Promoting Access to Primary Equity Markets. A Legal and Regulatory Approach
| Author | Felice B. Friedman; Claire Grose |
| Profession | Felice Friedman and Claire Grose are members of the Capital and Risk Markets Group in the World Bank's Financ |
| Pages | WPS3892 |
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Felice Friedman (ffriedman@worldbank.org) and Claire Grose (cgrose@worldbank.org) are members of the Capital and Risk Markets Group in the World Bank's Financial Sector Vice Presidency. The authors wish to thank Rudi van der Bijl, Alessandra Campanaro, Stijn Claessens, Tadashi Endo, Jorge Familiar, Patrick Honohan, Yongboem Kim, Jeppe Ladekarl, Rodney Lester, Susan Marcus, Tatiana Nenova, Michael Pomerleano and Dimitri Vittas for their valuable comments and suggestions. The authors are especially grateful to Dan Goldblum and Jaehoon Yoo for their contributions to the section on alternative markets.
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Strong capital markets are an engine of economic growth. By creating liquidity and generating information, markets encourage people to save and invest, and by increasing savings and investment and allocating risk, they contribute to economic development.1 Equity markets can be an effective source of financing for big and small companies alike. Going public may increase a company's status and have a positive impact on its relationships with customers and other outsiders.2 In this paper, we look at the question of how to create strong equity markets that can serve as a viable source of financing for domestic companies. We take a legal and regulatory approach to try to answer this question.
Capital market development is a function of a number of different conditions. Primary among these is a favorable macroeconomic environment, but, in addition, there needs to be supportive technical infrastructure, enforceable property rights and a policy that encourages private sector growth, an adequate bankruptcy system that supports creditor rights, well-developed legal and accounting and professions along with accounting and audit standards, and an efficient judicial system accompanied by credible enforcement. Fulfilling all of these conditions is difficult and takes a long time. Nonetheless, progress can be made and is being made. In this paper, we focus in particular on the legal and regulatory conditions necessary for capital market development. Economic growth is facilitated when the market operates under laws, regulation and supervision that cater to its current and future stages of development. Issuers and investors have more confidence in raising and investing funds in the equity market when the legal, regulatory and supervisory framework promotes new issues and, at the same time, provides adequate mechanisms for protecting investors.
Our objective in this paper is to identify the basic necessities that underpin a regulatory regime that is cost effective and strikes an appropriate balance between, on the one hand, laws and regulations that may be too restrictive to achieve a supply of capital and, on the other, those that may be so relaxed that investors feel that there is an unacceptable level of risk and do not care to venture into the market. In attempting to realize this objective we have considered the Objectives and Principles of Securities Regulation adopted by the International Organization of Securities Commissions (IOSCO) and the IOSCO Methodology for assessing their implementation. These high regulatory standards are intended to maintain fair, efficient and transparent markets, protect investors and reduce systemic risk.
Without doubting the importance and universality of the IOSCO Objectives and Principles, we believe that they do not provide a realistic roadmap to capital market development for emerging market economies. Therefore, we are putting forward a list of basic necessities for improving the laws and regulations of many emerging markets. We believe that, for these markets, putting into effect the basic Page 2 necessities will be a useful step along the way to full implementation of the Principles.
In this paper, we look first at the desirability of promoting access to primary equity markets in small emerging economies. Typically, companies in such markets rely primarily on short-term bank financing, or relatively small capital infusions from family, friends and trading partners. However, while this type of financing is self- limiting and does not promote the broader capital market development necessary to support economic growth, there are many obstacles to creating strong equity markets that can serve as a source of capital for such companies.
We explore the legal foundations for the successful operation of a primary market for securities and identify disclosure and effective monitoring and enforcement as essential elements of legal protection. Then we examine the incentives and impediments that companies face in listing their securities on domestic stock exchanges. We also look at recent initiatives that stock exchanges have taken in an endeavor to attract smaller enterprises to their lists by creating second boards or dividing the main board into different market segments. Stock exchanges, however, are not the only option for equity offers, and in many cases may not be the best available alternative. We therefore discuss different mechanisms for companies to raise funds outside of a formal stock market listing. Finally, we propose some recommendations for a simple legal and regulatory framework that will help promote access to primary equity markets, both the traditional exchange as well as other alternatives.
Much research has been conducted that shows that countries with better developed capital markets, markets that are deep and liquid and that operate smoothly and efficiently, also have stronger overall economies and more rapid economic growth. Equity markets, both formal and informal, are essentially meeting places for investors and sellers. Equity markets mobilize savings, allocate capital and risk, and exert external discipline on issuers. Without equity markets, smaller or riskier businesses may have difficulty finding financing. Without equity markets, banks themselves may have difficulty growing, and providing loans to more people. Without equity markets, investors are likely to be less willing to purchase and hold corporate bonds.3 Indeed, "the importance of financial markets in general, and stock markets in particular, for the efficient functioning of an economy cannot be exaggerated."4 And, as has been well-recognized since the Asian financial crisis of Page 3 the late 1990s, capital markets can serve as an important "spare tire" at times of market stress.5
Of course this begs the questions of what constitutes a capital market and how a successful one can be created. Formal organized stock exchanges have been established in many countries in recent years. However, many of these exchanges could not be characterized as successful, either in terms of performance indicators (i.e., liquidity, turnover, new issues, market capitalization, etc.), or in terms of their contribution to domestic economic growth. In many small emerging markets, stock exchanges simply have failed to thrive. They have only a few listings, new public offerings are rare, and there is hardly any trading. While trading frequently also occurs outside of the formal stock exchange on informal over-the-counter markets, these too have failed to generate equity market development on a significant scale.
Globalization and technology, in many ways forces for modernization and development, have contributed to this bleak picture. Where they are able, larger issuers from more advanced emerging markets sometimes escape their domestic constraints and dual list on global markets, particularly the New York Stock Exchange and the London Stock Exchange. For example, "by March 1995, over 87%, 54%, 62% and 71% of the Mexican, Argentine, Chilean and Brazilian local market indices, respectively, were available for trading in the United States in the form of ADRs."6 A recent World Bank study of capital markets in Latin America found, disturbingly, that domestic market reforms resulted in a larger proportion of issuers going abroad, and led to less liquidity and weaker markets at home.7
If emerging markets are unable to serve as a major source of capital for their leading issuers, perhaps, in the face of globalization, their strategic focus should be instead on serving the smaller, less well-known domestic issuer.8 Indeed, small and medium sized enterprises (SMEs) form the economic backbone of most emerging market economies. Instead of focusing on prime issuers who, it appears, may leave Page 4 home as soon as they are able, emerging markets could concentrate on improving access to finance for SMEs, and increasing market participation by domestic retail and institutional investors. However, while many emerging markets support a stock exchange, in most cases this has not seemed to be an effective source of financing for domestic SMEs.
Technological advances, which one would expect to benefit emerging markets and SMEs...
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