Investor Protectionism and Financial Market Size

A common denominator of market-based financial system like that of United States and U.K and bank-based financial system such as that of Germany or France is investor protection. The United States has a market-based system because its economy is largely dependent on property and financial asset value. Consequently, it has a large stock and bond markets creating a large market which attracts investors and companies from all over the world. This presupposes that the stock market and individuals (that is investors) play a significant critical role in corporate finance and governance as large fraction of individual portfolios is held in the equity market. Moreover, equity financing is practiced in this system.

On the other hand, bank-based systems are characterized by financial assets predominantly being held by financial institutions encompassing banks, mutual funds, insurance companies, pension funds and others. This means direct equity investment is small whilst individual investment is predominantly held in bank deposits, insurance policies, mutual and pension funds e.t.c. Debt financing comes mainly from banks instead of stock markets and so the stock market is comparatively small and less significant in this type of economic system. The fact is that, in market-based financial systems, investors property rights are protected well due to the fact that stocks and bonds markets are significant and form a higher percentage of the GDP. For example in 2003, financial assets was about 327% of GDP for U.S and 306% for U.K which are market-based dominant financial systems compared to 192% in Europe, 267% in Japan which tends to be bank-based dominant systems, an epitome of socialist systems [1}.

The large stock market size in terms of number of listed companies, aggregate market value relative to GDP and initial public offering (IPO) relative to population is a repercussion of the investor confidence and the quality of laws governing the market. Contrarily, inadequate protection rights minimize the integrity and size of the market as seen in the economies with dominant bank-based financial systems. Even in the efficient market-based systems where shareholders and creditors of the market are protected well by laws, political trends and shift in government policy can inhibit the smooth running of these markets. There is the tendency for governments to garner more power and control in terms of enforcement of the laws governing the market in times of deep economic recession.

A case in point is the financial market crash in 1929 which was followed by the government expansion and ownership in the Great Depression. However, much as laws need to be enforced to ensure investor protection, an expansion of government control of the market can be very ambitious besides reducing the efficiency of the market. That is why it is incumbent on the Federal government to critically examine the amount of power and reforms it seeks to control the market to avoid a rippling effect of market inefficiencies. Most importantly the market inefficiencies would emanate mainly from competition and capital gains impairment, no insulation from political influence on investment and operating decisions. The market is a privatization entity and so should be allowed to operate with some level of independence for efficiency and profitability. Reforms are necessary to ensure investor protection and subsequently confidence yet very robust reforms if not handled carefully can impact negatively the markets.

These times are similar to the Great Depression period and care needs to be taken to avoid the degenerating syndrome of “protectionism” as practiced in some socialist systems. We have learnt by observation and experience that the large size of the U.S market is also a result of large number of foreign individuals and company investments and any failure of the market spills into the economies of the rest of the world.