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Am I Eligible for Student Finance?

Am I Eligible for Student Finance?
International Student Guide

One of the major things student should ask, am I eligible for student finance Student worry if they are able to afford their living expenses as they are moving away from home. This includes educational materials and books, students have to consider rent, food, travel, and other household costs on top of their tuition fees. Student loans can help with these necessary expenses, but how do you know if you are eligible for student financeHow do beat the shortage of financial aid and funding

Qualifying for a student loan depends on many factors including where you live, which university or college you have chosen to attend, which course you are studying, if you have studied before, and your age.

Generally speaking, you will need to be a UK resident or have ‘settled’ status to qualify for a student loan. The university or college you are planning to attend must be a UK degree-awarding institution, a college which receives government funding, a private institution which offers specifically designated higher education courses, or one of the schools which take part in the SCITT (School-Centred Initial Teacher Training) Scheme.

Your course must lead to a first degree (such as a Bachelor of Arts, Education or Science), a Foundation Degree, a Diploma of Higher Education, a Certificate of Higher Education, a Higher National Diploma, or a Higher National Certificate. You are also likely to qualify if you are studying an Initial Teacher Training course.

Information regarding your eligibility can be found on government websites, and your college or university will also be able to help you determine if you are eligible, as well as guide you through the application process and help you avoid any unnecessary delays or mistakes with the paperwork.

There is plenty of help out there for students. In many cases, it is just a matter of asking for it!

Also review top 15 scholarships for International Students.

If you are looking for help with your Essay Writing, please get in touch with us today.

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Free Finance Essay: LSE & TMX Merger

EXECUTIVE SUMMARY

This case study seeks to analyse the intended merger between London Stock Exchange Plc and TMX Group, Inc, the operators of London and Canada’s largest stock exchanges respectively. The intended merger is offering TMX Group’s shareholders 2.9963 shares in the newly created entity, for every TMX share owned. The aim of the merger is supposedly to create synergies and shareholder wealth for all shareholders involved. On close inspection of the figures, and with the aid of financial theories, this study found that TMX’s shareholders stand to gain much more than LSE shareholders (35% compared to 10%) in the integration within the new company. Furthermore, synergies such as improved global market share and cost savings have been found to be achievable as a result of the merger, however forecasts for revenue improvements would take careful planning and implementation. The LSE-TMX merger is therefore recommended, given the consolidation of the industry, and the need to achieve scale in order to compete effectively.

1 INTRODUCTION

Mergers and Acquisitions between stock exchanges have been widespread globally, due mostly to the need to achieve scale and reduce costs through synergies (Guardian.co.uk, 2011). One of these proposed mergers has between the London Stock Exchange Group Plc and TMX, operator of Canada’s largest stock exchange. They have been in merger discussions recently that would see a new corporate entity formed; wherein LSE would own 55%, and TMX shareholders would own 45%, with the LSE CEO Xavier Rolet being the top boss in the newly formed organisation.

This supposed merger is recommended as an ideal move for LSE, given the competitive environment in which it operates, and the need to continuously expand globally after its acquisition of Borsa Italiana (Italian stock exchange). However, it has sparked criticisms and controversy on the Canadian front, as a number of parties, including the government and several top organisations have stated that a merger between both entities would reduce the status of Canada as a financial capital, and could subsequently result in Canadian firms opting to list in London and not Canada. FT.com (2011) describes Canadian authorities as “tricky” when it comes to foreign investments, as they could block bids by multinationals if it is perceived not to be in line with the national interest. Such as was seen in 2010, when the Canadian minister for Industry blocked a ?26bn takeover of a fertilizer group by an American mining group BHP Billiton.

This case study seeks to review whether mergers and acquisition increase shareholder wealth for both parties, and the sort of synergies that can be expected from such a relationship.

2 FINANCIAL PERFORMANCE INDICATORS

The diagrams below show a snapshot of the change LSE and TMX before the merger. Diagram 1 and 2 show the revenue growth in LSE and TMX Plc respectively. Both companies have witnessed steady growth over the past four years.

3 WHY MERGERS AND ACQUISTIONS ARE INTERESTING

Breedon and Fornasari (2000) notes that the main aim of mergers in organisations today is for companies to achieve global competitiveness, reduce costs, diversify and possibly improve growth and revenue by branching out into other sectors. Mergers are particularly rampant in highly competitive industries, where firms may be seen to be highly competitively or very fragmented and joining forces together with other players would assist organisations in achieving critical mass necessary to compete effectively.

With particular reference to shareholder wealth creation and synergies, several organisations attribute synergies and increasing profit as the core reason why they are merging. For instance cost reductions when duplicate processes and roles are eliminated would assist in improving net profit (Devos et al, 2009). Furthermore, the now increased size of the joint company could be leveraged while negotiating contracts, and be used in achieving economies of scale (Salama et al, 2003). Salama et al further note that mergers allegedly offer the opportunity for new customers in new markets, improved marketing, product development, access to distribution channels and cross selling. It would also help improve market leadership, maintain current positioning and can inspire vertical integration.

Even though these assertions are indeed interesting, the most interesting fact about mergers and acquisitions is the argument that down the line, most mergers fail to achieve the profit expectations, shareholder wealth and synergies they initially sought (Salama et al, 2003). This failure could be readily observed in the high price often offered in acquisitions, the substantial, albeit unmet promises given on employee retention, synergies and revenue growth, and the significant costs involved in concluding a merger and synergising operations. This area is therefore very important as a study of what actually makes mergers successful could assist us in analysing the LSE and TMX ongoing merger negotiations and draw recommendations on how they can improve shareholder wealth and achieve synergies.

4 RELEVANT STUDIES

Several studies have been published on merger synergies, and the value created afterwards. Stahal and Mendenhall (2005) theorized that one of the major rationales for mergers and acquisitions is the need for businesses to synergize their activities with that of a target company, which is strategically positioned to provide an increase in value. Therefore companies aspire to merge horizontally with competitors in the same industry or vertically with suppliers/buyers in order to synergize their operational processes in a bid to develop a coherent operational strategy that takes advantage of all elements of the business process, eliminates additional cost through redundancy and generates new revenue streams, thus promoting growth.

Christofferson et al (2004), in what they described as the winner’s cause argued, “when companies merge, most of the shareholder value is likely to go to the target. Indeed, on average, the buyer pays the seller all of the value generated by a merger, in the form of a premium of from 10 to 35 percent of the target company’s preannouncement market value.” A complimentary study conducted by Gomes et al (2007), found that the winner’s cause in this sense mostly materialises as a result of an overestimation of the synergies of a merger. These synergies are usually as a result of economies of scale and scope sought, new markets, leveraging of capabilities, and greater opportunities for the combined company.

Furthermore, Soderberg and Vaara (2003) argued that most acquirers usually have little information about the target company, especially when it comes to the human capital they are acquiring, which often leads to integration issues once the merger is completed. However, Chatterjee (2007), in his study of 264 larger mergers, found that the average synergy gains were 10.03% of the combined equity of both merged firms. Most of which came from tax savings (1.63%) and operational synergies (8.38%). Most of these operational gains were however due to “cutbacks in investment expenditures rather than by increased operating profits”. In conclusion, Holland and Salama (2010) noted “careful and well-planned integration strategies are responsible for sustainable learning occurring, leading to desirable synergies between firms engaged in a merger process”.

5 TESTING MERGER THEORY

5.1 SYNERGIES

The main objective given for the LSE and TMX merger is to create synergies, in a deal that would create the largest exchange globally in terms of the number of companies listed (6,700), and would also create an exchange where mining companies would be most concentrated. Furthermore, the combined companies are targeting an annual cost savings of ?35m by the second year after the merger, and a revenue growth of ?35m and ?100m in the third and fifth year respectively. Even though the revenue growth cannot be easily ascertained, the synergies can be readily verified. If they do merge, according to Breedon and Fornasari (2000) they would objectively increase in size, have the largest listing of mining companies, and be the world’s largest stock exchange based on the number of listed companies. Furthermore, it is indeed realistic that they can achieve cost savings in the second year, due possibly to cost cutting processes as illustrated by Chatterjee (2007).

However, revenue growth in the third and fifth year cannot be easily ascertained, and the likelihood of that happening, may be slim. According to Gomes et al (2007), even though cost reduction and market size synergies are indeed achievable in mergers due to the objective and easy manner in which they can be achieved following a deal, those centered on revenue growth are usually more difficult to achieve, and often result from very optimistic synergy expectations pre-merger.

5.2 SHAREHOLDER VALUE

The LSE and TMX merger is supposed to have a combined value of ?5 billion (including debt), and would be jointly headquartered in London and Toronto. LSE is offering TMX shareholders 2.9963 ordinary shares for every common share they have, and based on Diagram 4, that would result in them owning 45% of the combined company. However, in what way does this actually increase the value of shareholders in both companies?

Diagram 3: Pre and post merger valuation calculation. Source: FT.com (2011)

The diagram above shows the calculation of the pre and post merger valuation of both companies. Based on the market valuation of both companies on 9th of February 2011, when the merger was announced, they had a collective market cap of ?4.2bn. However, by offering TMX shareholders 2.9963 shares for every share held, they would own 45% of a ?5bn combined entity, which takes up their valuation to ?2.25 billion from ?1.70, thus representing a 35% increase on their current shares; whilst LSE shareholders only gain 10%.

Even though shareholders in both companies would increase their wealth as a result of the merger of both companies, TMX shareholders stand to gain a lot more than LSE shareholders. These findings contradict that of Salama et al (2003), who stated that the only shareholders that gain considerably from acquisitions are the target companies. In this situation, both companies stand to gain, just that the target gains a lot more. An explanation for this can be found from Chatterjee (2007), who stated that most mergers have to include a premium valuation for the targets to accept, and the substantial increase in valuation within the new entity could be regarded as a premium payment for the acquisition to take place. It can thus be said that LSE has paid a premium in order to acquire TMX, which has resulted in increased shareholder wealth for TMX shareholders.

5.3 INCREASING BARGAINING POWER AND EFFICIENCIES

In an effort to determine the status of past mergers, Salama et al (2003) reported that up to 60% of acquisitions fail, and this failure is mostly represented in their inability to achieve cost reduction or revenue growth objectives, or in the general lack of integration between both parties. However, Buono and Bowdith (1989) in contradiction noted that horizontal mergers do benefit organisations, even in situations where cost savings and revenue growth is difficult. They further noted that this benefit is usually in the form of market share growth and operational efficiencies that are crucial in multinational businesses seeking to establish critical mass in an increasingly global industry.

FT.com (2011) notes that the most stock exchanges are often chosen for listing based on their market value and popularity amongst investors. Therefore a stock market with a larger market share has more chance of attracting lists, than others. By joining forces with TMX, LSE would be able to gain a larger market share of the global stock exchange industry, thus being able to attract more listings, trading and revenue. Without this, it faces the fear of being taken over by larger players. Therefore, in light of these findings, the merger between LSE and TMX is therefore crucial in order for it to remain competitive and useful in the global stock exchange market.

Diagram 4: Market share of leading stock exchanges. Source: FT.com (2011)

6 DISCUSSION AND CONCLUSION

This study has considered the LSE and TMX findings in light of academic theories, and analyzed existing information with the aim of testing various theories. The major reason given for the merger, which is supposedly to achieve synergies, seems very achievable given the operations of both companies. By creating a multinational entity, the new entity would automatically become the largest exchange for mining companies, and would house the highest number of listed companies. This synergy is also well connected with the theory on bargaining power and efficiencies, as a larger LSE-TMX would attract more companies to list, help reduce overall costs, and improve efficiencies.

The manner and success rate of achieving these however depends highly on the careful planning and execution that goes into integrating both companies (Buono and Bowditch, 1989). If these were not done appropriately, then even though LSE-TMX would still be a large multinational stock exchange, by nature of its merger, it may not uphold its competitiveness or be able to the sort of efficiencies envisioned.

Finally, the merger does seem to create wealth for both shareholders, but the TMX shareholders stand to gain a lot more, mostly due to the premium being included in the price. This is therefore not a “merger between equals” (FT.com, 2011), but an acquisition of TMX by LSE, in a diplomatic manner aimed at appeasing Canadian authorities.

7 REFERENCES
Breedon, F and F Fornasari (2000) FX impact of cross-border M&A., Lehman Brothers, Global Economics Research Series, April

Buono, A.F., Bowditch, J.L. (1989), The Human Side of Mergers and Acquisitions, Jossey-Bass, San Francisco, CA

Chatterjee, S. (2007) Why is synergy so difficult in mergers of related businesses?, Strategy & Leadership, Vol. 35 (2), pp.46 – 52

Christofferson, S, McNish, R, & Sias, D (2004), ‘Where mergers go wrong’, McKinsey Quarterly, 2, pp. 92-99, Business Source Premier, EBSCOhost, viewed 8 April 2011.

Devos, E, Kadapakkam, P, and Krishnamurthy, S. (2009) ‘How Do Mergers Create ValueA Comparison of Taxes, Market Power, and Efficiency Improvements as Explanations for Synergies’, Review of Financial Studies, 22, 3, pp. 1179-1211, Business Source Premier, EBSCOhost, viewed 8 April 2011.

FT.com (2011) LSE and Canada’s TMX agree merger, www.ft.com, [accessed: 03/04/11]

Gomes, E., Donnelly, T., Morris, D., Collis, C. (2007), “Improving merger process management skills over time: a comparison between the acquisition processes of Jaguar and of Land Rover by Ford”, The Irish Journal of Management, Vol. 28 pp.31-58.

Google Finance (2011) TMX Group, Inc. financials, London Stock Exchange Plc. Financials, http://www.google.co.uk/finance?q=TSE:X&fstype=ii, [accessed: 03/04/11]

Guardian.co.uk (2011) TMX-LSE merger: a timeline of takeover battles, www.guardian.co.uk/business, [accessed: 03/04/11]

Salama, A., Holland, W., and Vinten, G. (2003), Challenges and opportunities in mergers and acquisitions: three international case studies: Deutsche Bank-Bankers Trust; British Petroleum-Amoco; Ford-Volvo, Journal of European Industrial Training, Vol. 27 pp.313-21.

Soderberg, A. M., and Vaara, E. (2003), Merging across Borders: People, Cultures and Politics, Copenhagen Business School Press, Copenhagen

Stahal, G.K., Mendenhall, M.E. (2005), Mergers and Acquistions: Managing Culture and Human Resources, Stanford University Press, Stanford

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Free Finance Essay: Royal Bank of Scotland Crisis

1.INTRODUCTION

The need for banks and financial institutions to grow beyond their normal businesses of accepting deposits and providing loans, into global giants that are diverse and often engage in sophisticated practices has been embedded as the pure nature of capitalism and market liberalisation. In the most recent decade, most global economies and organizations enjoyed unprecedented growth on the back of trade liberalisation and increasing financial services sophistication.

The need for these organizations to grow led to unscrupulous practices such as risky loans, high bonuses and reckless investments, together with high leveraged practices, all of which have been recognised as the major reasons why these institutions were hugely exposed to the financial crisis. Banks were the most affected, primarily because they were one of the major starters. They engaged in risky lending to businesses and individuals, invested in securities backed by subprime assets, and expanded like they intended to take over the world – mostly with leveraged funding and customer deposits. If they had not invested so rigorously in these risky securities, a huge number of those banks that were bankrupted or needed government bailout would have still been standing. They had to write down huge consumer and business loans that were defaulted, and also write down on the value of collateralized debt obligations they had in their portfolio. This led to huge losses, and depletion of capital reserves that prompted the intervention of the government in a huge number of global banking businesses.

This essay therefore aims to analyse the effects of the economic crisis on RBS Group, parent company of Royal Bank of Scotland, and NatWest. The group’s financial, operating and investment activities would be analysed in this study, with the aim of establishing the reasons why they fell the way they did compared to other UK banks, what could have been done better to alleviate such heavy losses, and what they could do now to repay government shareholding, and renew customer and investor confidence.

A background of the bank’s operations and investment activities would be outlined in the following chapter, followed by an analysis of what went wrong, its effect, steps that have been taken to alleviate such effects. Then finally an analysis of the bank’s current state compared to its rivals, and the effects of macroeconomic and industrial factors on its current and future operations.

2.BACKGROUND – ROYAL BANK OF SCOTLAND

The Royal Bank of Scotland group is a British banking and insurance holding company based in Scotland, and operating in Europe, North America and Asia-Pacific. Its main subsidiaries include the Royal Bank of Scotland, NatWest, Ulster Bank In Ireland, Citizens bank in the US, RBS Coutts, Churchill Insurance, Direct Line and Privilege (RBS, 2009).

RBS currently provides banking, private banking, insurance and corporate finance solutions to over 40 million customers worldwide (25 million in the UK) and 1 million small businesses. In terms of Group market share, RBS Group is currently the second largest provider of current accounts to customers in the UK (Mintel, 2009). Prior to the 2008 sub-prime mortgage financial crisis, RBS was the world’s largest company by assets, fifth largest in the world by market capitalisation and 10th largest company in the world (Financial Times, 2009).

RBS was established in 1727, and now has 2,278 branches and 118 business centres in the UK alone (RBS, 2009). RBS’ revenue and PBT has grown consistently, up until 2007 where it recorded a record turnover and PBT of ?32.3 billion and ?9.9 billion respectively. However, following write-downs on recent acquisitions and losses suffered during financing activities, RBS posted the greatest ever loss by a British company of ?34.5 billion profit after tax in 2008 (RBS Financials, 2009).

3.ANALYSIS OF RECENT ACTIVITIES

RBS Group has grown over the years through a series of acquisition and expansion across several market places in the UK, US, Europe and Asia Pacific. The organization expanded into new markets and increased market share through organic growth and acquisition.

Its major US acquisitions were in 1998 and 2004 when the bank acquired Citizens Financial Group and Charter One Bank respectively (RBS, 2009). The bank also acquired NatWest on 11th of February 2000, when it was declared the winner of the hostile take over battle of the bank against Bank of Scotland. RBS also acquired a 10% stake in the Bank of China for ?1.7 billion in August 2005, in order to further its international expansion into Asia-Pacific markets (Gumbel, 2009).

These acquisition activities in no way resulted in any shortcoming on the bank, but they even catapulted it into one of the biggest companies in the world. They made RBS a major player in the US and Asia retail and corporate banking industry, and also enabled it to leverage back office operations across the whole group. RBS had strong financials (Illustrated in figure 1). The figures show that up until 2007, its total assets, revenue and operating profit had been increasing consistently mainly as a result of these growth activities. These figures illustrate that the company was very strong and thereby never warranted a financial collapse or a takeover by the UK government. Then what went wrong?

Similar to any other UK or International bank, RBS suffered impairment charges against bad loans made out to bankrupt companies such as the American conglomerate LyondellBassell (?1.5 billion), and also about ?1 billion tied down in assets in Icelandic banks and Lehman Brothers (RBS, 2009). According to the Financial Times (2009) the bank also made losses through its global banking and markets division that was responsible for investing in Bernard Madoff’s Ponzi scheme, US subprime market and also in Lehman brothers. These losses resulted in huge capital shortfalls within the bank and impairment charges of ?8,072 billion, but are still commonplace amongst other UK banks like Barclays and HSBC that made provisions of ?5,419 billion and ?24,937 billion respectively within that same year, but still made reasonable profits and paid dividends to shareholders (Reuters, 2010).

A vast majority of RBS’ shortcomings, huge loss and failure during the credit crisis can be attributed to its acquisition of ABN Amro. It is widely believed that RBS hugely overpaid for ABN Amro and did not get the better of the deal (Ram, 2007). In October 2007, RBS led a consortium with Belgian bank Fortis and Spanish bank Banco Santander to acquire the Dutch bank ABN Amro for ?49 billion after a failed bid from Barclays Plc. RBS claims its share of the ABN Amro acquisition was ?10 billion, which was paid for mostly with cash (Kennedy, 2009). The consortium that was made up of RBS, Santander and Fortis, carved up and parted with different divisions of the bank. While Santander made forth with ABN’s Brazilian business Banco Real, and its Italian business Anton Veneta; RBS made do with the bank’s wholesale and Investment banking division, which already had a huge number of risky assets and was most exposed to the subprime mortgage markets (Ram, 2007).

RBS (2009) claimed that the acquisition would have boosted the bank into one of the formidable banking entities in the world if it acquired the right asset classes and done its due diligence. However, Griffiths (2009) believed that its subsequent failure was as a result of the exposure of ABN Amro to subprime mortgages, and the fact that the bank in itself overpaid and therefore severely depleted its capital base. However, we believe that the bank’s implicit culture of growth through acquisition is what prompted the acquisition spree, and even if the chairman – Fred Goodwin – had been forewarned about the global crisis, he may have still gone ahead of the deal. The bank’s willingness to become the world’s largest bank, has therefore catapulted it into one of the world’s greatest bank failures.

4.WHAT HAPPENED?

RBS’ fate and the effects of the credit crisis on its operations did not really materialise when it began venturing on a range of capital raising and divestment activities. The company floated a ?12 billion 11-for-18 rights issue, the largest ever in the history of Banking; sold Angels Trains, its train leasing subsidiary for ?3.6 billion and a 50% stake in Tesco Personal Finance for ?950 million. All these activities were in order for the bank to shore up its capital reserves following the acquisition of ABN Amro (The Times, 2009; Duncan 2008). Hurdle (2010) stated that several investors where weary of the extent to which the bank was exposed to credit mark downs and risky assets, however since the financial results were not yet out and investors had no reason to be concerned about the state of the bank’s financials, the rights issue was fully subscribed.

However on the 13th of October 2008, HM Treasury announced plans to inject an initial ?20 billion of new capital into RBS. In return, the Treasury would have a say in how the company is run, cut bonuses handed out to bankers, protect customer deposits and also help protect these banks’ toxic assets (Gumbel, 2009). RBS then intended to raise a seconds right issue of ?20 billion from investors, which was shunned as investors only took up 0.24% of the shares being offered as they were being offered at 65.5p per share and the shares were already trading on the floor at 52.7 per share (Duncan, 2008). Shareholders were also highly concerned about the potential nationalisation or ownership of the bank by the government, which would have profited the customers, but not the investors and not even the taxpayers (Gumbel, 2009). This resulted in government taking up the ?15billion that they underwrote for the issue, after initially investing ?20 billion of taxpayer funds in the bank. On the 28th November 2008, RBS was 58% owned by the government after the unsuccessful rights issue.

The fact that the government now owned 58% of the bank led to investor resentment regarding the bank, as they feared that the government would interfere in the bank’s operations and therefore prevent business as usual. However, these feelings where nothing compared to the earnings announcement on the 19th of January 2009 in which RBS expected to see write downs of ?20 billion following the purchase of ABN Amro and operating losses of over ?8 billion operating loss due to its exposure to the sub-prime market in the US. Shares fell 68.8% to 11p (Dunkley and Griffiths, 2009). The write downs associated with its acquisitions were due to the fact that the bank realised it overpaid during the acquisitions and the assets that had been paid for could never be sold for those prices, therefore confirming Ram’ (2007) allegations. Following the stock freefall and huge investor resentment, the government agreed to increase stake in RBS to 70% by converting ?5 billion in preference shares into normal shares thereby effectively controlling the company and eliminating the compulsory dividend payments of ?500 million regardless of whether the company made money or not.

Figure 2: RBS’s stock market prices from 30/01/07 – 28/01/10. Source: Reuters (2010).

Most other banks, as discussed earlier also suffered impairment charges with regards to credit and exposure to subprime mortgages, however they did not necessarily need government bailout, with the exception of Lloyds TSB that was encouraged to acquire HBOS. According to an article on BBC News (2009), the acquisition of ABN Amro was regarded as “worst and most ill-time takeover in history”. By the 20th of January 2009, a day after its earnings announcement, RBS’ value dropped to ?4.5 billion from ?75 billion two years earlier (Times online, 2009). It was now worth more than half the cash it paid in the deal to buy ABN Amro. RBS’ current market value is between ?18 –?20 billion (Reuters, 2010)

5.STEPS TAKEN TO ALLEVIATE

The effects of the financial crisis, especially on retail and commercial banks, really hampered consumer confidence. It was now the responsibility of the UK government to come up with schemes and plans in order to help cushion and bailout the banks, in order to prevent an overall mass resentment of the banking industry. The Asset Protection Scheme was therefore introduced in February 2008, which RBS committed to by signing up ?325 billion of toxic assets (RBS, 2009). The fact that the bank had that much toxic assets (5.5x its total shareholder equity and 13% of total assets), makes one wonder about the effectiveness of financial regulation in protecting the banks’ customers. If there was ample regulation that limited the amount of toxic assets that each bank could invest in, a much lesser percentage of toxicity could have been protected, thereby significantly affecting the UK Taxpayers (Slater and Ferreira-Marques, 2010). However Duke (2010) asserts that though these banks did engage in risky investment practices, the level of toxicity of these assets were not really known due to the sophistication of the financial system and collateralized debt securities. The scheme however helped to protect RBS’ assets against loss of future value. Signing up to the scheme effectively increased government shareholding to 84% of the bank, effectively part nationalising the bank, and leaving shareholders with only 16% shares in the company.

The organization now having learnt its lesson (under the thorough supervision from the UK government) has now opted to divest a range of assets such as its 4.26% stake in Bank of China ($1.6bn), and about one fifth of its businesses, in a bid to concentrate on its core markets (Murden, 2010). Recent developments include the 3Q 2009 loss of ?2.2 billion by RBS, particularly attributed to its sale of non-core assets; recent plans to divest early from the Asset Protection Scheme and also plans to sell off its Insurance assets, commodity trading business (RBS Sempra), about 318 bank branches (Guardian, 2009) and a ?1 billion pledge to UK manufacturing companies (RBS, 2009).

The following chapter would discuss the current effects of macro economic and industrial factors on the affairs within RBS.

6.MARKET AND INDUSTRY ANALYSIS

Following RBS’ record loss blunder last summer, the government stake within the organisations has consistently risen from 57% following a failed rights issue, to 70% following share conversion, and now 84% following its decision to join the Asset Protection Scheme, thereby effectively part nationalising one of the world’s largest banks. Shareholder equity has been diminished to as low as 16%, and the government now have total control on the activities within the organisation. That is a severe blow for an organisation whose main aim was to deliver profits and dividends to its shareholders, now it is managed like a welfare bank, selling off international assets, being less competitive and concentrating on its core market, in which the banking industry is already matured (Duke, 2010).

For all banks in developed, and even in developing countries, their affairs and future especially in the economic climate, is closely tied to government regulations. A proper illustration would be when President Obama announced plans to carve up banks, prevent them from owning hedge funds, private equity and proprietary trading desks. The shares of most banks that were engaged in these activities engaged in a freefall including that of RBS, which owns a joint venture RBS Sempra. The effect of this announcement would have meant that banks would have to carve out their investment banking divisions, which already accounts for a vast majority of profits in these organisations (Murden, 2010).

The US President’s announcement is the least of RBS’ problems. It is under intense regulatory pressure both from the EU and UK, to carve out its subsidiaries and make it much more slimmer and less competitive. It is said to be a punishment for the bank due to its risky practices that warranted government bailout. However, a decision for a bank to sell strategic business units and bank branches does not come likely. It would severely impact on turnover and profits, group shared services, and its market share in those core markets. RBS is being asked to sell RBS Sempra, a JV that made a profit of a profit of over $600m in 2008 (Murden, 2010). It is also being required to sell its Asian business, its Insurance business and up to 318 bank branches, in a bid to shore up its capital and repay the UK taxpayers. These businesses are thriving and were the core of RBS’ core strategy of leadership and expansion. The sales of these assets would severely reduce the bank’s assets, customer base and market share, and It may not be able to compete effectively in other markets apart from its traditional Retail and Corporate banking (Gumbel, 2009)

Also, with current public outcry concerning its bonus payout, there is bound to be more trouble for the organisation with regards to recruiting and retaining high performing staff. For instance, the public is concerned that the bank wants to pay out about ?1.5 billion in bonuses, amounting to an average of ?85,000 per staff, when competitors such as Barclays and JP Morgan paying more to their staffs (Patrick, 2010). Even if the bank were government owned, curbing and paying out minimal bonuses just like this would push staff away to competitors that are able to pay competitive packages and are not government controlled. According to Johnson (2009), the bank has already lost about 1,000 staff to competitors such as Barclays last year, and could lose even more staff if the row with the government over bonuses continues.

The organisation is also said to be suffering an increasing threat of credit markdowns, especially in its loans granted to Four Seasons, and also in Dubai’s real estate crisis (Slater and Ferrerira-Marques, 2010). These loan write downs reflect on the practices that the bank had always engaged in, and calls for stricter risk measures that ensures the bank faces lesser threat of write downs in the future. Apart from these measures and effects, the bank is also facing a customer crisis, in the way in which customer perceive the bank. If the bank continues to engage in credit markdowns and selling off its assets, customers may flee for more stable organisations that do not necessarily have that much government oversight. The same could be said for its employees and investors as well, with the government controlling all decisions.

There are also some legal issues affecting the organisation, as some of its shareholders are suing the bank over its right issue in 2008. They attest that they were not made fully aware of the risks associated in the ABN acquisition prior to their signing up for the shares. These investors paid 200p for RBS’ shares, only for it to drastically lose about 95% of its value months later when it announced its biggest annual loss (BBC News, 2009).

In terms of its industry analysis, the company is at a severe disadvantage when it comes to competitive rivalry. Due to its government ownership and uncertainty regarding its future, the company is struggling to compete for customers, employees and investors, against other formidable strong opponents like Santander, Barclays and HSBC. The bank has to sell its Insurance, private equity and over 300 branches. These would severely dent investor and employee confident and market share in a number of core markets. The bank also has to sell its transaction services business.

Based on figures in Table 1 below, RBS still accounts for 18% of all current accounts in the UK, with the lowest market cap of about ?21 billion (18th January 2009). Thereby illustrating that it is still able to compete effectively in the UK market, but to what levelIf the government keeps meddling in its affairs?

Current Account Market Share

Market Cap (? billion)

Total Assets (? billion)

PAT (? million)

Lloyds Banking Group

25%

?36

?1,195

?845

RBS Group

18%

?21

?2,508

-?38,513

HSBC First Direct

14%

?122

?1,736

?6,498

Santander

14%

N/A

N/A

N/A

Barclays

13%

?36

?2,320

?5,287

Table 1: Market share of top UK banks. Source: Reuters (2010)

The economic climate, and the government’s need for new competitors have severely reduced the barriers to entry into the banking system. It was recently announced that Blackstone Group and Virgin planned to open banks in the UK (BBC News, 2009). And guess whatThey plan to do so by hiring off staff and buying off bank branches that are being sold by RBS. The market capitalisations of most banks are less than 40% of what they were prior to the economic markdown. Even the ABN Amro that RBS bought for a large amount would not be worth that same fee now. Therefore there is a huge opportunity for start-up banks or even international banks to come into the market and compete effectively with existing players.

The major suppliers to the industry now are invariable the government who are providing insurance schemes and bailout funds to RBS. The government has enormous power and has been able to exercise it repeatedly in directing the actions of the organisation. Buyers, being bank customers also are weary, and the unwillingness of customers as a whole to join the bank can severely impair the bank’s ability to attract deposits and therefore make more money by lending it to other individuals and businesses. However, the banking industry is crucial in any economy, and is needed to provide credit to businesses, therefore there is no substitute product. This means that the government may continue to support the companies for as long as necessarily, so as to increase liquidity in the economy and provide businesses with adequate loans.

7.FUTURE PROSPECTS

Based on the information gathered and analysed in this study, it can be ascertained that RBS has a very bumpy road ahead. It has 84% government shareholding, and up until when it would be able to raise ?17,640 million (84% of current market cap – ?21bn), it would continue to have government oversight, and its operations, investment and financing activities would continue to be severely impeded. Its current aggressive asset sales that’s its current CEO – Stephen Hester is embarking on is more like a total opposite from the aggressive expansion strategy of former chairman – Fred Goodwin. As to whether RBS would return to profitability in the nearest future, we do not know. But the bank is still announcing credit write offs, so it doesn’t look too optimistic anytime soon.

Also, its strategy of winding down businesses, would severely reduce revenue and profitability figure in the short run, but with a competitive concentration on its core market, and a number of core brands, it could still compete effectively and drive growth locally in UK and EU. However, as forecasted by Norman (2009), that would not be for a few years to come. The bank is still going to find trouble attracting and retaining staff, and its customer base may not grow as well as it used to. However this is a great opportunity for the organization to draw up a new divestment strategy that would ensure it gets rid of regulatory oversight and returns back to profitability, shareholder influence and dividend payment in the nearest future.

8.CONCLUSION

RBS has shrunk in recent years, from a formidable force in global banking, to a part nationalised bank with intense regulatory oversight – that seems like punishment – from both the UK and EU regulators. The bank’s shortcomings occurred mainly as a result of its acquisition of ABN Amro, and not necessarily due to credit markdowns and subprime exposures. Its acquisition was been fuelled by a culture of aggressive growth and expansion in foreign markets, which delivered exceptional growth within those periods.

With the advent of the financial crisis, and near bank failure, came a 84% shareholding lifeline by the government, and with that came an intense regulatory oversight that has severely impeded the bank’s asset base, and even promoted a de-establishment of some core and noncore businesses. These factors have impeded the bank’s competitive strength with regards to current and prospective employees, shareholders and even customers, a disadvantage that may take some years to alleviate. It is therefore recommended that the bank drafts an achievable repayment plan over the coming years for it to be rid of government shareholding and return itself to competitiveness – albeit with a new lesson learnt.

9.REFERENCES

BBC NEWS (2009) RBS shares plunge on recession, www.bbc.co.uk, (accessed29/10/2009)

Duke, S. (2010) Pressure on Government to slash RBS payouts after global banking retreat on bonuses, www.dailymail.co.uk, accessed: 26/01/10

Duncan, H. (2008) RBS chiefs expect 95% to take up rights issue’,www.thisislondon.co.uk. (accessed 30/10/2009)

Financial TImes (2009) RBS et mon droit: HM deficits. ftalphaville,ft,com, (accessed 20/01/2009)

Griffiths, K. (2009) RBS suffers biggest loss in UK history, www.telegraph.co.uk, accessed: 26/01/10

Gumbel, P. (2009) Saving Britain’s Broken Bank, Fortune, 00158259, Vol 159 (10)

Howells, P. G., and Bain, K. (2005) The economics of money, banking and finance: a European text, Pearson Education, 602pp

Hurdle, J. (2010) Developer sues RBS unit for $8 billion, www.reuters.com, accessed: 25/01/10

Johnson, A. (2009) RBS suffers exodus in wake of bonus threats, The Express, www.allbusiness.com, accessed: 28/01/10

Kennedy, S. (2009) The curse of the ABN Amro acquisition, www.marketwatch.com,(accessed 31/10/2009)

Mintel (2009) – Current, Packaged and Premium Accounts – UK – June 2009 (accessed 20/01/2009)

Murden, T. (2010) RBS sale on track despite Obama ban, www.scotlandonsunday.scotsman.com, accessed: 27/01/10

Nayeri, F. (2009) British Bank RBS Gets Ready to Peddle Its Paintings, BusinessWeek online, 12/25/2009,

Norman, L. (2009) UK Defends Its Actions on Rescue of RBS, Wall Street Journal, www.online.wsj.com, accessed: 26/01/10

Patrick, M. (2010) RBS Branch Sale to Step Up A Notch As Possible Bidders Emerge, Dow Joines Newswires, www.online..wsj.com, accessed 28/01/10

Ram, V. (2007) What RBS Did Wrong, www.forbes.com. (accessed 30/10/2009)

Reuters (2010) Financial Statements for RBS, Lloyds TSB, HSBC, and Barclays, www.uk.reuters.com, accessed: 25/01/10

RBS (2010) RBS/NatWest Launch $1bn Fund in Support of UK Manufacturing Sector, www.rbs.com/media/news, accessed: 25/01/10

RBS (2009) What we do, www.rbs.com/about-rbs, (accessed 20/01/2009)

RBS Financials (2009) Company Announcements, www.investors.rbs.com, accessed: 25/01/10

Slater, S., and Ferreira-Marques, C. (2010) Hester refocuses RBS as assets go on block, www.reuters.com, accessed: 27/01/10

The Times (2009) Royal Bank of Scotland: the bank that sank, www.timesonline.co.uk (accessed 29/10/2009)

Times Online (2008) RBS shareholders shun ?15bn rights issue, www.timesonline.co.uk. (accessed 31/10/2009)

10. APPENDIX
2005

2006

2007

2008

Revenue (?bn)

?25,569

?28,002

?31,115

?31,413

Total Assets (?100 bn)

?7,768

?8,714

?19,005

?24,017

PAT (?bn)

?5,558

?6,497

?7,712

-?34,542

RBS 2005 – 2008 Financials

Categories
Free Essays

Free Finance Essay: Savings and Loans Crisis

1.INTRODUCTION

The financial industry encompassing banking, financial services and insurance companies play a very important role in the economy of any nation, and are therefore important in ensuring liquidity in the economy. They are strategically positioned to accept savings from customers, and provide loans to consumers and businesses for a reasonable profit. Their importance therefore lies in their ability to ensure consumers get value for money whenever they resort to save funds, and that businesses and consumers who need loans either for business operations, mortgage financing and/or personal activities can get adequate levels of financing, thereby ensuring continued economic growth.

However, history tells us that these financial institutions have always been known to digress from this traditional business model of ensuring economic growth and liquidity, into riskier profit making activities that could endanger the whole economy in the wake of an economy crisis, such as in the great depression of 1920s, savings and loan crisis of the 1980s, dotcom bubble burst in the early 2000s, and most recently the subprime mortgage crisis starting 2007. Therefore according to Hopkins and Hopkins (1984), the activities of these institutions must be properly regulated and monitored against risky, unscrupulous and economically dangerous activities. These activities may be poised to increase the value of the firm in the short term, and increase benefits attributable to core stakeholders, but may result in tragic occurrences such as the insolvency of a large number of organisations, which is what happened in the great depression, during the S&L crisis and also most recently in the subprime mortgage crisis.

A core example of these occurrences would be in the activities of savings and loan organizations in the United States from 1970 – 1990. Financial regulation, or more precisely – financial deregulation, has been acclaimed as one of the major causes of the scandal that forced about 50% of the S&L businesses in the US into insolvency (Mishkin, 1998; Curry and Shibut, 2000). A critical analysis of the causes, effects of financial deregulation, occurrences, and effects on financial regulation would be analysed in following chapters, in a bid to determine the extent to which regulation could have been employed in averting, or more importantly managing the crisis in a much more appropriate manner.

2.BACKGROUND – SAVINGS AND LOAN INDUSTRY

The savings and loan industry had been operating in the US since the 19th century, and was established under the premise of collecting savings from customers at market interest rates, then providing mortgage and personal loans to other consumers for a higher interest rate (Cebula and Hung, 1992). The businesses were owned by a number of shareholders, usually in a community, thereby limiting the extent to which one person or a group of people could have an influence on the activities of the organisation.

The industry experienced rapid growth during the post world war II era, when millions of service men returned after the war to set up their lives and build families (Mishkin, 1998). The baby boom era that erupted increased the need for real estate, which subsequently increased the number of houses built, and the number of mortgage loans provided for these houses. The period of rapid growth was closely followed by an increasing need for these institutions to attract deposits from customers, in order to fuel further mortgage loans, thereby increasing competition between retail banks and S&L organizations for better access to bank’s deposits (Kester and McGoun, 1989).

Regulation Q was therefore imposed as an interest rate cap that limited the rate that each industry (retail banking and S&L businesses) could give for customer deposit (FDIC, 2002). Thereby limiting competitive pressures within the market. However, this interest rate cap made it impossible for these organizations to compete effectively in times of high interest rates, as customers usually withdrew their deposits in order to earn more interest in money market instruments (Shoven et al, 1991). A series of regulatory changes were therefore proposed and implemented in the between 1980 – 1982, which affected the businesses that S&L businesses could lend to, and also impacted on their financial accounting and risk practices.

3.ECONOMIC AND FINANCIAL REGULATORY ISSUES

As proposed by Konoe (2009), economic and macro economic crisis that result in the fall of a huge number of businesses are not necessarily as a result of one factor, but of a combination of several factors that may have metamorphosed over a period of time. The issues that led to the huge fall of a number of S&L businesses could therefore be explained in terms of the current economy of the US at that period in time, the financial situations facing the industry, and regulatory frameworks in place to ensure ethical business practices across the industry.

a. Economic Issues

High Interest Rate volatility in the 1970s and early 1980s exposed S&L organizations to interest rate risks. These coupled with double digit inflation figures frequently resulted in asset/liability mismatch, in which the organizations were paying more interests for deposits, than were being obtained through fixed rate long term mortgage rates (Shoven et al, 1991).

The oil prices also doubled in 1979, owing to events in oil producing OPEC countries. These deterred real estate investments and subsequently crippled the value of residential and commercial properties in oil producing states. However the Tax Reform Act enacted in 1981 subdued this effect, and enabled homeowners to claim tax back on loss generated by properties they own (FDIC, 2002). This fuelled an increased activity in the real estate market, as a consortium of individuals and businesses came together to invest in the real estate market, in order to limit the level of tax they paid out on other corporate and individual profits (Kester and McGoun, 1989). However, five years later the Tax Reform Act of 1986 revoked those benefits attributable to loss bearing properties, thereby leading to a rapid fall in real estate prices, as they were no longer of appeal to corporate and individual investors seeking tax breaks. The fall in real estate prices as a result of tax break, and also the rise in oil prices, led to a situation whereby real estate was of a hugely reduced value in oil producing states, and also reduced in several other states likewise (Steward, 1991).

b. Financial Regulation

The interest rate ceilings that were imposed in the 1960s to limit competitive activities in the S&L industry were revoked in 1980, thereby allowing S&L businesses to compete against banks and other money market institutions in attracting customer deposits (FDIC, 2002). This enabled them to offer higher interest rates in order to attract deposits, often higher than the going market rate. These unrealistic interest rates led to scenarios whereby S&L businesses were paying higher rates for savings, much higher that rates obtained on their long term fixed rate mortgages. They therefore needed to engage in projects that earned higher loan rates, thereby subsequently increasing the risk profile of their loan portfolio (AP, 1991).

A series of regulatory reforms also ensued during that period, liberalized S&L powers thereby increasing the portion of their loan portfolio that could be lent for commercial purposes. The Financial Institutions Regulatory and Interest Rate Control Act of 1978 enabled savings and loan organizations to loan capital to construction and development companies up to 5% of their capital. Further statutory and regulatory changes that ensued also enabled these businesses to invest capital in other market categories apart from real estate (FDIC, 2002).

Other legislations put into place in 1980 also reduced the net worth requirements that S&Ls had to have in order to remain solvent and continue business as usual from 5% – 3% from 1980 – 1982. The Federal Home Loan Bank Board (Bank Board) also allowed S&L businesses to appear solvent by issuing income capital certificates. The Bank Board also removed limitations on the number of people that could own an S&L business from 400 stockholders, to just one. State governments such as California, Texas and Florida also followed the Federal Government’s regulation, enabling state savings and loan companies to invest 100% of customer deposits in any kind of venture they felt was appropriate (Cebula and Hung, 1992).

The Insurance board in charge of S&L deposits (Federal Savings and Loan Insurance Corporation – FSLIC), also increased the insurance on savings deposits from $40,000 – $100,000. Thereby increasing the amount of deposits in the S&L industry, as deposits were assured that the government would reimburse them for any deposit they made up to that amount in any insolvent S&L business (Calavita et al, 1999). The increase in deposit insurance also prompted the rise of brokered deposits, in which a broker would collate a large amount of deposit from investors, and invest them in the S&L offering the highest interest rates (Lannon, 1991). These according to Salinger (2005), facilitated dubious practices from these brokers, and risky practices from S&Ls who had to provide the highest interest rates in order to attract deposits, just so they could provide risky loans to businesses at even higher interests for them to break even. Mason (2004) asserts that this cycle is a major reason behind the dubious practices that accounted for over 15% of total insolvencies.

4.CRITICAL ANALYSIS OF THE EVENTS

a. Pre-Deregulation

According to the accounts of Mason (2004), the S&L businesses were already witnessing a downturn prior to the deregulation of the sector. They had increasing competition from money market instruments, which led to disintermediation in which customers opted to invest directly in the money markets that provided higher interest rates. They were unable to compete effectively due to interest rate volatilities and the caps already fixed by the government, which limited the rates they could offer. This economic situation therefore seems like some sort of two way situation in which S&Ls were stable but declining businesses during the initial regulatory period, and became more unstable, experienced sudden jerk in growth, an a subsequent decline in total value as a result of risky activities that ensued after deregulation. Hopkins and Hopkins (1984) asserts that if the industry was never deregulated in the first instance, it may have led to an era of consolidation in which businesses bought themselves out in a bid to establish larger S&L businesses that had more economic leverage and scale. However Kester and McGoun (1989) dictate in contrast to Hopkins and Hopkins, that certain aspect of the deregulation were actually needed, such as the removal of the interest rate ceilings, and the ability to loan to other businesses. These were needed because of the current state of the economy in which real estate prices were falling rapidly and interest rates were volatile. However they concludes that these should have been done with the same prejudice and oversight given to the banks that already enjoyed these benefits, and if those were enacted, the crisis that resulted in that economic situation could have been minimized or largely avoided.

However the Fed took the different approach and opted to deregulate the entire market, as this was seen as a method of stabilising growth in the market, ensuring profitability and liberalising the methods in which these thrift organisations lent money (Mason, 2004). The ability to lend to other parties apart from personal loans and homebuyers, and also collect deposits from brokers, were seen as a method of ensuring profitability and growth in the market (Curry and Shibut, 2000). Lannon (1991) states that these actions may have made sense as a true capitalist and free market approach, as these businesses could have been able to set their prices and compete effectively against each other and other organisations in the money market such as banks and financial institutions. These actions according to Barth et al (2004) would have ensured better survival for these businesses, as long as their activities were overseen, but it was not.

b. One man ownership

The risky activities of these organizations were escalated when the government enabled only one person to own an S&L business, as opposed to previous practices (Salinger, 2005). The major point raised in relation to this proposition, was why the government would allow banks’ competitors to be owned by one individual when the banks themselves were not allowed to be owned by one individualGuidelines on ownership were not imposed, and there were no set rules on the level of management competency that the companies needed to have in order to be run by one individual (Cebula and Hung, 1992).

According to Barth et al (2004), it was these deregulatory measures that actually prompted dubious accounting practices different from that of banks, which S&Ls were competing with, it also resulted in the introduction of higher than manageable interest rates and brokers who collated deposits from a number of parties and invested them into the best interest payer. If the market was never deregulated, then the interest rate ceiling would have always been enacted, and though that could have limited the competitive capacity of S&Ls, it would have also ensured that they adhered to their predominant practices, and never resorted to paying higher than manageable interest rates, or attracting brokered deposits in a bid to shore up their capital base (Mishkin, 1998). According to Shoven et al (1991), if the banks instead were limited in their ability to compete with S&Ls in specific regions or states, then it would have ensured that these companies could compete effectively in those given markets. Mason (2004) also states that enabling thrifts to act like bank without imposing the same regulatory oversight and accounting principles practices by banks was always headed for disaster.

c. Real Estate Tax Reform

One of the other major causes was the Tax Reform Act that was established and abolished in 1981 and 1986 respectively (Hermalin and Wallace, 1994). Investors were initially allowed to deduct loss-bearing assets from their tax payables, which prompted a series of passive investments in property, so investors could take up loss bearing assets that could be deducted from their annual earnings. These activities drove up the market value of real estate, and also the number of mortgages granted to these passive homebuyers. When this tax advantage was abolished in 1986, passive investors who had bought real estate as a method of claiming tax benefits began to offload as their properties had become financially useless. These drove down the prices of real estate as a huge number of investors were trying to offload their real estate properties (White, 1991). A fall in real estate value would result in losses for the homebuilders – which S&Ls were now allowed to lend to; and loss to homebuyers – whose home value may now be much less than the mortgage owed on it. Due to regulatory lax on accounting standards, most of these thrifts had equity values that were less than 2% of their total asset base, and still allowed to stay solvent (FDIC, 2002).

d. Depository Insurance

Finally, the depository insurance that was increased from $40,000 – $100,000 acted more like a moral hazard, since most depositors who were already aware of the risky business practices of these S&L businesses, did not have to care much about the solvency risk of the business where their deposits were held, since the government had already opted to secure deposits (Brewer and Mondschean, 1994). The question now was not on which businesses were safer to invest in, it was in which businesses had the higher deposit rate (Haveman, 1993). The S&L businesses therefore realised that in order to continue to attract deposits they needed to offer higher – sometimes unrealistic – interest rates (as fixed long term mortgages usually had lower rates), and in order for the company to breakeven on these interest rates, they needed to offer the loans at higher prices (Shoven et al, 1991). The only projects or businesses that would be willing to pay higher interest rates for their loans would be those that are unable to obtain prime loans – often handed out to organizations with good credit rating and business reputation.

Therefore based on these analyses, it could be deduced that a coherent analysis of the structure of the crisis would be:

Interest rate volatility and inability to compete with money markets
Removal of interest rate ceilings
Ability of S&L businesses to lend to organizations, as opposed to just mortgage lenders
Real Estate Tax reform act 1981 enabling investors to buy property for the sake of reducing tax payable
Deposit insurance increase from $40,000 – $100,000
Rise of brokered deposits
Real Estate Tax Reform Act 1986 removing tax benefits associated with loss bearing properties.
Flex of accounting rules, thereby allowing GAAP insolvent businesses to run under the RAP framework.

Hopkins and Hopkins (1984) further asserts that it was these risky lending, high interest rates and long term fixed mortgages that led to the widely acclaimed asset/liability mismatch occurring in the industry. The asset/liability mismatch in conjunction with the drastic fall in real estate crisis that ensued after the tax reform act of 1986, helped to catapult the crisis deeper.

5.RESULTANT EFFECT OF THE SCANDAL

a. Total Cost

The total cost of the crisis as at 31 December 1999 was $153 billion, which was bore by the US government ($124 billion), and the sales of failed thrift assets (29 billion) – Curry and Shibut (2000)

The cost that the US government bore was much higher than the intended target, when President Bush announced the bailout in 1989, and resulted in a huge national deficit within that period (Kester and McGoun, 1989).

b. Reduction in number of S&L businesses

The total number of S&L businesses had fallen from 3,234 in 1986 to 1,645 in 1995, while 1,043 thrift organizations with assets of over $500 billion failed (Curry and Shibut, 2000). This was due to aggressive closures by the regulatory authorities that had been slow to react initially. Assets of insolvent banks were seized, shareholders were wiped out, and troubled loans and deposits were sold to other thrifts and banks, while the residual assets were sold at the highest possible price (White, 1991). The main aim of the regulatory authorities was to return customer deposits and increase net present value of losses (Curry and Shibut, 2000).

Outstanding mortgages in the insolvent businesses were securitized in what is now called mortgage backed securities, and saved the regulatory authorities about $60 billion. The total market share of thrift organizations in terms of customer residential mortgages fell from 53% in 1975 to 30% in 1990 (Lannon, 1991)

6.REGULATORY REFORMS THAT ENSUED

Following President Bush’s speech in 1989 regarding the scale of the S&L crisis and the role the taxpayer had to play, it was clear that the current measures being put in place to tackle this crisis were not adequate enough to avoid an industry shutdown (Konoe, 2009). The Financial Institutions Reform, Recovery and Enforcement Act was therefore enacted in 1989, and passed by congress, and the main aim of this act was the restructure the US financial regulation, especially those supervising the thrift industry (FDIC, 2002).

The major aim of the regulation was the dissolve the incumbent FHLBB (Supervisory bank board) and FSLIC (Deposit Insurance for thrifts), and establish the Office of Thrift Supervision, which would now be in charge of regulating and supervising activities in the thrift industry, and the Resolutions Trust Corporation, responsible for taking over and liquidating assets of incumbent organisations (Calavita et al, 1999).

The FDIC, which was already responsible for deposit insurance for US banks were now given extended responsibility in insuring thrift organizations, therefore extending the same accounting, regulatory and risk standards expected of banks (FDIC, 2002).

According to Salinger (2005), these actions came late in time, as if they were enacted early in 1986, the number of losses witnessed by the industry could have been greatly reduced and some of the liquidity could have been averted. However a number of lessons have been learnt based on these occurrences, and some of these lessons would subsequently be used in managing the subprime crisis.

7.LESSONS LEARNT

The main lessons learnt from crisis that erupted within this period, was reflected in the method of supervision imposed on the thrift industry, and several other banks not necessarily operating in that capacity (Konoe, 2009). The Resolution Trust Corporation was entrusted to liquidate any thrift or bank that did not necessarily meet capital requirements, and fell short of regulatory standards in terms of risk profile and business activities. Apart from the 50% of thrifts liquidated, an extra 1,600 banks were also affected indirectly (Barth et al, 2004). Several operational guidelines were also imposed on the activities of thrift organizations; whilst the customers they could funds to were again restricted (Stewart, 1991).

The steps taken by the regulatory authorities within that period for the thrift companies are very much different from that taken recently during the subprime crisis, when the US government decided to bailout failed banks, financial and insurance companies with funds totally $700 billion. For instance, instead of pumping money in order to shore up the capital of these organizations, the authorities then seized their assets, wiped out shareholders, and sold these assets. These ensured that failed organizations with bad management were not allowed to continue business services, and resulted in a fewer number of thrift organizations that were able to conduct business effectively (Meier, 2008).

However, some of these strategies were adopted on a small scale for the failed Wachovia Bank, and several other state owned banks. The FDIC took over the assets of the company, and divided them based on their risk profile, then sold off these assets to other strong banks, whilst insuring them against future losses (Meier, 2008). This is very identical to the steps it took during the S&L crisis, and illustrates that the regulatory authorities have learnt their lessons with regards to managing and liquidating the assets of insolvent organizations.

The illusion that these organizations had learnt a lesson on a broad scale however, seems to have been lost when the same risky business practices and mortgage lending led to the failure of organizations during the subprime crisis (Konoe, 2009). It is even debated by Meier (2008), that it was the assurance of a bailout as witnessed during the S&L crisis, that warranted those practices, citing that the US government would bear the cost if the subprime mess ever went under – which it did.

8.CONCLUSION

Financial regulation is a two edged sword. Too much of it may lead to lack of competitive advantage and overregulation, while too little of it may lead endanger the whole financial economy, and whatever it stands for. Business practices that are solely based on profit maximization without consideration of the key stakeholders – which are the customers and tax payers that may eventually bear the brunt – would engage in activities that aim to increase their present net worth, with no consideration of future implications.

Therefore financial regulation of these activities should be carried out in such a way that it ensures that these practices run profitably, whilst still considering its benefits the whole economy.


9.REFERENCES
AP (1991) S. & L. Case Convictions, www.nytimes.com, accessed: 02/01/10

Barth, J. R., Trimbath, S., and Yago, G. (2004) The Savings and Loan Crisis: Lessons from a Regulatory Failure, The Milken Institute Series on Financial Innovation and Economic Growth, Vol. 5, 440pp

Brewer, E., and Mondschean, T. H. (1994) An Empirical Test of the Incentive Effects of Deposit Insurance: The Case of Junk Bonds at Savings and Loan Associations, Journal of Money, Credit & Banking, Vol 26, pp231 – 256

Calavita, K., Pontell, H. N., and Tillman, R. (1999) Big Money Crime: Fraud and Politics in the Savings and Loan Crisis, University of California Press, 281pp

Cebula, R. J., and Hung, C. (1992) The savings and loan crisis, Kendall/Hunt Pub. Co., 117pp

Curry, T., and Shibut, L. (2000) The cost of the Savings and Loan Crisis: Truth and Consequences, FDIC Banking Review, December 2000

FDIC (2002) The S&L Crisis: A Chrono-Bibliography, www.fdic.gov, accessed: 03/02/10

Haveman, H. A. (1993) Organizational Size and Change: Diversification in the Savings and Loan Industry after Deregulation, Administrative Science Quarterly, Vol. 38 (1), pp20 – 50

Hemalin, B. E., and Wallace, N. E. (1994) The Determinants of Efficiency and Solvency in Savings and Loans, Rand Journal of Economics, Vol. 25, pp45 – 71

Hopkins, W. E., and Hopkins, S. A. (1984) Savings and Loan Industry: Strategic Responses to Regulatory Change, Business & Society, Vol. 23, pp 37 – 44

Konoe, S. (2009) Financial Crises, Politics and Financial Sector Restructuring: A comparison between Japan and United States, Journal of Asian and African Studies, Vol. 44, pp497 – 515

Kester, G. W., and McGoun, E. G. (1989) Symposium on “The savings and loan industry: crisis or opportunity”, Organization & Environment, Vol. 3, pp235 – 253

Lannon, K. M. (1991) Records Management and the U.S. Savings and Loan Crisis, Records Journal, Vol. 3 (4), 125 – 167

Mason, D. L. (2004) From buildings and loans to bail-outs: a history of the American savings and loan industry: 1831 – 1995, Cambridge University Press, 349pp

Meier, B. (2008) Savings and Loan Crisis May Be Guide for Bank Bailout, www.nytimes.com, accessed: 02/01/10

Mishkin, F. S. (1998) The economics of money, banking and financial markets, Addison-Wesley, 732pp

Salinger, L. M. (2005) Encyclopedia of white-collar and corporate crime, SAGE, 974pp

Shoven, J. B., Smart, S. B., Waldfogel, J. (1991) Real Interest Rates and the savings and loan crisis: The moral hazard premium, National Bureau of Economic Research, Issue 3754 of Working paper series, 29pp

Stewart, A. W. (1991) The savings and loan crisis: a bibliography, Vance Bibliographies, 11pp

White, L. (1991) The S&L Debacle: Public Policy Lessons for Bank and THrift Regulation, Oxford University Press, 208pp

Categories
Free Essays

Free Finance Dissertation Topics

1.0. Introduction

The aim of this guide is to assist in selecting a finance dissertation topic and to provide practical advice on how to go about writing a dissertation. Finance dissertations incorporate numerous topics covering various aspects of financial management issues. Typically, writing a finance dissertation involves questions such as how to report the features of the design and how to adequately report research results. Consequently, the latter part of the guide serves as a handy reference source to navigate the writer through the process.

2.0. Categories and dissertation titles

2.1. Corporate Finance

2.1.1. An assessment of capital structure and corporate governance. Are differences in banking capital structure traceable to differences in quality of corporate governance in banks?

2.1.2. Integrating options theory in capital budgeting for innovation management. A case study of the oil and gas industry

2.1.3. An assessment of mergers and acquisitions in the Indian pharmaceutical industry. A focus on consolidation process and firm performance

2.1.4. An evaluation of risk management and corporate strategy in low budget airlines. A case study of Easyjet

2.1.4. Examining the impact of taxes on dividend policy. A study of the Ghanaian banking industry

2.2. Investment and Portfolio Management

2.2.1. An assessment of strategic portfolio management for analysing and improving overall asset value. A case study of the petroleum industry

2.2.2. Investigating term structure of volatility in the stock market of developing countries. A case study of Nigeria

2.2.3. A study of Management techniques for exchange rate exposure. Exchange rate risks through hedging from the perspective of UK-based investors investing in the USA.

2.2.4. Using the Capital Asset Pricing Model for performance evaluation in portfolio management. Analysing market microstructure effects on modelling Russian stock returns

2.2.5. A study of mean-variance portfolio theory: An assessment of Barclays international banking

2.3. International Financial Management

2.3.1. Measuring International financial management and profitability of SMEs in South Korea. A quantitative study

2.3.2. An analysis of foreign exchange rate management in multinational corporations: Foreign exchange rate management by the Japanese automotive industry

2.3.3. Assessing firm methods of determining the effectiveness of managing operational and economic risk. A case study of international Swiss banking

2.3.4. An analysis of the role of culture in effective operational risk management. A case study of the South African financial sector

2.3.5. Examining determinants of profitability in the European banking sector: A study of financial regulation and ownership issues

2.4. Business Continuity and Crisis Management

2.4.1. An evaluation of strategic contingency planning models for emergency management and business continuity in the UK banking sector

2.4.2. An examination of the 1997 Asian financial crisis and restructuring measures implemented by Singaporean business groups for future crisis management

2.4.3. An analysis of financial planning and budgeting for natural disasters. A study of hurricane prone states in the USA

2.4.4. A study of banking governance failures of the 2008 financial crisis in the UK and USA. An empirical study of lessons from the crisis

2.4.5. A study of shareholder perspective on business continuity and crisis management. Shareholder response to the 2008 financial crisis

2.5. Financial Planning and control

2.5.1. An evaluation of the benefits and problems associated with traditional budgeting in the UK manufacturing industry. A critical review of the literature

2.5.2. An analysis of financial planning and control in the airline industry. A case study of Emirates and Air France

2.5.3. A study of budgeting as a control tool in Nigerian SMEs. A quantitative study

2.5.4. An analysis of budgetary control and organisational culture on organisational performance. A case of study IT projects in the UK e-commerce industry

2.5.5. Evaluating financial planning control effectiveness in multinational corporations. A case study Coca cola

3. How to Structure a Finance Dissertation, Tips

For details on how to structure your finance dissertation, kindly check out the following post:

How to Structure a dissertation (chapters)
How to structure a dissertation (chapters and subchapters)
How to structure a dissertation research proposal

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“Effects of adapting International Financial Reporting Standards (IFRS) on the Financial Statements and Reporting Quality of the Micro Finance Institutions in Uganda”

1. Introduction:

Over the years Microfinance has become a diverse and growing industry. There are over hundreds of institutions in Uganda providing micro finance services (check website), ranging from grass roots self-help groups and NGOs to commercial banks that provide financial services to millions of microenterprises and low-income households. These Microfinance Institutions (MFIs) receive support and services not only from donor agencies, but also from investors, lenders, network organizations, rating firms, and a host of other specialized businesses.

MFIs must follow an industry-wide standard so that reporting to donors, lenders, and investors are accepted and understood by the recipients. It becomes much easier for the MFIs to prepare its accounts and reports if the recipients of the reports are also in agreement with the standards (pwc paper). For this purpose The SEEP Network in 2005 came up with a framework to provide microfinance practitioners with a means to develop financial statements and reports so that those statements and reports can be used for meaningful analysis and monitoring and are in accordance with International Financial Reporting Standards with (IFRS). However, even after the establishment of a framework some MFIs find it difficult to abide by, and many financial terms and indicators considered “standard” continue to differ in name and content among MFIs. This leads to confusion among practitioners and analysts and causes considerable distortions when comparing MFIs (SEEP report). For Example: Understanding the difference between arrears and portfolio at risk is important. Arrears measure the sum of all past due payments, whereas portfolio at risk is the total value of loans outstanding that have one or more past due payment. The word delinquency may refer to either, which leads to confusion.

As mentioned above MFIs also find it hard to comply with the International Financial Reporting Standards completely. For Example: MFIs normally follow a mixed accounting system where the accrual method of accounting is used for expenses and the cash method is used for interest earned on loans. Although the cash method of accounting may be acceptable for internal management reports, but according to IFRS and IAS an adjustment for accrued interest is required.

Therefore, the study will be identifying the differences in the financial reports of the MFIs compared to the IFRS.

2. Objective:

The major objective of the study is to gain an extensive understanding of the Micro Finance sector in Uganda and to identify the effects caused by the implementation of IFRS in the financial statements. While analyzing the implementation of IFRS, the focus of the study is also to identify the differences in the financial statements and reports and whether it complies with IFRS.

3. Literature Review:

3.1 Introduction:

Research has been conducted assessing Uganda’s accounting and auditing practices to ensure the quality of corporate financial reporting (Uganda, Accounting & Auditing, ROSC, 2005). Further more literature related to the micro finance industries consists of mainly its impact (USAID, 2001) and effects on poverty reduction (J. Morduch & B. Hale, 2001). Few guidelines and surveys were conducted by the SEEP Network and CGAP to determine the reporting standard of the Micro finance industry.

3.2 What is Micro Finance?

According to Marguerite Robinson the definition of Micro Finance is “Micro Finance refers to small scale financial services for both credits and deposits that are provided to people who performs agricultural activities; operate small and medium enterprises in developing countries, in both rural and urban areas”.

Micro-finance means transactions in small amounts of both credit and saving, involving mainly small-scale and medium-scale businesses and producers. Micro Finance Institution (MFI) set up centers in targeted areas with group members. These group members consists of 25-40 members per groups, this number will vary with different MFIs. The loans are normally disbursed to two or three of the members of self-selected groups (mostly female groups) and the whole group becomes responsible for the repayment by their fellow members. The other members only get their loans when the initial borrowers pay their installments regularly. Members have to attend regular meetings, usually weekly, to repay their loans.

The history of microfinance is often associated with the rise of nongovernmental organizations (NGOs) providing microcredit services to the poor and the development of a handful of microfinance banks. In the early 1990s, standards began to emerge calling for stronger financial management of microcredit providers, particularly in their delinquency management and reporting. At the same time, credit unions and banks involved in micro lending developed stronger monitoring techniques for their microcredit portfolios. As the micro finance industry grew in capacity and outreach the competition also started to increase, therefore, it became important for the industry to introduce a reporting standard which will increase transparency, facilitate comparability, improve decision-making, and increase investment by making it easier to observe and understand an MFI’s financial health.

3.3 Micro finance reporting standard:

Microfinance as an industry does not have a central body or mechanism to address compliance or updates to financial reporting standards. MFIs worldwide do not follow standards, and are only now beginning to use tools like International Financial Reporting Standards (IFRS)(new developments in mfis).

IFRS is a principle based set of 37 accounting standards. As the need for consistent worldwide reporting standards grows, the goal is to provide a general financial reporting guidance for public companies. Within the European Union (EU) companies with securities listed on stock exchange must adopt IFRS for their consolidated financial statements starting in 2005. Many other countries worldwide require IFRS as the leading reporting standard. Over 100 countries are currently using IFRS. There are many reasons for implementing IFRS. Most important is the comparability of financial statements worldwide. For investors and auditors the IFRS provide a cohesive view of the consolidated financial statements.

(http://ifrs-ebooks.com/ifrs-explanation.html)

Since 1990, MFIs have grown in size, type, number, and complexity (BoU report). At the same time, more emphasis has been placed on financial accountability, management, and viability. A growing acceptance of standards for micro finance has emerged since the early 1990s. In 1995, The SEEP Network produced a monograph, Financial Ratio Analysis of micro finance Institutions, which became the standard set of 16 ratios that micro finance institutions monitored. Then, in 2002, micro finance institutions, The SEEP Network, rating firms and donor agencies jointly developed Microfinance Financial Definitions Guidelines: Definitions of Selected Financial Terms, Ratios, and Adjustments for microfinance, known as the Financial Definitions Guidelines.

3.4 Overview of Micro Finance Industry in Uganda:

Uganda occupies an area of 241,038 sq km[1] in the heart of East Africa, with a total of over 34.6 million (July 2011 est.)[2]. Approximately 94 percent of the poor live in rural areas where about 75 percent of the population lives (CGAP, 2004) and depend on Agriculture, which contributes about 36.1 percent of the Gross Domestic Product (GDP).

Uganda’s financial system is characterized by the co-existence of formal and informal financial markets. The formal financial markets, which mainly comprise of commercial banks, development banks and credit institutions mainly exist in urban areas and offer a narrow range of financial services. They concentrate on providing working capital mainly to medium and large-scale enterprises. Furthermore, the formal financial institutions are inflexible in their operations, with respect to the needs of the small-scale enterprises and the poor people in the rural areas who may not have collateral or well-written feasibility studies to solicit for loans. As such, the rural areas, where the majority of poor people live, remain either under-banked or served by informal financial institutions.

MFIs in Uganda consist of moneylenders, micro-finance agencies, Non Government Organizations (NGOs), rural farmers’ schemes and savings societies that provide savings and/or credit facilities to micro and small-scale business people who have experienced difficulties obtaining such services from the formal financial institutions. Their range of activities include; deposit taking, savings schemes, small-scale enterprises, agriculture, real estate, group lending, retail financial services, giving advice on financial matters and training in business management.

The Microfinance industry in Uganda is in its advanced stage of evolution. Since the 1990s, Uganda has created a success story by developing the market for microfinance services, which has been considered a role model for Africa and even other regions (Goodwin-Groen et al. 2004). Its growth and development will be a function of the support and effort of practitioners, donors and the Government working together to create an enabling environment for its development. It is readily apparent that the Government is committed to economic and financial reforms. In addition to the other reforms being implemented through its economic policy framework, the Government has shown its commitment to reforming the financial sector. Operationalization of the Microfinance Policy and the legal and regulatory framework indicates renewed efforts and commitment to improving the financial system. The Government is acutely aware of the limitation of the traditional banking sector’s ability to mobilize savings from and extends credit to poor people in rural and urban areas. This population has a weak financial resource base and is in dire need of financial services that cater for its unique circumstances.

3.5 Regulatory Structure for Micro Finance in Uganda:

The current financial sector policy in Uganda aims primarily at systemic safety and soundness as a supporting bedrock for orderly growth. The policy, drafted by the BoU and approved by Government following multiple bank failures of the late 1990s, was significantly informed by the bitter lessons learnt from these failures and by incidences of fraudulent organizations that fleece the public. The role of Bank of Uganda, the financial sector regulator, is to ensure systemic safety, soundness and stability of the whole financial sector, and protection of public deposits in the regulated financial institutions.

Bank of Uganda issued the policy statement in July 1999 that established a tiered regulatory framework for microfinance business within the broader financial sector. The policy established four categories of institutions that can do micro-financing business in Uganda:

Tier 1: Commercial banks.Banks are regulated under the Financial Institutions Act revised in 2004. Since these are already sufficiently capitalized and meet the requirements for taking deposits as provided for in this Act, they are allowed to go into the business of microfinance at their discretion.

Tier 2: Credit Institutions (CIs). These institutions are also regulated under the Financial Institutions Act 2004. A number of them offer both savings and loan products but they can neither operate cheque/ current accounts nor be part of the BoU Clearing House. Like banks, they are permitted to conduct microfinance business since they are already sufficiently capitalized and meet the requirements for taking deposits provided for in the Act.

Tier 3: Micro Finance Deposit Taking Institutions (MDIs). This is the category of financial institutions that was created following the enactment of the MDI Act. Originally doing business as NGOs and companies limited by guarantee, these institutions transformed into shareholding companies, changed their ownership and transformed/ graduated into prudentially regulated financial intermediaries. They are licensed under the MDI Act and are subjected to MDI Regulations by BoU. Like Tier I and II institutions (banks and CIs), the MDIs are required to adhere to prescribed limits and benchmarks on core capital, liquidity ratios, ongoing capital adequacy ratios (in relation to risk weighted assets), asset quality and to strict, regular reporting requirements.

Tier 4: All other financial services providers outside BoU oversight. This category has SACCOs and all microfinance institutions that are not regulated – such as credit-only NGOs, microfinance companies and community-based organizations in the business of microfinance. These institutions have a special role in deepening geographical and poverty outreach, and in other ways extending the frontiers of financial services to poorer, remote rural people.

3.6 Overview of Accounting System in Uganda:

The Institute of Certified Public Accountants of Uganda (ICPAU) is the only statutory licensing body of professional accountants in Uganda. It was established by the Accountants Statute, 1992, but did not commence operations until 1995. The ICPAU is empowered by the statute to establish accounting standards and to act as a self-regulatory organization for professional accountants, which includes requirements for practicing as a professional accountant in Uganda.

The functions of the Institute, as prescribed by the Act, are:

To regulate and maintain the standard of accountancy in Uganda;
To prescribe or regulate the conduct of accountants in Uganda.

The objectives, of the institute included the regulation of accounting practice and the provision of guidance on standards to be used in the preparation of financial statements. As with most developing countries, and in cognizance with developments in the area of accounting at a global level, the ICPAU in 1999 adopted International Accounting Standards (IAS) without any amendments (Dumontier and Raffournier, 1998).

Prior to the adoption of IAS, there had been a proliferation of approaches to the preparation and presentation of financial statements in Uganda. One of the more obvious approaches to the presentation of financial statements was based on references to Generally Accepted Accounting Standards (GAAS) and firm law (Samuel Sejjaak, 2003).

3.7 Adaptation of IFRS in Uganda:

Since 1998, the Council of ICPAU has adopted International Financial Reporting Standards (IFRSs, IASs, SIC and IFRIC Interpretations) as issued by the International Accounting Standards Board (IASB), without amendment, for application in Uganda (IFRS for SMEs). International Financial Reporting Standards set out recognition, measurement, presentation and disclosure requirements dealing with transactions and other events and conditions that are important in general purpose financial statements.

The adoption of IFRS in Uganda to a larger extent is influenced by external factors such as foreign investors, international accounting firms, and international financial organizations among others. However, unless a country opens its doors to these institutions, there is little they can do to politicize the adoption process. The implication is that – the more a country is opened to the international environment, the higher the possibility that the country would be coaxed into adopting International Financial Reporting Standards.

4. Methodology:

The research will be conducted in an attempt to analyse the index and the quality of the accounting statements of the micro finance industry. Due to this reason the target of this study is the collection of empirical observations concerned to the effect of the adaptation of International Accounting Standards to the quality and quantity of the accounting information that are published.

The work of this study will be based on desk research only. A desk-based research will be initiated to make the essential link between theoretical frameworks and empirical observation. Mainly the study will focus on the comparative examination of the annual Financial Statements of Micro Finance Institutions in Uganda registered by the Bank of Uganda (BoU).

To examine and analyse the content of those Financial Statements so as to meet the objectives of the project and derive conclusions, the following methods will be taken into consideration.

Content analysis has been defined as a systematic, replicable technique for compressing many words of text into fewer content categories based on explicit rules of coding (Berelson, 1952; GAO, 1996; Krippendorff, 1980; and Weber, 1990). Content analysis enables researchers to sift through large volumes of data with relative ease in a systematic fashion (GAO, 1996). It can be a useful technique for allowing us to discover and describe the focus of individual, group, institutional, or social attention (Weber, 1990).

There are two general categories of content analysis: conceptual analysis and relational analysis. Conceptual analysis can be thought of as establishing the existence and frequency of concepts – most often represented by words of phrases – in a text. In contrast, relational analysis goes one step further by examining the relationships among concepts in a text.

(Writing Guides, http://writing.colostate.edu/guides/research/content/com2d3.cfm)

Another method that can be very significant to the study is the Comparative analysis. Comparative research, simply put, is the act of comparing two or more things with a view to discovering something about one or all of the things being compared. This method may also be appropriate for the study, as it will provide a comparison between the financial accounts of the MFIs with the IFRS.

Both content analysis and comparative analysis can be used for the determination of the study. Although there are some limitations with both methods it is thought as the most appropriate methods/tools for the purpose of the study. [TC1]


5. Conclusion:

Over the last two decade micro finance has transformed itself to a multi million-dollar industry. To continue its work in poverty reduction MFIs requires support from the international investors and donors. For this they would require to provide evidence of success, sustainability and transparency through the financial statements and reports. MFIs would require presenting the reports in a standardized format, which can be understood by the interest groups. Hence, the implementation of the IFRS became very important in this sector. However, it became quite difficult for the micro finance industry to totally comply with IFRS. Therefore, it is important to understand the effects of IFRS in the micro finance industry and what are differences that arise as the result of the implementation.[TC3]

6. References:

[1] Source: CIA – The World Fact book Website: https://www.cia.gov/library/publications/the-world-factbook/geos/ug.html

[2] Source: CIA – The World Fact book Website: https://www.cia.gov/library/publications/the-world-factbook/geos/ug.html

[TC1]Not clear what will you use for the study.

[TC2] [TC2]Maybe you can elaborate more on each method, and then discuss which method you are choosing and why?

[TC3]End with a statement on how this research is going to achieve this goal…

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International economics and finance

PART ONE INTRODUCTION

The most basic needs in an economic functioning is the starting of the expanding deficit and natural resources which are the essentials of making manufactured goods and are the most important foundation of consumption of economy. As the impact on the financial and economic development is a very entensive debate on its desirability in United Kingdom. Globalisation in both developed and developing countries have changed prior to the relatively unnoticed capital flows in the 1990’s. The UK is one of the richest countries in the world, especially with the current decline in the global economy. They are one of very few that is managing to keep their heads above water.

As broadly defined, a Balance of Payment Account records all of the financial transactions of the government with the rest of the world (international economy) over a period of one year. (Begg D, 1987). Essentially, each transaction is always recorded relating with the double-entry bookekeeping. Any amount involved must be entered on each of the two sides of the balance of payment accounts to complete the balances. If the two sides of the balalcen of payment account are not the same, then the case if imbalance occurs. Therefore, these balances are referred to as surpluses or deficits in the balance of payment account.

This assignment attempts to discuss how can there be deficits or surpluses of the balance of payment account if the balance of payment account must always balance. With the introduction in the first part, it states the definition and principles of balance of payment. Part two consists of Structure of a balance of payment account, how does balance of payment account balance, causes of balance of payment surplus or deficit, reasons for financing a short term deficit and the steps in rectifying or correcting the deficit. Part three is the last part where there is a conclusion of any suggestions pertaining why the balance of payment account must always balance. Part four states the referencing and bibliography and details of the sources of information used in this essay.

PART TWO Structure of Balance of Payment Account

The Balance of Payment Account is divided into two sections where the current account measures both the trade in goods and trade in services whilst the capital account tracks associated money flows with investment, services and the currency stabilisation of the UK. Any credit transaction must have a corresponding debit entry so therefore; the sums must always be equal or balance at the end of each transaction made. In 1998 the UK’s Balance of Payments transactions were brought into consideration with other members of the International Monetary Fund (IMF). The Balance of Payment’s statistics was classified into groups as follows: the current account, the capital account, the financial account and the international investment position.

How does a Balance of Payment Account balances?

As it has always been at the back of my mind when I was taught about the accounting principle of double entry, in every balance sheet there is a credit and debit entry. Every credit entry must have a sorresponding debit entry ans should always have an agreed sum of equal balance. Wherevet there is a surplus, there must be a deficit because they come to terms in a financial transaction and offset each other. Whenever the current account is a surplus, then there should be a deficit in the capital account. If there is a deficit in the capital account then it means that there is abruptly a rise in investment for the UK in the outside world but it cannot last because the other countries wolud also not want to be selling their assets to make another country benifiting from them. If the UK faces a current account surplus, then it is said to be that there is a flow of trade in goods and services funds. A current account surplus leads to an increase of external assets outside the UK.

On the other hand, if the current acount is on deficit there is a decrease of assets which are sold to finance the country. Each external transaction is entered in both the current and capital accounts to show the original transaction and how it has been financed.

Causes of Balance of Payment Surplus or Deficits

There can be so many ways of causes of the balance of payment reaching the level of surplus or deficits. There might be a time when other outside countries are facing current account deficits whilst the UK is facing current account surplus. Therefore this is the most essential time to point out what causes the current account deficit before trying to find ways of correcting them. The causes are explained below as follows:

An over valued exchange rate can be a factor of current account deficit as it is believed that it is a branch of the exchange rate being too high which can lead to high export rate and high foreign markets when the import rate is going cheaper. The rising and falling of the imports and exports will affect the current account.

The rising of the level of the economic growth can also be a good reason for current account deficit because when consumption and investment tends to rise, there is an increase in spending for consumers which will encourage the deteriorating of the current account. The greater the marginal propensity of import, there will be an increase in imports too.

Lack of capacity productivity, poor pricing and non-pricing competition can cause current account deficit because if there in insufficient capacity to meet the needs from their consumers from the producers, then the imported goods and services comes into terms with the satisfaction of excessive demand. Quality, design, offers and reliability can also be considered as they are very important factors. Whereas inflation is seen as a key role for international competitiveness. It the inflation rate of the UK is higher to the rest of the world, and then it will be less competitive to the rest of the world.the UK’s manufacturing sector has suffered over the last 25years because of low cost of production in some new industralised countries which is a declining comparative advantage.

Reasons for Deficits and Financing a Short Term Deficit

Ways of rectifying / correcting a Deficit

There can be ways in rectifying a deficit in the UK with government policies such as Expenditure Reducing Policies and Expenditure Switching Policies. In expenditure reducing policies, there can be higher direct taxes which can lead to a lower disposable income, increased interest rates to soften consumer confidence and consumption, and even the excess in the economy. By reducing the growth of domestic demand, it may encourage UK businesses to switch their production towards export markets. In other words, expenditure switching policies raises sterling price of imports, higher profitability of exporting but there can be an impact of lower exchange rate which depends on elasticity of overseas demand for UK exports. There can also be an instance of achieving a period of low relative inflation which helps the British economy with macroeconomic stability and important for their competitiveness.

PART THREE CONCLUSION

Currently, the UK is experiencing a current accouant deficit which is getting worst. On the other hand, it ignores the fact that trade deficits are linked to a weak pound currency. The government policy which is aimed at bringing an improvement of trade perrformance does not necessarily turn a deficit into a surplus but hence, the trade deficit is increasing around the world economy as the outside world is accpting the pounds in return for their import payments. The best thing the UK should dois to ignore the trade deficits and concentrate on the how to have a strong economy to attract foreign investment. Investors around the world are seeing the UK as a safe and profitable place for their savings so therefore, the trade deficit will still persisit and the British are better off because of it.

PART FOUR REFERENCING AND BIBLIOGRAPHY

Richard G L AND Chrystal K.A (2004) (10th Ed) Economics, Oxford: Oxford

University

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The modern finance theory is based on the capital asset pricing model

Abstract

As some anomalies are hardly explained by the traditional finance, the behaviour finance is introduced. It was first introduced by Kahneman and Tversky (1979), which they presented the prospect theory. In fact, investors’ behaviour often violates the expected utility theory, some of them trade irrrationally. Then Shefrin and Statman (1994) base on the CAPM, and put investor sentiment into the model to make the BAPM. They thought noise traders and information traders would interact and influenced the price setting, including the noise traders’ behaviour in the BAPM let the asset pricing more precise. Another important theory is the behavioral portfolio theory. The theory states that when investors choose portfolios, they on the one hand want to be security, while on the other hand they potentially also want to reach aspiration levels. So it lets BPT investors to choose bonds and lottery tickets together come true. According to these phenomenon which happen to investors’ portfolio selection, many researchers give their explaination. Generally speaking, bahaviour finance is based on two theories, which is limits of arbitrage and investor sentiment. DSSW model is based on the former theory while BSW model, DHS model and HS model are based on the latter one. There are also some more models in the behaviour finance area. These models can explain some anomalies, such as Closed-end fund puzzle and the equity premium puzzle. In this paper these two anomalies would be treated as examples to explain how behaviour finance explain these anomalies.

Introduction

The modern finance theory is based on the capital asset pricing model (CAPM), Markowitz’s Portfolio Theory, Arbitrage Pricing Theory (APT). The model CAPM is introduced by Sharpe (1964), Lintner (1965), and Black (1972). It provides the pricing mechanism of capital assets and the decision factor of risk is?(the relationship between firm returns and market returns). These theories are based on the Efficiency market hypothesis (EMH) and the CAPM can be used to test the EMH.

While its analysis framework confined within the scope of rational analysis, when more and more anomalies arise in the market, they are hard to be explained by standard finance which is based on the EMH. In this situation, the questioning of modern finance beginned when the prospect theory is introduced by Kahneman and Tversky (1979). And then the behavioural finance is introduced to explain these snomalies. The definition of behavioural finance is that

“Behavioural finance- that is, finance from a broader social science perspective including psychology and sociology- is now one of the most vital research programs, and it stands in sharp contradiction to much of efficient markets theory.” (Shiller, 2003 p83)

It is a Marginal subject and opposite to the traditional finance, and it tries to explain the importance of investors’ emotion and mental mistakes, which would influence their decision-making process (Ricciardi and Simon, 2000). At first, behaviour finance is marginalized as “ anomalies literature” (Frankfurter and McGoun, 2000).it has been researched for a long time, and then it has been accepted after more and more journals focusing on the discussion of anomalies.

Section 2 of the paper explains three main theories of behaviour finance, which are prospect theory, behavioural capital asset pricing theory and behavioral portfolio theory. Section 3 presents some models which provided by the behaviour finance. Section 4 discusses the application of behaviour finance to explain anomalies. Section 6 concludes.

Theory

2.1 Prospect Theory

Prospect theory is the one of the most important theory in the behavioural finance. Investors usually do not perform rationally, and prospect theory handles this issue. Expected Utility Theory is a kind of desceiptive model which is used to make decisions under risks, and the result is a criteria for investors to choose. While a large number of experimental research shows that investors choices are inconsistent with the basic tenets of utility theory. Kahneman and Tversky (1979) classify these differences into some areas, which is certainty effect, reflection effect and isolation effect.

2.1.1Certainty Effect

Certainty effect is people often underestimate outcomes which are probable when compare outcomes which are received with certainty (Kahneman and Tversky, 1979). In order to demonstrate this issue, Allais (1953) gives a series of choice problems. On of the problem is that:

Option 1: 2,500 with probability 0.33

2,400 with probability 0.66

0 with probability0.01

Option 2: 2,400 with certainty

The question is which option would give you the best chance to maximize your profitsThe result shows that 82% people choose the option 2 among 72 people, most of them violated expected utility theory. According to the expected utility theory, the profit in option 1 (2500*0.33+ 2400*0.66+ 0*0.01= 2409) is greater than the option 2 (2400), while people prefer choosing the profit which is certain rather than choosing the profit which is risk.

2.1.2 Reflection Effect

While when gains are replaced by loses, the result would be that the risk preference of people is contrary to the positive prospects, it transfers from risk aversion to risk seeking, and this is labeled as the reflection effect. For example, 92% people choose a probobility of 80% to loss 4000 when they are offered another choice which is a certainty loss of 3000. This example also shows that not only the positive domain violate the expected utility theory, but also the negative domain violate it in the same manner.

2.1.3 Isolation Effect

When people choose one investment between alternatives, they usually exclude the common factors to consider, and focus on their different components. This division would lead to different reslults, for the same pair of investments can be divided into common and distinctive components in many different ways. This phenomenon is called the isolation effect. For example there is two-stage choice problem, the first stage is that people have a probability of 0.25 to go to the second stage, and in the second stage, you have to have a choice between the winning 3,000 of certainty and winning 4,000 of 0.8 probobility. The result states that 78% of 141 people choose the former one. While in this game, people should have had a choice between 0.25* 0.8= 0.2 possibility to win 4,000, and a 0.25* 1.0= 0.25 possibility to win 3,000, and this choice was demotrated by Allais (1953) that a marjor of people would choose a 0.2 chance to win 4,000. so in this situation, people ignore the first stage and based on the second stage to choose prospect.

Prospect theory divides the choice process into two phases, one is editing and the other one is evaluation. Editing phase is used to analyse the options in order to get the simplified result, evaluation is to evaluate the edited prospects and choose one which has highest value. Editing includes four operations which are coding, combination, segregation and cancellation.

According to the prospect theory, if a prospect is regular (p + q < 1, or x ? 0 ? y, or x ? 0 ? y ), which also means neither strictly positive nor strictly negative, the equation would be:

(1)V(x, p; y, q) = ?(p) v(x) +?(q) v(y)

In this equation, the total value of an edited prospect is denoted V, and it is expressed by two scales. The first scale?is connected with each possibility p and the decision weight is?(p), the other scale is v, which the outcome is v(x) with a number x. the value of prospect in Equation (1) is the same as the result of expected utility theory.

While if the prospects are strictly positive or strictly negative, they must use another rule. When prospects are in the editing phase, they are often divided into two parts, which is the riskless part and the risky part. The evaluation would use the next equation:

If p + q = 1 and either x > y > 0 or x < y < 0, then

(2) V(x, p; y, q) = v(y) +?(p) [v(x) – v(y)]

It means that the value of a strictly positive or strictly negative prospect is the same as the sum of the value of the riskless part and the value-difference between the outcomes multipling the weight associated with the more extreme outcome.

Investors evaluation base on the value function and weighting function (Kahneman and Tversky, 1979). Prospect theory uses value function to explain the same meaning of utility. There are two arguments in the value function, the first one is the asset position which can be treated as reference point, and the other one is the magnitude of the change from the reference point. Value function normally concave for positive outcome and convex for negative outcome, and the losses is steeper than the gains. When the value approachs to the reference point, the value fuction is steepest, and the whole value fuction is S-shaped. Decision weights are usually different from the probability axioms, investors often overestimate the small probabilities, this situation often happens in gambling and insurance. While for other situations, decision weights are commonly lower than the corresponding probabilities

However, there are two drawbacks existing in the prospect theory. Firstly, it uses the value function and weighting function to evaluate theory, while there are no specific functions and instead using examples to explain. It is a kind of experimental process. Secondly, there is no specific standard for reference point, it makes the theory not so pricise.

2.2 Behavioural Capital Asset Pricing Theory

The behavioural capital asset pricing theory is based on the capital asset pricing model (CAPM) and the difference is that the behavioural capital asset pricing theory consider the behaviour of traders. It focuses on the market which noise traders and information traders affect each other. Information traders are traders in the condition of CAPM, they obey the Bayesian learning rule to evaluate the returns and most importantly, they never make cognitive errors. However, noise traders are contrary to information traders, they commit cognitive errors and break the Bayesian rules. These two traders interact and determine the asset price. Market is efficient when information traders are dominant in the market, while if dominant traders are noise traders, market is inefficient.

What is the difference between markets in which prices are efficient and markets in which prices are not efficientThe main difference is that there is a single driver property existing the market which prices are efficient. As Shefrin and Statman (1994, p345) said, “This single driver drives the mean-variance efficient frontier, the return distribution of the market portfolio, the premium for risk, the term structure, and the price of options.” It satisfies the minimun information which required to cause the changes to the outcome distribution of the market portfolio. While a second driver is introduced to the market by noise traders, and it let the price far away from the price efficiency. They often creat some abnormal returns to particular securities. The expected return of security is determined by behavioural ?, which is the ? of tangent mean variance efficient asset portfolio. Noise traders’ action let the relationship between security returns and beta weaker. While at the same time, they built a positive relationship between abnormal returns and beta (Chopra, Lakonishok, and Ritter, 1992). When the prices are efficient in the market, price efficiency protects particular noise traders. At that time, the function of noise traders is to rise the trading volume. However, if the prices are not efficient, new information cannot be a sufficient statistic. Yet prices, volatility, the premium for risk, option prices and the term structure are still influenced by old information. Noise traders affect the return of securities through the term structure and they can arouse inefficient inversion which exists in the term structure.

The behaviour? is introduced by the behavioural asset pricing model (BAPM), when the noise traders are included in the model, the behaviour? represents a lower risk than the traditional?. The BAPM research a series of issues such as risk premium, the term structure, and option prices in the situation of existing noise traders. The BAPM not only considers the performance characteristics of value, but also includes the characteristics of utility, therefore, on the one hand it has to accept the market efficiency when considering the unbeatable market, on the other hand it must reject the market efficiency when consider the irrational behaviours. This contradiction lead the finance to further research.

2.3 Behavioral Portfolio Theory

The behavioural portfolio theory (BPT) is introduced by Shefrin and Statman (2000) and it is based on the SP/A theory (Lopes, 1987) and Safety-First Portfolio theory (Roy, 1952). Roy’s (1952) safety-first theory and Markowitz’s (1952a) mean-variance portfolio theory are introduced at the same year, however their opinion are different to the Friedman-Savage puzzle. The former theory is consistent with the puzzle while the latter one is not. SP/A theory is a psychological theory and it has been a choice framework. Security, potential and aspiration are the meaning of letters SP/A and they also reflect investors’ choice under uncertainty.

The efficient frontier of BPT is different from the mean-variance efficient frontier, and the optimal portfolios of BPT and CAPM are not the same. BPT investors think about the expected wealth when they select portfolios. On the one hand, they want portfolios to be security, on the other hand they potentially want to reach aspiration levels. So BPT investors combine bonds and lottery tickets together.

The BPT is classified into two versions, a single mental account version (BPT-SA) and a multiple mental account version (BPT-MA). Their differences are that BPT-SA investors use a single mental account to manage their portfolios while BPT-MA investors use several mental accounts to integrate their portfolios. So BPT investors are the same as investors in the Friedman-Savage puzzle, they both present risk averse and risk seeking. They buy risk-free investments for the low aspiration mental account and buy speculative bonds for the high aspiration mental account.

BPT-SA investors treat the portfolio as a whole like mean-variance investors, and they also take covariances into consideration. So the framework of choosing portfolio are similar between BPT-SA and mean-variance theory, the difference is that their efficient portfolios are not the same.

Portfolios in the BPT-MA is like layered pyramids, and every layer has its own aspiration level. The bottom layer is designed to protect investors from poverty and the top layer let investors have a chance becoming rich. BPT-MA investors are quite different from BPT-SA investors, they ignore covariances and treat portfolios separately in to different mental accounts. Because BPT-MA investors ignore covariance between layers, there is a risk that they may put the same security but with different positions into different layers. The similar evidence is provided by Jorion (1994), he finds that when investors invest globally, they put securities and currencies into different layers of the pyramid, while he thinks the overlay structure is not so useful, because it overlooks covariances between securities and currencies and it leads to 40 basis points loss of efficiency.

Some Models

3.1 DSSW Model

Behaviour finance is based on two theories, which is limits of arbitrage and investor sentiment. According to the tradition finance, arbitrage plays a key role in achieving the market efficiency. Its basic point is that even irrational investors exist in the market and let prices deviate their value, rational investors would eliminate their influence to prices, and finally prices and the value are consistent. However, behaviour finance thinks arbitrage is not unlimited, one of the reason is that arbitrageurs are risk averse and have resonably short horizons, its posibility to be dominant is small. For example, when arbitrageurs sell assets short, they first must know noise traders are bullish and they must be bullish in the future, And then noise traders would buy back the stock. While it is hard to predict noise traders thought, so arbitrageurs have to bear the risk and this would limit their willingness to take position against noise traders.

The model consists of noise traders and sophisticated investors. There are some investors not following economists’ advice to invest, and they only trust their own research. So Black (1986) called these investors who have no private information and irrationally act “noise traders”. Noise traders obtain lots of information which comes from technical analysts, economic consultants and stockbrokers and they falsely believe this information is useful to predict the future price of risky asset. So noise traders choose portfolios according to such incorrect beliefs Alpert and Raiffa (1982). On the contrary, sophisticated traders make use of noise traders’ irrational misperceptions. They buy stocks when noise traders depress prices, while they sell stocks when noise traders think prices would be bullish.

According to the risk of noise traders, the model can explain some financial market anomalies. These anomalies are the excess volatility of and mean reversion in stock market price, the Mehra-Prescott equity premium, the closed-end fund puzzles and some other anomalies. However, there is a drawback existing in the model, which is that it can not explain how investors make decisions. The assumption is that investors base on the behaviour portfolio theory to choose their portfolios, according to the different layers, they make different investment choices even for same assets.

3.2 BSV Model

A huge amount of empirical evidence have shown two kinds of pervasive phenomenon, which are underreaction and overreaction of stock prices. Underreaction means that investors predict higher average return than the actual average return when good news are announced. in other words, the stock underreacts to the good news. if the average return comes from a series of announcements of good news and it is lower when compared with the average return coming from a series of bad news announcements, it is defined as overreaction (Barberis, Shleffer, and Vishny, 1998). BSV model is introduced by Barberis, Shleffer, and Vishny (1998). Investors often present two phenomena, which is conservatism and representativeness heuristic. Conservatism can be defined that people often react slowly when people encounter new evidence (Edwards, 1968). When investors face evidence which has high weigh but low strength, they do not care much about the low strenngh and react moderately to the evidence. While if the evidence has high strength but low weight, they overreact it like representativeness. Representativeness heuristic is the second important psychological phenomenon (Tversky and Kahneman, 1974). It means that investors focus on recent patterns in the data while give little weight to the properties of the population which generates the data (Fama, 1998). In the situation of representativeness heuristic, if a company performs well in the past and has a high growth, investor would ignore the truth that this well perform would hardly repeat itself. The result would be that they overestimate the value of the company and be disappointed when the expected growth does not come true. The BSV model bases on the two phenomena, and explain how investors decision-making model leads to the market price deviating the efficient market. The model also deals with the problem why arbitrage is limited, the reason it that investors’ sentiment are hard to forcast. The more extreme of investors’ sentiment, the more further of price away from the actual value.

It is known that earnings are a random walk, while investors falsely classify them into two earnings regimes. They underreact or overreact to a change in earnings, these lead to short-term momentum in stock returns and long-term reversal. The BSV model perform well on the anomalies it was designed to explain, while the forcast of long-term return reversal is not so good.

3.3 DHS Model

Daniel et al. (1998) also provide a model which includes investor sentiment to deal with the situation of overreaction and underreaction. They try to use psychological theory to support their framework and classify investors’ sentiment into overconfidence and biased self-attribution. Overconfidence is defined that investors often overestimate their forecast ability when they have more significant information than others, so they often overlook their prediction errors. Biased self-attribution is investors feel confident when they find public information is the same as their information, but the confidence would not decrease proportionately when public information is opposite to their private information.

According to the DHS model, it has been known that investors overreact to private information, while on the contrary investors underreact to public information signals. When public information signals eliminate behaviour bias, this would lead to short-term momentum of stock returns while long-run reversal. The model can reconcile this situation, it transfers the wealth from imperfect rational traders (e.g. noise traders) to rational traders and then price setting is dominated by rational traders. While even in this situation, rational traders could not be predominance in the long term. De Long et al. (1991) state that noise traders are risk averse and they prefer investing more money to risky, high expected return assets, if they overconfident about the true information signals, they would obtain more profits than those rrational investors. The forcasts of DHS are similar with BSV, they share the same empirical successes and failures. And this comment can also apply to Hong and Stein (1997).

3.4 HS Model

The model is provided by Hong and Stein (1999) in 1999, it also called the unified behaviour model. The model is different from BSV model and DHS model, it classifies agents into newswatchers and momentum traders. Each of them are restricted rational. Newswatchers making investment dicisions base on private information signals of movement of future values. Their drawback is that they do not use the current or past prices to choose portfolios. While on the contrary, momentum traders mainly base on the movement of past prices changes to invest. However, they also have limitations, which their forecasts should be “simple” function of the history of past prices. In this model, there is one more assumption, which is private information would spread slowly in the newswatcher group. The underreaction and overreaction are based on the private information spread slowly across the newswatcher population. As first, newswatchers underreact to the private information, then momentum traders try to make use of it to arbitrage, while it leads to overreaction.

Anomalies

4.1 Closed-end fund puzzle

There are some anomalies existing in the financial market, one of them is closed-end fund puzzle. The definition of it is that:

“The closed-end fund puzzle is the empirical finding that closed-end fun shares typically sell at prices not equal to the per share market value of assets the fund holds” (Shleifer and Thaler, 1992, p. 75).

The puzzle is that closed-end funds are sold with 10 percent premium at first, while after around 120 days, the premium of 10 percent moves to a discount of over 10 percent (Weiss, 1989). And then discounts fluctuate over the period of funds, they would narrow and then disappear until the closed-end funds terminate.

This proposition has been researched in the past, they pointed out that the value of securities maybe overstate when compared with their true value of the assets. And they provided three explainations, which are agency costs, tax liabilities and illiquidity of assets. Generally speaking, agency costs are constant, it cannot let prices fluctuate. Moreover, it even cannot explain why rational invettors buy funds at a premium initially and finally sell them at a discount. Restricted stock and block discount hypotheses are two versions of asset illiquidity, they explain the reason to sell stocks at a discount, that is, trading fees are expensive. The tax liabilities’ explaination is that the gain tax has included in the funds, so discounts happen. while these three standard explanations cannot explain the puzzle together or separately.

Another explaination is provided by De long, Shleifer, Summers and Waldmann (1990) (DSSW). They develop DSSW model to explain rational investors and noise traders interact in financial markets, and the key point is that noise traders’ sentiment are unpredictable. So the noise traders’ sentiment influence the demand of closed-end fund shares and then influence the changes in discounts.

The model makes two hypotheses, they assume rational investors are short horizons, they focus on the interim resale of prices rather than the present values of dividends. The other assumption is that noise traders’ sentiment is stochastic and hard to predicted by rational investors. If investors are optimistic about the return of funds, funds will be sold at premia or only a little discounts. While if noise traders are pessimistic, it will result of a large discounts. There are two kinds of risk when investors hold closed-end funds, which are the risk of holding the fund’s portfolio and the risk of noise traders’ sentiment causing prices changes. If noise traders become continuously pessimistic about closed-end funds, this risk would be systematic. And then its influence will not be restricted in the closed-end funds. According to this aituation, it is easy to find that holding the fund is risker than holding its portfolio, and then prices of closed-end funds would be lower than their true value.

There is a fact that closed-end funds are mainly traded by individual investors. And individual investors also invest small stocks. According to the empirical evidence which researched by Shleifer and Thaler (1992), it shows that the performance of small stocks also influence the changes of discounts. If the small stocks do well, the discounts of closed-end funds would be narrow.

4.2 the equity premium puzzle

When researchers observed the economy of the United States during 1889 to 1979, they found that the annual return of stocks was seven percent, however, the return of treasury bills was less than 1 percent after 1926. Mehra and Prescott (1985) stated that this huge gap causes from the huge difference of risk aversion. They explained the high equity premium with having excess of 30 risk aversion. While the actual figure observed is only close to 1. so it is a problem that why is the equity premium so large.

Benartzi and Thaler (1995) gived two concepts which comes from the psychology of decision-making. The first one is loss aversion, and the other one is mental accounting. Loss aversion is similar with the Kahneman and Tversky’s (1979) descriptive theory. It becomes more sensitive to loss money rather than increase wealth. It is also opposite to the expected utility theory. Mental accounting is defined that “mental accounting refers to the implicit methods individuals use to code and evaluate financial outcomes: transactions, investments, gambles, etc” (Benartzi and Thaler, 1995, p.74).

Investors are loss aversion, so if they invest stocks, they would care about the security of portfolios. While stock prices are fluctuated, frequent performance evaluation would make investors feel loss. So stocks are less attracted by investors. Only when the return of stocks keeps a high level, investors would replace bonds with stocks.

Barberis, Huang and Santos (2001) explain this puzzle in another aspect and they introduce a model. The model not only bases on the onsumption but also bases on fluctuations of investors’ loss averse. As it is known to all, investors are sensitive to their decrease of wealth rather than to increase. And The changes of loss aversion depends on investors’ prior investment performance. If investors are profit in the prior period, they would become less loss averse. While if the loss is over the profit, or there existing loss in the prior period, investors would become more loss averse. According to this situation ,it needs a large premium to let investors hold stocks.

However, the conclusion is made under some conditions. Firstly, researchers only use a single risky asset to do research for the sake of simplicity. So in the real economy which has lots of risky assets, it is not easy to identify what investors are loss averse about. Another one is that it is not clear to what range the preferences can interpret financial data and risky gambles.

Conclusion

The behaviour finance as a Marginal subject has been developed quickly during the recent years. It combines the finance, psychology, sociology and anthropology to explain finance. According to the empirical research of the finance market, some anomalies cannot be explained by the traditional finance. While the behaviour finance use a unique aspect to systematically explain these anomalies, such as Closed-end fund puzzle and the equity premium puzzle. compared with the traditional finance, the behaviour finance does not have a complete systematic theory. However, the prospect theory (Kahneman and Tversky, 1979), the behavioural capital asset pricing theory (Shefrin and Statman, 1994) and the behavioral portfolio theory (Shefrin and Statman, 2000) constitute the fundamental systematic behaviour finance theory. They introduce an evidence that investors not always perform as rational traders, there are a part of traders perform irrrationally. Traders do not obey the expected utility theory. Then talking about the prices setting, the original CAPM model which is used to set prices of asset is not appropriate, noise traders often commit cognitive errors and their actions would influence the price setting. So the BAPM model which includes the investors influence can make prices more real. The main point of BPT theory is that investors choose portfolios basing their different layers of needs. The bottom layer is designed to protect investors from poverty and the top layer let investors have a chance becoming rich. In order to explain anomalies, some models have been introduced. For example, DSSW, BSV, DHS and HS models. They investigate the influence of investors’ sentiment from two aspects, which are limits of arbitrage and investor sentiment.

However, the behaviour finance has its inherent drawbacks. As Fama (1998) states that even the behaviour finance can explain some anomolies existing in the capital market, it does not mean market efficiency should be abandoned. The data shows that the frequency of overreaction of stock prices is the same as underreaction, so it can be seen that anomalies are chance results in the market efficiency hypothesis. Moreover, anomalies existing in the long-term return are fragile, they tend to be a reasonable changes. Behaviour finance is the sum of anomolies which EMH and CAPM cannot explain, And it does not have its own independent evidence. So the development of behaviour finance needs further research.

Reference

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examine the effect of the adaptation of International Financial Reporting Standards (IFRS) in the Micro Finance sector in Uganda

Introduction

Aim:

The aim of the study is to examine the effect of the adaptation of International Financial Reporting Standards (IFRS) in the Micro Finance sector in Uganda and clarify the differences on the financial statements and reports.

Objective:

The major objective of the study is to gain an extensive understanding of the Micro Finance sector in Uganda and to identify the effects caused by the implementation of IFRS in the financial statements. While analyzing the implementation of IFRS, the focus of the study is also to identify the differences in the financial statements and reports and whether it complies with IFRS.

Background Context:

Microfinance has become a diverse and growing industry. There are over thousands of institutions in Uganda providing micro finance services (check website), ranging from grass roots self-help groups to commercial banks that provide financial services to millions of microenterprises and low-income households. These MFIs receive support and services not only from donor agencies, but also from investors, lenders, network organizations, rating firms, management consulting firms, and a host of other specialized businesses.

As with any major industry, microfinance needs accepted standards by which MFIs can be measured. Common standards allow for microfinance managers and board members to assess more accurately how their institution is performing. Institutions that apply industry standards are more transparent—it makes it harder to hide or obscure bad performance and easier to benchmark good performance. For MFIs, industry-wide standards can make reporting to donors, lenders, and investors easier to do if the recipients of the reports are also in agreement with the standards (pwc paper). Common standards provide the language that enables MFIs to communicate with other participants in the industry.

The history of microfinance is often associated with the rise of nongovernmental organizations (NGOs) providing microcredit services to the poor and the development of a handful of microfinance banks. In the early 1990s, standards began to emerge calling for stronger financial management of microcredit providers, particularly in their delinquency management and reporting. At the same time, credit unions and banks involved in micro lending developed stronger monitoring techniques for their microcredit portfolios.

Since 1990, MFIs have grown in size, type, number, and complexity (BoU report). At the same time, more emphasis has been placed on financial accountability, management, and viability.

However, many financial terms and indicators considered “standard” continue to differ in name and content among MFIs. This leads to confusion among practitioners and analysts and causes considerable distortions when comparing MFIs (SEEP report). The purpose of this study is to understand these distortions and confusions in the financial statements and reports and the effect of IFRS on it (rephrase it as a question).

Literature Review: (micro finance study…types of studies conducted)

Uganda at a Glance:

Uganda occupies an area of 236,040 km2 in the heart of East Africa, with a total of over 25.3 million people as per 2003 population census. Approximately 94 percent of the poor live in rural areas where about 75 percent of the population lives (CGAP, 2004) and depend on Agriculture, which contributes about 36.1 percent of the Gross Domestic Product (GDP).

Uganda’s economy is heavily dependent on agriculture, as about 80% of the work force is employed in this sector. Food crop production is the most important economic activity, accounting for over one quarter of the nation’s GDP, compared with only 5% for cash crops[1]. Manufacturing output contributes a further 9%. Coffee, tea, cotton, tobacco, cassava, potatoes, corn, millet, pulses, beef, milk, poultry are the major agricultural products in Uganda. Sugar, brewing, tobacco, cotton, textiles and cement are the main industries. Coffee accounts for the bulk of export revenues and other export commodities of Uganda are fish and fish products, tea, gold, cotton, flowers and horticultural products. Capital equipments, vehicles, petroleum, medical supplies and cereals are the major imported items.

Overview of Micro Finance Industry in Uganda:

The Microfinance industry in Uganda is in its advanced stage of evolution. Since the 1990s, Uganda has created a success story by developing the market for microfinance services, which has been considered a role model for Africa and even other regions (Goodwin-Groen et al. 2004). Its growth and development will be a function of the support and effort of practitioners, donors and the Government working together to create an enabling environment for its development. It is readily apparent that the Government is committed to economic and financial reforms. In addition to the other reforms being implemented through its economic policy framework, the Government has shown its commitment to reforming the financial sector. Operationalization of the Microfinance Policy and the legal and regulatory framework indicates renewed efforts and commitment to improving the financial system. The Government is acutely aware of the limitation of the traditional banking sector’s ability to mobilize savings from and extends credit to poor people in rural and urban areas. This population has a weak financial resource base and is in dire need of financial services that cater for its unique circumstances.

Regulatory Structure for Micro Finance in Uganda

The current financial sector policy in Uganda aims primarily at systemic safety and soundness as a supporting bedrock for orderly growth. The policy, drafted by the BoU and approved by Government following multiple bank failures of the late 1990s, was significantly informed by the bitter lessons learnt from these failures and by incidences of fraudulent organizations that fleece the public. The role of Bank of Uganda, the financial sector regulator, is to ensure systemic safety, soundness and stability of the whole financial sector, and protection of public deposits in the regulated financial institutions.

Bank of Uganda issued the policy statement in July 1999 that established a tiered regulatory framework for microfinance business within the broader financial sector. The policy established four categories of institutions that can do micro-financing business in Uganda:

Tier 1: Commercial banks.Banks are regulated under the Financial Institutions Act revised in 2004. Since these are already sufficiently capitalized and meet the requirements for taking deposits as provided for in this Act, they are allowed to go into the business of microfinance at their discretion.

Tier 2: Credit Institutions (CIs). These institutions are also regulated under the Financial Institutions Act 2004. A number of them offer both savings and loan products but they can neither operate cheque/ current accounts nor be part of the BoU Clearing House. Like banks, they are permitted to conduct microfinance business since they are already sufficiently capitalized and meet the requirements for taking deposits provided for in the Act.

Tier 3: Micro Finance Deposit Taking Institutions (MDIs). This is the category of financial institutions that was created following the enactment of the MDI Act. Originally doing business as NGOs and companies limited by guarantee, these institutions transformed into shareholding companies, changed their ownership and transformed/ graduated into prudentially regulated financial intermediaries. They are licensed under the MDI Act and are subjected to MDI Regulations by BoU. Like Tier I and II institutions (banks and CIs), the MDIs are required to adhere to prescribed limits and benchmarks on core capital, liquidity ratios, ongoing capital adequacy ratios (in relation to risk weighted assets), asset quality and to strict, regular reporting requirements.

Tier 4: All other financial services providers outside BoU oversight. This category has SACCOs and all microfinance institutions that are not regulated – such as credit-only NGOs, microfinance companies and community-based organizations in the business of microfinance. These institutions have a special role in deepening geographical and poverty outreach, and in other ways extending the frontiers of financial services to poorer, remote rural people.

Tier 4 institutions operate under various laws, none of which regulates them as financial institutions. The SACCOs are registered and in principle supervised under the Cooperative Societies Statute 1991by the Ministry of Trade, Tourism and Industry. The other governing laws for Tier 4 include the Companies Act (1969),the Money Lenders Act (1952)and the NGO Registration Act (1989). Supervision of these institutions is currently so weak that their regulation is of minimal effect because it is generic, all encompassing for all activities and not focused on financial oversight.

Overview of Accounting System in Uganda:

The Institute of Certified Public Accountants of Uganda (ICPAU) is the only statutory licensing body of professional accountants in Uganda. It was established by the Accountants Statute, 1992, but did not commence operations until 1995. The ICPAU is empowered by the statute to establish accounting standards and to act as a self-regulatory organization for professional accountants, which includes requirements for practicing as a professional accountant in Uganda.

The functions of the Institute, as prescribed by the Act, are:

To regulate and maintain the standard of accountancy in Uganda;
To prescribe or regulate the conduct of accountants in Uganda.

The objectives, of the institute included the regulation of accounting practice and the provision of guidance on standards to be used in the preparation of financial statements. As with most developing countries, and in cognizance with developments in the area of accounting at a global level, the ICPAU in 1999 adopted International Accounting Standards (IAS) without any amendments (Dumontier and Raffournier, 1998).

Prior to the adoption of IAS, there had been a proliferation of approaches to the preparation and presentation of financial statements in Uganda. One of the more obvious approaches to the presentation of financial statements was based on references to Generally Accepted Accounting Standards (GAAS) and firm law (Samuel Sejjaak, 2003).

International Financial Reporting Standards

Since 1998, the Council of ICPAU has adopted International Financial Reporting Standards (IFRSs, IASs, SIC and IFRIC Interpretations) as issued by the International Accounting Standards Board (IASB), without amendment, for application in Uganda (IFRS for SMEs).

International Financial Reporting Standards set out recognition, measurement, presentation and disclosure requirements dealing with transactions and other events and conditions that are important in general purpose financial statements.

Methodology: (description of the data…source…compare with other methods)

Into the frames of this proposal, the research will be conducted in an attempt to analyse the index and the quality of the accounting statements of the micro finance industry. Due to this reason the target of this study is the collection of empirical observations concerned to the effect of the adaptation of International Accounting Standards to the quality and quantity of the accounting information that are published.

The work of this study will be based on desk research only. A desk-based research was contacted to make the essential link between theoretical frameworks and empirical observation. Mainly the study will focus on the comparative examination of the annual Financial Statements of Micro Finance Institutions in Uganda registered by the Bank of Uganda (BoU).

To examine and analyse the content of those Financial Statements so as to meet the objectives of the project and derive conclusions, the Content Analysis will be used.

Content analysis has been defined as a systematic, replicable technique for compressing many words of text into fewer content categories based on explicit rules of coding (Berelson, 1952; GAO, 1996; Krippendorff, 1980; and Weber, 1990). Content analysis enables researchers to sift through large volumes of data with relative ease in a systematic fashion (GAO, 1996). It can be a useful technique for allowing us to discover and describe the focus of individual, group, institutional, or social attention (Weber, 1990).

There are two general categories of content analysis: conceptual analysis and relational analysis. Conceptual analysis can be thought of as establishing the existence and frequency of concepts – most often represented by words of phrases – in a text. In contrast, relational analysis goes one step further by examining the relationships among concepts in a text.

Content analysis offers several advantages to researchers who consider using it. In particular, content analysis:

–Looks directly at communication via texts or transcripts, and hence gets at the central aspect of social interaction

–Can allow for both quantitative and qualitative operations

– Can provides valuable historical/cultural insights over time through analysis of texts

– Allows a closeness to text which can alternate between specific categories and relationships and also statistically analyzes the coded form of the text

– Can be used to interpret texts for purposes such as the development of expert systems (since knowledge and rules can both be coded in terms of explicit statements about the relationships among concepts)

– Is an unobtrusive means of analyzing interactions

–Provides insight into complex models of human thought and language use

Content analysis suffers from several disadvantages, both theoretical and procedural. In particular, content analysis:

– Can be extremely time consuming

– Is subject to increased error, particularly when relational analysis is used to attain a higher level of interpretation

–Is often devoid of theoretical base, or attempts too liberally to draw meaningful inferences about the relationships and impacts implied in a study

– Is inherently reductive, particularly when dealing with complex texts

–Tends too often to simply consist of word counts

–Often disregards the context that produced the text, as well as the state of things after the text is produced

– Can be difficult to automate or computerize

(Writing Guides, http://writing.colostate.edu/guides/research/content/com2d3.cfm)

The content analysis will be used for the determination of the study. Although there are some limitations it is thought as the most appropriate method/tool for the purpose of the study.

Conclusion:

References:

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Literature review on entrepreneurial finance

Introduction
Research Proposal

Although it appears to be contentious whether availability of finance impacts on entrepreneurial entry to markets (Kim et al., 2006, p. 5), it is likely to be a critical factor in determining the early success or failure of any new start-up venture. What is more, it has also been implicated as an important factor in determining the ongoing success of the business (Marlow & Patton, 2005, p. 717; Capelleras et al., 2008, p. 688). The literature would also appear to indicate that the balance between the availability to and uptake by entrepreneurs of different forms of finance may have wider effects on the national economy (Deidda & Fattouh, 2008, p. 6). Therefore it may be important to gain a better understanding of the level of availability of different forms of finance to start-up ventures, along with different factors affecting their uptake by entrepreneurs.

Background

This section of the proposal provides a brief overview of the literature on the different financing options available to start-up ventures, focusing on bank finance and venture capital.

Bank Finance

There is a lack of recent research available as to trends in funding of entrepreneurs in The Netherlands. Understanding of such trends in other countries, where extensive research has taken place in the field of entrepreneurial finance, could result in the understanding as well as the applicability of general findings to The Netherlands and any other country.

Evidence confirms that banks continued to provide a major source of finance for SMEs in the 1990s (Hughes, 1997, p. 151) although it would be expected that the recent financial crisis could have impacted this (Udell, 2011, p. 103). While relaxing financial constraints may allow greater access to bank financing for entrepreneurs, it may also encourage excessive entry to the market and may also undermine bank-monitoring incentives according to Arping et al. (2010, p. 26).

Evidence from developing nations such as South Africa suggest that access to formal bank financing is likely to be a determinant of start-up rates in any given region (Naude et al., 2008, p. 111). There was however, little consideration in this paper as to whether availability of venture capital had any moderating effect on this relationship, and other sources suggest that this may be less important than availability of human capital (Kim et al., 2006, p. 5).

There may not only be issues associated with availability of bank finance, but also access to it. There is some suggestion within the literature that women may be somewhat disadvantaged in securing bank finance when compared to their male counterparts (Marlow & Patton, 2005, p. 717; Carter et al., 2007, p. 427). Other authors have disputed this, although it is possible that these differences could be accounted for by different geographical foci (Sabarwal et al., 2009, p. 1). There is also some suggestion that differences may exist between ethnic groups in access to bank finance (Smallbone et al., 2003, p. 291) while other personal characteristics of entrepreneurs could also create barriers (Irwin & Scott, 2010, p. 245).

The relationship between banks and entrepreneurs could be key to enabling access. Research from Italy suggests that there could be trust issues between young entrepreneurial firms and bank managers. This may be particularly true where there is perceived to be heavy monitoring, and may lead to lower levels of demand for bank financing (Howorth & Moro, 2006, p. 495). There is some evidence that the ownership of the bank itself may influence the relationships it forms with businesses of all types, including start-ups. In particular, the evidence suggests that firms are more likely to maintain exclusive relationships with state-owned banks, which may indicate greater levels of trust than compared to foreign or privately owned banks (Berger et al., 2008, p. 37).

The literature identifies some strategies that may be effective in helping to overcome these barriers. For example in emerging economies, networking has been implicated as an important strategy in helping small to medium enterprises (SMEs) secure bank financing. This more specifically relates to networking with customers and government officials (Le & Nguyen, 2009, p. 867). There is some suggestion that firms in developed countries are more likely to incorporate in order to access formal bank financing (Acs et al., 2008, p. 10).

Financing Preferences

It has been speculated that young businesses may require more than just monetary input, but also require access to expertise. This argument has been proposed predominantly in the context of technology firms, who may lack experience in research and development. Such businesses may benefit from expertise provided by venture capital firms who possess expertise and skills in this area (Keuschnigg & Nielsen, 2005, p. 222). It would however be suggested that this may extend into some other sectors on the basis of research by Kim et al. (2006, p. 5) which found that availability of human capital was instrumental in determining entrepreneurial entry to markets.

Quantitative surveys conducted amongst start-up firms has suggested that various characteristics of those ventures may determine the structure and types of finance which are utilized, including size, assets, growth orientation and owner characteristics (Cassar, 2004, p. 261). When selecting venture capital, businesses must consider contracts carefully, as these will have a significant impact on how the firm is able to exit at a later stage (Cumming, 2008, p. 1947).

de Bettignies and Brander (2007, p. 808) argue that venture capital may be preferred to bank finance when venture capital productivity is high and entrepreneurial productivity is low. Winton and Yerramilli (2008, p. 51) suggest that there may be different criteria for determining preference, based on preference for risky or safe continuation practices and relative costs associated with finance options. For example, they suggest that if venture capital companies lower their cost of capital, this may entice some entrepreneurs to switch from safe continuation strategies utilizing bank finance, to riskier strategies utilizing venture capital.

Study Aims and Objectives

It would appear that many of the studies discussed in the previous section have much to contribute to a better understanding of how entrepreneurs select between bank and venture capital financing. However, most have focused on only limited aspects of the issue. A literature review that aims to take a wider perspective may therefore be useful in providing a better understanding of what may be a relatively complex decision-making process. In particular, most of the evidence available has examined the availability and access to bank financing, with much less information available on comparison to venture capital availability and access. Yet contrasting the benefits and limitations of the two may be important in enabling entrepreneurs to make an informed decision when structuring their start-up finance arrangements.

Research Statement

The research aims to conduct a review of the literature that will enable comparison of benefits and limitations of bank finance and venture capital.

Research Questions

The following research questions will be addressed by the review:

Are there differences in the availability of and access to bank financing and venture capital to businesses
Does the availability and access to different types of finance impact choices made by entrepreneurs
Are there common barriers to bank finance and venture capital or are some barriers specific to one option

When successfully answered, the findings from the previous questions should give answer to the following question by means of a recommendation: Are there any strategies that may enable entrepreneurs to overcome these barriers?

References

Acs, Z.J., Desai, S. & Klapper, L.F. (2008) What does ‘Entrepreneurship’ data really showA comparison of the global entrepreneurship monitor and world bank group datasets. World Bank Policy Research Working Paper No. 4667. Accessed 13 May 2011, from: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1233043.
Arping, S., Loranth, G. & Morrison, A.D. (2010). Public initiatives to support entrepreneurs: Credit guarantees versus co-funding. Journal of Financial Stability, 6(1): 26-35.
Berger, A.N., Klapper, L.F., Peria, M.S.M. & Zaidi, R. (2008). Bank ownership type and banking relationships. Journal of Financial Intermediation, 17(1): 37-62.
Capelleras, J.-L., Mole, K.F., Greene, F.J. & Storey, D.J. (2008). Do more heavily regulated economies have poorer performing new venturesEvidence from Britain and Spain. Journal of International Business Studies, 39(4): 688-704.
Carter, S., Shaw, E., Lam, W. & Wilson, F. (2007). Gender, entrepreneurship, and bank lending: The criteria and processes used by bank loan officers in assessing applications. Entrepreneurship Theory and Practice, 31(3): 427-444.
Cassar, G. (2004). The financing of business start ups. Journal of Business Venturing, 19(2): 261-283.
Cumming, D. (2008). Contracts and exits in venture capital finance. The Review of Financial Studies, 21(5): 1947-1982.
de Bettignies, J.-E. & Brander, J.A. (2007). Financing entrepreneurship: Bank finance versus venture capital. Journal of Business Venturing, 22(6): 808-832.
Deidda, L. & Fattouh, B. (2008). Banks, financial markets and growth. Journal of Financial Intermediation, 17(1): 6-36.
Howorth, C. & Moro, A. (2006). Trust within entrepreneur bank relationships: Insights from Italy. Entrepreneurship Theory and Practice, 30(4): 495-517.
Hughes, A. (1997). Finance for SMEs: A UK perspective. Business and Economics, 9(2): 151-168.
Irwin, D. & Scott, J.M. (2010). Barriers faced by SMEs in raising bank finance. International Journal of Entrepreneurial Behaviour & Research, 16(3): 245-259.
Keuschnigg, C. & Nielsen, S.B. (2005) ‘Public policy for start-up entrepreneurship with venture capital and bank finance’. In V. Kanniainen & C. Keuschnigg (Eds.) Venture Capital, Entrepreneurship, and Public Policy. Cambridge, MA: The MIT Press, pp. 221-250.
Kim, P.H., Aldrich, H.E. & Keister, L.A. (2006). Access (not) denied: The impact of financial, human, and cultural capital on entrepreneurial entry in the United States. Small Business Economics, 27(1): 5-22.
Le, N.T.B. & Nguyen, T.V. (2009). The impact of networking on bank financing: The case of small and medium-sized enterprises in Vietnam. Entrepreneurship Theory and Practice, 33(4): 867-887.
Marlow, S. & Patton, D. (2005). All credit to menEntrepreneurship, finance, and gender. Entrepreneurship Theory and Practice, 29(6): 717-735.
Naude, W., Gries, T., Wood, E. & Meintijies, A. (2008) Regional determinants of entrepreneurial start-ups in a developing country. Entrepreneurship & Regional Development, 20(2): 111-124.
Sabarwal, S., Terrell, K. & Bardasi, E. (2009). How do Female Entrepreneurs PerformEvidence from Three Developing Regions. World Bank. Accessed 15 May 2011, from: http://siteresources.worldbank.org/INTGENDER/Resources/336003-1240628924155/Sabarwal_Terrell_Bardasi_Entrep_All_CWE.pdf.
Smallbone, D., Ram, M., Deakins, D. & Aldock, R.B. (2003). Access to finance by ethnic minority businesses in the UK. International Small Business Journal, 21(3): 291-314.
Udell, G.F. (2011). SME financing and the financial crisis: A framework and some issues. In G. Calcagnini & I. Favaretto (Eds.) The Economics of Small Businesses: An International Perspective. London: Springer Heidelberg, pp. 103-113.
Winton, A. & Yerramilli, V. (2008). Entrepreneurial finance: Banks versus venture capital. Journal of Financial Economics, 88(1): 51-79.

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The changes of Phillips curve under global economy, from two aspects of international trade and international finance to discuss Phillips curve —relationship between inflation and unemployment.

Introduction

During the Great Depression which was a severe worldwide economic depression in the decade preceding World War?, western countries experienced the high unemployment rate. In 1936, Keynes who is a British economist published the famous “The general theory of employment, interest and money”. The theory was helpful for policy makers to tackle unemployment. (Mankiw,G and Taylor,M)

However, after 1950s, inflation became the most concerned economic issue around the world in replace of unemployment. Due to the price rigidity, inflation couldn’t be explained by Keynesian economics.

The Phillips curve is named after a New Zealand-born economist A.W.Phillips. In1958, he published an article” The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957” in the quarterly economic journal Economica. Phillips observed the data of unemployment rate and the rate of wage inflation and concluded an inverse relationship between money wage changes and unemployment in United Kingdom during the period time examined. In the following years, Phillips curve was successfully demonstrated to be found in many countries.

The IS-LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market (Wikipedia).It can explain the aggregate demand and determine the employment. And the Phillips curve can express the aggregate supply of macroeconomics and explain the inflation. Thus, main Keynes’s theory consists of IS-LM model and Phillips Curve from two aspects of aggregate demand and supply. The Phillips Curve also has the significant meaning for economy policy: that is, macroeconomic policy can be trade-off between inflation and unemployment. The government can use higher inflation rate to achieve lower unemployment and vice versa. Therefore, the Phillips curve was considered as the main economic tool to make policy.

However, when people thought IS-LM model and Phillips curve could explain major macroeconomic issues, some economists began to doubt the accuracy of Phillips curve, one typical representative is Edmund Phelps, who is the winner of Nobel Prize for Economics in 2006. He suggested that inflation is not only related with unemployment but also related with the growth of prices and wages expected by employers and workers. His research contributed important insights in the Phillips curve which include adaptive expectation and imperfect information in the setting of prices and wages. Additionally, he presented the concept of the natural rate of unemployment and he thinks that there is no long run trade-off between inflation and unemployment. (Edmund S Phelps,1968).It can be seen from Figure 1,assume that at the beginning, the expected inflation rate is 0 and the natural rate of unemployment is 6%,under this situation, the economy is at point A and the Phillips curve is P1.If the economy is intervened by government, that is the government wants to use 4% inflation rate to achieve 3% unemployment rate, that means reaching point B; assume that the government achieves the goal, workers expect their real wages to decline, thus the nominal wages are required to increase to maintain their purchasing power. On the other hand, employers hire fewer workers due to the increases in wages, therefore, the unemployment rate return to the natural rate of unemployment. At this moment, the economy is at point C. The Phillips curve shifts upwards to P2.As a result, government’s economic policies do not work, that means inflation rate increases, however, unemployment rate does not go down. This is so-called”Phillips Curve with expectation”.

Figure 1 Phillips Curve with expectation

At present, the widely accepted view about Phillips curve is that “because people adjust their expectations of inflation over time, the tradeoff between inflation and unemployment holds only in short run.”(Mankiw, G and Taylor, M)New Keynesian economists modify the Phillips curve from two aspects: firstly, considering expectation; secondly, considering the supply shock.

The purpose of research

The reason why I am planning to focus my research on this topic is that with the development of economy globalization, the proportion of trade between countries or economies increase rapidly. For example, in 2005, the world merchandise trade and services trade account for world GDP respectively 47% and 11%, however, in 1990, those figures are respectively 32% and 8%.During the period of 1990 to 2005, the aggregate amount of world exports has increased annually by 9%, however, the average growth rate of world GDP was only 3%.Thus, under economic globalization, when modifying Phillips curve, the openness should be considered. My dissertation is aimed to analyze how Phillips curve shifts and changes under economic globalization.

The outline and methodology

At present, the major researches about this issue are focusing on NKPC model and put the model into small open economies to do empirical analysis. Then the New Keynesian Phillips Curve can be obtained. There are two methods can be used to modify the NKPC model: the first one is extended model of difference between domestic and foreign prices (Sbordone, 2002; Gali and Monacelli, 2005); second one is extended model of foreign exchange rate (Temple, 2002; Reinhart and Rogoff, 2004).

The outline of my dissertation is that firstly, presenting the theory and general New Keynesian Phillips curve model, then modify it from two aspects of international trade and international finance.

Secondly, analyzing the influences of domestic inflation and employment which are from international factors. The New Keynesian Phillips Curve model is generally written in the form: ?t=??t-1+?Et(?t+1)+?costt. Assume that ?t is inflation rate at time t, ?t-1 is inflation rate at time (t-1), Et(?t+1) is expected inflation rate of time t+1 according to that at time t, costt is cost of production per unit at time t,??(0,1),??(0,1),??(0,1).My research mainly focus on four aspects: 1)inflation effect on unit product cost, considering the formula above, the third part on the right is the changes of unit product cost under economy globalization. 2)inflation effect on international capital flow, the second part on the right of the formula above is expected inflation which makes individuals expect domestic real interest rates to change, people choose to invest in foreign.3)lagged effect of inflation, the first part on the right of the formula above is adaptive expectation.4)effect of inflation on employment ,overall, whether unemployment rate increases or decreases depend on other factors ,for instance, domestic employment rate and trade policy.

Thirdly, choosing two developed countries which are U.S and UK and one developing country which is Brazil and using OECD database or other databases to obtain figures about CPI, GDP implicit deflator, import price index and unemployment rate. The time period selected is 1992 to 2010 .Then using these data to do empirical analysis about NKPC model under economic globalization.

Finally, getting the conclusion. The expected results I want to get are that under economic globalization, in the short run, inflation rate and prices of imports shift in the same direction. The lower the prices of imports are, the smaller the slope of Phillips curve is and vice versa. As Figure 2 indicates,

I also expect that Phillips curves with different slopes adjust to different countries. The line ? with flatter slope is suited for developed countries due to the lower imports prices. However, the line ? with steeper slope is suited for developing countries because of its higher imports prices.

The framework of this dissertation consists of four parts:

The theory of Phillips curve

Shifts and changes of NKPC model under economic globalization

Empirical analysis about NKPC model under economic globalization

The significance of the theory and conclusion.

List of References:

Mankiw, G and Taylor, M, Macroeconomics. European Edition, p295

Wikipedia, http://en.wikipedia.org/wiki/IS/LM_model

Phelps, Edmund S. (1968). “Money-Wage Dynamics and Labor Market Equilibrium”. Journal of Political Economy 76 (S4): 678–711

Argia M. Sbordone, “Prices and unit labor costs: a new test of price stickiness”, Journal of Monetary Economics, (Elsevier: March, 2002) vol.49 (2), pages 265-292

Jordi Gali and Tommaso Monacelli,”Monetary Policy and Exchange rate Volatility in a small open economy”, Review of Economic Studies, (Blackwell Publishing: 2005), vol.72 (3), pp.707-734 07

Jonathan Temple,”Openness, Inflation and the Phillips Curve a Puzzle”, Journal of Money, Credit and Banking, (Blackwell Publishing: May, 2002), vol.34 (2), pp.450-68

Carmen M. Reinhart and Kenneth S.Rogoff, “The Modern History of Exchange Rate Arrangements : A Reinterpretation”, The Quarterly Journal of Economics(MIT Press: February 2004) vol.119(1),pp.1-48

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Law and Finance: Money Launderings Laws/CDD

Executive Summary

In the recent times, new and innovative methods of funds transfer through electronic methods across the borders have increased. These have opened new opportunities for money laundering and financing of terrorism. With the recommendations made by the FAFT that the principle of Customer Due Diligence (CDD), conducted by financial institutions, be set out in law, a robust CDD system would be of paramount importance for financial institutions in the UK should FATF’s recommendations be implemented in the UK. Owing to globalization of businesses, a recommendable CDD team should comprise of human resources specialists, IT experts, law experts, financial experts, representatives in various countries along with functional area managers with a good understanding of various cultures. This would bring about effectiveness and efficiency in the application of CDD measures in the current world with the increased use of New Payment Methods. As such, a firm wishing to provide NPM as one of its services or products should ensure that it has the CDD team in place with various expertise.

Introduction

Recently, economics has witnessed money laundering alongside the issue of the financing of terrorism, among other issues. In correspondence to this point, the United Kingdom has played a key role in the international fight against money laundering through anti-money laundering (AML) legislation which has been made possible through the impetus of international organizations such as the Financial Action Task Force (FATF). As recently as February 2012, the FATF recommended that the principle of Customer Due Diligence (CDD), conducted by financial institutions, be set out in law. This was advocated in the recent FATF report “International Standards on Combating Money Laundering and the Financing of Terrorism & Proliferation” published in February 2012. The following is a report by the head of AML at a large financial services firm, which advised the company’s board on the ‘perfect model’ for a robust system of CDD in order to ensure compliance should FATF’s recommendations be implemented in the UK.

Analysis of the objectives of an effective system of CDD and what it should contain

The term ‘robust’, when used in this context, implies that the CDD system in question should possess an ability to effectively perform its function even when its assumptions or variables are misrepresented. The CDD model to be implemented should work effectively, without failure, in a diversity of circumstances and as such, it should not conflict with the law. As such,

A perfect CDD system should contain tight and secure quality controls
There should be effective policies, processes and procedures in place to ensure compliance with the regulatory requirements in the global arena
Effective protective mechanisms should be put in place
It should be cost effective –maximising on benefits while minimising costs.
A perfect CDD system should be risk-sensitive
Adoption of procedures such as ‘know-your-customer’, should be adopted within individual Jurisdictions
Guidelines for the resolution of issues should be put in place should information made be inaccurate or insufficient.
It should be strict and as such in compliance with the legislative laws
It should be technologically competent given that the market is currently dominated by New Payment Methods which needs one to be technologically savvy

Contents of a Robust CDD System

A robust CDD system that can work in the current market described by high competition from the globe,

Should contain human resources specialists with a strategic view of the particular organization since there is much competition from the international market.
There should also be functional area managers in possession of technical expertise and the ability to think strategically (Rosenbloom 2002).
Should contain experts with good knowledge of the national culture since the current market structure is globally inclined (Rosenbloom 2002).
The institution in question should ensure that there is the inclusion of representatives from various parts of the world in the CDD team. These can help in the identification of data sources and as such help in the verification of the authenticity of various identities (Rosenbloom 2002).
The CDD team should comprise of a group of experts in the law with a good knowledge of law in various parts of the world

According to Steiner & Marini (2008, p.14), the objective of CDD should enable the AML of a financial institution to predict with confidence the type of transactions that a customer is likely to hold. This cannot be achieved without tight and secure quality controls in place.

Conceptually, CDD procedures begin by verifying the identity of the customer along with an assessment of the risks that may be associated with that particular customer. Enhanced CDD for high risk customers is highly recommended together with continuous due diligence of the customer base (Financial Action Task Force 2006).

An effective CDD system should comprise of effective policies, processes and procedures to ensure compliance of the financial institution with the regulatory requirements that would allow the institution to report any activity deemed suspicious (Steiner & Marini 2008, p.14). Furthermore, a robust system of CDD should be implemented with effective protection mechanisms equally directed to both the institution and its customers, considering, Data Protection Act provisions as well as the privacy rights of the customer. An effective CDD system should be cost effective and as such, it should deliver benefits to the institutions while respecting banking practices in the case of a banking institution (Mills 2011)

It is important to bring out the point that CDD systems are meant to protect banks and other financial institutions from reputational, operational, legal and application risks among others, as these would result in large financial costs (Booth et al. 2011, p.218). They are also made to ensure that financial institutions have sufficient knowledge of their clients and as such, this is meant to ensure that banks and other financial institutions do not accept customers who are outside their normalized risk tolerance or in other words, clients engaging in any unlawful business.

Knowledge of a client’s involvement in money laundering or terrorist financing is important as banks and other financial institutions, who fail to understand their clients, put themselves at risk of significant financial loss. Therefore, effective CDD systems should make it difficult for clients to disguise ownership of accounts within banks. As such, adoption of procedures such as ‘know-your-customer’, should be adopted within individual jurisdictions, as this forms part of effective CDD programs or systems (Booth et al. 2011)..

An effective CDD system seeks to ensure clear statements of the general expectations and specific responsibilities of staff. Thus, the management should allocate duties clearly with regards to who is responsible for reviewing or approving any changes to established risk ratings or to the profile of customers. As such, the AML of financial institutions should ensure sufficient customer information, since this is significant for the implementation of an effective system for monitoring suspicious activities (Schott, World Bank & International Monetary Fund 2006).

Insufficient customer information may make it hard for an AML to detect money laundering therefore, CDD system effectiveness can be achieved by incorporation of guidelines for the resolution of issues should the information obtained be inaccurate or insufficient (Mills 2011). In addition, current customer information maintenance is important if a CDD system is to be termed as effective.

Notably, CDD should begin by identifying the customer along with the verification of their identity by use of independent source documents, information and data. At the same time, AML should ensure that the provisions of the Data Protection Act are complied with (Hopton, 2009 p.42). The due diligence process should be carried out on a risk sensitive basis (Steiner & Marini, 2008). Besides, the measures taken should ensure consistency with the competent authorities along with enhanced due diligence applied to higher risk categories of customers. Simplified measures should be applied to lower risk customers. Strict compliance with the legislative laws should be observed (Booth et al. 2011). Accordingly, a high degree of transparency should be applied in the various transactions and as such, CDD should be applied in the preliminary stages of the establishment of a business relationship or in cases of excess cash transaction preparation (SchottWorld Bank & International Monetary Fund 2006, p.44).

Discussion of the risks, should there be gaps in the CDD processes

Following the globalization of businesses, global financial systems operate with clients from all over the world. In this context, it is important to note that if CDD measures are not appropriately applied, then, this gives an opportunity for various losses. As such, failure to conduct CDD can lead to a reputational risk which translates to adverse publicity as far as the practices of the business are concerned. Inaccurate application of CDD measures may in this case lead to a loss of public confidence and as a result, may jeopardise the integrity of the institution. Subsequently, borrowers, investors, depositors and other stakeholders may cease business with that institution should scandals arise (Booth et al. 2011).

Apart from the reputational risk, failure to conduct a careful CDD may lead to an operational risk. An operational risk refers to the loss incurred as a result of failed or inadequate processes, systems, external events and people involved. In addition, there is also a legal risk when one fails to carry out a full CDD measures (i.e. when one happens to leave gaps in the required processes). In particular, a legal risk has to do with the potential for law suits once involved in a money laundering case. Again, it may result in sanctions, unenforceable contracts, penalties and fines which may translate to significant financial costs (Steiner & Marini 2008). Furthermore, the institution’s licences may be revoked and this may lead to the closure of the institution and as such, may be expensive for the institution since the losses involved may be costly (Fagan & Munck 2009).

Likewise, there is also the risk of concentration associated with the losses emerging from excess credit or loan disclosure to one borrower. Therefore, a lack of knowledge of the customer and the customer relations with the other borrowers may place a bank and any other financial institution at risk (Marks et al. 2012). This may also be a concern when there are related counter-parties, common income sources, connected buyers or assets for repayment. A robust CDD will need to apply KYC (Know Your Customer) which entails the identification of the customer through their national identification card, location, address and other related documents (Demetis 2010, p.64). This should be incorporated together with the KYCB (Know Your Customer’s Business) and as such, this is achieved by means of transaction profile, nature and type of business along with the sources of funds (Knight,International Monetary Fund & Monetary and Exchange Affairs Dept 1998).

Furthermore, the CDD should further apply KYT (Know Your Customer’s Transactions) which enables the management to know the customer’s transactions through a continuous and careful monitoring of transactions. In addition, a CDD system will work well through the application of KYE (Know Your Employees) which is meant to examine the institution’s employees by carrying out background checks along with a continuous monitoring of the systems for trustworthiness and loyalty to the institution (Alldridge 2003). Moreover, there should be continuous monitoring of customers in order to establish whether there are customer behaviour changes over time and in this case, transactions and other related activities should be monitored (Demetis 2010).

It is imperative to note that a professionals within the financial sector can be sued for failing to perform due diligence. This is due to the fact that the institution has the obligation to conduct CDD and thus should be able to prove to any third party that every effort was made to ensure CDD (Tabb 2004) Similarly, if CDD were to fail, in such a case it would be advisable for the AML to close the account of that particular customer and as such to decline establishing a business relationship while ensuring that a suspicious transaction report is made.

Money Laundering and the Law

The approach of the FATF in recommending that the implementation of CDD measures
should be set out in law is viable and realistic in terms of the practical application of such legislative changes. This is due to the fact that setting the CDD measures in law will ensure that legal action can be taken to deal with cases where the CDD measures have not been applied appropriately. Again, setting CDD measures out in law will improve the effectiveness of CDD measures carried out on various customers. Taking the example of the first CDD measure recommended to be set out in law, will ensure that the names of the customers are known, the location, country of origin, web data sources verified and as such customer contacts taken into consideration (Demetis 2010, p.64).

In this respect, it will be mandatory for financial institutions to ensure that they only deal with customers with whom they are familiar. As a result, this will translate into effectiveness in the control of money laundering. In fact, this will ensure that all customers provide their details since it would be a requirement of the law along with the fact that this will also be incorporated in institutional policies and procedures. Therefore, before signing into any business relationship, customers and the institution in question will be governed by law, and failure to comply with this will lead both the customer and the institution in question to be held responsible.

In reference to the second CDD measure to be set out in law, it is vital and realistic in the sense that the beneficial owner identity information will be disclosed, and any failure to comply would call for legal action to be taken against the customer. In this sense, it will not be difficult for banking and other financial institutions to get such information as it will be set out in law. Again, the institutions will avoid conflicting with the law as they will have to comply with the CDD measures.

As far as the third CDD measure recommended by the FATF to be set in law is concerned, it is worth noting that obtaining information concerning the purpose and the intended nature of the relationship of the business will be a requirement of the law. As such, it will be required by the customer to avail such information as a requirement of the law rather than of the bank. This will make the work of the banking institutions and other related institutions much easier. Furthermore, the institutions will be forced to comply with the requirement of the law to implement the CDD measures.

On the other hand, the fourth CDD measure recommended by FATF to be set out in law requires conducting a continuous monitoring of CDD on the relationship of the business while scrutinizing the transactions undertaken in the course of the relationship. Such monitoring ensures consistency in terms of the business and risk profile together with the source of funds. Once these are set out in law, it may be vital but not realistic in the practical applications in the sense that the privacy of the customers along with the institutional processes may be compromised (Evanoff, 2009).

Subsequent to setting the financial principle that financial institutions should conduct, CDD should be set out in law with an aim that this will force institutions to comply; otherwise legal action would be taken. Again, such a step would translate to high levels of compliance by the institutions in question and as a consequence, effectiveness of anti-money laundering will be realized.

NPMs and the Law

The FATF recommendations requiring financial institutions to conduct CDD are viable and realistic, except for the fact that new payment methods (NPM) mean the law may need to more fully consider new technology. Notably, with an institution intending to make use of NPMs, money laundering may be inevitable. NPMs are well known for their vulnerability to money laundering and terrorist financing. Use of ATMs, prepaid cards, mobile and internet banking has presented a great opportunity for money launderers. However, there are some countermeasures that can prove viable. For instance, one countermeasure may be the implementation of a robust identification and verification procedures (FATF Report 2010).

Such countermeasures may place limits on the transaction amounts and frequency,and include strict systems of monitoring of these aspects. In fact, not all NPMs are subject to law in all authority and as such, they take in the use of internet and mobile payment. Most NPM providers offer their products or services through both internet and mobile interfaces (i.e. virtual) and the FATF recommendations do not specify the specific risks involved and as such, NPM providers may not apply the CDD measures (FATF Report 2010). In this case, the practical application of such legislative changes as recently recommended by FAFT may not yield fruits especially with the use of NPMs. In spite of the challenges associated with the use of NPMs, it is important to note that the electronic records produced in this case can help with law enforcement (Marks et al. 2012).

Importantly, a firm seeking to provide NPM as part of their service should consider the fact that there are three typologies depending on which one chooses to use. Here, the typology has to do with the third party funding whereby cards can be funded through the bank, cash and person to person transfers (FATF Report 2010, p.36). In addition, there is a second typology which includes the exploitation of a virtual nature (face-to-face) of NPM accounts (FATF Report 2010, p.40). This typology has the highest potential to facilitate criminals in money laundering. On the other hand, if the firm chooses the third typology (complicit NPM providers or their employees) there is also a high risk, as portrayed in findings made by the IPS where prepaid car providers were controlled by criminals and as such were promoting cases of laundering (FATF Report 2010, p.33).

From this perspective, where the regulation of NPM service providers are prepared, law enforcement agencies, supervisors, and legislators amongst others, are faced with various challenges. Simplified due diligence, digital currency, and suspicious transaction reporting in cross border cases, and law enforcement against foreign providers with identification of secondary card holders for instance, can go some way to counteract this (Financial Action Task Force 2006),. Therefore, FAFT’s recommendation that financial institutions should conduct CDD, is viable and realistic, except in cases relating to new payment methods (NPM) where its recommendations may have more limited impact.

Conclusion

Following the recent recommendation by FAFT to set the CDD measures out in law, a robust CDD system that would work effectively in this context should contain a team of experts. Specifically, it should contain human resources specialists, functional area managers with cultural understanding of various parts of the world due to globalization,, representatives from various parts of the globe to ensure authenticity of data sources along with a team of information technology experts. This would facilitate the use of New Payment Methods common in the current market and as such, the team of law experts would make this happen in compliance with law in various states of the globe.


References

Alldridge, P 2003 Money Laundering Law: Forfeiture, Confiscation, Civil Recovery, Criminal Laundering and Taxation of the Proceeds of Crime, Hart Publishing, Portland Oregon.

Booth et al. 2011, Money Laundering Law and Regulation: A Practical Guide, Oxford University Press, New York.

Demetis, DS 2010, Technology and Anti-Money Laundering: A Systems Theory and Risk-Based Approach, Edward Elgar Publishing, Massachusetts.

Evanoff, DD 2009, Globalization And Systemic Risk, World Scientific, New Jersey

Fagan, GH & Munck, R 2009, Globalization and Security: Social and cultural aspects. Introduction to volume 2, ABC-CLIO, Carlifornia

FATF Report 2010, Money Laundering Using New Payment Methods, Retrieved on 20th April, 2012 from http://www.fatf-gafi.org/dataoecd/4/56/46705859.pdf.

Financial Action Task Force 2006, Report on new payment methods, Retrieved on 24th April, 2012 from http://www.fatfgafi.org/media/fatf/documents/reports/Report%20on%20New%20Payment%20Methods.pdf.

Hopton, D 2009, Money Laundering: A Concise Guide for All Business, Gower Publishing, Ltd. Burlington.

Knight, MD & International Monetary Fund. Monetary and Exchange Affairs Dept 1998, Developing Countries and the Globalization of Financial Markets, Issues 98-105, International Monetary Fund.

Marks et al. 2012, Middle Market M & a: Handbook for Investment Banking and Business Consulting, John Wiley & Sons, New Jersey

Mills, A 2011, Essential Strategies for Financial Services Compliance, John Wiley & Sons, New Jersey.

Rosenbloom, AH 2002, Due Diligence for Global Deal Making: The Definitive Guide to Cross-Border Mergers and Acquisitions, Joint Ventures, Financings, and Strategic Alliances, John Wiley & Sons, New Jersey.

Schott, PA, World Bank & International Monetary Fund 2006, Reference Guide to Anti-Money Laundering And Combating the Financing of Terrorism, World Bank Publications.

Steiner, H & Marini, SL 2008, Independent Review for Banks – The Complete BSA/AML Audit Workbook, Lulu.com, North Carolina. Tabb, WK 2004 Economic Governance in the Age of Globalization, Columbia University Press, New York.

Categories
Free Essays

Finance and Law: Money Laundering and New Payment Methods

Executive Summary

In recent times, new and innovative methods enabling funds transfer through electronic methods across the borders have increased. These have opened new opportunities for money laundering and the financing of terrorism. As a result, this report explores the issues surrounding NPMs (New Payment Methods) and as such it has explored non-face-to-face typology as one of the most abused NPM typologies. Moreover, the vulnerabilities the NPM could expose in relation to the firm and its products such as fraud, reputational, legal and operational risks have been discussed in detail. Outstandingly, special considerations that NPM should include in their AML systems have been identified with the likes of data encryption, antispam, antiphishing and privacy policies along with limitation of the accessibility of personal data. Again, measures like setting out in the law the customer Due diligence measures, have been identified as effective tools directed towards the regulation and guidance relating to NPMs in order to better protect the firm and the customer, from the risks associated with the new payment methodologies.

Introduction

In the modern times, new and innovative methods of funds transfer through electronic methods across the borders have increased. These have opened up new opportunities for money laundering and the financing of terrorism. Following this point, the FATF (Financial Action Task Force) Typologies Report of 2006 on New Payment Methods (13th October 2006) recognized the emergence of the new payment methods as being far different from the traditional methods of money transfer. With the emergence of the new and innovative methods of cross border money transfers, AML (Anti-Money laundering) vulnerabilities increased. Subsequently, FATF published their report “Money Laundering Using New Payment Methods” (2010), which revealed the potential risks of money laundering and the financing of terrorism using the New Payments Methods. Furthermore, the report revealed the actual risks through an analysis of new case studies along with the particular typologies. In the light of this point, the purpose of this report is to remind the regulatory Authority department of the issues surrounding NPMs.

In connection to this point, an example of a NPM typology will be given explaining its mode of operation and its vulnerability to money laundering through a financial firm and its products. Accordingly, the report will identify and as such determine special considerations that NPM providers need to include in their AML systems in order to combat the abuse of NPMs through money launderings. Moreover, the report will reveal the measures which, if considered and implemented would improve guidance and regulation to NPMs translating to better protection of the firm and its customers.

NPM Typology 2: Non-face-to-face NPM accounts

Basically, typology two describes a model through which most NPMs rely on and as such it is a business model where minimal face to face interaction is utilized or it is absent. In the light of this point, Internet payment services (IPS) such as PayPal and moneybookers among others as such together with prepaid cards (MasterCard, Visa Electron, Maestro, etc) are utilized (Paulus, Pohlmann & Reimer 2005). Under this typology, online banking, prepaid internet payment products and digital currencies are commonly used. Notably, the non-face-to-face nature of most NPMs can facilitate cases of money laundering through the abuse of the system by the criminals. On the other hand, typology one has to do with third party funding whereby cards can be funded through the bank, cash and person to person transfers. Additionally, there is the third typology (complicit NPM providers or their employees).There is also a high risk as portrayed in findings made in the past of IPS and prepaid card providers who were controlled by criminals and as such promoted cases of laundering

How Non-face-to-face NPM accounts can be utilized for money laundering and terrorist financing purposes

According to Financial Action Task Force (2006), several cases were brought out through which NPM products were used to launder illegitimate proceeds. This was accomplished by theft of identity together with money being stolen from bank accounts or credit and debit cards through the use of computer hacking. It was also accomplished through phishing, which describes a fraudulent e-mail designed to bring about the theft of information or identity. Owing to such abuses, the criminals managed to hack through the computers with such information and as a result, bank accounts, credit and debit cards were used as reference translating to funding of IPS or prepaid card accounts (FATF Report 2010).

In such a case, it is not easy to determine or rather detect a suspicious activity. Likewise, the non-face-to-face typology facilitated money laundering through fake and stolen identities being used to create NPM accounts. In such cases, IPS or prepaid cards are used as transit accounts for the financing of terrorists’ activities and money laundering.

Therefore, a firm wishing to offer NPM as one of its products, should critically consider the way NPMs makes AML systems vulnerable to money laundering activities. It is important to take note of the fact that most of the services offered in this typology are virtual in the sense that the customers dealt with are virtual and in such a case cross-border transfers are common. So to speak, identification, verification and monitoring systems should be implemented in such a manner that they can detect any form of money laundering. However, this may be limited by the fact that credit risk does not exist in this typology (FATF Report 2010). Therefore, the service providers may not be so concerned with the money laundering activity detection since this may not bring about credit risks to them.

Vulnerabilities the NPM could expose in relation to the firm and its products

A firm offering NPM products and services should be careful of misuse and abuse by criminals and terrorists since the typology deals with virtual customers. In actuality, a firm offering such a service or product should understand the risk of exploitation of the non-face to-face nature of NPM accounts whereby criminals may use fake identities, documents or stolen identities and documents (FATF Report 2010). The firms should understand the exposure of the firm and its products to money laundering activities carried out by hacking and phishing of account information and identities (Bidgoli 2006, p.399). In reality, the firm venturing in such a business should ensure that it has functional identification, verification and monitoring systems in order to avoid the risks associated with such dealings. Such risks involve the reputational implications if customer’s accounts are hacked. In the same manner, the firm should be careful of operational risks which refer to the loss incurred as a result of failed or inadequate processes, systems, external events and people involved (Bidgoli 2006, p.399).

In addition, there is also a legal risk if the identification, verification and monitoring systems are not implemented with tight surveillance to detect illicit activities by terrorists. In particular, a legal risk has to do with the potential for law suits once involved in a money laundering case. Again, it may result in sanctions, unenforceable contracts, penalties and fines which may translate to significant financial costs (Steiner & Marini 2008). Furthermore, the institution’s licences may be revoked and this may lead to the closure of the institution and as such, may be expensive for the institution since the losses involved may be costly (Fagan & Munck 2009).

Special considerations that NPM providers need to include in their AML system

Following the increased use of NPMs, service providers should reform and as such restructure their AML systems from the traditional way of operation to a more modern one. In this sense, NPM providers need to involve verification, identification and monitoring systems to track records even in the real time. In line with this point, NPM providers should install anti-phishing mechanisms during login and as such, personalized images next to password prompts should be implemented (Moore 2010, p. 145). As a security measure, TLS Encryption and authentication should be applied by NPM service providers. In the same line of thought, NPM providers should also employ antispam policies and as such, employees should be restricted from interfering or rather exposing personal information of the accounts of the customers (Moore 2010, p. 145).

In essence, controls to combat the abuse of the NPMs and counteract any potential risk to the firm should begin with customer due diligence (CDD). In line with this point, use of ATMs, prepaid cards, mobile and internet banking has presented a great opportunity for money launderers. However, there are some countermeasures that can prove viable. For instance, one countermeasure may be the implementation of robust identification and verification procedures (FATF Report 2010). In spite of the challenges associated with the use of NPMs, it is important to note that the electronic records produced in this case can help with law enforcement (Marks et al. 2012).

Essentially, NPM providers should include a robust identification system and as such, should not allow a double holding on accounts by one user. This is to suggest that they should ensure that there is no confusion of identities. This is given to the reason that some individuals may hold several accounts under the same identity. At the same time, NPM providers should place limits on the transaction amounts and frequency and as such should include strict systems of monitoring on these aspects. Along with this point, Simplified due diligence, digital currency, and suspicious transaction reporting in cross border cases, and law enforcement against foreign providers with identification of secondary card holders should be applied (FATF Report 2010).

As earlier on mentioned, CDD should be carried on the customers even if they are not in face to face contact. This can be accomplished by ensuring that the names of the customers are known, the location, country of origin, web data sources verified and as such customer contacts taken into consideration (Demetis 2010, p.64). One should also consider using financial transaction records of the particular customers from wherever the place in the world.

For instance, moneybookers (Skrill) in its verification of identity, will ask for the name of the customer, verification of the identity through a scanned national identity card, address and location and they also ask for a utility bill, bank statement, passport or driving license, with which it is meant to verify one’s identification (Janczewski 2008). Obtaining such information may not be easy but it can be made possible by employing various agencies and expertise from around the world. This is due to the fact that customer base is worldwide and as such, national cultural understanding would be of paramount importance.

Specific considerations NPM providers need to include in their AML system

Therefore, the following considerations should be included in AML systems for a firm wishing to work as a NPM provider:

The AML system should contain effective policies, procedures and processes while carrying out the identification and verification of the customers.
It should as well contain protective measures such as personalized images next to password prompts in the case of internet based payment methods along with data encryption, antispam and antiphishing policies.
Protective measures should as well be put in place within the web system and the computers themselves which contain personalized details and information in order to counter the hacking of computers.
The AML system should as well ensure compliance with the legislative laws where applicable since some of the NPMs do not have clear provisions as far as compliance with the law is concerned
Representatives from various parts of the world should be involved in the AML system in order to help in carrying out of CDD. This has the advantage of ensuring the right data sources are provided along with the verification of their authenticity (Rosenbloom 2002).
AML system should involve a group of experts in human resource, IT (information technology) and experts with good knowledge of national culture just to mention a few (Rosenbloom 2002). This has the advantage of ensuring that the NPM provider operates competitively.
The AML system should as well put flexible procedures in order to cope with the changing environmental factors since the legal framework for the operation of NPM providers is not well established.
Risks involved in NPM business

From a broader point of view, considerations that NPM providers need to include in their AML system range from law, human resources and various technologies among others as such. In this respect, it should be clear to NPM providers that engaging in NPM products calls for tight surveillance owing to its vulnerability to money laundering and the financing of terrorist activities. Again in this context, NPM providers should be careful with regards to how they carry out their CDD along with the whole operation of their AML systems. This is given to the reason that there are various risks associated with failure to carry out an effective Customer Due Diligence (Steiner & Marini 2008).

In particular, NPM providers, if caught in money laundering and/or financing of terrorist scandal, are faced with a considerable reputational risk. Following the globalization of businesses, global financial systems operate with clients from all over the world. In this context, it is important to note that if CDD measures are not appropriately applied, then, this gives an opportunity for various losses. As such, failure to conduct CDD can lead to a reputational risk which translates to adverse publicity as far as the practices of the business are concerned. Inaccurate application of CDD measures may in this case lead to a loss of public confidence and as a result, may jeopardise the integrity of the institution. Subsequently, borrowers, investors, depositors and other stakeholders may cease business with that institution should scandals arise (Booth et al. 2011).

Apart from this point, AML system failure may lead to law suits whereby the particular NPM provider may be sued for facilitating money laundering. This is due to the fact that the institution has the obligation to conduct CDD and thus should be able to prove to any third party proof that every effort has been made to ensure CDD is carried out (Steiner & Marini 2008). Similarly, if CDD were to fail, in such a case it would be advisable for the AML to close the account of that particular customer and as such to decline establishing a business relationship whilst ensuring that a suspicious transaction report is made.

In view of that, any AML systems implemented should be in line with the law. At the same time, it should not leave gaps while carrying out Customer Due Diligence since this may result into operational risks (Booth et al. 2011). This has subsequent consequences of the suit by law and financial costs. A continued monitoring of the customers should be ensured and as such, this will help NPM providers to avoid cases of computer hacking, multiple accounts by the same Identity, fake identities, stolen identities and in the larger perspective this would prevent phishing of the customer accounts and information altogether.

NPMs and the Law

Notably, with an institution intending to make the use of NPMs, money laundering may be inevitable. NPMs are well known for their vulnerability to money laundering and terrorist financing. Use of ATMs, prepaid cards and mobile and internet banking has given a great opportunity for money launderers although there are some countermeasures that can prove viable. In this connection, one countermeasure may be the implementation of a robust identification and verification procedure (FATF Report 2010). Especially with the non-face-to-face typology, robust identification and verification would be of a supreme importance.

In line with this point, limits on the transaction amounts and frequency should be monitored with strict systems of observation. In fact, not all NPMs are subject to law in all authority and as such, they take in the use of internet and mobile payment. Most of the NPM providers provide their products or services through both internet and mobile (i.e. virtual world) systems and the FATF recommendations do not specify the specific risks involved and as such, NPM providers may not apply the CDD measures (FATF Report 2010). In spite of the challenges associated with the use of NPMs, it is important to note that the electronic records produced while carrying out transactions can help to carry out law enforcement.

Importantly, a firm seeking to provide NPM as one of their services should consider the fact that there are three typologies depending on which one chooses to use. As such, the first typology has to do with the third party funding whereby cards can be funded through the bank, cash and person to person transfers (FATF Report 2010, p.36). Furthermore, there is the second typology which takes in the exploitation of the virtual nature (non- face-to-face) of the NPM accounts (FATF Report 2010, p.40). This typology has the highest potential by its ability to facilitate criminals in money launderings. On the other hand, if the firm chooses the third typology (complicit NPM providers or their employees) there is also a high risk as portrayed in findings made in the past of IPS and prepaid card providers who were controlled by criminals and as such promoting cases of laundering (FATF Report 2010, p.33).

In order to better protect the firm and the customer, from the risks associated with the new payment methodologies, new laws and regulations should be implemented in order to regulate the NPMs operations. Again in this context, measures such as the implementation of anti-phishing measures should be put in place. As such, it should be provided by the law that if they are not implemented, law suits should be applied. Besides this point, antispam policies (softwares, hardware and processes) directed towards combating proliferation of spam or keeping spam from entering the system should be implemented (Moore 2010). Equally important, measures to protect computers with personal details should be protected from hacking. Accordingly, for non-face-to-face NPM accounts, there should be provisions in the law to ensure that firms comply and as such put in place measures to prevent the cases of hacking, phishing just to mention a few.

In the same line of thought, if implemented, tight surveillance within the various websites present in the internet should be carried out and as such, it should be a provision of the law for every NPM provider to carry out such surveillance. This can be possible in a virtual world through representatives in various countries with expertise in both identification and verification of data sources (Rosenbloom 2002). Technologies such as firewall, encryption of data, limiting accessibility to customer data and the development and implementation of privacy policy are of paramount importance as measures for combating activities of money laundering and financing of terrorist activities (Rosenbloom 2002). With such measures in place, both the firm and the customer can be protected from the risks associated with the new payment methodologies.

Currently, where the regulation of NPM service providers is active, law enforcement agencies, supervisors, and legislators, among others as such, are faced by various challenges some of which include simplified due diligence, digital currency, and suspicious transaction reporting in cross border cases and law enforcement against foreign providers with the identification of secondary card holders among others as such. Therefore, the most important thing to do is to ensure that the requirement for implementation of AML systems for each NPM provider is set out in the law. At the same time, firms providing NPMs and the customers can be better protected if the regulatory authorities would set it out in the law that all NPM providers apply data encryption, anti-phishing, privacy and antispam policies and limitation of data accessibility.

Conclusion

The report has identified several considerations NPM providers need to include in their AML system in order to combat the abuse of the NPMs and counteract any potential risk to the firm. Non-face-to-face typology has been identified as one of the examples that is mostly utilized and as such the most vulnerable to abuse by money launderers and criminals. As such technologies such as data encryption, establishment of antispam, antiphishing and privacy policies have been identified as effective tools for combat. Limited data accessibility should be incorporated in order to ensure the protection of customer information and private details.

In order to improve on regulation and guidance relating to NPMs and to better protect the firm and the customer from the risks associated with the new payment methodologies, measures directed to this effect should be set out in law. Again, identification and verification of data sources through representatives in various countries across the world in order to ensure the authenticity of various documents is an important tool and a consideration that NPM providers need to include in their AML system in order to combat the inherent money laundering vulnerabilities of the system.


References

Bidgoli, H 2006, Handbook of Information Security, Threats, Vulnerabilities, Prevention, Detection, and Management, John Wiley & Sons, New Jersey

Booth et al. 2011, Money Laundering Law and Regulation: A Practical Guide, Oxford University Press, New York.

Demetis, DS 2010, Technology and Anti-Money Laundering: A Systems Theory and Risk-Based Approach, Edward Elgar Publishing, Massachusetts

Fagan, GH & Munck, R 2009, Globalization and Security: Social and cultural aspects. Introduction to volume 2, ABC-CLIO, California

FATF Report 2010, Money Laundering Using New Payment Methods, Retrieved on 20th April, 2012 from http://www.fatf-gafi.org/dataoecd/4/56/46705859.pdf.

Financial Action Task Force 2006, Report on new payment methods, Retrieved on 24th April, 2012 from http://www.fatfgafi.org/media/fatf/documents/reports/Report%20on%20New%20Payment%20Methods.pdf

Janczewski, L 2008, Cyber Warfare and Cyber Terrorism, Idea Group Inc (IGI), Hersbey, PA.

Marks et al. 2012, Middle Market M & a: Handbook for Investment Banking and Business Consulting, John Wiley & Sons, New Jersey

Moore, T 2010 Economics of Information Security and Privacy, Springer, New York.

Paulus, S, Pohlmann, N & Reimer, H 2005, ISSE 2005: Securing Electronic Business Processes: Highlights of the Information Security Solutions Europe 2005 Conference, Springer, New York.

Rosenbloom, AH 2002, Due Diligence for Global Deal Making: The Definitive Guide to Cross-Border Mergers and Acquisitions, Joint Ventures, Financings, and Strategic Alliances, John Wiley & Sons, New Jersey.

Steiner, H & Marini, SL 2008, Independent Review for Banks – The Complete BSA/AML Audit Workbook, Lulu.com, North Carolina. Tabb, WK 2004 Economic Governance in the Age of Globalization, Columbia University Press, New York.

Categories
Free Essays

“Financial Crises and Corporate Finance: Causes, Context and Consequences”

1.0 Introduction – background to financial crash of 2007-8

This essay will examine the background and unfolding of the 2007-2008 financial crisis and its impact on the theory and practice of corporate finance. I will analyse whether changes to the way the financial and non-financial corporate sector operated over recent years contributed to the depth and severity of the crisis. Specifically, financial deregulation in the 1990s in financial markets and the securitisation of the corporate sector (Ball, 2009), have led to claims that the ‘solution’ to the so-called agency problem of aligning manager and shareholder interests may have actually made the crisis worse. I will argue that the easing of regulations on the mortgage loan sector especially increased the risks of a financial crisis developing by creating the environment for a massive financial asset bubble. Historically low interest rates and ‘easy money’ policies of the US Federal Reserve under Alan Greenspan following the bursting of the technology bubble in 2000 created conditions for the bubble. I will also examine whether the growth in markets for innovative financial products such as CDOs disguised risks and even mispriced assets in the mortgage market by separating the obligation to fund the original loans from the trading of such obligations as collateralised debt. The outcome of the crisis in terms of future corporate financial behaviour and regulatory reforms of the corporate sector will be reviewed.

2.0 Corporate finance models and the financial crisis – the role of CSR

Critics of the corporate sector such as Simms have argued that the narrow focus among publicly listed companies on short-term profits over and above sustainable long-term corporate health, helped cause the financial crisis of 2007-9. The process of selling off traditionally run companies to global multinationals had led to the disappearance of famous companies such as Twinings and Cadbury from the British economy, and the loss of jobs related to these closures. Simms is not alone in claiming that the narrow pursuit of short-term profits as well as excessive pay among senior executives has not served the interests of the wider economy and stakeholders including workers and pension funds. Simms sees the selling off and closure of great British enterprises as the result of the loss of traditional family business ethics and their replacement by financial sector values of high returns to investors.
Fernandez-Feijoo Souto (2009) analyses the financial crisis in terms of the opportunities it presents for companies to refocus on corporate social responsibility. CSR is seen as growing in importance as part of the corporate culture although there is difficulty in defining what CSR actually means. Fernandez-Feijoo Souto argues that the financial crisis has provided a new urgency to the need to clarify what defines CSR and how it should be implemented. This includes building a name as a responsible business and relating this to growing revenue, keeping key personnel, understanding consumer’s bias toward companies with a good CSR brand; changing relationships through the value chain based on trust and treating customers and suppliers well; improving conditions which in turn reduce employee turnover and raise productivity, and reducing legal conflicts by complying with regulations. Simms argues that companies with a business model that has CSR built into it have been shown to be much better adapted to survive the challenges of the global financial crisis than companies that have followed a short-term profit strategy. He uses the examples of Bear Sterns and Lehmans, which traded under the saying “Let’s make nothing but money,” as classic examples of the kind of approach that led to disaster. However for each such example, one can point to a similar company, such as Barclays or Goldman Sachs, that have continued to thrive during the financial crisis despite having the same financial focused ethos. This is reflected in the evidence of numerous studies the result of which show unproven links between CSR and cost, profit and longevity (Fernandez-Feijoo Souto, 2009). There is evidence also of a split between positive economic results and more negative financial results, meaning that potentially short term financial gains may come at the cost of longer term economic performance.
Lipton, Lorsch and Mirvis (2009) state: “Excessive stockholder power is precisely what caused the short-term fixation that led to the current financial crisis.” They point to money managers focused on short-term financial results who fuelled excessive risk taking. This tendency was favoured by government and regulators failing to impose checks on risk taking. Lipton, Lorsch and Mirvis see a “direct causal relationship between the financial meltdown and the short-term focus” of stockholders.

3.0 The role of securitisation in the financial crisis

Securitisation of the mortgage and loan market, which developed in the 1990s, is seen by some commentators as central to the development of the financial crisis of 2007-8. Securitisation of asset-backed bonds is the process of creating debt instruments from a package of loan assets, usually home loans, commercial loans and retail loans such as credit card debt or auto loans. This allows banks to release value from the assets on their balance sheet. The asset-backed market was developed in the United States and grew rapidly from the early 2000s. Banks and other originators of mortgages sold on packages of their loans to an issuer, usually called a special purpose vehicle (SPV). The purpose of the securitisation is to reduce the institution’s balance sheet, which allows its return on equity to rise and also releases capital for other purposes. The process of securitisation enables the issuer to achieve enhanced credit ratings, usually up to AAA investment grade (Sundaresan, 1997). The credit rating of the original loan does not affect the rating of the SPV, even if the original mortgage holder defaults on the loan or is declared bankrupt. The securitisation deals are normally rated by credit ratings agencies such as Moody’s, Fitch or Standard & Poor’s. The investment bank or investor which purchases the SPV securities will often approach an insurer to gold plate the deal by providing a credit default guarantee for the SPV in the event of default (Teasdale, 2003). It has been argued that the complexity of securitisation restricts the ability of investors to assess risk, and that securitisation markets are likely to be subject to serious declines in underwriting standards.

3.1 Credit Default Swaps – analysis of impact of CDS market in the financial crisis

The huge growth of the credit default swap (CDS) market is considered by many analysts to be one the worst elements of securitisation. The Bank for International Settlements reports that the CDS market increased in size from $6 trillion in 2004 to $57 trillion in June 2008 measured by notional principal (Stulz, 2010). The government bailout of AIG brought the CDS market to global attention, and led some commentators to see the CDS market as the primary cause of the financial crisis. As Stulz (2010) argues, there are two problems with the CDS market. First, the sellers of credit default swaps are not able to bear the risks they took on, so some of the benefit of credit default swaps in terms of hedging are actually unfounded – ultimately leading to the $80 billion bailout of AIG. Second, because of their inherent leverage of a CDS, they can enable investors to take more risky positions. The availability of these instruments to non-risk-averse investors may lead to risk being under-priced. However, Stultz shows how the CDS market performed remarkably well around the default of Lehman Brothers. The credit default swap market did not cause the subprime mortgage defaults or the disappearance of liquidity. Excessive leverage by financial institutions and the collapse of the housing market was the cause of the crisis. For example, AIG borrowed heavily to acquire home loan-backed securities and it made even bigger losses on its portfolio of home loan-related securities than on its credit default assets.

4.0 Ponzi schemes and failure of investment banks to report criminal behaviour

The crisis also revealed outright criminal activity taking place in the investment sector, most famously in the case of Bernard Madoff, whose wealth management business was exposed as a Ponzi scheme with $65 billion funds missing from accounts. Madoff was sent to prison for 150 years. JP Morgan acted as banker to Madoff but did not report their suspicions about his activities to the SEC (Ferguson, 2012). Critics have commented that there have been very few prosecutions of investment bankers for such activities as ‘shorting’ the very stocks that they recommended to their clients (Lewis, 2010). The Securities and Exchange Commission and New York prosecutors have brought very few prosecutions and no one has faced criminal conviction. Ferguson points out that Morgan Stanley’s Howie Hubler began to bet against securities connected to the subprime market in 2004 with management approval (Ferguson, 2012). The title of Ferguson’s film ‘Inside Job’ refers to the pattern of investment bankers and lawyers whose clients are banks then taking senior judicial and political roles in the government and financial authorities. This, it is argued, has caused a disincentive to go after the banks for actions that could be prosecuted.

5.0 Reform of corporate finance regulations – legislation and limits of reform

Reform of the banking and wider corporate sector has been discussed and enacted in a variety of forms in the US and Europe. Banks have undergone stress tests to see if they could cope with further financial crises. The UK authorities have begun to reform corporate governance to give shareholders greater power to oversee compensation of executives, such as binding votes on executive pay, but this has not yet been implemented. New rules on the levels of reserves that banks must hold in order to ensure they are able to cope with future crises were agreed in November 2010 at the G20 summit in Seoul. G20 Finance Ministers backed the Basel Committee on Banking Supervision’s plans for capital and liquidity requirements for financial institutions. However most of these new reserve requirements have not yet been enforced, partly because the banking sector remains extremely fragile following the financial crash with high level of debts still threatening the financial system. Following the crisis, there were many calls for the separation of retail and investment banking, or even the breaking up of ‘too big to fail’ banks, but these have not been acted on by government. President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in July 2010. The Act marks the biggest reform of the US financial sector since the Great Depression (Avery, 2011). Section 939A of the Act effectively bans the use of credit rating agencies in an attempt to improve capital requirements for US banks. However implementation is likely to take many years.
In America economists such as Paul Krugman have called for a return of the Glass Steagall Act 1933, which was put in place following the 1929 Wall Street Crash and then removed in the 1990s as part of the liberalisation of the banking sector (Krugman, 2011). Countries with stronger regulation of their banking sector, including Canada, Australia and Germany, did not suffer a banking crisis in the manner of the UK and USA, where regulation was ‘light’.

6.0 Conclusion: comparison with regulatory response to 1929 Financial Crash

By comparison with the response of authorities to the Great Crash of 1929, it can be argued that through to 2012, five years after the crisis began, major reforms to the banking sector and to corporate governance in the US and UK have not been implemented in the way they were in the 1930s. This may be a result of the fact that governments and securities oversight authorities are far less independent of the corporate finance sector than they were in the 1930s. The financial services sector has grown in relation to GDP compared to its position in the 1930s, and its political influence is far greater. This means that reform and regulation has been much slower and weaker than it was in the last Great Depression. Calls for reform will not go away, especially as the crisis continues in Europe and North America. Action on corporate governance, and implementation of proposals for financial and banking reform will be required in order to prevent further financial crises occurring in the future.

REFERENCES

Avery, A. W.; 2011. Basel III v Dodd-Frank: What Does it Mean for US Banks, Who’s Who Legal.
Ball, A. 2009. The Global Financial Crisis and the Efficient Market Hypothesis: What Have We LearnedThe University of Chicago Booth School of Business, Journal of Applied Corporate Finance, Volume 21, Issue 4, pages 8–16, Fall 2009

Ferguson, C; 2012, Heist of the century: Wall Street’s role in the financial crisis, The Guardian, 20 May 2012.
http://www.guardian.co.uk/business/2012/may/20/wall-street-role-financial-crisis

Fernandez-Feijoo Souto, B.; 2009. Crisis and Corporate Social Responsibility: Threat or OpportunityInternational Journal of Economic Sciences and Applied Research, Vol. 2, No. 1, 2009.

International Corporate Governance Network (ICGN), 2008, Statement on the Global Financial Crisis.
Krugman, P and Wells, R., 2011, The Busts Keep Getting Bigger: WhyNew York Review of Books,14 July 2011
Lewis, M. 2010, The Big Short, Allen Lane, Penguin.
Lipton, M; , Lorsch, J. W. and Mirvis, T.N, Schumer’s Shareholders Bill Misses the Mark, Wall St. Journal, 12 May, 2009
Mirvis, Wachtell, Lipton, Rosen & Katz, 2010. Corporate Governance and the Financial Crisis: Causes and Cures, February 28, Harvard Law School Forum on Corporate Governance and Financial Regulation.
Sims, A; 2010. The power of corporate finance is an amoral hazard, The Guardian, 8th September, 2010.
http://www.guardian.co.uk/commentisfree/cifamerica/2010/sep/08/power-corporate-finance-amoral-hazard
Stulz, R.M., 2010, Credit Default Swaps and the Credit Crisis, Journal of Economic Perspectives, Vol. 24, No. 1: 73-92.

Sundaresan, S., Fixed Income Markets and Their Derivatives, South-Western Publishing, 1997, chapter 9.
Teasdale, A; 2003, The Process of Securitisation. YieldCurve.comhttp://www.yieldcurve.com/Mktresearch/files/Teasdale_SecuritisationJan03.pdf

Categories
Free Essays

Finance and Accounting Assignment

Part A:

Grey Plc is a distributor of professional equipment and supplies and has shown varying performance over the past three years. This report will aim to analyze the trends in financial performance of the company through the aid of liquidity ratios, profitability ratios, asset utilization ratios, gearing ratios, and investors’ ratios. The report will begin with an analysis of the company’s liquidity position, followed by its profitability, asset utilization, gearing ratios, and investors’ ratios.

Liquidity Analysis:

The firm’s liquidity position can first be measured through its current ratio which shows a firm’s ability to meet its current liabilities through its current assets. In the case of Grey Plc, the firm’s current ratio is increasing from 2009 to 2011 as it began from 2.00 in 2009, increased to 2.13 in 2010, and then further increased to 2.18 in 2011 which means that the firm has approximately double the current assets to pay off its current liabilities. One of these current assets is cash as the company’s cash balance has increased from ?100,000 in 2009 to ?150,000 in 2010 and then to ?250,000 in 2011. This shows that the company is in a highly liquid position as it is increasing its cash balance. However, this may also mean that the firm is not properly investing its free cash to earn a return. The company’s acid test ratio got lower from 2009 to 2010 but then increased in 2011 to 1.40 showing that in previous years inventory may have been a larger part of the firm’s current assets than it was in 2011.

Profitability Analysis:

The profitability ratios show how well the company is generating profit. The company’s sales have increased from 2009 to 2011, which shows a positive trend as sales were 5% more in 2010 than they were in 2009 and were 10% more in 2011 than they were in 2009. However, the company’s gross profit percentage has decreased from 2009 to 2010 from 40% to 33.6% which means that there may have been an increase in the company’s cost of goods sold. However, the company’s operating profit percentage has decreased from 2009 till 2011 from 7.8% in 2009 to 7% in 2011. This means that while the company’s sales have increased, either the company’s cost of goods sold have increased or the company’s operating expenses may have increased, which caused a reduction in the company’s operating profit margin. Moreover, the company’s bad debts have also increased by 10% per annum which is an additional expense to the company. The expansion programme in 2009 may have been a cause to the company’s decreasing operating profit margin as well.

Asset Utilization Ratio Analysis:

A problem that can be seen within the company is the company’s accounts receivable turnover ratio which is decreasing through the years. This shows that the company is not able to quickly recover its accounts receivable which is not seen as a positive sign as the company’s bad debts balance is also increasing. The firm’s inventory turnover ratio is increasing which means that the firm is quickly able to turn its inventory into sales which is seen as a positive sign and can also be attributed to the fact that the company’s sales volume has increased. This suggests that the company is not holding large amounts of inventory stagnant. The company’s accounts payable days have also increased from 2009 to 2011 from 60 days in 2009 to double amounting to 120 days in 2011 which means that the company keeps cash in circulation for a longer period of time which can be seen as a positive aspect. Thus, while the company’s accounts receivable turnover is decreasing, the company is performing positively in inventory turnover and accounts payable days.

Gearing Ratio Analysis:

The company has decreased its level of gearing from the year 2009 to 2011 as gearing was at 40% in 2009, decreased to 35% in 2010, and further decreased to 30% in 2011. This means that the company is relying less on external finance and loans and is thus less financially geared which is also a positive performance indicator. The company’s interest cover ratio is decreasing from 2009 to 2011 which means that the company is less able to cover its level of interest with its outstanding debts. However, while the ratio is decreasing, it is still high at 7 times in 2011 which shows that the company is sufficiently capable of catering to its outstanding debt.

Investors Ratio Analysis:

The company has announced dividends of ?750,000 every year which is seen as a positive performance indicator. Moreover, the company’s earnings per share have increased significantly from 0.55 to 1.20 from 2009 to 2011 respectively which also shows a high growth level. The company’s operating cash flow per share has also increased over the years. Consequently, Grey Plc’s return on capital employed has also shown a positive trend from 8.5% in 2009 to 8.7% in 2011. The company’s return on equity has also increased from 15% to 20% respectively which shows that the company is substantiating adequate returns from its investment.

Conclusion of Analysis:

Grey Plc has shown commendable performance over the years and has been able to gain adequate returns in each of the respective areas defined above. To calculate the company’s Working Capital Cycle in days, we need to consider that the company’s accounts payable in days is increasing and the company’s inventory turnover is increasing, yet the company’s accounts receivable turnover is decreasing which means that the company’s working capital cycle is becoming longer. This is not a positive trend as it is eroding the performance of the company and in order to increase its working capital cycle in days, it is essential for the company to decrease its level of bad debts and increase its accounts receivable turnover.

Then the company will also be able to increase its net profit and will thus help the company improve its overall performance.

Part B:

(A)The theory of constraints is a management paradigm which describes operational or management processes as not being highly restrained by a large number of constraints but limited to a small number of constraints. The theory of constraints determines that there is usually one constraint in the managerial process which acts as the “weakest link” between the other parts of the process. The theory believes in removing this weakest link in order to improve the whole process and focuses upon finding the weakest part of the process in order to restructure the whole process around it (Bierman & Schmidt, 2012).

The theory of constraints emphasizes that in order to optimize short-term decision making, a firm’s managers should find bottlenecks or problems in the managerial or operation process and attempt to remove them in order to increase efficiency (Bierman & Schmidt, 2012).

(B) (i) A bottleneck resource is an asset which slows down the production process and causes other processes to slow down as well. It is also the machine which is using the most capacity (Mason, 2007). The bottleneck resource in the situation described in this case may be machine 1 as it requires the most machine hours per unit and also spends the most machine hours on product C. Product C has the least demand yet machine 1 spends the most time on producing it which may be a cause for it to be termed as a bottleneck resource.

(ii) Each machine has a limited capacity of 12,000 hours out of which it must produce products A, B, and C. Machine 1 requires 0.15 hours to produce product A, 0.20 hours to produce product B, and 0.20 hours to produce product C. With a 12,000 hours capacity, the machine can produce 12,000/0.55=21,818 products. Machine 2 requires 0.10 hours for product A, 0.18 hours for product B, and 0.15 hours for product C. Accordingly, the machine can produce 12,000/0.43= 27, 906 products. Machine 3 requires 0.10 hours for Product A, 0.15 hours for Product B, and 0.10 hours for Product C. Accordingly, the machine can produce 12,000/0.35=34,285 products.

So all three machines combined can produce 84,009 units. Thus, the company should produce 34,000 units of product A, 25,009 units of product B, and 25,000 units of product C. This will ensure that the company meets the demand for these products and uses all the capacity of the machines.

(C) The percentage of demand that Product A occupies is 25,000/70,000=0.35%. The percentage of demand that Product B occupies is 24,000/70,000=0.34% and the percentage of demand that Product C occupies is 21,000/70,000=0.30 %.

The breakeven point for product A: (x) (25) = (15) +70,000

25x=85,000

X=3,400

The margin of safety is 34,000-3,400=30,600 units

The breakeven point for Product B: (x) (28) =15+68,000

28x=83,000

X= 2,964

The margin of safety is 25,009-2,964= 22,045 units

The breakeven point for Product C: x32= 15+60,000

32x=75,000

X=2,344 units

The margin of safety is 25,000-2,344=22,656 units

Thus, the optimal mix for each of the products is well above the breakeven point which means that using all three machines will enable the firm to produce efficiently and effectively.

Part C:

There are various investment appraisal methods which allow a firm to assess whether an investment is optimal and will produce the required returns or not. One of the popular investment appraisal methods includes the Net Present Value Method. According to the Net Present Value Method, the cash flows expected from an investment are discounted back to assess their present value. Usually, the investment with the higher Net Present Value is selected as the most worthy or optimal investment (Isaac, Leary, & Daley, 2010).

According to the Net Present Value Method, Project B is most appropriate for Blue Plc as it has a higher Net Present Value than Project A which amounts to ?36 million. There are advantages and disadvantages involved in using the Net Present Value Method which include the fact that the Net Present Value method accounts for the time value of money and measures the effects of inflation and other similar factors which may affect the value of the cash flows that the business is likely to generate in the future. Another advantage is that the cash flow before the beginning of the project and after the end of the project is considered in calculating the value of the Net Present Value. Measures such as the profitability of the projects and the risk involved in the project are both given high priority in the calculation of Net Present Value. Moreover, using this measure helps maximize a firm’s value (Isaac, Leary, & Daley, 2010).

There are also certain disadvantages of using the Net Present Value method, which include the fact that it is difficult to use and that the net present value cannot give an accurate assessment of which project would be a better investment if the projects are mutually exclusive or if they are not of equal value. Moreover, calculating the appropriate discount rate is rather difficult and may not be accurate. The discount rate is usually estimated which may mean that it may vary in actual terms. The Net Present Value may not give an accurate decision if the projects are of unequal duration and can thus not be used in all situations (Reilly & Brown, 2011).

However, in the case of Blue Plc, both projects A & B are of equal duration measuring four years and both require an initial investment of ?20 million. Thus, in this case using the Net Present Value Method may be appropriate as both projects are of the same duration and require equal investment and the same cost of capital.

The other investment appraisal method that can be used to assess the feasibility of investments is the payback period. As Project A and Project B are both of the same duration and both require four years for execution, the payback period for Project A is 4.5 years, which is longer than its execution. Comparatively, the payback period for Project B is 3.6 years, which is less than that required for the execution of the project and is less than that required in Project A. Therefore, according to the payback period method, Project B is the optimal investment as it has a lower payback period.

The advantage of using the payback period method is that it is simple to use and understand. This method enables a company to identify the project with the quickest return on investment, especially in the case when the company has limited cash and can only invest in a project which allows it to regain its money back as fast as possible. This is the case with Blue Plc as the company can only invest in one project and would require its money back as fast as possible (Bierman & Schmidt, 2012).

However, one of the problems with the use of the payback period method is that it completely ignores the time value of money and does not consider or evaluate the fact that cash flows may not be regular and may occur later on in the process of the project. There may also be some projects which have an acceptable rate of return but still do not meet the requirements for the payback period. This method also does not consider any cash flows that a project would generate after the initial investment has been recovered. Thus, it does not accurately give an assessment of the profitability of a project but only evaluates how long it will take to recover the initial investment of a project. Using this method may mean a company overlook many attractive projects only because the company is focusing upon short-term profitability alone (Bierman & Schmidt, 2012).

According to Blue Plc’s case, the payback period is lower which means that it is a feasible project with a higher rate of return. However, we must ideally combine this analysis with the analysis of other factors such as the Net Present Value to determine whether this project is the most optimum investment or not.

Accordingly, the better investment appraisal method is using the Net Present Value method as it accounts for the time value of money and also measures subsequent cash flows that a project generates after the initial amount has been recovered. The payback period is simple but does not provide a fully accurate picture. Moreover, in the case of Blue Plc when the cost of capital, duration of the project, and the initial investment required in the project are the same for both projects, the Net Present Value is the most appropriate investment appraisal method to use in evaluating the feasibility of both projects (Kim, Shim, & Reinschmidt, 2013).

However, using either method has generated the same result as Project B seems to be the optimal choice regardless of whether the payback period is used as the investment appraisal method or whether the payback period is used as the investment appraisal method.

Part D:

(A)There are various sources of finance that can be used by a business in order to finance its operations. However, the use of these sources of finance also involves various advantages and disadvantages. A privately owned business can use the owner’s savings and personal assets to finance business expansion or to finance the start of a business (Beck & Demirgue-Kunt,2006). The advantages of using this source of finance are that the owner does not have to pay any interest or share any of the profits with investors or others as he/she is using their own money in the business venture. There are also no acquisition costs and no major hassle in raising or using this source of finance. However, there is also risk involved for the owner in using his/her own personal savings which includes the fact that he/she may lose all of this money if the business goes into a loss (Berger & Udell, 1998).

Another source of finance for a business is allowing investors to invest in the business. In the case of a sole trader or a private limited company, the owners can allow partners to join in the investment or can turn the company into a public limited company.In the case of a public limited company, the owners can sell shares on the stock exchange in order to gain more finance. However, this will also mean that the owners of the company will lose a substantial amount of control in the company once investors are allowed to invest in the company. They will also be required to keep their investors happy and this can be a tiresome and pressurizing ordeal also resulting in conflicts. Profits will also have to be divided with the investors, meaning that the owners cannot keep all of the profits to themselves. On the other hand, the owners of the business will also be able to share the risk with other investors and will not be solely liable for all of the business losses (Mason, 2007).

Another major source of business finance is bank loans. They can provide a quick and reliable source of funding which also enables businesses to keep their persona operating cash to themselves for emergency situations. A business may also be exempted from paying back their loan in full if they file for bankruptcy and provided that they do not have the required amount. However, in order to obtain a bank loan, a business may have to provide collateral which may be a hassle or it may be difficult for a firm to obtain a loan if they do not have the required collateral. Interest payments will also have to be made on the loan which will mean that the business has to return more than they actually borrowed. Payments on the loan will also be due at specific times regardless of whether the business is doing well or whether it is not doing well (Beck & Demirgue-Kunt, 2006).

Another source of finance for businesses is government grants and loans. Some governments provide start-up and expansion programs to facilitate their business sector and these can prove to be a highly valuable opportunity for businesses to receive free finance. The interest rates on these loans are also much lower than the rates on other loans and are usually provided without collateral. However, the problem with obtaining government loans and grants is that there is usually a lot of red tape that has to be surpassed before the loan can be granted and thus it is not available to all businesses. The loan or grant is still a loan or grant and eventually has to be repaid (Berger & Udell, 1998).

(B) Break-even analysis uses a firm’s selling price of products against a firm’s fixed and variable costs in order to determine the quantity of products that a firm needs to sell in order to recover the costs it has incurred to produce those products. There are certain assumptions that the break-even analysis makes in order to calculate this quantity. First of all, the break-even analysis assumes that all costs can be categorized as either fixed costs or variable costs. However, on a practical basis, it is nearly impossible to accurately classify costs into these categories because some costs have both a variable and fixed proportion. Another assumption is that fixed costs remain constant at any level of activity, even when there is no production. However, this may also not pose a highly accurate picture and may not be able to accurately depict the true nature of fixed costs as some fixed costs may begin to vary with differing levels of output (Al-Habeeb, 2012).

The break-even analysis also assumes that the unit selling price will remain constant. However, in the contemporary business environment, this is not practical as the unit selling price may vary with differing consumer tastes and purchasing habits. As competition increases, firms may be constantly changing their unit selling price which then makes the break-even analysis void and inaccurate. The breakeven analysis also keeps inventory levels, the design of the product, efficiency and productivity levels, and variable costs constant (Tsorokidis et al, 2011).

The contemporary business environment involves high rates of competition, innovation, and varying productivity and efficiency levels. Moreover, other business problems and issues may also affect the rate of sales and the level of costs at various times in the production and selling process. Thus, in such cases, the break-even analysis is a highly limited model in assessing the number of units needed for sales to break-even (Berger & Black, 2011).

On the other hand, the break-even analysis is a simplistic model which can at least give a business a rough idea regarding how many units it needs to sell in order to recover its costs. It can be used in cases where selling prices and costs remain constant and perhaps in businesses where it is easy to categorize these costs into the separate categories of fixed and variable costs. Businesses should not completely rely upon the break-even analysis and may have to use other more thorough accounting methods in order to determine the optimum quantity to sell which would enable them to achieve a profit (Berger & Black, 2011).

Accounting and forecasting models are usually based upon assumptions and none of them exist without disadvantages. Thus, it is essential for a business to use all of these models with caution and only use them as a guideline in order to calculate various results for their business.

References

Alhabeeb, M. J. (2012). “Break?Even Analysis.” Mathematical Finance. pp.247-273.

Beck, T., & Demirguc-Kunt, A. (2006). “Small and medium-size enterprises: Access to finance as a growth constraint.” Journal of Banking & Finance, Vol.30(11) pp.2931-2943.

Berger, A. N., & Black, L. K. (2011). “Bank size, lending technologies, and small business finance.” Journal of Banking & Finance. Vol.35(3) pp.724-735.

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.

Isaac, D., O’Leary, J., & Daley, M. (2010). Property development: appraisal and finance. Palgrave Macmillan.

Kim, B. C., Shim, E., & Reinschmidt, K. F. (2013). Probability Distribution of the Project Payback Period Using the Equivalent Cash Flow Decomposition. The Engineering Economist. Vol.58(2), 112-136.

Liesen, A., Figge, F., & Hahn, T. (2013). “Net Present Sustainable Value: A New Approach to Sustainable Investment Appraisal.” Strategic Change. Vol.22 (3?4) pp.175-189.

Mason, C. M. (2007). “Informal sources of venture finance.” The life cycle of entrepreneurial ventures .pp. 259-299. Springer US.

Berger, N. & Udell, G. (1998). “The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle.” Journal of Banking & Finance. Vol.22 (6), pp.613-673.

Reilly, F. K., & Brown, K. C. (2011). Investment analysis and portfolio management. CengageBrain. com.

Tsorakidis, N., Papadoulos, S., Zerres, M., & Zerres, C. (2011). Break-Even Analysis. Bookboon.

Categories
Free Essays

Contemporary issues in Finance

Introduction

“How have financial markets reacted to financial-sector reforms after the crisis?” By Schafer et al. is an article in pursuit for the extent to which the financial reforms have been adopted in many countries globally. The global economic crisis caused financial strategists to look into ways through which they would change their financial systems to counteract the effect of the crisis. This paper is a critique of this article in the manner it reported whether the reforms have been had a positive impact to the independent countries. The paper will also point out the shortcomings in the article about the financial reforms.

Summary of the article

This is a well researched and documented article covering the extent to which financial reforms have been adopted by many countries in the world. Schafer et al. articulates that Lax-financial sector regulation is the major cause of the global crisis that forced policy makers to innovate ways of dealing with the reforms. However, the introduction of reforms by various countries or multinational companies has had a lot of varied impact based on the reform and country. This is evident from reviewing the banks stock returns that demonstrate that four major reforms in the US and Europe has drastically reduced the bailout expectations. The Dodd-Frank Act is one of the major reforms initiated that has caused the strongest effects while the German restructuring law provided the least effects after the reforms were implemented in response to the global crisis (Schafer e al. 2013).

The G20 sorted to establish radical measures to overhaul the financial system after it was identified that the existing financial system was faced by a near collapse. The financial system was faced by the collapse because there were unprecedented support measures from the public sector and central governments that would deal with the global economic crisis that hit the world in 2009 (Veronesi & Zingales 2010). As a result, each country decided to initiate its measures independently providing structural measures that promoted prohibitions of activities whilst ring fencing of the retail banking (O’Hara & Shaw 2010). These measures are a major impact in the regulating the financial strategies of the world although most people observe that nothing much happened during the crisis and even the so called reforms have had less impact to the countries. At this point, only the financial strategists can be able to understand the impact of the reforms as it does not make sense in the eyes of a person who does not understand how financial matters are dealt with in business.

The article covered the regulatory events in the banking industry between June 2009 when the global crisis was at its peak and 2011 when the reforms had started bearing fruits to some countries. Four major reforms in the article are; the Dodd-Frank Act in the US, the reforms proposed by the Vickers report in the UK, the restructuring law and bank levy in Germany, and the too-big-to fail regulation in Switzerland (Schwert 2011). The reforms were used by different countries using different approaches to deal with the weakness demonstrated by the global economic crisis. The weakness revealed through the crisis include; a prohibition of risky activities, ring fencing of systemic activities, establishment of resolution procedures and special capital regimes for systemically important banks to address the weakness in Volcker rule in the US, UK, Germany and Switzerland (Fratianni & Marchionne 2009).

Critique

This article is well informed about the financial strategies, and its analysis gives an accurate position regarding the impact and effect of the reforms. This is due to the fact that the information used to analyze the questions was obtained from the bank stocks information for different countries based on their financial strategies. Its objective was to answer two questions: has anything happened in financial regulation after the global financial crisis and whether the structural reforms have been registered in equity valuations and credit default in their individual banks. According to the article, it has found out that the answer to these two questions is yes. Further, this means that the reforms initiated in the four major countries has been able to bailout expectations and lower the equity returns in their markets.

Under normal financial environment, these two questions cannot be categorically being stated as yes. Based on the financial mechanisms it is hard to predict whether enough has happened because the reforms were developed specifically with the interest of promoting the safety of the financial system. The article demonstrates that the major four reforms have been able to lower the bailout expectations in their respective countries. As research as established, lower rates of bailout expectations have an impact of creating a lower risk taking individuals (Boyd & Gertler 2004). Therefore, at this point it is difficult to tell whether the reforms have been effective or simply people in these countries have become risk a vase. The best answer for the questions highlighted in this article is that the only time would effectively determine whether the reforms have effectively instituted measures to deal with the economic crisis in the future.

On the other hand, it is not standards to identify at what level is the reform successful. There is no standard measure to be applied to the four reforms to be able to explain whether they have attained the ultimate goal or more strategies should be implemented. The basis used in the article is a drop in the equity prices and a subsequent increase in the credit default swaps which does not shut down the system in the individual countries. A comprehensive and successful strategy should be able to distort the cause of the systemic risk so that it cannot happen in the future. This can be effectively be done by comparing the results to the funding costs deferential (Ueda & Weder di Mauro 2013) In this measurement criteria, the values of the current financial year are compared to the values of 2009 which will demonstrate whether the reforms have effectively reduced the distortions or at what level has the distortions been reduced.

In regard to the second question, the article establishes that some of the reforms are better than others. This is true because every reform was developed with an underlying and competing philosophy. The reforms were not commonly developed to serve the same problems and weakness brought out by the global crisis. For example, the Volcker Rule and the ring fencing approach can be applied in different banking systems. Contrary, the Swiss and Germany reforms were instituted to promote capital buffers and adverse resolvability. As such, the default swap changes do not accurately pointy at the effectiveness of the reform strategy. The impacts provided by the four reforms do not pass to be used as the criteria to determine which among the reforms has been able to deal with the weakness provided in its financial system after the crisis. For example, the Germany reform cannot be ruled out as ineffective, but it is just irrelevant to the financial practices because it is executed at the national level. Here, no system can effectively point at its impact in dealing with the crisis. Therefore, the best assessment of the reform implemented on each of the four named above lies in the future.

The G20 initiated the development of the reform strategies with the aim of reducing the impact of the global crisis. Although the strategy might have well been good, it is difficult to develop a common strategy that would be applied to all the countries in the world. For example, in the Eurozone, the financial problem has been identified and a vigorous supernatural reform strategy implemented best to the identified problem which is majorly with the banking unions. Based on this example, it is difficult to develop a common strategy treaty would give the solution to the different financial systems. This is because problems are not identical for all the countries. Additionally, the Basel process is a good global initiative, but it has not established a robust framework for the establishment of cross-country resolutions to be instituted. However, this has lead to individual countries in initiating different banking systems that they deem better for their problems. As a result, these different approaches may lead into a more devastating financial problem than the global crisis.

Conclusion

The article “How have financial markets reacted to financial-sector reforms after the crisis?” points at the fact that the financial markets have been abler to deal with the effects of the global crisis. It focused on four major reforms that were initiated in the G20 countries in response to the crisis. Although this article provides factual data from the banks in individual country, its conclusion may not be accurate. It is difficult to answer the question provided in the article because the strategies have been implemented at national level by each country. Secondly, the problems are not the same for the various systems therefore it can be established further which of the strategies has been able to deal with the crisis effectively. Therefore, the best answer for the argument presented in the article is to wait for time to tell whether the reforms are comprehensive. It is only after the fullest of time that it will be established whether a reform strategy has been abler to completely distort the system that generates the crisis.

References

Boyd, J & Gertler, M .2004, “The Role of Large Banks in the Recent U. S. Banking Crisis”, Federal Reserve Bank of Minneapolis Quarterly Review, 18(1), 2–21.

Fratianni, M & Marchionne, F. 2009, “Rescuing Banks from the Effects of the Financial Crisis”, MoFir Working Paper Series, 1(30), 1.

O’Hara, M & Shaw, W. 2010, “Deposit Insurance and Wealth Effects: The Value of Being ‘Too Big To Fail’, Journal of Finance, 45(5): 1587–1600.

Schafer, A, ISchnabel, and Weder di Mauro, B .2013, “Financial Sector Reform After the Crisis: Has Anything Happened“, CEPR Discussion Paper 9502.

Schwert, G. 2011, “Measuring the Effects of Regulation: Evidence from the Capital Markets”,

Journal of Law and Economics 24, 121–145.

Ueda, K & Weder di Mauro, B. 2013, “Quantifying Structural Subsidy Values for Systemically Important Financial Institutions”, Journal of Banking and Finance 1(12): 128.

Veronesi, P & Zingales, L. 2010, “Paulson’s Gift”, Journal of Financial Economies 97(3), 339–368.

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Free Essays

Understanding Finance and the Current Crisis

Abstract

The recent financial crisis has raised several different questions as to how the crisis emerged, in the first place, and whether there were any aspects of financial management that would have increased the extent of the crisis, or could be used to assist during the recovery period.

Although the two primary areas that have been explored in the existing literature, namely the housing bubble and the slack credit criteria, it would appear that the real value of the existing literature came from the analysis of how the two factors interact, in terms of mitigating the ongoing economic crisis. Further research is required in this area, in order to gain a greater understanding of normal business cycles and how policy decisions can be used to influence behaviours, rather than being entirely reactive to external changes.

Introduction

The current financial crisis which has been seen to be at the heart of the economic difficulties began in 2007 and has produced multiple questions as to how the basic principles of finance interacted with the crisis and the way that this could be used as a means of identifying potential crises, before they happen, thus potentially offering a means of assisting in the economic recovery.

By looking at the way in which the recent financial crisis has spread across the globe, a great deal of insight can be gained as to how finance operates and how potential this can create a dramatic knock-on effect which will ultimately impact on the global economic position. The aim of the literature review is to analyse the various different research papers which have emerged as a result of the current crisis, with a view to gaining a much deeper understanding of the various financial issues. More specifically, behavioural finance will be explored, as a means of identifying any gaps in understanding, as well as potentially offering explanations as to the behaviours which either mitigate or exacerbate the depth of the current economic crisis.

The literature review will look at issues associated with asset fluctuations and financial behaviours associated with credit which are seen to be the two key factors before considering how both of these have impacted on the overall economic behaviours and the implications that this has for both the current economic crisis and future research in this area.

Asset Fluctuations

Although there have been several different factors which have links to the recent economic crisis, with much research looking at the way in which the financial market moves, when various different analytical information reaches the market (Keynes 1930), it is suggested, in this case, that where there has been a dramatic increase in asset prices which cannot necessarily be explained by financial fundamentals, there are likely to be situations that result in a boom followed by a bust (Garber, 2000). Research in this area has indicated that, where asset prices deviate from what would be expected, based on fundamental financial factors, there is some form of inefficiency within the market which, at some point, will need to be redressed.

Further research goes on to look at the situation where the price of the asset extends itself to such an extent that it goes outside of what would be considered to be normal boundaries and a bubble is formed. This is commonly referred to in the press as the housing price bubble, with reference to housing assets and the way in which they increased, at an unreasonable rate, over a relatively short period of time (Zheng, 2005).

A great deal of effort has been put into attempting to explain asset price bubbles and why these bubbles arise, with a variety of different explanations being put forward.

One particular theory which has emerged as to why an asset bubble may arise is that individuals behave in an irrational manner when making investment decisions. Despite this, some models have developed which allow for rational behaviour, but which also allow for an asset bubble to arise, for example, where investors may have expectations about how the assets are likely to change in value, in the future (Brunnermeier, 2001). This was put forward by Blanchard and Watson, back in 1982, where it was argued that there is no need for the asset price to always be equal to the fundamental underlying value of the assets and a bubble could be established based on rational expectation. This suggests that asset movements, such as that experienced in the housing market immediately prior to the financial crisis, would not necessarily be linked to irrationality and there may be other factors which ensure that these extreme bubbles will arise.

Analysis has also taken place in terms of what causes the bubbles ultimately to disappear and whether there are aspects of behavioural finance which can be used to explain this trigger point, which is seen to be fundamental to the economic crisis, during the last few years (Marazzi, 2010).

It is argued that the slightest shock can create a bust situation, for example, where there is a slight change in fundamental values or the beliefs of the investors. As investors change their approach, the slightest shift can ultimately create vision turmoil to establish a bust. Consider, for example, in the housing crisis where a slight change in how mortgage holders were able to repay the amount owed immediately created a liquidity problem within the lenders. It can be seen, therefore, that even a slight change in the circumstances of the borrowers can create an asset pricing situation where the fundamental value of these assets drop and the likelihood of repayment reduces (Gorton and Ordonez, 2012).

Credit Booms

The other area of relevance is seen to be the areas of credit and how the credit markets influenced the financial behaviours leading up to and during the financial crisis (Brusco and Castiglionesi 2007). To a large extent, it can be argued that the increase in the asset price of housing across the US and UK was due to relatively easily available credit conditions that allowed a wide variety of individuals to purchase properties that were stretching their financial position to such an extent that, when fundamental factors changed, such as employment, the asset price could no longer be maintained. Based on the research, it has been suggested that the recent economic crisis was, in fact, down to a credit situation within the financial markets and not necessarily the asset itself, namely houses.

Immediately prior to financial crises, there is indication that there was also a rapid increase in the amount of credit being made available, and during the recent financial crisis, the focus has been on credit availability for the purposes of purchasing property. However, similar issues have also emerged in short-term credit, such as personal loans and credit cards allowing individuals to gain access to credit streams that their income would not necessarily suggest should be available to the rational lender (Calomiris and Kahn, 1991).

Interestingly, research has indicated that a credit boom will often happen as a result of a prolonged period of positive economic shock or following from a particular, economic growth in a region or market. This will suggest that where there was a great deal of growth and buoyancy within the housing market, this was a precursor to the credit boom (Claessens et al., 2010). It is also argued that monetary policies are also seen to be linked to the credit crisis, and that an understanding of the financial decision-making within the financial market can have a detrimental effect on whether or not the credit boom takes place. For example, it is suggested that low interest rates encouraged the US housing market and that more people were able to borrow money, at this lower interest rate. This shows an indication that a monetary policy decision, namely to reduce interest rates can have a knock-on effect on asset prices and credit availability, all of which has been arguably fundamental when it came to the recent economic crisis (Lansing, 2008).

This type of activity has been referred to as financial liberalisation, whereby investors of every kind are more inclined to take financial risks and to pursue new financial opportunities, such as purchasing property. This type of liberalisation could also be seen as inherently linked to the willingness of banks to lend to customers and to have less stringent lending criteria which would appear to be linked to the volatility within the housing market, as having such financial flexibility within the banking sector allowed for the housing assets to boom, at an irrational level. This again suggests the notion that external factors and policies can ultimately change behaviours of agents within the financial markets and the decisions that they make, in terms of their own investments and their own decision-making (Dell’Ariccia, Igan and Laeven, 2012)

Combined Impact on Financial Markets

Having identified that there are the two factors in the unnaturally high price of assets, namely housing assets and the lenient credit conditions which were placed on the market through policy decisions such as low interest rates and low interference with banking regulations that have been deemed to be inherently linked to the recent credit crisis, it is unsurprising that a wide amount of research has been undertaken to look at how these factors came together to create the shift in the financial markets that have occurred, in recent years.

By looking at the combined movement within the credit markets and within the housing market, it was established that there were substantial differences between the movements experienced as a result of external factors during a period of economic crisis and the reactions of similar changes during periods of stability. This suggests that the financial markets behave differently during a crisis, something which may be very relevant to how policymakers should behave when looking to navigate their way out of the financial crisis period.

It has been identified that one of the key factors linked to a bust which is likely to result in a credit crisis can be seen in the volatility of the movement within the financial markets.

Having identified that the two issues of available credit and the increasing house prices are inherently linked and that both factors led to the credit crisis, the researchers largely moved on to identifying how these factors have created the behaviours seen within the economy, in the last few years.

Banking institutions have been perceived to be central to this, as these were the institution that lent the money and made credit available in the first place and also the first institution to suffer when the asset price dropped from the exceptionally high level and borrowers began to default. Research has looked at the way in which the banking institutions operate under these conditions, as it is perceived to be a particularly important means of determining the impact that the financial market is having on the credit crisis and the potential recovery. An argument has been presented which suggests that, where borrowing and lending is collateralised in some way and the market price of that collateral changes for the negative, the organisation simply cannot rely on this collateral, in order to continue its operations (Schleifer, 2000). In this case, collateral is deemed to be housing assets, although many of the financial institutions use complex arrangements in order to bundle the debts and sell them on to third parties, although fundamentally they were linked to the housing assets which were dropping as a result of changes in monetary policies and increasing concerns over the sustainability of house prices. Crucially, it is therefore argued according to rational behaviours where investors (in this case house buyers) opinions on the likely future for the assets and their own ability to sustain the assets change, so do the financial markets surrounding these assets, something which is particularly exacerbated when policy decisions result in an increase in interest rates and fears relating to employment levels, all of which creates a spiralling situation and potentially volatile reactions from investors.

Implications of the crisis

A large portion of the research and the literature in this area looks at the causes of the economic crisis and attempts to identify patterns that could offer explanatory value as to why the crisis happened in the way that it did. However, it is contended in this literature review that the real value comes from identifying the implications of the asset and credit crisis, in terms of the reactions of financial institutions and how this can potentially be used as a means of recovery for the future.

Specific research looking at the reasons for the financial bubble indicated that banking institutions were central to the crisis, in terms of encouraging excess lending and therefore also encouraging the unnaturally high house prices, which became unsustainable, in the long run.

Some of the literature has focused almost entirely on the economic crisis and the impact that this has had on longer-term economic activity (Claessens, Kose, and Terrones, 2012). Research has indicated that, whilst the economic crisis itself created problems in the housing market, it also ultimately led to greater widespread recession than would normally be expected in the typical cycle associated with the performance of the economy.

Various different research approaches have been taken in order to compute the precise impact that the recent economic crisis has had on financial markets and how this can ultimately be used to pave the way forwards. The approach taken by Claessens, Kose, and Terrones, 2012, used traditional methodology of analysis the business cycles, in order to identify whether or not a recessionary period is being entered into. This theoretical approach argued that recessionary periods, which are associated with a form of asset crisis, in this case a credit and housing would cost more to the economy overall than any drop associated simply with equity prices, e.g. as part of the traditional business cycle.

Of perhaps more interest regarding this topic, going forward, is the way in which the financial markets are likely to recover from the period of recession, with research suggesting that recovery will typically be low and weak in comparison with the volatility of the drop, in the first place (Kannan, Scott, and Terrones 2013). This body of research is deemed to be highly relevant, as it not only looks towards linking the concept of credit crisis with the way in which the financial markets are behaving, but also explores how these two factors can interact, in order to deal with the recovery, in the most appropriate way, something which is likely to be of interest to policymakers and those within financial markets, for the future.

Future possible research and conclusions

Despite the myriad of different research papers which focus on different aspects of the credit crisis and have looked at the interaction between credit and housing, as well as external monetary factors, the real value comes from understanding the reactions and behaviours of an economic crisis, as a means of improving recovery prospects. One particular area of research that would be beneficial in this regard is the way in which the financial markets fluctuate, even where there is no ultimate crisis. This is deemed to be important, as there is a cycle that emerges within the financial markets which must necessarily be understood, if the true measure of a crisis is to be established, in the future. Without understanding what is perceived to be ‘normal’, it is simply impractical to appreciate the cause and effect of abnormal periods within the economic cycle and how these can be reduced or mitigated, in the long run.

References

Blanchard, O. J., and M. W. Watson, (1982), “Bubbles, Rational Expectations and Speculative Markets,” in Crisis in Economic and Financial Structure: Bubbles, Bursts, and Shocks, P. Wachtel, ed. Lexington Books: Lexington

Brunnermeier, M. (2001). Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis and Herding, Oxford: Oxford University Press.

Brusco S. and F. Castiglionesi (2007). “Liquidity Coinsurance, Moral Hazard and Financial Contagion,” Journal of Finance 62, 2275-2302.

Calomiris, C. and C. Kahn (1991). “The Role of Demandable Debt in Structuring Optimal Banking Arrangements,” American Economic Review 81, 497-513.

Claessens, S., G. Dell’Ariccia, D. Igan, and L. Laeven, (2010), “Cross-Country Experience and Policy Implications from the Global Financial Crisis,” Economic Policy. A European Forum, April 2010, Vol. 62. PP. 269-93

Claessens, S., M. A. Kose, and M. Terrones, (2012), “How do Business and Financial Cycles Interact?” Journal of International Economics, Vol. 87, pp. 178-90.

Dell’Ariccia, G., D. Igan, and L. Laeven, 2012, “Credit Booms and Lending Standards: Evidence from the U.S. Subprime Mortgage Market,” Journal of Money, Credit and Banking, Vol. 44, pages 367-84.

Garber, P. M., (2000), Famous First Bubbles: The Fundamentals of Early Manias, Cambridge, MA: MIT Press

Gorton G. and G. Ordonez, (2012), “Collateral Crises,” NBER Working Papers, No. 17771, National Bureau of Economic Research, Inc.

Kannan, P., A. Scott, and M. E. Terrones, (2013), “From Recession to Recovery: How Soon and How Strong,” in S. Claessens, M. A. Kose, L. Laeven, and F. Valencia, eds., Financial Crises, Consequences, and Policy Responses, forthcoming.

Keynes, J. M., (1930) The Great Slump of 1930. London: The Nation & Athen?um.

Lansing, K. J., 2008, “Speculative Growth and Overreaction to Technology Shocks,”

Working Paper Series 2008-08, Federal Reserve Bank of San Francisco.

Marazzi, C. (2010) The Violence of Financial Capitalism, NY:

Schleifer, A., (2000), Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press, Oxford

Zheng, Z., (2005) From Rationality to Bounded Rationality, Australian Economic Papers, December, 455-474.

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Free Essays

Problems of Inequality and Poverty in Finance

Abstract

Inequality and poverty are realities for the majority of developing economies around the world. Intuitively, financial development leading to economic growth should have a positive relationship between the reduction of income inequality (and therefore social inequality) and poverty eradication. Successful regulation of the financial sector leading the economic and political stability will have the effect of increasing access to capital through increased foreign direct investment. In this way FDI can be used to improve access to microfinance which has been identified by the UNDP and developing countries as a primary strategy to poverty eradication as a long-term goal.

Introduction

Literature on poverty alleviation notes that levels of poverty can be decomposed in two distinct ways. The first is through rapid economic growth and the second is though a change in the distribution of income in that economy (Bourguignon, 2004). This literature acknowledges the inherent link between poverty alleviation, economic growth and income redistribution. In terms of statistical representation, Besley and Burgess (2003) prove that in order for alleviation of poverty to occur, developing countries need to effect an annual growth of 3.8% in the Gross Domestic Product (GDP) in order to half poverty in the next decade which is currently less than half the average growth recorded in recent decades. Therefore although financial development has been shown to produce faster rates of economic growth, literature still remains largely unconvinced of the link between financial development and poverty alleviation (Beck et al., 2004). It goes without saying that income inequality perpetuates social inequality by affording lower-income groups limited access to necessities, commodities, health and education which in turn creates a recurring cycle of poverty and inequality in itself. This paper therefore aims to explore the link between financial development and inequality in poverty alleviation with a particular focus on developing countries in Africa. The central hypothesis of this paper asserts that if there is a positive relationship between financial development and the reduction of income inequality, financial development can be used as a means of alleviating poverty in developing countries.

The Impact of Financial Development on Income Inequality

The impact of financial development on the reduction of income inequality is not settled in current research outcomes, with certain models implying that development enhances opportunities for growth and reduces inequality. However, that this reduction is hampered by imperfections in the financial markets with factors such as credit restraints impeding the flow of capital to poorer individuals and communities, therefore enforcing inequality in income and intensifying the wealth disparity in these developing economies (Beck et al., 2004). According to these models, financial development plays the role of reducing these credit restraints and therefore improving the availability of capital for redistribution in lower-income groups and thereby accelerating growth.

Contrary to these models however, Haber et al. (2003) note that in low-income countries, poorer members of society remain in rural areas and therefore rely on access to capital through family connections and as a result, financial development will only result in assisting the high-income end of the spectrum. Overall therefore, this may have a negative impact on income inequality. Evidence from developed economies suggest a nonlinear approach to financial development which asserts that at higher levels of economic development, there is increasing wealth available to a larger percentage of the population which may have the effect of offsetting this negative impact (Greenwood & Jovanovic, 1990). The problematic element of this nonlinear model is that reaching higher levels of economic development may take substantial economic growth over a long-period of time, which does little to address immediate concerns of income inequality.

Indicators of financial development include the improvement of information and transactions costs, and the availability and distribution of capital. For developing countries, which often experience a lack of availability of credit, there is a larger reliance on foreign direct investment and private credit institutions to provide capital. In these regions there is a large reliance on micro-finance institutions (MFIs) to improve the access to capital for low-income groups. Case studies in developing countries have proven that access to microfinance has a positive impact on poverty alleviation and income inequalities (Meagher, 2002). Practice however has shown that MFI access is in itself problematic as it requires strict regulation of the financial services industry in that country in order to ensure both consumer and investor protection (Omino, 2005). The success of MFIs in providing access to capital relies heavily on a coherent strategy by the government of the country through the central banking institution or primary financial regulation authority.

The Use of Microfinance for Poverty Alleviation

One could argue that the use of microfinance as a means of poverty reduction and income redistribution is a moot point, as it has been popularly acknowledged as a primary long-term strategy for the eradication of poverty. The United Nations Development Programme prioritized microfinance as part of their broader international agenda as a measure of poverty alleviation (UNDP, 1997). As part of this international mandate, the UNDP provided avenues where commercial financial institutions could gain funding from the UNDP as a means of providing microfinance to low-income families with comparatively lower repayment demands and in doing so, catering for the social economic burdens carried by the nationals of the countries involved (UNDP, 2004). This agenda is one that has been adopted by financial regulation authorities in developing countries. The Central Bank of Liberia, for example has adopted a new regulatory framework which provides a unified approach to regulation of the financial sector with a specific focus on MFIs, acknowledge the mandate of the UNDP to make use of these institutions for wealth redistribution and poverty eradication (Central Bank of Liberia, 2009), which was a goal specifically supported by the United Nations Capital Development Fund (UNCDP, 2008). The support for these forms of financing institutions is not specific to Liberia with the UNDP and UNCDP offering similar support to other developing countries around the world, with a specific focus on improving financial development through effective regulation in the sector.

The rationale behind the use of MFIs as a primary means of poverty reduction lies in the access that it gives to lower income groups to encourage small business. This acts as a grassroots approach to wealth redistribution and therefore the use of MFIs has been identified as a primary method of poverty alleviation in developing countries, such as Liberia (Central Bank of Liberia, 2005). Financial development through the use of non-traditional means of providing access to credit for lower-income groups requires unified regulation of the banking sector in developing countries. This necessitates a hierarchical approach to regulation which effectively regulates the relationship between the national financial policy of the country, macroeconomic financial institutions and MFIs. The effect of consistent regulation in this way has the effect of stabilizing the economy of the country, as an unstable economic environment generates inflation which has a proven effect on microenterprise that is more severe than established, wealthier companies or corporations (Franks, 2000). Therefore ensuring a stable economic environment is essential to continued wealth redistribution and ultimately poverty alleviation.

A case study of the Philippines further showed that the investment in poverty alleviation in this way enhanced the economic and political resources of the average household and as a result had a positive effect on social capital and cooperation through the encouragement of production and industry (Quinones & Siebel, 2000). This in turn had a positive effect on the political stability in this region which further encourages foreign direct investment (FDI) in the economy of the country. The knock-on effect of FDI in developing countries is self-explanatory with a positive result on economic growth and greater access to capital. An unfortunate reality however faces many African nations which represents the converse situation, where many years of poor financial management have led to inherent corruption within the system and in order to make use of the available support offered by the UNDP and UNCDP, these countries require a significant financial overhaul which is low on the priority list for many countries. This is particularly true of developing countries that have suffered the effects of oil wealth, which has had a negative overall effect on economic growth despite an abundance of natural resources which has compounded wealth disparity and poverty (Mahdavy, 1970).

Conclusion

The evidence presented in this paper shows that there are a number of factors required for financial development to positively contribute to a reduction of income inequality (and therefore social inequality) and poverty eradication. The most important factor is effective and unified regulation of the financial sector of the country, which will have the effect of stabilizing the economy and therefore stabilizing interest rates, but also in the stabilization of the political climate in the country. Theoretically, this positions these economies favorably in terms of FDI which will have the effect of increasing the amount of capital available for redistribution. By redistributing wealth at a lower-income level, the nonlinear financial effects of economic growth can be expedited with a realistic alternative to gradual wealth distribution in favour of bottom-up wealth creation. In this way, financial development tackles the problem of wealth disparity and the associated poverty levels from a top-down and bottom-up approach which can reasonably be expected to increase the rate of economic growth, and doing so in a manner that does not rely on singular capital redistribution that may be plagued by imperfections in financial markets. In this way, financial development can be used as a means of alleviating income inequalities and poverty levels in developing countries.

References

Beck, T., Demirguc-Kunt, A. & Levine, R. (2004) Finance, Inequality and Poverty: Cross Country Evidence. NBER Working Paper Series, Working Paper 10979

Besley, T. & Burgess, R. (2003) Halving Global Poverty. Journal of Economic Perspectives, 17, pp. 3-22.

Bourguignon, F. (2004) The Poverty-Growth-Inequality Triangle. World Bank mimeo.

Central Bank of Liberia (2005) Integrating Financial Services into Poverty Reduction Strategies: Institutional Experience of Liberia West-African Regional Workshop, Monrovia: CBL

Central Bank of Liberia (2009) Microfinance Policy and Regulatory & Supervisory Framework for Liberia Monrovia: CBL

Franks, J. (2000) Macroeconomic Stabilization and the Microentrepreneur. Journal of Microfinance, 2, pp. 69-91

Greenwood, J. & Jovanovic, B. (1990) Financial Development, Growth, and the Distribution of Income, Journal of Political Economy, 98, pp. 1076-1107

Haber, S., Razo, A. & Maurer, N. (2003) The Politics of Property Rights: Political Instability, Credible Commitments, and Economic Growth in Mexico. Cambridge University Press.

Mahdavy, H. (1970) ‘The Patterns and Problems of Economic Development in Rentier States: The Case of Iran’ In Studies in the Economic History of the Middle East, ed. M. A. Cook. London: Oxford University Press

Meagher, P. (2002) Microfinance Regulation in Developing Countries: A Comparative Review of Current Practice Maryland: IRIS Centre

Omino, F. (2005) Regulation and Supervision of Microfinance Institutions in Kenya. Essays on Regulation and Supervision, Central Bank of Kenya, No. 5

Quinones, B., & Seibel, H. (2000) Social capital in microfinance: Case studies in the Philippines. Policy Sciences, 33, pp. 421-433

United Nations Development Programme (1997) Microstart Programme Geneva: UNDP

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Free Essays

Financial Crises and Corporate Finance: Causes, Context and Consequences

1.0 Introduction – background to financial crash of 2007-8

This essay will examine the background and unfolding of the 2007-2008 financial crisis and its impact on the theory and practice of corporate finance. I will analyse whether changes to the way the financial and non-financial corporate sector operated over recent years contributed to the depth and severity of the crisis. Specifically, financial deregulation in the 1990s in financial markets and the securitisation of the corporate sector (Ball, 2009), have led to claims that the ‘solution’ to the so-called agency problem of aligning manager and shareholder interests may have actually made the crisis worse. I will argue that the easing of regulations on the mortgage loan sector especially increased the risks of a financial crisis developing by creating the environment for a massive financial asset bubble. Historically low interest rates and ‘easy money’ policies of the US Federal Reserve under Alan Greenspan following the bursting of the technology bubble in 2000 created conditions for the bubble. I will also examine whether the growth in markets for innovative financial products such as CDOs disguised risks and even mispriced assets in the mortgage market by separating the obligation to fund the original loans from the trading of such obligations as collateralised debt. The outcome of the crisis in terms of future corporate financial behaviour and regulatory reforms of the corporate sector will be reviewed.

2.0 Corporate finance models and the financial crisis – the role of CSR

Critics of the corporate sector such as Simms have argued that the narrow focus among publicly listed companies on short-term profits over and above sustainable long-term corporate health, helped cause the financial crisis of 2007-9. The process of selling off traditionally run companies to global multinationals had led to the disappearance of famous companies such as Twinings and Cadbury from the British economy, and the loss of jobs related to these closures. Simms is not alone in claiming that the narrow pursuit of short-term profits as well as excessive pay among senior executives has not served the interests of the wider economy and stakeholders including workers and pension funds. Simms sees the selling off and closure of great British enterprises as the result of the loss of traditional family business ethics and their replacement by financial sector values of high returns to investors.

Fernandez-Feijoo Souto (2009) analyses the financial crisis in terms of the opportunities it presents for companies to refocus on corporate social responsibility. CSR is seen as growing in importance as part of the corporate culture although there is difficulty in defining what CSR actually means. Fernandez-Feijoo Souto argues that the financial crisis has provided a new urgency to the need to clarify what defines CSR and how it should be implemented. This includes building a name as a responsible business and relating this to growing revenue, keeping key personnel, understanding consumer’s bias toward companies with a good CSR brand; changing relationships through the value chain based on trust and treating customers and suppliers well; improving conditions which in turn reduce employee turnover and raise productivity, and reducing legal conflicts by complying with regulations. Simms argues that companies with a business model that has CSR built into it have been shown to be much better adapted to survive the challenges of the global financial crisis than companies that have followed a short-term profit strategy. He uses the examples of Bear Sterns and Lehmans, which traded under the saying “Let’s make nothing but money,” as classic examples of the kind of approach that led to disaster. However for each such example, one can point to a similar company, such as Barclays or Goldman Sachs, that have continued to thrive during the financial crisis despite having the same financial focused ethos. This is reflected in the evidence of numerous studies the result of which show unproven links between CSR and cost, profit and longevity (Fernandez-Feijoo Souto, 2009). There is evidence also of a split between positive economic results and more negative financial results, meaning that potentially short term financial gains may come at the cost of longer term economic performance.
Lipton, Lorsch and Mirvis (2009) state: “Excessive stockholder power is precisely what caused the short-term fixation that led to the current financial crisis.” They point to money managers focused on short-term financial results who fuelled excessive risk taking. This tendency was favoured by government and regulators failing to impose checks on risk taking. Lipton, Lorsch and Mirvis see a “direct causal relationship between the financial meltdown and the short-term focus” of stockholders.

3.0 The role of securitisation in the financial crisis

Securitisation of the mortgage and loan market, which developed in the 1990s, is seen by some commentators as central to the development of the financial crisis of 2007-8. Securitisation of asset-backed bonds is the process of creating debt instruments from a package of loan assets, usually home loans, commercial loans and retail loans such as credit card debt or auto loans. This allows banks to release value from the assets on their balance sheet. The asset-backed market was developed in the United States and grew rapidly from the early 2000s. Banks and other originators of mortgages sold on packages of their loans to an issuer, usually called a special purpose vehicle (SPV). The purpose of the securitisation is to reduce the institution’s balance sheet, which allows its return on equity to rise and also releases capital for other purposes. The process of securitisation enables the issuer to achieve enhanced credit ratings, usually up to AAA investment grade (Sundaresan, 1997). The credit rating of the original loan does not affect the rating of the SPV, even if the original mortgage holder defaults on the loan or is declared bankrupt. The securitisation deals are normally rated by credit ratings agencies such as Moody’s, Fitch or Standard & Poor’s. The investment bank or investor which purchases the SPV securities will often approach an insurer to gold plate the deal by providing a credit default guarantee for the SPV in the event of default (Teasdale, 2003). It has been argued that the complexity of securitisation restricts the ability of investors to assess risk, and that securitisation markets are likely to be subject to serious declines in underwriting standards.

3.1 Credit Default Swaps – analysis of impact of CDS market in the financial crisis

The huge growth of the credit default swap (CDS) market is considered by many analysts to be one the worst elements of securitisation. The Bank for International Settlements reports that the CDS market increased in size from $6 trillion in 2004 to $57 trillion in June 2008 measured by notional principal (Stulz, 2010). The government bailout of AIG brought the CDS market to global attention, and led some commentators to see the CDS market as the primary cause of the financial crisis. As Stulz (2010) argues, there are two problems with the CDS market. First, the sellers of credit default swaps are not able to bear the risks they took on, so some of the benefit of credit default swaps in terms of hedging are actually unfounded – ultimately leading to the $80 billion bailout of AIG. Second, because of their inherent leverage of a CDS, they can enable investors to take more risky positions. The availability of these instruments to non-risk-averse investors may lead to risk being under-priced. However, Stultz shows how the CDS market performed remarkably well around the default of Lehman Brothers. The credit default swap market did not cause the subprime mortgage defaults or the disappearance of liquidity. Excessive leverage by financial institutions and the collapse of the housing market was the cause of the crisis. For example, AIG borrowed heavily to acquire home loan-backed securities and it made even bigger losses on its portfolio of home loan-related securities than on its credit default assets.

4.0 Ponzi schemes and failure of investment banks to report criminal behaviour

The crisis also revealed outright criminal activity taking place in the investment sector, most famously in the case of Bernard Madoff, whose wealth management business was exposed as a Ponzi scheme with $65 billion funds missing from accounts. Madoff was sent to prison for 150 years. JP Morgan acted as banker to Madoff but did not report their suspicions about his activities to the SEC (Ferguson, 2012). Critics have commented that there have been very few prosecutions of investment bankers for such activities as ‘shorting’ the very stocks that they recommended to their clients (Lewis, 2010). The Securities and Exchange Commission and New York prosecutors have brought very few prosecutions and no one has faced criminal conviction. Ferguson points out that Morgan Stanley’s Howie Hubler began to bet against securities connected to the subprime market in 2004 with management approval (Ferguson, 2012). The title of Ferguson’s film ‘Inside Job’ refers to the pattern of investment bankers and lawyers whose clients are banks then taking senior judicial and political roles in the government and financial authorities. This, it is argued, has caused a disincentive to go after the banks for actions that could be prosecuted.

5.0 Reform of corporate finance regulations – legislation and limits of reform

Reform of the banking and wider corporate sector has been discussed and enacted in a variety of forms in the US and Europe. Banks have undergone stress tests to see if they could cope with further financial crises. The UK authorities have begun to reform corporate governance to give shareholders greater power to oversee compensation of executives, such as binding votes on executive pay, but this has not yet been implemented. New rules on the levels of reserves that banks must hold in order to ensure they are able to cope with future crises were agreed in November 2010 at the G20 summit in Seoul. G20 Finance Ministers backed the Basel Committee on Banking Supervision’s plans for capital and liquidity requirements for financial institutions. However most of these new reserve requirements have not yet been enforced, partly because the banking sector remains extremely fragile following the financial crash with high level of debts still threatening the financial system. Following the crisis, there were many calls for the separation of retail and investment banking, or even the breaking up of ‘too big to fail’ banks, but these have not been acted on by government. President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in July 2010. The Act marks the biggest reform of the US financial sector since the Great Depression (Avery, 2011). Section 939A of the Act effectively bans the use of credit rating agencies in an attempt to improve capital requirements for US banks. However implementation is likely to take many years.

In America economists such as Paul Krugman have called for a return of the Glass Steagall Act 1933, which was put in place following the 1929 Wall Street Crash and then removed in the 1990s as part of the liberalisation of the banking sector (Krugman, 2011). Countries with stronger regulation of their banking sector, including Canada, Australia and Germany, did not suffer a banking crisis in the manner of the UK and USA, where regulation was ‘light’.

6.0 Conclusion: comparison with regulatory response to 1929 Financial Crash

By comparison with the response of authorities to the Great Crash of 1929, it can be argued that through to 2012, five years after the crisis began, major reforms to the banking sector and to corporate governance in the US and UK have not been implemented in the way they were in the 1930s. This may be a result of the fact that governments and securities oversight authorities are far less independent of the corporate finance sector than they were in the 1930s. The financial services sector has grown in relation to GDP compared to its position in the 1930s, and its political influence is far greater. This means that reform and regulation has been much slower and weaker than it was in the last Great Depression. Calls for reform will not go away, especially as the crisis continues in Europe and North America. Action on corporate governance, and implementation of proposals for financial and banking reform will be required in order to prevent further financial crises occurring in the future.

REFERENCES

Avery, A. W.; 2011. Basel III v Dodd-Frank: What Does it Mean for US Banks, Who’s Who Legal.

Ball, A. 2009. The Global Financial Crisis and the Efficient Market Hypothesis: What Have We LearnedThe University of Chicago Booth School of Business, Journal of Applied Corporate Finance, Volume 21, Issue 4, pages 8–16, Fall 2009

Ferguson, C; 2012, Heist of the century: Wall Street’s role in the financial crisis, The Guardian, 20 May 2012.
http://www.guardian.co.uk/business/2012/may/20/wall-street-role-financial-crisis

Fernandez-Feijoo Souto, B.; 2009. Crisis and Corporate Social Responsibility: Threat or OpportunityInternational Journal of Economic Sciences and Applied Research, Vol. 2, No. 1, 2009.

International Corporate Governance Network (ICGN), 2008, Statement on the Global Financial Crisis.

Krugman, P and Wells, R., 2011, The Busts Keep Getting Bigger: WhyNew York Review of Books,14 July 2011

Lewis, M. 2010, The Big Short, Allen Lane, Penguin.

Lipton, M; , Lorsch, J. W. and Mirvis, T.N, Schumer’s Shareholders Bill Misses the Mark, Wall St. Journal, 12 May, 2009

Mirvis, Wachtell, Lipton, Rosen & Katz, 2010. Corporate Governance and the Financial Crisis: Causes and Cures, February 28, Harvard Law School Forum on Corporate Governance and Financial Regulation.

Sims, A; 2010. The power of corporate finance is an amoral hazard, The Guardian, 8th September, 2010.
http://www.guardian.co.uk/commentisfree/cifamerica/2010/sep/08/power-corporate-finance-amoral-hazard

Stulz, R.M., 2010, Credit Default Swaps and the Credit Crisis, Journal of Economic Perspectives, Vol. 24, No. 1: 73-92.

Sundaresan, S., Fixed Income Markets and Their Derivatives, South-Western Publishing, 1997, chapter 9.

Teasdale, A; 2003, The Process of Securitisation. YieldCurve.comhttp://www.yieldcurve.com/Mktresearch/files/Teasdale_SecuritisationJan03.pdf

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Examining the selection criteria for equity finance investment in social enterprise

Research Methodology

The main purpose of this section is to discuss how the primary research has been carried out and the rationale for the choice of methodology. The conclusion of the literature review showed that there are currently no publically agreed criteria for social venture capital funding and very little in the way of conclusive advice for social enterprises attempting to raise this kind of funding. As a result, it is important to gather primary data to facilitate the development of robust conclusions and to answer the research questions.

When proposing a research methodology for an in-depth study such as this, Saunders et al. (2009) suggest that it is practical to build the research methodology and research design in such a way that it supports the overall aim and objectives of the research. As such, every aspect of the methodology must reflect the overall purpose of the research, and be geared towards answering the research question and accomplishing its objectives (Neuman, 2000).

This chapter therefore outlines the methodology through which the research objectives were met, and the question answered. Several important factors, such as the research philosophy, design, strategy and data collection are highlighted. Issues relating to the research’s validity, generalizability and reliability are also discussed.

Research Philosophy

According to Easterby-Smith et al (2008), it is important to understand the research philosophy being adopted in management research, as it helps clarify how the research should be designed, approached, and how data could be collected and analysed. Easterby-Smith et al also note that an understanding of the research philosophy could help the researcher in creating, designing and identifying research that may not in line with past experiences.

Based on the research aims and objectives, the researcher deemed it most appropriate to adopt an interpretivist philosophy. This is due to the overriding aim of this research, which is to understand the reasons behind social enterprise funding, thus implying that there is a need to understand human responses to a situation, thereby making the result of the findings potentially subjective in nature (Denzin and Lincoln, 2003). Saunders et al (2009) note “interpretivism is an epistemology that advocates that it is necessary for the researcher to understand differences between humans in our role as social actors”

The researcher will need to make sense of the subjective and socially constructed meanings expressed by respondents, as per the interpretivist philosophy (Saunders et al, 2009). The interpretivist perspective can be argued to be decidedly appropriate when it comes to management research due to the complexity and uniqueness of business situations (Saunders et al, 2012; Neuman, 2000). As a result of this choice, the positivist philosophy would not be adopted in this study, as it would be ineffective to adopt a philosophy that observes and generalises social reality (Robson, 2002). Collis and Hussey (2003) also argue that the positivist philosophy cannot help understand the inner feelings, attitudes and human emotions behind social enterprise investments, as these could differ from one investor to another.

Research Approach

According to Collis and Hussey (2003) a research that adopts an interpretivist philosophy should be inductive in its approach. An inductive approach to research can help to gain an understanding of human interpretation to events, which is especially useful in management research, where the attitude and motivation of stakeholders matter (Saunders et al, 2009). As this study is concerned with understanding how social enterprise investors determine their investment criteria, then it is useful for this research to adopt an approach that makes it possible to understand human emotions and attitudes, compared to the deductive approach that is usually based on generalised scientific principles and academic theories (Bryman and Bell, 2007).

Research Purpose

As the aim of this study is to identify what social venture capitalists look for in an investment opportunity, this lends itself very much to an exploratory research methodology. According to Robson (2002, pg. 59), “an exploratory research is a valuable means of finding out what is happening; to seek new insights; to ask questions and to assess phenomena in a new light.” Saunders et al (2009) also state that an exploratory research is useful if the aim of the research is to understand a problem, find out what’s happening, or when the researcher is particularly unsure about a research problem. As such, an exploratory study is an ideal design, as it helps to answer this research’s question more effectively.

An exploratory study has been chosen compared to descriptive studies – which portray accurate events of people, events or situations (Robson, 2002), because this research seeks to ‘find out’ and not to ‘narrate’. Furthermore, the literature review already shows that there is insufficient information on selection criteria on social enterprise investments, which defeats the purpose of a descriptive study. The same also applies to explanatory studies, where the emphasis is to study a situation and explain the relationship between two or more variables (Saunders et al, 2009). This study is not designed to assess the relationship between variables, but rather to understand investor attitude. An exploratory study is therefore the most effective form of answering the research question.

Data Collection

Saunders et al. (2009) suggest that when gathering primary data for an inductive exploratory study, it is normal that much of the data will be qualitative in nature. While there is a considerable amount of quantitative data around the subject of venture capital and social enterprise, these statistics are not sufficient to clarify investment criteria. A further issue with quantitative data is that this research does not seek to reconcile hypothesis and as a result, a methodology needs to be chosen that produces qualitative data. To answer the research question, and to develop a better understanding of this new development for both the social VC and social enterprise industries, it is important to collect data that is rich in opinion and explanation (as recommended by Morris and Wood, 1991). Qualitative data collection is therefore the most appropriate for this research.

As it is anticipated that much of the primary data gathered for this study will be qualitative in nature, Saunders et al. (2009) suggests that there are several techniques for gathering primary data. These include inter alia interviews, surveys, focus groups, case studies, and participant observation. To obtain rich data that will be sufficient to allow for analysis, the development of themes, and sufficient contrast of opinion, techniques such as questionnaires and general surveys with large samples are unlikely to be effective (Morris and Wood, 1991). Firstly due to the fact that they will not provide the necessary opinion to answer the research question but more importantly due to the fact that there is a limited sample of available respondents with the necessary experience in their industry, as will be clarified in the data sources section of this methodology.

While both the VC industry and the social enterprise ‘movement’ are well established, the actual link between them is relatively new and as a result it is important to select a technique that allows for the development of theories to emerge during data collection and analysis. A longitudinal study would potentially be ideal as would the case study method, since both of these allow for the opportunity for the discovery of interesting new ideas and theories (Adams and Schvaneveldt, 1991). A longitudinal study is not appropriate for this dissertation due to the time constraints, and so a cross-sectional study is more appropriate. While there was the potential to carry out a case study of either a social VC fund or a social enterprise, this would have only provided information around one organization. To effectively analyse the link between two industries it is more appropriate to gather data from a broad cross section of organizations and links to avoid either any bias or “isolate opinion” (Collis and Hussey, 2003).

According to Belk (2008), the main weakness of qualitative data collection is that it can be limited by insufficient resources. This means that because interviews are resource intensive, a narrower range of opinion is gathered. However Collins & Hussey (2003) argue that if the interviews are well structured even though they only gather the opinions of a relatively small research population the depth and breadth of data gathered and the fact that it is contextually relevant is certainly sufficient in terms of data validity and reliability for an exploratory study such as this.

Having established the time limitations and the issue that the potential sample is limited but should be sufficiently broad, interviews emerge as the most appropriate methodology. As Sanders et al (2009) explains, there are a number of different ways that an interview can be conducted. It is first important to establish which structure of interview is the most appropriate. There are three main categories of interview structure, and these are: structured, semi-structured and unstructured. The primary distinction between them being the level of freedom given to the researcher in terms of asking different questions to interviewees, and varying the length allowed for the responses (Saunders et al, 2009).

The literature showed that there is no clarity as to either the criteria used for funding or for the advice to those seeking funding, and as a result there needs to be the opportunity for the interviewees to express opinion and provide information that moves beyond the confines of a set of structured questions. To develop new and interesting theories, it is essential that the interviews allow for different responses (Robson, 2002). However, this dissertation has a limitation of length which prevents unstructured interviews from being an appropriate technique as it could potentially allow for too much data to be collected making analysis overly complex or it could prevent the necessary focus on the issues related to the research question. Semi-structured interviews allow for sufficient data to be collected while also providing the flexibility that is necessary for the researcher to develop both original insight and sufficient opinion for the analysis (Bryman and Bell, 2007).

Data Sources and Data Collection Techniques

Since it has been established that the author shall conduct semi-structured interviews, it is important at this stage to re-visit the research questions, which are as follows:

When evaluating social enterprises for equity investment, which criteria are considered most important
Do social venture capitalists differ in their evaluation criteria compared to commercial venture capitalists

Secondary research question:

What are the drivers for the social venture capitalists

A questionnaire has been developed accordingly and used as a guideline, allowing for flexibility of the discussion and giving the respondents room to reject certain questions or focus on questions that was within their expertise, whilst still ensuring answers to the more critical questions. This semi-structured format is favourable also because it allows for discretion and prioritization in time management, without the need to interrupt or inconvenience the respondent (Neuman, 2000).

Primary data has been gathered using said questionnaire, from five individuals that are responsible for screening social enterprises in the UK for access to equity investment. Five interview respondents were seen as ideal for a number of reasons. Firstly, this research is exploratory in nature; secondly, time constraints would have made it difficult to gather and analyse data from more than five respondents; and lastly, it was difficult to gain access to these individuals.

The semi-structured interviews were conducted over the phone and in face-to-face environments, as per the respondents’ preference. The questionnaire was shared beforehand allowing the respondents time to consider and prepare for the questions if need be, as well as to filter out respondents who were not well suited. Research participants were encouraged to expand upon their responses to allow the researcher to gather a wide range of data (Belk, 2008). The interviews were audio-recorded with consent and subsequently transcribed verbatim[1], in order to allow the researcher to focus on the interview and fully engage with the respondent, without compromising on the accuracy of the data collected (Robson, 2002). This further allowed for the researcher to take note of additional non-verbal communication to enrich the quality of data retrieved (Kvale and Brinkmann, 2009). At the end of each interview, a summary was developed in order to reflect upon the progression of the interview process and start developing any findings. This “stop and reflect” process in between interviews, as recommended by Saunders et al (2009), has allowed the researcher to adapt to this new knowledge and delve deeper into the research questions with each ensuing interview. This process has led to an additional set of questions on the questionnaire[2], with the aim of addressing four new research questions:

Is there in fact a market/demand for equity investment in social enterprise in the UK
Is there a supply/demand balance of social enterprises to social investment
How do SIFIs interact
What does the future of social investment look like

Once the data had been gathered, the author administered data reduction techniques (Miles and Huberman, 1994) by critically reviewing and selectively focusing on key parts of the extended text which are the transcripts. By extracting relevant pieces of information to answer our research questions, along with our notes throughout the interview process, the author was then able to codify the data, which was then subject to thematic analysis. Data collection, data analysis and the development and verification of the propositions have been very much an interactive and interrelated set of processes, whereby actual analysis occurred throughout. The flexibility of this process was key to enabling more insightful data and propositions, as enabled by an inductive approach.

Issues of Reliability, Validity and Generalisability

Reliability denotes the extent to which findings from a research can provide consistent findings, if another study were to adopt its data gathering and sampling technique (Easterby-Smith et al, 2008). The major threats to research liability: respondent bias, respondent error, interviewer bias and interviewer error (Robson, 2002) were avoided by:

Sending the questionnaires to the respondents beforehand to avoid misinterpretation of intent or questions.
Audio-recording the interviews, and taking ‘time-outs’ to reflect on the answers and ask further questions.
Analyzing the data using data-reduction techniques, in order to prioritize the key findings and avoid loss of data.

Validity, according to Saunders et al (2009) “is concerned with whether findings are really about what they appear to be about”. The interview questions were based on the research question, thus linking respondent answers to the overall aim of the research. Furthermore, the respondents were accredited professionals with industry insight on social enterprise investments. As a result, they were most fit to answer the interview questions. This helped ensure the data collected and analysed was valid.

Generalisability measures the extent to which research findings are generalizable to other research settings (Saunders et al, 2009). Due to the inductive nature of this study, it is the researcher’s opinion that the findings of this research are generalizable to social enterprise investments in the UK. The findings from this research could help explain how investors determine what social enterprises they would invest in the UK. This is due to socio-economic factors that may differ from one country to another.

Ethics

With any primary research it is imperative that matters relating to research ethics are taken into account (Denzin and Lincoln, 2003). This includes ensuring that research participants have a clear understanding of what the research will entail and their contribution to the research. Research participants have agreed to support the research voluntarily, and so Denzin and Lincoln (2003, p.114) describe this as “informed consent”. The author has explained the nature of the research and reassured research participants of their role. Furthermore, confidentiality will be maintained through ensuring anonymity of research participants throughout this dissertation, only divulging participants’ names on a need to know basis to dissertation assessors. Not only is this ethical best practice, but Bryman & Bell (2011) also highlight the fact that it further ensures that the researcher gathers legitimate data which is not subject to inadvertent bias, for example a research participant feels that they must say nice things about their supervisor. In this instance because the research is heavily reliant on personal opinion then it is imperative that research ethics are observed.

Due to the respondents’ varying assumptions in definition when referring to key research terms, such as “social enterprise” and “social venture capital”, all questions were clarified in detail where necessary, and the author ensured an alignment of understanding prior to collecting data.

References

Adams, G. R. and Schvaneveldt, J. D. (1991) Understanding Research Methods, Longman Group: UK, 406pp

Bryman, A. and Bell, E. (2007) Business Research Methods, 2nd Ed, Oxford University Press: Oxford, 786pp

Collis, J. and Hussey, R. (2003) Business Research: A Practical Guide for Undergraduate and Postgraduate Students, 2nd Ed, Palgrave McMillan: NY, 374pp

Easterby-Smith, M., Thorpe, R., and Lowe, A. (2008) Management Research: An Introduction, 2nd Ed, SAGE: London, 194pp

Morris, T. and Wood, S. (1991), ‘Testing the survey method: continuity and change in British industrial relations’, Work, Employment & Society, Vol. 5 No. 2, pp. 259- 82.

Neuman, W. L. (2000) Basics of social research: qualitative and quantitative approaches, Pearson: UK, 391pp

Robson, C. (2002) Real world research: a resource for social scientists and practitioner – researchers, 2nd Ed, Wiley-Blackwell: NY, 599pp

Saunders, M., Lewis, P. and Thornhill, A. (2009) Research methods for business students, Fifth Edition, Pearson Education: NJ, 624pp

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Insights provided by behavioural finance for personal finance strategy creation

Abstract

Behavioural finance’s potential to impact personal finance planning has long been a topic of substantial debate.This essay examines the correlation of the field of behavioural finance to the formation of personal strategy with the goal of illustrating the strengths and weaknesses of the approach. The results of this study illustrate the close bond that lies between the psychological state and the investment patterns undertaken by active investors. This research will be of interest to any person studying the impact of behavioural finance on personal strategy.

Introduction

The field of behavioural finance is argued to have a considerable impact on personal financial planning, personal finance and strategy formation (Banerjee, 2011). This area is cited by many to have the capacity to dictate the plan that a person might choose to employ during the course of forming a personal investment strategy. Effective planning is central to the identification and subsequent illustration of systemic and habitual manners that can be both positive and detrimental in the course of creating the best price and return on investment (Baker et al, 2010). Beginning with a clear examination of impact, this essay sets out to define and provide a demonstration of the impact that behavioural finance can have on the entirety of a personal financial strategy with the intent of providing the means to avoid future mistakes.

Behavioural Finance

Benartzi (2010) defines the area of behavioural finance as the use of psychological based insights to create economic strategy. This approach demonstrates the potential impact that day to day emotions and basic intuition can have on a personal financial situation. In many cases, the use of emotion to operate investment strategy has resulted in a significant failure or systematic issues that continuously plague the investor (Benartzi, 2010). This suggests that some emotion-based investing is either ill-timed or ill-conceived and therefore faulty and liable to lead to significant losses in the short- to mid-term. Conversely, many argue that intuition, based on effective knowledge, has the capacity to lift an investor above the majority and provide a method of obtaining great investment gains (Benartzi, 2010). In contrast to emotional investing, basing a strategy on an inherent skill or talent is suggested here to have the innate capability to achieve the end goal of base profit. However, the line between emotional or biased investment and undiluted intuition seems to be slight and extraordinarily slippery, leading directly to poor financial planning.

Meier (2010) illustrates the position that many mainstream investors can be identified as the classical or standard variant. This form of investor commonly assumes that they know what is in the best interest of their portfolio and it is well within their power to implement (Meier, 2010). This method of investment operates on the notion that rivalry between firms will maintain competition and therefore require minimal oversight, enhancing trust in the endeavour. However, this view is offset by the behavioural financial argument that contends that investors are often confused or misled, and despite the best intentions of many investors there is often significant lack of follow through during the strategy process (Meier, 2010). This suggests that psychology has direct and compelling impact on any formation of a personal investment plan and that often less than optimal decisions are made. Further expanding on this point is the practical issue of the need for regulation in a world often described as corrupt and morally bankrupt (Paramasivan et al, 2009). Taken together, the separation of mainstream theory from behavioural reality seems to lead many investors to incomplete assumptions and poor patterns of investment behaviour and financial planning.

McAuley (2009) illustrates the view that common decision making is based a concept referred to as heuristics or common sense rules of thumb. These approaches utilise the same capacity that humankind has employed to make day to day decisions for centuries (McAuley, 2009). However, many investors commonly use poor or mistaken data in their efforts to make a profitable investment in often volatile markets (Forbes, 2009). This concept supports that notion that there is the opportunity for investors to utilise an incorrect data model in order to create strategies, which in turn can lead to substantial losses and an eventual fundamental failure of strategy. Further expanding on this point is the creation of bias during the assessment process (McAuley, 2009). Bias is commonly defined as randomised departures from the rational process, although there is often a link to the rational base (Subrahmanyam, 2008). This suggests that some decision making is based on inherently poor material, which in turn is credited with leading the entire strategy to decline. With each loss there is a continual perpetuation of the bias cycle, with negative actions resulting in consistently negative consequences (Baker et al, 2011). Alongside this link to emotional investment patterns, there have been several forms of bias recognised and addressed during the process of personal fjnance formation and financial planning.

Insufficient adjustment is the inherent bias on the part of the investor to overlook the larger market picture and remain too conservative in their investment approach (McAuley, 2009).With this lack of confidence in the building strategy on the part of the investor, there is a very dim prospect for the personal financial planning efforts to make a significant gain. Further, this bias could in fact hold back an investor from reaching out to an emerging opportunity, which in turn can become a fatal habit. Conversely, the bias of overconfidence is credited with much of the investor losses over the course of the past recession and decade (McAuley, 2009). This bias has the inherent capacity to compel an investor to disregard sound advice or patterns in favour of other highly questionable actions (McAuley, 2009). This suggests overconfidence can easily overextend or compromise a working strategy.

Modern financial theory has been developed in order to explain and develop the area of behavioural finance (Debondt et al, 2010). Redhead (2008) points to the Prospect Theory as a key method of determining the context of an investor’s behaviour. This approach argues that there are three separate components that must be considered in regards to an investor’s behaviour (Redhead, 2008):

a) The perceived elements that are subject to bias. This identifies and illuminates the personal components that are tied to an investment decision.
b) Investors are far more concerned with immediate losses and gains as opposed to overall level of wealth.
c) Investors feel losses much more dearly than they do gains.

Each of these elements ties into the state of the investor’s emotional and psychological balance preceding their investment strategy, which in turn provides the means to assess and adapt a developing investment plan (Redhead, 2008).

Deaves et al (2005) contends that loss aversion is among the most powerful of the behavioural patterns expressed by anxious investors. In order to offset the concerns many potential market participants follow eight recommendations that have been found to have a direct impact on the formation and execution of a personal financial plan (Deaves et al, 2005):

1) Take a holistic view of the available assets and associated liabilities. There is and must always be room to adapt and adjust.

2) As much as possible allow for the maximum amount of affordable pay to be automatically invested within the client portfolio. This often takes the decision point away and offers a long term yield benefit.

3) Disregard the past actions and base investment decisions on future estimates of costs and benefits.

4) Take a long-term, as opposed to a short- to mid-term view of the investment portfolio.

5) Avoid any passing fad or quick trend promising a quick turnaround.

6) Past performance is no guarantee of future earnings.

7) Save as much as possible, as often as possible.

8) Stay the course.

This approach to behavioural finance suggests that utilising elements of theory to assist in the creation of proper strategy is actively engaging the psychological tendencies of the investors in order to capitalise on their inherent strengths as well as avoid their innate detriments. Yet, despite the efforts of some financial planners many common investment mistakes continue to take place no matter the system in place (Montier, 2007). A very common loss aversion tendency that is credited with the loss of many investors’ assets is the tendency to hold on to a losing stock for too long based on past performance or associated issues (Benartzi, 2010). This is based on the very real emotional base of pleasure seeking and pain aversion. If person sells a successful stock and gains a profit, pleasure is felt, thereby encouraging the investor (Benartizi, 2010). Conversely, letting a failing stock linger, and losing money is credited with very physical manifestations of pain, which in turn lead to poor decisions the state of personal finances and personal finance planning (Benartizi, 2010).

Risk aversion in behavioural finance has the potential to manifest in several different identities in the course of determining a personal financial strategy (Montier, 2007). This is a suggestion that the method that an investment is packaged and presented, or framed, has a direct bearing on the application or implementation of the proposal. Using tools including cash back incentives, or gifts, is a common method for inducing investors to overlook other data in favour of investing in the underlying company (McAuley, 2010). This suggests that a favourable set of circumstances to the investor have an impact on the manner and method of investment, prompting many advertisers and financial planners to readily target specific behaviour elements during their efforts to spur .

Hens et al (2008) argue that in many cases an investor has an expected utility of the associated investment that is unrealistic. Many leading financial strategists state unequivocally that no one human can be fully informed on any single investment (Pompian, 2006). This leads to the investor believing that they have more control than is present in the endeavour, which in turn leads to a diminished or detrimental return. Baker et al (2010) credits many of the investment decisions made by investors as based on the discounting of the future potential in favour of the quick and present, albeit smaller, rewards. This need for immediate satisfaction has a direct impact on the ability for a portfolio to make the most of the assets available.This suggests that successful personal planning will focus on the mid to long term investments with a clear determination to avoid any quick or offhand investment decisions. Baker et al (2010) extend the point of the need to avoid physical distraction by illustrating studies that connect the gastronomically centred portion of the brain to the segments related to the investment areas. This is an indication that habits that are common in the population, including over eating and poor diet, can be extended to the investment portfolio. Emerging methods including surveys, interviews and focus groups are allowing for the concept of behavioural finance to be incorporated into mainstream investing (Muradoglu et al, 2012). With clear success in defining and removing behavioural impediments, many investors are looking to this field of research for potential edges in determining future strategy.

Conclusion

Behavioural finance is argued to provide substantial impact on personal finance and personal planning and the results of this essay support that contention. Despite the desire for a black and white investment environment, there is no escaping the impact that inherent bias, shortcoming and basic human error play on the implementation of an effective investment scheme. The material presented illustrates the potential for personal bias based on such base elements as the food consumed prior to making decisions, yet, the process of identification has the potential to offset the negative and enhance the positive. Further, intuition has been credited with propelling many investors to success, yet, this is separate from the decision making process that allows for the creation of bias and the inclusion of errant material.

A clear benefit to the implementation of a personal financial strategy is knowledge of the elements that make up the field of behavioural finance, allowing the creation of an effective process to offset any negative pattern of investment behaviour. In the end, as with all manner of investments, it comes to discipline, skill, patience and the determination of the investor to not be swayed in the face of adversity but hold to the reality of any situation.

References

Baker, H. and Nofsinger, J. (2010). Behavioural finance. 1st ed. Hoboken, N.J.: Wiley.

Baker, M. and Wurgler, J. (2011). Behavioural corporate finance: Wiley.

Banerjee, A. (2011). Application of Behavioural Finance in Investment Decisions: An Overview. The Management Accountant, 46(10).

Benartzi, S. (2010). Behavioural Finance in Action. Allianz 1(1) p. 3-6.

Brigham, E. and Ehrhardt, M. (2005). Financial management. 1st ed. Mason, Ohio: Thomson/South-Western.

Deaves, R. and Charupat, N (2005). Behavioural Finance. Journal of Personal Finance 1(1). P. 48-53.

DeBondt, W., Forbes, W., Hamalainen, P. and Muradoglu, Y. (2010). What can behavioural finance teach us about finance?. Qualitative Research in Financial Markets, 2(1), pp.29–36.

Forbes, W. (2009). Behavioural finance. 1st ed. New York: Wiley.

Hens, T. and Bachmann, K. (2008). Behavioural finance for private banking. 1st ed. Chichester, England: John Wiley & Sons.

McAuley, I (2009). Understanding human behaviour in financial decision making. Centre for Policy Development 1(1). p. 1-5.

Meier, S. (2010). Insights from Behavioural Economics for Personal Finance. Behavioural Economics and Personal Finance 1(1). p. 1-3

Montier, J. (2007). Behavioural investing. 1st ed. Chichester, England: John Wiley & Sons.

Muradoglu, G. and Harvey, N. (2012). Behavioural finance: the role of psychological factors in financial decisions. Review of Behavioral Finance, 4(2), pp.68-80.

Paramasivan, C. and Subramanian, T. (2009). Financial management. 1st ed. New Delhi: New Age International (P) Ltd., Publishers.

Pompian, M. (2006). Behavioural finance and wealth management. 1st ed. Hoboken, N.J.: Wiley.

Redhead, K. (2008). Personal finance and investments. 1st ed. London [u.a.]: Routledge.

Sewell, M. (2007). Behavioural finance. University of Cambridge. UK

Subrahmanyam, A. (2008). Behavioural finance: A review and synthesis. European Financial Management, 14(1), pp.12–29.

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MSc Development Finance

Furthering my knowledge in finance and economics is one of my goals. As a native of Brunei, a developing country, I would like to contribute to my country’s progress with the use of the knowledge and skills that I acquired during my undergraduate studies. Majoring in accounting and economics has provided me extensive knowledge of various economic principles and theories and their application in the business world. Although the University of Manchester has given me sufficient knowledge in the field that I have chosen, I believe that pursuing to study under this programme would provide me a broad yet focused knowledge in development finance and its practical application in the public sector.

I chose to pursue this programme because of its international focus, group work, and emphasis on learning public finance, bank and non-bank financial institutions, international finance organizations, aid agencies and other finance-related areas of study that can help in understanding how the financial theories governing our country and the world economy work. The program is also designed to teach me financial inclusion and microfinance in relation to poverty reduction.

My interest in development finance first sparked during my junior years. My wish to contribute to my country’s progress was further intensified by a course about economic policies of developing countries and their role in the international market. Working at the Ministry of Foreign Affairs and Trade Development in Brunei under the Finance Department for summer internship last summer 2007 has also provided me first-hand experience and knowledge in international trade.

I am confident that this university has the capacity to provide students with knowledge beyond the conventional financial educational program. The programme of University of Manchester also includes strengthening the analytical decision-making skills of students. It also offers wider academic opportunities and school resources that will deepen my expertise and broaden my perspectives. I am especially interested and looking forward to the overseas field visit which is a crucial part of the programme.

Most of the countries visited are developing countries like Brunei which face similar economic situations. The programme also allows students to conduct research in government and non-government organizations and other universities in the U.K. This can not only broaden my knowledge and hone my skills in finance, but also enhance my socializing and communication skills.

With hopes and persuasion in my mind, I aim to establish a career that can contribute to the further development of the financial situation in my county. One of the careers that I have in mind is a job in Brunei Investment Agency (BIA). As mentioned earlier, my country is a developing country. Although we are an oil-producing country, I believe that in terms of investment and contribution to the world economy, there is still much room for progress. Through this programme, I know that I would be able to obtain what is necessary to achieve my goal. Thus, I see myself successful in a career on this field and making Brunei a more developed and investment-focused country.

 

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Chapter 4 Public Finance Answers

Part 2 – Public Expenditure: Public Goods and Externalities Chapter 4 – Public Goods 1. a. Wilderness area is an impure public good – at some point, consumption becomes nonrival; it is, however, nonexcludable. b. Satellite television is nonrival in consumption, although it is excludable; therefore it is an impure public good. c. Medical school education is a private good. d. Television signals are nonrival in consumption and not excludable (when broadcast over the air). Therefore, they are a public good. e. An automatic teller machine is rival in consumption, at least at peak times.

It is also excludable as only those patrons with ATM cards that are accepted by the machine can use the machine. Therefore the ATM is a private good. 2. a. False. Efficient provision of a public good occurs at the level where total willingness to pay for an additional unit equals the marginal cost of producing the additional unit. b. False. Due to the free rider problem, it is unlikely that a private business firm could profitably sell a product that is non-excludable. However, recent research reveals that the free rider problem is an empirical question and that we should not take the answer for granted.

Public goods may be privately supported through volunteerism, such as when people who attend a fireworks display voluntarily contribute enough to pay for the show. c. Uncertain. This statement is true if the road is not congested, but when there is heavy traffic, adding another vehicle can interfere with the drivers already using the road. d. False. There will be more users in larger communities, but all users have access to the quantity that has been provided since the good is nonrival, so there is no reasons larger communities would necessarily have to provide a larger quantity of the nonrival good. 3.

We assume that Cheetah’s utility does not enter the social welfare function; hence, her allocation of labor supply across activities does not matter. a. The public good is patrol; the private good is fruit. b. Recall that efficiency requires MRSTARZAN + MRSJANE = MRT. MRSTARZAN = MRSJANE = 2. But MRT = 3. Therefore, MRSTARZAN + MRSJANE > MRT. To achieve an efficient allocation, Cheetah should patrol more. Chapter 4 – Public Goods 4. The Search for Extra-Terrestrial Intelligence is a public good because it is nonrival and presumably non-excludable. The government should pay for the research only if the SMB is greater than the SMC. . Aircrafts are both rival and excludable goods, so public sector production of aircrafts is not justified on the basis of public goods. If policymakers erroneously assume that the benefits of the mega-jetliner are public, then they would find the efficient level of production by vertically summing demand curves rather than horizontally summing demand curves. This causes the benefits to be significantly overstated and could be used to justify such high costs. 6. It is unlikely that if Pemex were privatized that the situation would lead to a monopoly situation. Comparing oil production to telephone service is not a correct comparison.

In the case of the telephone company, there was only one provider of telephone service. In the case of oil production, there would be only one producer in Mexico, but many competitors providing oil from which Mexico could buy. The newly privatized company would have to compete to sell its goods. It would likely become more efficient than the state run company because of this competition. 7. This debate is similar to the debate about private versus public education. Public sector production is often associated with higher costs (for both schools and prisons), but there may be other reasons society would prefer public to private provision.

These reasons typically relate to equity considerations. For schools, the main argument is to make sure everyone child has the opportunity for a good education. For prisons, there may be a fundamental conflict between fair and humane treatment of prisoners and keeping costs low. For example, equity might require that prisoners be fed nutritious meals, but giving them bread and water for every meal might be less expensive. This question asks students to give personal opinions about privatizing prisons, so there is no single “right” answer. 8.

The experimental results on free-riding suggest that members of the community might voluntarily contribute about half of the required amount. The reason these citizens wanted to use private fundraising was because the state government redistributed tax dollars from wealthy districts to poor districts (the so-called Robin Hood plan), so using private donations was a way to avoid losing tax dollars to other districts. 9. Books are not a public good. They are both rival (two people cannot read a book at the same time) and excludable (you can keep a person from reading a book).

But if the goods libraries provide are a sense of community or a better educated populace, these would qualify as public goods. If the public good aspect of the library is to produce a better educated populace, then perhaps the classic books are a better choice. 10. Hiring private military firms to provide military support in Afghanistan, Iraq, or Darfur would be similar to the example of airport security in the text. One might argue that a private firm would not provide adequate training, use unethical or especially aggressive methods to shorten the conflict, thus lowering costs to increase profits.

Proponents would argue that such things could be stipulated in a well-written contract. However, no Part 2 – Public Expenditure: Public Goods and Externalities contract can specify every possible contingency. In high conflict situations this may be especially true as the opposing side will not be predictable. 11. a. Zach’s marginal benefit schedule shows that the marginal benefit of a lighthouse starts at $90 and declines, and Jacob’s marginal benefit starts at $40 and declines. Neither person values the first lighthouse at its marginal cost of $100, so neither person would be willing to pay for a lighthouse acting alone. . Zach’s marginal benefit is MBZACH=90-Q, and Jacob’s is MBJACOB=40-Q. The marginal benefit for society as a whole is the sum of the two marginal benefits, or MB=130-2Q (for Q? 40), and is equal to Zach’s marginal benefit schedule afterwards (for Q>40). The marginal cost is constant at MC=100, so the intersection of aggregate marginal benefit and marginal cost occurs at a quantity less than 40. Setting MB=MC gives 130-2Q=100, or Q=15. Net benefit can be measured as the area between the demand curve and the marginal benefit of the 15th unit. The net benefit is $112. 5 for each person, for a total of $225. 2. Each day the private decision of each fisherman would equate private cost with private benefit. Therefore, 7 would show up because then each fisherman would catch four fish. If the fishermen catch less than four fish, then they will stay home. The net benefits to society are 0 fish (the benefit to the seven fishermen is 4 fish (7×4=28) and the cost to society is 4 fish per fisherman (7×4=28)). The efficient number of fishermen to show up at the lake is the number that will maximize social net benefits, which happens where the social marginal benefit equals the social marginal cost.

This occurs at four fishermen, where the net social benefits equal 12 fish (4×7 – 4×4). Access to the lake is an impure public good. It is rival – if one fisherman has access to the fish, the others have less access. It is, however, non-excludable because it is difficult to keep people from fishing at a lake. 13. Britney’s marginal benefit is MBBRITNEY=12-Z, and Paris’s is MBPARIS=8-2Z. The marginal benefit for society as a whole is the sum of the two marginal benefits, or MB=20-3Z (for Z? 4), and i s equal to Britney’s marginal benefit schedule afterwards (for Z>4).

The marginal cost is constant at MC=16. Setting MB=MC along the first segment gives 20-3Z=16, or Z=4/3, which is the efficient level of snowplowing. Note that if either Britney or Paris had to pay for the entire cost herself, no snowplowing would occur since the marginal cost of $16 exceeds either of their individual marginal benefits from the first unit ($12 or $8). Thus, this is clearly a situation when the private market does not work very well. Also note, however, that if the marginal cost were somewhat lower, (e. g. , MC? ), then it is possible that Paris could credibly free ride, and Britney would provide the efficient allocation. This occurs because if Britney believes that Paris will free ride, Britney provides her optimal allocation, which occurs on the second segment of society’s MB curve, which is identical to Britney’s MB curve (note that Paris gets zero marginal benefit for Z>4). Since Paris is completely satiated with this good at Z=4, her threat to free ride is credit if Britney provides Z>4. See the graph below. Chapter 4 – Public Goods MBParis MBBritney

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Student: Finance and Foods Market

FI-516 – WEEK 2 – MINI – CASE ASSIGNMENT Select a major industrial or commercial company based in the United States, and listed on one of the major stock exchanges in the United States. Each student should select a different company. Avoid selecting an insurance company or a bank, as the financial ratios for these financial businesses are different. Write a 7 – 8 page double spaced paper answering and demonstrating with calculations and financial data the following questions: 1. What is the name of the company? What is the industry sector? * The company name is Whole Foods Market Inc. Whole foods market, Inc. is the Food Retailers & Wholesalers industry. * The products include: grocery, seafood, bakery, prepared foods, meat and poultry, dietary and nutritional supplements, vitamins, specialty (beer, wine and cheese) body care products, floral and household products and pet products. 2. What are the operating risks of the company? * Organic foods market has several laws and regulations relating to health, sanitation and food labeling. * FDA, FTC, CPSC, USDA and EPA have set standards for the manufacture, packaging, and advertising of organic products. If failure to qualify these standards could result in the confiscation of marketing and sales licenses. 3. What is the financial risk of the company (the debt to total capitalization ratio)? Debt to total capitalization ratio = Debt / (Shareholder’s equity + Debt) ————————————————- 1,300,770 / 4,292,075 = 30. 31% 4. Does the company have any preferred stock? No, the Whole foods market, Inc. does not have any preferred stock. 5. What is the capital structure of the company? : Short term portion of Long Term Debt, Long Term Debt, Preferred Stock (if any), and market value f Common Stock issued and outstanding? * Capital structure: ————————————————- Total Debt to Total Equity: 0. 60 ————————————————- Total Debt to Total Capital: 0. 60 ————————————————- Total Debt to Total Assets: 0. 42 ————————————————- Long-Term Debt to Equity: 0. 58 ————————————————- Long-Term Debt to Total Capital: 0. 58 * The Whole foods market, Inc. does not have any short-term portion of long-term debt, and there is no preferred stock. Long-term debt: $17. 44 million * The Whole foods market, Inc. has 300,000 share authorized and $178. 89 million shares issued and outstanding at 2011. 6. What is the company’s current actual Beta? ————————————————- * The current actual Beta is 0. 66 7. What would the Beta of this company be if it had no Long Term Debt in its capital structure? (Apply the Hamada Formula. ) ————————————————- BL= B1 [1+(1-T) (D/E)] ————————————————- = 0. 66 / [1+(1-0. 35) (0. 43)] ————————————————- 0. 52 8. What is the company’s current Marginal Tax Rate? ————————————————- 35% 9. What is the Cost of Debt, before and after taxes? The cost of debt before taxes is 6. 7%, and after taxes is 4. 5%. 10. What is the Cost of Preferred Stock (if any)? The Whole foods market, Inc. does not have any preferred stock. 11. What is the Cost of Equity? ————————————————- Cost of Equity = (Dividends per share/current market value of stock)+Growth Rate of Dividends ————————————————- = (0. 40 / $86. 47) + 0. 56% ———————————————— = 0. 01 12. What is the cash dividend yield on the Common Stock? The cash dividend yield on the common stock is 0. 56 (0. 60%) 13. What is the Weighted Average Cost of Capital of the company? The Weighted Average Cost of Capital is 7% 14. What is the Price Earnings Multiple of the company? ————————————————- Current market value of stock / EPS ————————————————- = $86. 47 / 2. 21 ————————————————- = 39. 13 15. How has the company’s stock been performing in the last 5 years?

In May 2007, the price of common stock was $39. 74 per share, but it dropped to $8. 19 per share in 2009. Although after the recession of price drop, the price begins the raise up to $86. 47 per share now. 16. How would you assess the overall risk structure of the company in terms of its Operating Risks and Financial Risk (Debt to Capitalization Ratio)? Total debt/total equity| 0. 0063| Total debt/total capital| 0. 0063| 17. Would you invest in this company? Why? Or Why not? * Officially I would invest portion of my assets into the portfolio. Since the price has raise from the last two years in an even steady price.

Even though they have two small period of time that drop for about 15%. Overall the stock market seems to be passive about the movement of the behavior optimistically. Therefore be hold within the smaller beta that show less variable of the changes. I believe this could be a chance to be rich! 18. The last page of your paper should be a Bibliography of the sources you used to prepare this paper. Bibliography: * http://www. wikinvest. com/stock/Whole_Foods_Market_(WFM) * http://www. thestreet. com/quote/WFM/details/company-profile. html * http://yahoo. brand. edgar online. com/displayfilinginfo. spx? FilingID=8260392-165255- 169255&type=sect&TabIndex=2&companyid=10959&ppu=%252fdefault. aspx%253fcik%253d865436 * http://www. investopedia. com/terms/d/debt-to-capitalratio. asp#axzz1v5caUyeq * http://www. marketwatch. com/investing/stock/wfm/profile * http://finance. yahoo. com/q? s=WFM&ql=1 * http://www. investopedia. com/terms/c/costofequity. asp#axzz1v5caUyeq * http://www. thestreet. com/quote/WFM/details/growth-rates. html * http://www. wikiwealth. com/wacc-analysis:wfm * http://markets. ft. com/research/Markets/Tearsheets/Financials? s=WFM:NSQ

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Finance Strategy

Strategic Corporate Finance Required Articles/Cases (Included in Harvard Course Pack) The following is a list of articles you will find when you register with HBR and purchase the Course Pack. Cost of Capital (CAPM, WACC): Case: Midland Energy Resources, Inc. : Cost of Capital (Brief Case), Joel L. Heilprin, Timothy A. Luehrman (Product number: 4129-PDF-ENG) Accompanying Student Spreadsheet: Midland Energy Resources, Inc. : Cost of Capital, Spreadsheet for Students, Joel L. Heilprin, Timothy A. Luehrman (Product number: 4140-XLS-ENG) Article: “What’s Your Real Cost of Capital? James J. McNulty, Tony D. Yeh, William S. Schulze, Michael H. Lubatkin (Product number: R0210J-PDF-ENG) Article: “Applying the Capital Asset Pricing Model,” Robert S. Harris (Product number: UV0402-PDFENG) Article: “Does the Capital Asset Pricing Model Work? ” David W. Mullins Jr. (Product number: 82106PDF-ENG) Article: “The Corporation’s Cost of Capital and the Weighted-Average Cost of Capital,” Kenneth Eades (Product number: UV0389-PDF-ENG) Article: “Business Valuation and the Cost of Capital,” Timothy A.

Luehrman (Product number: 210037PDF-ENG) Financial Accounting (Statement Analysis): Article: “Introduction to Financial Ratios and Financial Statement Analysis,” William J. Bruns Jr. (Product number: 193029-PDF-ENG) Article/Case: “An Overview of Financial Statement Analysis: The Mechanics,” Brandt Allen, Paul Simko (Product number: UV0911-PDF-ENG) Case: Financial Statement Analysis (Identify the Industry), Graeme Rankine (Product number: TB0069PDF-ENG) International: Case: Groupe Ariel S.

A. : Parity Conditions and Cross-Border Valuation, Timothy A. Luehrman, James Quinn (Product number: 4194-PDF-ENG) Accompanying Student Spreadsheet: Groupe Ariel S. A. : Parity Conditions and Cross-Border Valuation, Timothy A. Luehrman, James Quinn (Product number: 4196-XLS-ENG) Article: “Cross-Border Valuation,” Kenneth A. Froot, W. Carl Kester (Product number: 295100-PDF-ENG) Mergers and Acquisitions: Article: “The New M&A Playbook,” Clayton M.

Christensen, Richard Alton, Curtis Rising, Andrew Waldeck (Product number: R1103B-PDF-ENG) Net Present Value: Book Chapter: “Net Present Value and Internal Rate of Return: Accounting for Time,” (Product number: 5245BC-PDF-ENG) Strategy & Innovation: Article: “Blue Ocean Strategy,” W. Chan Kim & Renee A. Mauborgne (Product number: R0410D-PDFENG, 2004) Article: “The Five Competitive Forces That Shape Strategy,” Michael E. Porter (Product number: R0801EPDF-ENG) Article: “Innovation Killers: How Financial Tools Destroy Your Capacity to Do New Things,” Clayton M. Christensen, Stephen P. Kaufman, Willy Shih (Product number: R0801F-PDF-ENG)

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Microfinance in the Philippines: An Overview

Microfinance is often defined as the provision of small loans, usually called microcredit, to the underprivileged in order to help them put up their own businesses and become self-reliant. In the Philippines, where the poverty incidence rate stands at 40%, microfinance has begun to play a major role towards helping the poor explore different methods of sustainable development. The government has since helped this happen by establishing the Microfinance Unit (MFU) within the National Anti-Poverty Commission (NAPC).

There are several major microfinance institutions in the Philippines, but among the largest is that of the Ayala Corporation and the International Institute for Rural Reconstruction (IIRR). These institutions work towards reducing poverty through the different means of microfinance and sustainable development by conducting financial programs that will benefit the poor. Specifically, they provide financial services such as microcredit, microsavings or microinsurance to the poor. These different forms of microfinance are largely done by the aforementioned institutions with support from the national government in terms of building up their institutional capacity to support greater scales of financial service.

It has been noted that the presence of a national microfinance strategy, as well as the establishment of various related institutions will work towards improving the Philippine economy. As outlined in the national strategy for microfinance, one of the end goals of the multi-faceted program is to achieve a liberalized and market-oriented economy where both the private and government sectors work together in order to sustain the continued development of appropriately-oriented financial and credit policies.

Overall, the practice of microfinance in the Philippines has yet to reach its full potential and only time can tell if it will be an effective tool as a method of poverty reduction.
References

Performance Monitoring Report (2005). Microfinance Council of the Philippines, Inc.

Retrieved October 22, 2007 from http://www.microfinancecouncil.org/

Regulatory Framework for Microfinance in the Philippines (2001). Philippine Department of

Finance. Manila, Philippines: DOF

Republic of the Philippines National Strategy for Microfinance. Global Development

Research Center – Governance of Microfinance Institutions. Manila, Philippines:

National Credit Council of the Philippines

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International Finance

Chapter 4 Practice Problems Percentage Depreciation • Assume the spot rate of the British pound is $1. 73. The expected spot rate one year from now is assumed to be $1. 66. What percentage depreciation does this reflect? • ($1 66 – $1 73)/$1 73 = –4. 05% ($1. 66 $1. 73)/$1. 73 4 05% Expected depreciation of 4. 05% percent Inflation Effects on Exchange Rates • Assume that the U. S. inflation rate becomes high relative to Canadian inflation. Other things being equal, how should this affect the (a) U. S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? Demand for Canadian dollars should increase, ? Supply of Canadian dollars for sale should decrease, and ? The Canadian dollar’s value should increase. 1 Interest Rate Effects on Exchange Rates • Assume U. S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U. S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? ? Demand for pounds should increase, ? Supply of pounds for sale should decrease, and ? The pound’s value should increase. Income Effects on Exchange Rates • Assume that the U.

S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U. S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of th Canadian dollar? f the C di d ll ? ? Assuming no effect on U. S. interest rates, demand for dollars should increase, ? Supply of dollars for sale may not be affected, and ? The dollar’s value should increase. Trade Restriction Effects on Exchange Rates • Assume that the Japanese government relaxes its controls on imports by Japanese companies.

Other things being equal, how should this affect the (a) U. S. demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen? ? Demand for yen should not be affected, ? Supply of yen for sale should increase, and ? The value of yen should decrease. 2 Effects of Real Interest Rates • What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies? ? The higher the real interest rate of a country relative to another country, the stronger will be its home currency, other things equal. Speculative Effects on Exchange Rates Explain why a public forecast about future interest rates could affect the value of the dollar today. Why do some forecasts by well-respected economists have no impact on today’s value of the dollar? ? Speculators can use anticipated interest rate movements to forecast exchange rate movements. ? Th may purchase f i securities b They h foreign iti because of their f th i expectations about currency movements, since their yield will be affected by changes in a currency’s value. ? These purchases of securities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates. It was already anticipated by market participants or is not different from investors’ original expectations. Interaction of Exchange Rates • Assume that there are substantial capital flows among Canada, the U. S. , and Japan. If interest rates in Canada decline to a level below the U. S. interest rate, and inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar against the U. S. dollar? ? If interest rates in Canada decline, there may be an increase in capital flows from Canada to the U. S. ? In addition, U. S. investors may attempt to capitalize on higher U.

S. interest rates, while U. S. investors reduce their investments in Canada’s securities. ? This places downward pressure on the Canadian dollar’s value. 3 Interaction of Exchange Rates • How might this affect the value of the Canadian dollar against the Japanese yen? ? Japanese investors that previously invested in Canada may , p shift to the U. S. Thus, the reduced flow of funds from Japan would place downward pressure on the Canadian dollar against the Japanese yen. Relative Importance of Factors Affecting Exchange Rate Risk • Assume that the level of capital flows between the U.

S. and the country of Krendo is negligible and will continue to be. But there is a substantial amount of trade between the U. S. and the country of Krendo. Which affect, high inflation or high interest rates will be seen in the value of the Krendo’s currency? Krendo s • The inflation effect will be stronger than the interest rate effect because inflation affects trade flows. ? The high inflation should cause downward pressure on the kren. Speculation • Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $. 5 to $. 14 in 10 days. The following interbank lending and borrowing rates exist: U. S. dollar Mexican peso Lending Rate Borrowing Rate 8. 0% 8. 3% 8. 5% 8. 7% Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. 4 Speculation 1. Borrow MXP70 million 2.

Convert the MXP70 million to dollars: MXP70,000,000 ? $. 15 = $10,500,000 3. Lend the dollars through the interbank market at 8. 0% annualized over a 10-day period. The amount accumulated in 10 days is: $10,500,000 ? [1 + (8% ? 10/360)] [ ] = $10,500,000 ? [1. 002222] = $10,523,333 4. Repay the peso loan. The repayment amount on the peso loan is: MXP70,000,000 ? [1 + (8. 7% ? 10/360)] = 70,000,000 ? [1. 002417] = MXP70,169,167 5. Based on the expected spot rate of $. 14, the amount of dollars needed to repay the peso loan is: MXP70,169,167 ? $. 14 = $9,823,683 6.

After repaying the loan, Blue Demon Bank will have a speculative profit of: $10,523,333 – $9,823,683 = $699,650 Speculation • Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $. 15 to $. 17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. Speculation 1. Borrow $10 million 2. Convert the $10 million to pesos (MXP): $10,000,000/$. 15 = MXP66,666,667 3. Lend the pesos through the interbank market at 8. % annualized over a 30-day period. The amount accumulated in 30 days is: MXP66,666,667 ? [1 + (8. 5% ? 30/360)] [ ] = 66,666,667 ? [1. 007083] = MXP67,138,889 4. Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 ? [1 + (8. 3% ? 30/360)] = $10,000,000 ? [1. 006917] = $10,069,170 5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based on the expected spot rate of $. 17) is: MXP67,138,889 ? $. 17 = $11,413,611 6. The profits are (could be): $11,413,611 – $10,069,170 = $1,344,441 5

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The overview of Last In/First Out and First In/Last Ou

The overview of Last In/First Out and First In/Last Out is now completed for the date and time of your choice to discuss the company matters. The information from last month is was completed at the end of the month and the present is kept current on a daily base as management needs to be up to date of the inventory and financial levels of the company.

Reducing federal and state income corporate taxes are important as this may allow the company to see a decrease in expenses over the time. Looking at the expenses of the company and viewing the incomes of the employees will allow the company to make the decision as to Last In/First Out or First In/Last Out to save the company finances. Although looking at the inventory will allow the management to view the Last In/First Out and First In/Last Out as to the timing of the inventory growth.

Using First In/Last Out will allow the company to still grow as the inventory increases and the company will still profit. Using Last In/First Out will allow the company to be at a stand point and no increases are made. Understanding the decision that is made must be final, this information will be viewed and continued to be up to date for any financial issues that may arise before and after the meeting and decisions are made.

By looking at the short and long term on Cost of Goods Sold this will allow you to make the judgment of the Last In/First Out and First In/Last Out and it shows the profit for the company in the past and allow you to predict the future. Good luck with your decision and I stand by you on the choice that is made.

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Marvel Holdings

To determine Whether or not it will be difficult for Marvel or other companies in the MacAndrews and Forbes holding company to issued debt in the future, we should analyze two perspectives, one is historical and the other one is the future perspective.

Historically, Marvel Holdings issued zero-coupon senior secured notes which were all secured by Marvel’s equity rather than its assets or operating cash flows. However, this was a very attractive offer since the stock price was trading above $25 per share which had a value of $1.9 billion, well above the face value of the bonds issued. The interest payments on these bonds would be made from revenues received through tax sharing agreements between Marvel and Marcel III Holdings; moreover, all issues were scheduled to mature in April 1998, which in other words, the company would have a huge cash outflow when the bonds came to maturity.

After the issurance of debt, company’s revenue decrease due to the comic book and trading card business failure, which caused share price to fall significantly. Despite the problems of revenue fallen, Marvel acquired SkyBx and financed the acquisition with $190 million of additional debt in early 1995. S&P then downgraded the holding companies debts from B to B-.

The fianancing structure and the revenue fallen problems lead to Marvel announced that it would violate specific bank loan covenants due to decreasing revenue and profits. Moody downgraded Marvel’s public debt after the announcement and caused the price of the zero-coupon bonds to fall drastically by more than 41%. Moreover, their two largest institutional holders desided to sell the bonds even at a price of $0.37 per dollar of face value. When the resturcture plan was announced, the stock price fell by more than 41% and the zero-coupon bonds fell by addition 50%, to $0.18.

As shown on the Balance Sheet, there was a $625.8 millions of current portion of long-term debt in 1996 which was increased significantly compare to previous years. Moreover, the short-term borrowing has also appeared on liability in the year of 1996. Total long-term debt and total liabilities also increased drastically in 1995 and more significantly in 1996.

From the Consolidated statement of operations, the cost of sales increased since 1995. Moreover, the amortization of goodwill increased which is due to the decrease in revenue of trading cards and comic books. Interest expense also increased due to significant increase in debt. All these caused a loss in income and earning per share becomes negative at the end of 1995.

Based on all the above historical evidences, it will be really difficult due to the fact that the company has a debt-to-total capital ratio of 88% which is $805.4 million in total debt and $107.4 million in equity. With the downgrade of the public debts, it will make the financing situation even worse since the issueing notes or bonds will not raise as much financing as when the rating is good and will be more costly since the interest rate has to increase due to the increase in risk.

In the future perspective, a restructure plan was mentioned by Perelman. However, Marvel was facing three options:

1. if marvel was going under chapter 7 liquidation, the debtholders would get around 70% of the original value and the holding company debtholders and equityholders would get nothing.

2. If Marvel did not aquire Toy Biz, the total enterprise value would between be no more than $660 which was not enough to settle the debt, and the equity would again be worthless.

3. If Marvel acquired Toy Biz, the company could transform into an integrated entertainment company which would operate theme restaurants, movie studio, entertainment software, and etc. Marvel believed with the growth of new media exposure, they would be able to have modest growth and pay secured and unsecured creditors in full. This plan had passed the feasibility test, which in other words, the company was not likely to be liquidized or reorganized.

let’s assume Marvel implement the restrurture plan and make modest growth of profit. As they slowly payoff the debts, start earning profit and rebuild their reputation, It will become easier to raise debt. Moreover, if their performance is good, it might be even possible to increase their rating which will lower the cost due to the decrease in default risk.

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Finance Manager

Fiscal Policy in Kenya: Looking Toward the Medium-to Long-Term By Kamau Thugge, Peter S Heller, and Jane Kiringai[1] Executive Summary Kenya’s authorities, in articulating their vision for the next two decades of Kenya’s development, understood clearly that fiscal policy would need to play a critical role in influencing the pace at which the economy will grow and its capacity to deal with the key challenges that will arise over the next several decades.

Domestic policy challenges include a high population growth, rapid urbanization, significant weaknesses in infrastructural capacity, inadequate levels of investments, and pressures for decentralization. External challenges include security risks as well as an uncertain global economic growth environment. Fiscal policy will not only affect macroeconomic stability, but also whether Kenya can transition to a higher economic growth path, reduce its high poverty rate, and address its substantial income, asset, and regional inequalities.

The paper by Thugge, Heller and Kiringai examines whether Kenya’s medium-term fiscal policy strategy is responsive to addressing the potential scale of the challenges confronting Kenya, particularly given the inevitable uncertainties assicuated with the global economic environment. It also takes stock of the impact of recent developments on the viability of the original strategy. Kenya is likely to face in the next two decades and the scope of its policy goals for this period.

Section II will briefly identify both the domestic policy challenges that Kenya’s fiscal policy-makers must address in coming years as well as the different potential external policy environments within which these policies must be formulated. Section III reviews the Government of Kenya’s (GOK) fiscal policy strategy, as broadly embodied in its recently issued long-run perspective–Vision 2030, but more concretely in the Medium Term Plan for 2008/09-2012/13 and the Medium-Term Budget Strategy Paper (MTBSP) for 2009/10-11/12.

In particular, it will examine the economic and institutional assumptions underlying this strategy; the policy choices made in terms of the balance between the roles of the public and private sectors; the choice among alternative public spending priorities; the way in which possible downside risks are addressed; the approach to financing fiscal initiatives; and the sustainability of the fiscal and debt strategy. Section IV will then assess whether the GOK’s chosen policy strategies appear both responsive to the long-term policy challenges identified in Section II and robust to the downside risks in the external economic environment.

II. Medium to long-run challenges In Vision 2030, Kenya aspires to achieve middle-income status by 2030 through the realization of a 10 percent per annum real growth rate for the period 2012-2030. This is a highly ambitious objective although not an unreasonable aspiration, given the importance of Kenya to the regional economy of East Africa and the many assets that Kenya possesses in terms of its human capital and its industrial, service, and tourism potential.

But achieving this goal will require that Kenya successfully pursue disciplined and ambitious policies that will confront the many domestic and external policy challenges it now faces. It will also require a bit of luck and a bit of skill by Kenyan policy-makers in adapting to the uncertain global economic policy environment that will undoubtedly emerge in the next two decades. Fiscal policy will need to be finely balanced if Kenya is to achieve the Vision 2030 objectives.

It must facilitate rapid growth—both through the provision of needed infrastructure and human capital—while still being responsive both to the demands of the population for basic public services and the potential downside risks that may emerge. Yet fiscal policy must also be sustainable. Fiscal space will be precious if the various expenditure objectives are to be met without compromising macroeconomic stability or raising doubts about Kenya’s solvency. If growth proves less than anticipated—as occurred in 2008 and as expected in 2009—the needed fiscal space may prove inadequate to finance the required government outlays.

Under these circumstances, unrestrained recourse to additional borrowing could jeopardize Kenya’s solvency and crowd-out its private sector. a. Domestic policy challenges to which fiscal policy should respond There are several important obstacles that could impede Kenya’s progress toward achieving the high growth rate targeted through 2030. First, after years of neglect, Kenya has only recently begun to address the inadequacy of its infrastructure for the realization of a modern, 21st century economy.

Deficiencies exist in terms of Kenya’s port facilities, its trunk and secondary roads, its railroad system, its energy plant, and in the availability of clean water and sanitation facilities. While telecommunications has been the bright light of the last several years, there is still much to be done to make the system fully accessible and the proposed undersea fiber-optic cable, The East Africa Marine System, should help in this regard. Vision 2030’s emphasis on rebuilding and creating a productive infrastructure is rightly supported by international observers (e. . , in the IMF’s 2009 staff report) and appears responsive to this challenge. [2] But creating this infrastructure will be costly and could easily outstrip the domestic financial capacity of the government if it were to go it alone, justifying the government’s interest in seeking public-private partnerships as well as external financial support. Second, while Kenya is blessed with relatively a high quality and deep base of human capital, it has yet to find ways to deploy it more efficiently.

Among African countries, Kenya has always been known for the high aspirations of its population for education and the drive of its citizens for self-betterment. But the productivity of Kenya’s educational system has long been a source of concern, and the continuing weaknesses in the health system have meant that infant and mortality rates are still too high, that malaria still poses a heavy health burden, and that the AIDS epidemic has cost Kenya significant losses among its most productive citizens. 3] The success of many Asian countries in realizing high growth rates when they were at Kenya’s stage in the demographic transition derived from their ability to productively employ the rising share of the working-age population. Strengthening the quality and exploiting the productive use of Kenya’s human capital, particularly looking forward, must thus be a high policy priority. Third, governance concerns remain an obstacle to Kenya fully exploiting its growth potential through foreign investment inflows.

While the World Bank’s “Doing Business Indicators” suggest some improvements in creating the conditions for a receptive foreign investment climate (with Kenya ranking among the world’s top ten reformers in 2006/07), Kenya still ranks only 82nd on this index out of 181 countries, and ranks 147 out of 180 countries in terms of Transparency International’s index of perceptions of corruption for 2008. [4] Prioritizing and effectively carrying out the necessary institutional reforms, while not requiring substantial fiscal resources, may still prove costly and difficult in political economy terms.

More important, it may play a critical role in determining whether Kenya can meet its ambitious investment goals in infrastructure, given that they are to be primarily financed from private sources through public-private partnerships. Fourth, to achieve its target growth, Kenya will not only need to raise significantly its pace of investment (from an average of 19% of GDP in 2005/06 to 2007/08 to over 30% by 2012/13), but also to maintain the relatively low incremental capital-output ratio (ICOR) of about 3 that it has experienced over the last few years.

The latter may prove difficult. Among low and low-middle income countries, an ICOR of about 4 seems the norm (see World Bank, 2009). For the few non-oil-based countries in the world that have experienced growth rates as high as 10% for a sustained period, investment rates have been in the range of 40% of GDP plus (e. g. , China), reflecting a loss of efficiency in capital investment (and thus a higher ICOR). For Kenya to realize more efficiency from its investments, it must demonstrate a concomitant capacity to mobilize human capital resources effectively (e. . , rectifying both the under- and overstaffing of different public service activities), efficiency in the utilization of capital inputs, adequate attention to routine and periodic maintenance of existing infrastructure and a focus on investments that are of particularly high return (the latter influencing the appropriate structure of Kenya’s public and private investment programme). Linked to these issues is the low absorptive and implementation capacity in the key infrastructure line ministries, particularly for foreign-financed projects.

A key challenge that will determine whether the desired change in the composition of expenditure materializes will be the actual implementation rate of the development budget. In the past, actual expenditures have fallen well short of budget estimates, and in particular, absorption of donor development assistance has been very low—usually below 50 percent of budgeted amounts. Increasing the implementation capacity of the infrastructure ministries, and especially that of the Ministry of Roads and Public Works, will, therefore be critical.

Fifth, generating the required financing for a higher level of investment will be a further challenge. A sound fiscal policy will constrain how much can directly be provided from the budget, leading to the acknowledged need to rely on the private sector, domestic and external, for the remaining financing. The modalities by which Kenya provides incentives and deals with the risks associated with public-private partnerships, and improves governance, will determine the extent of foreign capital participation in Kenya’s investment programme.

Six, despite the progress made in reducing poverty incidence from 57% in 2002 to 46% in 2006 (MTBSP, paragraph. 14), Kenya still faces high income and asset inequality as well as significant regional inequality in incomes and assets. While rapid growth over the next two decades would do much to reduce absolute poverty levels, the number of absolute poor will still remain substantial. Together with continued high inequality, this would constitute a significant drag, in political economy terms, on Kenya’s ability to obtain popular support for an ambitious resource mobilization and savings effort.

Certainly, unless addressed, income inequality will constrain growth in the country, dampen the scope for poverty reduction and create an environment for social and political unrest. Seventh, and linked to the latter point, current fiscal decentralization efforts to address regional inequality through the use of a devolved funds mechanism are subject to potential vulnerabilities. In principle, through community-based projects, such an approach can have a positive impact on grass roots[5] support.

However, slippages in governance and accountability, efficiency, or effectiveness in the use of devolved funds could undermine their potential impact, with political pressures engendering spending programs that would not normally meet benefit-cost criteria or address the existing regional maldistribution of resources. In the medium term, three potential threats to the effectiveness of a devolved funds approach require attention.

First, is the poverty-weighted allocation criteria, which effectively incentivises constituencies to be ranked poor in order to qualify for a higher share of the devolved resources. Second, the provision of such ‘free’ budgetary resources may dampen revenue generation efforts at the local level. Third, the disconnect between community-based projects and the provision for operations and maintenance within the central budget can limit efficiency and effectiveness in the use of these funds[6].

All of the above factors might be considered as relevant in formulating current budgetary policies. But Kenya also confronts other future developments that can easily undermine the long-term capacity of the economy to sustain rapid growth. These include: • The rapid rate of urbanization: By 2025, Nairobi and Mombasa will have to invest in urban infrastructure (e. g. , housing, water, sewage, transport, schools and health facilities) to accommodate a virtual doubling of their populations. 7] The size of other urban centers will more than double by 2025 (from 3. 8 million to 9. 3 million). [8] Overall, the urban population is projected to triple to 21-22 million. Such urban infrastructure investments are likely to be of a lower overall productivity (thus implying a higher ICOR), further constraining the prospects for achieving the high efficiency level required to realize a 10% annual growth rate. • The continued high overall population growth rate: Kenya’s fertility rate of 5 is high.

The population aged 5-14—the prospective primary and secondary school-age groups—is anticipated to rise during 2005-2030 by at least 60 percent (more than 5. 2 million children). This highlights both the prospective increase that will be needed in spending on Kenya’s primary and secondary school system and the substantial expansion that is likely to be needed for tertiary education facilities. The latter will be particularly costly, and will put enormous pressure on the education budget (with one tertiary student costing the equivalent of 40 primary students).

Without policies that will encourage a reduced fertility rate, Kenya’s capacity to create fiscal space by shifting the composition of government expenditure towards growth-enhancing investments will be severely limited. • The pressures for job creation arising from population growth: In the next 6 years, Kenya’s education system will produce at least 14 million new school leavers seeking jobs. While the public sector cannot be responsible for their employment, government expenditure policies will need to be sensitive to the job creation possibilities associated with the realization of the government’s expenditure program.

This burgeoning employment challenge also highlights the importance associated with a successful transition to a high growth policy framework, since this will be the key to meeting the continuing pressure for job creation over the medium- to long-term. • Cost pressures in the public sector: as with most middle-income and industrial economies, rapid productive growth in the economy typically will outpace productivity growth in the government sector.

As wages in the public sector respond to market wage developments in the private sector, this will create cost-push pressures on public service delivery (particularly in the social sectors) (the so-called “Baumol effect”), pushing up the recurrent cost budget and generating further need for a higher revenue share. • The looming costs of climate change: Recent World Bank reports suggest that Kenya is among the countries most at risk from an increased frequency and intensity of drought conditions.

Addressing the potential deleterious effects on agricultural productivity will require a combination of intensified investment in water-control systems that promote enhanced efficiency in the use of water resources; a further shift in the role of nonagricultural outputs (and thus a capacity to become competitive in earning the foreign exchange required for a higher level of food imports); and new R&D efforts at promoting agricultural techniques robust to drought and uncertain precipitation conditions.

Given the importance of Mombasa as Kenya’s principal port, the probability of a sea level rise raises the question of when it will become necessary for Kenya to undertake the investments required to cope with the potential longer-term damages to Mombasa and what alternative approaches might be needed to ensure a continued viable port capacity. Less of a challenge and more of an opportunity is the possibility that Kenya might be able to exploit its comparative advantage with respect to solar and geo-thermal energy generation, and earn additional export and fiscal revenues from selling carbon credits to other high-emission countries. The budgetary risks associated with recognized contingent liabilities: the most obvious include those associated with the pay-as-you-go budgetary funding of civil service pensions; the potential for the National Social Security Fund (NSSF) to be relatively unfunded; and the possibility of losses associated with the parastatal sector. The anticipated effort by the Government to seek public-private partnerships in a number of infrastructure projects carries with it the potential for additional contingent liabilities. b. External policy challenges

Kenya’s ability to achieve its Vision 2030 objectives is not wholly subject to its own making. The global financial crisis which commenced in 2008 has adversely impacted Kenya, and highlighted the importance of external factors in influencing the growth of an economy. Kenya is vitally integrated within the global economy, being dependent on external commodity markets for its exports and critical energy imports, sensitive to the state of global tourism markets, significantly reliant on remittances, a recipient of aid flows, and ambitious in its pursuit of both direct foreign investment flows and possible external credits.

In geopolitical terms, it has already experienced terrorist incidents and is a vital transport hub for many important countries in Central Africa. But of course the future is uncertain, particularly if one is considering policy options looking out more than 20 years. There is, thus, an important argument for seeking a policy program that is robust to potential downside risks and the possibility of very different external environments. One approach to exploring the robustness of the Vision 2030 fiscal strategy is to examine its viability in the context of alternative scenarios of the future.

In 2005, the World Bank undertook just such an exercise to consider alternative scenarios for how the global economy might evolve through 2020. Each of the three scenarios elaborated were meant to constitute “relevant, compelling, plausible, and logically consistent”, but, importantly, divergent stories of what the global economy might look like in 2020. As emphasized by the Bank, “no single scenario will ever come true in its entirety, but if it is to be a valuable stone against which to sharpen one’s strategy, one must believe it just might! Box 3 provides a brief summary of these three different worlds, and section IV will examine more concretely the robustness of Vision 2030 in the context of these scenarios. At this point, what is important to emphasize are the key external policy factors to which the success of Vision 2030 might prove sensitive, and the way in which these scenarios highlight potential issues to which Kenyan policy makers might need to be responsive. Among the key factors that could affect Kenya’s prospects, the following appear most relevant: Robustness of global growth: Kenya’s capacity for mobilizing the fiscal resources required to implement its public investment program (and equally the prospect for the private sector to also achieve the targeted growth in its investment share) will be strongly influenced by the pace and structure of global growth. Given its dependence on external commodity and tourism services, a slower global growth scenario (such as in the GU scenario) would probably be reflected in slower Kenyan growth, lower fiscal revenues, and the need for a smaller budgetary envelope.

How would the budget be prioritized in such circumstances? Would the same infrastructure and human capital investment priorities be relevant under a lower global growth scenario? Certainly, with the pace of population and urban growth (not to mention climate change) not affected by external factors, the pressure would be to cutback on precisely those investments most likely to generate additional growth and employment!

Moreover, if global growth were to be dominated by a higher share derived from emerging markets, would this adversely affect Kenya (perhaps through reduced tourism from industrial countries)? Would reduced dynamism in the US and European economies imply a lower level of concessional financing, or would Kenya be able to obtain such assistance from alternative sources (e. g. , China and India)? With changes in the pace or sources of global growth, would Kenya still be able to realize the currently anticipated level of direct foreign investment flows?

Would these derive from different sources and if so, would they be directed to the same sectors? |Box 1: Alternative Scenarios for the World of 2020 | | | |The following provides a brief summary of how these different worlds will appear, with our focus principally on the character of | |the alternative potential external economic environments facing Kenya. | | |Affluence, Ltd. (AL) | |Years of rapid, US-centered, economic growth will nearly double world GDP, an annual increase of more than 4 percent. States have | |shifted their focus from guaranteeing outcomes to providing opportunities.

Rapid innovation and new technologies enable continuous | |improvements in productivity, which global corporations spread around the world as they expand. But economic success is not | |universal. Forty less competitive countries have been left behind due to geographic isolation, poor governance, small market size, | |or lack of strategic relevance. For most major economies, however, the United States has guaranteed political stability and open | |trade-conditions that have encouraged the creation of massive amounts of wealth. |Globalization Unwinding (GU) | |Through 2020, economic growth has been slow worldwide, averaging less than 2 percent for more than a decade. Weaker states have | |collapsed, as economic pressure translates into domestic unrest, while other states have resorted to authoritarianism or populism | |in order to stay in power. Costs of military interventions, energy price volatility, and years of deficits brought a sharp | |contraction in the US economy, and the consequent dollar crisis triggered a global economic downturn.

Europe and Japan lacked the | |dynamism to lead the world out of recession, while the growth engines of China, India, Korea, and other “emerging economies” all | |sputtered-as did those of Russia and Latin America. Most developing countries have proven unable to mitigate the worst effects of | |the downturn. A deep-seated cynicism about the value of free markets prevails in the world, and economic decisions are generally | |focused on short-term returns. Protectionism grew rapidly following the downturn, and the path to recovery looks difficult. | | |Competing Horizons (CH) | | | |Large emerging markets of China, India, Brazil, Indonesia and much of Southeast Asia have sustained rapid long-term | |growth—particularly in comparison to older industrialized economies—and a second wave of developing countries has joined their | |ranks. The developing world accounted for almost two-thirds of global GDP growth between 2005 and 2020.

Regional economic powers | |have started to contest US primacy in their regions, and in global forums. Poles of cutting-edge R&D have emerged, with growing | |numbers of firms from these high-growth countries rivaling the multinational companies from the United States, Europe, and Japan. | |Many other developing countries have grown rapidly following improved policies and governance and benefiting from rising volumes of| |global trade. However, rising tensions between Old World and New World powers seem inevitable in the medium term.

Despite strong | |networks of trade and continued rising demand for raw materials and basic commodities, growth in parts of the developing | |world—particularly in parts of Africa—remains low. In addition, the environmental costs of broad-based growth are significant: | |accelerating environmental degradation and severe resource constraints for water, strategic minerals, and energy are the order of | |the day. | | | |* Source: World Bank, Rehearsing for the Future: the World and Development in 2020 (Washington DC, 2006) (www. worldbank. rg/2020) | • Scale of security threats: the alternative scenarios highlight the potential for different degrees of ethnic, terrorist and regional security tensions. Kenya may thus need to be prepared for the possibility of a higher level of security-related military outlays than presently envisaged under Vision 2030. Depending on the extent of external financial support to deal with terrorism and regional security threats, this may prevent the realization of the current strategy to shift funding away from such “other sectors” for the purpose of creating fiscal space for social or growth-oriented outlays. Nature of the trade environment: the extent to which further global trade barriers are reduced, or rather shifted towards bilateral or regional trading arrangements, may potentially influence the pace of growth and potentially the sources of Kenya’s principal comparative advantage, again influencing both the prospects for revenue mobilization and the focus of the investment programme. • Importance of governance concerns: Were there to be a shift in the global economic center more towards emerging market countries, there might be a reduced incentive for Kenya to focus as much on governance issues.

However, given the possibility of the AL scenario also arising, and given the merits on political economy grounds for strengthening Kenya’s governance and regulatory system (particularly given the increased role envisaged for PPPs), current strategies would appear robust to the alternative possible scenarios. • Pace of technological change: Alternative scenarios also suggest differences in the future pace of technological change. This could be important, particularly with respect to certain kinds of infrastructure (e. g. , in the energy and possibly the ICT sectors).

Would the nature of infrastructure investment decisions be influenced by the possibility that newer and more advanced technologies might make existing infrastructure or technologies inappropriate? All of these uncertainties raise the question of whether fiscal policy, to be robust under alternative scenarios, should be more conservatively managed, particularly with respect to the level of nonconcessional borrowing that would be appropriate in financing the investment program (or more pointedly, in the level of any fiscal debt anchor that might be considered in managing fiscal policy).

They also raise questions as to the core investment programme which would appear appropriate, given the uncertainty as to which scenario might eventuate. III. Kenya’s fiscal strategy underpinning the Vision 2030 A. Background and macroeconomic assumptions Under the Economic Recovery Strategy (ERS) covering the period 2003-07, Kenya made significant progress in macroeconomic management and in implementing key structural and governance reforms. As a result, the economy staged a remarkable broad-based recovery as growth of real GDP accelerated from 0. 5 percent in 2002 to 7. percent in 2007. In the aftermath of the post-election-violence (PEV) in early 2008 and the global economic slowdown, growth fell sharply in 2008 to 1. 7 percent. In 2009, the economy is projected to rebound only slightly to 2. 5 percent . Underpinning the good economic performance of recent years was the implementation of sound macroeconomic policies, and in particular, through 2007, the pursuit of a prudent fiscal stance in which the overall budget deficit (on a commitment basis, including grants) was contained to an average of about 2 per cent of GDP compared with a target of 3. percent in the ERS. As a result, there was a net domestic repayment of 0. 7 percent of GDP in 2007/08, relative to a net borrowing of 3. 6 percent of GDP in 2002/03, thereby contributing to a decline in the ratio of net domestic debt to GDP from 23 per cent in 2002/03 to roughly 17 per cent in June 2008. This facilitated a reduction in interest rates and an expansion of credit to the private sector in support of productive activities.

With the conclusion of the ERS at end-2007, the Kenyan Government elaborated a medium-term development plan, the National Vision 2030, aimed at achieving rapid economic growth and poverty reduction. The vision had three pillars: • an economic pillar whose goal was to achieve and then sustain annual real GDP growth of 10 percent by 2012 with a view to making Kenya a middle-income country by the year 2030; • a social pillar aimed at creating a cohesive society enjoying equitable social development.

This pillar would address inequality and poverty challenges faced by many Kenyans and move Kenya towards achieving some of the Millennium Development Goals; and • a political pillar calling for an issues-based, accountable and democratic political system. Achieving the Vision 2030 growth target would require Kenya to increase its investment share in GDP from about 22 percent in 2007/08 to 33 percent by 2012/13. Over the same period, domestic savings would need to increase from about 16 percent of GDP to 28 percent. Details of the key indicators underpinning the macroeconomic framework are provided in Table 1. Table 1: Key Macroeconomic Indicators Underpinning Vision-2030 and the Medium-Term Plan | | |2007/08 |2008/09 |2009/10 |2010/11 |2011/12 |2012/13 | | | |Medium-term projections | |(Annual percentage change) | |National accounts and prices | |6. 2 |8. 3 |9. |9. 7 |10. 0 | |Real GDP |5. 7 |7. 5 |5. 0 |5. 0 |5. 0 |5. 0 | |CPI (end of period) |28. 5 | | | | | | |(In percent of GDP) | |Investment and savings | | | | | | | |Investment |21. |21. 9 |23. 3 |27. 3 |29. 9 |32. 6 | |o/w Central Government |8. 2 |8. 6 |8. 4 |8. 6 |9. 0 |9. 5 | |Gross domestic savings |15. 9 |15. 1 |17. 4 |21. 8 |24. 6 |27. 5 | |o/w Central Government |0. 4 |1. 6 |2. 7 |2. 9 |3. 2 |3. | |Central government budget | | | | | | | |Total revenue |21. 3 |21. 6 |21. 8 |21. 8 |21. 9 |22. 0 | |Total expenditure and net lending | | | | | | | |Overall balance (incl. grants) |29. 4 |28. 6 |27. 6 |27. 6 |27. 8 |28. | |Domestic debt, net (eop) | | | | | | | |Total Public Sector Debt |-6. 2 |-5. 6 |-4. 2 |-4. 0 |-4. 0 |-4. 0 | | |17. 8 |16. 8 |16. 5 |15. 7 |15. 0 |14. 3 | | |41. 6 |43. 0 |40. 2 |41. 3 |38. 0 |38. | |External sector | | | | | | | |Current account (incl. official transfers) | | | | | | | |Reserves (months of import cover) |-6. 0 |-6. 8 |-5. 9 |-5. 5 |-5. 3 |-5. 1 | | | | | | | | | | |3. |3. 5 |3. 7 |3. 9 |4. 2 |4. 5 | Source: Ministry of Finance; Medium-Term Budget Strategy Paper, 2008/09-2010/11. The fiscal framework underpinning the Vision 2030 scenario called for increased spending on the critical “flagship” projects, while at the same time ensuring that the overall fiscal deficit (after grants) would progressively narrow from 6. 2 percent of GDP in 2007/08 to a sustainable level of around 4 percent of GDP over the medium term. This would allow net domestic debt to decline substantially from 17. 8 percent of GDP to 14. 3 percent by 2012/13.

The strengthened fiscal position would be supported by the implementation of revenue administration measures by the Kenya Revenue Authority (KRA), which would sustain the revenue-to-GDP ratio at around 22 percent throughout the medium-term. Under Vision 2030, public expenditure was to be restructured in favor of development spending and other priority social interventions. Improved management of public sector finances was expected to lead to a positive shift in investor and creditor confidence as well as to boost growth by providing the fiscal resources to raise public development spending from 8. percent of GDP in 2007/08 to 9 ? percent of GDP by 2012/13. B. The Medium-Term Plan, 2008-2012 (MTP)[9] To understand how the Kenya government envisaged the role of fiscal policy in its broad vision for development in the coming two decades, it is useful to begin with the first five-year development strategy, the Medium-Term Plan (MTP), issued in 2008 and intended to be the instrument for implementing the Vision 2030 development strategy. Two important elements underpin the MTP. First, the MTP clarified how overall resources in the economy would be allocated among the three pillars and the enabling sectors (i. . the Foundations for National Transformation) during the course of the first five-years of the Vision 2030 (see Annex Figure 1 and Annex Table 1). In particular, it highlighted the overwhelming importance that would be played by investments in infrastructure projects, particularly beginning in 2010/11. [10] While in 2008/09 and 2009/10, 21 percent of the resources was to be on infrastructure,[11] this share was to rise in the three subsequent years to about 60 percent with a heavy emphasis on roads (reflecting the inadequate maintenance and limited construction on new roads during the 1990s and earlier).

The MTP also indicated that (with the exception of a short burst in 2009/10), the social sector would absorb about 20 percent of available resources. Spending on the economic sector pillar was to drop sharply after 2008/09 (being replaced by infrastructure spending), but would then be held roughly constant for the remaining four years of the MTP period (see Annex Table 1). [12] Second, given the limited resources available to Government, the MTP emphasized that the financing of infrastructure should rely heavily on the private sector through the use of public-private-partnership (PPP) financing initiatives.

For the five-year period, at least 80 percent of infrastructure spending should expect to be financed through PPPs, particularly starting in 2010/11. Thus, the success of infrastructure financing would be predicated on two important fundamentals: first, that domestic savings could be increased from about 16 percent of GDP in 2007/08 to reach 28 percent of GDP in 2012/13 and second, that a legal and regulatory framework for public-private-partnerships could quickly be put in place so investors would feel comfortable about investing in this strategy.

Regarding the latter, we note that a PPP framework has been developed but has yet to be made operational. C. Medium-Term Budget Strategy Paper, 2009/10-2011//12 (MTBSP) Each year, the MTBSP provides much more detail on the government’s fiscal framework over the next three budget years, not only in terms of the allocation and financing of the budget for the different government ministries, but more importantly with regard to the key policy objectives. The most recent MTBSP was issued in June 2009 at the time of the Budget

Speech for fiscal year 2009/10. Unlike the MTP, the MTBSP is guided by the need to be prudent on growth prospects to mitigate the risk of being overly optimistic, and in the event that higher than expected growth rates are achieved, the medium-term macroeconomic framework can be modified accordingly, with the higher revenues allocated to priority expenditures. Table 2 below summarizes the main macroeconomic indicators underpinning the more cautious fiscal framework in the 2009 MTBSP.

The table reveals the striking contrast between what had been assumed in the Medium-Term Plan for the next few years and the new assumptions dictated by recent domestic and external developments. Reflecting the domestic and external shocks of 2008 and 2009—the violence following the December 2007 election and the global economic slowdown—real GDP growth over the next three years is now projected to average under 5 percent, much lower than the 6. 8 percent projected in the 2008 MTBSP and half the 10 percent targeted under Vision 2030. | |Table 2: Key Macroeconomic Indicators Underpinning the MTBSP, | | |2007/08 |2008/09 |2009/10 |2010/11 |2011/12 | | | |Prel. Est. | | | | | | |Medium term projections | |(Annual percentage change) | |National accounts and prices | | | | | | |Real GDP |4. 0 |2. 5 |3. 1 |5. 2 |6. 4 | |CPI (end of period) |29. |18. 0 |10. 1 |5. 9 |5. 0 | |(In percent of GDP) | |Investment and savings |19. 1 |18. 1 |19. 2 | | | |Investment |8. 2 |7. 6 |10. 2 |22. 1 |23. 3 | |o/w Central Government |13. 5 |11. 9 |14. 1 |8. 9 |9. 1 | |Gross national savings |1. |1. 7 |2. 3 |17. 3 |19. 0 | |o/w Central Government | | | |3. 1 |3. 5 | |Central government budget | | | | | | |Total revenue |22. 0 |22. 6 |22. 3 |22. 5 |22. 6 | |Total expenditure and net lending |27. 2 |28. 5 |30. 3 |28. |28. 3 | |Overall balance (incl. grants) |-3. 5 |-4. 9 |-6. 6 |-4. 5 |-4. 2 | |Domestic debt, net (eop) |16. 9 |18. 5 |20. 6 |21. 1 |21. 1 | |Total Public Sector Debt |39. 3 |42. 6 |44. 5 |44. 3 |43. 8 | |External sector | | | | | | |Current account incl. off. ransfers |-5. 6 |-6. 2 |-5. 1 |-4. 8 |-4. 3 | |Reserves (months of import cover) |3. 4 |2. 8 |2. 9 |3. 1 |3. 5 | Source: Ministry of Finance; and the MTBSP, 2009/10-2011/12 With respect to the saving-investment balance, there is also a significant divergence between the MTP? s medium-term targets and the revised targets in the 2009 MTBSP. For example, the saving-to-GDP ratio is projected to reach 19 percent compared with 24. 6 percent in the MTP in 2011/12—a shortfall of 5. percentage points of GDP. Similarly, the investment-to-GDP ratio is now projected to reach only 23. 3 percent in 2011/12 compared with 29. 9 percent in the MTP—a shortfall of 6. 6 percentage points of GDP. Virtually all the projected shortfall in both saving and investment are associated with the private sector as public sector saving and capital spending are broadly as envisaged in the MTP. The large projected shortfalls in private sector saving and investment suggests that the Vision 2030 growth objectives are unlikely to be met within the timeframe originally envisaged of 2012/13.

Moreover, unless the level of productivity rises sharply (or the ICOR is reduced markedly compared with the target in the MTP) in the next few years, achieving the growth objectives of the Vision 2030 with lower investment is unlikely to be realized. Therefore, to avoid a prolonged divergence between actual outcomes and the Vision 2030 objectives, it is critical for Kenya to fast track the implementation of key reforms aimed at rapidly improving the investment climate, while putting in place the institutional framework to facilitate private sector participation in infrastructure projects through the PPPs.

Without these reforms, the timeline for achieving the Vision 2030 growth objectives will not only be delayed substantially but could be seriously compromised. As in the previous year, the 2009 MTBSP also aims at maintaining revenue collection at around 22 percent of GDP over the medium term. This is quite reasonable by historical Kenyan standards and high by Sub-Saharan African standards, and reflects an assumption that revenue collection will keep up with growth in nominal GDP.

No major tax rate increases are envisaged in line with Kenya’s intention to maintain a competitive climate for foreign and domestic investors by reducing the cost of doing business. Avoiding higher taxes seems, at this time, to be a reasonable policy position, though the issue of a further increase in the overall tax share will become more important to consider as one moves further into the next decade (as discussed below). The MTBSP rightly takes a cautious view on the availability of grants and concessional loans, which are projected at roughly 3. 5 percent of GDP annually through 2011/12.

However, even for this amount of financing to become available, the MTBSP recognizes that improving public expenditure and financial management will be critical in order to give comfort to development partners that their resources are being efficiently used to support economic growth and poverty reduction. The decision to exclude budget support in formulating the medium-term framework is informed by the recent success of having more predictability in budget execution by ensuring that resources allocated to line ministries are not disrupted by the ups-and-downs of donor relations and conditionalities.

This practice has been highlighted positively by Standard and Poor’s and Fitch Ratings. However, as the 2008 MTBSP emphasized, the exclusion of budgetary support should not suggest a slowdown in implementing reforms in public expenditure management, in the financial sector, and in the restructuring and/or privatizing of public enterprises. Indeed, the assumed lower donor inflows should be accompanied by an intensification of the pace of structural reforms, especially in the modernization of tax and customs administration, to ensure Kenya’s recent financial independence is sustained in line with KRA’s motto of “Tulipe Ushuru–Tujitegemee. ”

On the expenditure side, the 2009 MTBSP proposes an increase in overall spending from 28. 5 percent of GDP in 2008/09 to 30. 3 percent followed by a gradual reduction thereafter to about 28 percent by 2011/12, while simultaneously effecting a slight shift in the composition of expenditure towards development projects. As a result, the share of recurrent outlays in total outlays will have declined from a high of 90 percent in 2002/03 to 80 percent in 2006/07 and to 67 percent by 2010/11. This is consistent with Vision 2030’s objective of increased funding for the flagship infrastructure projects while still maintaining macroeconomic stability.

Reflecting the importance of the other pillars of Vision 2030, and in particular, the social pillar, the proposed expenditure profile in the 2009 MTBSP provides for spending on education and health to remain broadly unchanged at around 30 percent of total spending over the medium-term (Table 3). [13] This follows significant increases in resource allocation to both sectors in recent years. Nevertheless, it may still be necessary to provide more resources to both sectors (see below) and this will require careful prioritization of spending to create the fiscal space for the shift in budget priorities.

In particular, spending on other parts of the budget (including public administration, defense, internal security, etc), which is currently projected to remain broadly stable at around 46 percent of total spending, may need to be rationalized in order to release resources for the social sectors. . |Table 3: Spending on the Social and Economic Sectors (in percent of total expenditure) 1/ | | |  |2007/08 |2008/09 |2009/10 |2010/11 |2011/12 | |Social Sectors |28. % |29. 3% |30. 4% |30. 6% |29. 6% | | Health | 6. 1% |5. 7% | 6. 8% |6. 0% |6. 0% | | Education |22. 0% |23. 6% |23. 6% |24. 7% |23. 7% | |Economic Sectors |… |24. 8% | 22. 9% |23. 6% |24. 8% | | Productive, incl.

Agriculture |… |4. 3% |3. 5% |4. 3% |4. 4% | | Physical Infrastructure |… |20. 5% |19. 5% |19. 3% |20. 4% | |Other |… |45. 9% |46. 7% |46. 3% |45. 6% | |Total |… |100. 0 |100. 0 |100. 0 |100. 0 | / Source: The Medium-Term Budget Strategy Paper, 2009/10-2011/12 Based on the projected revenue and expenditure, the overall budget deficit (after grants) is estimated to initially rise from 4. 9 percent in 2008/09 to about 6 percent of GDP in 2009/10—reflecting the impact of the fiscal stimulus package—and then decline to 4. 2 percent by 2011/12. (see Table 2). It is anticipated that concessional financing, mainly from multilateral institutions, non-concessional borrowing through the issuance of sovereign bonds, and domestic borrowing will cover the deficits.

The projected domestic borrowing (including issuance of domestic infrastructure bonds) would result in a gradual increase in the stock of outstanding net domestic debt from 17 percent of GDP in 2007/08 to about 21 percent in 2011/12. This increase, while necessary in the context of the economic slowdown and government policy response, carries with it the risk of potentially crowding out of the private sector. This could pose difficulties in allowing the private sector to play its role in financing economic activities consistent with achieving the higher growth path. D. Overall fiscal and debt sustainability

The projected medium-term fiscal deficits are broadly consistent with fiscal and debt sustainability. Throughout the period covered by the MTBSP, the ratio of public sector debt-to-GDP fluctuates within a narrow range of 40-44 percent of GDP, implying that the net present value of debt-to–GDP ratio is well below 35 percent. [14] It should be noted that the issuance of sovereign bonds to fund high-return infrastructure projects does carry some debt sustainability risks arising from the exchange rate, making it important that the projects be subjected to rigorous cost-effectiveness analysis.

Also, some caution may be needed with regard to the timing of issuance of these bonds, given the increased borrowing spreads currently facing many developing countries, as well as the recent and potential further depreciation of the Kenya Shilling against the Euro and the US dollar. Regarding contingent liabilities, a significant amount has already been taken into account in the context of the financial restructuring of the National Bank of Kenya (over Ksh. 21 billion) and during the course of privatizing Kenya Telecom.

However, owing to lack of data, not all potential contingent liabilities from the parastatal sector and from the pension scheme have been included in the debt sustainability analysis. Including such contingent liabilities would increase the official public debt and the risk of the overall public debt becoming unsustainable. Another potential source of contingent liabilities is the Government’s planned heavy reliance on public-private-partnerships to finance many of the infrastructure projects for Vision 2030. It will be critical to ensure that increased use of the PPP framework is well managed and minimizes potential contingent liabilities.

Reliance on PPPs in some instances involves some assumption of the government ultimately, in the future, financing the purchase of the privately-built assets. Moreover, depending on the terms of an individual PPP, the government could bear a number of potential risks associated with each project (demand risk, financing risk, political risk, supply risk, legal risk, etc). The Government appears to be cognizant of this danger, and intends to establish a PPP unit in the Ministry of Finance to vet all new PPP funded projects.

In the meantime, the Government should avoid any new PPP projects before the finalization of the PPP legal and regulatory framework. E. The Potential Role of PPPs Can and should Kenya realistically rely on PPP mechanisms? First, there are some areas of public infrastructural spending where potentially the private sector may be willing to invest and provide services without the need for a PPP (e. g. , as has already been demonstrated in the telecommunications sector). In other sectors, the challenge is for the government to ensure that the same public policy factors that originally motivated public sector investment and provision, e. . , equity factors, natural monopoly conditions, or externalities, are taken into account in the way in which the private sector produces and delivers services. Here the government’s task is to ensure that a clear and well-designed regulatory structure is in place, particularly with regard to pricing policy. Second, private financing in the form of a PPP entails both opportunities and risks to a government, and management of these risks is essential if there is to be a genuine sharing of both the gains and the associated risks between the public and private sectors.

What makes a PPP attractive to a government is the ability to harness the potential of the private sector to construct and operate a facility with greater efficiency than would be the case for the public sector, with such efficiency gains offsetting the presumably higher borrowing or equity costs associated with private as opposed to government borrowing. Such efficiency gains are particularly relevant when the private sector can bundle the construction and operating phases of a project, thus allowing for internalization of cost-reducing incentives (Scandizzo and Sanguinetti, 2009).

At the same time, by substituting the private sector for public provision, the government can also save scarce public funds and relieve strained budgets. But PPPs can also be used, inappropriately, to bypass spending controls and move public investments off budget and debt off the government’s balance sheet. This could leave governments bearing most of the risks involved and face large fiscal costs over the medium to long term.

Experience in other countries suggests that to work effectively and for a PPP to be an appropriate approach, several key prerequisites should be satisfied: the quality of services should be contractible; there should be competition or incentive-based regulation; as noted, there should be an appropriate distribution of risks; the institutional framework should be characterized by political commitment, good governance, clear supporting legislation (including with regard to pricing); and a transparent procedure for award of performance incentives and enforcement of sanctions throughout the concession period.

Finally, a government needs to have a capacity, both in the finance and sector ministries, to effectively appraise and prioritize public infrastructure projects; design PPPs; evaluate affordability, value for money and risk transfer; correctly select those projects that are appropriate to undertake as PPPs; draft and scrutinize contracts, monitor, manage and regulate ongoing projects, and undertake periodic performance evaluations (see Sutherland et al, 2009; Scandizzo and Sanguinetti, 2009; IMF, 2004; and Tchakarov, 2007).

This underscores the importance of Kenya moving at a deliberate pace to put in place a strengthened management capacity in the Ministry of Finance and given, past governance failures, caution to ensure that the government sector is not burdened with excessive risks that ought legitimately to be borne by the private sector. In terms of negotiating the distribution of risk, the experience of Latin American countries with PPPs suggests that some are appropriately borne by the private partner—those associated with the construction or the operation of the project in particular.

Others, such as political and regulatory risk, clearly should be borne by the government. Others—such as market demand risk, some supply side risks (the cost of foreign exchange, some factor cost risks), may be influenced by government but not fully under its control. How such risks are shared is an obviously important and sensitive aspect in the negotiation of a PPP with a private partner, since it will bear on how large are the contingent risks to which a government is exposed. Experience also has taught that governments entering into PPPs need to be aware, that there is a strong tendency for contracts to be renegotiated.

Tchakarov (2007) notes that in Latin America and the Caribbean, over 30 percent of PPPs were renegotiated (particularly in transportation and water projects), often within the first two to three years of the award of a PPP. Key factors forcing renegotiation have included the fixed term nature of concession contracts, the challenges posed by demand risk, poor decisions at the design stage, government acceptance of aggressive bidding, or changes in the rules of the game by the government after the contract award.

Tchakarov also notes that an “improper regulatory framework and poor regulatory oversight [can] increase the chances of conflict, rent capture by operators, or opportunistic behavior by government. ” In sum, private sector financing offers important opportunities for Kenya to augment its fiscal space for infrastructure, but successful exploitation of this source requires important capacity building within the government in order to ensure both fiscal savings and efficiency gains relative to public provision.

F. Risks The MTBSP recognizes that the underlying medium-term assumptions are not without risks, and that the projected rate of economic growth may not be achieved. Under such circumstances, the MTBSP indicates that the government would take appropriate measures to mitigate the risks to macro-economic stability, such as by delaying or scaling back on expenditures on non-priority programs. However, the MTBSP does not identify which programs would be curtailed should revenues fall short of projection. IV.

Assessing the Vision and the Medium-Term Budget Strategy ADoes Vision 2030 and the MTBSP Address the Key Challenges facing Kenya? In assessing Kenya’s fiscal policy going forward, it is probably best to work from the plans indicated in the recent MTBSP, primarily because Vision 2030 and the MTP provide less detail on the macroeconomic and fiscal policy framework. Vision 2030 is also of course more ambitious in its objectives for growth, so that any doubts raised about the MTBSP would only be more the case concerning Vision 2030.

At the outset, it is worth pointing out that the fiscal framework in the MTBSP appears to be based on fairly conservative assumptions and has introduced some degree of flexibility that can accommodate several alternative scenarios. In particular, the assumed lower growth in the MTBSP compared with the Vision 2030 is, regrettably, realistic in light of recent global developments. However, the projected constant ratio of revenue-to-GDP ratio also comes at a time when KRA is undertaking significant reforms in the customs and tax administration.

This means that there is likely to be a revenue windfall. The projected disbursement of concessional loans in line with GDP assumes no improvement in absorption capacity in the key line ministries from the low levels of between 40-50 percent and the authorities have underscored this as an objective to pursue in coming years. With the recent enhanced monitoring of project implementation, the absorption of donor funds should increase. The exclusion of donor budget support from the framework at a time when PFM/PEM reforms are on-going also suggests a potential upside in donor support.

Finally even with the increase in government spending associated with the fiscal stimulus, the level of public sector debt to GDP ratio still provides some scope for additional domestic borrowing to fund key infrastructure projects, if warranted, without jeopardizing Kenya’s debt sustainability status. All in all, with the exception of the growth scenario, most of the other assumptions appear fairly cautious and leave room for some over performance. Thugge et al make several key observations on these issues.

While acknowledging that the authorities have articulated a sensible and ambitious policy strategy, recent domestic political events and the global economic downturn highlight the setbacks to its realization almost from the outset. Revenue shortfalls, limited efforts at rationalizing spending in noncritical sectors, and the slow pace of civil service rationalization will limit the potential for meeting policy objectives in the health and education sectors, both in terms of levels of spending and efforts at increased sectoral efficiency.

The need for increased infrastructural spending is recognized, but financing efforts remain impeded by the lack of progress on setting out the policy framework for enhanced private sector participation and an improved investment climate. Enhanced revenue efforts will also be needed, particularly from personal and corporate income taxes and from an increase in the effective VAT rate. Fifth, the MTP calls for a sharp increase in overall investment in order to achieve the planned 10 percent real GDP growth.

However, in light of the sharply lower medium-term levels of saving and investment now projected in the MTBSP, the government needs to move with deliberate speed to implement structural reforms and improve the investment climate in order to raise productivity rapidly. Without a significant increase in total factor productivity, achieving the Vision 2030 growth objectives could be seriously impaired.

One implication of the limited amount of resources available to G