Lecture 2
FINANCIAL MARKETS AND
TRANSACTION COST
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Readers
• Allen et al (2011), African financial systems: A
review. Rev. of Dev’t Finance I:79-113.
• Burton and Lombra (2006), The financial
system and the economy: Principles of money
and banking, 4ed. Thomson-South Western.
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Learning objectives
• After this unit of the module, you should
know:
– The various ways of classifying financial markets.
– The nature of the African financial system.
– Basic concepts underlying the operations of
financial markets
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Lecture Plan
• Introduction
• Financial Markets
• Basic concepts underlying financial market
operations
• Conclusions
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UNIT 2: FINANCIAL MARKETS AND TRANSACTION COSTS
FINANCIAL MARKETS
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Financial Market
• Type of financial claim:
– Equity Market
– Money Market
– Bond Market
– Foreign Exchange Market
• Length of term for which instrument is traded:
– Money market
– Capital market
• Primary and secondary markets
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1. Classification based on type of
financial claim
• Equity market
– Market for the buying/selling of stocks/shares and
derivatives eg. LSE,JSE, ZSE etc.
• Bond market
– Market for buying and selling bonds issued by
governments-municipal and national governments,
corporates etc.
• Foreign exchange market
– Buying and selling of foreign currencies and derivatives.
• Money market
– Buying and selling short term papers or instruments.
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2. Length of term for which instrument
is traded
• Money market
– Market for financial assets with original maturity
of less than one year.
– Eg. Treasury bills, commercial paper and NCDs
• Capital market
– Market for financial assets with an original
maturity of more than one year.
– Eg. Corporate bonds, stocks, mortgages and
Government Treasury notes and bonds
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3. Primary and Secondary Market
• Primary market
– The market in which a security is sold for the first time.
[Security, financial instrument or claim may be used interchangeably].
– New issues such as IPOs are sold in the primary market.
• Secondary market
– The market in which previously issued securities are sold.
• The difference between the two markets are only conceptual ..eg of car
dealerships, pre-owned and new cars are sold on different lots on the
same premises.
• While the secondary market do not generate new funds for issuers that
raised capital on the primary market, the mere existence to the secondary
market improves the market for new issues.
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4. Whether arranged transactions
occur instantaneously or in the future
• Spot market
– A market in which the trading of financial securities take place
instantaneously.
• Financial futures market
– Organised markets that trade financial futures agreements.
– Securities are standardized in terms of quantities and delivery
dates.
– Eg. There are four contracts in a year. March, June, Sept. and
December.
• Financial forward markets
– Markets that trade financial forward agreements usually
arranged by banks, brokers or other dealers.
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• Derivative market
– Financial futures market where the value of the
financial instrument( the futures and forward
agreements) “derive” their values from the
underlying instruments such as gov’t bonds,
shares of equity, commodities, etc that are traded
on a future date.
– Financial forward and futures markets are
examples of derivative markets.
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Unit 2: Financial Markets
INTERNATIONAL FINANCIAL
ARCHITECTURE
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International Financial Architecture
•
•
•
•
•
•
Bilateral donors
Private/commercial sector/banks etc
Multilateral donors
Global funds
NGOs
Private philanthropy
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International Finance System
Bilateral Donors
DAC Donors: eg.
EU
Bilateral
Development
Banks &
Agencies
Other OECD
Donors
(non-DAC)
Emerging Donors
(eg. China*
India,Brazil, South
Korea etc)
Private
Commercial
Sector
Firms (e.g. FDI,
corporate social
responsibility)
Multilateral
Donors
The World Bank
Global Funds
NGOs
Global
Environment
Facility
International
NGOs
(CARE Int., PLAN
Int., Oxfam etc)
The Global Fund,
GAVI
National NGOs in
Donor Countries
IMF
Commercial
Banks
(eg. loans,
export credit,
export
guarantees)
Private
Investors (e.g.
portfolio and
equity
investments)
UNDP
Regional
Development
Banks, eg, ADB
Other banks,
Islamic Dev. Bank
etc
UN special
agencies
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National NGOs in
Developing
Countries
Private
Philantropy
Bill and Melinda
Gates
Foundation;Ford
Foundation;
Wellcome Trust,
etc
Householdsremittances and
other private
transfers
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AFRICAN FINANCIAL SYSTEMS
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Introduction
• Continent of 53 countries
• Economically and cultural diverse
• Varying financial systems at different levels of
development
• Reviews is done regionally:
– North Africa
– West Africa
– East Africa
– South Africa
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Themes covered
•
•
•
•
Banks
Non-bank institutions
Money and capital market
Microfinance institutions
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Foreign banks as a percentage of total
banks by region
Region
2000
2006
Eastern Africa
44
56
Northern Africa
29
37
Southern Africa
51
56
Western Africa
51
54
Source: Allen et al (2011) as quoted from Stijn et al, 2008
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Market capitalisation, listings and liquidity of the main
stock exchanges 2009
Region
Country
East Africa
Kenya
Northern Africa
Southern Africa
capitalization
Listings
Turnover
Trade/Cap.
39
55
4.59
1.65
Tanzania
-
-
Uganda
-
-
Egypt
48
305
60.07
28.04
Morocco
69
78
45.73
32.38
Tunisia
23
49
16.23
3.18
Botswana
34
20
2.74
0.89
-
-
Malawi
Mauritius
55
88
8.06
3.38
Namibia
9
7
2.84
0.24
246
363
57.27
119.76
5
-
-
-
-
South Africa
Swaziland
Zambia
West Africa
Cote d’Ivoire
20
38
2.01
0.58
Ghana
16
35
1.96
0.37
11.01
2.71
Nigeria
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Structure of financial markets
presentation
•
•
•
•
Introduction
Financial Markets
International financial architecture
African financial system
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UNIT 2: FINANCIAL MARKETS AND TRANSACTION COSTS
CONCEPTS UNDERLYING THE
OPERATIONS OF FINANCIAL MARKETS
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Concepts
•
•
•
•
•
•
•
Transaction cost
Economics of transactions
The principal-agent problem
Asymmetric information
Adverse selection
Moral hazard
Conclusion
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Introduction
• Financial markets operate within an institutional
framework or system.
• The aim here is to get the system to function in an
optimal manner.
• Challenges in most developing countries hamper
development of the financial markets and that
affects economic growth negatively.
• Challenges often arise from the high transaction cost.
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Transaction cost
• This is the cost incurred in undertaking an
economic or financial transaction.
• Financial intermediation is a critical factor in the
determination of transaction cost.
• Financial intermediation plays four roles:
– Provision of adequate liquidity risk sharing
– Reduction of inefficiencies arising from information
asymmetry
– Alignment of incentives to reduce moral hazard and
adverse selection
– Facilitation of scale economies
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Liquidity risk sharing
“risk to a bank’s earnings and capital arising
from its inability to timely meet obligations
when they come due without incurring
unacceptable losses.”*
Source: Office of the US Comptroller, 2000
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Transaction cost cont’d
• Good intermediation contributes to the reduction of
financial costs.
• Government has a role in the provision of an enabling
environment that reduces transaction cost:
– Provision of sound regulatory environment
– Enforcement of property rights
• Components of transaction cost:
– Search cost
– Enforcement
– Measurement etc
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Economics of contract
• The relationships in the financial market is governed by
a number of contracts.
• Market participants and the markets themselves are
regulated by contracts.
• Contracts are often not perfect but efforts can be made
to produce efficient and workable contracts.
• Complete contracts addresses every foreseeable
contingency. But they don’t exist.
• Legally incomplete contracts are contracts based on
available information and sometimes unverifiable
information.
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Economics of contracts cont’d
• The cost of the design and enforcement of contracts may be
reduced with good legal and institutional infrastructure.
• Incomplete contracts have a negative impact on transaction
costs.
• The differentiation of formal economies from informal ones is
largely dependent on whether the design and enforcement of
contract is achieved in a formal way or in an informal way.
• The principal-agent phenomenon is another factor that has an
impact on transaction cost
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The Principal-agent Problem
• Also referred to as the agency dilemma based on the
work of Ross (1973) and Jensen and Meckling (1976).
• The theory describes the challenges from conditions of
asymmetry of information when a principal hires an
agent.
• The principal and agent usually don’t have the same
set of motivations.
• But the agent is supposed to pursue the interest of the
principal.
• Mechanisms are adopted to ensure the alignment of
the motivations of the two parties.
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Principal-agent theory, cont’d.
• Tools to ensure that the agent pursues the
interest of the principal include:
–
–
–
–
Commissions
Profit sharing
Performance contracts
Share options (sometimes taken to absurd levels)
• “fat cat” pay. On top of salaries executives usually receive
share options. The right to acquire shares in the company at
some point in the future at concessionary rates if certain
targets are met.
– Threats of dismissal
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Principal-agent problem cont’d
• Separation of corporate ownership and
control comes with agency costs.
• The principal-agent problem is largely due to
information asymmetry between the agent
and the principal.
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Asymmetric Information
• This is related to decision making in transactions when one party
has more or better information than the other.
• Akerlof (1970) forms the basis of the theory regarding asymmetric
information.
– “The market for lemons: qualitative uncertainty and the market
mechanism”.
• Asymmetric information explains to a large extent the inefficiencies
in the financial markets in which DFIs operate.
• Akerlof argues that asymmetric information explains the existence
of the adverse selection problem.
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Information asymmetric cont’d
• The absence of equal access to information by the two parties
involved in a transaction also constitute information
asymmetry.
• There may also be unequal capacities to process available
information.
• Information asymmetry is very important issue for an efficient
credit market.
• Absence of effective credit markets do not promote
entrepreneurship.
• The availability of credit promotes economic growth (Levine
et al, 2000).
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Information asymmetry – cont’d.
• One of the key financial market where information asymmetry
is important is the credit market.
• Developing country markets faces higher information
asymmetry and that is reflected in the size of the credit
markets.
• Domestic credit to the private sector in most developed
countries is over 100% of GDP.
• The figure is around 20% for most countries in Africa.
• Tanzania, 16%; Senegal, 24% and Zambia, 15%.
• Mauritius , 88%; SA, 145%.
• US, 190%; UK, 210%
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Information asymmetry cont’d
• Low credit levels is not entirely due to resource availability in
the banking sector, its also because a small proportion of the
total deposit mobilised is lent out.
• The existence of high degree of information asymmetry
means prospective lenders are unable to figure which
borrowers are credit worthy.
• Information asymmetry partly accounts for market
imperfections or inefficiencies that characterise financial
markets in developing countries.
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Adverse selection
• It arises from information asymmetry in a financial market,
such as the credit market.
• It is the challenge that confronts a lender in distinguishing
between good-risk and bad-risk investments, because the
borrower has information that the lender does not.
• Also refers to a market process in which bad results occur due
to information asymmetries between buyers and sellers.
• The "bad" products or customers are more likely to be
selected. Hence the term “adverse selection”
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Adverse selection problem: Example 1
• If consumers are unable to determine the quality
of a product because they lack full information,
they pay an average price.
• Because of the average price offered prospective
sellers of quality products lack the incentive to
offer their products for sale.
• Sellers of bad products, “lemons”, sell their bad
products at the price offered by consumers,
hence, the term adverse selection.
• Bad products are offered because the sellers
don’t have much to loose.
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Adverse selection: Example 2
• If investors can’t figure out the correct value
of firms they offer to pay an average price for
equity in those firms.
• Good firms will not offer to sell equity because
they expect higher than average valuations.
• Bad firms rather offer equity for sale
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Moral hazard
• Moral hazard ensues when a party insulated from
risk has the incentive to behave differently than it
would behave if it were fully exposed to the risk.
• It may also be seen as an example of information
asymmetry where a contract or relationship places
incentives upon one party to take (or not take)
unobservable steps which are prejudicial to another
party.
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Example of moral hazard problem
• Securitisation of sub-prime mortgages.
– Securitisation is the process by which a company packages
or bundles its illiquid assets into a security.
• An example of risk transfer that has serious moral
hazard implications.
• When banks traditionally underwrite mortgages they
bear the full risk of default, if the mortgages are
bundled and sold the risk of default is transferred.
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A view on subprime mortgages
• “even the doziest mortgage broker can originate
subprime mortgages for even the least creditworthy
borrowers. The fact that the borrowers are incapable of
making payments on the mortgage will magically be
priced into the mortgage by the securitization process,
which will bundle the mortgage with other mortgages
originated by a similarly lax process and sell the lot to an
unsuspecting German Landesbank attracted by the high
initial yield. Everyone will make fees on the deal,
everyone will be happy” [Hutchinson 2008].
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Moral hazard problem of too big to fail
Source: The Economist.
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Concluding Remarks
• Financial development in most of Sub Saharan is not well
developed, the markets are also fragmented.
• Low level of economic development in Africa may be in part due to
the poor state of the financial system.
• Transaction cost and information asymmetry are some of the
leading factors that account for the low level of financial
intermediation.
• The phenomena are responsible to a large extent the credit market
imperfection associated with developing countries.
• Policy measures that seek to foster efficiency in the financial market
will have to include measures aimed at:
– Enhancing transparency in the operations of financial institutions
– Reduction of transaction cost from the perspective of both sides of the
market.
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