Designing a Financial Market Structure in Post-Crisis Asia -How to Develop Corporate Bond Markets for a Balanced Corpora

1. Designing a Financial Market Structure in Post-Crisis Asia-How to Develop Corporate Bond Markets for a Balanced Corporate Financing- 10 May, 2001 By Dr. Sayuri Shirai

2. After the Asian Crisis - Strong and Increasingly Prevalent Views- • Heavy dependence on the banking sector was the cause of the crisis and the banking system did not perform properly in Asia  thus, causing double mismatches  less emphasis should be placed on banks • Need to focus more on developing domestic capital markets, particularly bond markets

3. Stylized Facts on Financial Market Structures • Dominance of the banking system for financing firms’ new investment • Increasingly depending on capital markets, • But, largely underdeveloped corporate bond markets (issue size, liquidity, maturity, limited investor base, infrastructures, etc.)

4. Therefore, we need to ask:

5. [I] First Category of Fundamental Questions 1.Why are commercial banks generally dominant at the relatively early stage of economic development and corporate formation? 2. What are raison d’être, functions, and features of bank loans according to the existing theoretical and empirical studies? 3. If those studies stress banks’ unique roles, then what went wrong with the banking system in Asia?

6. [II] Second Category of Fundamental Questions 1.Why are corporate bond markets largely underdeveloped? 2. Why does it take a long time to establish viable and sound capital markets, particularly bond markets, even in advanced countries? 3. Are Asian countries be able to develop bonds market in a relatively short time span?

7. What are the Fundamental Differences between Bank Loans and Corporate Bonds?

8. Firms’ Choices of Bank Loans and Bond Finance Depend on 3 Factors: 1. Extent of Severity of Information Asymmetrybetween Ultimate Creditors and Ultimate Borrowers 2. Stages of Economic DevelopmentLarge, Reputable Firms + Diversified Institutional, Individual Investors 3. Development of Informational, Legal, and Judiciary Infrastructures

9. 1. Information Asymmetry 3 Agency Problems: 1. Ex-ante: Adverse Selection  select borrowers who prefer risky projects 2. Interim: Moral Hazard  break commitments and yield bad outcomes 3. Ex-post: Liquidation Costs  discontinue loans to viable borrowers • Information Gathering and Monitoring Costs

10. [A] Participants

11. [B] Different Methods to Reduce Agency Problems Between Banks and Borrowers Between Issuers and Public Investors

12. 2. Stages of Economic Development and Corporate Formation [A] Features of Investors and Borrowers

13. [B] Supply and Demand Factors Developing Countries Developed Countries •Limited supply • Many highly-qualified issuers • Limited demand • Many and diversified investors Practical Solutions Bank-based Bond market-based in developing countries in developed countries

14. 3. Features of Informational, Legal and Judiciary Infrastructures [A] Objectives Bank Loans Bond Finance How to limit excessive risk- How to ensure public taking behavior by banks and confidence in the bond systemic banking crises market

15. Bank Loans 1. Enforceable banking laws i. scope, types of services ii. entry regulation 2. Prudential regulations (capital adequacy, limit on credit concentration, foreign currency exposure, accounting, audit, disclosure rules imposed on banks) Bond Finance 1. Enforceable securities law i. full disclosure of information ii. penalize accountant, auditors investment banks for false information iii. penalize insider trading, market manipulations 2. Proper accounting, auditing, disclosure rules set on issuers [B] Main Instruments

16. Bank Loans 3. Supervisory authorities (monitor compliance with prudential regulations) 4. Deposit insurance system 5. Lender of last resort 6. Collateral (registration, assessment, collection) 7. Insolvency laws (liquidation, reconstruction) Bond Finance 3. SEC (monitor compliance with the securities laws, licensing of issuers) 4. Risk-rating and other information generating agencies 5. Comprehensive judiciary system (investigate and bring civil and/or criminal enforcement actions against the violators of the securities laws)

17. Bank LoansBond Finance Banking system can survive Stringent informational, even without adequate legal, and institutional informational, legal, and infrastructures are judiciary infrastructures prerequisite (provided that banks hold proper incentives)   Banks emerge at the early Take time to develop stages of economic development and corporate formation

18. Based on Understanding of the Fundamental Differences, What are the Inherent Features and Main Advantages of Bank Loans and Corporate Bonds?

19. Inherent Features

20. Main Advantages Bank LoansCorporate Bonds 1. Staged financing 1. Minimize double mismatch 2. Efficient payment system 2. Lower borrowing costs 3. Deposit mobilization 3. Efficient resource allocation 4. Efficient liquidation 4. Promote securitization 5. Maturity transformation 5. Maturity transformation

21. If Existing Studies Stress Unique Advantages of the Banking System, Then What Went Wrong with Commercial Banks in Asia?

22. Features and Failures of Asian Banks 1. Family businesses • When internally financed, family ties based on reputation emerge in the absence of adequate informational, legal and judiciary infrastructures  Agency problems hardly exist owing to: a. Hardly no separation between owners, managers and financiers b. Self-enforcement mechanism based on reputation and readily available information

23. 2. When firms expand, need external funding Bank loans may be preferred due to: a. Avoiding the dilution of equity of current stockholders and hence the control of the founders over decision making, and b. Numerous SMEs  Highly idiosyncratic information c. Inadequate legal and information infrastructures that ensures confidence of public investors  Thus, banks emerge as institutions to mitigate agency problems through forming long-term “relationships”

24. 3. Three main factors for the failure of banks a. Government interventions in directing credit for projects selected by governments b. Bailing out banks regardless of viability c. Bank ownershipstructure  Reduce banks’ incentives to process inside information and monitor firms  Heavy reliance on collateral without monitoring  Inadequate prudential supervision  “Relationship-based” shifted to “cronyism”

25. Why are Corporate Bond Markets Largely Underdeveloped in Asia?

26. Five Factors Affecting the Underdeveloped Corporate Bond Markets 1. Underdeveloped government bond markets  lack of benchmark bonds used for pricing 2. Illiquid secondary markets due to government policy • Interest rate policy • Transaction tax or stamp duty • Liquidity requirement • Regulation on asset portfolio of provident funds, etc. 3. Limited Supply 4. Limited Demand 5. Inadequate informational, legal, and judiciary infrastructures weaken investors’ confidence

27. Then, What Asian Countries should Do?

28. 1.Place the first priority on strengthening the soundness of the banking sector since banks are likely to remain dominant. i. Remove government policies that distorted banks incentives to collect information and monitor borrowers internal risk management ii. Then adopt prudential regulations

29. 2. Meanwhile, improve the necessary informational, legal, and judiciary infrastructures for a sound corporate bond market since it will require time to do so. 3. Also, consider the role of the banking sector in corporate bond markets because of the declining profitability from the traditional banking services and given its dominance: Banks will be the major underwriter, issuer and guarantor of corporate bonds.

30. 1-3 suggest: Banking system and corporate bond markets are complementary Bank loans are substituted for premature corporate bond markets Intermediate financial market structure

31. Financial Structure in Asia in the Medium Term would be …. Ultimate Borrowers Non-financial Firms Corporate Bond Bank Loans Banks Bond Issuers Banks, Other Financial Institutions Institutional Investors Banks, Pension Funds... Underwriters Banks, Other Financial Institutions Ultimate Savers Households, Firms

32. As a Result, New Problems are Emerging in the Banking System

33. 1.Greater concentration of economic resources • and political power to the banking sector • 2. Provision of loans more extensively to small • unknown firms => higher default ratio • 3. Generate conflicts of interests between banks • and public investors of securities • e.g. Underwrite securities of troubled borrowers where the proceeds of the issues are used to pay off banks’ own loans to the firms • e.g. Encourage securities purchases via imprudent lending to customers

34. Thus, the strengthening of the soundness of the banking sector should be emphasized even further (compared to the solely bank-based economy) • a. Banks need to improve internal risk assessment skills • because of the growing number of lower quality borrowers • b. Banks need to adopt new risk management and • operational skills needed for underwriting and transacting • new financial services and coping with new types of risks • c. Appropriate forms of corporate structures of banks need to • be carefully examined => universal banking, bank holding • companies, or subsidiaries of banks

35. Policies for Developing the Corporate Bond Markets

36. 1.Develop government bond markets through regular issuance with various maturities 2.Remove regulations that discourage the development of secondary markets for government bonds (e.g, interest rate controls, taxes, liquidity requirement) 3. Impose strict regulations on market manipulation to protect investors 4. Improve settlement systems to limit systemic risks of the whole financial system 5. Encourage the establishments of other intermediaries such as pension funds, mutual funds through deregulation