The early financial market development process stressed the importance of capital accumulation, and the role of financial institutions in that process. However, this journal emphasize more on the important capital allocation and budgeting process in institutions. This is because the researchers had seen the imperfect of capital accumulation even in the likely economic situation for capital accumulation. Furthermore, the earlier financial market development paid only limited attention to problems of incentives, managers managed it well because it was their jobs but it can also cause conflicts interest between manager and shareholders due diverge view on it. Hence, the new economic paradigm stresses the importance of imperfect and costly information in the economy; and the difficulties of enforcing contracts on choosing good managers and projects, and of providing them with incentives to ensure they work hard and act in the interests of the shareholders. In addition, as i have come to understand capital markets and financial institutions better within developed countries, it has become clear that what is remarkable is not that they do not work perfectly, but that they work at all. There are several proposals suggested with his views that capital market imperfections are endemic, and the governments are not capable of correcting this 'market weakness'.
Capital markets perform several critical roles: they aggregate savings and they allocate funds. In the fund allocations, banks continue to perform an important task, in ensuring that the funds are used in the way promised by the borrower and the borrower should responds to new contingencies by paying the interests to the providers of capital. When the bank provide these services, the risks facing savers are diversifiable. Banks and other financial institutions take the relatively small savings of large numbers of individuals, aggregate them together, and make funds available for their customers, larger-scale enterprises. Moreover, one of the central function of financial institutions is to assess which managers and which projects are most likely to yield the highest returns. Therefore, those who have funds are not necessarily those who are most capable of using the funds; financial institutions perform an important role in transferring funds to those for whom the returns are highest. In addition, once the loan has been made, it is important to monitor that the funds are spent in the way promised, and that the project is well managed. These two functions of financial institutions are referred to as their screening and monitoring roles.
The three most important forms in which capital is provided are equity, long-term loans, and short-term loans. From the perspective of the entrepreneur, equity has two related distinct advantages, risk is shared with the provider of capital and there is no fixed obligation for repaying the funds. Thus, if times are bad, payments to the providers of capital are suspended. However, there are some good reasons for issuing equities which are risk averse individuals with good investment projects and requiring more capital than they have will also issue shares. Besides, there is an adverse signal associated with issuing new equities, the value of firms' shares decreases when they issue shares. This serves as an important deterrent to issuing shares, because entrepreneurs do not have a fixed commitment incentives are attenuated, shareholders only get a fraction of profits, and managers have an incentive to divert profits to their own use. This study has stressed how imperfect information and free rider problems provide theoretical explanations for why take-overs and other market mechanisms provide only limited discipline on managerial behavior, and consequently, for why managers have considerable autonomy.
Short-term loans give the firm much less discretion with the conditions that need to make interest payments, and the bank can request its funds back at each of the due dates. The firms rely heavily on the bank and they will get into problems if bank refuse their loan renewal. Besides, loan markets also face different aspects of the three problems of enforcement, selection, and incentives than equity markets face. Finally, both providers of loans and equity have an incentive to monitor the actions of the borrower but lenders may be in a more effective position for doing so, because their ability to withdraw credit.
Bonds represent a half-way house between short-term loans and equity. With a bond, a firm has a fixed commitment. It must pay interest every year, and it must repay the principal at a fixed date. As a result, all the problems we have discussed above arise with bonds. Bonds have one significant advantage and disadvantage. Because the lender cannot recall the funds, even if he is displeased with what the firm is doing, the firm is not on a 'short' leash, the way it is with loans. This has the advantage of enabling the firm to pursue long-term policies but the disadvantage of bond allowing the firm to pursue policies which adversely affect the interests of bondholders. Therefore, bond covenants may provide some restrictions, but these generally only foresee a few of the possible contingencies facing firms. The second reason that bonds play small rile in raising capital is the unwillingness for firms to be put on short leash. A firm which knows that it will be undertaking safe actions, and that its projects are really good will be willing to subject itself to the continued scrutiny of its bankers. Those who do not want such close scrutiny include those who think there is a high likelihood that eventually they will fail to pass muster. Thus, even if there were some economies associated with long term commitments, the market might not provide these commitments.
Allocating capital is thus a much more complicated matter than the simple 'supply and demand' paradigm suggests. Even the simplistic advice given by 'Chicago' economists is based on the hypotheses that free markets whether for chairs, tables, or capital are tied with Pareto efficient resource allocations; and the policies that move the economy closer to free market solutions are welfare enhancing. All three of these presumptions are incorrect. We have already argued against the first and there is no intellectual foundation for either of the other two. The second best theorems of Meade (1955) and Lancaster and Lipsey long ago showed that in economies in which there were some distortions, removing one distortion may not be welfare enhancing. While they did not have in mind the kinds of problems with which we are concerned here, the basic lesson remains valid in this context as more fundamentally. Greenwald and Stiglitz (1986, 1988a) showed that economies in which markets are incomplete or in which information is imperfect are not constrained Pareto efficient; because the existence of government intervention. Thus, an analysis of government policies towards capital markets needs to take into account the fundamental problems to which we have called attention. There may exist government policies which will enhance the capability of the market economy to raise and allocate capital. Several possible policies are discussed to support my view.
Banks versus securities markets as sources of funds. The first, and most obvious implication of our analysis is that the LDCs must expect that firms within their economies will have to rely heavily on bank lending, rather than securities markets, as sources of funds. While it may do little harm for governments to try to promote the growth of securities markets, both markets for equities and long-term bonds, these are likely to provide only a small fraction of the funds firms require.
Foreign investment and banks. . Lack of reputation serves as an effective entry barrier for domestic banks would exacerbate both the moral hazard and adverse selection problems. The local banks may find it difficult to raise the required equity and these arguments suggest that foreign banks and firms may be more reliable in allocating capital efficiently than domestic banks and firms. Furthermore, domestic firms are not only at a reputation disadvantage, they are also at a risk disadvantage. For example, international firms can diversify over a wide portfolio but if the domestic banks have a portfolio of assets that is widely diversified among domestic risks, the common risks only will make their portfolios riskier. Moreover, the restrictions on foreign banks and on capital flows out of the country may be one way of channeling funds to domestic entrepreneurs and of subsidizing domestic banks and corporations and prevention domestic monopolization. Thus, if one or two banks dominate the domestic banking industry, restrictions on foreign banks may simply serve to protect those firms' monopoly rents because these firms may not be particularly efficient allocators of capital, and the disparity between their interests and a broader sense of national.
Secondary and primary financial markets. Secondary financial markets is the markets that centered on the exchange of ownership claims. While, primary financial market is mainly focus on raising and allocating capital. I stress this because the two aspects of financial markets are often confused. Even the recent innovations in financial markets have been concerned with the secondary market, new instruments have been invented and transactions can be recorded more quickly but this does not mean that the economy functions more efficiently. In particular, the primary financial markets may not perform their roles any better. For instance, McKinnon (1988) has argued persuasively that flexible, unmanaged exchange rates have imposed enormous risk burdens on producers engaged in international trade, risks which they cannot divest adequately through futures markets. Newbery and Stiglitz (1981, 1984) also in the same view that 'freeing up' capital markets, allowing funds to flow freely abroad, is necessarily welfare enhancing. However, the economic theory provides no presumption that freeing up secondary capital markets is necessarily welfare improving so all of this suggests are no easy policy answers. In some cases, governments have unintentionally served to exacerbate the problems we have identified rather than reduce them.
Multinationals. The reason why foreign banks may be able to perform an important role in allocating capital is multinationals because they have one advantage over banks, they typically provide capital in the form of equity. While equity has distinct advantages over debt, it provides more effective risk sharing, and thus leads firms to act in a less risk averse manner and resulting, strengthen the shocks sustainability of the economy. Thus, it may be desirable for governments in to recognize the important role that multinationals can play in the development process, rather than putting impediments in their way.
Risk sharing by government. For the reasons mentioned before, equity markets are unlikely to provide effective risk-sharing opportunities. Moreover, governments only pay more role on the profits sharing rather than risk sharing. As Domar and Musgrave (1944) recognized, if the government fully shares in gains and losses, it can actually encourage risky investment; Though this is not the occasion to provide a detailed technical proposal of how this may be done, I should note that there are several ways in which governments can share risk much more effectively than they do at present.
Government risk reduction strategies. In addition, there are policies which the government can undertake which reduce the riskiness of the environments in which firms operate, and given the limited opportunities for risk sharing provided by markets, this can provide a strong stimulus for the economy. In particular, it can increase both the willingness of firms to borrow and the willingness of banks to lend. These policies can be both microeconomic and macroeconomic in nature. Stabilizing the price of export crops will not only have a direct effect on the producers of export crops but it will also have an indirect effect to the variability of income of the producers of export crops gives rise to variability in the demand for non-traded goods.
The major shift in the prevailing economic paradigm had reflected our views to economic policy. We now recognize that especially for small open economies, the problems of macro-economic coordination stressed in the earlier development planning literature may be far less important than the microeconomic problems of selecting projects and choosing good managers to manage those projects. One of the functions of the economy's financial institutions is not only to raise capital, but to channel funds to the most profitable opportunities, and to ensure that those funds are well used. We need to think more about what kinds of institutions can most effectively perform these functions because centralized government bureaucracies and large public credit institutions may be poorly situated to perform those functions. However, there may be ways in which the government can assist in the development of a variety of institutions which can play an important role. So I am put forward some quite tentative proposals which suggest some ways in which government policy can be designed to reflect the broad set of concerns which I have raised.