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(C) 2014 Melvin H Jameson Slide 2 Slide 3 Functions of a financial system: Payment system - facilitate trade Link savers and borrowers Allocation of capital- investment decisions Corporate governance- control within the enterprise (C) 2014 Melvin H Jameson Slide 4 Alternatives for organizing Command Maoist China, Soviet Union Market Mixed China today (C) 2014 Melvin H Jameson Slide 5 Fulfillment of financial system functions MarketCommand Payments Banking system Capital allocation Bank lending Securities markets: Bonds (debt) Stock (equity) Bank lending as directed by state. (political control) Governance Equity holders Lenders (creditors) State ownership (political control) (C) 2014 Melvin H Jameson Slide 6 Macroeconomic policy implementation MarketCommand Monetary policy Open market operations Bank system regulations Irrelevant (directed lending creates money as needed) Exchange rate policy Pure market (float) Market intervention (fixed; or managed float) Irrelevant (currency not freely convertible) Interest rate policyResults from above Interest rates can be set to differ from world rates if capital controls imposed (C) 2014 Melvin H Jameson Slide 7 Some types of market financial systems Financial market emphasis Anglo-American system Bank emphasis German system (Family) Group structure Japan: Zaibatsu Keiretsu Korea: Chaebol Latin America, SE Asia etc. (C) 2014 Melvin H Jameson Slide 8 2. Quality of market infrastructure (C) 2014 Melvin H Jameson Slide 9 Quality of legal environment influences the financial system General rule of law Enforceability of contracts affects all areas; particularly finance Creditor rights If weak inhibit banking and all lending Shareholder rights If weak inhibit equity markets; lead to concentrated ownership (C) 2014 Melvin H Jameson Slide 10 Market infrastructure Rule of Law Accounting standards Efficiency of legal system Corruption Will the government repudiate contracts (C) 2014 Melvin H Jameson Slide 11 Market infrastructure Creditor rights Does a reorganization require creditor consent? Do secured creditors rank first in asset distribution? Does an automatic stay prevent secured creditors from seizing their security during the bankruptcy process? Does debtor control assets during the legal process? (C) 2014 Melvin H Jameson Slide 12 Market infrastructure Shareholder rights Are all shares entitled to one and only one vote? Is proxy voting by mail allowed? Is cumulative voting (all my votes for one director) or proportional board representation of minorities allowed Do minority shareholders have a judicial venue to challenge board decisions? Do existing shareholders have a preemptive right to purchase new stock issues? (C) 2014 Melvin H Jameson Slide 13 Example: Italy Toxic Italy WSJ 11/3/14 p. A10 The article is interested in the prospects that quantitative easing will work in Italy, but this leads to an illuminating discussion of several aspects of the countrys financial system. (C) 2014 Melvin H Jameson Slide 14 Adaptations of financial systems A countrys financial system adapts in response to the quality of its legal environment. (C) 2014 Melvin H Jameson Slide 15 Financial system and legal system Market system Requires strong legal system, enforceable contracts - bankruptcy rules - minority shareholder rights Bank system Legal system available, but more relationship based Groups An internal capital market substitutes for enforceable external legal contracts (C) 2014 Melvin H Jameson Slide 16 3. China: Financial environment of a blended system (C) 2014 Melvin H Jameson Slide 17 Case study: Blended model Chinese system Domestic capital market run by direction Currency market Convertible for trade account Not convertible for capital account Article: After earning cash in China, trick is getting it out Discussion: Why is full currency convertibility incompatible with a controlled capital market? (C) 2014 Melvin H Jameson Slide 18 Shadow Banking Informal responses to gaps in official banking system Wealth management products Official bank reluctance to lend to the private sector Low legal ceiling on bank interest rates Entrusted lending WSJ 5/2/14 p. C1 Big publicly traded companies provide funds To small companies lacking capital market access Routed through banks, for a fee (C) 2014 Melvin H Jameson Slide 19 Official reforms of banking Promised program to allow private entry into banking WSJ 11/20/13 p. C3 Retail and tech companies have been providing online financial services Have expressed interest in setting up banks Stated interest in a market-driven banking system. Specific reforms to look for: Relaxation of interest rate ceilings on deposits Introduction of deposit insurance (C) 2014 Melvin H Jameson Slide 20 Securities markets Shanghai - Hong Kong stock exchange market link opened 11/17/14. Issues with Chinese securities markets Unreliable financial disclosure Uncertain minority shareholder protections Little or no role in corporate governance (C) 2014 Melvin H Jameson Slide 21 4. Funds transfer under full or partial currency blockage (C) 2014 Melvin H Jameson Slide 22 Parallel Loan U.S. parent Spanish subsidiary $ Loan United States Spanish parent U.S. subsidiary Loan Europe No funds cross any border. Nevertheless, each parent effectively lends to it foreign subsidiary. (C) 2014 Melvin H Jameson Slide 23 Parallel Loan: alternative structure Dow U.S. Monsato U.S. $ Loan United States Monsato Europe Dow Europe Loan Europe No funds cross any border. Dow effectively lends to European subsidiary. Monsato borrows from its European sub. Parallel Loan (C) 2014 Melvin H Jameson Slide 24 Parallel Loan (side note) Note similarity to a currency swap. As loans are repaid, the U.S. company pays euro (from sub) and receives $ Hedges against decline in value of euro reducing value of payments received. A swap provides this hedge by netting the two interest payments: requiring payment of only the difference resulting from the exchange rate movement. (C) 2014 Melvin H Jameson Slide 25 Back-to-back loan U.S. parent CitiBank Deposit United States U.S. subsidiary Venezuela U.S. parent converts a direct loan to a bank loan. This may receive more favorable treatment in the event of currency blockage. Back-to-back loan (C) 2014 Melvin H Jameson Slide 26 Other means of funds transfer Payment for capital Dividends Interest (intra company loans) Principal (C) 2014 Melvin H Jameson Slide 27 Means of funds transfer (2) Payments for goods & services Transfer prices (amount of payment) Terms of payment: Leading or lagging payments Currency of internal invoicing (C) 2014 Melvin H Jameson