

C. Determinants of stock market performance

So far we have looked at the pre-crisis and crisis performance, but to gain a betterunderstanding of the performance-crisis sensitivity, we next investigate the likelydeterminants of the stock market performance during the pre-crisis and crisis periods.We describe the variables below and the expected sign of our coefficients.

5 Source: MSCI Barra and Hartford Investment Monitoring


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TABLE 5 Stock Market Performance

This table presents stock market performance, such as (a) the stock market return,measured based on an index measured in U.S. dollars, and (b) the risk-adjusted stockmarket return, as proxied by the Sharpe Ratio. We obtain the underlying data fromDatastream. We present this data for a pre-crisis period (Sep 2005 thru Dec 2006) and forthe crisis period (Nov 2007 thru Feb 2009). These variables are described in more detailin the paper.

Pre-Crisis Period Crisis Period Name of the country Return (%) Sharpe Ratio Return (%) Sharpe RatioArgentina 53.96 1.18 -70.01 -2.01Australia 35.28 1.63 -66.39 -3.11Bahrain 7.07 0.27 -51.04 -1.83Bangladesh 11.00 0.56 -0.31 -0.43Bulgaria 22.77 0.93 -79.94 -3.73Botswana 59.01 2.04 -51.36 -2.66Brazil 72.16 1.54 -58.59 -1.47Canada 25.14 1.05 -59.06 -2.40Chile 29.01 1.55 -41.41 -1.95China 95.20 3.24 -58.47 -1.80Colombia 54.26 1.16 -37.32 -1.03

Cte dIvoire 59.48 1.68 -28.37 -0.96Croatia 88.99 2.66 -63.21 -2.39Czech Republic 42.87 1.28 -60.04 -1.81Egypt 35.31 0.79 -61.16 -1.78Ecuador 37.05 2.58 -6.82 -0.53Estonia 28.89 1.08 -73.29 -2.94France 36.72 1.96 -58.75 -3.16Germany 44.69 2.18 -61.92 -2.98Ghana 6.13 0.89 -32.52 -1.28Hungary 14.81 0.50 -77.32 -2.80India 67.61 1.96 -67.07 -2.00Indonesia 94.23 2.27 -66.07 -2.07Italy 31.22 1.91 -66.81 -4.17Israel 10.76 0.35 -31.51 -1.36Jamaica -4.04 -0.73 -38.65 -1.42Japan 24.64 1.21 -45.85 -3.65Jordan -34.99 -1.33 -27.83 -0.65Kuwait 11.34 0.43 -63.74 -3.29Kenya 72.22 2.69 -51.49 -0.73


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TABLE 5 (Continued) Stock Market Performance

Pre-Crisis Period Crisis Period Name of the country Return (%) Sharpe Ratio Return (%) Sharpe RatioLatvia 19.07 0.81 -76.30 -3.71Korea 47.94 1.41 -69.18 -3.23Lebanon 28.89 0.85 -16.83 0.55Lithuania 9.74 0.36 -78.34 -3.01Malaysia 32.80 1.82 -46.44 -2.34Mauritius 48.18 2.25 -56.87 -1.00Mexico 75.31 2.35 -58.48 -2.55Morocco 86.01 2.20 -22.08 -0.84

Namibia 24.92 0.74 -15.66 -0.63 Nigeria 50.24 1.69 -64.45 -2.13Oman -0.18 -0.23 -40.84 0.10Pakistan 27.94 0.66 -73.13 -2.33Peru 103.85 2.40 -48.86 -1.63Philippines 70.66 2.67 -55.50 -2.52Poland 56.12 1.39 -76.94 -3.19Romania 67.73 1.07 -89.87 -3.21Russia 111.19 2.08 -75.43 -2.26Saudi Arabia -39.76 -0.52 -47.16 -0.90

Slovak Republic 20.56 0.62 -46.40 -1.25Slovenia 90.22 2.98 -53.66 -2.04South Africa 41.18 1.23 -57.06 -2.19Sri Lanka 33.79 1.09 -47.23 -3.33Taiwan Province of China 28.89 1.05 -57.82 -2.31Thailand 13.58 0.46 -56.98 -2.05Trinidad and Tobago -9.12 -1.17 -7.32 0.25Tunisia 51.19 2.40 -4.69 0.69Ukraine NA -1.98 -88.81 -4.45Turkey 19.64 0.63 -71.26 -1.90United Arab Emirates -44.46 -1.29 -70.79 -2.34United Kingdom 28.17 1.82 -60.76 -4.17United States 16.40 1.15 -52.67 -3.62Venezuela 89.66 1.86 -35.50 -1.09Average 38.25 1.20 -52.90 -2.05Median 33.79 1.20 -57.44 -2.06


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Change in II Credit Rating: We measure the change in Institutional Investor countrycredit rating, as a percentage from the pre-crisis level during the crisis period. We expecta positive relationship between a change in II credit rating and the stock market

performance.

Turnover Ratio: We measure turnover as the market value traded, measured as a percentage of market capitalization from the World Development Indicators (WDI)database. Since this measure is an indicator of market liquidity, we expect a positiverelationship between stock market turnover and the stock market performance. However,during crisis periods, we could see the `darker side of liquidity as investors first pullmoney out of the most liquid markets rather than the most risky markets, simply becauseit is easier to do so. If the `darker side of liquidity were to prevail, we expect a negativerelationship between stock market turnover and stock market performance during thecrisis period.

Private Credit/GDP: We use private non-guaranteed credit, measured as a percentage of

GDP from the World Development Indicators (WDI) database. As described earlier inthis paper, we expect a positive relationship between private credit/GDP and the stockmarket performance. However, if the banks were an important channel of propagation ofthe recent financial crisis, we expect the above sign to be negative during the crisis

period.

Oil Producer: To capture sectoral decomposition, we use an indicator variable that takes avalue of one if our sample country produces more than a million barrels per day, and zerootherwise. While we do not have specific predictions on this coefficient, this variablecaptures if a sample countrys performance could be explained by its exposure to the oilsector, as measured by this variable.

Market Cap/GDP: We use market capitalization, measured as a percentage of GDP fromthe World Development Indicators (WDI) database to proxy for the level of financialmarket development. As described earlier in this paper, we expect a positive relationship

between Market Cap/GDP and the stock market performance.

We begin the analysis by presenting correlations among the explanatory variablesdescribed above and the stock market performance during both the pre-crisis and crisis

periods.

[Table 6 (Correlations in Pre-Crisis and Crisis Periods) goes here ]

As described above, since banks were an important channel of propagation of the recentfinancial crisis, we find that the correlation changes from positive in the pre-crisis periodto negative in the crisis period. We also find some evidence that correlations increased

between our variables during the crisis period as compared to the pre-crisis period.

We next present regression analysis using the above mentioned determinants.Specifically, we regress stock market performance on the above mentioned variables.


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TABLE 6 Correlations in Pre-Crisis and Crisis Periods

This table presents the correlation matrix of the variables that we use in theregression analysis in Table 6. These variables are described in more detail inthe paper. We define the pre-crisis period to be from Sep 2005 thru Dec 2006,and the crisis period to be from Nov 2007 thru Feb 2009.

Panel A: Pre-Crisis Period Variable Stock Mkt. Change in Turnover Private Oil Marke

Name Return II Rating Ratio Credit/GDP Producer Cap./G

Stock Mkt. Return 1.0000 Change in II Rating 0.2934 1.0000 Turnover Ratio -0.2243 -0.0811 1.0000 Private Credit/GDP 0.1907 0.1680 -0.2182 1.0000 Oil Producer 0.0391 0.1952 0.2491 -0.1214 1.0000 Market Cap./GDP -0.2143 -0.2171 0.2659 -0.1520 0.1888 1.0000

Panel B: Crisis Period Variable Stock Mkt. Change in Turnover Private Oil Marke

Name Return II Rating Ratio Credit/GDP Producer Cap./GStock Mkt. Return 1.0000 Change in II Rating 0.2322 1.0000 Turnover Ratio -0.2830 0.0169 1.0000 Private Credit/GDP -0.2802 -0.0836 -0.2319 1.0000 Oil Producer -0.1396 0.1556 0.3259 -0.1259 1.0000 Market Cap./GDP -0.0985 0.2396 0.3258 -0.0930 0.3196 1.0000


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TABLE 7 Stock Market Performance in Pre-Crisis and Crisis Periods

This table reports the coefficient estimates, and the level of statistical significance ofregressions, where the dependent variable is the stock market performance during the pre-crisis period (Sep 2005 thru Dec 2006) and for the crisis period (Nov 2007 thru Feb 2009).These variables are described in more detail in the paper. The standard errors and t-statisticsassociated with the ordinary least squares estimates are adjusted for heteroscedasticity.

Pre-Crisis Crisis Period Period

Variable Coeff. t -Stat. Coeff. t -Stat. Intercept 38.965 4.85 -37.022 -6.06Change in II Rating 0.766 1.76 0.309 2.12Turnover Ratio -0.083 -1.11 -0.092 -2.74Private Credit/GDP 0.416 0.80 -0.603 -3.93Oil Producer 7.025 0.50 -6.946 -1.55Market Cap./GDP -0.080 -1.06 -0.016 -0.37

Adjusted R-square 0.072 0.205

Our evidence in Table 7 shows that, as expected, the change in institutional investorcountry credit rating is an important determinant of the stock market performance, bothduring the pre-crisis and the post-crisis periods. The coefficients are statisticallysignificant at the 10% level (t-stat 1.76) during the pre-crisis period and at 5% level (t-stat2.12) during the crisis period. We also find evidence consistent with the dark side ofliquidity during crisis periods. That is, the coefficient of stock market turnover isnegative and statistically significant at the 1% level (t-stat -2.74). In contrast, thisvariable is statistically insignificant during the pre-crisis period.

Finally, we find that the coefficient of private credit/GDP is positive (albeit statistically

insignificant) during the pre-crisis period, suggesting the link between banking sectordevelopment and stock market performance. Nevertheless, given that the bank channelwas an important propagating mechanism during the recent financial crisis, we findevidence consistent with it during the crisis period.

D. Stock market outlook: near term


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The global economy is recovering faster than expected. The IMF has noted that theglobal economy is recovering, but it still expects to contract in 2009. The expectation isthat the global economy will contract by 1.1 per cent in 2009. The IMF expects that theglobal economy will then grow by 3.1 per cent in 2010. However, these forecasts areconditioned on the implementation of the stimulus measures adopted countries around the

world.6

Thus, there is growing evidence that the global economy has stopped contracting, givingrise to a surge in stock market performance around the world. In the US, the blue chipindex has stunningly gone up 50% since its low in early March. It is now approaching10,000, but it still remains sharply below its peak of over 14,000 in October 2007 over30% loss. Is the glass half full or half empty? Given that the recession has virtuallyended, the sharp rally since March is defensible on the basis of fundamentals and themarkets expectation of recovery moving forward. On the negative side, of course, thereis a concern about another bubble in the making.

Emerging markets have performed even better. Some stock markets, including Brazil,already have surged from their lows earlier this year. As Figure 3 shows below, emergingmarkets rose faster than the US market in the pre-crisis period but fell faster and furtherthan the US last year now going up further and faster than the US this year. The MSCIEmerging Market index, which tracks emerging-markets shares, has skyrocketed, relativethe US market [61% versus 11%] since the beginning of this year . Again, the behavior ofemerging markets, such as Brazil, Mexico, China, and India, can be rationalized on the

basis of fundamentals, since they have better growth opportunities than the matureadvanced countries. There are, of course, possibly higher risks which are being masked

6 IMF, World Economic Outlook, October 2009.


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by the rally, since accounting standards, governance, and disclosure tend to be weaker inthese markets. In the policy section we will discuss measures for improved capacity ofemerging stock markets, with a focus on emerging markets.

Figure 3: Stock Market Performance of US and Emerging Markets

V. Policies

The current crisis has been globalized, with a collateral damage from the US spreadingall over the globe. What is disturbing is that there is no commensurate globalization ofresources to repair this damage. Immediately after the onset of the crisis and by

November 2008, globally about $2.6 trillion dollars were used to bail out banks and otherfinancial institutions and to stimulate growth. During that same period, loan guaranteesamounted to $2.7 trillion globally. 7 More recently, the US has committed an additionalstimulus package of about $800 billion and very likely to commit more resources to cleanup the toxic assets and to restructure banks. Thus, staggering quantities of resources have

been committed around the world.

7 BW (12-1-08).


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In addition, efforts are under way for a new global financial order. The IMF has emergedas a central player both in policy responses to crises and financial system reforms movingforward. 8 For sure, as witnessed in the most recent G20 summits, the more powerfulemerging economies, such as China, India, Brazil, and South Africa will be gaining moresay in any redesign of the governance of the IMF, but the other emerging countries

should not be left out and just be bystander victims of the excesses of institutions in themore powerful countries. Moreover, under the evolving global regulatory environment,emerging countries should be full participants in the design of mechanisms for oversightand regulation of globally systemic financial institutions.

Below we catalogue a variety of longer term reforms to foster well functioning stockmarkets that help mitigate the severity and frequency of future financial crises. Based onthe available evidence, we have argued that an efficiently regulated and operating

banking system is vital for the existence of well functioning stock markets. Therefore,our catalogue will begin with some key reforms for the banking regulatory scheme andthen move onto measures for developing and building capacity of stock markets.

1. Building infrastructure for crisis resolution

Policy responses and reforms triggered by a financial crisis should have two pillars:mechanisms for crisis resolution and mechanisms for prevention/mitigation of futurecrises. Countries should position themselves strongly in terms of reforms when theymove back into a growth path again as the global economy recovers. Therefore, it is nowan opportune time to put into place an efficient system of mechanisms for crisisresolution and crisis prevention/mitigation.

First, there should be a mechanism for direct injection of capital into banks, bank holding

companies, and shadow banks. The latter were outside the normal regulatoryframework prior to the onset of the global crisis. The mechanism calls for accurateidentification of viable but undercapitalized institutions. Moreover, the approach targetsinstitutions rather than instruments to address the capital and credit crunch. There is agood rationale for capital injection (government intervention). These institutions facestress due to market panic, although they are fundamentally viable and not be subject toliquidation. Of course, the government should seek quid pro quo in the form of partialstake through holdings of preferred stock and warrants. In fact, it can be argued that thewarrants held by the government have a desirable feature of mitigating bank incentivesfor excessive risk taking.

Second, the government can purchase illiquid (toxic) securities off the bank balancesheets rather than, or in addition to, direct capital injection. The government has a specialadvantage over the private agents in the crisis environment in that it is deep pocketed and

8 The IMF is upsizing as its client base is expanding due to the global financial crisis. It had downsized afew years back as its client base dwindled. Thus, the IMF is rescued by the global crisis. . The Fundsresource base has now expanded as a result of the G-20 declarations, with the resource pledge scaled up .to US $750 billion.


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presumed to be a patient investor to buy and hold assets for resale when the marketsstabilize. If the plan succeeds, it prevents panic and asset fire sales, and hence affords

banks immediate liquidity, and hence leads to a revival of the credit market. The Paulson bailout plan in the US was driven by the asset purchase motive, but moved away towardcapital injection. Currently the modified version of the Paulson plan is in operation

through private-public partnership that helps facilitate price discovery.

2. Reforming banking regulation

The current crisis provides an opportunity to rethink about the regulatory schemes in acomprehensive way. What is brought home is the build-up of risk exposures not only by

banks but shadow banks stemming from regulatory gaps and distorted incentives ofdecision makers in the banking and the overall financial system. The current crisisinspires a variety of ways to reform banking regulation.

First, banking regulation should have appropriate capital standards to reduce excessive

risk taking by bank owners. Capital standards should track differences in the bank riskopportunities and they should not be one size fits all. Different banks are likely tomaximize the socially desirable level of bank value at different levels of risks, and capitalstandards should be differentiated to reflect that. This has implications for global capitalstandards as well. Capital regulatory rules should not be standardized at a uniform level,

but should be country specific, and even bank specific. In addition, the current crisismakes it clear that there should be supervision and monitoring of the liquidity position of

banks, particularly a mismatch between short term bank liability and the long term assetsthat are financed, in addition to the capital position.

Second, shadow banks should be brought under the same regulatory umbrella astraditional banks. The current crisis has exposed that financial systems breed institutionswhich are complex with functions similar to what banks do. Traditional banks basicallyaccept deposits and lend to transform deposits into longer term assets. It turns out thatthere are non-banks, such as money market funds, investment banks, hedge funds, which

perform very similar functions but in a more complex and non-transparent fashion.These shadow banks have been outside the banking regulatory regime. As dynamicfinancial systems innovate, there will be more such shadow banks, but the regulatorysystem should be integrated to treat them similarly to the other banks.

Third, apart from shadow banks, the crisis has revealed an emergence of systemicallycritical or interconnected institutions and entities that can hostage the entire globalfinancial system with adverse consequences on economic systems around the world.This is an opportune time to think about the design of systemic regulation. The currentcapital standards are inadequate in dealing with systemic risk. There is a growingconsensus for some type of systemic regulation, but the debate on how it should bedesigned is unsettled. Systemic risk is easier to define than measure, since it is quite achallenge to measure the impact of an institution to the potential failure of the entiresystem? However, any such measure should have such determinants as size,


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interconnectedness, and complexity. Conditioned on such a measure, capital standardswill then vary and even be raised beyond those banks which are not systemically critical.

Some have argued that institutions and companies too big to fail should be broken up tofacilitate systemic regulation. However, there are two unsettled issues. First, it is not

easy to determine an optimal size of an entity, and you dont want the government toinadvertently generate diseconomies of scale. Second, smaller institutions, betting onhighly correlated activities (e.g., banks betting on house prices) can engender similarcontagion and systemic failure of the system.

3. Reforming stock market regulatory and legal regime

Informational efficiency and public confidence through transparent and credible financialdisclosure rules are vital for the functioning of stock markets. Financial statements should

be trusted and transparent about firms listed on the stock exchanges. Legislation alonecannot produce public confidence. We know there is no shortage of legislation around

the world. To foster public confidence, there should be an even playing field, with strictenforcement of laws and rules by a credible and independent judiciary and regulatory body.

Thus, legal and regulatory systems characterized by private property protection, investor protection, contract enforceability are vital for the development of stock markets. This issupported by the available literature. For instance, Lombardo and Pagano (2000)underscore the impact of institutional quality on the stock markets and provide evidencethat stock market returns are positively related to respect for law, lack of governmentcorruption, efficiency of the judicial system, and accounting quality.

Thus, a well functioning stock market system requires regulatory schemes that promote,rather than inhibit, private initiative, and foster investor confidence in the functioning ofthese markets. It means that the government fosters an environment for strictenforceability of private contracts and transparent accounting disclosures and procedures,consistent with best international practices. Moreover, the regulatory system shouldinclude a strong securities and exchange commission capable of enforcing securities lawsand developing its own self-regulatory rules.

It is to be recognized, though, that government regulation of stock markets should bemore of an oversight over self-regulatory agencies, with such an oversight coming from,for instance, the Securities and Exchange Commission, an organ of the government. Self-regulatory organizations formulate rules for business and professional conduct of theirmembers by building on the capacity and wisdom of individuals inside the member firms.

4. Reforming corporate governance

As stock markets develop and innovate, the corporate sector should be moving to best practices in corporate governance. Stock markets will not function properly withoutquality corporate governance. Although privatization programs bring companies to a


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disciplinary force of the stock market system, corporate insiders may still engage inactivities harmful to capital contributors. Once investors lose confidence in corporategovernance, the companys ability to raise funds and grow will be impaired. Countries,which are committed to the stock market economy, should strengthen institutions forcorporate governance and adopt best international practices in terms of measures for the

effectiveness of the corporate board, executive compensation practices, a system ofdisclosure rules, and increased protection of shareholder rights against controllingshareholders/management.

First, it should be recognized that best practices in corporate governance call for aseparation of the role of the government as a regulator and business operator, andfostering board independence through a majority non-executive directors. The growingconsensus around the globe is that the corporate board be independent of the chiefexecutive officer. Moreover, the compensation committee should be composed ofindependent directors to bring transparency and prevent ill-designed compensationstructures that promote aggressive risk behavior that leads to instability and crisis.

Finally, the stock exchanges themselves, in their role as self-regulators, should establishstandards for listing of companies, consistent with best governance practices.

Second , quality corporate governance calls for a well designed compensation structurethat provides proper incentives for decision-makers. The current global crisis has drawnattention to the level and structure of executive compensation in the United States.Misaligned incentives can distort investment decisions toward more aggressive andexcessively risky, eventually leading to the kind of crisis we are witnessing currently.Overly generous compensation packages and the widespread use of stock option grantsmay have created incentives for aggressive risk behavior which is now being partly

blamed for the current crisis. On the other hand, properly designed, top managementcompensation can serve as a key mechanism of corporate governance with the potentialto provide the right incentives to perform in a way that maximizes the enterprise value.

The executive compensation setting process should be transparent and should be devoidof the influence of the executives themselves. Executives can influence the process in avariety of ways. In particular, they can dominate the nomination of directors in the boardcompensation committee. They can also exert influence through seats in interlocking

boards. Therefore, one important reform of corporate governance is a requirement for thecompensation committee of the board to be totally independent. This independence isachieved from appointing directors outside the company and with no direct or indirectrelationships with the company. Moreover, there should be a majority independentoverall board. In fact, the movement for board independence is growing around theworld. 9

9 The transparency of the compensation plans is enhanced through disclosure rules requiring that allelements of executive compensation, including retirement benefits and indirect compensation, be disclosedto the shareholders. There is also a growing movement for shareholders to vote on the equity-linkedcompensation plans.


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5. Regionalization of stock markets

Markets in certain regions tend to be thin and illiquid (see Table 4). One way to enhancedepth and liquidity of these markets is through consolidation of regional markets .

Regionalization and exchange consolidation has an added advantage of accelerating themomentum of integration of these countries into the global financial economy. Whileinjecting more liquidity into the markets, it allows regional companies to mobilize bothdomestic and global financial resources. There are certain prerequisites for marketconsolidation, and they include, establishment of regional securities and exchangecommissions, regional self-regulatory organizations, harmonization of legal andregulatory systems, harmonization of accounting reporting systems, along with clearance,settlement and depository systems, and harmonization of tax policies for securityinvestments.

6. Privatization through stock markets

A growing number of countries around the world have used the stock markets for large scale privatizations of state-owned enterprises. In general, the stock market vehicle is an importantmeans of depoliticizin g privatization programs, since it allows for price discovery, and hencemakes it possible for the privatization shares to be fairly and transparently priced.Moreover, large scale privatizations help enhance depth of the stock market. This issupported by the available evidence. Perotti and van Oijen (2001), looking at a sample ofemerging markets, argue that there is a positive relationship between privatization

programs and stock market development.

There are additional, but less obvious, benefits of market-based privatization programs..First, state-owned enterprises are brought into the domain of market discipline andimproved corporate governance. In the public domain, state-owned enterprises lackeffective governance mechanisms and face little competition. Privatizing them and

bringing them to the discipline of the stock markets should improve corporate efficiencyand performance. Second, local stock markets provide an opportunity for participation of localinvestors through purchases of privatization shares. This also helps dispel concerns about foreigngrab of domestic privatization assets. Third, privatization programs through the stockmarket promote diversity of ownership resources in the economy, and hence helpalleviate public concerns that stock markets cater to the few elite in society. .

7. Building capacity for oversight of risk and risk management

At the center of the global financial crisis is excessive risk which is fueled by excessiveleverage. We got there as a result of distorted incentives for risky behavior that garneredhuge rewards in boom periods. However, that is not the whole story. The risk exposuresalso became so complex and intertwined that they became opaque and beyond ordinary


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capacity to restrain. As the good times rolled, even the traditionally reputable institutionstook huge bets through excessive leverage. 10

The lesson for those which are committed to a well-functioning and dynamic stockmarket system is straightforward. Financial innovation and dynamism are risky. The

solution is not to avoid risk but to develop capacity to manage risk. First, globally,financial systems have become increasingly innovative and sophisticated, and they will be evenmore so with ever advancing technology. The development of the stock markets andtheir derivatives calls for a commensurate development of talented financial manpowercapable of managing risk. Sufficient resources should be committed to improve businessschool curricula in universities and training programs at financial market institutions.

Second, well-functioning stock markets demand well-informed participants: investors,investment advisors, brokers, accountants, government regulators, and self-regulators .Like financial institutions, financial regulators should also understand the risk exposuresthat build up in the system, and this is becoming even more important in this increasingly

complex and interconnected environment. Therefore, literacy in financial regulationrequires literacy in risk management and control. University programs should besupplemented by specialized training programs to produce financial manpower andregulatory force that is appropriate for well-functioning stock markets. Otherwise, therewill be a large gap between regulatory talent and industry talent in the management andoversight of risk. 11

8. Building and maintaining reliable stock market database

Despite the extensive political, economic and financial sector reforms, in certain regionsgenuinely reforming countries get lumped with other countries which have suffered

negative image of war, conflict, corruption, violation of human rights, etc. Thisinformation gap can be costly, and it can affect credit worthiness measures that are published internationally.

This makes it clear for building and maintaining a database for reliable economic andcapital market data that captures the diversity of countries and the financial circumstancesof private institutions, listed companies, and banks. The timeliness and reliability offinancial data are crucial for making reliable estimates of investment risks. The financialsystem knowledge and database is an area for regional co-operation in terms of poolingresources. The added benefit of these databases is that they allow for first-rate researchto be conducted on these markets by researchers around the world.

9. Fostering macro economic and political stability

10 For instance, in 2007 Goldman Sachs had only $43 billion in equity to support $1 trillion of assets(Economist, October 18, 2008).

11 The other issue is compensation gap between regulators and the industry they are regulating, and that brings up a vast issue that is still unsettled in the advanced countries.

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Macro-economic and political instabilities lead to volatility in the stock markets. Theaccumulating evidence is that macroeconomic stability, such as low and predictable ratesof inflation, fosters stock market development and helps stabilize the financial system.High economic and political instability can lead to severe information asymmetries in the

stock market. This in turn induces excess volatility in the market, serving as a breedingground for noise traders and gamblers. This would be destabilizing to the stock market aswell as the economy at large. As the stock market ceases to accurately reflect thefundamentals, a speculative bubble is likely to emerge, which will then burst into a crisissimilar to what we are witnessing today. Political risk is not just associated with politicalunrest. It often arises from lack of quality institutions, such as law and order anddemocratic accountability, which then contribute to increased risk premia in financialmarkets. Political risk is also associated with the odds of adverse changes in government

policies.

10. Managing the pendulum: concluding remarks

We conclude with the following remarks. First, there should be a proper balance between two prevailing polar views. The government is the problem. The government isthe solution. The flip side of this is the market, of course. The pendulum shifted too faron the side of the government being the problem, and hence lax regulation andinstitutions too big to fail. Now the pendulum may shift too far on the side of thegovernment being the solution. We have already witnessed what could happen when welet markets rule. However, while the regulatory reforms are needed, we should resist thetemptation of overshooting the other way, of government rule of business and finance.

Second , as we know from financial history, financial crises are endemic to financial

systems, including stock markets that are dynamic and innovative. On the other hand, thecurrent global financial crisis has reinforced a stark lesson that finance needs regulation.But not more regulation. We need to have good regulation. Moving forward regulatoryreforms help remove regulatory gaps, but they should not be expected to eliminatefinancial crisis in the future. However, if these reforms produce good regulatory schemes,they should reduce the frequency and severity of future crises.

Third, the damage from this crisis is so severe that a temptation may exist both in policy and popular circles to reverse a course toward the old dysfunctional and command financialeconomy. The temptation for reversal is being fueled in part by the advanced countries inwhich government intervention has become rampant in the crisis resolution. However, theglobal crisis should not be an occasion to reverse course but a rare opportunity to improve, oreven redesign, the financial and regulatory structure for the 21 st century. The analysisand the reform proposals in this paper are intended to contribute to that front.


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