Investor protectionism and financial market size – A review

A common denominator of market-based financial system like that of United States and U.K and bank-based financial system such as that of Germany or France is investor protection. The United States has a market-based system because its economy is largely dependent on property and financial asset value. Consequently, it has a large stock and bond markets creating a large market which attracts investors and companies from all over the world. This presupposes that the stock market and individuals (that is investors) play a significant critical role in corporate finance and governance as large fraction of individual portfolios is held in the equity market. Moreover, equity financing is practiced in this system.
On the other hand, bank-based systems are characterized by financial assets predominantly being held by financial institutions encompassing banks, mutual funds, insurance companies, pension funds and others. This means direct equity investment is small whilst individual investment is predominantly held in bank deposits, insurance policies, mutual and pension funds e.t.c. Debt financing comes mainly from banks instead of stock markets and so the stock market is comparatively small and less significant in this type of economic system. The fact is that, in market-based financial systems, investors property rights are protected well due to the fact that stocks and bonds markets are significant and form a higher percentage of the GDP. For example in 2003, financial assets was about 327% of GDP for U.S and 306% for U.K which are market-based dominant financial systems compared to 192% in Europe, 267% in Japan which tends to be bank-based dominant systems, an epitome of socialist systems [1}.

The large stock market size in terms of number of listed companies, aggregate market value relative to GDP and initial public offering (IPO) relative to population is a repercussion of the investor confidence and the quality of laws governing the market. Contrarily, inadequate protection rights minimize the integrity and size of the market as seen in the economies with dominant bank-based financial systems. Even in the efficient market-based systems where shareholders and creditors of the market are protected well by laws, political trends and shift in government policy can inhibit the smooth running of these markets. There is the tendency for governments to garner more power and control in terms of enforcement of the laws governing the market in times of deep economic recession. A case in point is the financial market crash in 1929 which was followed by the government expansion and ownership in the Great Depression. However, much as laws need to be enforced to ensure investor protection, an expansion of government control of the market can be very ambitious besides reducing the efficiency of the market. That is why it is incumbent on the Federal government to critically examine the amount of power and reforms it seeks to control the market to avoid a rippling effect of market inefficiencies. Most importantly the market inefficiencies would emanate mainly from competition and capital gains impairment, no insulation from political influence on investment and operating decisions. The market is a privatization entity and so should be allowed to operate with some level of independence for efficiency and profitability. Reforms are necessary to ensure investor protection and subsequently confidence yet very robust reforms if not handled carefully can impact negatively the markets. These times are similar to the Great Depression period and care needs to be taken to avoid the degenerating syndrome of “protectionism” as practiced in some socialist systems. We have learnt by observation and experience that the large size of the U.S market is also a result of large number of foreign individuals and company investments and any failure of the market spills into the economies of the rest of the world.

Now, I would not want to complete this article without a discussion of the commonalities of the market-based and bank-based financial systems with regards to investor protection. In any economy, there is a positive correlation between market-based and bank-based financial systems and what ever takes place in market-based reflects in the bank-based financial systems. So for those economies with financial systems which are dominantly bank-based, investor protection is also very important as no individual would want to invest in a system with no solid foundation for protection of investor rights. The fact remains that in this type of financial system, individuals do not invest directly in the equity market. However, indirectly they do by their investing in banks, mutual funds, insurance companies and other financial mediators. One recount of what happen in Wall Street in the past few years which had serious negative ramifications on the banking system of the U.S with spill-over to the rest of the world banking system. The corollary is that if the bank-based financial system is corrupted it would factor into the market-based financial system of the economy. So if the equation is right, it is inevitable that corruption in banks, mutual fund companies, insurance companies are candidates of shocks for the stock market and consequently the market-based financial system.

Currently, analysts are edging Americans to save more and that would presumably be in the banks. It is imperative that “protection” not “over-protection” for these savers is ensured. Coincidently, households in partially socialist systems like Japan are already ahead of America. This is because in Japan and other partially socialist countries, households put significantly more of their savings in the banks than the stock market. It is true that such socialist mannerisms would hurt the America economy as consumer spending (which is about 70% of GDP) is reduced. Nevertheless, if investor protection is assured, consumer confidence would rise with subsequent increase in consumer spending which would improve the GDP. The fact is consumer spending has implications on the other three GDP factors namely investment, government spending and net exports. It is the fervent wish of all Americans and the rest of the world that the dare-devil monster economic virus called “inflation” does not rear its head in the next months or years to come. In default, it would cause investors to turn to supposed recession proof financial assets like gold and probably bonds which would also be a plus for the stock market. The other side of the coin is that if there no competent investor protection in America investors would be forced to look for investment in other countries which would also affect the U.S economy. Investments in gold mining in places like Ghana, Chile would then become viable for these investors if investors protection is deemed suitable in these countries.

Reference:
[1] CEIC Data Ltd, International Financial Statistics, and National Sources

By Charles Horace Ampong [M.Sc(Eng), MBA(finance)],
GLG Councils Consultant