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Comments on Capital Markets and Their Size, Structure and Regulation

English Pages, 6. 5. 1997

It is a great pleasure to be here this morning, to welcome all of you in Prague and to discuss one of the new, very recent institutions of our economy - capital markets. I am also honored to introduce our special guest and distinguished speaker Joseph Stiglitz.

While preparing myself for this meeting, I took into my hands a small booklet with the title “Financial Systems for Eastern Europe’s Emerging Democracies” written by Joseph Stiglitz in 1993 (and published by the International Center for Economic Growth, San Francisco, Occasional Paper, No. 38) which was based on his earlier talk in Prague.

I agree with him that „well-functioning capital markets are at the heart of a well-functioning capitalist economy“ (p. 7). I also agree that „of all the markets in the economy, the capital markets are perhaps the most complicated and least understood“. And finally, I agree that „the structure of capital markets appears vastly different among major capitalist economies“ which makes it practically impossible to translate one simple piece of legislation in one country and to implement it in another.

There is no doubt that capital markets are different from ordinary markets and that they need more government intervention or regulation than ordinary markets. The only point is how to intervene, how to regulate them without constraining them unnecessarily and without expecting too much from the regulator who is a human being as the rest of us with his well-defined utility function which he tries to maximize and who operates in a world of intensive rent-seeking and in a world of the well-known fallacies of regulation. I am not very optimistic about regulation in general and about regulation of capital markets in particular.

Let me say a few words about the whole issue as I see it.

In the last couple of years our capital market has grown much faster than anyone expected. It is easy to criticize our expectations with the benefit of hindsight but it happened and I would dare to argue that we were not alone in making the same or similar forecasting mistake. We know that we gave it a strong accelerating impulse by our voucher privatization but - again - I expected a much slower beginning.

I have to confess that in the early nineties, in the moment of liberalization of the whole economy, I fully shared Joseph Stiglitz’s view that „to a large extent, equity markets are an interesting and amusing sideshow, but they are not at the heart of the action“ (p. 32). I expected - for some non-negligible time to come - that banks would play a dominant role in raising funds and in the allocation of capital. Even now this remains true from the quantitative point of view here but we understood that the capital markets play a role which is much bigger than their pure size.

We, therefore, started our economic transformation with heavy reliance on the banking system. While trying to expand rapidly the totally undeveloped or almost non-existent banking system - we probably underestimated the imposition of sufficiently high capital requirements (which is what Joseph Stiglitz strongly recommends in his booklet) and, at the same time, we did not succeed in strictly dividing the financial and production sectors of the economy. We - more or less - accepted the German (or continental) type of banking with its strong inter-relationships between banks and firms in the production sector. We see many problems with it now. I did not want it even then, but I am not sure we could have started differently.

I am aware of the fact that with the spontaneous evolution of our financial markets, with literally millions of share-holders and hundreds of investment companies and funds, mostly as a result of voucher privatization, we did not succeed in helping to create one important public good which is the sufficient degree of information about the financial position of the firms. It is partly the result of the lack of intensity of transactions in our today’s markets which is unavoidable (the markets are shallow and, therefore, not sufficiently efficient), and it may be - at the same time - the result of some delayed legislative measures on the side of the government.

The question of lags in public policy is, however, not simple. One well-known expert in the field of economics of information, Joseph Stiglitz, mentioned in his study that „much of the return in capital market consists of rent-seeking“ (p. 15) and I have to admit that in the past some of us did not immediately believe all the critics of our capital markets because they usually played their own card and did not take sufficiently into consideration the existing stage of the evolution of our economic systems. Their criticism was very often undistinguishable from the complaints of those who just occured a loss by making a wrong investment.

As you know, the Czech government recently introduced the so called „package of measures“. If I put aside its macroeconomic side, one of its main intentions is to make our financial markets more transparent and more standard. By declaring such an intention we wanted to send a strong signal both to domestic and foreign investors.

The main institutional change of this policy package as far as the capital markets are concerned is the creation of an independent Securities and Exchange Commission. We hope that it will be interpreted positively on the side of investors and we will try to manage it by a respected team of professionals. As an economist, I know that the term „independence“ has its own problems but we will try to avoid the interference of various vested interests among capital market participants.

The second field of change concerns the problems that currently exist through excessive concentration of ownership in the hands of our major banks. The respective authorities were given three months to analyze the situation and prepare a legislation which would eliminate the worst aspects of this concentration and allow for gradual divestiture by the banks of their fund management subsidiaries. We will also prepare an amendment to the existing laws which would eliminate the share ownership in the investment funds by fund managers and would also ban the funds from dealing with related parties of the fund manager.

The economic package further strengthens the role of depository banks (custodians) to the investments funds. The negligence in this area will be dealt with very strictly and will mean losing the licence for this service. There are many other suggestions but it is not my ambition to go into details here.

We know as well that the main problem is not the legislation itself. It is becoming more and more standard. The problem is law enforcement and sufficient control and regulation. There is a clear need to speed up the judicial procedures and to establish specialized financial courts dealing with bankruptcies and matters related to capital markets.

At the end I would like to make a short remark concerning foreign investors. Some of them have invested in the investment funds which were created during the first and the second wave of the voucher privatization. The dominant feature of that procedure were substantial discounts to the net asset value of the funds. In some cases the discounts reached 70-80%. To a discriminating investor this would clearly indicate a specific risk which the market placed on such an investment. Regardless of this „warning“, they bought into these funds and now are crying for help. We were inexperienced and innocent, they should not have been.

Nevertheless, I believe we have the first, kindergarden stage behind us and from now on the situation will be different. For investors their life will be in some respect easier, in another respect it will be more difficult, because more standard.

Václav Klaus, Introductory Comments at the First Annual Conference on Capital Markets Effects of Regulation on Economic Growth, Prague, 6 May 1997.