Financial Crisis and Stock Markets: Issues, Impact, and Policies* by Lemma W.

Senbet
University of Maryland

Amar Gande
Southern Methodist University

Abstract
The financial crisis stemming from the burst of the housing and credit bubble lead to a shutdown of the credit markets and spread around the globe, with the resultant massive destruction of equity and real estate wealth. The drastic crisis of investor confidence triggered massive selloffs in the stock markets around the world. The adverse consequences of the crisis have been transmitted both through the financial and real sectors, 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 has engendered collateral damage to several countries without fault of their own. This policyoriented piece focuses on the stock markets from various regions and assesses the impact of the crisis broadly and, in more specific terms, the macro and country factors contributing to the impact. In particular, we examine the comparative stock market performance across countries during the pre-crisis and post-crisis period both in absolute and risk-adjusted terms. These performance metrics are then related to a variety of factors, such as institutional investor ratings, sectoral concentration, market depth and liquidity. We will then draw lessons from the crisis to come up with long term policy reforms which are also partly guided by the root causes as detailed in the beginning section of the paper.

*Preliminary: Not for Quotation

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

I. Introduction
The financial crisis stemming from the burst of the housing and credit bubble lead to a shutdown of the credit markets and spread around the globe, with the resultant massive destruction of equity and real estate wealth. The drastic crisis of investor confidence triggered massive selloffs in the stock markets around the world. The markets, which were integrated into the global financial economy, got hit first. However, even those which were weakly integrated got adversely affected due to transmission of the crisis through the real sectors. The real sector transmission of the crisis has manifested itself in the plunge of exports and commodity prices due to the slump in global demand, shrinkage in foreign direct investments and portfolio flows. On the financing side, the global crisis of confidence lead to a sharp rise in cost of borrowing in the credit markets, with a rationing of emerging and pre-emerging economies out of the credit markets altogether. The global crisis is unlike anything we have witnessed since the Great Depression, and every region of the globe has been hit. The global slump in demand and plunging global trade has hurt countries in East Asia and Latin America. Eastern and Central European countries, such as Hungary, the Czech Republic, and Poland got hit even harder as a result of diminishing exports to Western Europe. They also got caught up caught up in the misfortunes of major European banks which themselves had experienced huge losses due 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 capital flows 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-bills rose by $456 billion in 2008, almost to the same magnitude as the decline in private capital flows to emerging economies. Ironically, the US Treasury securities benefitted from the US being the epicenter of the global financial crisis. At the global aggregate level, the IMF and the World Bank figures indicate that the world economic growth moving into a negative territory, the worst economic performance of generations. Moreover, according to the newly released World Bank report, the global economy would shrink in 2009.2 The dramatic global crisis has resulted in dramatic responses by the governments around the world, particularly of the G-20 countries. In particular, the more advanced countries have committed staggering resources to the tune of trillions of US dollars in the form of fiscal 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 2

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

In the stock equity sector, the selloffs and plunging stock prices have resulted in massive destruction of equity wealth around the globe. This paper will focus on the stock markets and assesses the damage and the macro and specific country factors contributing to this impact. In particular, we examine the comparative stock market performance across countries 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 institutional investor ratings, sectoral concentration, market depth and liquidity. We will then draw lessons from the crisis to come up with long term policy responses. To guide the policy prescriptions for building capacity of the stock markets, we motivate our analysis based on the available evidence that provides a positive linkage between stock market development and economic development. It turns out that multiple functions that stock markets perform provide a channel for this linkage; beyond savings mobilization, the stock markets are avenues for risk sharing, price discovery, promotion of 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 markets and help reduce the frequency and severity of financial crisis in the future. At the heart of these guides are risk management capacity, best practices in corporate governance, design features of executive compensation, market-based privatizations, stock market consolidations (where they are thin) through regional cooperation, financial literacy in private and regulatory circles, etc. Moreover, based on the argument for complementarity between stock market development and a well-functioning banking system, policy guides include reforms in capital regulation and systemic regulation as inspired by the current crisis. The global crisis has revealed serious gaps in oversight of systemically critical institutions, such as AIG in the US, which built up excessively high, yet non-transparent (e.g., credit default swaps) 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 which were outside the traditional regulatory structure, but they grew to a point where their failure 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 one large country can adversely affect other regions, calling for an era of globalized reforms of the financial systems, including stock markets. The paper is organized as follows. Section II provides an overview of the root causes of the 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 prevention of 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 stock market economy. A particular attention is on the linkage between stock market development and economic development. Section IV provides an analysis of the stock market 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 2

of stock market sensitivity to the crisis. Section V catalogues a series of long-term reforms to develop and build capacity of stock markets in mitigating the severity and frequency 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 factors have emerged that have contributed to the build-up of the excesses that devolved into the largest financial crisis in recent memory. The collapse of the venerable financial institution, Lehman Brothers, and its filing for bankruptcy on September 15, 2008 sparked a massive loss of confidence in the credit and stock markets. In fact, this lead to a complete shutdown of the credit markets. Many have argued that the sudden reversal of fortunes in the financial markets in September 2008 was rooted in the unsustainable housing bubble that began bursting in 2006. However, the housing bubble was not accidental, and it was accompanied by a credit (mortgage boom), excessive leverage in the financial sector, an era of low interest rates and easy money, complex securitization of 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 global dimension of the crisis is astounding. In part, it is related to the exposure of the rest of the world to the US housing market through holdings of mortgage backed securities. These mortgage backed securities (MBS) derive value from the underlying mortgages and were sold around the world. Thus, through this vehicle, the US housing market got globalized, 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, with the collapse of the stock markets resulting in massive loss of equity wealth. The damage spread quickly to those stock markets which are integrated into the global financial economy, but in a short span of time, through transmission through the real sectors, it got to those countries which were not even that integrated globally. In this section we will attempt 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 alltime high in 2006. Over a ten-year period ending in 2006, a typical house had increased about 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 since 2000 to about US $15 trillion.

Figure 1: House Bubble and Bust

An important component of the mortgage credit was in the form of sub-prime lending targeted to borrowers providing little or no down payment, and with those questionable and troubled credit histories, and minimal income requirement for loan origination. In 2006, the booming sub-prime market reached 25% of all mortgages. Subprimes were typically adjustable rate mortgages with low initial teaser rates but can be reset to higher interest rates over time due to rising interest rates or expiring teaser periods. . As monthly repayments go up, more mortgages could go into default. Further, financial institutions pool both prime and subprime mortgages and issue securities backed by these mortgage 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 the mortgages. At the beginning of the burst of the bubble, about 25% of the subprime mortgages were in delinquency, and the estimate was that 12 million borrowers had negative net worth. The crisis in the subprime market came in the open when many subprime 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 this massive global crisis. As we know now from September 2008 (Black September), the 4

mortgage market collapsed altogether with most of the values of the MBS backed by subprime evaporating, with increasing crisis of confidence in the credit market. . Spreads relative to LIBOR skyrocketed. Even the LIBOR itself shot up. The credit market effectively froze! B. Excessive leverage and too big to fail When major financial institutions and banks began reporting huge losses resulting mainly from mortgage backed securities, the global panic ensued with a flight to safety from even 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 by financial 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 and simultaneous collapse of Wall Street institutions (see Table 1). This triggered staggering government intervention unseen for generations.
[Table 1 (Black September) goes here]

Table 1 lists financial institutions characterizing massive failures, and these institutions were deemed too big to fail or systemically critical. As the table shows, they were also hugely levered. Take the case of two giants - Fannie Mae and AIG. Fannie is a massive government sponsored agency (GSE) which is at the center of the mortgage pooling and securitization. It operated with implicit government guarantees but outside the formal regulatory scheme. AIG is the largest insurance company in the world and completely private prior to government bailout. What are the commonalities between these two giants? 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 of the $11 trillion mortgages outstanding when the trouble got uncovered in September 2008. 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 products division. It also became huge with about $1 trillion assets in 2008. Its financial products division sold credit default swaps (CDS) to insure debt holders against defaults, focusing on corporate and mortgage insurance. AIG emerged as a central player of the CDS market which is huge with trillions of dollars in notional values. In fact, at the height of the boom, it was estimated that the AIG credit default swap portfolio reached over $400 billion, which then brought down the company when the mortgage market collapsed. Thus, as Table 1 shows not only are these troubled institutions deemed too big to fail or systemically 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 had only $80 billion of equity to support $1 trillion of assets. The government intervened when both Fannie Mae and AIG were on the verge of collapse. The government rescue of Fannie Mae was triggered by systemic implications of the collapse, leading to potential collapse of small financial institutions and banks which are holders of mortgage backed 5

TABLE 1 Black September

( As of September 29, 2008)

Institution Fannie Mae AIG Equity ($billion) 55.00 80.00 Assets ($billion) 3,000.00 1,000.00 Source Mortgages Insurance, Credit default swaps, Sub-prime crisis; run/panic Mortgages Mortgages Mortgages Mortgages Mortgages Mortgages

Bear Stearns Lehman Merril Lynch Lehman WAMU Indymac Wachovia

18.00 28.00 35.00 28.00 26.00 1.00 75.00

400.00 639.00 1,000.00 639.00 310.00 32.00 812.00

securities issued by Fannie Mae, further credit crunch in the housing market, and further decline in housing prices. Similarly, there was a concern that the counterparts to AIG would 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 financial economy, 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 exchange the government took positions through holdings of warrants and/preferred stock in the companies. This is, of course, tantamount to partial nationalization. In the case of Fannie Mae, the entity effectively got transformed from being a government sponsored agency (GSE), with implicit government guarantee, into a government owned enterprise (GOE) with explicit guarantee. AIG also got partially nationalized, and at the time of the bailout the governments position amounted to 80% ownership interest in the firm.

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 in the form of excessive risk-taking by the institutions whose interests are not aligned with society when there are explicit or implicit guarantees (e.g., Fannie Mae). Depository institutions have typically explicit deposit insurance, but other institutions (e.g., Wall Street firms) may grow to be too big to fail or become interconnected. The latter falls under the category of implicit guarantee. Whether explicit or implicit, the guarantees increase incentives to take excessively risky assets relative to what is socially desirable. Weak corporate governance and flawed executive compensation contracts can further exacerbate the distorted incentives, allowing executive to be amply rewarded on the upside but escaping the downside. In fact, the current global crisis has drawn ample attention to the possibility that flawed compensation plans might have been among the causes of the global financial crisis by fostering a business environment of greed and excessive risk-taking. This concern was also expressed in the wake of the corporate scandals associated with the information technology 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 for the companies comprising the S&P 500 index. This amounted to about 500 times that of the 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 the increase 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 grants may have created incentives for aggressive risk behavior which is now being partly blamed for the current crisis.
3

Business Week ( September 11, 2000).

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

Average Executive Compensation of Top Firms

normalized to 1 in 1980
3 4 5 6 7 89 10 1 1970 2

1980

1990 Year Murphy_index

2000 Frydman_index

2010

D. Grade inflation With increasing complexity in financial innovation and mortgage backed securities, many have suggested that there was on an overreliance on credit rating agencies. The complex instruments were granted a blessing by these raters, but as it turns out they grossly underestimated the risks, with low risk securities receiving a seal of approval for AAA rating. These safe securities were purchased by investors around the world, including institutional investors, such as pension funds, mutual funds, and banks. The riskier securities were channeled to the hedge funds. Moreover, money funds are required by regulation 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 fostered absorption of enormous volume of securities. The sad story is that the ratings totally 8

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 at least two reasons for grade inflation: (a) the incentive structure facing the rating agencies and (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 securitization and financial innovation produced complex securities which were too hard and opaque to rate (see below). D. Complex and non-transparent financial innovation The 1990s saw financial innovation characterized by complex instruments, such as collateral debt obligations, credit default swaps, with the primary goal of transferring risk from 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 and transparency, 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 were sold around the world. Under mortgage securitization, individual mortgages were put into pools of assets out of which mortgage backed securities (MBS) are created. The pools are sold to special purpose vehicles (SPVs) which then finance them through complex securities involving multiple tranches. The payoffs to a tranche are derived from the principal and interest repayments, prepayments, and default risks of the underlying mortgages, but in a complex fashion. Tranche instruments were produced in a wide variety of forms but subject to few disclosure requirements. They became opaque and illiquid. That is why when the crisis surfaced; the market participants had no idea what these securities were really worth. Thus, the opacity and illiquidity created from complex securitization contributed to the freezing of the credit markets and a dramatic loss of investor confidence in the system. E. Easy money and global imbalance During the boom period, the Federal Reserve Board maintained short interest rates low despite the asset market bubble. These rates were sustained by global macroeconomic imbalances in trade and capital flows, with huge savings from export-led Asian economies that were being channeled to the US. The imbalances reflected excessive savings in many emerging economies, particularly East Asian economies, while the US saw shortage of savings, relative to investments. This imbalance was consequential. The US and some advanced economies saw massive capital inflows for about a decade despite low short and long-term interest rates.

III. Stock Markets: Finance Matters

In the wake of the collapse of Lehman Brothers, the stock market reacted brutally around the 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 policy makers and economists. Finance matters. Paradigms in economics do not pay much attention 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 current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behavior themselves, like amassing huge positions in mortgage-backed securities. The crisis has revealed their dark side. Since they also have good side, we cannot live without them. It would be useful to point out the positive dimension, particularly of the stock markets, before we discuss their vulnerability to outside shocks. Moving forward, we need to understand better the workings of the increasingly 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 stock market development and economic growth of countries. The available empirical evidence is that well-functioning stock markets, along with well-designed institutions and regulatory systems, foster economic growth. The evidence is particularly encouraging to those countries which have already established the stock markets or to those which are contemplating 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 in lowering the costs of mobilizing financial resources and in ensuring that these resources are allocated efficiently in the sense of being channeled to their highly valued use. The value creation from optimal resource allocation contributes to economic growth. One can begin with a broad observation linking stock market development with economic development. Broadly speaking, the available evidence is consistent with countries with better developed and deeper stock markets experiencing faster economic growth. In the seventies and eighties, for instance, most East Asian countries experienced high economic growth while most Latin American countries saw low growth. It was also observed, during the same period, that stock market capitalizations were higher in East Asia than in Latin America.
4

There is little research on this issue in the context of financial markets in the Middle East, although this region 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-rich countries.

10

B. Channels for linkage between stock market development and economic development 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 an exit strategy both for investors and issuing firms. Thus, liquidity is a crucial feature of stock market development. It also provides a channel for more efficient corporate governance and resource allocation, whereby resources are allocated to the most productive and innovative firms. The existing empirical evidence supports a positive linkage between stock market liquidity and economic growth; countries with more liquid markets 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 the multiple 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 vehicle for individuals to better meet their risk preferences and liquidity needs, potentially increasing the savings rate in the economy. Second, stock markets promote growth at the firm level, since the listed firm is now able to mobilize capital at a lower cost of capital as risk 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 is created 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 by selling their stock positions through the market. Fourth, stock markets can serve a vital governance function by exerting external pressure and discipline on management in an environment with imperfect information and incentive conflicts between corporate decision-makers and suppliers of capital. The price discovery function of the stock market is the key in this regard, since the market provides a signal for the quality of managerial performance. Moreover, the market price and information disclosure allows investors to uncover target firms for potential takeover by virtue of active trading of target shares. Once control is transferred, inefficient management may be removed and replaced by an alternative management team that responds to the interests of capital owners. What is even equally powerful is the threat of takeover which has a disciplining effect on management so as not be vulnerable to actual takeover. . C. Observed characteristics of stock markets The foregoing discussion has provided an economic rationale as to why stock markets matter. It is not their existence per se that matters, but the extent to which they provide multiple functions, such as capital mobilization, risk sharing, liquidity, and governance. Given that these functional characteristics are a channel for the linkage of stock market 11

and economic development, it would be useful to examine the observed characteristics of markets around various regions of the world. We will use indicators of these functions to characterize 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 is further augmented by G-20 countries, and select countries from the Dubai and Middle Eastern 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 the crisis 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 countries around the world. In particular, we present data on (a) the extent of stock market depth and development, proxied by the market capitalization, measured as a percentage of GDP, (b) the stock market liquidity measured by turnover (i.e., stock market value traded as a percentage of market capitalization), and (c) the number of listed companies in each of the sample countries.
[Table 4 (Stock Market Characteristics) goes here]

Several patterns emerge from Table 4. We find, on average, the market capitalization, as a 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 on average 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 (precrisis) since it bottomed in 1982 with the Dow Jones index then at 800. Other asset classes, including housing, did exceedingly well during that same period. Such prolonged asset boom periods clouded risk perception with an illusion that things would continue 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 countries covered in the S&P Emerging Markets Database (EMDB), which is further augmented by G20 countries, and select countries from the Dubai and middle east region.

Name of the country Argentina Australia Bahrain Bangladesh Bulgaria Botswana Brazil Canada Chile China Colombia Cte dIvoire Croatia Czech Republic Egypt Ecuador Estonia France Germany Ghana Hungary India Indonesia Italy Israel Jamaica Japan Jordan

Country Code ARG AUS BHR BGD BGR BWA BRA CAN CHL CHN COL CIV HRV CZE EGY ECU EST FRA DEU GHA HUN IND IDN ITA ISR JAM JPN JOR

Continent South America Australia Asia Asia Europe Africa South America North America South America Asia South America Africa Europe Europe Africa South America Europe Europe Europe Africa Europe Asia Asia Europe Asia South America Asia Asia

13

TABLE 2 (Continued) Sample Countries Country Code KWT KEN LVA KOR LBN LTU MYS MUS MEX MAR NAM NGA OMN PAK PER PHL POL ROU RUS SAU SVK SVN ZAF LKA TWN THA TTO TUN UKR TUR ARE GBR USA VEN ZWE

Name of the country Kuwait Kenya Latvia Korea Lebanon Lithuania Malaysia Mauritius Mexico Morocco Namibia Nigeria Oman Pakistan Peru Philippines Poland Romania Russia Saudi Arabia Slovak Republic Slovenia South Africa Sri Lanka Taiwan Province of China Thailand Trinidad and Tobago Tunisia Ukraine Turkey United Arab Emirates United Kingdom United States Venezuela Zimbabwe

Continent Asia Africa Europe Asia Asia Europe Asia Africa South America Africa Africa Africa Asia Asia South America Asia Europe Europe Asia Asia Europe Europe Africa Asia Asia Asia South America Africa Europe Europe Asia Europe North America South America 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 higher number indicates a lower level of country risk) from the Institutional Investor Magazine as of September 2007 and March 2009 that span the global financial crisis. The last column shows the change in the country credit rating during this period. Sept 2007 44.40 90.20 69.30 27.80 61.20 66.40 61.20 94.40 77.60 75.90 56.60 20.10 60.60 74.40 51.40 33.00 71.40 94.00 94.80 37.60 66.00 62.30 50.20 85.40 68.30 36.20 89.80 44.80 74.90 30.60 March 2009 28.30 86.70 68.20 25.10 54.10 66.90 62.50 91.60 76.70 74.10 55.30 19.40 57.60 74.70 49.90 25.60 61.00 91.50 92.60 34.40 59.20 59.90 47.50 79.40 67.80 32.80 85.70 43.80 74.40 26.80 Change (%) -56.89 -4.04 -1.61 -10.76 -13.12 0.75 2.08 -3.06 -1.17 -2.43 -2.35 -3.61 -5.21 0.40 -3.01 -28.91 -17.05 -2.73 -2.38 -9.30 -11.49 -4.01 -5.68 -7.56 -0.74 -10.37 -4.78 -2.28 -0.67 -14.18

Name of the country Argentina Australia Bahrain Bangladesh Bulgaria Botswana Brazil Canada Chile China Colombia Cte dIvoire Croatia Czech Republic Egypt Ecuador Estonia France Germany Ghana Hungary India Indonesia Italy Israel Jamaica Japan Jordan Kuwait Kenya

15

TABLE 3 (Continued) Institutional Investor Country Credit Ratings (Scale of 0-100) Sept 2007 65.00 79.40 28.70 67.90 72.80 56.20 70.00 54.20 50.20 40.00 69.10 40.20 58.20 52.20 71.20 59.30 67.50 69.60 70.90 81.60 66.70 33.50 81.30 64.10 65.20 60.70 47.90 51.70 76.80 94.40 94.10 45.10 8.00 61.66 65.00 March 2009 55.20 72.60 26.10 59.80 70.30 55.40 65.70 53.70 49.70 35.50 69.80 21.90 58.80 47.10 71.50 52.50 64.60 72.40 73.60 81.50 61.10 30.80 78.80 59.60 65.20 58.70 35.60 49.00 76.00 88.50 88.00 40.70 4.60 58.22 59.80 Change (%) -17.75 -9.37 -9.96 -13.55 -3.56 -1.44 -6.54 -0.93 -1.01 -12.68 1.00 -83.56 1.02 -10.83 0.42 -12.95 -4.49 3.87 3.67 -0.12 -9.17 -8.77 -3.17 -7.55 0.00 -3.41 -34.55 -5.51 -1.05 -6.67 -6.93 -10.81 -73.91 -5.91 -8.70

Name of the country Latvia Korea Lebanon Lithuania Malaysia Mauritius Mexico Morocco Namibia Nigeria Oman Pakistan Peru Philippines Poland Romania Russia Saudi Arabia Slovak Republic Slovenia South Africa Sri Lanka Taiwan Province of China Thailand Trinidad and Tobago Tunisia Ukraine Turkey United Arab Emirates United Kingdom United States Venezuela Zimbabwe Average Median

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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 value traded, measured as a percentage of market capitalization, and (c) the number of listed companies. 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 2007 2008 33.03 15.93 158.16 66.55 NA NA 9.93 8.44 55.10 17.75 47.77 27.42 102.78 36.55 164.42 71.58 129.92 78.15 197.31 72.37 49.07 35.92 42.20 30.20 112.67 38.64 42.21 22.57 106.75 52.75 9.32 8.68 28.81 8.45 107.00 52.31 63.47 30.33 15.88 21.05 34.34 12.01 154.57 53.02 49.01 19.20 51.04 22.71 144.16 67.40 94.37 49.86 101.58 65.60 249.31 179.11 167.72 NA 49.67 31.64 17 Turnover 2007 2008 9.90 19.31 110.50 103.06 6.60 12.00 92.30 137.26 34.20 10.77 2.20 3.05 56.20 74.27 84.70 123.72 23.00 21.17 180.10 121.30 13.10 13.21 2.50 4.08 8.60 7.42 68.70 70.39 45.60 61.85 7.00 3.55 34.90 25.40 131.50 152.45 179.70 191.54 3.90 5.19 106.00 93.01 84.00 85.19 64.40 71.30 220.40 284.24 55.40 58.87 2.90 3.65 141.60 153.23 49.10 72.69 76.20 83.16 10.60 11.83 Listed Cos. 2007 2008 107 107 1,913 1,924 43 45 278 290 369 334 18 19 442 432 3,881 3,755 238 235 1,530 1,604 96 96 38 38 353 376 32 28 435 373 35 38 18 18 707 966 658 638 32 35 41 41 4,887 4,921 383 396 301 294 654 630 41 39 3,844 3,299 245 262 181 202 51 53

Name of the country Argentina Australia Bahrain Bangladesh Bulgaria Botswana Brazil Canada Chile China Colombia Cte dIvoire Croatia Czech Republic Egypt Ecuador Estonia France Germany Ghana Hungary India Indonesia Italy Israel Jamaica Japan Jordan Kuwait Kenya

TABLE 4 (Continued) Stock Market Characteristics Mkt Cap/GDP 2007 2008 10.82 4.76 107.09 53.24 43.90 33.64 26.06 7.66 174.41 95.97 83.48 39.79 38.89 21.42 100.50 76.16 8.05 7.22 52.04 23.48 NA NA 49.17 13.96 98.76 43.65 71.66 31.22 48.81 17.12 116.51 82.21 134.29 52.68 9.30 5.35 61.39 21.55 293.77 177.51 23.34 10.62 82.85 39.35 74.75 50.87 15.29 15.86 78.31 13.51 43.69 14.85 NA NA 139.19 70.00 145.06 82.63 NA NA NA NA 83.98 41.86 67.57 31.64 Turnover 2007 2008 4.80 1.79 201.60 181.18 10.40 6.88 10.10 59.86 53.50 33.24 8.00 8.85 31.00 34.33 42.10 31.05 3.70 2.84 28.20 29.30 27.70 44.24 173.50 115.96 8.80 6.33 34.10 22.16 47.50 45.68 58.90 75.02 161.50 137.82 0.50 0.37 12.30 6.91 55.00 60.61 12.40 17.21 64.20 78.20 2.30 2.55 13.30 25.48 2.60 3.73 134.70 118.52 82.80 89.85 270.10 226.85 216.50 232.26 1.34 NA 5.10 NA 60.40 64.02 34.90 44.24 Listed Cos. 2007 2008 41 35 1,767 1,798 11 11 40 41 1,036 977 90 41 125 125 74 77 9 7 212 213 125 127 654 653 190 199 242 244 328 349 328 314 111 127 153 120 87 84 422 425 235 234 475 476 37 37 50 49 276 251 319 284 90 96 2,588 2,415 5,130 5,603 60 60 82 81 610 607 212 213

Name of the country Latvia Korea Lebanon Lithuania Malaysia Mauritius Mexico Morocco Namibia Nigeria Oman Pakistan Peru Philippines Poland Russia Saudi Arabia Slovak Republic Slovenia South Africa Sri Lanka Thailand Trinidad and Tobago Tunisia Ukraine Turkey United Arab Emirates United Kingdom United States Venezuela Zimbabwe Average Median

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Table 5 presents the stock market performance during the pre-crisis period. We choose September 2005 thru December 2006 (16 months) as the pre-crisis period to facilitate comparison with return performance during the crisis period, characterized by a 16month 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 BRIC countries (i.e., Brazil, Russia, India and China) each experienced more than 50% increase during 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 just in the US alone. The stock markets declines in 2008 were 37% in the US, 38% in Latin America, 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 become decoupled from the cycles of the more advanced countries. In fact, initially it appeared that they were unaffected by initial 2007 sub-prime crisis, fueling the conventional wisdom. However, they too got hit eventually by the global crisis. Even the oil-rich Gulf States and Russia, which were thought of being immune to the crises in the US and the advanced countries, suffered a dramatic crisis of confidence. The right panel of Table 5 presents the stock market performance of our sample countries during 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 more than 50% during the crisis period. Each of the BRIC countries dropped much more than 50% during the crisis period, giving up a large part of the gains they made during the precrisis period. C. Determinants of stock market performance So far we have looked at the pre-crisis and crisis performance, but to gain a better understanding of the performance-crisis sensitivity, we next investigate the likely determinants of the stock market performance during the pre-crisis and crisis periods. We describe the variables below and the expected sign of our coefficients.

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 stock market return, as proxied by the Sharpe Ratio. We obtain the underlying data from Datastream. We present this data for a 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. Pre-Crisis Period Return (%) Sharpe Ratio 53.96 1.18 35.28 1.63 7.07 0.27 11.00 0.56 22.77 0.93 59.01 2.04 72.16 1.54 25.14 1.05 29.01 1.55 95.20 3.24 54.26 1.16 59.48 1.68 88.99 2.66 42.87 1.28 35.31 0.79 37.05 2.58 28.89 1.08 36.72 1.96 44.69 2.18 6.13 0.89 14.81 0.50 67.61 1.96 94.23 2.27 31.22 1.91 10.76 0.35 -4.04 -0.73 24.64 1.21 -34.99 -1.33 11.34 0.43 72.22 2.69 20 Crisis Period Return (%) Sharpe Ratio -70.01 -2.01 -66.39 -3.11 -51.04 -1.83 -0.31 -0.43 -79.94 -3.73 -51.36 -2.66 -58.59 -1.47 -59.06 -2.40 -41.41 -1.95 -58.47 -1.80 -37.32 -1.03 -28.37 -0.96 -63.21 -2.39 -60.04 -1.81 -61.16 -1.78 -6.82 -0.53 -73.29 -2.94 -58.75 -3.16 -61.92 -2.98 -32.52 -1.28 -77.32 -2.80 -67.07 -2.00 -66.07 -2.07 -66.81 -4.17 -31.51 -1.36 -38.65 -1.42 -45.85 -3.65 -27.83 -0.65 -63.74 -3.29 -51.49 -0.73

Name of the country Argentina Australia Bahrain Bangladesh Bulgaria Botswana Brazil Canada Chile China Colombia Cte dIvoire Croatia Czech Republic Egypt Ecuador Estonia France Germany Ghana Hungary India Indonesia Italy Israel Jamaica Japan Jordan Kuwait Kenya

TABLE 5 (Continued) Stock Market Performance Pre-Crisis Period Return (%) Sharpe Ratio 19.07 0.81 47.94 1.41 28.89 0.85 9.74 0.36 32.80 1.82 48.18 2.25 75.31 2.35 86.01 2.20 24.92 0.74 50.24 1.69 -0.18 -0.23 27.94 0.66 103.85 2.40 70.66 2.67 56.12 1.39 67.73 1.07 111.19 2.08 -39.76 -0.52 20.56 0.62 90.22 2.98 41.18 1.23 33.79 1.09 28.89 1.05 13.58 0.46 -9.12 -1.17 51.19 2.40 NA -1.98 19.64 0.63 -44.46 -1.29 28.17 1.82 16.40 1.15 89.66 1.86 38.25 1.20 33.79 1.20 Crisis Period Return (%) Sharpe Ratio -76.30 -3.71 -69.18 -3.23 -16.83 0.55 -78.34 -3.01 -46.44 -2.34 -56.87 -1.00 -58.48 -2.55 -22.08 -0.84 -15.66 -0.63 -64.45 -2.13 -40.84 0.10 -73.13 -2.33 -48.86 -1.63 -55.50 -2.52 -76.94 -3.19 -89.87 -3.21 -75.43 -2.26 -47.16 -0.90 -46.40 -1.25 -53.66 -2.04 -57.06 -2.19 -47.23 -3.33 -57.82 -2.31 -56.98 -2.05 -7.32 0.25 -4.69 0.69 -88.81 -4.45 -71.26 -1.90 -70.79 -2.34 -60.76 -4.17 -52.67 -3.62 -35.50 -1.09 -52.90 -2.05 -57.44 -2.06

Name of the country Latvia Korea Lebanon Lithuania Malaysia Mauritius Mexico Morocco Namibia Nigeria Oman Pakistan Peru Philippines Poland Romania Russia Saudi Arabia Slovak Republic Slovenia South Africa Sri Lanka Taiwan Province of China Thailand Trinidad and Tobago Tunisia Ukraine Turkey United Arab Emirates United Kingdom United States Venezuela Average Median

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Change in II Credit Rating: We measure the change in Institutional Investor country credit rating, as a percentage from the pre-crisis level during the crisis period. We expect a 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 positive relationship between stock market turnover and the stock market performance. However, during crisis periods, we could see the `darker side of liquidity as investors first pull money out of the most liquid markets rather than the most risky markets, simply because it is easier to do so. If the `darker side of liquidity were to prevail, we expect a negative relationship between stock market turnover and stock market performance during the crisis 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 in this paper, we expect a positive relationship between private credit/GDP and the stock market performance. However, if the banks were an important channel of propagation of the 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 a value of one if our sample country produces more than a million barrels per day, and zero otherwise. While we do not have specific predictions on this coefficient, this variable captures if a sample countrys performance could be explained by its exposure to the oil sector, as measured by this variable. Market Cap/GDP: We use market capitalization, measured as a percentage of GDP from the World Development Indicators (WDI) database to proxy for the level of financial market 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 variables described 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 recent financial crisis, we find that the correlation changes from positive in the pre-crisis period to 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.

TABLE 6 Correlations in Pre-Crisis and Crisis Periods

This table presents the correlation matrix of the variables that we use in the regression analysis in Table 6. These variables are described in more detail in the 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.

Variable Name Stock Mkt. Return Change in II Rating Turnover Ratio Private Credit/GDP Oil Producer Market Cap./GDP

Stock Mkt. Return 1.0000 0.2934 -0.2243 0.1907 0.0391 -0.2143

Change in II Rating 1.0000 -0.0811 0.1680 0.1952 -0.2171

Panel A: Pre-Crisis Period Turnover Private Ratio Credit/GDP

Oil Producer

Market Cap./GDP

1.0000 -0.2182 0.2491 0.2659

1.0000 -0.1214 -0.1520

1.0000 0.1888

1.0000

Variable Name Stock Mkt. Return Change in II Rating Turnover Ratio Private Credit/GDP Oil Producer Market Cap./GDP

Stock Mkt. Return 1.0000 0.2322 -0.2830 -0.2802 -0.1396 -0.0985

Change in II Rating 1.0000 0.0169 -0.0836 0.1556 0.2396

Panel B: Crisis Period Turnover Private Ratio Credit/GDP

Oil Producer

Market Cap./GDP

1.0000 -0.2319 0.3259 0.3258

1.0000 -0.1259 -0.0930

1.0000 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 of regressions, where the dependent variable is the stock market performance during the precrisis 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-statistics associated with the ordinary least squares estimates are adjusted for heteroscedasticity.

Pre-Crisis Period Variable Intercept Change in II Rating Turnover Ratio Private Credit/GDP Oil Producer Market Cap./GDP Adjusted R-square Coeff. 38.965 0.766 -0.083 0.416 7.025 -0.080 0.072 t -Stat. 4.85 1.76 -1.11 0.80 0.50 -1.06

Crisis Period Coeff. -37.022 0.309 -0.092 -0.603 -6.946 -0.016 0.205 t -Stat. -6.06 2.12 -2.74 -3.93 -1.55 -0.37

Our evidence in Table 7 shows that, as expected, the change in institutional investor country credit rating is an important determinant of the stock market performance, both during the pre-crisis and the post-crisis periods. The coefficients are statistically significant at the 10% level (t-stat 1.76) during the pre-crisis period and at 5% level (t-stat 2.12) during the crisis period. We also find evidence consistent with the dark side of liquidity during crisis periods. That is, the coefficient of stock market turnover is negative and statistically significant at the 1% level (t-stat -2.74). In contrast, this variable 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 sector development and stock market performance. Nevertheless, given that the bank channel was an important propagating mechanism during the recent financial crisis, we find evidence 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 the global economy is recovering, but it still expects to contract in 2009. The expectation is that the global economy will contract by 1.1 per cent in 2009. The IMF expects that the global economy will then grow by 3.1 per cent in 2010. However, these forecasts are conditioned 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, giving rise to a surge in stock market performance around the world. In the US, the blue chip index has stunningly gone up 50% since its low in early March. It is now approaching 10,000, but it still remains sharply below its peak of over 14,000 in October 2007 over 30% loss. Is the glass half full or half empty? Given that the recession has virtually ended, the sharp rally since March is defensible on the basis of fundamentals and the markets expectation of recovery moving forward. On the negative side, of course, there is 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, emerging markets rose faster than the US market in the pre-crisis period but fell faster and further than the US last year now going up further and faster than the US this year. The MSCI Emerging Market index, which tracks emerging-markets shares, has skyrocketed, relative the US market [61% versus 11%] since the beginning of this year. Again, the behavior of emerging markets, such as Brazil, Mexico, China, and India, can be rationalized on the basis of fundamentals, since they have better growth opportunities than the mature advanced countries. There are, of course, possibly higher risks which are being masked

IMF, World Economic Outlook, October 2009.

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by the rally, since accounting standards, governance, and disclosure tend to be weaker in these markets. In the policy section we will discuss measures for improved capacity of emerging 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 spreading all over the globe. What is disturbing is that there is no commensurate globalization of resources 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 other financial institutions and to stimulate growth. During that same period, loan guarantees amounted to $2.7 trillion globally.7 More recently, the US has committed an additional stimulus package of about $800 billion and very likely to commit more resources to clean up the toxic assets and to restructure banks. Thus, staggering quantities of resources have been committed around the world.

BW (12-1-08).

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In addition, efforts are under way for a new global financial order. The IMF has emerged as a central player both in policy responses to crises and financial system reforms moving forward.8 For sure, as witnessed in the most recent G20 summits, the more powerful emerging economies, such as China, India, Brazil, and South Africa will be gaining more say 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 the more powerful countries. Moreover, under the evolving global regulatory environment, emerging countries should be full participants in the design of mechanisms for oversight and regulation of globally systemic financial institutions. Below we catalogue a variety of longer term reforms to foster well functioning stock markets that help mitigate the severity and frequency of future financial crises. Based on the 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 and then 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 future crises. Countries should position themselves strongly in terms of reforms when they move back into a growth path again as the global economy recovers. Therefore, it is now an opportune time to put into place an efficient system of mechanisms for crisis resolution 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 regulatory framework prior to the onset of the global crisis. The mechanism calls for accurate identification of viable but undercapitalized institutions. Moreover, the approach targets institutions rather than instruments to address the capital and credit crunch. There is a good rationale for capital injection (government intervention). These institutions face stress due to market panic, although they are fundamentally viable and not be subject to liquidation. Of course, the government should seek quid pro quo in the form of partial stake through holdings of preferred stock and warrants. In fact, it can be argued that the warrants held by the government have a desirable feature of mitigating bank incentives for excessive risk taking. Second, the government can purchase illiquid (toxic) securities off the bank balance sheets rather than, or in addition to, direct capital injection. The government has a special advantage 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 a few years back as its client base dwindled. Thus, the IMF is rescued by the global crisis. . The Funds resource 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 markets stabilize. 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 toward capital 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 a comprehensive 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 of decision makers in the banking and the overall financial system. The current crisis inspires 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 risk opportunities and they should not be one size fits all. Different banks are likely to maximize the socially desirable level of bank value at different levels of risks, and capital standards should be differentiated to reflect that. This has implications for global capital standards 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 crisis makes 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 assets that are financed, in addition to the capital position. Second, shadow banks should be brought under the same regulatory umbrella as traditional banks. The current crisis has exposed that financial systems breed institutions which are complex with functions similar to what banks do. Traditional banks basically accept deposits and lend to transform deposits into longer term assets. It turns out that there 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 dynamic financial systems innovate, there will be more such shadow banks, but the regulatory system should be integrated to treat them similarly to the other banks. Third, apart from shadow banks, the crisis has revealed an emergence of systemically critical or interconnected institutions and entities that can hostage the entire global financial system with adverse consequences on economic systems around the world. This is an opportune time to think about the design of systemic regulation. The current capital standards are inadequate in dealing with systemic risk. There is a growing consensus for some type of systemic regulation, but the debate on how it should be designed is unsettled. Systemic risk is easier to define than measure, since it is quite a challenge to measure the impact of an institution to the potential failure of the entire system? However, any such measure should have such determinants as size,

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interconnectedness, and complexity. Conditioned on such a measure, capital standards will 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 to facilitate 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 to inadvertently generate diseconomies of scale. Second, smaller institutions, betting on highly correlated activities (e.g., banks betting on house prices) can engender similar contagion and systemic failure of the system. 3. Reforming stock market regulatory and legal regime Informational efficiency and public confidence through transparent and credible financial disclosure rules are vital for the functioning of stock markets. Financial statements should be trusted and transparent about firms listed on the stock exchanges. Legislation alone cannot 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 strict enforcement 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 is supported by the available literature. For instance, Lombardo and Pagano (2000) underscore the impact of institutional quality on the stock markets and provide evidence that stock market returns are positively related to respect for law, lack of government corruption, 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 of these markets. It means that the government fosters an environment for strict enforceability of private contracts and transparent accounting disclosures and procedures, consistent with best international practices. Moreover, the regulatory system should include a strong securities and exchange commission capable of enforcing securities laws and developing its own self-regulatory rules. It is to be recognized, though, that government regulation of stock markets should be more 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. Selfregulatory organizations formulate rules for business and professional conduct of their members 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 without quality corporate governance. Although privatization programs bring companies to a

29

disciplinary force of the stock market system, corporate insiders may still engage in activities harmful to capital contributors. Once investors lose confidence in corporate governance, the companys ability to raise funds and grow will be impaired. Countries, which are committed to the stock market economy, should strengthen institutions for corporate governance and adopt best international practices in terms of measures for the effectiveness of the corporate board, executive compensation practices, a system of disclosure rules, and increased protection of shareholder rights against controlling shareholders/management. First, it should be recognized that best practices in corporate governance call for a separation of the role of the government as a regulator and business operator, and fostering board independence through a majority non-executive directors. The growing consensus around the globe is that the corporate board be independent of the chief executive officer. Moreover, the compensation committee should be composed of independent directors to bring transparency and prevent ill-designed compensation structures that promote aggressive risk behavior that leads to instability and crisis. Finally, the stock exchanges themselves, in their role as self-regulators, should establish standards for listing of companies, consistent with best governance practices. Second, quality corporate governance calls for a well designed compensation structure that provides proper incentives for decision-makers. The current global crisis has drawn attention to the level and structure of executive compensation in the United States. Misaligned incentives can distort investment decisions toward more aggressive and excessively risky, eventually leading to the kind of crisis we are witnessing currently. Overly generous compensation packages and the widespread use of stock option grants may have created incentives for aggressive risk behavior which is now being partly blamed for the current crisis. On the other hand, properly designed, top management compensation can serve as a key mechanism of corporate governance with the potential to 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 devoid of the influence of the executives themselves. Executives can influence the process in a variety of ways. In particular, they can dominate the nomination of directors in the board compensation committee. They can also exert influence through seats in interlocking boards. Therefore, one important reform of corporate governance is a requirement for the compensation committee of the board to be totally independent. This independence is achieved from appointing directors outside the company and with no direct or indirect relationships with the company. Moreover, there should be a majority independent overall board. In fact, the movement for board independence is growing around the world.9

The transparency of the compensation plans is enhanced through disclosure rules requiring that all elements of executive compensation, including retirement benefits and indirect compensation, be disclosed to the shareholders. There is also a growing movement for shareholders to vote on the equity-linked compensation 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 enhance depth and liquidity of these markets is through consolidation of regional markets. Regionalization and exchange consolidation has an added advantage of accelerating the momentum of integration of these countries into the global financial economy. While injecting more liquidity into the markets, it allows regional companies to mobilize both domestic and global financial resources. There are certain prerequisites for market consolidation, and they include, establishment of regional securities and exchange commissions, regional self-regulatory organizations, harmonization of legal and regulatory systems, harmonization of accounting reporting systems, along with clearance, settlement and depository systems, and harmonization of tax policies for security investments. 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 important means of depoliticizing privatization programs, since it allows for price discovery, and hence

makes it possible for the privatization shares to be fairly and transparently priced. Moreover, large scale privatizations help enhance depth of the stock market. This is supported by the available evidence. Perotti and van Oijen (2001), looking at a sample of emerging 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 and improved corporate governance. In the public domain, state-owned enterprises lack effective governance mechanisms and face little competition. Privatizing them and bringing them to the discipline of the stock markets should improve corporate efficiency and performance. Second, local stock markets provide an opportunity for participation of local
investors through purchases of privatization shares. This also helps dispel concerns about foreign grab of domestic privatization assets. Third, privatization programs through the stock

market promote diversity of ownership resources in the economy, and hence help alleviate 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 excessive leverage. We got there as a result of distorted incentives for risky behavior that garnered huge rewards in boom periods. However, that is not the whole story. The risk exposures also 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 institutions took huge bets through excessive leverage.10 The lesson for those which are committed to a well-functioning and dynamic stock market 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 even more so with ever advancing technology. The development of the stock markets and their derivatives calls for a commensurate development of talented financial manpower capable of managing risk. Sufficient resources should be committed to improve business school 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 exposures that build up in the system, and this is becoming even more important in this increasingly complex and interconnected environment. Therefore, literacy in financial regulation requires literacy in risk management and control. University programs should be supplemented by specialized training programs to produce financial manpower and regulatory force that is appropriate for well-functioning stock markets. Otherwise, there will be a large gap between regulatory talent and industry talent in the management and oversight of risk.11 8. Building and maintaining reliable stock market database Despite the extensive political, economic and financial sector reforms, in certain regions genuinely reforming countries get lumped with other countries which have suffered negative image of war, conflict, corruption, violation of human rights, etc. This information 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 and capital market data that captures the diversity of countries and the financial circumstances of private institutions, listed companies, and banks. The timeliness and reliability of financial data are crucial for making reliable estimates of investment risks. The financial system knowledge and database is an area for regional co-operation in terms of pooling resources. The added benefit of these databases is that they allow for first-rate research to 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). 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. .

11

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Macro-economic and political instabilities lead to volatility in the stock markets. The accumulating evidence is that macroeconomic stability, such as low and predictable rates of 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 breeding ground for noise traders and gamblers. This would be destabilizing to the stock market as well as the economy at large. As the stock market ceases to accurately reflect the fundamentals, a speculative bubble is likely to emerge, which will then burst into a crisis similar to what we are witnessing today. Political risk is not just associated with political unrest. It often arises from lack of quality institutions, such as law and order and democratic accountability, which then contribute to increased risk premia in financial markets. 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 is the solution. The flip side of this is the market, of course. The pendulum shifted too far on the side of the government being the problem, and hence lax regulation and institutions too big to fail. Now the pendulum may shift too far on the side of the government being the solution. We have already witnessed what could happen when we let markets rule. However, while the regulatory reforms are needed, we should resist the temptation 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, the current global financial crisis has reinforced a stark lesson that finance needs regulation. But not more regulation. We need to have good regulation. Moving forward regulatory reforms help remove regulatory gaps, but they should not be expected to eliminate financial 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 financial economy. The temptation for reversal is being fueled in part by the advanced countries in which government intervention has become rampant in the crisis resolution. However, the global crisis should not be an occasion to reverse course but a rare opportunity to improve, or even redesign, the financial and regulatory structure for the 21st century. The analysis and the reform proposals in this paper are intended to contribute to that front.

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References
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