Challenges of Globalizing Financial Systems
Hashemite University/Jordan
21-22/10/2009
Conference Proceedings
Volume 1
1 Globalizing Financial System and Economic Growth in the Middle East: An Implication in Property Market
Anas A. Al Bakri School of Economics and Finance (SEF) College of Business University of Western Sydney (UWS) Sydney ● Australia
Submitted to The 1st Scientific Conference “Challenges of Globalising Financial Systems” 21-22 Oct 2009 Faculty of Economics and Administrative Sciences Hashemite University, Jordan
Abstract One of the main reasons for this paper which focusing on globalizing financial system (GFS) and economic growth and an implication in property markets in the Middle East (ME) is because there is an increase in funds flowing from developed industrial countries toward the emerging ME markets particularly property market. Evidence from financial analysts, economic theories and financial indicators that are presented in this paper suggest that GFS should be approached carefully in the ME, with good institutions and macroeconomic frameworks viewed as important. The review of the available evidence does not, however, provide a clear road map for the optimal rapidity and running of GFS. Therefore, this paper aims to provide theoretical and empirical evidences, which explore the effect of GFS on the economic growth particularly in emerging property market and property companies’ (PCs) performance in the ME.
Key Words: Globalizing financial system (GFS), economic growth, emerging property markets, property company (PC) and global financial crisis.
1.0 Introduction Financial systems play a critical role as a channel for the transfer of financial resources such as capital, funds, assets and property from net savers to borrowers. The analysis of the globalizing financial system (GFS), the economic growth, the property market and property company (PC) performance has attracted a great deal of interest in recent times. The term GFS refers to an area of research in financial economics that covers many aspects of inter-
2 relationships between financial system participants. The issues of GFS, analysis of economic growth and property market performance in emerging markets in the Middle East (ME) have received a great deal of interest among academic researchers and practitioners. In recent year, the changing nature of the financial system has become an increasing focus of policy interest and of academic studies. It has been argued and depending on the point of view of the financial analysts and economists, these changes and GFS may be seen as (i) necessary and welcome progress towards a more efficient of local financial system, which provides financial institutions (FIs) more cost-efficiently and allocates capital more efficiently than has been previously the case; and/or (ii) they are seen as threatening to financial system stability and as a development towards a financial system that is level to crisis at frequent periods (IMF, 2006; World Bank, 2008). IMF (2006) shows that financial system are the combination of all FIs, institutional and individual investors and financial markets together, which have an essential and major role in the performance of the economy. Ross (2002) noted that in today’s economy, financial system mainly consist of a central bank, banks, non-bank financial institutions (NBFI), and financial markets. The emerging property markets in some developing countries such as the ME markets have achieved considerable improvements over the last ten years. Several factors have played vital roles in these improvements, such as the conduct of sound macro economic policies, financial system reforms, privatization, financial liberalization, and stock market integration. One of the main reasons for this paper focusing on GFS and economic growth and an implication in property markets in the ME is because there is an increase in funds flowing from developed industrial countries toward emerging financial markets; particularly property markets in the ME. Hence, these Middle Eastern financial systems are becoming increasingly important in terms of GFS. Therefore, this paper aims to provide theoretical and empirical evidences, which explore the effect of GFS on the economic growth particularly in the emerging property market and PCs performance in the ME. In particular, this research focuses on emerging markets in this region, namely Bahrain, Egypt, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia, Syria and United Arab Emirates. The ten countries that are considered in this study have adopted several sound macroeconomic polices and financial system reforms over the last ten years which have contributed to higher economic growth. These policies and reforms include trade and financial liberalization, privatization programs
3 and openness to foreign directed investment (FDI). Moreover, these reform policies are considered as indispensable in order for these countries to face the growing financial and economic challenges that resulted from the recent financial crises and changes in the global economy. Thus, GFS without an appropriate set of requirements might lead to few economic growth benefits especially in property markets and more output and unpredictability consumption in the short run. The rest of the study is structured as follows: section 2 outlines an overview of GFS; a revision of the related features and factors. Section 3 presents the benefits and the relationship of the GFS and economic growth in the ME, which determines the direct and indirsct channels to enhance economic growth that derived from GFS. While section 4 determines the effect of GFS on the emerging property market and PCs performance in the ME. The section 5 highlights the impact of global financial crisis on economic growth and property market performance in the ME. The last section (6) presents the conclusions, contributions and recommendations for this study.
2.0 Globalizing Financial System (GFS); Features and Factors Globalizing financial system (GFS) and financial system integration are, in principle different concepts. GFS is an aggregate concept that refers to rising global linkages through cross- border financial flows (IMF, 2008). Financial system integration refers to an individual country’s linkages to international capital markets. For instance, increasing GFS is necessarily associated with rising financial system integration on average (IMF, 2008; World Bank, 2008). Based on literature and empirical evidence, GFS helps to raise the economic growth rate in the ME through a number of channels (AMF, 2008). Some of these directly affect the determinants of economic growth. On the other hand, indirect channels, which in some cases will be even more important than the direct ones, include increased production specialization due to better risk management, and improvements in both macroeconomic policies and institutions induced by the competitive pressures or the “discipline effect” of globalization (World Bank, 2008). Features of global capital flows within GFS in the ME are: 1- The level of global capital flows has risen substantially in the last 5 years. Not only has there been a much greater volume of flows among developed industrial countries
4 but there has also been sudden increase in flows between industrial and the emerging ME economics, and 2- This increase in global capital flows to the ME is the outcome of both “pull” and “push” factors. (i) Pull factors arise from changes in policies and other aspects of opening up by the ME (Brau and McDonald, 2009). These include liberalization of capital accounts, domestic stock markets, and large-scale privatization programs. (ii) Push factors include business cycle conditions and macroeconomic policy changes in both the developed and the emerging ME markets (Brau and McDonald, 2009). The rapid development of communication and widespread of using the Internet in the ME - as one aspects of globalization- has been considered as important tool for GFS and financial markets; especially property market (Sherman and Rowley, 2006). This tool enable institutional and individual investors, agents, traders and all participants in financial system to have the access to information, and consequently the ability to manage their portfolio more efficiently. IMF and World Bank (2008) reported that some of major factors, which encouraging high level of interest in GFS and investments by local and global institutional and individual investors in the ME are: - Lack of local financial investment opportunities - Interest rate differentials - Greater liquidity of global stock markets - Political and economic diversification - Perceived comparative advantage - Substantial growth in available investment funds - Changes in foreign investment policy - Investment stability - Strong economy - Improved global communication and financial system information - Access to investment capital - Greater collection of investment choices
3.0 Globalizing Financial System and Economic Growth in the Middle East 3.1 Introduction
5 At the beginning of the 21st century a huge amount of capital flows into the ME financed infrastructure projects such as railroads and direct investment in foreign companies (Foreign Direct Investment- FDI) have been increased (Marashdeh, 2007). A stock markets in the ME as one of the main financial system combination, which it is a system that allows both institutional and individual investors to easily buy and sell financial securities such as stocks, bonds, commodities - such as valuable metals or agricultural goods- and other tangible items of value at low transaction costs and at prices that reflect efficient markets (Marashdeh, 2007). On the other hand, according to Bloomberg, Macquarie Research (2009), eight of the top ten best performing stock markets in the world in 2008 were in the ME. Saudi Arabia has become one of the world’s largest emerging stock markets by capitalization. This liquidity, along with the high oil prices in the Q2 and Q3/2008 has created a substantial cash surplus in the region (Macquarie Research, 2009).
3.2 The GFS Direct and Indirect Channels Enhancing Economic Growth in the ME In theory, there are a number of direct and indirect channels through which embracing GFS enhances economic growth in the ME. These channels are inter-related in some ways, but this explanation is useful for reviewing the importance of each channel. However, it has confirmed difficult to empirically identify a strong causal relationship between GFS and economic growth. The following points represent the direct channels, which will be enhancing the economic growth in the ME: 1- Allow for increased investment in the ME while provides a higher return on capital (ROC, ROI) than is available in developed industrial countries. This effectively reduces the risk-free rate within the ME. 2- Improves the allocation of risk through following steps: (i) Increased risk sharing opportunities between global and local investors help to diversify risks (Claessens et al 2004). (ii) This ability to diversify in turn encourages FIs to take on more total investment, thereby enhancing economic growth. (iii) As capital flows increase, the domestic emerging stock market becomes more liquid, which could further reduce the equity risk premium, thereby lowering the cost of raising capital for investment (Claessens et al 2004). 3- International portfolio flows can increase the liquidity of domestic emerging stock markets in the ME (Marashdeh, 2007). Hence, increased global ownership of
6 domestic FIs generate a variety of other benefits such as: (i) Foreign FIs participation can facilitate access to international financial markets (Saunders and Millon, 2004). (ii) It improves the regulatory and supervisory framework of the domestic FIs industry (Saunders and Millon, 2004). (iii) Foreign FIs introduce a variety of new financial instruments and techniques and also promote technological improvements in domestic markets (Saunders and Millon, 2004; Brau and McDonald, 2009). 4- Financially globalized economies seem to attract an exceptionally large share of FDI inflows, which have the potential to generate technology spillovers and to serve as a channel for passing on better management practices (AMF, 2007). These spillovers can raise aggregate productivity and, in turn, boost economic growth.
High ROI/ROC
Increase Capital Flows Globalizing Economic Financial Increase Risk Growth System Sharing
Increase Liquidity
Raise Aggregate Productivity
Figure 1. Direct Channels to Enhance Economic Growth
On the other hand, the following points represent the indirect channels, which enhance the economic growth in the ME: 1- Specialization in production increases productivity and economic growth is intuitive. In principle, GFS plays a useful role by helping countries in the ME to engage in international risk sharing and thereby reduce consumption volatility (AMF, 2007). Eventually, this risk sharing would indirectly encourage specialization, which in turn would raise the economic growth rate in the ME.
7 2- GFS increases productivity in an economy through its impact on the government’s ability to credibly perform to a future course of policies (AME, 2008; World Bank, 2008). More specifically, the disciplining role of GFS changes the dynamics of domestic investment in an economy to the extent that it leads to a reallocation of capital towards more productive activities in response to changes in macroeconomic policies. 3- A country’s readiness to undertake GFS interpreted as an indicator that it is going to practice more responsive policies towards foreign investment in the future (IMF, 2008). The removal of restrictions on capital outflows leads to an increase in capital inflows, indeed, increase economic growth. Many countries, including, GCC, Egypt, Jordan and Lebanon have received significant capital inflows after removing restrictions on capital outflows (AMF, 2007).
Specialization in Production Improve Productivity
Government
Ability Economic Globalizing Reduce Financial Growth Engage in Consumption System International Volatility Risk Sharing Increase Capital Country In/Outflows Readiness Improve Carefully of Resource Financial Allocation Operations
Figure 2. Indirect Channels to Enhance Economic Growth
3.3 GFS Impact on Economic Indicators in the ME The gross domestic product (GDP) for the ME is projected to slow to 3.9 percent in 2009 and a quick resolution of the global financial crisis in high income countries could produce an increase in GDP to 5.2 percent in 2010 (CIA, 2008). The region witnessed a sharp rise in inflation as a result of the surge in global prices for food and feed grains, together with an
8 increased demand in several economies. The world is becoming more urban, and decisions are increasingly being decentralized to cities and municipalities. The following collected data are from the World Bank, International Monetary Fund (IMF), and the CIA (2007; 2008). These data include: Population; GDP in US dollars; GDP per capita; inflation rate; unemployment rate; trade and government statistics. The following Tables 1 and 2 show some of economic statistics comparison (2007- 2009) for GDP as one of economic growth indicators in the ME (Arabian Business, 2009). Also Tables represent inflation, unemployment rates, and current account balance in the ME.
9 Table 1 Economic Statistics for GDP in the ME (2007-2009) Country Population GDP 2007 GDP 2008 GDP 2008 Forecasted World Ranking GDP Per Capita World Ranking (Million) (Billions$) (Billion US$) % GDP 2009 GDP 2008 2008 GDP Per Capita % US$ 2008 Bahrain 0.779 17.40 19.675 13.09 13.43 96 25,245.41 32 Egypt 75.045 127.97 158.255 23.67 23.95 52 2,108.80 116 Jordan 5.854 15.83 19.124 20.79 21.92 98 3,266.52 103 Kuwait 3.443 111.51 159.73 43.24 43.46 51 46,396.74 19 Lebanon 3.799 24.64 28.024 13.73 13.83 83 7,375.85 68 Oman 2.595 40.39 56.318 39.43 40.04 68 21,703.79 34 Qatar 1.098 73.26 116.851 59.51 59.74 56 106,459.62 2 KSA 24.897 381.94 528.322 38.33 39.09 20 21,220.62 35 Syria 19.88 38.97 44.492 14.17 14.43 75 2,237.96 114 UAE 4.764 190.74 269.956 41.53 42.40 36 56,666.70 8 Middle East - 1,399.70 1,919.11 37.11 37.22 0 - - Advanced - 39,188.16 42,694.95 8.95 9.74 0 - - Economies The World - 54,584.92 62,054.13 13.68 14.02 0 - - World's Ave - 301.57 342.84 13.69 14.03 0 - - Source: Developed for this study
10 Table 2 Economic Statistics for Inflation, Unemployment Rates and Current Account Balance in the ME for 2008 (Indexed to Year 2000) Country Inflation Rate % World Ranking Unemployment Rate % Current Account World Ranking Balance (% GDP) Bahrain 12.6 127 3.5 1.802 14 Egypt 17.8 61 8.7 0.561 59 Jordan 15.3 86 13.0 -1.846 158 Kuwait 13.2 107 2.2 4.459 3 Lebanon 13.4 103 10.0 -1.398 148 Oman 12.9 119 5.0 1.006 26 Qatar 17.6 63 0.6 4.291 4 KSA 12.2 145 15.0 3.249 7 Syria 12.5 131 9.0 -2.722 74 UAE 12.0 N/A 12.7 2.256 10 Middle East - - - 2.285 0 Advanced Economies - - - -1.008 0 The World - - - - - The World's Average - - - - - Source: Developed for this study • Data for inflation are end of the period, not annual average data. The index is based on 2000=100. • Current Account Balance based upon balance of payment, and calculated as the sum of the balance of individual country.
11 The above Table 1 shown that GDP for World Average in 2008 is 13.69% which is more than was in 2007. In the forecasted current year, 2009, GDP for the World will be US$64,167.96 Billion, which is 3.41% more than the 2008 figure. At the same time, GDP for the ME in year 2008 is US$ 1,919.11 Billion. On the other hand, in the previous year, 2007, GDP for the ME was US$ 1,399.70 Billion, but GDP for the ME in 2008 is 37.11%, which is more than was in
12 2007. In addition, in the forecasted year, 2009, GDP for the ME will be US$2,140.45 Billion, which is 11.53% more than the 2008 figure (CIA, 2008). Investment (% of GDP) for the World in year 2008 is 23.528 %, in the following forecasted year, 2009; Investment (% of GDP) for the World will be 23.58 %, which is 0.23% more than the 2008 figure. At the same time, investment (% of GDP) for the ME in year 2008 is 24.546 %, hence the ME is 1.02 more than the average. Further, in the current forecasted year, 2009, Investment (% of GDP) for the ME will be 25.75 %, which is 4.89% more than the 2008 figure (CIA, 2008).
As shown in Table 2 current account balance (% GDP) in the ME in year 2008 is 22.856 %. However, in the previous year, 2007, it was 18.36 %. Hence, current account balance (% GDP) in the ME in 2008 was 24.46% more than it was in 2007. In addition, in the current forecasted year, 2009, current account balance (% GDP) in the ME will be 17.05 %, which is 25.40% less than the 2008 figure (CIA, 2008). Middle Eastern countries that responded to high food prices by increasing wages of select groups to help mitigate the worst of the impact on living standards are now having to deal with increased inflationary effects. In December 2008 developments in global commodity markets over the last three years, notably in 2008, have had an impact on the ME, and resulted in substantial up and down shifts in terms of trade, current account positions, and external financing requirements. While these shifts occurred at a time when the external environment for growth and for international finance deteriorated, GDP held up well through 2008 and the pace of GDP growth for the ME was unchanged in 2008 from the strong 5.8 percent registered in 2007 (World Bank, 2008). Following Table 3 shows real GDP growth rate and consumer inflation rate as annual percentage change in the ME for period (2006-2009).
Table 3 Real GDP Growth Rate and Consumer Inflation Rate in the ME (2006-2009) (Annual Percentage Change-Based on GDP 2000 Constant Prices) Country Real GDP Growth Rate Consumer Inflation Rate 2006 2007 2008 2009 2006 2007 2008 2009 Bahrain 6.5 8.1 6.3 2.0 2.1 3.3 3.5 3.5 Egypt 7.1 7.2 6.5 5.4 7.6 9.5 17.1 9.7 Jordan 6.3 6.0 6.0 3.6 6.3 5.4 14.0 6.5 Kuwait 6.3 4.6 6.1 0.7 3.1 5.5 10.4 5.7
13 Lebanon 0.0 4.0 5.5 3.0 1.5 6.7 11.7 5.7 Oman 7.2 6.1 6.0 1.5 3.4 5.9 12.4 6.0 Qatar 12.0 9.5 16.0 7.0 11.8 13.8 15.0 11.2 KSA 3.2 3.4 4.2 0.7 2.2 4.1 9.9 4.5 Syria 5.1 6.6 6.5 3.2 10.0 4.5 14.7 6.0 UAE 9.4 5.2 7.4 0.5 9.3 11.1 18.6 5.2 Source: Developed for this study, ESCWA, (2009)
On the other hand, Saudi Arabia (KSA) ranks 27th in the global competitiveness report 2008- 2009 issued from WEF. Several countries in the ME are in the upper half of the rankings, led by Qatar (26th), Saudi Arabia (27th) and United Arab Emirates (31st). Following Table 4 represents the global competitiveness of the ME (2008- 2009). Table 4 Global Competitiveness Index for ME Countries 2007-2008 Comparison Market GCI (2008-2009) Ranking GCI (2007-2008) Ranking USA 1 1 Singapore 5 7 Germany 7 5 Japan 9 8 Hong Kong 11 12 UK 12 9 France 16 18 Australia 18 19 Malaysia 21 21 Qatar 26 31 KSA 27 35 Spain 29 29 UAE 31 37 Kuwait 35 30 Bahrain 37 43 Oman 38 42 Jordan 48 49 Italy 49 46 Syria 78 80 Egypt 81 77 Source: WEF (2009)
14 3.4 Stock Markets in the ME The ME is one of the world's fastest growing markets in the banking and capital markets sector. The region's financial services sector is in the midst of an enormous repair. The evidence is that a competitive banking sector, liquid equity and debt markets in the ME, operating according to market principles and intermediating savings (domestic and foreign) for market-based investment, are strongly associated with higher growth rates in the region. Developed financial markets tend to promote efficiency in allocating investments, and hence contributing to the productivity growth by: • Improving the management of risk • Identifying productive projects and efficient firms • Promoting corporate governance • Mobilising savings, and • Justifying the adverse effects of financial shocks. The emerging financial market and financial investment liberalization have been the origin of many recent cases of GFS in the ME. In the main participants of financial systems are investors and FIs such as banks, investment companies, insurance companies, mutual funds and pension funds. Therefore, stock market is the best medium of raising funds (IMF, 2006)1. FIs which need financing for growth and development, they easily raise required funds by contributing in stock exchange market. Today, more than ever before, the high performance of FIs, specifically PC is dependent upon quick access to accurate and up-to- date information especially data between investors and other FIs in financial market. Stock market in general facilitates the raising of capital, transfer of risk, and global trade such as in the currency markets. World Bank and many of studies such as Claessens, et al. (2004), and Marashdeh (2007) noted that the benefits which developing countries such as the ME achieved from opening stock market are: 1. Like trade in goods, freer trade in services raises the growth of GDP. 2. There is an added weave for financial services. 3. Well functioning service industries contribute to growth in different ways: an efficient financial sector allows resources to be deployed where they have the highest returns2.
1 International Monetary Fund, IMF Article IV 2006 http://www.worldbank.org2
15 4. A country that liberalizes its services sector is likely to liberalize its stock of capital. The emerging securities markets in the ME have achieved substantial improvements in the last decade. Several factors have played vital role in the ME financial markets growth, such as the achievement of higher economic growth, monetary stability, stock market reforms, privatisation, financial liberalization and institutional framework for investors (Claessens, et al. 2004). These markets in the ME are considered small comparatively despite the region contains some of the developing world’s largest institutional investors in the global bond market (El-Erian & Kumar, 1994, p. 15) Marashdeh (2007) noted that the performance of financial market in the ME and the prices of stocks depend significantly on the speculation of the investors. Hence, over- responses and incorrect speculation can give rise to unreasonable behavior of the financial market. Excessive optimistic speculation of future predictions can raise the prices of stocks to a tremendous high and unnecessary pessimism on the part of the investors can result in extremely low prices (Syrian Securities and Exchange Commission, 2006). Today, with the expansion of economies of the ME, there has been unprecedented growth in new FIs targeting to compete with global players for a greater share of the regional financial markets.
4.0 The Effect of Globalizing Financial System on Emerging Property Markets in the Middle East 4.1 Emerging Property Market Today, investments in property markets are generally seen as the most reliable source of return on investment (ROI). Large investors often look to add variety to their global property portfolio by distributing their investments globally over numerous property investment market (Dapaah et al. 2002)3. Property takes two forms: direct property investment and indirect property investment. Within the former, investments are made in “real” and “tangible” assets and enjoy a steady cash flow from rental income (Dapaah et al. 2002). The latter is often defined as pooled investment vehicles, whether this involves listed PCs, listed and unlisted property funds or unlisted property syndicates. There are differences between the indirect property investment forms. PCs are those companies that are listed on stock exchange markets and engage in property investment or development activities. Real Estate
3 Dapaah, K., Wee, S., and Ebrahim, S. (2002) Real estate portfolio diversification by sources of return. Journal of real estate portfolio management, 8(1), 1-4
16 Investment Trusts (REITs) are traded on major stock exchange have significant income- producing property portfolio but subject to meeting certain conditions, thus that they are able to avoid taxation at the corporate level. Global property investment has taken on increased importance in recent years as institutional investors seek portfolio diversification opportunities in both the developed and emerging property markets, with ME countries having been a strong focus for this activity (RREEF 2007). Many of previous researchers have highlighted the benefits of including global property investment in a mixed-asset portfolio (Hoesli et al 2004). In addition, global property diversification has been shown to be more effective in the emerging property markets in the ME than in the traditional property markets. This has been further enhanced by the increased PCs in many of the ME. Therefore, it is important to define in more detail what represents of emerging market. Any type of financial market such as the property market is considered as an emerging market if it has started a transition process, growing in size and increasing in complexity. According to the International Financial Corporation of the World Bank Emerging Markets Database (IFCWBEMD), a financial market is classified as “emerging” if it is located in a low or middle income economy, and if its investable market capitalization is low relative to its per capita GDP. Emerging property market improvement has become a catchphrase in modern financial system theory and several researchers emphasize the desirability of property market improvements in emerging markets in the ME. This argument from researchers asserted that there are no barriers to funds movement between or from developed to emerging markets, which leads to a more efficient allocation of the financial resources, and funds will seek higher returns to investment. The property market is characteristically divided into residential, commercial, and industrial segments. In particular, the unique characteristics of the property market must be accommodated. These characteristics include (Spillman, 2006)4: • Durability. A building can last for decades or even centuries, and the land underneath it is basically permanent. Because of this, property market is modeled as a stock/flow market.
4 Real Estate Financing and Investing, ULI Workshops. Group LLC
17 • High Transaction Costs. Buying and/or moving into a home costs much more than most types of transactions. These costs include search costs, property fees, moving costs, legal fees, land transfer taxes, and deed registration fees. • Property can be purchased with the expectation of attaining a return, or with the intention of using it or both. • A less Volatile Investment. While returns from property can vary considerably, on average, shares have previously generated better investment returns for investors. Returns also tend to be much stable from property compared to shares because of rental yields. • Long-Term Benefits. Given the “boom and bust” character of property, a long-term investment strategy is important when considering and investment is this type of asset. Property investment experts advise that, if you buy or/and invest quality property in right location at a realistic price, it is possible to ride the highs and the lows of property by adopting a long-term strategy.
4.2 Emerging Property Market Performance in the ME As PCs and institutional investors deal with the booming property market in the ME, they see many fascinating opportunities and many more challenges are concerns, such as investment products, and regulatory environments. Table 5 presents significance of the emerging ME property markets compared with developed markets and world average. Table 5 Significance of Property in Middle East 2008 Countries 2007 Real 31-Oct-08 31-10-08 31-10-08 31-10-08 Stk Estate ($bn) Total listed Total RE v Stock market Mkt v Listed RE ($bn) Listed RE ($bn) (%) (%) Total Asia 3,664 431.7 11.78% 8,024 5.38% Total Europe 7,818 256.1 3.28% 8,840 2.90% Total Middle East/Africa 177 26.1 14.80% 776 3.37% Total Latin America 836 1.7 0.20% 1,450 0.12% Total North America 6,460 404.0 6.25% 12,572 3.21% World 19,347 1,243.8 6.43% 32,373 3.84% Source: Developed for this Study, EPRA (2008).
18 While 2007 was a record year for global commercial property transactions, with transaction volume exceeding $1 trillion (Real Capital Analytics (RCA), 2008), the global financial crisis had major impact on all financial markets in 2008 and 2009 including property markets. This has seen major commercial property investors and lenders such as (Lehman Brothers, AIG, Merrill Lynch, Wachovia, Hypo and Fortis) experience major financial difficulties (RCA, 2008). In the emerging ME property markets, the size in terms of total economic value of property growth is currently $40-45bn (5-6% of GDP). Also which residential forms the major chunk with 90-95% of the market, commercial property sector is distant second with 4-5% of the market and organized retail with 1% of the market (AMF, 2008)5. Further, over next five years, the emerging ME property markets are expected to grow of 20%, driven by 18-19% growth in residential property, 55-60% in retail property, and 20-22% in commercial property (AMF, 2008). Global property investors are aware that the growth in the purchasing power of the domestic market is fantastic for the long-term profitability of all investments in the ME property markets. Therefore, generally, the future predictions for the property market in the ME countries are positive. The report from Macquarie Research, July (2009) provides the property securities 12- month returns and volatility to Jun 2009, which represented in the following Table 6.
5 http://www.realinvestmag.com
19 Table 6 Middle Eastern Property Securities 12- Month Return and Volatility - Jun 2009 December/2008-Jun/2009 Comparison Listing countries Annual 08 return Annual 09 Annual 08 Annual 09 Annual 08 Annual 09 RE equity % return RE return equity return equity volatility RE volatility RE equity % market % market % equity % equity % Bahrain -22.28 -43.80 -30.98 -40.80 NA NA Egypt -70.56 -45.22 NA -38.24 17.15 75.84 Jordan -43.13 -52.92 NA NA NA NA Kuwait -43.73 -55.90 -38.03 -47.26 49.56 62.81 Lebanon -26.28 -32.58 -19.42 NA 55.00 49.13 Oman NA NA NA NA NA NA Qatar -34.30 -62.08 -25.25 -40.59 55.93 66.68 KSA -49.35 -36.05 -55.48 -37.75 52.12 52.39 Syria NA NA NA NA NA NA UAE -78.88 -70.95 -46.59 NA 60.82 74.03 Middle East & Africa -55.90 -46.93 - - - 63.69 Asia -58.53 -1.95 - - - 69.38 Asia developed -54.82 -9.34 - - - 68.56 Asia emerging -66.83 21.15 - - - 72.69 Americas -43.52 -39.02 - - - 106.81 Oceania developed -55.28 -38.32 - - - 81.93 Europe -52.84 -41.44 - - - 71.17 Europe developed -48.12 -36.58 - - - 69.70 Europe emerging -82.56 -71.46 - - - 91.97 2008 Annual Return % 2009 Annual Return % 2008 Annualized 2009 Annualized volatility % volatility % Global -53.73 -25.69 72.32 80.09 Global Developed -49.68 -26.87 72.62 82.63 Global emerging -65.18 -22.07 71.38 71.39 Source: Developed for this study, Bloomberg, Macquarie Research (2009) While the global financial crisis has had a major effect on the property market and PCs performance in 2008, in both the ME and globally, the listed PCs entities are closely linked with the considerable stock market’s volatility over this period of the global financial crisis. However, 2008 has presented a different scenario. Most property markets in both globally and the ME have seen reduced cross-border investing, with local players dominant and global investors retreating from a global focus to a local focus to maximize local market
20 opportunities. Further, this reduced cross-border investing in 2008 has clearly been evident in the emerging ME markets, as well as for the most European markets was typically higher than for the ME. Jones Lang LaSalle (2008) on the survey shared the views of more than 350 developers, sovereign wealth funds, and high net worth investors conclude that the property markets in the ME are expected to outperform those in other regions for up to two years. The Middle Eastern property securities markets composition in 2008 and 2009 has been summarized in the following Table 7. Table 7 Middle Eastern Property Securities Markets Composition- Jun 2009 December/2008-Jun/2009 Comparison Listing countries Companies Market cap Market cap Market Sector Mkt % of global listed <£100m £100m-£1bn cap >£1bn cap £bn RE equity Mkt 08 09 08 09 08 09 08 09 08 09 08 09
Bahrain 3 3 0 0 2 2 0 0 0.3 0.2 -0.05 0.03 Egypt 19 19 14 13 5 5 0 1 2.2 3.1 0.34 0.42 Jordan 20 20 16 17 4 3 0 0 0.9 0,8 0.14 .10 Kuwait 35 35 18 18 16 16 0 0 05.1 4.4 0.79 0.59 Lebanon 1 1 0 0 0 0 1 1 1.9 2.5 0.29 0.34 Oman NA NA NA NA NA NA NA NA NA NA NA NA Qatar 3 3 0 0 1 1 2 2 4.3 4.0 0.66 0.53 KSA 9 9 0 0 6 6 3 3 9.3 9.1 1.43 1.22 Syria NA NA NA NA NA NA NA NA NA NA NA NA UAE 8 8 1 1 4 4 3 3 7.3 7.4 1.11 0.99 Middle East & Africa emerging 214 209 133 122 60 68 12 13 46.6 49.4 7.14 6.60 Asia 753 743 444 385 243 277 56 77 297.9 394.6 44.67 52.67 Americas 383 380 198 187 140 143 42 41 176.3 169.4 26.98 21.94 Europe 593 575 372 384 155 166 22 17 107.1 106.9 16.40 14.27 Global 2068 2031 1243 1172 617 677 139 155 653.3 749.3 100.00 100.00 Source: Developed for this study, Bloomberg, Macquarie Research (2009) In the ME there is no effective means by which a bank or other lenders for property investment could exclude risks. Therefore, with banks and other financial institution in the ME having a reduced lending capacity, this has seen an increased cost of capital and an increased risk premium attached to property investment. This has presented particular difficulties for those property investors in the ME with high debt levels and needing to refinance this debt exposure. In many instances in the ME, these property investors have been
21 unable to sell their properties at reduced values and have sort to reduce their debts levels via recapitalizing and restructuring their balance sheets using expensive and capital raising. Hence, this has clearly impacted on the ability of major property investors to make further property acquisitions, as well as the future likelihood of reduces tenant demand in a slowing global economy, despite major government efforts to stimulate the economy in many countries in the ME.
4.3 Significance of the Top Fifty PCs in the ME These are tumultuous times for PCs across the ME. The current global financial crisis has made funding more difficult, institutional investors more worried, and the property markets more risky. The following Table 8 provides general statistics for the top fifty ME PCs. Table 8 Statistics of Emerging Property Markets in the Middle East (All prices are in USD) June 2009 Country Ranging Number of Total Market Total Net Profit Total Average Average % Companies Capital* Assets Share Price Increase Saudi Arabia 1 19 64.51 B 21.98 B 71.41 B 11.87 27.68 UAE 2 10 30.66 B 28.42 B 63.18 B 0.75 33.42 Qatar 3 7 29.2 B 9.69 B 26.17 B 10.73 11.68 Kuwait 4 6 22.19 B 3.21 B 45.55 B 1.96 65.27 Oman 5 2 12.06 B 1.029 B 6.51 B 2.51 58.27 Jordan 6 2 11.55 B 0.812 B 5.47 B 8.53 17.05 Syria 7 1 4.08 B 938 M 4.60 B N/A 6.90 Lebanon 8 1 2.43 B 224.19 M 2.57 B 19.70 19.11 Bahrain 9 1 3.24 B 94.3 M N/A N/A 37.0 Egypt 10 1 1.98 B N/A N/A 2.45 4.8 Total 50 Source: developed for this research, based on Table 2.12 Arabian Business, Jun (2009). * Market capital: Represents the aggregate value of company or a stock. It is obtained by multiplying the number of shares outstanding by their current price per share. The property market in the Gulf countries, especially Dubai has been hit by falling property prices, and developers have slowed or canceled projects. 20 percent of the investments in Dubai are directly linked to the property market, which was greatly hit by the financial crisis. In the ME markets, the biggest transparency improvements were found in Dubai, Abu Dhabi (UAE), and Bahrain. Syria is the only country from the ME whose transparency is
22 categorized as opaque level. The ME attracts more global attention from property investors which brings the transparency issue to the forefront of the regional government’s agendas. With a growing interest in the region, Jones Lang LaSalle has concentrated on fourteen markets this time around opposed to the three back in 2006.Out of the lot, Dubai has emerged as the major focus of property development across the ME over the past five years. Further, the improved transparency of Dubai has certainly been one of the major driving forces behind this trend. Dubai has witnessed the greatest improvement in transparency over the past two years of any market covered by the property transparency index. Following Table 9 shows the transparency levels of property markets in the ME. Table 9 Transparency of Property Markets in the Middle East Transparency Level Market Highly Transparent Australia, USA, UK, France, Hong Kong, Singapore Transparent Germany, Spain, Italy, Malaysia, Japan Semi- Transparent Dubai (UAE), Bahrain, Abu Dhabi (UAE) Low Transparent Saudi Arabia, Egypt, Oman, Qatar, Kuwait Opaque Syria Not Covered Jordan, Lebanon Source: JLL (2009)
On the other hand, the 2008 Corruption Perception Index (CPI) scores 180 countries (the same number as the 2007 CPI). A low rank refers to highly clean, and high ranking refers to high corrupt. Following Table 10 represents the CPI of the ME countries includes other selected countries as international benchmarks. Table 10 Corruption Perception Index of the Middle Eastern Countries: 2008 Country Ranking Denmark, New Zealand, Sweden 1 Singapore 4 Australia 9 Hong Kong 12 Germany 14
23 UK 16 Qatar 32 UAE 34 Bahrain 46 Jordan, Oman 53 Kuwait 60 China 72 Saudi Arabia 79 India 82 Lebanon 99 Egypt 105 Syria 138 Source: WEF (2009)
When the institutional and individual investors realized that the emerging securities markets in the ME have efficiency, they decide to transfer cash from the property investment market and go to invest in the stock market instruments. That causes the prices of property go down because the increase in supply of properties.
5.0 Global Financial Crisis Impacts on GFS and Economic Growth in the ME The fundamental financial system of the country is a sound and prosperous basis. The origin of current global financial crisis has been noted that the decade of the 21st saw a commodities boom, in which the prices of most important properties rose again after the late-twentieth century commodities recession of 1980-2000. But in 2008, the prices of many commodities
24 such as oil and food, got so high to cause real economic damage, threatening and a reversal of globalization6. The financial phase of the current financial crisis led to emergency interventions in many national financial systems (IMF, 2008). The international stock markets had crashed, as million stocks were sold in a single day’s trading and millions of American investors suddenly found themselves destitute. This time, there would be no quick recovery. For, despite developed countries assurances, financial and economic problems had been gathering over the years. The stock markets in the ME, too, had been spoilt by success. Thousands were buying on the margin, borrowing heavily to acquire stock, certain that they could repay their loans from the attractive profits they expected to make on resale (Macquarie Research Equities, 2009). With money pouring in, the market went from strength to strength, buoyed up by its own self-confidence. But amount had to come when the market could no longer float on euphoria alone. As the global financial crisis developed into genuine recession in many major economies, economic stimulus meant to recover economic growth became the most common policy tool. To date, the direct effects of the global financial crisis experienced by most developing economies in the region have been relatively mild, as banks and financial investment institutions in the ME were not large holders of subprime mortgage-backed securities (AMF, 2008; World Bank, 2008). But indirect effects are increasingly becoming evident with spread on sovereign debt increasing and equity market witnessing sharp decline. Gross capital flows to countries in the ME have also declined, and expected to weaken further (Arabian Business, 2008). The global financial crisis affects all employees and unemployment rate in the ME. Thousands of workers lost their jobs during the following months of global financial crisis, and so, the slump continued until now, unemployment rates around the world have being increased more than ever before. In general, GDP as one of economic growth indicators in the ME is estimated to have averaged 6.5 percent in 2008, up slightly from 6.4 percent in 2007. On the other hand, a jump in bank borrowing from $4 billion to $14 billion over the last year to Jun 2009 offset a falloff of some two-thirds in bond and equity issuance in the period, but outright decline in capital inflows is likely as we move into 2010. Further, the strict regulations imposed by the central banks in some countries in ME such as Saudi Arabia,
6 http://research.cibcwm.com/economic_public/download/smay08.pdf.
25 Qatar, UAE, Kuwait, Bahrain and Oman, Lebanon, Syria, Egypt and Jordan were crafted to make these immune to political crisis; and so far, this has applied to the global economic crisis as well. However, economic statistics shows that the Middle Eastern FIs remain, under the current circumstances, high on liquidity and reputed for their security. Thus, the global financial crisis has increased requests for merger approvals, particularly for failing FIs. Institutional investors suggest emerging markets in the ME, Asia-Pacific and Eastern Europe will be least affected by global financial crisis. Conversely, North America and Europe are felt to be most seriously impacted by global financial crisis (Jones Lang LaSalle (JLL), 2009). Towards the end of the 2009, the huge public and government spending programs around the world began to take effect, bringing the promise of renewed growth in the developed countries and recovery for the world economy growth.
6.0 Conclusions and Recommendations 6.1 Conclusions There is no systematic examination of how the GFS affected on economic growth and property market performance in the ME. The lack of a strong and robust effect of GFS on economic growth does not necessarily imply that theories that make this connection are wrong. The evidences and indicators that have been presented in this study suggest that GFS should be approached carefully in the ME, with good institutions and macroeconomic frameworks viewed as important. The review of the available evidence does not, however, provide a clear road map for the optimal rapidity and running of GFS. GFS helps countries to reduce macroeconomic volatility. The Middle Eastern economics may have little choice but to strengthen their financial system linkages eventually in order to improve their economic growth potential in the long run (CIA 2007; 2008). The problem is how to manage the short- run risks apparently associated with GFS. Hence, GFS without a proper set of preconditions might lead to few economic growth benefits and more output and consumption volatility in the short run. It is important to acknowledge that the scale of the current financial crisis is unprecedented. The implications have been much more thoughtful than any previously witnessed and are being felt all of the ME countries – a consequence of the increasingly GFS and open global financial markets. While the Middle Eastern financial systems are continuing to attract top investment projects, with billions of dollars, there are some concerns that the
26 global credit and financial crisis could see funding dry up, especially now that the big spending Gulf Countries (GC) are being hit by the global financial crisis (IMF, 2009). GFS increased the emerging financial systems and economic growth in the ME (Arabian Business, 2009). While the role of the GFS in the ME in promoting economic growth has been challenged in the past, it is now widely recognised. In addition, it is evident that a large competitive banking sector, liquid equity and debt markets, which operating according to market principles and intermediating savings (domestic and foreign) for market- based investment are strongly associated with higher economic growth rates, property market and PCs performance in the ME. GFS development, economic growth and property market and PCs performance are an efficient way of attracting local and foreign investors to invest in financial instruments in the ME. Hence, it is important to understand exactly how GFS in the ME and emerging property markets operate and the likelihood to attract more investors to invest in the ME. Due to the benefits that resulted from GFS, it has been widely accepted in the literature that GFS plays a vital role in improving resource allocation through the financial markets, thereby increasing safety of financial operations and also strengthening the local property markets. With the continued effect of the global financial crisis into 2009, seeing significantly reduced property investment activity globally, this has seen many major global investors retreat to their local markets seeking local investment opportunities in often distressed local environment. This will continue to play out over 2009-2010 effecting all property markets including these in the ME. Hence, as result of this situation, it is seeing significantly reduced economic growth particularly in property markets in the ME over 2009- 2010. 6.2 Contributions 1. Identifying the characteristics of GFS, economic growth and property market and PCs performance in the ME. 2. Contributing to a better understanding of the influence of GFS on economic growth; particularly property markets in the ME. 3. Providing a background of the emerging property markets in the ME and how it could continue to be important information for investors. 4. Examining the impact of the global financial crisis on the economic growth and emerging property market performance in the ME. 6.3 Recommendations
27 1. Global unemployment has rocketed and there has been a dramatic increase in the numbers of business liquidations, including a number of prominent long established brand names. This trend is set to continue throughout the developed economies over the course of 2009 unless critical action is taken by world leaders on a rescue package that will enable the international money markets to start functioning again – time is something many businesses do not have. 2. The ME countries need to enhance its understanding and promote wealth creation within the local economy. 3. Increased knowledge to developing new investment sector performance indices for PCs in the ME property market regarding emerging markets. 4. The ME governments are expected to exert pressure on nationalized or part nationalized banks to start lending to the property and construction industry in a bid to help kick start the economy and a consensus exists among the wider property development industry that any lending that is likely to be forth coming will be made available for regeneration or social housing provision. 5. Restoring confidence to the financial markets and stimulating economic activity in the ME will be central to the economic growth and property market recovery.
References Al-Karasneh., and Fatheldin, M. (2005). “Market structure and performance in the GCC banking sector evidence from Kuwait, Saudi Arabia and UAE”. Retrieved on 10/Jan/2009, http://www.wto.org. Arab Monetary Fund, 4, 391-414. Arab Monetary Fund (AMF). (2008). Articles and Publications. Retrieved on 15/ Feb/2009, http://www.wto.org. Arab Monetary Fund (AMF). (2007). Financial Reforms in Gulf countries (GCC) retrieved on 15/Feb/2009, http://www.wto.org. Arabian Business, (2009). Real estate statistic and issues. Brau, E., and McDonald, I. (2009). Successes of the International Monetary Fund: Untold stories of cooperation at work. Palgrave Macmillan, New York.
28 Claessens, S., Daniela K., and Sergio L. (2004). Stock market development and internationalization: Do economic fundamentals spur both similarly? CEPR Discussion Paper, 3301. CIA Fact Book. (2007; 2008). Statistics and various issues. Damascus Securities Exchange (DSE). (2009). Retrieved 15/March/2009 www.dse.gov.sy Dapaah, K., Wee, S., and Ebrahim, S. (2002). Real estate portfolio diversification by sources of return. Journal of Real Estate Portfolio Management, 8, (1), 1-4 El-Erian, M., and Manmohan, S. (1994). Emerging equity markets in Middle Eastern countries, IMF Working Paper, 94-103. EPRA news. (2007;2008) Gourinchas, P., and Jeanne, O. (2006).The Elusive Gains from International Financial Integration. The Review of Economic Studies Limited. 73 (3), 715-745. Hoesli, M., Lekander, J., and Witkiewicz, W. (2004). International evidence on real estate as a portfolio diversifier. Journal of Real Estate Research, 26(2), 165-206 International Monetary Fund (IMF). (2007). Articles and Publications. Retrieved 13/December/2009. International Monetary Fund (IMF). (2008). Articles and Publications. Retrieved 13/December/2009. International Monetary Fund (IMF). (2006). “Arab Republic of Syria”, IMF Article IV Consultation, 1-4. Jones Lang LaSalle. (2008). Global real estate transparency index. Macquaries Securities Group. (2009). Global property securities analytics; Monthly Report, Jan. Macquarie Research Equities (2009). Global property securities analytics; Monthly Report, July. Malkiel, B. (2003). The efficient market hypothesis and its critics. Journal of Economic Perspective, 17, 59-82 Marashdeh, H. (2007). Are the Stock Markets in the Middle East Region Efficient? International Review of Business Research Papers, 3 (5), 297-307 Real Estate Investment Magazine. (2009). Retrieved 10/Feb/2009, http://www.realinvestmentmag.com
29 Real Estate Investment Magazine. (2007). Retrieved 10/November/2008, http://www.realinvestmentmag.com Ross, P. (2002). Commercial bank management, 5th edition. The McGraw-Hill, Book Companies, New York. RREEF. (2007). Global real estate securities Saunders, A., and Millon, M. (2004). Financial markets and institutions, 2nd edition. McGraw-Hill. Sherman, H., and Rowley, D. (2006). To invest or not to invest: that is the question. Journal of the International Academy for Case Studies, 12 (6), 59-75 Spillman, S. (2006). Real Estate Financing and Investing, ULI Workshops. Group LLC. Syrian Securities and Exchange Commission (SSEC). (2008). Retrieved 4/Sept/2008, http://www.scfms.sy, Damascus-Syria World Bank. (2007; 2008). Various issues. World Economic Forum. (2007). The Global Competitiveness Report.
30 THE GLOBAL FINANCIAL CRISIS AND NATIONAL FINANCIAL SYSTEMS
SURVIVAL: ISSUES, DILEMMA AND SOLUTIONS.
By
Obademi Olalekan Emmanuel
Department of Financial Studies,
Redeemer’s University,
Km 46, Lagos/Ibadan Expressway, PMB 3005, Redemption Camp
Ogun State, Nigeria.
Tel: +2348036285605, +2348083777571.
Email: [email protected] or [email protected]
Abstract
This paper focuses on global financial crisis and its implications on the economy of nations.
The questions asked to which answers were given among others include: Is the globalization of finance profitable against the backdrop of the failure of banking institutions in the United
States of America that has snowballed into a global financial crisis. If yes, does the benefits derivable from the globalization of finance actually outweigh the adverse consequences as is being witnessed now. How reasonable is the proposition for an unregulated economy in the
31 light of market failures being seen as synonymous with the failure of capitalism. Efforts were made to propose solutions to reducing the effects of global financial crisis by developing countries and Nigeria in particular with a suggestion of the need to restructure the existing international financial architecture among many others.
1.0 Introduction]
Against the background of the recent and current global financial crisis traceable to corporate irresponsibility on the part of some financial sector players in developed countries especially
United States of America in the housing and credit markets, many economists and non- economists are raising their voices against the globalization of finance evident as the integration of the financial systems of many countries of the world.
Briefly defined, financial crisis describes various negative changes in the financial system evident as sudden loss of value of assets, banking sector panics, credit crunch, sovereign defaults and stock market crashes among others.
Looking at the cause of the crisis more insightfully the bursting of the United States of
America housing bubble and high default rate on sub-prime mortgage lending i.e. the giving of loans to individuals at interest rate below the prime lending rate with the expectation that
32 the properties purchased will appreciate in value and will yield returns that can ensure
repayment and adjustable rate mortgages are things to point at. The rise in the interest rate
payable and the fall in the price of houses made envisaged refinancing of loans difficult by
borrowers. In addition there were high risk lender practices being a fall-out of ineffective
regulation of the banking sector which is almost translating to a contagion i.e. the spread of
crisis from one institution to the other or one country to another from the understanding of a
systemic risk.
On the whole however, there have been many views on the causes of the financial crisis and
these can be summarized under the following;
a. The inability of home owners to make mortgage payments.
b. Poor sense of judgement by borrowers and lenders.
c. Speculation and overbidding during borrowing period.
d. Risky mortgage products
e. High personal and corporate debt
f. Complex financial innovation that concealed default risk
g. Lack of proper government regulation
The issue now is that with the integration of financial systems and the already spill-over
effects of the crisis how should national financial systems respond? Another question is
whether the globalization of finance’s benefits outweighs the adverse effects.
The growth of trade, deliberate removal of barriers and the advancement of technology have led to the integration of the financial systems of nations with each other. This however has both beneficial and adverse consequences depending on what factors are on display at any point in time not minding the present financial crisis in the world.
33
As a result of the globalization of finance, people in different countries have the opportunity of owning financial assets denominated in foreign currencies at home and abroad.
Consequently, developing countries that are often characterized by low total bank deposits and sometimes unorganized stock exchanges can with the embrace of the globalization of finance expand their access to capital and develop their financial systems.
Essentially dismantling barriers to international capital flow according to literature is thought to improve the welfare of capital deficient nations and by extension increase international trade which will ultimately lead to the growth of the economy and enhance poverty reduction.
The proposition is that opening the capital account will tend to equalize rates of return leading to more investment and higher growth for developing countries.
Judging from the fact that the financial system of some developing countries does not even match up in value to the size of an average bank in some developed nations, the following characteristic features are noticeable in such countries:
a. High financial intermediation cost
b. Limited scope of risk diversification.
c. Limited liquidity in capital markets
d. Limited access to financial services and risk management products
It has been adduced that the globalization of finance can reduce these shortcomings
despite the fact that it also brings new risks that need to be managed.
34 Globalization which is promoted by the growth of technology, migration, trade, tourism, currency convertibility and capital account liberalization makes the mobility of capital higher than it has ever been in the history of mankind. Individuals and firms who own idle funds do benefit from the globalization of finance largely through the possibility of reduced risk and improved returns synonymous with global diversification.
In clear terms, the benefits or advantages of the globalization of finance include;
a. The ability to earn greater returns on assets by the owners of funds.
b. The possibility of accessing funds at lower cost by the people in the receiving nations
which many times are developing countries.
c. It helps in smoothening variations in consumption as small countries are more prone
to weather shocks and natural disasters etc.
Major evidences of the globalization of finance include the increased volume of offshore deposits by individuals and non-bank institutions of developing countries. In addition, portfolio flows to developing countries have grown since the 1980s although they did experience some ups and downs during the 1990s. Another indicator of financial globalization was the widespread use and growth of foreign currency deposits during the
1990s. Also the use of industrial countries currencies is on the increase in many developing countries.
However, it is instructive to say that the effects of the globalization of finance is not absolutely positive as it has been found also to have negative implications on the economy of
35 nations especially as it concerns their financial systems. It is worth mentioning that the globalization of finance also brings about the following;
a. Complication of the financial sector policy formulation and implementation.
b. Volatility of the financial system operations.
c. Loss of policy making independence.
Scholars in favour and those opposed to the present globalization of finance have based their arguments on diverse economic views. Those opposed to it have been clamouring for a return to the pre-globalized Breton Woods era which those in favour of financial system globalization believe is an economic model proposition that will not do developing countries any good. It is then reasonable to take a second look at the position of these opposing views for one to be able to take an objective stand.
2.0 A Review of Literature on Financial Globalization and Economic Development.
In the light of the challenges posed by the globalization of finance contrary to the seemingly over-emphasized benefits as some have claimed, what middle point should the argument for financial globalization take?
There is no doubt that the leap in technological advancement has promoted globalization on all fronts with its attendant benefits. Adekanye (1990) posited that the money market has become relatively developed due to swift flow of information.
Dahlman and Mody (1992) speaking in the same vein posited that the growth of information technology has led to the minimization of cost of production as a result of reduced processing and delivery time, lower transaction cost, lower inventory cost and less material waste.
36 Sunkel et al (1995) in their report agreed that the present world scenario is such that we have
a more integrated economic transaction and by implication the promotion of international
trade. The question then is whether it is all smooth stories looking back at the issue of capital account liberalization within the scope of the globalization of finance.
Kraay and Rodrik (1998) in their study found that there is little empirical link between capital account liberalization, growth and investment rates.
Eichengreen (2001) in support of the position of Kraay and Rodrik asserts that the inability to establish a link between capital account liberalization and growth might not be unconnected with difficulty in measuring the liberalization of capital account. A related
explanation is that capital account liberalization is not totally associated with increased
capital inflow as it could result in increased capital outflow as well especially when the
domestic policy environment is unfavorable.
Another angle to it is that risk adjusted rates of return in many developing countries may not
be attractive enough to engender sufficient capital inflow. In instances where there are
inflows, the liberalization of capital account may be offset by outflows. However, proponents and supporters of the globalization of finance believe that the benefits inherent in the smoothening of variations in consumption distortions in small economies are significant.
This proposition was supported by Bosone, Honoban and Long (2002) who posited that small countries often have higher export demand variability. Hence the volatility of small
countries commodity terms of trade and their private consumption as well as the unenviable
Gross Domestic Product gives some basis for supporting the globalization of finance.
37 According to Reynolds (1965) foreigners holding equity and risk-sharing assets often absorb part of national volatility. Also local residents holding foreign assets provide diversification against their own country expressing a supply decline or a fall in export prices. Capital liberalization also increases the volatility of Gross Domestic Product (GDP) as inflows of capital can without notice turn into outflows as it did in Russia and East Asia which resulted in exchange rate crisis.
In addition, foreign inventory assets and liabilities provide investors with some protection against inflation, instability and repression of interest rates. On the part of government though, this is often a dangerous bait because if it is not properly contracted, lower cost of a foreign currency loan often translate in the immediate to lower budget deficit as a percentage of GDP. However if the currency of the borrowing country is devalued while the loan is on, it becomes a serious problem.
Looking at it from the net addition to the economy, the relative better access of domestic banks to foreign investors’ capital helps in building a strong financial system where lower production costs and lower cost of risk absorption is the case. This is consistent with the understanding of benefits related to economies of scale. The arrival of foreign banks in other countries also often stir up healthy competition that puts domestic banks on their toes.
Foreign banks being more efficient than local ones help stimulate better service delivery.
Despite the aforementioned benefits, there are still inherent risks in the globalization of finance. For example in the event of the devaluation of a country’s domestic currency, foreign currency liabilities or debts may cause a borrower to go bankrupt. The way to go
38 round this risk is for financial institutions to hedge foreign exchange risk by matching their
foreign exchange deposits with foreign currency loans.
Another issue is that citizens employed in local financial institutions may lose their jobs as a
result of the competition induced by the globalization of finance. This position was supported
by the argument that foreign banks that are new entrants often price their products especially
loans below that of domestic operators in order to attract and gain business. They are often wiling to accept smaller margins than the domestic competitors and over time may push domestic operators out of the market. There is also the assumed impression that foreign banks are more stable than local ones and the tendency is for depositors to move funds to the foreign banks in what has been termed a flight to quality as experienced during the Asian crisis and the Tequila crisis in Argentina.
In another sense it is not likely that small borrowers will benefit from the influx of foreign banks. What is not known is whether foreign owners of funds will be willing to make funds available to small users especially in the informal sector where the greater population of businessmen in developing countries fall. Berger et al (2000) in their study found that small businesses are more unlikely to get credit from foreign banks than the larger ones.
3.0 The Global financial crisis, the Nigerian financial system and the economy.
There is no gainsaying that the global financial crisis is affecting different nations of the world including Nigeria though in different magnitudes. Worse hit are the different national financial systems that are in themselves the transmission mechanism of the crisis to other sectors of the economy by virtue of their intermediation roles. This is in agreement with Alan
39 Greenspan (1997) assertion that the interdependence between markets and market participants within and across national boundaries will be transmitted far more rapidly through out the world economy. Earlier pointers to the fact that a crisis in one part of the world will reverberate strongly to others was seen in the turmoil in the European exchange rate mechanism in 1992, the plunge in the exchange value of the Mexican peso at the end of
1994 and early 1995 and the sharp exchange rate adjustments in Asian economies.
In an attempt to downplay the effects of the crisis on the Nigerian economy and so as not to cause any panic in the nation, the managers of the Nigerian economy gave the impression that the country was insulated from the crisis. Nothing could be more untrue even in the light of the crash in the prices of stocks in the capital market, the fall in the revenue accruing to the country from crude oil, reduction in lending to the real sector.
Also against the background of the similarities that have been drawn between the margin lending to finance the purchase of stocks in the Nigerian Stock Exchange by people who do not have sufficient income to service the loans with the weird United States and United
Kingdom mortgage lending it is evident that the Nigerian economy cannot be totally insulated from the effects of the crisis. It is equally instructive to note that many Nigerian banks are involved in joint financing of projects with foreign banks and any crisis rocking such partners will also affect the Nigerian bank in question. Moreover some of our banks have offshore credit lines that have already been withdrawn as a result of the effect of the crisis in those foreign nations where the funds originated.
40 Another angle to it is that Nigeria uses a lot of foreign donor partner funds to finance development projects and it is obvious that the quantum or value of such funds will fall in response to the global credit crunch. In summary effects of the crisis on Nigeria as is being witnessed now includes;
a. The collapse of commodity prices
b. Revenue contraction
c. Stock market crashes
d. Declining capital inflow
e. Decrease in foreign reserves and pressure on the exchange rate
f. Reduced foreign trade finances for banks
g. Foreign partner divestment from the capital market.
It is gladdening however to know that in the wake of the global financial crisis, proactive measures were taken by the government to mitigate its impact, such measures includes;
a. a review of the cash reserve from 4% to 2%.
b. Reduction of liquidity ratio from 40% to 30%
c. Reduction in the monetary policy rate from 10.25% to 9.75% and which have gone
further down
d. Rescheduling of existing bank facilities granted for the purpose of buying shares into
long tenure
e. The suspension of the recapitalization of capital market operations
f. The suspension of the common accounting year-end policy for banks.
41 The aforementioned measures are good but they have not sufficiently positioned the banking industry well. For example the industry liquidity decreased from 52.95% in September 2008 to 49.22% in October 2008 and as at now has fallen beyond the October figure. On the part of the capital market operations, there has been a significant decline of all indices of measuring capital market performance
STATISTICAL SUMMARY OF MARKET PERFORMANCE IN 2008
2008 2007 % Change
Market Capitalization N9.56 trillion N13.295trilliion (28.1)
The NSE All-Share Index 31,450.78 57,990.22 (45.8)
Total Turnover Volume 193.14bn shares 138.1bn shares 39.85
Total Turnover Value N2.4 trillion N2.1trillion 14.3
Average Daily Volume 775.65 million units 570.6 million units 35.94
Average Daily Turnover N9.55 billion N8.62 billion 10.8
New Issues Approved N2.2 trillion N2.4 trillion (8.3)
Number of listed Companies 213 212 0.5
Number of listed Securities 301 309 (2.6)
Number of trading days 249 242 2.9
Source: SEC Quarterly March 2009
The insurance industry has not fared any better, if anything at all, it has been worse hit as there has been a continuous decline in premium earnings since global financial crisis started taking its toll on the financial system.
4.0 National Financial Systems Survival; Nigeria in Focus
42 Against the backdrop of the threats national financial systems are prone to and specifically
Nigeria, what survival strategies should be put in place to prevent the adverse effects of the globalization of finance and also to maximize the benefits of financial globalization knowing too well that there is no way the globalization trend can be stopped. Then since no nation can successfully isolate itself from the already existing and on-going globalization of finance, the risk associated with capital account liberalization can be reduced by putting in place strong and workable financial regulations and supervision.
The crisis witnessed in East Asia in the 1990s and the one being witnessed in America has been linked to the weakness of financial regulations and supervision which Nigeria must learn from so as not to make a similar mistake even now that banks capital base have been increased reasonably.
Also the appropriate capitalization of different operators in the financial system i.e. insurance firms, capital market operators, banks, and other non-bank financial institutions must be pursued as necessary so that we can have a strong financial system that can withstand periodic shocks. Though the Nigerian financial system is not yet strongly integrated into the global financial system and this has saved us from the strong impact of the present crisis in a way due to the fact that the use of credit cards is still at its lowest ebb, it is obvious that in no distant future, the use of credit cards will become increasingly popular.
One other thing that has saved Nigeria to some extent in this period of global financial crisis is the conservative approach of Nigerian banks to lending which has helped in reducing the size of non-performing loans from 25% in 2001 to about 8.5% in 2007 according to the
Central Bank of Nigeria.
43
It must equally be borne on mind that the stability of the financial system is dependent on a sound public policy backed by adequate disclosure of timely and accurate economic and financial data. This will be of benefit to investors while policy makers also will be enabled to assess the extent of potential emerging threats to the financial system. As well, there is the need for the enhancement of financial institution’s internal risk management system and extra vigilance. This becomes imperative as the financial system operations increase in size because envisaged risks could mean that any procedural or policy misalignment could result into the financial system being severely punished.
5.0 Conclusion and Recommendations
In the light of all the issues discussed above, there are people canvassing for the national approach to finance evident as the adoption of national currencies and previous preferences of nations to rely largely on internal or domestic funds to drive their economies as a way to forestall the negative effects of the globalization of finance. It is instructive to say that this protectionist approach to national financial system management will not be beneficial to the economy in question in the long-run.
Though contrary to the view of some early supporters of the globalization of finance like
Alan Greenspan who in 1997 expressed the view that the existence of environment of inflationary expectations being built into both business planning and financial contracts will ultimately give way to an environment of lower inflation in future have not materialized,
44 what ought to be done by nations of the world is adjustments of public and economic policies to counter the effects of evident or emerging crisis.
In conclusion, if funds from other countries will benefit Nigeria as well as other national economies, it is germane for the following to be ensured;
a. Effective regulation and supervision of active players in the financial system to avoid
fraud.
b. Ensure good information flow especially to users of funds.
c. Transparency, market integrity and deliberate check on corruption.
d. Prudent investment by banks and pension funds.
e. Proper legal frameworks to check and punish the abuse of procedures.
f. Developed infrastructure to support the financial system such as power and effective
communication system.
g. The economy has to be diversified to be less import dependent.
h. The capital base of banks may have to be increased further.
g. Only reputable foreign financial institutions should be allowed entry into the domestic
economy.
On the whole, if developing countries are to benefit maximally from the globalization of
finance, there is the need for a restructuring of international financial architecture of
world financial institutions and their personnel structure.
45 References
1. Adekanye, F.A (1990) “Innovations, Technology and the Nigerian Finance Sector” Paper and Proceedings of the Director’s Seminar, Financial Institutions Training Centre, Lagos.
2. Alan Greenspan (1997) “The Globalization of Finance” Keynote address at Cato Institute
15th Annual Monetary Conference” www. Goggle.com Checked on 15th June 2009.
3. Berger, A. N et al (2000) “ The Ability of Banks to Lend to Informationally Opaque Small
Business” FRB Chicago Working Paper Series.
4. Bossone B, Honohan P, Long M (2002) “Policy for Small Financial Systems” Financial
Sector Policy For Developing Countries” Oxford University Press.
5. Dahlman, C and A.Mody (1992) “ Performance and Potential of Information Technology
An International Perspective” World Development 20 (12)
6. Eichengreen, B (2001) Capital Account Liberalization, What Do Cross Country Studies
Tell Us? World Bank Economic Review 15(3)341-64
7. Kraay, A (1998) “In Search of Macroeconomic Effects of Capital Account Liberalization”
World Bank Development Economic Research Group, Washington D.C
8. Reynolds, C. (1965) “ Development Problems of an Export Economy: The Case of Chile and Copper” Homewood Ill. Irwin.
9. Rodrik, D (1998) Who Needs Capital Account Convertibility? Essay in International
Finance. Princeton, N.J
10. Sunkel, Scholte and Carlsson (1995) “ World Business Council For Sustainable
Development for the United Nation’s Global Compact” 5(9)
46 Cross-sectional Tests with Time Varying Market Betas and Macroeconomic Sensitivities : Case Finland
Virk, Nader Shahzad* June 21, 2009
Abstract
This study investigates macro multifactor model with time varying factor sensitivities for 25 Finnish sector indices from 1988:04 to 2008:07. Static and dynamic factor sensitivities are projected with OLS and GMM estimation methods respectively with Fama and Macbeth (1973) rolling regressions. CAPM as the singular source of risk responsible for cross sectional spread in asset returns is rejected with formal testing procedures. The R2 for macro model explains the most amongst all horse race cross sectional regressions. Importantly, the specification tests for macro model couldn’t reject the null with both OLS and GMM betas at 5% level in full sample and also for sample before the introduction of euro with OLS betas. The results inferred with OLS and GMM factors sensitivities are largely consistent besides macro model rejecting the null with unconditional betas more often than conditional factor betas.
Keywords: macro multifactor model, time varying factor sensitivities ,OLS, GMM, Fama and MacBeth (1973) method ,rolling regressions, CAPM, R2 and conditional model .
JEL Classifications: G12, E44.
*HANKEN School of Economics, Department of Finance and Statistics, P.O. Box 479, 00101 Helsinki, Finland. Email: [email protected] The author would like to thank Johan Knif, Saint Kuttu, Hilal Butt and Ihsan Badshah for useful discussions and suggestions. Mika Vaihekoski is also acknowledged for his constructive comments onto the development of the paper while presenting the paper at Graduate School of Finance Summer Research workshop Finland (May, 2009).
1 Introduction
Post Fama and French (1992) unconditional tests for Capital Asset Pricing model (CAPM) are regarded insufficient to explain cross sectional variations in stock returns. Their results compelled the asset pricing literature with the evidence that the unconditional CAPM is unable to explain returns generated on certain characteristics of asset returns. It propelled alternative theories and testing procedures departing from the original model along several dimensions. Promising avenues of research preserving the single factor structure have been conditional variants of the CAPM (Harvey (1989), Ferson and Harvey (1991), Jagannathan and Wang (1996), Lettau and Ludvigson (2001), Ang and Chen (2006)).
47 Lewellen and Nagel (2006) questions the success of different specifications of conditional models. They argue that the increased explanation from these models is actually concomitant to their cross sectional design and for ignoring key theoretical assumptions regarding the slope coefficients. In contemplation otherwise, after the work of Ross (1976) there is no paucity for additional risks that could explain return structure in the literature such as, market equity or size (ME) and Book to Market ratio (B/M) by Fama and French (1993), momentum factor by Jegadeesh and Titman (1993), liquidity risk factor by Pastor and Stambaugh (2003) etc. The empirical results of these studies also demonstrate the substantial success of multifactor models than the single factor conditional versions of CAPM. Another import strand of literature is macroeconomic explanation for returns reding certain changes or future expectations for macroeconomic variables and interest rate variables shifting the demand curve for the stocks7. Chen, Roll and Ross (1986) broached such explanations for stock returns to test if economic state variables are systematic influences in consistence with financial theory. The macro variables in the Chen et al. (1986) study were selected apriori and significant impact of certain factors on stock returns was reported. The topic is interesting for the fact that a number of studies related stock markets with macro variables and studies (Kaneko and Lee (1995), Lee (1992), Fama (1981)) determined a positive relation between stock returns and real economic activity. Similarly, Jones and Kaul (1996) obtained significant impact of crude oil price and exchange rate on the share prices for the Japanese market. Bessler and Opfer (2004) studied the impact of macro variables on German sector indices allowing for the parameter time variation with Fama and MacBeth (1976),FM, method and reported greater impact of macro variables on banking sector than other industries. The asset pricing literature on Finnish market is quite rich in content. The CAPM testing with time varying betas and in conditional settings are numerous such as Berglund (1986), Malkamäki (1993), Berglund and Knif (1999). Vaihekoski (2000,) provided unconditional tests of single and multifactor models in international settings using Finnish size and industry portfolios. Vaihekoski (2007) found the pricing of market wide liquidity risk. The studies from Nummelin and Vaihekoski (2002) and Antell and Vaihekoski (2007) tested international asset pricing models and noted pricing of global risk and currency risks respectively without driving local risks redundant for Finnish stock returns. The former study was carried from Finnish investors perspective and latter from US investors standpoint. These finding provided sufficient impetus for Finnish market global integration from segmented market which as late as in 1993 abolished all restrictions on foreign ownership. These studies also tested the impact of macro factors such as inflation risk, currency risk etc. but used in more as control variables than driven to explain the cross sectional variation in Finnish stock market as the testing hypothesis. Junttila, Larkomaa and Perttunen (1997) provide a detailed survey on the studies on Finnish stock market with macroeconomic perspective. Their survey noted that the studies were carried in prior periods for aggregated market index as dependant variable and estimation technique generally been factor analysis to get the independent factors of macro variables in APT framework. Limiting the scope of studies for economy wide inference and concealing vivid macro variables impact as state variables affecting the investors preferences. In order to contribute Finnish asset pricing literature this study test a macro discount factor (MDF) model for monthly returns of 25 sector indices for a period from 1988:04 to 2008:07, with formal specification tests. This approach allows to infer at broader level than previous studies with macro variables in Finnish asset pricing literature . The discount factor methodology
7 Theory suggests that information regarding the expansion of an economy/business/firm (continuation or discontinuation) will shift the demand curve for the stocks ( right or left). In a similar fashion there are certain movements for demand curve for shares of the firms or stock market as a whole also for other macro and interest rate variables.
48 is narrated for simplicity of method as noted in Cochrane (2004) that all factor models are extensions of consumption based models with different definitions for pricing kernel under additional assumptions. This study employs variables used in Chen et al (1986) such that macro variables describe the investment set that governs and predicts the next period cross sectional changes in asset returns. For that reason different cross sectional specifications for market factor are compared in a horse race with proposed MDF model. In order to estimate these cross sectional tests time varying betas are estimated with FM methodology with 60 month rolling window. Since such studies are abundant for developed markets like US and other integrated stock markets but such analysis at the scale and content carried down in this paper is missing in Finnish literature. Finnish stock market provide an interesting laboratory test for such asset pricing tests because of its relative small size than major developed markets and for huge transformations experienced by Finnish economy over studied the period of time . Overall these idiosyncratic characteristics provide additional meaning to asset pricing tests in the context of prolific developed emerging market and relative comparison to extant developed asset pricing literature. Finnish market is more bank based than market based same as Germany than US market where prices are determined in market oriented dynamics. Therefore, the probable results are anticipated to be more aligned to German literature than US studies because of market structure relevance. This expectation for Finnish economy are results from Germany where reportedly macro factor conditioned cross sectional settings explains better than the Fama and French size and value premium factors (Schrimpf, Schröder and Stehle (2007)). But these results are not in accordance with the US results where Fama and French (1993) reports fallibility of macro variables while accounting for size and BM factor mimicking portfolios. In an similar manner, Jagannathan and Wang (1996) also reject the Chen et al (1986) macro explanation accounted with conditional CAPM framework. Because of copious literature on CAPM in natural gambit unconditional and macro scaled CAPM are also tested. For testing mispricing is jointly zero Gibbons, Ross and Shanken (1989) GRS F-test is calibrated, an inferential method, not done at such an larger scale and intent. Vaihekoski (2000) did estimated this specification test while testing for six size ranked portfolios and seven industry portfolios but under international model settings and different set of variables for variation in excess returns. In order to draw empirical inferences this study rested upon cross sectional R2 (usually a standard) of tested models and additionally formal specification tests to examine if tested models generate the sampling errors to press mispricing to zero as hypothesized by null. For comparative analysis performance of market factor and horse race models estimations over changing economic horizons, for example, severe recession in early 90’s in Finland , European integration, change in monetary policies and currency changeover etc., highlights the need to study the data along different samples. Therefore, all models are also estimated in two further sub samples of before and after introduction of euro8, that is, 1988:04 to 1998:12 and 1999:01 to 2008:07 referred as specification B and C respectively where as full sample period estimations will be referred as specification A . The results are in line with enormous CAPM literature testifying the empirical bareness of CAPM model and scaled conditional version doing no further improvement. This study notes that the explanatory power of market index is considerably reduced when accounted for macro variables. The MDF model in terms of 9R2 out performed all other cross sectional specifications with an average explanation of 56% for all samples against meager R2 ranging from 0.08 to 0.16
8 The euro was launched on 1 January 1999 and this reference date is also mentioned on the European Central Bank though the currency notes and coins were circulated by 1 January 2002. 9 The R2 for 2nd pass cross sectional regressions with FM method are averages of M temporal regressions.
49 and 0.02 to 0.20 for other tested models in the study with time varying betas and constant betas respectively. Importantly , the MDF model estimated with OLS time varying sensitivities suppress the mispricing to zero for full sample and sample after the introduction of euro at conventional 5% confidence interval. The MDF model could also not be rejected for full sample with GMM estimated factor sensitivities in specification A. The rest of the paper is organized as follows. Next section details the method part and section three covers the data . The penultimate section explains the estimations for the studied models and section five concludes the article.
2 Models and Methodologies
2.1 Conditional SDF Models
Conditional asset pricing models can be derived from the first order condition for an investor holding risky asset , under the absence of arbitrage , as given by the asset pricing theory,
Et−1 [M t Ri,t | Ωt−1 ]= 1 (1)
where, Ri,t is the nominal return to the asset ‘i’ and M t is stochastic discount factor (sdf) that prices all risky pay offs such that law of one price holds for all assets in the economy and all
states of the world and Et−1[]| Ωt−1 represents the expectation taken conditional on the investor’s
information set[]Ωt−1 at time t-1. Assuming a linear functional form for the sdf
M t = at−1 + bt−1Rm,t , (2) prices the assets that law of one price holds for all assets in the economy and in all states of the world and with the existence of risk free rate in the economy we can reach the beta pricing equation of CAPM theory. This implication is the result of the underlying assumption of complete markets such that sdf is unique and same for all agents pricing the assets at equilibrium
and Rm,t is the proxy used for the return to wealth portfolio and at-1 and bt-1 are time varying free parameters. Substituting the sdf factor representation in (2) the expected return beta representation of CAPM (3) is obtained with disclosure price of market risk depending on the volatility of discount factor such that,
e e Et−1 (Ri,t ) = μi,t−1 + β t−1Rm,t + ε i,t (3)
50 In order to test the conditional validation of market model GMM10 method is employed with the specified over identified moments. The cornerstone of GMM (conditional) estimation is a set of population moment conditions which are deduced from the assumptions of the econometric model. In order to test the conditional model the instruments are selected from set of macro variables namely term structure spread, unemployment rate, exchange rate and inflation changes
and appropriate market index lags. Let zt−1 be a vector of these potential predictors observable 11 at time t selected on the basis of Hansen’s JT statistics. The residuals gT (θ ) should be uncorrelated with the components of zt−1 .The GMM matrix to minimize the errors is such that,
gT (θ ) = f (vt ,θ ) ⊗ zt−1 = 0 , i=1,2,…,25 (4) The GMM estimator based on population moment conditions is the value of θ that minimizes,
T T ⎧ −1 ' ⎫ ⎧ −1 ⎫ QT (θ ) = ⎨T ∑ gT (θ ) ⎬W ⎨T ∑ gT (θ )⎬ ⎩ t=1 ⎭ ⎩ t=1 ⎭ (5) where W12 is a non-negative definite matrix that usually depends on the data but converges to a constant positive definite matrix as T → ∞ estimated with Hansen’s (1982) two step GMM method.
2.2 Macro Stochastic Discount Factor Model
If single factor model fails, then as per the expectation of this study a K factor macro model will suffice. The employed factors if are not a portfolios of traded assets , the time series tests
can not be applied because in such instances the null hypothesis doesn’t imply that μi in the time series regressions is zero. The described model in (6) is the multi factor extension to linear factor model implied in (3) by the sdf time varying factor sensitivities. Assuming sdf of the form * * M t = At−1 + Bt−1Ft , where Ft is K ×1 vector of employed factors and Bt are the factor sensitivities of K factors to sdf such that
K * Et−1 (Ri,t ) = μi + ∑ Bt−1Ft i=1 (6).
10 OLS framework require independent and identically distributed (IID) normal return assets and homogeneity of residuals whereas, GMM performs the estimation with asymptotic theory of the long run convergence of parameters and doesn’t restrict for distributional assumptions for the test assets and residuals.OLS is only a special case of GMM such that if e ’ zt instrument vector is (1 R m,t) . GMM estimation provide us with the same parameter estimates as of OLS under the given instruments . In fact, pretty much any asymptotic test one may want to consider can be estimated within the GMM framework. 2 11 in distribution. Note that χ q− p converges to a E[ f (vt ,θ ) ⊗ zt ] = 0 which, under H0: J T = T × QT (θ ) the asymptotic properties of the moment condition are used in deriving the χ2 limit. 12 In this paper we employed the Newey and West (1987) method for estimation of spectral density matrix. The spectral density matrix is constructed with heteroskedasticity and autocorrelation consistent (HAC) standard errors with Bartlett kernel and Newey and West’s optimal lag-selection algorithm routine (manually specified in STATA 9) to account for autocorrelation in the model’s estimated standard errors for detailed review of these concepts refer to Newey and West (1987(a) & (b)) and Alastair R. Hall (2006).
51 * Multi factor model in (6) is driven for the explanation of the stock returns where, Bt = ( βi,m
βi,∆TS βi,∆DXR βi,∆CCI βi,∆EIR βi,UI βi,∆LGB ) and Ft=( Rm,t ∆TSt ∆DXRt ∆CCIt ∆LGB1 ∆EIR1 UI1). In order to model equation (6) is regressed for a rolling window of 60 months to project time varying macro betas to account time variation in employed factor sensitivities such that, e e Ri,t = μi +βi,mRm,t +βi,ΔTSΔTSt +βi,ΔDXRΔDXRt +βi,ΔCCIΔCCIt +βi,ΔLGBΔLGBt +βi,ΔEIRΔEIRt +βi,UIUIt +εi,t ,i=1,2,…,25
(7) e The instrument vector zt−1 = (1 Rm,t−1 TSt-1 UEt-1 ∆TSt ∆DXRt ∆CCIt ∆LGBt ∆EIRt ∆UIt)’ is e employed with excess information from variables TSt−1 , UEt−1 and Rm,t−1 ensuant to reported correlation of these variables with market factor for estimation of conditional sensitivities. Empirical evidence on the time series predictability of excess stock returns over business cycle horizons suggests that factor risk premia are time varying. A conditional specification of the multi factor sdf with time varying parameters conveniently explains the cross sectional spread of asset returns accounting for time variation in factor premia. The conditional time varying factor sensitivities with the rolling window from 1st stage FM method regressions with GMM method are estimated and in the 2nd stage M temporal cross sectional regressions are ran to get the factor prices of macro and market risks such that ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ e Ri,t =λ0,t +λm,t βm,t−1+λΔTS,t βΔTS,t−1+λΔDXR,t βΔDXR,t−1+λΔCCI,t βΔCCI,t−1+λΔLGB,t βΔLGB,t−1+λΔEIR,t βΔEIR,t−1+λUI,t βUI,t−1+αi,t
(8). Inferences from the M cross sectional estimations is mainly cornered to the joint test of zero residuals and for the prices of factor risk significant t-values are calculated from the sampling distribution of M number of prices of factors, as laid down by the FM (1973).In addition to conditional models, the unconditional time varying sensitivities with no additional information or instrument are estimated with least squares method.
3 DATA
The total return end of period monthly sector indices are retrieved from DATASTREAM for a period from 1988:04 till 2008:0713. The choice of starting period for data is because of the fact that DataStream indices generally goes back in time as far as March, 1988 (the longest available time period common to all sector indices ).The data length is reasonable for long run analysis and comprises 244 monthly observations. The DATASTREAM total return indices are adjusted for dividends, splits and other forms of cash payouts and show a theoretical growth in the stock over a specified period. The log percentage returns are thence estimated for the retrieved data for further testing and inference.
13 Only for sectors insurance, paper and industries metals & mines the starting date is different from remaining sectors in the sample ,that is, starting from 1989:07, 1989:10, and 1989:11 respectively.
52 The summary statistics for excess14 monthly returns for respective indices along with the sub samples are provided in Table1. The values for means and standard deviations for all sample returns are annualized. Negative average realized returns especially in
14 In this study one month inter bank offer rate is proxy for risk free rate where the risk free rate series is completed with HELIBOR for period before 1999:01 and for later period series is complemented with monthly EURIBOR offer rate. All indices (sector and market) are percentage returns less the risk free rate or excess returns.
53 Table 1 Summary Statistics for Market and Sector Indices The summary statistics are for the industry portfolios studied in the paper. The sectors household goods and home constructions, waste and disposable services, industrial goods and services, technology hardware and equipment and software and computer service are abbreviated with HHG&HC, W&D Services, Industrial G&S, Technology H&E and S&C Services respectively. Table reports monthly percentage log returns for the portfolios along with minimum, maximum and standard deviation values for the sample specifications denoted A, B and C for full sample, before the introduction of euro and after the introduction of euro respectively. The samples A, B and C consist of 244, 129 and 115 monthly observations respectively. The p-values are reported for Jarque-Bera test for normal distribution null and Ljung and Box (1978) test statistics’ p values are reported for the null that autocorrelation coefficients up to 12 lags are zero.
Market Non Food & Drug Broadline Consumer Forestry W&D Health General Index Banks Financials Insurance Financial Retailers Retailers Staples & Paper Paper HHG&HC Services Care Retailers A:1988:04 to 2008:07 Mean 5.67 2.16 2.38 3.49 6.63 2.89 0.93 2.53 -1.03 -5.64 4.31 7.62 2.24 0.93 Std. Dev. 29.57 34.40 33.31 38.70 29.97 26.38 25.27 26.08 31.81 35.91 31.54 31.67 22.65 25.27 Skewness -0.24 0.17 -0.02 0.03 -0.26 0.14 -0.19 0.38 -0.27 -0.18 0.51 0.72 -0.20 -0.19 Kurtosis 4.21 5.49 7.79 9.39 4.34 5.83 3.74 5.83 3.87 3.34 4.52 6.72 4.30 3.74 Normality (p-value) 0.00 0.00 0.00 0.00 0.00 0.00 0.03 0.00 0.00 0.30 0.00 0.00 0.00 0.03 Q(12) 0.00 0.00 0.00 0.07 0.00 0.36 0.39 0.16 0.32 0.23 0.00 0.69 0.07 0.39 B:1988:04 to 1998:12 Mean 7.52 -4.36 -3.02 -3.87 9.49 0.73 -0.35 3.31 -0.36 -3.61 6.93 6.70 -2.48 -0.35 Std. Dev. 27.78 42.60 41.18 48.24 27.56 26.69 25.21 26.09 34.03 39.53 34.57 36.22 24.62 25.21 Skewness -0.21 0.29 0.15 0.21 -0.24 0.83 -0.34 0.83 -0.15 0.00 0.69 0.80 -0.25 -0.34 Kurtosis 3.08 4.32 6.14 7.58 2.99 6.42 4.58 5.18 3.54 2.76 4.67 6.65 4.23 4.58 Normality (p-value) 0.61 0.00 0.00 0.00 0.55 0.00 0.00 0.00 0.36 0.87 0.00 0.00 0.01 0.00 Q(12) 0.00 0.01 0.03 0.15 0.00 0.77 0.12 0.49 0.17 0.09 0.00 0.56 0.00 0.12 C:1988:04 to 1998:12 Mean 4.91 10.09 9.18 11.90 4.77 6.28 2.53 0.94 -1.34 -7.19 1.57 9.38 6.57 2.52 Std. Dev. 31.69 21.82 21.36 26.18 32.70 26.18 25.32 26.16 29.17 32.06 27.77 25.77 20.35 25.32 Skewness -0.25 -0.19 -0.71 -0.57 -0.25 -0.69 -0.03 -0.11 -0.50 -0.55 0.04 0.40 0.02 -0.03 Kurtosis 4.78 2.79 3.60 3.93 4.86 5.25 2.83 6.49 4.31 4.21 3.31 3.69 3.76 2.83 Normality (p-value) 0.00 0.63 0.00 0.01 0.00 0.00 0.92 0.00 0.00 0.00 0.78 0.07 0.25 0.92 Q(12) 0.15 0.76 0.03 0.01 0.18 0.02 0.05 0.01 0.56 0.45 0.01 0.53 0.45 0.01
Normality (p-value) 0.00 0.19 1.00 0.00 0.28 0.06 0.15 0.00 0.68 0.56 0.36 0.57 Q(12) 0.14 0.00 0.19 0.40 0.01 0.00 0.01 0.04 0.95 0.13 0.00 0.11 C:1988:04 to 1998:12 Mean 1.02 -1.33 3.57 -3.65 11.11 9.52 8.60 19.72 15.56 3.68 -13.60 3.28 Std. Dev. 28.47 19.19 27.00 22.71 24.24 22.38 20.22 23.57 29.93 45.01 45.59 44.49 Skewness -0.07 -0.51 -0.57 -0.54 -0.30 -0.16 -0.49 -0.36 -0.67 -0.54 0.08 -0.51 Kurtosis 4.77 3.47 4.16 4.35 2.71 3.02 3.07 2.86 3.80 4.28 3.40 4.27 Normality (p-value) 0.00 0.05 0.00 0.00 0.34 0.78 0.09 0.28 0.00 0.00 0.65 0.00 Q(12) 0.15 0.76 0.03 0.01 0.18 0.02 0.01 0.56 0.45 0.01 0.45 0.01
Table 1 Summary Statistics for Market and Sector Indices (continued)
Consumer Basic General Industrial Industrial Industrial Industries Technology Media Services Materials Industrials Engineering Industrials G&S Machinery Metals and Mines H&E S&C Services Technology A:1988:04 to 2008:07 Mean 6.94 -0.56 0.74 -1.09 7.85 2.97 6.10 11.13 7.39 14.98 4.62 14.75 Std. Dev. 31.08 21.80 29.15 30.02 25.69 26.37 23.33 25.03 31.75 44.61 41.85 44.00 Skewness 0.36 -0.23 -0.21 -0.82 -0.22 -0.35 -0.32 -0.44 -0.39 -0.21 0.03 -0.20 Kurtosis 4.31 3.84 3.43 6.52 3.30 3.86 3.75 3.72 3.46 3.52 3.59 3.52 p-value 0.00 0.01 0.15 0.00 0.24 0.00 0.01 0.00 0.02 0.10 0.17 0.11 Q(12) 0.20 0.00 0.27 0.31 0.04 0.00 0.02 0.02 0.79 0.02 0.05 0.02 B:1988:04 to 1998:12 Mean 12.04 -0.05 -1.52 1.43 4.89 -2.83 3.79 3.55 -0.94 26.91 22.76 26.83 Std. Dev. 33.19 23.90 30.95 35.30 26.91 29.39 25.80 26.09 33.40 44.39 37.93 43.70 Skewness 0.57 -0.10 0.01 -0.86 -0.14 -0.35 -0.20 -0.45 -0.15 0.09 0.12 0.09 Kurtosis 3.87 3.76 3.01 5.88 3.63 3.76 3.74 4.16 3.28 2.58 3.57 2.57 questions for the validity of the tests carried down in this paper. Boudoukh, Richardson, and Smith (1993) found negative return states to be related to periods of high short-term interest rates and downward-sloping term structure. These indications were observed in recession experienced by Finland in early 1990’s a probable raison d'être for negative mean returns witnessed for certain sectors and in certain times. Mostly the sectors with negative excess returns are with domestic orientation for example, Banks, Insurance, Retailers etc. a fact also reported by Vaihekoski (2000). The p-values reported in Table 1 for Ljung Box test statistics for twelve lags though rejects the zero autocorrelation null for thirteen sector in specifications A whereas, in specification B and C twelve sectors reject the null at 5% percent critical values. In order to test the normality of test assets the p-values for Jarque- Bera test rejects the normality null for eleven out of 25 sector indices in full sample and samples B and C corresponding number is thirteen. Table 2 reports the set of basic macro variables and derived variables. The two way relationship between stock market and macroeconomy is well documented. Chen et al (1986) described “no satisfactory theory would argue that relationship between financial markets and macroeconomy is entirely in one direction”. The general equilibrium theory describes the adjustment of financial market demand curve (left or right) with the available new information regarding the future profits, economic expansion or interest rates etc. Besides, all economic variables are endogenous and none is precipitating, therefore, using macro variables for explanation of stock market returns as explanatory variables may invalidate the statistical inferences for reasons of endogeneity, multi-collinearity and two way causality. In order to deal with endogeneity of macro variables and stock market innovations to selected variables are preferred in this study as priced risks. Because under the equilibrium the level of macro variables(usually estimated with a lag) is some how already processed information and the unanticipated part is more valuable and informative. It not only help to the analysis to explore the effect of uncertainty surrounding macroeconomic factors on stock returns along side reducing the serious correlation among them for robust estimations. Also , this approach is consistent with the idea that innovation process series of a variables contains different information that the level of the series and for cases such as studied in this paper can be more domineering. In the scope of this study macro variables are in consideration as systematic influences to investment risk, the selection of macro variables likely to effect asset returns is critical. Chen et al (1986) goes through detailed discussion over this argument and also describe the logical signs for employed exogenous variables. The analysis carried down in this paper the selected macro variables at end of period t prevailing in period t+1 are Innovations to term structure of interest rates are : ∆TS=TS(t)-TS(t-1) The exchange rate changes (DXR) are estimated as the log relative of exchange rate at the end of month t to the prevailing rate at the end of month t-1. Innovations for DXR are estimated: ∆DXR(t)=DXR(t)-DXR(t-1) Consumer confidence index (CCI) is developed upon telephonic survey measuring personal and Finnish economic development and is firstly used in the frame of such study in Finland. The changes in CCI are calculated as ∆CCI(t)=CCI(t))-CCI(t-1) The return to 10 year long government bond (LGB) is used as maturity risk premium and shocks to maturity premium are : ∆LGB(t)= LGB(t)-LGB(t-1) Changes in Expected Inflation rate (∆EIR) are: ∆EIR(t)=EIR(t)-EIR(t-1) Unanticipated inflation (UI) are the inflationary shocks from the actual inflation rate at end of period t minus the estimated EIR(t) with time series method explained in Table 2.
Table 2 Explanatory Variable, Symbols and Definitions
The explanatory variables are listed, along with the symbols and respective definitions in the paper. The macro information variables are detailed as basic and derived variables. The series for unemployment rate starts from 1989:01 from the stat fin database and is backwards extended to 1988:04 for the full sample with series obtained from Bank of Finland, which has an correlation of 0.98 with series from Statistics Finland for overlapping period. The consumer confidence index is obtained from BOF till 2007:04 and later period data is completed from Statistics Finland.
Symbol Variable Definition/Source Basic Variables
Rf Risk free rate Percentage monthly return on one month inter bank offered rate /Bank of Finland (BOF) LGB Long term govt. Bond Percentage monthly return on Finnish ten years Govt. bonds/ BOF
EXR [€/$] Exchange Rate Euro per US dollars exchange rate/BOF UE Unemployment Rate Percentage monthly rate/ Statistics Finland CPI Consumer Price Index The price development of goods and services (base year 1981)/Statistics Finland Consumers’ monthly views and expectations on individual and national development/BOF and Statistic CCI Consumer Confidence Index Finland
Derived Variables IRt Inflation rate Percentage log relative of consumer price index ln[CPI(t)/CPI(t-1)]
RHOt Real interest rate (ex post) Rf(t-1)-IR(t) EIRt Expected inflation rate Time series method15 Rf(t)=E[RHO(t+1)/(t)]+E[I(t+1)/(t)] UIt Unanticipated inflation IR(t)-EIR[(t)/t-1)] DXRt Exchange rate changes Percentage log relative of exchange rate ln[EXR(t)/EXR(t-1)]
TSt Term Structure LGB(t)-One month Inter bank rate (t)
Table 3 reports the correlations coefficients of pairs for the innovation processes of macro variables along with market index. First lag of market index , TS and UE are used as potential instruments for conditional macro sensitivities and for that reason their association coefficients are also reported with innovation processes . Table 3 doesn’t report correlation coefficients for the levels of all macro variables, the correlation among innovation processes drops to -0.07 to 0.27 from substantial -0.8 to 0.57 among the levels of macro variables. In addition to the variables listed in Table 2 the monthly and yearly industrial production growths in the Finnish economy , Industrial confidence index and foreign direct investment (FDI) were also retrieved from the online data bases of euro stat , confederation of Finnish Industries and BOF respectively but these explanatory variables provided no improvement in
15 Irving Fisher (1930) noted that nominal interest rates can be expressed as the sum of an expected real rate and an expected inflation rate as modeled in Fama and Schwert (1977) and Fama and Gibbons (1984).
57 Table 3 Correlations between Macro Variables and Instruments The Spearman rank correlation coefficients are reported , as the measure for association among the listed variables. The measure is suitable for non normal data sets, as the macro variables generally are. The correlation of explanatory variables with TS, UE and first lag of market Index are also reported signifying the importance of these variables as instruments for the GMM estimations.
Market Market Index Index(t-1) TS UE ∆TS ∆DXR ∆CCI ∆LGB ∆EIR UI Market Index 1.00 Market Index(t-1) 0.24 1.00 TS 0.18 0.20 1.00 UE 0.19 0.20 0.57 1.00 ∆TS 0.02 0.04 0.23 0.06 1.00 ∆DXR -0.01 0.00 0.07 0.01 0.05 1.00 ∆CCI 0.05 0.21 0.15 0.16 0.12 0.07 1.00 ∆LGB -0.15 -0.10 -0.01-0.16 0.27 -0.07 0.01 1.00 ∆EIR 0.14 -0.05 -0.03-0.02 0.00 0.03 -0.06 -0.01 1.00 UI 0.10 0.00 0.11 -0.12-0.04 0.12 -0.07 0.10 0.04 1.00 terms of cross sectional and statistical explanation and therefore, were dropped from the analysis.
4 Estimations and Results
In the following, the results from estimated models are discussed. Firstly, the empirical results from the unconditional and conditional market models in time series and cross sectional regressions are discussed. Then the results from macro model with constant and time varying betas are presented.
4.1 Unconditional and Conditional Models
The results for unconditional and conditional model are reported in Appendix II (Tables 9 & 10)respectively) over all sample specifications. The validity of instruments used in GMM estimations is tested with Hansen’s J-statistics reported in Table 9. Besides, for sector industrial engineering in A and industrial G&S in B the test statistic isn’t able to reject the over identifying restrictions for all sectors and samples. The estimations for CAPM with OLS and GMM methods show sufficient compliance in generated outputs. The validity of further conditioning down is just statistical and otherwise no meaningful improvement in the variations of sectoral returns across the cross section is observed. The results in general describe regarding the violation of constant beta assumption in both static and dynamic CAPM settings. The results points towards diminution of market index in role as sole factor able to explain cross sectional variations in asset returns over changing periods of time and in long run for Finnish stock market. The t- statistics reported
58 Static CAPM 1.5 1
2523
.5 4 24 8 16 2 3 9 1 18 15 10 20 21
% F ittedR etu rn s 1411 17 613 1275
0 22 -.5 -.5 0 .5 1 1.5 % Realized Returns
Conditional CAPM 1.5 1
2523
.5 21 2218 2041411 24 % F ittedR etu rn s 3 10 11227519 6 0 17815 16 9 -.5 -.5 0 .5 1 1.5 % Realized Returns
Figure 1 Pricing errors generated by Static and Conditional Models This figure presents pricing error plots for the time series static and conditional CAPM . Mean realized excess returns (horizontal axis) are plotted against the mean realized excess returns implied by the respective asset pricing model (vertical axis). The digits 1,…, 25 represents the sector indices in order of narration in Appendix I Table 8. The sample period is 1988:04–2008:07.
in Tables 9 and 10 are not able to reject the zero intercept null hypothesis with model generated sampling errors. Figure 1 show the cross sectional power of the market beta for full sample with static and dynamic settings. Both the testing procedures provide us with substantial pricing errors. The static case provide haphazardness in fit for the cross sectional explanation of sector returns. The conditional case project lower percentage returns, except paper industry, than realized percentage returns with considerable differences such that the largest noted monthly difference is 1% per month for sectors Technology H&E and Technology . The instability of betas over periods and dampening of it in later period suggest the need for exploration of additional risk factors in Finnish economy. It also details regarding invalidated assumption of constant betas used almost among all asset pricing models. The results for the unconditional and conditional models usher the thrust for pricing of assets in Finnish market to
59 the efficient market hypothesis (EMH) and unpredictability of industry returns. The contrarian argument can be exploration for the omitted variables in the models with capacity to predict next period returns. Enormous literature argue for impossibility of perfectly efficient markets a scenario in which there wouldn’t be profits for collecting information. But, with the sophistication involved in trade of managed portfolios characterized upon certain asset traits to explain abnormal asset returns. The asset pricing theory can’t be left so naive to remain with pricing of non scaled unpredictability regressions and a case in which there would be no incentive or compensation for collecting information . The market participants trade in order to optimize their wealth and gains. The agents beating the market besides pure chance are with the information not available to others, a violation to the complete agreement assumption and EMH. For that reason this study stresses to look for additional source of priced risks (macro) with respect to investors information set. In order to map investment set we test implications conditioned on observable data for macro variables in the models with which supposedly agents price assets.
60 Table 4 Joint Tests for Zero Intercept across CRS Table 6 reports the cross-sectional tests, that is, small sample GRS F-test and asymptotic χ2 test. The variance covariance matrices are constructed with the residuals of models in (2) and (4) for respective sample specifications.
Unconditional Model(OLS) Conditional Model(GMM)
Joint test H0: μi=0 A: 1988:4 to 2008:7 F test statistic (p-value) 3.01 (<0.001) F test statistic (p-value) 4.14 (<0.001) χ2(25) (p-value) 53.57 (<0.001) χ2(25) (p-value) 107.42 (<0.001) B: 1988:12 to 1998:12 F test statistic (p-value) 2.38 (0.007) F test statistic p-value 2.74 (0.002) χ2(25) ( p-value) 64.47 (<0.001) χ2(25) (p-value) 87.1 (<0.001) C: 1999:1 to 2008:7 F test statistic (p-value) 2.26 (0.01) F test statistic (p-value) 3.48 (<0.001) χ2(25) ( p-value) 72.83 (<0.001) χ2(25) ( p-value) 91.07 (<0.001)
The non rejection of null for the time series regressions make the cross sectional joint test more spawning. As argued by GRS (1989) inference based upon time series null can be grossly misleading. Since , univariate inferential method don’t account for the cross correlation of estimation errors of the intercepts and can lead to ambiguous cross sectional inferences. A feature duly covered in the GRS (1989) F-test and is more prudent for providing insights when mean variance efficiency of the model can’t be rejected with conventional inferential statistics. All the same, the ambivalence in inferring from univariate testing method is observed from the results reported in Table 4.The GRS F-test and its asymptotic counterpart χ2–statistic overwhelmingly reject the joint null. The market factor in no respect is able to explain the variations in average returns of industry returns across the CRS and is incapacitated to press the average mispricing down to zero. The observation of over rejection of null by the asymptotic theory test statistics as compared to OLS statistics reported by GRS(1989) is also observed in the estimated results.
4.2 Main Empirical Results: Cross sectional Regressions
The thrust of this study is to draw inference across the CRS of industry returns , different cross sectional settings with constant and time varying betas (both static and dynamic) are tested. For simplification purposes the unconditional (static) betas and conditional (dynamic) betas will referred with OLS betas and GMM betas respectively interchangeably onwards. The cross sectional regressions to observe market premium as priced risk with time invariant betas (both with OLS and GMM market sensitivities) over the sample periods is tested under two specifications of unrestricted and restricted case. The 2nd stage results for regressions test for ∧ residuals/pricing errors α i = 0are jointly zero and whether the market premium is priced, that is ∧ , λ ≠ 0 . There is no departure of inference among 2nd stage results with betas estimated with OLS and GMM methods regarding the predicament for CAPM theory. All test statistics reject the model detailed in Table 5 across all samples. The price of market risk is insignificant across
61 Table 5 2nd pass Joint Test for Restricted Model ∧ ∧ ∧ ∧ ∧ ∧ ∧ nd e e The 2 pass unrestricted and restricted estimations, with equations Ri = a+ λ β i + α i and Ri = λ β i + α i respectively with constant unconditional and conditional market betas are done with OLS method only. The R2 and 2 joint χ -test for the both model across all sample specifications are provided in columns 5 and 6 respectively. λOLS nd and λGMM signifies price of static and dynamic beta risk respectively. aOLS and aGMM are 2 pass intercepts with OLS and GMM market betas respectively. The t-statistics with Shanken corrected standard errors are reported in (). The significant coefficients at 5%,1% and 0.01% critical values are presented in bold fonts along with respective t- stat.
2 2 aOLS λOLS aGΜΜ λGΜΜ R χ -test p-value A:1988:04 to 2008:07 0.04 0.55 - - 0.19 39.21 0.002 (0.08) (1.18) - 0.60 - - 0.55 79.67 <0.001 (1.32) - - 0.23 0.20 0.03 41.67 0.001 (0.31) (0.29) - - - 0.49 0.42 83.15 <0.001 (0.96) B:1988:04 to 1998:12 -0.20 0.71 - - 0.09 51.97 <0.001 (0.22) (0.78) - 0.49 - - 0.25 91.66 <0.001 (1.09) - - -0.15 0.69 0.20 67.77 <0.001 (0.22) (1.14) - - - 0.55 0.34 96.31 <0.001 (1.23) C:1999:12 to 2008:07 0.57 -0.60 - - 0.13 78.12 <0.001 (0.79) (0.81) 0.19 - - 0.02 346.41 <0.001 - (0.43) - - - - 0.70 -0.81 0.17 65.16 <0.001 (0.88) (0.99) - - - 0.27 0.04 249.17 <0.001 (0.42) all samples with standard errors adjusted for estimated regressors with Shanken (1992) correction. The reported signs for beta risk is correct for specification A and B but in C even the predicted sign with both OLS and GMM betas is incorrect. The R2 for the restricted model is generally substantially more than unrestricted case, a common feature for such regression, where the beta risk tend to capture the variations because of mispricing. The model in terms of R2 with conditional betas performs better than OLS betas for specification B and C whereas in A is better with static betas. But rejection of null and low R2 in unrestricted case cast serious doubts on the model’s performance to explain the cross sectional variations in tested assets. The FM regression reported in Table 6 with time varying market betas doesn’t provide any
62 Table 6 Fama and ΜacBeth 2nd Stage Estimations ∧ ∧ ∧ ∧ e Ri,t = λ 0,t + λ βm ,t β m,t−1 + α i,t The results for standard FM 2nd stage cross sectional regressions with 5 year rolling sensitivities are presented with 2 least squares method. λ β is price for market risk with time varying market sensitivities. The average R for the FM cross sectional regressions is reported in column 4 for all sample specifications, whereas, column 5 carries the formal specification test for the model that average mispricing is jointly zero for all indices. The significant coefficients at 5%,1% and 0.01% critical values are presented in bold fonts along with respective t-stat. Parameter t-stats are provided in ().
2 2 λ0 λ β ,t Obs. Avg.R χ -test p-value
OLS:1993:03 to 2008:07 0.28 0.47 4600 0.16 39.21 0.01 (0.67) (0.71) GΜΜ:1993:03 to 2008:07 0.74 0.15 4600 0.09 41.23 0.01 (1.96) (0.49) OLS:19993:03 to 1998:12 0.14 1.98 1725 0.16 46.57 0.00 (0.19) (2.06) GΜΜ:1993:03 to 1998:12 1.21 0.59 1725 0.08 49.17 0.00 (1.60) (1.36) OLS:2003:12 to 2008:07 0.55 -0.24 1400 0.14 33.91 0.04 (0.81) (0.30) GΜΜ:2004:01 to 2008:07 0.89 -0.83 1400 0.09 49.51 0.00 (1.51) (1.61)
different results than earlier constant beta estimations. The specification test rejects the model for all samples and even the model R2 is not better than the constant beta case. Especially the FM regressions with GMM estimated betas provide lower model R2 than the constant beta case. The beta risk is only priced with OLS estimated betas for sample B at 5% critical values .The coefficients for beta risk are with wrong sign for specification C with both type of estimated betas. Another aspect noted in FM regressions is that the average mispricing with GMM betas is larger than OLS betas. On the whole, regressions with FM16 method also fails to explain the cross sectional variations in the asset returns and doesn’t provide any conclusive support for the linear relationship between market betas and asset returns. The results for the MDF model are reported in Table 10. The model provide insignificant intercepts for all samples and betas types. The presented results in all three specification show the forecasting ability of employed factors, where changes in term structure spread are priced throughout except for full sample with GMM betas at 5% critical value. The ∆TS risk premium is negative priced risk but with GMM betas in C. The negative risk premium for ∆TS indicates the stocks inversely related to positive changes in long rates over short rates considered more valuable (yielding better returns) and vice a versa. The pricing ability of term structure changes
16 While carrying FM regressions I also tried to test the model with a measure of non-market risk (the error term from first pass regression for respective sectors) and squared market betas but these variables were with some serious correlation with market betas and henceforth dropped in order to avoid spurious regression problem.
63 Table 7 2nd Stage Estimation with Time Varying Macro Betas ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ ∧ e Ri,t =λ0,t +λm,t βm,t−1+λΔTS,t βΔTS,t−1+λΔDXR,t βΔDXR,t−1+λΔCCI,t βΔCCI,t−1+λΔLGB,t βΔLGB,t−1+λΔEIR,t βΔEIR,t−1+λUI,t βUI,t−1+αi,t
The FM method cross sectional regressions with macro time varying sensitivities are reported in the table estimated with least squares method. Macro model 2nd stage estimations are done in three sample specifications with OLS and st GMM estimated betas from 1 stage rolling regressions. λ∆TS,t , λ∆DXR,t , λ∆CCI,t , λ∆EIR,t , λUI,t , λ∆LGB,t and λm,t are prices for risks namely ∆TS, ∆DXR , ∆CCI, ∆EIR, UI, ∆LGB and market index respectively. Also the another important feature about FM regressions is that the one period lagged beta to the excess returns risks are employed in order to observe the next period predictability of asset returns. Column 10 detail the average R2 for the FM cross sectional regressions and column 11 provides the formal asymptotic χ2-test for testing that 2nd stage regression alphas are jointly zero in 2nd stage cross sectional regressions. The significant coefficients at 5%,1% and 0.01% critical values are presented in bold fonts along with respective t-stats provided in ().
Λ0 λMkt,t λ∆TS,t λ∆DXR,t λ∆CCI,t λ∆LGB,t λ∆EIR,t λUI,t Obs. Avg. R2 A:1993:03 to 2008:7 OLS 0.50 0.26 -0.40 0.17 0.25 -0.07 -0.08 0.05 4600 0.56 (1.03) (0.37) (2.60) (0.32) (0.54) (1.35) (0.88) (0.53) GMM 0.49 0.31 -0.24 0.67 -0.01 0.08 0.02 0.11 4600 0.57 (0.95) (0.49) (1.75) (1.21) (0.27) (0.16) (0.27) (1.29) B:1993:03 to 1999:12 OLS 1.08 1.05 -1.05 2.16 0.65 -0.13 0.10 -0.13 1725 0.56 (1.54) (1.09) (2.67) (3.00) (0.80) (1.06) (0.64) (1.79) GMM 1.30 0.81 -0.70 1.76 -0.04 0.61 0.12 -0.08 1725 0.55 (1.34) (0.81) (1.99) (2.07) (0.35) (0.83) (0.79) (1.97) C:2003:12 to 2008:07 OLS -0.25 0.50 -0.03 -1.63 0.60 -0.08 -0.28 -0.23 1400 0.57 (0.25) (0.45) (2.01) (1.51) (0.76) (1.48) (1.37) (1.18) GMM -0.58 0.74 0.01 0.37 -0.05 0.34 0.03 -0.13 1400 0.58 (0.59) (0.71) (2.11) (0.32) (0.86) (0.34) (0.14) (0.73)
for Finnish asset returns is also in line to studies for German stocks where Schrimpf, Schröder and Stehle (2007) report success of conditional CAPM model scaled with term spread performing about as well as the Fama and French (1993) three factor model. This fact regarding the pricing ability of term spread is reported in number of studies elsewhere for example Chen et al (1986), Estrella and Hardouvelis (1991) and Bessler and Opfer (2004). This study attributes the informational content in term structure of interest rates for future business conditions to be of significant importance and downwardly incorporated in asset returns. Unanticipated inflation is priced risk with GMM betas only for specification B. If the power of the test is decreased at 10% critical values then UI is also found significant in B with OLS betas with same sign and nearly same size. Chen et al (1986) and Pearce and Roley (1988) report a negative relationship between unanticipated inflation and stock returns. The later study also discussed literature for the exposure of stock returns to inflationary changes and found anticipated part of inflation non priced and the unanticipated part priced during high and volatile inflationary regimes. This fact is consistent with result reported in this study where the unanticipated inflation is negatively priced only in B where Finnish economy was passing through recession coupled with high inflation and soaring interest rates. The inflation rate for period 1988:07 to 1992:12 on average was 0.38% per month than the full sample average of 0.19 per month. Pearce and Roley (1988) reported in historical data inverse relationship between inflation and future out put and positive relationship between stock returns and economic activity. Presumably, these relationships may cause diminishing returns with increases in inflation and concomitantly also predict higher future returns for increased level of future out put. Exchange rate changes are significantly priced for sample before the introduction of euro and are positive. In the sense of international asset pricing models the exchange rate variations are considered major source of uncertainty affecting stock returns temporal movements aligned to orientation of firms. But , this study focuses on the cross sectional performance of the model to discuss the exchange rate sensitivity with regard to firm types is out of the context of study. Wu (2008) ,is more relevant to the tests carried in this paper, studied different international asset pricing (I-APM)) models with FM regressions for a selection of 16 developed markets. The results in his analysis suggest, for the ability in forecasting the cross sectional variation in expected returns, I-APM with exchange rate risks out performs other settings for selected developed markets. The effect of exchange rate movements is asymmetric to appreciating- depreciating currency regimes as reported by Koutmos and Martin (2003). The exchange rate sensitivity reported in Table 7 with OLS betas is consistent with these results where for an depreciating currency regime in sample B we got positive and significant coefficients for exchange rate changes and negative but significant coefficient for specification A and C. The exchange rate exposure is positive for specification A and B with GMM betas whereas is significant for B only. The exchange rate exposure in specification C with GMM betas is the lone instance where the reported coefficient is not in line with presented literature. Besides, in the proposed model no other macro variable is found significant along with market beta risk. In order to observe the parsimonious effect of these macro variables univariate 2nd pass cross sectional regressions are presented in Appendix II Tables 11 and 12. Analyzing the parsimonious signs of coefficients with respective multifactor representation parameters notify in full sample only the parameters for changes in expected inflation and UI are with wrong signs . For sub sample B all the coefficients are with correct signs and in specification C changes in terms structure and expected inflation are with opposite sign to what given by Tables 11 and 12 respectively. The absolute difference being marginal to reported coefficients for ∆TS , that is, 0.06. The changes in consumer confidence index firstly tested for the cross sectional variation of asset returns for Finnish market don’t have any particular impact. This survey based expectation index have significant coefficients for specification B and C with OLS and GMM betas respectively but when we controlled for other macro variables the significance of changes in CCI is driven insignificant. The substantial improvement among earlier specifications and MDF model is the increased R2. The MDF model reports consistent measure for the explanatory power of the model which remains in a narrow range of 55% to 58% for all specifications regardless of beta types and explains the most among the tested models. The most important finding in this article is specification test can’t reject the model at 5% for full sample. The only other instance is in specification C with OLS betas only where model can’t be rejected with substantial power of the test other model is rejected for specification B. Besides, over rejection of the model with GMM estimated betas is also witnessed in the results.
5 Conclusion
This study investigated unconditional MDF model with time varying unconditional and conditional factor sensitivities for 25 Finnish sectors. All the estimations are cross sectional for drawing inferences from the laid down models and hypotheses. Using formal specification tests for the mean variance efficiency this study found no evidence for validation of CAPM regardless of estimated betas type or its temporal behavior. The failure of conditional market model for Finnish market provide totally opposite check for conditional models in general. This inference is validated even in terms of R2 as the studies for conditional CAPM modeling in other markets mostly suggests an enhancement of information by allowing the parameters to change through time or scaling with additional information than unconditional testing. However , in the case of this study the conditioning variables are restricted to macro variables and market index lagged information. A study testing the conditional model with different and larger set of conditioning variables for cross sectional explanation of assets spread can be an interesting next step to extend and may also shed further insight of the information content for explanation of return variations in assets. The MDF model out performs other horse race cross sectional settings and report highest explanation in terms of R2 (substantially large to other tested settings). Importantly, the specification tests for full sample couldn’t reject the null with both OLS and GMM betas at 5% level. A fact also reported for specification B with OLS betas whereas MDF model for all other samples is rejected. Also there is considerable consistency among the calibrated price of risks for the employed factors in MDF model over all samples. The specification test tend to over reject the null with GMM betas than estimated with OLS betas in all the unconditional cross sectional settings tested in the paper. In order to explore for cross sectional spread of assets for further examination different conditional methods are suggested, for example, canonical asset pricing model, the habit formation model with surplus consumption by Campbell and Cochrane (1999), macro consumption to wealth (cay) co-integrated variable by Lettau and Ludvigson (2001), Jagannathan and Wang (1996) conditional specifications etc. to name a few among others.
66 Appendix I
Table 8 The DATASTREAM sector indices employed in the study here are corresponded with representative numbers labeled in Figure 1.
Sector names Representative no. Banks 1 Financials 2 Insurance 3 Non Financial 4 Food & Drug Retailers 5 Broadline Retailers 6 Consumer Staples 7 Forestry & Paper 8 Paper 9 Household Goods and Home Construction (HHG&HC) 10 Waste and Disposable (W&D) Services 11 Health Care 12 General Retailers 13 Media 14 Consumer Services 15 Basic Materials 16 General Industrials 17 Industrial Engineering. 18 Industrials 19 Industrial Goods and Services (G&S) 20 Industrial Machinery 21 Industries Metals & Mines 22 Technology Hardware and Equipment (H&E) 23 Software and Computer (S&C) Services 24 Technology 25
67 Appendix II Table 9 μ β Unconditional CAPM Estimations e e The unconditional market model Ri = i + i,m Rm + ε i,t is estimated for sample specifications represented with A, B and C for periods 1988:04 to 2008:07, 1988:04 to 1998:12 and 1999:01 to 2008:07 respectively with least squares method. The table reports the exposure to intercept and market risk for each sector index along with R2 for the model. The coefficients significance at 5%, 1% and 0.01% with respective t-stats (with standard errors from sampling distribution of estimated parameters) are presented in bold. The reported t-test for the hypothesis H0: μi=0 is with the model generated sampling errors.
Non Food & Drug Broadline Consumer Forestry & W&D Health General Banks Financials Insurance Financial Retailers Retailers Staples Paper Paper HHG&HC Services Care Retailers A:1998:04 to 2008:07 μ -0.10 -0.13 -0.07 0.08 0.16 -0.02 0.12 -0.40 -0.77 0.14 0.47 0.01 -0.02 (0.18) (0.27) (0.12) (1.28) (0.35) (0.04) (0.27) (0.88) (1.31) (0.27) (0.87) (0.03) (0.04) β 0.61 0.70 0.76 1.01 0.29 0.34 0.30 0.68 0.62 0.49 0.40 0.34 0.34 (9.58) (12.34) (11.02) (145.48) (5.38) (6.71) (5.68) (12.76) (9.25) (8.11) (6.31) (7.64) (6.71)
H0: μi=0 t-statistics -0.02 -0.02 -0.01 0.01 0.06 -0.01 0.05 -0.07 -0.15 0.03 0.14 0.00 -0.01 p-value 0.99 0.98 0.99 0.99 0.95 1.00 0.96 0.95 0.88 0.97 0.89 1.00 1.00 2 R 0.28 0.39 0.35 0.99 0.11 0.16 0.12 0.40 0.28 0.21 0.14 0.19 0.16 B:1998:04 to 1998:12 μ -1.05 -0.99 -1.16 0.18 -0.24 -0.38 -0.08 -0.66 -0.87 0.08 0.18 -0.61 -0.38 (1.37) (1.56) (1.52) 1.66 (0.40) (0.74) (0.16) (1.32) (1.15) (0.11) (0.22) (1.41) (0.74) β 1.09 1.18 1.23 0.98 0.48 0.55 0.58 1.00 0.79 0.80 0.60 0.64 0.55 (11.44) (14.85) (12.88) (74.19) (6.45) (8.70) (8.75) (16.09) (8.33) (9.47) (5.89) (11.91) (8.70)
H0: μi=0 t-statistics -0.12 -0.10 -0.12 0.02 -0.06 -0.08 -0.02 -0.08 -0.14 0.01 0.04 -0.12 -0.08 p-value 0.90 0.92 0.91 0.98 0.95 0.93 0.99 0.93 0.89 0.99 0.97 0.91 0.93 2 R 0.51 0.63 0.57 0.98 0.25 0.37 0.38 0.67 0.35 0.41 0.21 0.53 0.37 C:1999:01 t0 2008:07 μ 0.73 0.62 0.80 -0.02 0.40 0.15 0.12 -0.27 -0.77 0.05 0.65 0.61 0.15 (1.29) (1.18) (1.24) (0.95) (0.58) (0.23) (0.17) (0.38) (0.99) (0.06) (0.97) (1.12) (0.23) β 0.19 0.29 0.32 1.03 0.13 0.15 0.06 0.41 0.46 0.23 0.23 0.07 0.15 (3.12) (4.97) (4.52) (363.82) (1.71) (1.99) (0.82) (5.16) (5.32) (2.82) (3.11) (1.22) (1.99)
H0: μi=0 t-statistics 0.41 0.24 0.27 0.00 0.34 0.11 0.20 -0.07 -0.19 0.02 0.31 0.91 0.11 p-value 0.68 0.81 0.79 1.00 0.74 0.91 0.84 0.94 0.85 0.98 0.76 0.36 0.91 2 R 0.08 0.18 0.15 0.99 0.03 0.03 0.01 0.19 0.20 0.07 0.08 0.01 0.03
Table 9 Unconditional CAPΜ Estimations (continued)
Consumer Basic General Industrial Industrial Industrial Industries Technology S&C Media Services Materials Industrials Engineering. Industrials G&S Machinery Metals & Mines H&E Services Technology A:1998:04 to 2008:07 μ 0.39 -0.23 -0.19 -0.26 0.45 0.01 0.31 0.80 0.66 0.56 -0.01 0.55 (0.73) (0.72) (0.47) (0.49) (1.20) (0.02) (0.94) (2.02) (1.07) (1.46) (0.02) (1.47) β 0.38 0.44 0.64 0.34 0.53 0.60 0.50 0.43 -0.08 1.34 0.86 1.32 (6.11) (11.63) (13.26) (5.53) (12.19) (14.44) (13.04) (9.33) (1.09) (29.81) (11.93) (30.45)
H0: μi=0 t-statistics 0.12 -0.06 -0.04 -0.09 0.10 0.00 0.07 0.22 0.99 0.05 0.00 0.05 p-value 0.90 0.95 0.97 0.93 0.92 1.00 0.94 0.83 0.32 0.96 1.00 0.96 2 R 0.13 0.36 0.42 0.11 0.38 0.46 0.41 0.27 0.01 0.79 0.37 0.79 B:1998:04 to 1998:12 μ 0.74 -0.41 -0.72 -0.23 -0.05 -0.78 -0.15 -0.11 -0.14 1.22 1.38 1.42 (0.93) (0.99) (1.69) (0.28) (0.11) (1.82) (0.38) (0.23) (0.18) (2.19) (1.78) (2.26) β 0.42 0.64 0.94 0.56 0.73 0.87 0.74 0.65 -0.10 1.21 0.82 1.30 (4.27) (12.58) (17.77) (5.51) (12.97) (16.19) (15.08) (10.83) (1.05) (13.25) (8.48) (16.52)
H0: μi=0 t-statistics 0.22 -0.08 -0.09 -0.05 -0.01 -0.11 -0.03 -0.02 -0.17 0.13 0.21 0.14 p-value 0.83 0.94 0.92 0.96 0.99 0.91 0.98 0.98 0.86 0.89 0.83 0.89 2 R 0.13 0.55 0.71 0.19 0.57 0.67 0.64 0.48 0.01 0.68 0.36 0.68 C:1999:01 t0 2008:07 μ 0.00 -0.17 0.16 -0.37 0.82 0.68 0.63 1.56 1.29 -0.2 -1.58 -0.30 0.00 (0.37) 0.24 (0.62) (1.42) (1.32) (1.30) (2.58) (1.59) (0.74) (1.65) (0.86) β 0.35 0.27 0.38 0.15 0.37 0.38 0.30 0.25 -0.04 1.25 0.89 1.34 (4.45) (5.21) (5.19) (2.27) (5.72) (6.68) 5.60 (3.68) (0.48) (27.30) (8.45) (34.70)
H0: μi=0 t-statistics 0.00 -0.07 0.05 -0.27 0.25 0.20 0.23 0.70 3.33 -0.02 -0.19 -0.02 p-value 1.00 0.94 0.96 0.79 0.81 0.84 0.82 0.49 0.00 0.98 0.85 0.98 2 R 0.15 0.19 0.19 0.04 0.22 0.28 0.22 0.11 0.00 0.91 0.39 0.91
69 μ Table 10 β Conditional CAPΜ Estimations e e The conditional market model Ri,t = i + i,m Rm,t + ε i,t with scaled up information with instruments from a set of macro variables , that is , term structure spread, unemployment rate, exchange rate and inflation changes and appropriate market index lags. The appropriate instruments are chosen with respect to the
Hansen’s JT statistics such that applied moment conditions can’t be rejected. The specification A, B and C represents sample periods 1988:04 to 2008:07, 1988:04 to 1998:12 and 1999:01 to 2008:07 respectively. The coefficients significance at 5%, 1% and 0.01% with respective t-stats (with standard errors from sampling distribution of estimated parameters) are presented in bold. The reported t-test for the hypothesis H0: μi=0 is with the model generated sampling errors.
Non Food & Drug Broadline Consumer Forestry W&D Health General Banks Financials Insurance Financial Retailers Retailers Staples & Paper Paper HHG&HC Services Care Retailers A:1998:04 to 2008:07 μ 0.17 0.13 0.07 0.03 0.07 -0.12 -0.08 -0.52 -1.21 0.07 0.39 0.03 -0.29 (0.31) (0.28) (0.12) (0.48) (0.13) (0.22) (0.12) (1.23) (2.35) (0.11) (0.65) (0.04) (0.58) β 0.62 0.83 0.91 0.99 0.36 0.48 0.48 0.67 0.92 0.75 0.35 0.33 0.43 (2.67) (3.40) (3.19) (36.56) (2.06) (2.73) (1.71) (5.76) (5.48) (3.98) (0.62) (0.69) (2.98) H0: μi=0 t-statistics 0.03 0.02 0.01 0.00 0.02 -0.03 -0.02 -0.09 -0.15 0.01 0.13 0.01 -0.08 p-value 0.97 0.99 0.99 1.00 0.98 0.98 0.99 0.93 0.88 0.99 0.90 0.99 0.94 J-stat (p-value) 0.29 0.51 0.50 0.31 0.94 0.35 0.36 0.17 0.39 0.99 0.79 0.87 0.28 R2 0.28 0.37 0.33 0.99 0.10 0.12 0.08 0.40 0.20 0.16 0.15 0.19 0.14 B:1998:04 to 1998:12 μ -0.72 -0.93 -0.79 0.12 -0.11 -0.36 -0.11 -0.68 -1.85 0.18 0.32 -0.21 -0.62 (1.18) (1.41) (1.38) (1.26) (0.18) (0.56) (0.16) (1.41) (2.14) (0.24) (0.35) (0.23) (1.10) β 1.00 1.25 1.13 0.97 0.41 0.44 0.66 0.92 1.26 1.00 0.55 0.42 0.67 (4.51) (4.61) (4.38) (26.38) (2.81) (2.59) (4.30) (5.59) (3.41) (4.34) (0.48) (0.85) (3.73) H0: μi=0 t-statistics -0.09 -0.09 -0.09 0.02 -0.03 -0.10 -0.02 -0.09 -0.18 0.02 0.07 -0.06 -0.11 p-value 0.93 0.93 0.93 0.99 0.97 0.92 0.98 0.93 0.86 0.98 0.94 0.95 0.91 J-stat (p-value) 0.35 0.30 0.44 0.22 0.94 0.45 0.92 0.07 0.21 0.33 0.93 0.20 0.44 R2 0.51 0.64 0.56 0.98 0.25 0.36 0.37 0.67 0.22 0.40 0.23 0.46 0.36 C:1999:01 to 2008:07 μ 0.85 0.58 0.74 -0.02 0.37 0.18 0.29 -0.17 -0.86 -0.29 0.24 0.56 0.15 (1.56) (1.07) (1.41) (0.77) (0.52) (0.34) (0.30) (0.25) (1.43) (0.43) (0.38) (1.12) (0.21) β 0.20 0.46 0.50 1.03 0.13 0.08 0.14 0.54 0.75 0.35 0.32 0.12 0.29 (0.88) (2.42) (2.28) (123.37) (0.23) (0.14) (0.41) (3.04) (2.69) (0.82) (0.94) (0.41) (1.11) H0: μi=0 t-statistics 0.47 0.14 0.16 0.00 0.31 0.25 0.22 -0.04 -0.13 -0.09 0.08 0.51 0.06 p-value 0.64 0.89 0.87 1.00 0.76 0.80 0.83 0.97 0.90 0.93 0.93 0.61 0.95 J-stat (p-value) 0.23 0.35 0.42 0.51 0.61 0.99 0.41 0.37 1.00 0.24 0.13 0.70 0.76 R2 0.08 0.11 0.11 1.00 0.03 0.03 . 0.17 0.12 0.04 0.06 0.01 0.00
70 Table 10 Conditional CAPΜ Estimations (continued)
Consumer Basic General Industrial Industrial Industrial Industries Technology S&C Media Services Materials Industrials Engineering. Industrials G&S Machinery Metals & Mines H&E Services Technology A:1998:04 to 2008:07 μ 0.39 -0.37 -0.27 -0.25 0.56 -0.25 0.43 1.00 0.56 0.71 -0.26 0.70 (0.82) (1.00) (0.59) (0.48) (1.36) (0.62) (1.02) (2.38) (0.89) (1.33) (0.35) (1.35) β 0.48 0.43 0.60 0.34 0.60 0.67 0.36 0.20 -0.03 1.13 1.34 1.14 (2.08) (3.50) (4.40) (1.53) (4.40) (4.13) (1.71) (0.82) (0.14) (6.38) (5.80) (6.50) H0: μi=0 t-statistics 0.10 -0.10 -0.05 -0.09 0.11 -0.04 0.14 0.58 2.35 0.07 -0.02 0.07 p-value 0.92 0.92 0.96 0.93 0.91 0.97 0.89 0.56 0.02 0.94 0.98 0.94 J-stat (p-value) 0.39 0.15 0.45 0.91 0.01 0.88 0.65 0.80 2.70 0.25 0.57 0.24 R2 0.13 0.36 0.42 0.11 0.37 0.46 0.38 0.19 0.26 0.77 0.26 0.78 B:1998:04 to 1998:12 μ 0.65 -0.36 -0.46 0.30 0.43 -0.82 0.39 0.42 0.00 1.56 0.98 1.56 (0.79) (0.71) (0.77) (0.51) (0.88) (1.66) (0.69) (0.80) (0.01) (2.35) (0.98) (2.30) β 0.68 0.52 0.55 0.29 0.52 0.76 0.29 0.21 -0.78 1.42 1.52 1.43 (1.49) (3.70) (2.45) (1.11) (3.69) (4.49) (1.24) (0.88) (1.30) (4.71) (4.99) (4.80) H0: μi=0 t-statistics 0.12 -0.09 -0.10 0.13 0.10 -0.13 0.17 0.25 0.00 0.14 0.08 0.14 p-value 0.91 0.93 0.92 0.90 0.92 0.89 0.87 0.80 1.00 0.89 0.94 0.89 J-stat (p-value) 0.96 0.10 0.58 0.40 0.11 0.18 0.02 0.16 0.57 0.72 0.27 0.74 R2 0.08 0.53 0.59 0.15 0.52 0.67 0.40 0.26 . 0.67 0.10 0.68 C:1999:01 to 2008:07 μ -0.01 -0.60 0.21 -0.45 0.98 0.48 0.53 1.75 1.53 -0.20 -1.59 -0.23 (0.02) (0.86) (0.32) (0.68) (1.62) (0.81) (0.82) (2.98) (1.81) (0.43) (1.66) (0.51) β 0.39 0.49 0.57 0.09 0.41 0.72 0.40 0.30 -0.07 0.98 0.94 0.98 (1.88) (1.35) (3.34) (0.45) (0.97) (1.47) (1.10) (0.73) (0.25) (9.88) (3.39) (10.12) H0: μi=0 t-statistics 0.00 -0.14 0.04 -0.58 0.26 0.07 0.14 0.63 2.28 -0.02 -0.19 -0.03 p-value 1.00 0.89 0.97 0.57 0.80 0.94 0.89 0.53 0.02 0.98 0.85 0.98 J-stat (p-value) 0.98 0.17 0.59 0.65 0.44 0.15 0.37 0.28 0.46 0.70 0.40 0.69 R2 0.15 0.06 0.14 0.04 0.22 0.05 0.19 0.10 0.00 0.84 0.39 0.85
71
Table 11 Parsimonious Regressions with OLS estimated Factor Sensitivities The factor risks employed in MDF model are tested in single factor cross sectional regressions in order to get the parsimonious sign and coefficients of the tested risks in MDF model.The coefficients significance at 5%, 1% and 0.01% with respective t-stats (with standard errors from sampling distribution of estimated parameters) are presented in bold.
λ0 λm,t λ∆TS,t λ∆DXR,t λ∆CCI,t λ∆LGB,t λ∆EIR,t λUI,t Obs. Avg. R2 A:1993:03 to 2008:7 0.32 0.39 4600 0.17 (0.79) (0.56) 0.87 -0.18 4600 0.09 (2.01) (1.88) 0.82 0.24 4600 0.07 (2.10) (0.55) 0.89 0.65 4600 0.08 (2.26) (1.77) 0.88 -0.01 4600 0.09 (2.12) (0.19) 0.79 0.02 4600 0.07 (2.01) (0.21) 0.84 -0.03 4600 0.09 (2.09) (0.36) B:1993:03 to 1999:01 0.31 1.86 1725 0.15 (0.44) (1.99) 1.91 -0.50 1725 0.09 (2.52) (2.04) 1.58 1.23 1725 0.06 (2.20) (2.12) 1.83 1.36 1725 0.09 (2.48) (2.10) 1.67 -0.03 1725 0.10 (2.21) (0.39) 1.54 0.13 1725 0.08 (2.08) (0.99) 1.75 0.02 1725 0.09 (2.37) (2.15) C:2003:12to 2008:07 0.56 -0.48 1400 0.15 (0.84) (0.57) 0.39 0.03 1400 0.08 (0.65) (1.69) 0.47 -0.79 1400 0.07 (0.84) (0.83) 0.42 0.14 1400 0.07 (0.75) (0.22) 0.45 -0.03 1400 0.09 (0.77) (1.04) 0.45 -0.10 1400 0.08 (0.78) (0.53) 0.30 -0.12 1400 0.10 (0.48) (0.89)
Table 12 Parsimonious Regressions with GMM estimated Factor Sensitivities 73
The factor risks employed in MDF model are tested in single factor cross sectional regressions in order to get the parsimonious sign and coefficients of the tested risks in MDF model.The coefficients significance at 5%, 1% and 0.01% with respective t-stats (with standard errors from sampling distribution of estimated parameters) are presented in bold.
λ0 λm,t λ∆TS,t λ∆DXR,t λ∆CCI,t λ∆LGB,t λ∆EIR,t λUI,t Obs. Avg. R2 A:1993:03 to 2008:7 0.49 0.20 4600 0.12 (1.18) (0.41) 0.75 -0.14 4600 0.09 (1.81) (1.92) 0.76 0.67 4600 0.07 (1.91) (1.56) 0.94 0.02 4600 0.08 (2.36) (1.00) 0.83 0.64 4600 0.08 (2.10) (2.01) 0.79 -0.04 4600 0.07 (2.02) (0.69) 0.82 -0.03 4600 0.09 (2.01) (0.59) B:1993:03 to 1999:01 0.44 1.51 1725 0.10 (0.52) (2.43) 1.90 -0.40 1725 0.08 (2.56) (2.30) 1.50 1.63 1725 0.07 (2.07) (2.30) 1.81 0.04 1725 0.08 (2.53) (0.81) 1.82 1.13 1725 0.08 (2.49) (1.87) 1.60 0.13 1725 0.08 (2.16) (1.07) 1.69 -0.01 1725 0.11 (2.29) (2.11) C:2003:12 to 2008:07 0.14 -0.21 1400 0.12 (0.21) (0.28) 0.28 0.06 1400 0.08 (0.44) (2.29) 0.39 0.14 1400 0.06 (0.66) (0.17) 0.50 -0.05 1400 0.09 (0.79) (2.08) 0.27 0.66 1400 0.08 (0.45) (1.48) 0.45 -0.21 1400 0.08 (0.78) (2.02) 0.18 -0.15 1400 0.09 (0.29) (1.30)
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Fama, Eugene F. and French, K.R., 1993, Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics. 33(1), 3–56. Fama, E. and French, K.R. ,1995, Size and Book-to-Market Factors in Earnings and Returns, Journal of Finance, 50(1), 131-156. Fama, E. F. and French, K.R., 1996, Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance. 51(1), 55–84. Fama, E. F. and French, K.R., 1997, Industry Costs of Equity, Journal of Financial Economics, 43(2) ,153–193. Fama, E. F. and French, K.R.,1998, Value Versus Growth: The International Evidence, Journal of Finance, 53(6), 1975–1999. Fama, E. F. and French, K.R.,2004, The Capital Asset Pricing Model: Theory and Evidence, Journal of Economic Perspectives, 18(3),25-46. Fama, E.F. and Gibbons, M. R., 1984,A Comparison of Inflation Forecasts, Journal of Monetary Economics, 13(3), 327-348. Fama, E.F. and MacBeth, J.D. ,1973, Risk, Return and Equilibrium: Empirical Tests, The Journal of Political Economy, 81, 607-636. Fama, E. F. and Schwert, G. W.,1977,Human Capital and Capital Market Equilibrium, , Journal of Financial Economics, 4(1), 95-125. Fisher I.,1930, The Theory of Interest: As Determined by Impatience to Spend Income and Opportunity to Invest it, 1954 reprint, New York: Kelley and Millman. Graham, J.R. and Harvey, C.R.,2001,The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics, 60,187-243. Gibbons, M. R., Ross, S. A. and Shanken J., 1989, A Test of the Efficiency of a Given Portfolio, Econometrica,. 57(5),1121–1152. Gultekin, N.B. , 1983, Stock Market Returns and Inflation: Evidence from Other Countries, Journal of Finance, 38(1), 49-65. Hall, A.R., 2005, Generalized Method of Moments, Oxford University Press. Hansen, L. P., 1982, Large Sample Properties of Generalized Method of Moment Estimators, Econometrica, 50(4), 1029-1054. Hansen, L.P., and Richard, S.F.,1987, The Role of Conditioning Information in Deducing Testable Restrictions Implied by Dynamic Asset Pricing Models, Econometrica, 55(3),587- 613. Hansen, L. P., and K. J. Singleton (1982), Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models, Econometrica, 50, 1269-1286. He, J. and Ng, L.K.,1994, Economic Forces, Fundamental Variables and Equity Returns, Journal of Business, 67(4), 599-609. Jagannathan, R and Wang, Z.,1996, The Conditional CAPM and the Cross-Section of Expected Returns, Journal of Finance, 51, 3-53. Jegadeesh, N., and Titman, S.,1993, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance. 48(1), 65–91. Jensen, M.C. ,1968, The Performance of Mutual Funds in the Period 1945–1964, Journal of Finance, 23(2), 389–416. Jiro, E.K., Portfolio Theory and The CAPM: Theory and Tests, Sloan School of Management. Jones, C. M., and Kaul. G.,1996, Oil and the Stock Market, Journal of Finance, 51(2), 463- 491. Kallunki, J.P., Martikainen,M, Martikainen,T., and Yli-Olli, P., 1997, The Finnish Stock Market: A Survey of Some Empirical Evidence and Its Practical Relevance, The Finnish Journal of Business Economics, 46, 4, 474-495
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Kan, R. and Zhang, C.,1999, Two-Pass tests of Asset Pricing Models with Useless Factors, Journal of Finance, 54(1), 203-235. Kandel, S. and Stambaugh, R.F.,1995, Portfolio Inefficiency and the Cross-section of Expected Returns, Journal of Finance, 50(1), 157-184. Kaneko, T., Lee, B.S.,1995, Relative Importance of Economic Factors in the US and Japanese Stock Markets, Journal of the Japanese and International Economies, 9(3), 290–307. Lee, B.S. (1992), Causal Relations among Stock Returns, Interest Rate, Real Activity and Inflation, Journal of Finance, 47(4), 1591-1603. Levy, R.A.,1974, Beta Coefficients as Predictors of Returns, Financial Analysts Journal, 30(1),61- 69. Lewellen, J. and Nagel, S., 2006. "The Conditional CAPM does not explain Asset Pricing Anomalies," Journal of Financial Economics, 82(2), 289-314. Lintner, J., 1965, The Valuation of Risk Assets and Selection of Risky Investments in Stock Portfolios and Capital Budgets, Review of Economics and Statistics, 47(1), 13-37. Malkamäki, M., 1993, Essays on Conditional Pricing of Finnish Stocks, Bank of Finland Publication, Series B:48. Markowitz, H.,1952, Portfolio Selection, The Journal of Finance, 7(1), 77-91. Markowitz, H.,1959, Portfolio Selection: Efficient Diversification of Investments, Cowles Foundation Monograph No. 16. New York: John Wiley & Sons, Inc. Merton, R.C.,1973, An Intertemporal Capital Asset Pricing Model, Econometrica, 41(5),867– 87. Newey, W. K., and K. D. West (1987), Hypothesis Testing with Efficient Method of Moments Estimation, International Economic Review, 28, 777-787. Nummelin, K. and Vaihekoski, M.,2002, World Capital Markets and Finnish Stock Returns, European Journal of Finance, 8, 322-343. Nyberg, P. M. and Vaihekoski, M., 2005, Descriptive Analysis of Finnish Equity, Bond, and Money Markets 1920-2004, Unpublished manuscript, Available at SSRN:http://ssrn.com/abstract=790444 Nyberg, P. and Vihriälä, V.,1993, The Finnish Banking Crisis and Its Handling, Bank of Finland Discussion Papers. Pastor, L. and Stambaugh, R. F., 2003, Liquidity Risk and Expected Stock Returns, Journal of Political Economy, 111(3),642-685. Pastor, L. and Stambaugh, R.F.,1999, Costs of Equity Capital and Model Mispricing, Journal of Finance, 54(1), 67–121. Pearce, D.K. and Roley , V.V., 1988, Firm Characteristics, Unanticipated Inflation and Stock Returns, Journal of Finance , 43(4) 965-981. Reinganum, M. R.,1981, A New Empirical Perspective on the CAPM, Journal of Financial and Quantitative Analysis, 16(4), 439–62. Roll, R.,1977, A Critique of the Asset Pricing Theory’s Tests; Part I: on Past and Potential Testability of the Theory, Journal of Financial Economics, 4, 129-176. Roll, R. and Ross, S.A.,1994, On the Cross-Sectional Relation between Expected Returns and Betas, Journal of Finance, 49(1), 101-121. Rosenberg, B., Reid, K. and Lanstein, R.,1985, Persuasive Evidence of Market Inefficiency, Journal of Portfolio Management, 11, 9-17. Ross, S.A., 1976, The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, 13, 341-360. Ross, S.A.,1977, Return, Risk and Arbitrage, in I. Friend and J.I. Bicksler (eds.), Risk and Return in Finance, Massachusetts: Ballinger, 189-218. Shanken, J.,1992, On the Estimation of Beta-Pricing Models,. Review of Financial Studies, 5, 1-33.
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Shanken, J.,1985,Multivariate Tests of the Zero Beta CAPM, Journal of Financial Economics, 14, 327-48. Shanken, J., 1985, Multi-Beta CAPM or Equilibrium-APT, Journal of Finance, 40(4), 1189- 1196. Sharpe, W.F., 1964, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance, 19(3), 425-442. Stambaugh, Robert F. ,1982, On The Exclusion of Assets from Tests of the Two-Parameter Model: A Sensitivity Analysis, Journal of Financial Economics. 10(3), 237–68. Vaihekoski, M.,2007, On the Calculation of the Risk Free Rate for Tests of Asset Pricing Models, Unpublished manuscript, Available at SSRN:http://ssrn.com/abstract=958471 Vaihekoski, M.,2004, Portfolio Construction for Tests of Asset Pricing Model,. Financial Markets, Institutions & Investors,13(1),1-39. Vaihekoski, M.,2000, Unconditional International Asset Pricing Models: Empirical Tests, The Finnish Economic Papers, 13(2) 71-88. Vaihekoski, M.,1997, The Finnish Stock Market: Recent Trends and Important Events, The Finnish Journal of Business Economics, 46(4) 526-543.
Islamic Finance: A Therapy for Healing the Global Financial
Crisis
Miranti Kartika Dewi17 *Researcher of Centre for Islamic Economics and Business ** Lecturer of Department of Accounting Faculty of Economics, University of Indonesia
17 Corresponding author can be contacted by email: [email protected].
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Ilham Reza Ferdian * Student of Master of Science on Finance Programme Kuliyyah of Economics and Management Sciences International Islamic University Malaysia ** Fellow of PT. Bank Muamalat Indonesia
ABSTRACT
Global financial crisis which hit many too-big-too-fail countries and financial institution in the world was mainly made happen by debt securitization. Derivative instruments resulted from this process obviously were not backed by real asset. When any party came up with investment on these instruments, the investment would never support the development of real sector economy, instead, it just worsen the situation by creating bubble economic. This condition becomes more harmful when the securitized debts default. This practice is strictly forbidden according to Islamic finance principles. It has inherent risk management tools to prevent the crisis. This paper attempts to examine the root of the financial crisis and find the solution from Islamic finance principles.
Keywords: Financial crisis, Derivative, MBS, CDO, CDS, Islamic finance
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“The credit and capital markets have grown too rapidly, with too little transparency and
accountability. Prepare for an explosion that will rock the western financial system to its
foundations.” (Barberton and Lane (1999)
INTRODUCTION
As mentioned by Barberto and Lane (1999), the explosion just became a reality. Though the crises in the US and Europe were one of the crises series which regularly hit the world starting from the 20th century, most economists view that the current financial crisis is the greatest one that beat the world economy, even if compared with the Great Depression in
1930s.18
Figure 1: Chronologies of the World’s Economy Crisis
Source: Sakti (2009), with some adaptations
Since current global financial crisis is frightened can bring prolonged period of economy downturn, it is very important to find ways to cure it. However, as always done by a doctor before giving medical treatment to his patients, it is important for us to firstly observe the ground of the problem.
18 Roy Davies and Glyn Davies (1996) in their book entitled “A History of Money from Ancient Times to the Present Day mentioned that until their book was launched, there were more than 20 crises happen in the world, and all of them are financial crises.
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ROOT OF THE CURRENT GLOBAL FINANCIAL CRISIS
The Bank for International Settlement (BIS) has mentioned on its 2008 annual report that the root of almost all crises has been excessive and imprudent lending by banks. Furthermore, this factor also becomes important cause that makes this current crisis happen, which was boomed with defaults of subprime mortgages in the United States on 7th February 2007
(Sakti, 2009).
The default was made happen by excessive and imprudent mortgage lending given by
Washington Mutual to many high-risk home purchasers in the US. In return, the purchasers should pay certain amount of service fees to Mutual. This mortgage lending was then securitized by the Mutual and sold to mortgage guarantee institutions (Fannie Mae and
Freddie Mac) to earn more funds. Furthermore, the guarantors pooled and packaged the mortgages into instrument called Mortgage backed Securities (MBS). This type of instrument later sold to the Wall Street. After that, the Wall Street re-packaged the MBS into another derivative instrument called as Collateralized Debt Obligations (CDOs) and sold them to some investment banks, e.g. Lehman Brothers (Karim, 2009). From this stage, the investment banks sold the instruments by mixing prime and subprime debt to pass the entire risk of default of even subprime debt from mortgage originators to the ultimate purchasers who would have normally been reluctant to bear such a risk. But do to this camouflage packaging; the buyers could not clearly see the inherent risk of the financial instrument they bought. As a result, the lending to subprime borrowers and speculators increased steeply
(Chapra, 2008). Illustration of the root of the financial crises can be seen in the following figure.
Figure 6: Root of the Recent Global Financial Crises
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Those unhealthy practices lead to nationalizations of a number of banks by the governments in the US, the UK, Europe and a number of other countries. In consequence, the creditors became uncertain with the situations and sought for protection against default by buying derivatives like Credit Default Swaps (CDSs). By owning these instruments, they pay a premium to hedge funds for the compensation they will receive in case the debtor defaults.
Another problem here is that the hedge funds did not only sell the CDSs to creditors, instead, they also sell the derivatives to a large number of others who were willing to bet on the default of the debtor. They even resold the swaps to others.
Figure 4: Growth in Outstanding CDSs
Source: BIS Quarterly Review, 2008 on FSA (2009)
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Consequently, the hedge funds as well as the investment banks could not afford to pay such incentives to the instrument buyers. Such default, therefore, brought those institutions to unavoidable bankruptcy and those buyers to extremely high investment losses.
EFFECT OF THE GLOBAL FINANCIAL CRISIS
While globalization has made fewer borders between countries, this panic situation also spread to other part of the world. Both institutional and individual investors of the US, UK, and European countries hastily withdrew their investments in capital markets of developing countries, such Indonesia, and make their domestic investors become even more panic. This condition somewhat brought destabilization of the country economy, and brought problem on the country exchange rate. To calm down the domestic investors, the government took an initiative to close the capital market for some days and made public explanations that the country real sector economy was still on control and people were expected not to panic for that situation. This is because crisis on financial sector will bring very harmful impacts on the real sector if not immediately settle down.
Figure 5: Real vs Financial Activity in the Economy
Source: Sakti (2009), with some adaptations
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Additionally, Sakti (2009) noted that the volume of transactions in the world money markets (which consist of currency speculation and derivative market transaction) amounted
US$ 1.5 trillion in a day, while in very contrast, the transaction volume in the world real sectors amounted only US$ 6 trillion in a year. This non-productive activity is frightened to bring real economy situation in a long time of crisis – a crisis which the impacts may really and directly harm the people of the world.
Figure 6: Real vs Financial Activity in the Economy
Source: Sakti (2009), with some adaptations
CAN ISLAMIC FINANCE BECOME SOLUTION?
We sent aforetime our messengers with Clear Signs and sent down with them the Book and the Balance (of
Right and Wrong), that man may stand forth in justice… (HQ Al Hadid (57): 23)
By deeply think about the above Qur’an verse, that Islam will bring justice in the world, the answer on question whether Islamic finance can become solution on the current global economic crisis is very firm. However, how to explain this?
Some thoughts expressed by Miskhin (1997) are quite suitable to summarize the crisis problems. According to him, there are three factors that may lead to crisis: 1) inadequate market discipline in the financial system resulting from the absence of profit and loss sharing
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(PLS); 2) expansion in the size of derivatives, particularly CDSs; and 3) the “too big to fail” concept.
Those three above problems are actually can be anticipated by ways of implementing the Islamic finance principles, which aimed to realize greater justice in human society.
Firstly, by implementing PLS-based transactions, the risk of transaction is not entirely shifted from financier to financed party; instead they are required to share in the risk. In return, the financier is also entitled for profit generated by the business of the financed party. This is because Islam regulates that al-ghurm bil ghunm – there is no reward can be generated without taking any risk. This principle, basically, act as a control toward higher market discipline. This is because the financiers are really encouraged to be more careful in assessing the risk of the financed parties before giving any funding to them. Furthermore, to ensure the financiers that they will get appropriate profit sharing, they are needed to monitor the use of funds by the financed parties. These mechanisms will later establish higher market discipline and even more stable economy.
Moreover, for any transaction that cannot be accomplished by mean of PLS, Islam also suggests the way. However, rather than using direct borrowing-lending mechanism,
Islam commands that the transaction shall be based on the sale or lease of real, not imaginary, assets by means of Islamic schemes such as murabahah, ijarah, salam, and istisna. For applying the schemes, the real assets involved on the transaction must be fully owned and possessed by the seller/lessor. Furthermore, it shall be done with the intention to make take-and-give delivery without any other camouflage stratagem; such as buy back (bai al-‘inah). Additionally, in the case of default by buyers/lessees, the sellers/lessors have to entirely borne it by themselves.
Implementing the Islamic schemes above may bring some positive impacts. One of which is avoidance of gambling by third parties who bet for compensation for others’ losses,
84 85 as case of the CDSs transactions. Islam does not allow securitization of unreal asset, as well as debt, as done by its conventional counterpart. This ruling can inhibit the debt from rising far above the size of the real economy. Besides, the Islamic principle on fully ownership may anticipate short-selling practice which can harm the market by oversupply phenomenon, which later can lead to exorbitant decrease in asset prices during a crisis.
In addition, borrowing-lending process with charging interest, as mostly practiced in today economy, may bring big problem in the economy. This is because the creditor is not encouraged making such double assessment. As a result, the volume of unhealthy credit will substantially increase and lead to excessive leverage, and to an unsustainable rise in asset prices, living beyond means, and speculative investment (Chapra, 2008). Shall we connected with the “too big to fail” concept, the effect of this expansion of damaging credit phenomenon are even more harmful, since the central bank will definitely come to the big banks rescue and not allow them to fail. In Islamic finance principle, borrowing-lending cannot be categorized as profit making transaction (tijarah); instead, it has to be put under social activity (tabarru) which aimed to help the poor or needy people, eliminate poverty, expand employment and self-employment opportunities and, in result, to help reduce inequalities of income and wealth.
From the above explanations, it is definite that Islamic finance may become a solution on overcoming the current global financial crisis. However, there also some thoughts to be pondered on the current practice of Islamic finance. One of the causes is the lack of Islamic financial human resources who have expertise in both sharia and finance. This phenomenon may lead to the fact that due to “risk-prudential” reason, the practices of Islamic finance nowadays are still not dominated by PLS-based transaction. Most scholars view that Islamic finance practices are only replicating the conventional ones by changing the contract names from “credit” become “murabahah or ijarah” which still give fixed return to the financier
85 86 and eliminate the word of “interest”. Therefore, for Islamic finance to become unquestionable therapy in healing the global financial crisis, many aspects shall also be prepared, including human resources, regulations, as well as support by governments, practitioners, academicians to promote its prominence.
CONCLUSION
As most crises which happened in the last 20th centuries, the current global financial crisis was also caused by imprudent lending transaction which then worsen by the excessive derivative and speculative transaction on the capital market. When default could not be further avoided, the crash on capital market led to banking crisis, which later brought to crisis on financial sector and harm the real economy sector. Islamic finance, which prohibits the practice of riba, gharar, and maysir, may act as powerful medicine to heal the crisis.
However, it has to be appropriately practiced as guided by the sharia. More importantly, supports from human resources, regulations, is needed to make the medicine working more effective.
REFERENCE
Al Qur’an nur Kariim Chapra, Umer (2008), “The Global Financial Crisis: Can Islamic Finance Help?” Paper of Ibn Khaldun Lecture Series held by Institute of Islamic Banking and Insurance, London, United Kingdom, November 10, 2008. Federal Reserve Authority (FSA) (March 2009), The Turner Review: A regulatory response to the Global Banking Crisis. Karim, Adiwarman A. (2009), “Islamic Economic: Challenges and Opportunities in the Global Financial Crisis” Paper presented on Public Lecture Series held by Centre of Islamic Economics and Business, Faculty of Economics, University of Indonesia, Depok, Indonesia, February 18, 2009. Miskhin, Frederic (1997), “The Causes and Propagation of Financial Instability: Lessons for Policymakers”, in Federal Reserve Bank of Kansas City (1937), Maintaining Financial Stability in a Global Economy, Proceedings of a Symposium Sponsored by the FRB Kansas City, Jackson Hole, Wyoming, August 28-30, pp.55-96. Sakti, Ali. (2009), “Islamic Economic: Challenges and Opportunities of Monetary Authority in the Global Financial Crisis” Paper presented on Public Lecture Series held by
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Centre of Islamic Economics and Business, Faculty of Economics, University of Indonesia, Depok, Indonesia, February 18, 2009.
Islamic Financial Institutions and the Concept of Governance
Bashar H. Malkawi
1. Introduction Existing conventional banking markets have become saturated, adversely impacting return- on-asset and return-on-equity ratios, while Islamic banks, with faster growth rates, have gained traction in many countries. Islamic finance moved beyond the simple Islamic banking model of paying investment account holders a variable profit or loss share which nonetheless tended to mimic market interest on deposits. This procedure does remain the core business of Islamic banks, but deposit alternatives have ceased to be an important source of funds for the latter. With the advent of securitization technology in the mid-1980s, market-oriented Islamic finance models were quickly devised. The market for Shari’ah compliant financing transactions has grown significantly in the past years. Currently, the Islamic finance market exceeds US $350 billion with a present growth rate of fifteen percent (Sorenson, 2008: 657). Even, Western institutions have become increasingly involved in Islamic financing. Shari’a compliant retail products, from home and auto mortgages and checking accounts, to bond (sukuk) issuance and project finance requirements, as well as derivative transactions are just some of the product applications being designed for the Islamic financial markets (Griswold,
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2008: 413-429). As Islamic banking and finance move internationally, the industry faces several challenges including the issue of governance.
The institution of Shari’ah board is one of the most important components of corporate governance of Islamic Financial Institutions (IFIs).19 The Shari’ah board has profound influence on the day-to-day practice of finance in providing advisory and consultative services to IFIs. Due to the significant growth in the Islamic finance industry worldwide and the recent global financial crisis, the Shari’ah board needs a proper governance framework. The article is divided into seven sections. Section one provides an introduction while section two defines the meaning of Shari'a board and governance. Section three provides brief historical background of Shari’ah governance. Section four discusses the role the Shari’ah board plays. Section five analyses the Shari’ah governance process. Section six, provides a discussion on selected issues and challenges that may affect the development of Islamic finance. Finally, section seven provides a set of conclusions.
2. Defining Shari’ah Governance
Shari’ah governance refers to the system as to how Shari’ah board is being controlled and directed for the purpose of Shari’ah compliance. Shari’ah board is an independent body entrusted with the duty of directing, reviewing, supervising the activities of IFIs for to insure Shari’ah compliance.20 Shari’ah board reports to and is accountable to the management of IFI. It is the responsibility of the Shari’ah board to work with management to ensure that everything about the financial product or service is in compliance with the principles and precepts of the Shari'ah and, equally as important, to ensure that there is sufficient transparency in the Shari'ah process so that the product or service is understood by consumers or investors to be Shari'ah-compliant.
19 Like conventional financial institutions, IFIs are engaged in the business of dealing in money such as collection of deposits and lending and investing. However, the fact, which distinguishes them, is that their dealings with depositors are based on profit and loss sharing rather than a fixed pre-determined interest. This signifies an IFI's fiduciary role where it is considered to be dealing in trust money. 20 Shari’ah board is normally comprised of specialized jurists in Islamic commercial law and experts in the field of Islamic jurisprudence.
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In carrying out its duty, the Shari’ah board needs a clear framework and structure to ensure its independence and effectiveness. On this basis, Shari’ah governance can be defined as a set of organizational arrangement as to how the Shari’ah board is directed, managed, governed and controlled (Alsanosi, 2009: 248). Shari’ah governance is considered as unique kind of governance in financial architecture as it concerns with the religious aspects of the overall activities of IFIs as compared to the conventional concept of corporate governance. Shari’ah governance aims at ensuring the Islamicity of financial transactions so as to uphold the integrity of the IFIs as inspired by all stakeholders via strengthening the institution of Shari’ah board.
In the light of the above conceptual definition, this paper attempts to explore specifically the governance framework of Shari’ah board of IFIs. Bearing in mind that there are other fatwa institutions which issue rulings pertaining to Islamic banking and finance such as the Council of Islamic Fiqh Academy, the Egyptian Office of the Mufti, the Council of Islamic Studies, Al-Azhar, Cairo, Egypt, the Council of Islamic Fiqh, Muslim World League, the General’s Presidency of Ifta’ in Saudi Arabia and others, the scope of this paper nevertheless is only confined to the governance of Shari’ah board of IFIs.21 In this regard, it is worth noting that such fatwa institutions are excluded from the definition of Shari’ah governance in this paper. Meanwhile, although the term Shari’ah board has been used interchangeably with other names such as Shari’ah committee, Shari’ah Advisory Body, Shari’ah Advisory Council, Shari’ah Control Board, Shari’ah Adviser, Shari’ah Control Committee, Shari’ah Controller, Shari’ah Council and Religious Committee, this paper prefers to use the term Shari’ah board.
21 Fatwa is a nonbinding advisory opinion to an individual questioner (mustafti) in connection with ongoing human affairs. A fatwa may cover issues concerning mosques, intergenerational transmission of property, and marriage of children, and banking operations and interest. Fatwa began as a private activity that was independent of any state control before being transformed into a mechanism of religious legitimization. The formulation of fatwa is patterned after a question-answer model. Islamic Legal Interpretation: Muftis and their Fatwas 4-32, 286-296 (Muhammad Khalid Masud et al. eds., Harvard U. Press 1996).
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3.0 Historical Development of Shari’ah Governance
The widespread of Islamic banking and finance sector along with increasing numbers of Shari’ah boards require a specific organizational arrangement to provide a standard of appropriate behavior and code of conduct for governance. Shari’ah governance concerns the management, establishment and affairs of the Shari’ah board which is normally comprised of fiqh scholars who have the authority to issue fatwa via collective ijtihad.22 The establishment of the Shari’ah board is relatively new in the Islamic financial system. In 1976, the first Shari’ah board of the Faisal Islamic Bank of Egypt was instituted (Kahf, 2004: 17-36).
In the early period of Islamic finance practice, there was no special body that responsible to advise Islamic banks pertaining to Shari’ah matters. The formation of the Mitr Ghams Savings Bank in 23 July 1963, the Nasser Social Bank in Egypt in 1972 and the Dubai Islamic Bank 1975 were made without setting up any Shari’ah body as part of its governance structure. Although without such Shari’ah supervisory boards, the activities of those banks did not diverge from the goal of Islamic economic.
There are few independent international entities established to support the Islamic financial sector on the aspect of Shari’ah governance such as the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB). The AAOIFI has developed over 20 Shari’ah standards including the standard on Shari’ah Supervisory Board: Appointment, Composition and Report, Shari’ah Review, Internal Shari’ah Review and Audit and Governance Committee for IFIs (New Horizon, 2004: 15). In addition to issuing several standard guidelines for IFIs, the IFSB also has set up Shari’ah Governance Working Group to develop Shari’ah governance standard
22 Ijtihad is considered one of the sources of Islamic law. Ijtihad means reasoning and strict legal analogy. To establish direct support for a legal proposition a Muslim legal scholar should be able to pinpoint to a verse of the Qur’an, or at least a tradition or saying (sunna) of the Prophet Muhammad. While the Qur’an provides the written law, the sunna supplies a sort of case law, consistent with the Qur’anic text. If direct support of a legal proposition in the Qur’an and sunna is not possible, then a Muslim legal scholar seeks ijtihad. A scholar must find a verse in the Qur’an, a sunna of the prophet, or a rule on which consensus was achieved as the point of departure. Then the direct cause, purpose or rationale, narrowly conceived, must be determined, and the relationship between the two concerns, the one in which there is a rule and the one to which one is considering extending the rule, must be elucidated in such a way as to demonstrate that the rule should be extended. For example, the Qur’anic prohibition of drinking wine extends to other alcoholic beverages without concern about gray areas.
90 91 that could be adopted by IFIs worldwide23. At the country level, the Central Bank of Malaysia (CBM) has issued the Guidelines on the Governance of Shari’ah Committee for the IFIs (BNM/GPS1) in December 2004. Also, the State Bank of Pakistan has issued the exposure draft Instruction and Guidelines for Shari’ah Compliance in Islamic Banking Institutions this year (SBP, 2008).
Regardless of the positive development of Shari’ah governance of IFIs, it is observed that there are few significant issues involved particularly in the aspect of Shari’ah governance process such as the Shari’ah board’s independence, different standard guidelines, conflict of laws, enforceability of the board’s ruling, appointment, qualification and the board’s advisory and executive roles. The IFSB, under its Shari’ah Governance Working Group, is expected to issue a standard guideline for Shari’ah governance process. With diversity in the implementation of Shari’ah governance in IFIs, a high standard of Shari’ah governance practice should be promoted to ensure that the institution of Shari’ah board could play its role effectively.
4.0 Roles of Shari’ah Board
The role of Shari’ah board varies from one board to another depending upon the nature, extent and degree of Shari’ah compliance. Inspired by the foundational dimension and the epistemology of Tawhid of Shari’ah corporate governance, the Shari’ah board has fiduciary duties towards all stakeholders of the IFIs. Moreover, the integrity of IFIs greatly depends on the status of Shari’ah compliance, impact of products, professional competence and behavior towards and observance of Shari’ah norms (Ayub, 2007: 467). In this aspect, the Shari’ah board plays a fundamental role in ensuring and enhancing the credibility of IFIs.
Objectives of the Shari’ah board are to guide IFIs in the setting of policies and regulations according to Shari’ah in approving their financial transactions from legal side and in preparing their contracts for future
23 The Shari’ah Governance Working Group consists of 23 members including consultants and the chairman, Dr. Abdulrahman A. Al-Hamidy, Deputy Governor for Technical Affairs Saudi Arabian Monetary Agency (IFSB, 2008).
91 92 transaction according to Islamic law (DeLorenzo, 2007). Even though, these objectives are common to all Shari’ah boards of the IFIs, some of them play different functions and roles. For this reason, the roles of the Shari’ah board can be explained in three different categories namely Shari’ah board at the international level institution, central bank and securities commission and individual IFI.
At the international level, we may refer to the roles played by the Shari’ah board of the AAOIFI, the IDB and the Dow Jones Islamic Market Indexes (DJIM). The AAOIFI has laid down the objectives of its Shari’ah board to include duties in realizing harmonization and convergence in the concepts and application amongst the Shari’ah supervisory boards of IFIs so as to avoid contradiction or inconsistency between the fatwas. The AAOIFI Shari’ah board is also involved in the development of Shari’ah approved instruments, examining any inquiries referred to and reviewing the standards which AAOIFI issues in accounting, auditing and code of ethics and related statements to ensure that these issues are in compliance with the rules and principles of Islamic Shari’ah (AAOIFI, 2008). The AAOIFI Shari’ah board mainly functions as a body to harmonize fatwa, to develop, examine and review the Shari’ah standards. The Shari’ah board does not have power to enforce its rulings or decision upon any IFIs. The IDB Shari`ah board acts as an advisory roles to the IDB by issuing Shari’ah opinions. It is also involved in developing the governance standard of Islamic financial institutions together with the IFSB.24 On the other hand, the DJIM Shari`ah board has specific responsibility to provide Shari’ah advice on matters relating to the Shari`ah compliance of the indexes' eligible companies (DJIM, 2008).
The Shari’ah board at individual IFI level performs a range of responsibilities which include participation in product development and structuring activities, reviewing and approving matters related with Shari’ah, issuance of fatwa, Shari’ah auditing, issuance of an annual certification of Shari’ah compliance (Mcmillen, 2006: 141) and insuring the Shari’ah compliance of IFIs’ investment in shares, equities, Sukuk and
24 IFSB. (2007). Guidance On Key Elements In The Supervisory Review Process Of Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions And Islamic Mutual Funds). Bahrain: IFSB. p. ii. The Shari’ah board consists of Sheikh Mohamed Mokhtar Sellami as a Chairman, Sheikh Saleh bin AbdulRahman bin Abdul Aziz Al Husayn as a Deputy Chairman, Sheikh Abdul Sattar Abu Ghodda, Sheikh Hussein Hamed Hassan, Sheikh Mohammad Ali Taskhiri and Sheikh Mohamed Hashim Bin Yahaya as members.
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other business avenue (Ayub, 2007: 363). Provision on the duty and objective of the Shari’ah board at the respective IFI can be found in the article of association, statutory laws, central bank’s guidelines, the AAOIFI and the IFSB standards. For example, the article of association of Faisal Bank of Egypt provides that the Shari’ah board shall follow in its business and relation with the management of the bank and its various components the same means and shall exercise the same competence accorded to the auditors under the statutes”. This provision asserts that the Shari’ah board of the Faisal Islamic Bank of Egypt operates as an internal control body of ex ante auditing, ex post auditing and the calculation and payment of zakah (Briston and El-Ashker, 1986). Article 35 of the Shamil Bank of Bahrain mentions that the Shari’ah board has duty to ascertain that the investment and activities of the bank including its subsidiary and affiliated company conform to the Shari’ah principles. Interestingly, article 36 further requires the board of directors to take the necessary actions by referring the Shari’ah board so as to ensure that all investments and other business activities conform with the Shari’ah.
In addition, the AAOIFI Governance Standard for IFIs 2005, No. 1, relate to Shari’ah Supervisory Board: Appointment, Composition and Report provides universal guideline as to the roles and functions of the Shari’ah board. It states that Shari’ah board is entrusted with the duty of directing, reviewing and supervising the activities of IFIs so as to ensure that they are in compliance with the Shari’ah principles. The AAOIFI Standard states that the primary objective of the establishment of the Shari’ah board is to advise IFIs in its operation, to analyze and evaluate Shari’ah aspects of any banking and financing activities.
Based on the above explanation, the roles of the Shari’ah board normally involves three main areas i.e. the issuance of fatwa via collective ijtihad, supervision (raqabah) and audit (mutabaah). The Shari’ah board at the bank's level plays key function in advising Shari’ah matters so as to ensure that its operations comply with Shari’ah principles at all time, endorsing and validating relevant documentations pertaining to the products and services, as
93 94 well as the internal policies, manuals and marketing advertisements and ensuring all its decisions are properly implemented25. The Shari’ah board at the central bank's level acts as the highest Shari’ah authority for the respective IFIs. At the international level, such as the AAOIFI, the Shari’ah board engages mostly in the aspect of harmonization and development of Shari’ah standards whereas the DJIM Shari’ah board concerns on the Shari`ah compliance of the indexes' eligible companies in the stock market.
5.0 Shari’ah Governance Process
The utmost important element of Shari’ah governance refers to its process. Shari’ah governance process represents the instrumental functions of Shari’ah board as part of the institution of corporate governance of IFIs. This section provides brief explanation on the Shari’ah governance process and this includes Shari’ah board’s structure, appointment, composition, procedural aspects, qualification, audit and Shari’ah report.
5.1 Shari’ah Board’s Structure
Banaga and Tomkins (1994: 10) have classified three main types of Shari’ah boards namely the Shari’ah board which is composed of Shari’ah scholars, the judicial adviser who is authorized to deal with Shari’ah issues and in-house Shari’ah department staffed with Shari’ah expert(s) who provide professional services in relation with Shari’ah matters. Another form of Shari’ah board allows other than Shari’ah scholars to be appointed as its members as in the case of State Bank of Pakistan (SBP) and the CBM. This paper offers a further classification of Shari’ah board into internal and external Shari’ah boards whereby the former refers to in-house Shari’ah board of IFIs and the latter to the Shari’ah board at the central bank, securities commission, the AAOIFI, the DJIM and Shari’ah consultant. In addition, there is also a regulatory or supervisory agency, the IFSB, that does not issue fatwa but play a role in developing Shari’ah governance standard.
25 The Shari’ah board has also power to approve the articles of corporation and authorize all the Islamic financial products (Al-Mahmoud, 2007: 9).
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5.1.1 Internal Shari’ah Board
Generally, IFIs are required to establish its Shari’ah board as stated in its article of association.26 The internal Shari’ah board structure may vary from one board to another. However, the objective of the establishment of Shari’ah board as stated in the article of association determines the nature of its governance structure. Majority of the internal Shari’ah board of the respective IFIs are responsible for the issuance of fatwa, supervision and audit has the following lines of responsibility.
5.1.2 External Shari’ah Board
External Shari’ah board can be further classified into National Shari’ah board, International Shari’ah board and Shari’ah Consultant.
(a) National Shari’ah Board
There are few Shari’ah boards established by the respective governments particularly at the central banks' or securities commission' level. This Shari’ah board acts as the highest fatwa authority for IFIs and its decision is final and binding. The difference between Shari’ah board of the central bank and securities commission is that the former deals with general aspect of Islamic banking and finance while the latter primarily focuses on the Shari’ah issues pertaining to Islamic securities.
(b) International Shari’ah Board
International Shari’ah board normally refers to independent Shari’ah body either established by mutual cooperation of several Muslims countries
26 Some of IFIs do not have Shari’ah board such as Iskan Finance of Australia where they refer the existing various fatwa issued by leading Islamic scholars and seek the opinion from Al-Azhar University, Egypt. The establishment of the Shari’ah board in Islamic banks however was determined as a prerequisite for admission into the IAIB (Rammal, H.G. 2006: 205).
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such as the AAOIFI, the IDB or in the form of Shari’ah advisor for Islamic Market indexes as in the case of DJIM.27 The AAOIFI Shari’ah board has different functions from the internal and national Shari’ah board as it plays a role in developing Shari’ah standards and to promote uniformity of Shari’ah governance practices (AAOIFI, 2008). The IDB Shari’ah board issues Shari’ah opinions as well as works closely with the IFSB in developing Shari’ah governance standard. For instance, the DJIM Shari`ah board was established with a specific task to advise and counsel Dow Jones Indexes on matters relating to the Shari`ah compliance of the indexes' eligible components (DJIM, 2008). Generally, the AAOIFI and DJIM Shari’ah boards are comprised of eminent Shari’ah scholars in the world from diverse backgrounds. These scholars are considered as the leading experts in fiqh al-muamalat28 and enjoy high authority in the Shari’ah aspect of Islamic banking and finance.
5.1.2 Regulatory and Supervisory Agency
The IFSB is considered as regulatory or supervisory agency with the exclusive aim to support the Islamic finance industry in term of regulation, guideline, training, research, database, standard practice and to promote greater uniformity. The IFSB does not have its own Shari’ah board as it plays different role with the internal and external Shari’ah board. Moreover, the IFSB does not issue any fatwa or rulings pertaining to Islamic banking and finance. The objectives of the IFSB include establishing various standards and recommending them for adoption, providing supervisory and regulatory guidelines, encouraging cooperation among member jurisdictions, facilitating training and development, undertaking research and establishing databases of participants in Islamic finance industry (IFSB, 2008a). In the aspect of Shari’ah governance, the
27 The DJIM were introduced in 1999 and is considered as the first benchmarks to represent Islamic-compliant portfolios in the stock market. 28 Fiqh al-Muamalat (Islamic rules on transactions) presents a framework for conduct in the civil arena. It is concerned solely with legal relationships between members of the society. Under muamalat, any action that is not specifically or generally described as prohibited automatically becomes permissible.
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IFSB has set up Shari’ah Governance Working Group with specific objective to draft Shari’ah governance standard that could be adopted by any IFIs. It is expected that the IFSB Shari’ah governance standard which will be ready in the near future may be able to disseminate good practice particularly in the aspect of Shari’ah governance process.
5.2 Appointment
In contemporary practice, members of Shari’ah board are appointed by shareholders in the annual general meeting (AGM) or by the board of directors. The International Association of Islamic Bank states that in order to ensure freedom and independent, members of the Shari’ah board must not be working as personnel in the bank and are not subject to the authority of board of directors (Rammal, 2006: 205; El-Nagar 1980). In addition, the AAOIFI standard provides that shareholders, not the board of directors, have the authority to appoint members of the Shari’ah board in the AGM.29 This is to ensure the independence of the Shari’ah board because the management board does not have power to appoint as well as to dismiss any members of the board as the authority is vested in the AGM. In the case of appointment made by the AGM based on recommendation made by the board of directors, the Shari’ah board is allowed to attend the board of directors meetings to discuss the religious aspects of their decisions (Abu Ghudda and Abdul Sattar, 2001: 6).
In practice, board of directors in numerous IFIs appoints members of the Shari’ah board such as the case of Jordan, Malaysia and Pakistan. Article 27 (a) of the Jordanian Islamic Banking Law provides that the Management Board will appoint a Shari’ah advisor amongst the experts on Shari’ah rulings for a maximum period of five years (Bakar, 2002: 78).30 Article 8 of the BNM/GPS1 places the power of appointment in the hands of the Board of Directors
29 For instance, in the case of the Shari’ah board of al-Rajhi Bank in Saudi Arabia, the appointment is made by the AGM with the recommendation of the board of directors. An executive committee that consists of two Shari’ah board members and the secretary reports to the Shari’ah board (Al-Rajhi, 2008). 30 This practice has been changed with the amendment of Article 58 of Law 28 of 2000 in 2003. The appointment of Shari’ah board members are made by the AGM and the members may be dismissed only through two-third majority of the board of directors and endorsed by the general assembly (Grais and Pellegrini, 2006).
97 98 upon recommendation of its Nomination Committee and by obtaining prior written approval of the CBM. In Pakistan, the appointment of Shari’ah board must be approved by the board of directors in case of domestic IFIs and in case of foreign banks having Islamic banking subsidiaries the appointment shall be made by the management (SBP, 2008).
The practice is different in the case of the appointment of Shari’ah board members at the central banks' level whereby the power is vested in the government as in the case of Shari’ah board of the Central Bank of Sudan31, Malaysia and the UAE. In Malaysia, members of the Shari’ah board of the CBM are appointed by the Minister of Finance on the recommendation made by the board of directors pursuant to section 16B (2) of the CBA. In the UAE, the authority grants power to the Shari’ah board of the Central Bank of the UAE to approve and endorse the appointment of Shari’ah board at the respective banks by virtue of article 5 of the Federal Law No. (6) of 1985 (Hasan, 1996: 30-31). On the basis of the above, it can be said that there is no uniform standard regarding the method of appointment of Shari’ah board members.
5.3 Composition
Shari’ah board is composed of Shari’ah scholars who are experts in fiqh al-muamalat and usul fiqh.32 In term of composition of the Shari’ah board members, it varies from one IFI to another. In international institutions and central banks, Shari’ah board is usually comprised of leading international and regional scholars. On the other hand, Shari’ah board of the respective IFIs consists of regional and local scholars.33
By and large, many IFIs appoint between three to six members of the Shari’ah board. The AAOIFI Shari’ah board is composed of no more than twenty members among Shari’ah scholars who are appointed by the Board of Trustees for a four-year term. The AAOIFI
31 Section 3 of the Directive Order of the Minister Directive (No. 184) 1992 has listed the names of the Shari’ah board members of the Bank of Sudan. 32 Islamic law is divided into two disciplines: fiqh, which the content of the sacred law, and usul al-fiqh, the principles by which it is deduced. Usul is a system of rules by which new law is derived from a fixed body of source materials. It deals with such problems as how to derive a general rule from a known particular case, how words can legitimately be interpreted, and so on. John Walbridge, Logic in the Islamic Intellectual Tradition: The Recent Centuries, Vol. 39 No. 1 Islamic Stud. 55, 68 (2000). 33 Internationalist scholars refer to Shari’ah board members who most often sitting in the Shari’ah boards of the investment fund and international organizations such as the AAOIFI and the IDB and have expertise and experience in sophisticated financial transactions in a various jurisdictions around the world (Mcmillen, 2006: 140).
98 99 standard requires at least three members at the IFIs level and this is followed by a few countries such as Bahrain, Dubai, Jordan34, Lebanon35, Philippines36, the UAE37 and Malaysia. For instance Article 16 of the BNM/GPS1 requires a minimum of three members and further requires the IFIs to set up a Shari’ah secretariat in order to ensure that the Shari’ah board would be able to function effectively. The Shari’ah governance in Indonesia requires a minimum of two members and maximum of not more than half numbers of board of directors of the respective IFIs.38 Shari’ah board of the State Bank of Pakistan is comprised of two Shari’ah scholars and three experts in the area of banking, accounting and law. At the individual IFIs in Pakistan, there must be at least one Shari’ah advisor (Ayub, 2007: 473).
5.4 Qualification
It is contended that the ideal qualification of the board members are to those who are experts in Shari’ah and law specifically in the area of fiqh al-mualamat and usul fiqh. The reason behind this requirement is that the Shari’ah board mostly deals with the issues related with commercial law in character.39 This is in parallel with Article 12 of the BNM/GPS1 whereby it requires that the Shari’ah board members to either have qualification or possess necessary knowledge, expertise or experience in Islamic jurisprudence or Islamic commercial law.40 Paragraph 2 of the Guidelines on Islamic Private Debt Securities issued by the Securities Commission of Malaysia requires that the appointment of the Shari’ah advisors in relation with the approval of the structure of Islamic bond must be of good reputation and well versed in fiqh al-muamalat and usul fiqh and having at least three years experience in Islamic financial transactions. Article 28 of the Regulations of Faisal Islamic Bank of Sudan requires members of the Shari’ah board to be scholars of the Shari’ah or scholars of comparative law.
34 Article 58 of Law 28 of 2000 as amended by Law No. 46 of 2003 35 Law No. 575 on Establishing Islamic Banks in Lebanon. 36 The Republic Act No. 6848 and Manual of Regulations for Banks-Implementing Rules and Regulations provides regulation on the Shari’ah governance. 37 The Federal Law No. (6) of 1985 of the UAE 38 The Act No. 7 of 1992 of the Republic of Indonesia as amended by Act 10 of 1998, Regulation 4/1/PBI/2002 is the governing law on the aspect of Shari’ah governance (Grais and Pellegrini, 2006). See also Ilyas, (2008). 39 See Bakar, (2002: 74-89). 40 Section 16 of the BNM/GPS1 further provides that the Shari’ah committee members may be disqualified if he fails to meet the requirements or breach of corporate governance such as he has acted in a manner which may cast doubt on his fitness to hold the position of a Shari’ah Committee member; has been failed to attend 75 per cent of meetings scheduled for Shari’ah Committee in a year without reasonable excuse; has been declared a bankrupt, or a petition under bankruptcy laws is filed against him; was found guilty for any serious criminal offence, or any other offence punishable with imprisonment of one year or more; or subject to any order of detention, supervision, restricted residence or banishment
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Similar provision can be found in section 3 of the Guideline of the Supreme Shari’ah Supervisory Board, Bank of Sudan (Al-Darir, 2001: 5, 19-20).
Nevertheless, the AAOIFI standard allows the appointment of non-expert in fiqh al- muamalat to be a Shari’ah board member41 with a purpose to strengthen the ability of of Shari’ah board to scrutinize and understand banking business and its operations42. This position is followed by several countries such as in the case of the SBP and the CBM. Members of the Shari’ah board of SBP and CBM have various expertise and background in accounting, law, and business. The SBP has gone even further by imposing very strict conditions for Shari’ah board members. In term of educational qualification, any board member must have a degree from any recognized WaffaqulMadaris with a minimum of 2ed Class Bachelor Degree with Economics or degree with Takhassus Fil Fiqh and sufficient understanding of banking and finance or Post Graduate Degree in Islamic Jurisprudence or Usuluddin or LL.M (Shari’ah) from any recognized university with exposure to banking and finance. In terms of experience and exposure, any member must have at least 3 years experience of giving Shari’ah rulings or at least five years experience in research and development in Islamic banking and finance. The SBP also insists on the capability of mastering or having reasonable knowledge of Arabic and English languages (SBP, 2008a). All of these requirements will enable to establish a higher standard of practice of the Shari’ah governance in IFIs.
5.5 Shari’ah Audit
Unlike conventional banks, IFIs are required to undertake Shari’ah auditing process for purpose of ensuring that all transactions are in conformity with Shari’ah principles. The main objective of the Shari’ah audit is to ensure that the management of the IFIs is in compliance with Shari’ah rules and principles as interpreted and decided by the Shari’ah board. The scope of Shari’ah auditing is different from normal auditing task as it concerns specifically the Shari’ah aspect and the process is guided by Islamic principles.
41 This Shari’ah board member however needs to have a certain degree of knowledge of Islamic commercial law. In this regard, the majority of the Shari’ah board members must be Shari’ah scholars in order to avoid the dominance of inexpert Shari’ah advisors in the decision making process (Bakar, 2002:77-78). 42 The institution of Shari’ah board could be extended to a system level board consisting of scholars from various disciplines of economics, finance, Shari’ah, management and commercial law (Iqbal, 2004: 59).
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In most IFIs, the Shari’ah audit is carried out by internal auditors as either part of the regular internal audit or as a separate unit of Shari’ah audit. The Shari’ah compliance framework in Pakistan mandates Shari’ah audit annually and auditors of the SBP conduct periodical Shari’ah compliance inspection in every individual IFIs. Additionally, the SBP has issued a manual for Shari’ah audit for the respective IFIs to ensure uniform audit process, Shari’ah compliance and to enhance the credibility of the Islamic finance system (Ayub, 2007: 474).
The Shari’ah board has responsibility to perform the pre-audit, during the work audit and post-audit functions. This is evident by the finding of a research by Aboumouamer (1996: 285-288) where it found that 78 per cent of Shari’ah board members perform the pre-audit function, 80.5 per cent during the work audit and 61 per cent in the post audit. Some of the Shari’ah boards do not engage directly in the Shari’ah auditing process due to their small number. Moreover, the Shari’ah board is not qualified to perform the auditing task because of lack of audit skills and required knowledge on the operational side of IFIs activities (Banaga, Et al, 1994: 65). Typically, the Shari’ah board will involve only in the Shari’ah auditing process when there is dispute or issue over Shari’ah matters which need the board’s deliberation. This requires that the auditor, who is responsible to undertake Shari’ah auditing process, to possess adequate religious knowledge to be able to identify Shari’ah issues and give an opinion on compliance with Shari’ah rules.
Khan, (1985: 36-38) views that the specific areas in which the Shari’ah auditor would report to include bahkhs (decrease in the quality of the product, tatfif (causing damage to the other party in weights and measures), uqud (contract), ihtikar (hoarding), khiyanah (embezzlements), israf (extravagance), tanajush (bidding up prices in auction by planting a fake bidder) and speculation. The scope of Shari’ah audit reporting proposed by Khan seems to cover a very wide area of audit which is ambiguous and complex. In practice, the Shari’ah audit report includes observations and assessment of systems and controls for Shari’ah compliance, recommendations for potential improvements and corrective actions need to be taken (SBP, 2008) and the audit of zakat fund (Aboumouamer, 1996: 79-80). In the event of disputes or conflict of opinion between management and Shari’ah auditors, the matters may be referred to the Shari’ah board of the respective IFIs. Similar situation with the normal auditing process, the Shari’ah audit report shall also be tabled before the Audit Committee of the IFIs.
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5.7 Shari’ah Report
The Shari’ah board is required to submit an annual report to the board of directors of the individual IFIs.43 The annual report will then be submitted to the AGM for approval. The content of the annual report of Shari’ah board includes information as to the duties and services rendered to the respective IFIs, fatwa issuance, Shari’ah board’s activities and declaration on the Shari’ah compliance (Banaga, Et al, 1994:11-13). Draft Guideline for Shari’ah Compliance in Islamic Banking Institutions of Pakistan mandates specific requirements of Shari’ah report which include the examination of all transactions, relevant documentation and procedures, to observe whether the IFI has complied with Shari’ah rules and principles, to scrutinize whether the allocation of funds, profit sharing ratios, profits and charging of losses in accordance with Shari’ah and to ensure that any earnings that have been realized from illegitimate sources have been credited to charity account (SBP, 2008). Furthermore, the AAOIFI Shari’ah standard requires individual IFI to provide the Shari’ah report with specific format guidelines.
In contemporary practice, the format and content of the Shari’ah report are different and even some of the Shari’ah boards do not submit its annual report to the AGM. A survey conducted by Grais and Pellegrini (2006: 34) found that 4 out of 13 institutions offering Islamic financial services have failed to issue the Shari’ah report. Another research carried out by Maali, Et al, (2003: 24-25) found that from a sample of 29 banks out of 88 full flagged IFIs identified (59 banks failed to respond), only 72 per cent or 21 banks provided the report of the Shari’ah board. The Shari’ah report is very important as an endorsement to the compliance with Shari’ah principles and it is considered as a crucial mean by which the
43 For instance section 22 of the BNM/GPS1 provides that the Shari’ah Board shall report functionally to the Board of Directors. This reporting structure reflects the status of the Shari’ah board as an independent body of the IFIs.
102 103 general public and interested parties find information as to what extent services and products of the IFIs meet the Shari’ah requirements. For this reason, due to the very essence of the Shari’ah report, the Shari’ah board shall issue the Shari’ah report annually in accordance with the specific format laid down by the AAOIFI Shari’ah standard.
Conclusion Shari’ah governance adds additional values to the existing corporate governance framework. It inculcates transparency, trust, ethical behavior, credibility, philosophy, values and beliefs under lying faith and beliefs (aqidah), Shari’ah and ethics (akhlaq) (Nathan and Ribieri, 2007: 477). The institution of Shari’ah board in IFIs further enhances the potential of Shari’ah research in areas of finance and economic; enable to modernize the fiqh opinions and rulings and to ensure the Islamic financial activities are in accordance with the Shari’ah rules and principles. Then again, there were also criticisms on the current development of Shari’ah governance particularly to the affairs of the Shari’ah board. Kahf, (2004) mentions that many Shari’ah advisors of the IFIs are now being alleged as bankers’ window-dressers and overstretching the rules of Shari’ah to provide easy fatwas for the new breed bankers. Although this allegation has not been proven by any empirical research, the negative perception upon the Shari’ah board should be obliterated with the implementation of strong and good Shari’ah governance.
The need to have effective Shari’ah Governance is crucial to strengthen the credibility of Islamic financial system. Failure to provide efficient Shari’ah governance would inevitably lead to serious disruptions in the market which would have dire consequences for Islamic finance industry. Such Shari’ah governance framework must be able to address various issues as discussed above. The Shari’ah standards of the AAOIFI and the IFSB are very important for purpose of bringing the standardization of the Shari’ah practices so as to ensure that Islamic finance industry will be at par with the global Shari’ah standard. The standards are expected to resolve effectively many issues in the aspect of Shari’ah governance process. Referring to the diverse perception and acceptability on the AAOIFI and the IFSB standards by IFIs around the world, there must be strong mechanisms to ensure their universal adaptation. For this purpose, studies need to be conducted to examine, analyze and scrutinize the possible adaptation of AAOIFI and IFSB standards in various markets.
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In conclusion, the foregoing discussion seems to suggest that the existing Shari’ah governance framework needs further enhancement and improvement in order to reinforce the development and growing of Islamic finance industry. Hence, the article calls for a further research to study and examine the existing Shari’ah governance practice with a purpose to identify a proper and high standard of Shari’ah governance framework for IFIs.
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Business cycles, Financial Crises, and Stock Volatility
Dr. Samer A.M. Al Rjoub Associate Professor of Finance Department of Banking and Finance Hashemite University P.O.Box 330195 Zarqa 13133, Jordan Phone: +962-53903333 Fax: +962-53903344 [email protected] Email:
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Business Cycles, Financial Crises, and Stock Volatility
Abstract ______
We estimate GARCH-M model to measure the impact of the financial crisis on stock market returns and volatility by introducing dummy variables in the mean and variance equations to measure the behavior of stock return and volatility during the crises. We examine the impact of these crises, namely, the Mexico's Tequila crises of 1994, the Asian /Russian crises in 1997-1998, September 11th attack in the United States in 2001, Iraq war in 2004, financial crisis in November 2005 and the global financial crisis of 2008-2009, on the behavior of stock returns during the crises. Not surprisingly stock returns are reliably negative during financial crisis. The dummy variable is negative when we account for the local stock market crash during 2005 and the global financial crises of 2008. It's surprisingly that stock returns are reliably positive during the Iraq war in 2004. This can be justified by the fact that money migrate from Iraq to Jordan during the Iraqi war and much of that flow to the stock market causing the boom in 2004 and much of 2005. Other crisis shows no impact on Amman stock exchange returns. Volatility behavior during crises behaves in different manners. Imported Crises cause volatility to decrease or increase based on the general public expectations. If expectations are pessimistic, the effect will be resembled by dampen demand for investment causing volatility to decrease and the size trading to decrease. If expectations are optimistic volatility will increase derived by the increased size of investment. The local stock market crash during 2005 and the global financial crises of 2008 show no impact on volatility with insignificant coefficients. This behavior is justified by the fact that the Jordan stock market has no depth or breadth
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JEL classification: G01 Financial Crises Key words: GARCH-M model, financial crisis
Business Cycles, Financial Crises, and Stock Volatility
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Stock prices have been a business-cycle indicator since at least Macaulay (1938) where stock return volatility behave differently around business expansions and contractions. Several theories about the relation between stock volatility and macroeconomic have emerged over the years among the most exciting are the Shiller (1981a,b,a984) and summers (1986), where volatility affect the economy when rational investor bear uncertainty risk due to sociological factors. An alternative theory posits that the volatility of stock returns reflect uncertainty about future cash flows and discounts rates under the assumption that market prices discounts unexpected future information into current prices. But even these theories was refuted by some researchers such as Schwert (1988) who concludes that stock return volatility increased too much during the great depression to be explained by increases in the volatility of variables that reflect future cash flows. Schwert (1989) also stated that the Shiller idea of irrational exuberance or sociological behavior driven actions is unclear and can raise some questions about why these factors does not affect capital or consumption goods market or even labor. In this article we will relate stock return volatility in the Jordan stock market index to business cycle and financial crisis with special attention to the latest financial crises of the year 2008. GARCH in mean model is used to estimate conditional volatility in the stock market index and dummy variables are used to account for business cycle and crises. I use dummy variables equal to 1 during cycles and 0 otherwise; also I use dummy variables to measure the behavior of stock returns and volatility for six months before and after the crises.
This paper enriches the empirical work by accommodating the following issues. Firstly, this paper adjusts for changing volatility of time-series shocks, autocorrelation, and/or fat tails in the distribution of average returns. Secondly, this paper adds further insight into the effect of financial crises on the stock returns behavior during period of irregular conditions and relates them to business cycle.
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The main results support the theoretical background that financial crises affect negatively stock market returns. Stock returns are reliably negative during financial crisis. The dummy variable is negative when we account for the local stock market crash during 2005 and the global financial crises of 2008. It's surprisingly that stock returns are reliably positive during the Iraq war in 2004. This can be justified by the fact that money migrate from Iraq to Jordan during the Iraqi war and much of that flow to the stock market causing the boom in 2004 and much of 2005. Other crisis shows no impact on Amman stock exchange returns. Volatility behavior during crises behaves in different manners. Imported Crises cause volatility to decrease or increase based on the general public expectations. If expectations are pessimistic, the effect will be resembled by dampen demand for investment causing volatility to decrease and the size trading to decrease. If expectations are optimistic volatility will increase derived by the increased size of investment. The local stock market crash during
2005 and the global financial crises of 2008 show no impact on volatility with insignificant coefficients. This behavior is justified by the fact that the Jordan stock market has no depth or breadth
Section 2 summarizes the major theoretical arguments linking stock volatility with macroeconomic behavior. Section 3 discus business cycles and stock market crashes in
Amman stock exchange and show how stock volatility behaves during these episodes.
Section 4 discuss sample and data, Section 5 contains GARCH-M specifications to calculate time varying volatility. Section 6 summarizes the empirical results and section 7 concludes.
2. A Review of Related Literature:
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Studies about the effect of financial crises on volatility behavior are rare and recent. The first concern was introduced by Schwert (1989) then followed by a number of research papers done on both developed and emerging markets with divergence of results. These crises were characterized by a set of empirical charactersitics that were identified as sudden shocks to volatility, market crashes, corrections in asset prices and currency sharp depreciations.
Schwert (1989), investigate the behavior of stock prices and volatility in the United States documenting its relation with business cycles and financial crashes, in the period between
1834 and 1987. The author, use two different methods of modeling volatility; the linear autoregressive model, and the nonlinear regime switching model. Schwert (1989), show that stock return volatility increases after stock prices falling, during recessions, and around financial crisis. He also show that stock markets respond deeply to the banking crisis, where stock prices drop and interest rate increase before the major crisis, interest rate decrease and stocks volatility increase after the major crisis.
Following the same line of research, Schwert (1990), examine the relationship between daily stock returns and volatility behavior during and around crisis with increased focus on the
1987 October crash of. Using daily data from 1885 to 1987 Schwert show that stock return volatility increases when stock prices collapse and during business cycle recessions and bank crisis.
Choudhry (1996), study stock return volatility persistence in emerging markets before and after 1987 crash. He uses GARCH in mean approach and monthly data from six emerging stock markets. Choudhry (1996) found that volatility behavior around 1987 crash is changing
109 110 but these changes were not uniform across countries and are related to factors other than the crisis itself.
Aggarwal, Inclan and Leal (1999), use iterated cumulative sums of squares (ICSS) algorithm and GARCH (1,1) dummy variable model to determine the nature of events (global, local, social, political, or economic) ,during the period between May 1985 and April 1995, which apparently cause sudden changes in the volatility of emerging stock markets. Using daily closing stock market indices values for ten emerging stock markets44, results show that the periods of increased volatility in emerging markets tend to be corresponding to important country specific economic, political and social events rather than global events
Using Taiwan daily data and ARCH (3)-M model, Fang (2001), documents a significantly negative depreciation effect with no heteroscedasticity in the stock return process, suggesting that the expected depreciation is a cause of the changing variance. The evidence further shows that the stock market volatility has increased during the period of the Asian financial crisis 1997-1998, with no change in the corresponding time-varying risk premium.
Shin (2005) , examines the weekly relationship between expected stock returns and conditional volatility in 14 emerging international stock markets using both a parametric and a flexible semiparametric GARCH-M model for the period from January 1989 to May 2003.
Shin (2005) reports insignificant but positive relationship between expected stock returns and
44These markets are : Argentina, Brazil, Chile, India, Korea, Malaysia, Mexico, Philippines, Taiwan, Thailand, Japan, Hong Kong, Singapore, Germany, United Kingdom and United State,
110 111 conditional volatility for most of his sample. Furthermore the author shows that global emerging market crisis seems to have a significant impact on stock volatility behavior.
Hammoudeh and Li (2008) examines sudden changes in volatility for five
Gulf area Arab stock markets using the iterated cumulative sums of squares (ICSS) algorithm and analyzes their impacts on the estimated persistence of volatility. This algorithm identifies large shifts in volatility of the stock markets during the weekly period 1994 to 2001. The authors found, using weekly period from 1994 to 2001, that most of the Gulf Arab stock markets are more sensitive to major global events than to local and regional factors. Moreover after accounting for large shifts in volatility, the GARCH (1,1) models significantly reduces the estimated persistence of the volatility in the Gulf stock markets.
3. Business Cycles and Stock Market Crashes in Amman Stock Exchange:
Amman Stock Exchange had witnessed two main drastic changes in the general stock market index documented in the 20th and the 21 centuries The first stock market crash was in
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November the 8th, 2005 where the market starts to collapse and the stock prices index dropped by 43.7 percent by December 17, 2006 closing at 5267.3. The second stock market crash is the one which we suffer from these days that accompany the world financial crises.
After reaching the peak on June 18, 2009, the market crashed falling by 51.7 percent by
March 3, 2009, closing at 5372.9.
Table 1 records the 25 largest increase and decreases in ASE monthly stock returns in the period between January 1, 1992 and July 2, 2009, measured by percentage change in weighted price index. We can observe from the table that the most two negative monthly returns occurred during the 2008 crisis where it registered a negative percentage change of
21.37 and 12.79 in October and November respectively, next four most negative returns occurred during 2005-2006 crisis, where it registered a negative percentage change of 8.19,
9.35, 11.43 and 12.48 in November 2006, December 2005, February 2006 and June 2006 respectively. The most three positive returns were in the year before 2005-2006 crises where about 66 percent of the largest increases and decreases in monthly returns occurred during and prior crisis. We can observe that a large percentage of the extreme returns occurred in a brief periods of financial crisis.
To pinpoint episodes of recessions and economic slowdown I gave the years with negative or less than 4% growth a dummy of 1 and otherwise 0. This procedure is done for both GDP and GNP and the resulted figures of the interactive dummies are as showed in Figure 1.
Figure 1 introduces three episodes of recessions in Jordan during the years 1967-1970 and
1985-1989 and 1999-2000. From now on I will use only the growth of GDP for the purpose of testing episodes of recessions and volatility behavior.
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In what follows we will see whether stock return volatility exhibit some pattern around recession. For that we use interactive dummy variable to measure the behavior of stock return volatility around recession and economic slowdown. So we subdivide the study sample into three sub-samples six months before and after recessions and slowdowns and the recession and economic slowdown period. The results are shown in Table 3. As we can see from the results volatility is the highest in recessions and economic slowdown with standard deviation of 89% compared to 33% and 66% six months before and after.
4. Sample and Data Values of value-weighted ASE index were collected from the ASE monthly market information for the period January 1992 to December 200945 for a total of 210 monthly observations. The sample period covers many global, regional and local events. these events were; the Mexico's Tequila crises of 1994, the Asian /Russian crises in 1997-1998,
September 11th attack in the United States in 2001, Iraq war in 2004, financial crisis in
November 2005 and the global financial crisis of 2008-2009.
To compute stock market returns, Rt, we took the log deference for the monthly general price index weighted by market capitalization.
Summary statistics are presented on Table 5 for the different period’s specifications, which end in the year 2009. The statistics include the average arithmetic mean, standard deviation and the distribution moments.
The null hypothesis of a Gaussian distribution is rejected; estimates of kurtosis and skewness support the existence of conditional heteroskedasticity, which induces a fat-tailed distribution of index and Ramadan returns. Jarque-Bara test statistics are strongly significant at the 1%
45 For the sake of urging investing in public shareholding companies and broaden the shareholders base, the government removed the 10% tax on cash dividend as of the first of January, 2002.
113 114 level for all of the return portfolios and show non-normality. Overall, there is strong evidence of changing risk premia and excess return volatilities. Table 5 shows also the average monthly returns across the colander years. Index return for the full period shows positive returns of 0.848% during the study sample, when we control for dummy variables that define deferent crises index monthly return declines dramatically to negative 0.069% , 0.51% and
0.271 % for the Mexico , Asian/Russian and Global 2008 crises respectively. Other crises show decline in average monthly index return.
5. Methodology
A generalized autoregressive conditional heteroskedasticity in mean (GARCH-M) model is used to test for the effect of financial crises on stock returns and stock returns volatility, adjusting for measurement errors by assuming a time-varying structure. With tractability and predictability as a major concern, we start with a univariate GARCH-M model applied individually to each of the crises. To test for the effect of crises on stock return behavior the model has the following form:
2 2 Rt = α t Rt−1 + β t dit +ϑtσ t + ε t ,ε t ~ N(0,σ t ) 2 2 σ t = ωi + γ t dit + ξtε t−1 + ϕtσ it−1...... (1)
where Rt is the return for the monthly stock market index, dit is a dummy variable where di
2 equals 1 for crises i and zero otherwise, and so on, and σ it is the conditional variance for index returns at period t. Results for the maximum likelihood use both Berndt-Hall-Hall-
Hausman (BHHH) and Marquardt algorithms for maximization. GARCH assumes that the residuals are iid; however even if the distribution of the residuals is not normal, the estimates are still consistent under quasi-maximum likelihood (QML) assumptions.
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6. Empirical results:
Table 6 contains the estimates of equation (1) from 1992-2009, along with diagnostics test for the adequacy of the model specification.
We estimate GARCH-M model to measure the impact of the financial crisis on stock market returns and volatility by introducing dummy variables in the mean and variance equations to measure the behavior of stock return and volatility during the crises. The dummy variable takes a value of 1 in the period of crisis and 0 otherwise.
We examine the impact of these crises, namely, the Mexico's Tequila crises of 1994, the
Asian /Russian crises in 1997-1998, September 11th attack in the United States in 2001, Iraq war in 2004, financial crisis in November 2005 and the global financial crisis of 2008-2009, on the behavior of stock returns during the crises. Results are reported in Table 6. Not surprisingly stock returns are reliably negative during financial crisis. The dummy variable is negative when we account for the local stock market crash during 2005 and the global financial crises of 2008. The coefficients of dummy variable in the mean equations are -7.29 with p-value of (0.0005) and -7.58 with p-value of (0.0144) respectively. It's surprisingly that stock returns are reliably positive during the Iraq war in 2004. The coefficient of the dummy variable is 1.67 with p-value of (0.0278). This can be justified by the fact that money migrate from Iraq to Jordan during the Iraqi war and much of that flow to the stock market causing the boom in 2004 and much of 2005. Other crisis shows no impact on Amman stock exchange returns. When we look at the coefficient of the dummy variable in the variance equation, interesting results emerge. The dummy variables that represent the Mexico's Tequila crises of 1994 and the Asian /Russian crises in 1997-1998 has reliably negative coefficients of -2.007107 and -0.938280 with p-values (0.0004) and (0.0779) respectively. Crises cause volatility to decrease. The the Iraq war in
2004 cause volatility ti increase by 1.609803
(0.0000). Finally the dummy variable that account for the local stock market crash during 2005 and the global financial crises of 2008 shows no impact on volatility with insignificant coefficients.
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Diagnostics test for the adequacy of the model specification shows that our models are correctly specified. Ljung-Box Q statistics test for serial correlation shows that all GARCH equations are free of serial correlation at lags 12 and 24. For all crises specifications ARCH
LM test strongly suggests that there is no ARCH terms left in standardized residuals and that the estimates of the GARCH models support the GARCH (1, 1) in mean specification. The
GARCH model encompasses an autocorrelation correction and is robust under non- normality.
7. Conclusion:
We examine whether stock return volatility exhibit some pattern around recession. For that , we use interactive dummy variable which subdivide the study sample into three sub-samples of six months before and six months after recessions and slowdowns and the recession and economic slowdown period. The results proves that volatility is the highest during recessions and economic slowdown with standard deviation of 89% compared to 33% and 66% six months before and after.
Further , we estimate GARCH-M model to measure the impact of the financial crisis on stock market returns and volatility by introducing dummy variables in the mean and variance equations to measure the behavior of stock return and volatility during the crises. We examine the impact of these crises, namely, the Mexico's Tequila crises of 1994, the Asian
/Russian crises in 1997-1998, September 11th attack in the United States in 2001, Iraq war in
2004, financial crisis in November 2005 and the global financial crisis of 2008-2009, on the behavior of stock returns during the crises. Not surprisingly stock returns are reliably negative during financial crisis. The dummy variable is negative when we account for the local stock market crash during 2005 and the global financial crises of 2008. It's surprisingly
116 117 that stock returns are reliably positive during the Iraq war in 2004. This can be justified by the fact that money migrate from Iraq to Jordan during the Iraqi war and much of that flow to the stock market causing the boom in 2004 and much of 2005. Other crisis shows no impact on Amman stock exchange returns. Volatility behavior during crises behaves in different manners. Imported Crises cause volatility to decrease or increase based on the general public expectations. If expectations are pessimistic, the effect will be resembled by dampen demand for investment causing volatility to decrease and the size trading to decrease. If expectations are optimistic volatility will increase derived by the increased size of investment. The local stock market crash during 2005 and the global financial crises of 2008 show no impact on volatility with insignificant coefficients. This behavior is justified by the fact that the Jordan stock market has no depth or breadth
Table 1: Positive and Negative Monthly Returns in ASE: 1993-2009
Negative Monthly Returns Positive Monthly Returns Date % Changes Date % Changes 1 30-Oct-2008 -21.37% 28-Apr-2005 23.56% 2 30-Nov-2008 -12.79% 30-Nov-2004 19.50% 3 29-Jun-2006 -12.48% 31-Jan-2005 17.22% 4 28-Feb-2006 -11.43% 31-Oct-2007 16.77% 5 28-Dec-2005 -9.35% 31-May-2009 12.96% 6 30-Nov-2006 -8.19% 30-Jun-2008 12.79% 7 31-Aug-2008 -8.13% 31-Oct-2004 11.99% 8 29-Sep-2008 -7.40% 31-Jan-2007 11.37% 9 31-Aug-1993 -7.32% 30-Nov-2003 11.09% 10 30-Jun-2009 -7.01% 30-Jun-1993 10.88% 11 30-Mar-2006 -6.43% 30-Jun-2005 10.78% 12 29-Nov-1995 -6.43% 30-Sep-1992 10.34% 13 29-Mar-2007 -6.04% 31-Mar-2005 9.73% 14 26-Feb-2009 -5.88% 29-May-1993 9.65% 15 31-Mar-1996 -5.63% 30-Nov-2005 9.20% 16 31-Oct-1998 -5.51% 31-May-1995 8.75% 17 27-Feb-2003 -5.01% 31-Jul-2003 8.63%
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18 31-May-1992 -4.91% 31-Jul-2005 8.59% 19 30-Nov-1993 -4.73% 31-May-1997 8.34% 20 31-Mar-2008 -4.67% 28-Feb-2008 8.16% 21 27-Apr-2000 -4.59% 30-Apr-2008 7.98% 22 30-Sep-1998 -4.59% 29-Jan-2004 7.94% 23 29-Jan-2009 -4.36% 29-Apr-1992 7.88% 24 30-Apr-2002 -4.18% 30-Dec-2007 7.66% 25 31-Mar-2004 -4.17% 30-Apr-2003 7.51% Source: Azzam, H., 2009, Financial Crises, Stock returns and Volatility in an Emerging Stock Market: Case of Jordan, unpublished thesis, Hashemite University
Table 2: Gross Domestic and National Products
GNP at current market GDP at current market GGDP GGNP year Prices (2) Prices (1) 1964 203.0 200.8 NA NA 1965 217.2 214.2 0.0667 0.0699 1966 239.2 235.0 0.0971 0.1012 1967 229.9 225.6 -0.0400 -0.0388 1968 205.7 200.4 -0.1117 -0.1052 1969 256.3 249.6 0.2455 0.2459 1970 235.1 228.4 -0.0849 -0.0827 1971 247.5 242.2 0.0604 0.0527 1972 285.7 281.6 0.1626 0.1543 1973 316.7 310.1 0.1012 0.1085 1974 394.8 385.7 0.2437 0.2466 1975 449.5 435.9 0.1301 0.1385 1976 589.3 567.3 0.3014 0.3110 1977 712.3 690.4 0.2169 0.2087 1978 818.5 795.4 0.1520 0.1490 1979 1009.7 982.5 0.2352 0.2335 1980 1198.2 1164.8 0.1855 0.1866 1981 1506.2 1448.7 0.2437 0.2570 1982 1714.3 1649.9 0.1388 0.1381 1983 1835.8 1786.6 0.0828 0.0708 1984 1923.3 1909.7 0.0689 0.0476 1985 1965.8 1970.5 0.0318 0.0220 1986 2223.2 2240.5 0.1370 0.1309 1987 2236.5 2286.7 0.0206 0.0059 1988 2261.0 2349.5 0.0274 0.0109 1989 2234.0 2425.4 0.0323 -0.0119 1990 2521.4 2760.9 0.1383 0.1286
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1991 2736.9 2958.0 0.0713 0.0854 1992 3424.3 3610.6 0.2206 0.2511 1993 3735.2 3884.3 0.0758 0.0907 1994 4206.9 4358.3 0.1220 0.1262 1995 4597.8 4714.6 0.0817 0.0929 1996 4799.9 4912.2 0.0419 0.0439 1997 5090.1 5137.4 0.0458 0.0604 1998 5604.0 5609.9 0.0919 0.1009 1999 5769.4 5778.2 0.0300 0.0295 2000 6094.1 5998.6 0.0381 0.0562 2001 6496.7 6363.7 0.0608 0.0660 2002 6879.0 6794.0 0.0676 0.0588 2003 7312.6 7228.8 0.0639 0.0630 2004 8320.4 8090.8 0.1192 0.1378 2005 9243.4 8953.7 0.1066 0.1109 0.1750 0.1827 2006(3) 10932.6 10520.9 0.1141 0.1245 2007(3) 12293.8 11721.5 0.2105 0.2091 2008(3) 14864.6 14189.5 Source: Department of Statistics. Note: (1) = GDP at Basic Prices + Net Taxes on Product. (2) = GDP at Market Prices + Net Factor Income from Abroad. (3) Preliminary. GGDP stands for the growth in GDP and GGNP stands for growth in GNP and is the author own calculations.
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Figure 1: Interactive Dummies for Periods of Recessions:RECGGDP is the result of multipling a dummy variable by GGDP, and RECGGNP is the result of multiplying a dummy variable by GGNP .04
.00
-.04
-.08
-.12 65 70 75 80 85 90 95 00 05
REC2GGDP REC3GGNP
Table 3
Summery Statistics for Stock Returns Index Before, During, and After Recessions and
Economic Slowdowns
Six months before During recessions and Six months after slowdowns Mean 0.027 -0.117 -0.012 Median 0.000 0.000 0.000 Maximum 3.570 4.842 3.118 Minimum -1.713 -4.699 -5.664 Std. Dev. 0.338 0.897 0.606 Skewness 7.391 -0.925 -4.669 Kurtosis 81.20 15.48 60.09 Jarque-Bera 55421.20 1394.562 29284.14 Probability 0.000 0.000 0.000
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Table 4 Amman Stock Exchange Summery in 2009
2009 The Indicator Jan Feb Mar Apr May Jun Trading Volume (JD million) 600.1 979.7 1171.21205.1 1108.1 962.2 Weighted Price Index (point) 5971 5619.7 5625.2 5650 6382.4 5935 Turnover Ratio (%) 4.9 8.6 10.6 11.3 8.4 7.5 No. of Listed Companies 263 265 268 270 272 272 Market Capitalization (JD million) 24353 23074 23188 23328 26016 24334 Market Capitalization / GDP (%) 207.8 196.9 197.8 199 222 171.5
Table 5 Descriptive statistics of the general index returns, and index return conditional on crises The crises are the Mexico's Tequila crises of 1994, the Asian /Russian crises in 1997-1998, September 11th attack in the United States in 2001, Iraq war in 2004, financial crisis in November 2005 and the global financial crisis of 2008-2009.
1992:01- RAsian /Russian Rsepattack _ iraqwar Rt RMexico's Tequila RSeptember 11th attack RNovember 2005 R Global 2008−09 2009:06 Mean 0.848 -0.069 0.046 0.059 0.190 -0.506 -0.271 Std. Dev. 5.506 0.420 0.833 0.967 0.393 2.858 2.344 Skewness 0.061 -6.158 3.854 3.720 1.576 -4.029 -5.753 Kurtosis 5.553 49.36 31.99 31.80 3.485 31.18 61.68 Jarque-Bera 57.15 20139 7875 7743 89 7517 31286 Probability 0.000 0.000 0.000 0.000 0.000 0.000 0.000
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Table 6: Effect of Financial and Economic Crises or Stock Market Index Returns. Univariate GARCH (1,1)-M model applied individually to each of the crises. The test for the effect of crises on stock return behavior use the following model specification
2 2 Rt = α t Rt−1 + β t d it +ϑtσ t + ε t ,ε t ~ N(0,σ t ) 2 2 σ t = ωi + γ t d it +ξ t ε t −1 +ϕ tσ it−1...... (1)
where Rt is the return for the monthly stock market index, dit is a dummy variable where di equals 1 2 for crises i and zero otherwise, and so on, and σ it is the conditional variance for index returns at period t.
With With Dummy With Dummy With Dummy Dummy Variables With Dummy With Dummy Variables Variables for Variables for for the Variables Variables for for financial the Mexico's , the Asian th global September 11 Iraq war in crisis in Tequila crises /Russian financial attack in 2001 2004 November of 1994 crises in crisis of 2005 1997-1998 2008- 2009
Mean Equation
2 0.129 0.013 0.017 0.043 0.051 0.030 βt (GARCH term, σt ) (0.0361) (0.2540) (0.1093) (0.5480) (0.0002) (0.0153) -0.98 0.319 1.119 1.675195 -7.293 -7.584 ϑt (Dummy) (0.1202) (0.7340) (0.2403) (0.0278) (0.0005) (0.0144) 0.192 0.217 0.195 0.181 0.156 0.189 αt (Rt-1) (0.0057) (0.0025) (0.0047) (0.0070) (0.0284) (0.0073) Variance Equation 1.377 0.1989 -0.270 -0.213 0.469 0.397 ωi (Constant) (0.2453) (0.5368) (0.0117) (0.0217) (0.4510) (0.4707) 2 0.159 0.099 -0.029 -0.031 0.109 0.105 ξt (ARCH term, εt-1 ) (0.0803) (0.0476) (0.2910) (0.4285) (0.0941) (0.1049) 2 0.805 0.908 1.028 1.028 0.870 0.882 ϕt (GARCH term, σt ) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) -2.007 -0.938 3.013 1.609 4.770 9.148 γ t (Dummy) (0.0004) (0.0779) (0.0000) (0.0000) (0.3545) (0.3466)
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R-squared 0.052 0.043 0.064 0.070 0.169 0.100 Adjusted R-squared 0.024 0.015 0.036 0.043 0.145 0.073 Durbin-Watson stat 1.948 1.984 1.976 1.969 2.084 2.031 No. of Observations 210 210 210 210 210 210
Convergence achieved 68 46 56 46 42 54 after N iterations Ljung-Box Q Statistics 8.0545 9.3859 8.1121 7.8991 6.7436 10.145 (12) 0.781 0.670 0.776 0.793 0.874 0.603 20.836 16.115 17.894 22.059 18.996 17.629 Ljung-Box Q Statistics 0.648 0.884 0.808 0.576 (0.752) 0.821 (24) 0.109745 0.516240 0.678673 0.054356 0.848954 0.250928 ARCH LM 0.74077 0.473264 0.4109 0.8158 (0.357) 0.616957 NOTES: The p-values are in parenthesis, Results for the maximum likelihood use both Berndt-Hall-Hall- Hausman (BHHH) and Marquardt algorithms for maximization.
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The Securities Law of Jordan
By
Ahmed Al-Waked*
1. Introduction
Securities markets are means of capital raising. The better they perform, the more likely savors will be motivated to supply capital, thereby reducing its costs to industry, who themselves will be motivated to seek capital from the public.46 Securities markets also represent an avenue for investment promotion. Securities could provide higher return to savors than other financial assets, which encourages financial saving and channels it into productive investment and thus promoting growth. Securities trading, thus, contribute to the
"liquidity" and "efficiency" of the market.47 Moreover, securities markets provide business financing without the drawbacks of borrowing.48 Therefore, the introduction of efficient securities market is vital to the success of the economy.49
*
46 Other capital-raising techniques include commercial loans and direct investments. Investment and loans raise perils to the economy. From the Jordanian perspective, direct investment may be perceived by the general population as a "western takeover." The securities literature often assumes that stock trades are mutually beneficial. See, e.g., Thomas Lee Hazen, Rational Investments, Speculation, or Gambling? Derivative Securities and Financial Futures and Their Effect on the Underlying Capital Markets, 86 Northwestern University Law Review 987 (1992) (suggesting that securities regulation is premised on the view that government should not interfere with investment decisions). 47 A basic principle of economics is that voluntary exchange is efficient because it helps move resources to those who value them most highly, as measured by willingness to pay. The classic statement of this proposition is, of course, Adam Smith's discussion of the "invisible hand." See Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations 456 (R.H. Campbell & A.S. Skinner eds., 1976) (1776). 48 Placing banks in positions of exceptional power over their borrowers may be optimal for banks, but it may not be optimal for the rest of society. Direct lending by commercial banks, as the only means of capital raising, gives the banks a dominant position in the corporate governance system. Germany and Japan are examples of such a system. The banks may use their dominant power over the corporate governance to prevent companies from undertaking risky projects. See Jonathan R. Macey & Geoffrey P. Miller, Corporate Governance and Commercial Banking: A Comparative Examination of Germany, Japan, and the United States, 48 Stanford Law Review 73, 96 (1995). 49 Securities markets are not without their critics. John Maynard Keynes, who likened stock markets to casinos, once proposed that society might be significantly better off with less stock trading. John M. Keynes, The General Theory of Employment, Interest, and Money 159-60 (1st Harbinger ed. 1964). A handful of contemporary scholars have followed Keynes' lead by questioning the social benefits of high-volume stock
126 127
An efficient securities market is instrumental in the sale of state-owned enterprises.50
Securities market can facilitate the valuation of these enterprises through objective comparable valuation measures, and generate public support for the privatization program as it serves as a forum for the transfer of companies into the hands of investors. Based on the perceived benefits of securities market, Jordan's dilemma is not whether to have or not to have securities market; rather, how Jordan should regulate securities trading and to what extent the regulation will successfully jumpstart a viable securities market.
Numerous issues are involved in the creation of a securities market.51 However, the focus in the article will be on the securities law. Accordingly, the article will give a brief account of the history of securities regulation in Jordan. It will then analyze the statutory provisions of the current securities law and explore the key issues in greater depth. The article provides a comparison between the Jordanian securities law and United States (U.S.) and other foreign laws, whenever it is appropriate.52 Finally, the article concludes by arguing that the securities law is far from being complete and suggesting ways in which the Jordanian securities market can be improved.
2. Historical Background on the Jordanian Securities Market
trading. See James Tobin, On the Efficiency of the Financial System, Lloyds Bank Review, 1-2, 15 (stock markets are "too speculative") (July 1984). See also Lynn A. Stout, Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation, 81 Virginia Law Review 611 (1995) (questioning economic benefits of financial markets and their "casino aspect" and implying that traders are irrational. Stock trading leads to social waste of resources as short-term speculation is socially destructive). Despite the criticism directed toward the securities market, there is general enthusiasm for deregulation and unfettered competition and many scholars admire the efficiency of financial markets. 50 See John H. Dobell & Farnaz Kashefi, Doing Business in the Middle East: A Primer for U.S. Companies, Cornell International Law Journal 413, 444-447 (2005). 51 To set up a securities market, there are several elements involved in this process including; 1) promoting the establishment of savings institutions such as insurance companies and the Social Security Corporation; 2) clarifying the role of government agencies such as the Ministry of Industry and Trade and Jordan Securities Commission; 3) eliminating barriers in banking laws; 4) reforming company law; 5) reforming tax laws; and 6) restructuring the judiciary. See Committee Presents Report to King Abdullah Proposing Changes Needed to Jordan's Financial Market, Jordan Times (October 30, 2000). 52 The Jordanian securities industry has received assistance from its more experienced Western colleagues. See Jordan Securities Commission Draws on US' SEC Expertise, Jordan Times (April 5, 2004) (the U.S. SEC is the world's renowned leader in securities regulation and oversight. With more than 70 years of experience enforcing the United States' securities laws and regulations, the organization is uniquely qualified to provide assistance to Jordan in the development of its laws).
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Despite lacking a specific legal structure to govern it, Jordan developed a primitive system of trading in securities. In the 1930s, the Jordanian public already subscribed to and traded in shares of public shareholding companies.53 The first corporate bonds were issued in the early sixties. The market of shares and bonds had an enormous impact on the Jordanian capital markets; it created, for the first time, the nucleus of a securities industry.
The unorganized nature of trading in securities prompted the Jordanian government to contemplate the idea of setting up a formal market to regulate issuance of and dealing in securities, in a manner that would ensure safe, speedy and easy trading, and protect small savors through a mechanism that would define a fair price based on supply and demand.54
Successive economic plans called for the establishment of such a market, and various parties started to prepare, with the government's support, for setting up an organized securities market.55 In 1970s, the Central Bank conducted intensive studies, in cooperation with the
World Bank's International Finance Corporation (IFC), and it became clear that the size of the national economy and the share of the private sector in it through public shareholding companies and its broad investor base justified such a step. Such a market was perceived as a creator of and caterer for much needed opportunities for economic growth which would stimulate and spurt economic activity.
After a tortuous drafting process, the efforts of the government bore their fruit, and Law
No. 31 of the year 1976 was promulgated, and what was known as Amman Financial Market
(AFM) was consequently established. A resolution of March 16, 1977 set up an AFM
Administration Committee, which immediately went into action; and operation on AFM
53 The Arab Bank was the first public shareholding company to be established in Jordan in 1930, followed by Jordan Tobacco and Cigarettes in 1931, Jordan Electric Power in 1938, and Jordan Cement Factories in 1951. See Amman Stock Exchange, Capital Markets Profile, available at > (last visited pages.php?menu_id=151&local_type=0&local_id=0&local_details=0#1 128 129 started on the 1st of January, 1978. As of its inception, AFM was entrusted with a dual task, namely the role of a securities and exchange commission and the role of a traditional stock exchange. The modernization of the legal rules governing the capital market is a key to economic development. Therefore, in 2002, Jordan issued its Securities Law ushering in a new era of capital market regulation.56 During the past five years, the stock exchange in Jordan has been the site of fervent activity. Shares of ---- companies are actively being traded.57 Total market capitalization is ---- billion with a market Price/ Earnings Ratio (P/E Ratio) of ---. This capitalization qualified Jordan as one of the largest securities market in the Middle East region.58 The securities market in Jordan is, to some extent, internationalized.59 This internationalization of the securities market increases the availability of funds from foreign investors. Jordan's securities market journey of unprecedented development merits an examination of the Securities Law. 3. The Main Features of the Securities Law of 2002 It should be noted, from the outset, that securities regulation in Jordan is different from the traditional regulatory model existing in developed countries. While securities regulation in the U.S. and the United Kingdom (U.K) primarily responds to changing conditions in already existing markets, Jordanian regulation is designed to assist in building and developing the market.60 Therefore, it should anticipate, rather than respond to, market needs. 56 See Provisional Securities Law No. 76 of 2002, Official Gazette No. 4579 (December 31, 2002). 57 58 See Yasmine El-Rashidi, Small Mideast Markets Shine, Wall Street Journal C16 (March 21, 2005) (discussing the surge in Arab stock indices and market capitalization of the 14 official Arab stock exchanges). 59 Sales of outstanding issues to non-Jordanians grew to Jordanian Dinar 1,293.6 million in 2007, and purchases of outstanding issues from non-Jordanians grew to Jordanian Dinar 787.4 million in 2007. See Amman Stock Exchange, Foreign Investment, available at < http://www.ase.com.jo/>. Several reasons could explain this trend in the Jordanian market. For instance, advances in communications technology in the processing of transactions facilitated the trading of securities and the settlement of transactions. Deregulation in areas such as foreign exchange controls and reduced restrictions on participation by investors in the Jordanian securities market also served to facilitate the internationalization. 60 Scandals have produced increased levels of regulation in the U.S and U.K. For example, in 1929, after a sharp crash on the New York Stock Exchange, security prices fell into a staggering decline. By 1932, common stocks 129 130 The Securities Law of 2002 lies in 124 articles divided into twelve chapters. Several regulations have been issued to implement the law.61 The Securities Law and implementing regulations establish an independent market regulator, govern the licensing of brokers, mandate public disclosure from issuers, and regulate other aspects of securities trading. This section will analyze the main features of the Securities Law. 3.1 Scope of the Securities Law A complete understanding of any statutory scheme requires attention to definitions of operative terms. The most important terms are "security" and, to a lesser extent, "offer." As clear from its title, the Securities Law regulates transactions in securities. Securities enjoy several characteristics. Securities, unlike goods, are created rather than produced. They have no intrinsic value and are merely chose in action, namely, legally enforceable rights or interests in something else.62 They convey upon their holders an interest either as owners or creditors of the issuer. The determination of whether an instrument is a security is often the threshold issue in determining whether or not the Securities Law applies. The Securities Law of 2002 defines the term "security" by first enumerating a list of specific types of instruments that are, per se, considered securities.63 For example, securities include stocks, bonds and other debt instruments issued by the government or public institutions, and investment units issued by investment funds. The list ends in a "catch-all" phrase, which empowers the respective had lost almost ninety percent of their pre-crash value. This catastrophic loss of value shocked the saving and investing middle class. The entire economy fell into a Depression, with severe unemployment and deflation in asset values. A Senate Committee investigated the crash, and revealed shocking misconduct by bankers and businesspersons. This economic crisis led to the issuance of most federal securities laws in the early 1930s such as the Securities Act of 1933. See John H. Walsh, A Simple Code of Ethics: A History of the Moral Purpose Inspiring Federal Regulation of the Securities Industry, 29 Hofstra Law Review 1015, 1019, 1043-1052 (2001). See also Jennifer G. Hill, Regulatory Responses to Global Corporate Scandals, 23 Wisconsin International Law Journal 367, 382-385 (2005). 61 Legislation is customarily written to provide the general framework. Regulations are enacted to implement statutes and basic law and to add some detail to many of the matters left outstanding by the legislation. Regulations cannot change, add, or amend the provisions of the legislation. The drafting of implementing regulations is done either pursuant to an entrustment clause in an enacting law or by an issuing department. See Hossam El-Ehwany, Introduction to Law (2004). 62 See Provisional Securities Law No. 76 of 2002, supra note 11, article 114. 63 Id. article 3.b. 130 131 regulatory body to expand on the definition as it sees fit.64 The Jordanian Securities Law includes a second step: a short list of exempted instruments that fall outside the securities category and do not need to be regulated by Jordan Securities Commission (JSC).65 The list excludes commercial papers, documentary credits, money transfers, instruments exclusively traded among banks, and insurance policies. As noted above, the Securities Law of 2002 adopts a traditional approach by defining the term "security" and then broadly empowers the JSC to expand this definition through its rulemaking power. The list approach is flexible as it allows the administrative body to adapt to changes and innovations in the market. For example, the JSC could bring investment contracts within the coverage of the Securities Law. The strength of the laundry list approach adopted in the Jordanian Securities Law is that it removes the question of what a security is from the courts and legislature, and places it in the hands of the administrative body governing the securities market. Thus, the Securities Law of 2002 does not utilize a judicial- evolving definition of "security" as the case in the U.S.66 The Jordanian judicial system lacks the capacity to deal with complex financial matters. Therefore, administering the law by the JSC, which act through a rulemaking process, seem as the best shot of creating a functional system. Investors seeking to enter the Jordanian securities market can enjoy certainty as to which instruments and transactions are regulated under the law. An offer is defined in the Securities Law as any communication that has the effect of selling or offering for sale a security.67 The definition of an offer excludes preliminary negotiations among underwriters. Rather than attempt to define the exact situations where an offer does or does not occur, the Securities Law uses an effect-based definition that covers all 64 Any other instrument the Securities Commission believes it should be a security. Id. article 3.b.9 65 Id. article 4. 66 See Thomas Lee Hazen, The Law of Securities Regulation 39-42 (St. Paul, Minnesota: West Publishing Co., 5th ed. 2005) (courts have used various tests for determining whether a security exists. Courts have found that scotch whiskey, self-improvement courses, cosmetics, pooled litigated funds, and fruit trees to be securities). 67 See Provisional Securities Law No. 76 of 2002, supra note 11, article 2. 131 132 situations where the communication has the effect of offering to sell a security. This expansive definition eschews the intent-based formula of U.S. securities law in favor of an objective standard.68 The authority of the JSC will play a vital role in determining whether there has been an offer or not. Issuers do not have to conduct offerings of securities by themselves. Underwriting professionals, such as investment bankers, can be involved in the issuance process. According to the Securities Law, an underwriter is a person "who administers the issuance and marketing of securities on behalf of the issuer.69 The involvement of underwriters in the issuance process makes the process efficient and helps the development of the securities market in Jordan. 3.1 The Key Institutions Operating in the Securities Market The capital market of Jordan comprises, inter alia, a primary securities market and a secondary securities market.70 The former describes a market in which new securities are sold, hence its association with initial public offerings (IPO), while a secondary market is one in which outstanding issues of securities are traded.71 Their distinction can be drawn by an assessment of their functions. The primary market is used to raise new capital for enterprises while the secondary market provides required liquidity for investors to arrange their portfolio 68 See J. Colin Sullivan, SEC Offshore Press Conference Safe Harbors: Lack of Objectivity Leads to Uncertainty and Ineffective Rulemaking, 23 Boston University International Law Journal 177, 185-186 (2005) (an offer is everything that even though not couched in terms of an express offer, conditions the public mind or arouses public interest in the particular securities. Further, actions that are calculated, by arousing and stimulating investor and dealer interest in the issuer's securities and by eliciting indications of interest from customers to dealers and from dealers to underwriters set in motion the distribution process, and thus are offers). 69 See Provisional Securities Law No. 76 of 2002, supra note 11, article 2. 70 An emerging, but important, component of the capital market in Jordan is the bond market. This market is composed of both government securities and corporate papers. It is essential for these debt securities to be listed. See Directives for Listing Securities on the Amman Stock Exchange of 2004, article 17-19 (July 1, 2004). There is also trading of financial futures and options, which is conducted through ASE. The availability of these derivative products allows investors to design and implement more effective risk and portfolio management. These products bode well for the development of the Jordanian financial market as they allow market participants to undertake three principal activities: to speculate, to arbitrage, or to hedge against adverse conditions in the cash market. 71 Id. article 2. 132 133 to best meet their individual needs. The trading of listed securities in Jordan is currently the domain of Amman Stock Exchange. The central feature of the restructuring effort advanced by the Securities Law of 2002 was the separation of the supervisory and legislative role from the executive role of the capital market. The latter was left to the private sector, whereby the supervisory and legislative role was entrusted to Jordan Securities Commission, and Amman Stock Exchange and the Securities Depository Center played the executive role. The capital market in Jordan consists of an intertwined body of related institutions, entrusted with the responsibility for promoting and developing the market. A. Jordan Securities Commission The first of key institutions operating in the securities market is the JSC - the primary regulatory body. The JSC has the capacity to take all the actions necessary to carry out its prescribed responsibilities and it reports directly to the Prime Minister.72 The Securities Law provided a straightforward statement of the financial and administrative independence of the JSC.73 This statement was intended to prevent undue influence in the SEC affairs and to help the JSC to accomplish its mission. As a feature of professionalism, the JSC is prohibited from engaging in any commercial activity, having a special interest in any project intended for profit, lending any funds, or owning or issuing any securities.74 The sole job of the JSC should be market regulation. Thus, the regulators must hold themselves separate from what they regulate. The Securities Law of 2002 contains several provisions that minimize conflicts of interest. Article 11 requires each member of the JSC to make a full disclosure of securities he owns or controls and securities owned or controlled by his relatives, defined in article 2 as spouses and minor children, as well as all changes in his portfolio going forward. Article 11 also prohibits the 72 See Provisional Securities Law No. 76 of 2002, supra note 11, article 7. 73 Id. article 7.a. 74 Id. article 9.a. 133 134 JSC members from engaging in any other profession or job in any company, in the government, or public or private institutions or providing any advice to these entities. However, this prohibition applies only to JSC members and does not extend to the JSC employees. Article 24 ensures that all unpublished information obtained by the JSC or its employees is treated as confidential, only to be disclosed by the JSC if necessary for the protection of investors. The Securities Law of 2002 details the structure of the JSC. The JSC shall be run by a Board consisting of five full-time members, all natural Jordanians and qualified market professionals.75 These members will be appointed for a five-year term, renewable only once by a Royal Decree. The Board is headed by a single Chairman and a Deputy Chairman appointed through a decision by the Council of Ministers. There are several provisions that describe actions and meetings of the board and outline duties of Chairman of the Board.76 The Board is charged with the oversight of the Jordanian securities market. The JSC is financially independent as the government is not the JSC only source of revenue. The financial independence avoids the JSC any budgetary drawback by the government. The SEC sets fees for a variety of activities and retains these funds.77 However, retaining fees by the JSC could leave it susceptible to pressure in order to generate revenue through undue enforcement actions if there is any kind of budgetary shortfall. The JSC should maintain a reserve equal to the double of its expenditures as reported in its annual budget.78 The reserve can be used to cover any shortages in revenue. Although the JSC is financially independent, its finances are checked by submitting an annual report, accompanied by the budget, to the Council of Ministers outlining the JSC activities in the 75 Id. article 10. 76 Id. articles 13 & 14. 77 The financial resources of the SEC include the fees for registration, listing, trading, and licensing, charges against using its facilities, fines, any funds provided by the government, and any other sources determined by the SEC. Id. articles 27 & 28. 78 Id. article 29.b. 134 135 past year.79 Additionally, as a form of finance check, the JSC must deposit all excess receipts with the treasury. The Securities Law grants the JSC the powers necessary to accomplish its mission. Specifically, the Securities Law gives the JSC a non-exclusive list of twenty powers that provide for administrative needs of the market.80 For example, the JSC has the power to set policies and plans. In addition, the JSC has full rulemaking authority as it is the sole body with the authority to issue rules, directives, and instructions related to the Securities Law.81 This language intends to give the JSC the necessary flexibility to develop and adapt rules as the Jordanian capital market evolves. The JSC is further charged to conduct investigations or inspections in order to perfect its oversight of the market and determine if a person has violated or is about to violate the Securities Law or any of its rules and regulations.82 This language is similar to the language found in U.S. securities law.83 To achieve its investigatory task, the JSC has the power to issue subpoenas, take evidence, and inspect any record as suitable. According to the text of the Securities Law, the JSC make most, if not all, of the vital decisions concerning the operation of the Jordanian securities market. By drafting flexible language and choosing a system that can adapt through new rules, rather than new legislation, the JSC should be able to encounter unforeseen demands and quickly adapt to a growing and developing Jordanian economy. However, such a flexibility and system, places a burden on the JSC to draft, implement, and update a comprehensive set of rules. Moreover, the JSC needs to carefully consider how best to exercise its authority as there is few checks on the JSC's powers. B. Amman Stock Exchange 79 Id. article 26. 80 Id. article 12. 81 Id. article 12.q. 82 Id. article 17.a & b. 83 See Securities Act of 1933, 19, 48 Stat. 74 (codified as amended at 15 U.S.C. 77s (2006)). 135 136 The second key institution central to the Securities Law of 2002 is Amman Stock Exchange (ASE), which took over the functions of AFM. The Securities Law established one stock exchange, ASE, as the entity authorized to carry on trading in securities.84 The existence of a single exchange achieves economy of scale purpose, leads to most efficient pricing and liquidity, and simplifies the task of regulatory oversight. An over-the counter market (OTC) is not available. The Securities Law correctly chose not to overburden the Jordanian securities business with OTC.85 The ASE is not a governmental organization but rather a private, non-profit organization with administrative and financial independence.86 As a private organization, composed of members who are brokers or dealers, ASE can craft rules for listed companies in areas where lawmakers lack the proper jurisdiction, provided that the rules comply with the applicable securities laws. Making ASE a non-profit entity could restrict the incentive to become a member of the Exchange. However, the structure of the Jordanian market, with only one stock exchange, makes it impossible for a broker-dealer to conduct business without being a member of the ASE. The problem may arise with the development of an OTC market where broker-dealers are able to transact business outside the stock exchange and therefore do not need its membership. However, the development of the OTC market in Jordan at this stage is not likely to happen. Although ASE can hardly be compared to the New York or London Stock Exchanges, it follows some of their traits. ASE enjoys an independent, self-regulatory nature, which was 84 See Provisional Securities Law No. 76 of 2002, supra note 11, article 65.a. 85 The term "over-the-counter market" is used to describe stocks not traded on an exchange. It is much easier to control an auction market (such as a stock exchange), which is physically concentrated in one place, than to regulate an OTC market, with its amorphous structure and lack of centralized trading. Even though the OTC market can be made more organized through the introduction of the automated trading system (like NASDAQ, a computer screen-based market with no central exchange or trading floor which functions by collecting figures for both purchase and sale prices entered by brokers around the U.S.), only few countries—such as the U.S. and U.K--have such a system, and it would be too ambitious to project the same for Jordan. See Onnig H. Dombalagian, Demythologizing the Stock Exchange: Reconciling Self-Regulation and the National Market System, 39 University of Richmond Law Review 1069 (2005). 86 See Provisional Securities Law No. 76 of 2002, supra note 11, article 65.a. 136 137 attractive for several reasons.87 With the stock exchange as independent as possible from the central government, it helps ease the burden and workload on the regulators while making the market more responsive to the needs of issuers, brokers, and investors. Unlike a legislator, a quasi-self-regulatory ASE can adopt innovative approaches to problems and modify ineffective solutions quickly by its own rule-making process. Although ASE designs and administers its own rules, it has a quasi-self-regulatory structure as it is subject to the JSC' oversight. JSC can monitor and supervise the work of ASE.88 This quasi-self-regulatory framework diminishes some of the potentially negative aspects of a "pure" self-regulatory regime, which include bias and inadequate enforcement of rules.89 ASE is governed by a Board of Directors comprised of seven members-two representing banks licensed as brokers and brokers which are owned by or associated with banks, two representing brokers that are not among those mentioned earlier, three representing the private sector.90 It is noticeable that the Board of Directors of ASE does not have representatives of government agencies. The ASE regulations provide for direct election of directors.91 All remaining details concerning the structure, operation and procedures of the Board are decided by the rules of ASE. The Board of Directors can propose bylaws which decide most policy issues concerning operation of ASE. The Board of Directors could issue any other rule or directive deemed necessary to protect investors through ensuring fairness, efficiency, and transparency in the Exchange's affairs. C. The Securities Depository Center The arm of ASE is the Securities Depository Center (SDC). While the trading activity takes place in the Exchange, the SDC has control over everything that happens after the buy 87 See Jarad D. Hunter, "No Crying in Baseball"--and No more Crying on the Stock Markets: An Alternate- Hybrid Approach to Self-Regulation, 74 University of Cincinnati Law Review 639, 642-645 (2005). 88 See Provisional Securities Law No. 76 of 2002, supra note 11, article 65.g. 89 Pure or voluntary self-regulation is characterized by no direct governmental oversight. See Neil Gunningham & Joseph Rees, Industry Self-Regulation: An Institutional Perspective, 19 Law & Pol'y 363, 366 (1997). 90 See By-Law of the Amman Stock Exchange of 2004, article 17.b (April 1, 2004). 91 Id. article 19. 137 138 and sell orders are matched – clearance, settlement, and registration.92 The SDC is an independent public entity with the mission of creating and maintaining property rights.93 The presence of independent registry will not allow the management of Jordanian companies to over-issue securities, by simply running printing presses. However, in deference to the SDC status as an independent entity, the JSC retains the power to approve, veto, or amend any rule of the SDC.94 The power given to the JSC is an important check, especially since the SDC has the authority to set its own charges.95 The SDC acts like a data bank of securities. After buy and sell orders are matched, the SDC will clear the transaction by confirming its details such as price and quantity. The SDC computer system will settle the transaction by transferring consideration from the buyer's to the seller's accounts and transferring title in the securities to the buyer. After the transaction settles, the SDC will register the new ownership by amending the list of equity holders for the company in question. The SDC enjoys a monopoly on all deposit, transfer, clearance, settlement and registration business.96 Therefore, the SDC records will be the only evidence of securities ownership in Jordan. The SDC must register all transactions effectuated and reported to and received by the SDC. To provide guarantee to investors, the SDC could issue ishaars of ownership (advices) upon the request of an investor.97 However, the use of ishaars could raise a problem. The Jordanian securities market has a tradition of using certificates of registration as a proxy for the property rights of investors. Secondary trading of certificates of registration could continue to be used by brokers, unless the SDC's ishaars come to replace them in the eyes of 92 See Provisional Securities Law No. 76 of 2002, supra note 11, article 77.a. Clearance, settlement, and registration are the three steps that complete a standard securities transaction. ASE calls for final settlement by T + 2 (date of trade plus two days). It remains unclear how much is the percentage of securities transactions in Jordan that fail to settle. 93 Id. article 76. 94 Id. article 83. 95 Id. article 84. 96 Id. article 77.b. 97 See Instructions for Registration, Deposit, and Settlement of Securities of 2004, article 4.c (September 1, 2004). 138 139 investors. In addition, ishaars and certificates of registration may create an opportunity for traders to defraud unsophisticated investors who are not aware of the fact that certificates of registration have no value and do not represent any recognized rights. The JSC and SDC will have to address the role that ishaars or certificates of registration will play in the future of the Jordanian securities market, and how they can be integrated into the computerized system at the Exchange. The SDC has advantages as it is considered the most efficient way to operate a securities market. The system of SDC is cheaper and more efficient than the traditional methods of clearance, settlement, and registration.98 By choosing the system of SDC, Jordan availed itself of the conveniences and efficiency of modern information technology.99 However, there can be drawbacks for using this system. For example, the SDC system is more vulnerable to security risks than a paper-based system. Therefore, the SDC needs to invest in strong computer security measures to ensure public confidence in the system. Moreover, using the computerized SDC system could raise concerns for some investors in Jordan who are used to dealing in paper representations of their ownership rights. There should a high standard of accountability for the SDC. 3.2 Disclosure Used both as a shield against fraud, deception, and manipulation, and as a building block of an efficient market, the practice of public disclosure has taken root in many countries.100 Like most of its counterparts in other countries, the Securities Law of 2002 98 The settlement, clearance, and registration system designed in Jordan was a departure from the time-honored ways of most developed securities markets. See Mark Gillen and Pittman Potter, Convergence of Securities Laws and Implications for Developing Securities Markets, 24 North Carolina Journal of International Law & Commercial Regulation 83, 93 (1998). 99 See Thaer Qadoumi, The Effect of Conversion to Electronic Dealing System on the Operating Efficiency and Performance of Amman Stock Exchange, 11.2 Al-Balqaa Journal for Research and Studies 73, 87-92 (2006) (the use of technology in Amman Stock Exchange, which is very recent, has lead to reduction in costs, improvement in transparency, and increase in the volume of trade on the Exchange). 100 See Samuel Wolff, Implementation of International Disclosure Standards, 22 University of Pennsylvania Journal of International Economic Law 91, 97-103 (2001) (review disclosure standards in several jurisdictions such as Australia, Israel, Luxembourg, Mexico, the U.S., and the U.K). See also Merritt B. Fox, Optimal 139 140 holds public disclosure as one of its fundamental tenets. The Jordanian Security Law follows the philosophy that the government does not guarantee the quality of investments, but rather assures that all the information is disclosed to the investing public.101 Absent disclosure of information regarding the issuer of securities, average retail investors have no mechanism for distinguishing between high and low quality enterprises, hampering efficient allocation of capital. An initial public disclosure should be made prior to the sale of a security, and continuing disclosure should be made for as long as the shares are listed. The Securities Law requires issuers of securities to notify the JSC. A prospectus must be filed with and approved by the JSC and published to the public prior to an offer to sell any security.102 However, there are certain cases whereby the issuer is exempt from filing a prospectus. Exemptions are left to the rulemaking power of the JSC and may be based on limitations on either the number of purchasers or the amount of offering.103 For example, an exemption from submitting a prospectus could be granted if the number of investors is limited and those investors are capable of assessing and bearing the investment risks. Limited offering exemptions may come handy in Jordan, where many potential issuers could be unable to afford the costs of filing a prospectus. As such, the introduction of exemptions to filing a prospectus will help expand the Jordanian securities market. Regulatory Areas for Securities Disclosure, 81 Washington University Law Quarterly 1017, 1022-1025 (2003) (discussing the benefits derived from disclosure for issuers). 101 There has been an approach that requires the disclosure of certain information to a private or public administrative body that will assess the merits of investment in the securities and will only allow the distribution if investment in the securities met some minimum quality standard. This was the approach of early state "blue sky" legislation in the U.S., first enacted in the state of Kansas. This legislation was later adopted in several states and in other jurisdictions. See Jonathan R. Macey & Geoffrey P. Miller, Origin of the Blue Sky Laws, 70 Texas Law Review 347 (1991). 102 See Provisional Securities Law No. 76 of 2002, supra note 11, articles 34.a & 41.a. 103 Id. article 36. 140 141 Compared with the U.S. securities laws, the Jordanian Securities Law of 2002 makes no distinction between a prospectus and a registration statement.104 The absence of such distinction is appropriate given the size of the Jordanian capital market and should simplify the registration process by eliminating many of the complexities of the pre-registration period. The content of the prospectus is set forth in the rules decreed by the JSC rather than in a schedule or annex attached to the law.105 Thus, the Securities Law of 2002 lays down the general categories of necessary information - issuer data, securities data, audited financial data - but leaves it to the JSC to decide how much and what nature of each is sufficient. For example, the JSC could require a prospectus to contain information regarding the issuer's financial history and statement on its use of profits. The JSC has powers to regulate prospectuses. It must approve all prospectuses before they become valid, but the Securities Law restricts the JSC powers by authorizing only three reasons to reject a prospectus.106 The JSC has thirty days to either approve or deny the prospectus.107 The thirty-day limit protects the issuer against bureaucratic inefficiency of the JSC. The JSC also decides how long each individual prospectus will remain valid.108 The JSC must be informed, in writing or electronically, of any change in the information 104 A public offering under U.S. securities laws requires the filing of a registration statement, which includes the prospectus. A prospectus is Part I of the registration statement and is the portion of the registration statement that is delivered to the investor, to the offeree or purchaser. The registration statement is not delivered to the investor, but is filed with the Securities and Exchange Commission. The registration statement has to be reviewed, cleared and declared effective by the Securities and Exchange Commission before sales can be confirmed. U.S. law contemplates a two-step registration process comprised of a waiting period and a post- registration period. The law does not prohibit oral offers during the waiting period. Also, in recognition of the fact that the prices of securities change rapidly and cannot be known in advance, U.S. regulations allow issuers to deliver a so-called preliminary prospectus. See Michael G. Byers, Eschew Obfuscation - The Merits of the SEC's Plain English Doctrine, 31 University Memphis Law Review 135, 166-168 (2000). This complex scheme of the U.S. securities laws is not contemplated by the Jordanian Securities Law. 105 See Provisional Securities Law No. 76 of 2002, supra note 11, article 34.a.2. 106 The listed reasons are: 1) if the prospectus does not conform to the requirements of the Securities Law or regulations or instructions issued pursuant thereto; 2) the prospectus or any accompanying information contains false, inaccurate or misleading data or it omits materials facts that enable the investor to make an investment decision, or that it presents information in a way that renders the information set forth false, misleading or inaccurate; 3) if the required fees for the effectiveness of the prospectus are not paid. Id. article 41.b. 107 Id. article 39 108 Id. 141 142 contained in the prospectus that may affect the value of the security.109 Thus, the Securities Law contains an objective standard that requires notification of any material event that "may" have an impact. The Securities Law of 2002 allows an issuer to sell only after the prospectus has been approved by the JSC and it forbids the sale of a security without the buyer first receiving the prospectus.110 Thus, the Securities Law requires not only that the prospectus is "sent" to the buyer but actually is "received" by the buyer. The Securities Law requires the prospectus to be sent to the buyer prior to the sale date, rather than allow it to accompany the delivery of the security. In the future, the JSC could permit delivery of the prospectus to accompany confirmation of the transaction. After the prospectus has been approved and published and all the required fees have been paid, offers may be made through a prospectus, an advertisement, or other written materials.111 The Securities Law does not require the issuer to clear the writing or other advertising materials with any regulator prior to its use. Instead, it relies on requiring a prospectus to be approved prior to sending the written materials and delivery to the buyer prior to the actual sale date. This system could provide sufficient protection against fraud and deception with a minimal burden on the issuer. Issuers of securities should not view a prospectus in Jordan as a selling document only but also as insurance. Prospectus is insurance because it is important to fully disclose all material facts, not omit any facts, in order that the prospectus not be challenged subsequently by investors on the grounds that it failed to fully disclose the company, its prospects and its business. Therefore, it could be more important to view the prospectus as insurance document in some respects than it is to be a selling document, or at least a comfortable 109 Id. article 40. 110 Id. article 34.c. 111 The JSC will issue instructions detailing the content and use of advertisements, but the Securities Law requires that, at a minimum, such advertisements must contain a summary of the prospectus. Id. article 34.b. 142 143 balance has to be struck, so that issuers do not have liabilities under the securities law after the sale. Along with the requirement of initial public disclosure, the Securities Law of 2002 gives great attention to the requirements of periodic disclosure. The need for periodic disclosure is arguably even greater than the need for initial disclosure, as companies only go public once but continue to be traded afterwards. The rationale behind the periodic disclosure system is to increase the quality, quantity and timeliness of information flowing from issuers to investors. The Securities Law requires annual and semi-annual reports containing financial statements.112 Financial statements could include balance sheet, income statement, statement of equity, and a cash flow statement. Annual reports which contain the financial statements must be filed no later than ninety calendar days after the end of the fiscal year and should be audited as required by the law.113 The auditing requirement applies only to annual reports. Issuers are required also to file and publish a report describing the board of directors and any change in its composition. In addition to annual and semi-annual reports, issuers must keep the JSC abreast of any material events that occur between the reporting periods.114 Material events include, for instance, events that may affect the price of a stock. Furthermore, ASE has the power to compel disclosure of any issuer-specific data and publish this information.115 The exercise of this power requires no preliminary publication of the reasons or grounds, nor is it subject to any prior application for an order from the courts. The disclosure rules allow the public to review and make copies of any prospectus, report, or data that have been publicized and filed 112 Id. article 43.a. 113 Id. 114 Id. article 43.d. The disclosure requirements under the Jordanian Securities Law resemble those requirements under U.S. securities laws. However, only the reporting obligation relating to material events does not exist in U.S. law. See Steven E. Bochner and Samir Bukhari, The Duty to Update and Disclosure Reform: The Impact of Regulation FD and Current Disclosure Initiatives, 7 Stanford Journal of Law, Business & Finance 225, 232 (2002) (under the continuous disclosure regime that issuers have operated within for nearly seventy years since the passage of the 1933 Act, they file quarterly and annual reports. Neither the securities acts nor Securities and Exchange Commission rules prescribe a specific duty to file any material facts changes). 115 See Amman Stock Exchange Disclosure Directives of 2004, article 3.b (September 1, 2004). 143 144 with the JSC.116 Public access to reports and data should maximize investor confidence in the capital market. The JSC defines the exact form and amount of information required in the periodic reports.117 For example, the JSC could require submission of a management statement forecast of current and future developments expected to have significant effect on the company's financial position. Since the Securities Law does not contain an annex outlining the forms and instructions for disclosure submissions, the JSC has been granted the power to develop these forms and instructions by directives.118 The directives will, therefore, specify all the important details required in each submission, including required supplementary documents, methods of public disclosure, and information regarding which company officers should sign each submission to certify its authenticity and accuracy. The approach adopted by the Jordanian Securities Law seems logical as it grants the JSC the authority to determine the content and form for disclosure submission via directives. This approach is better than filling the Securities Law with pages of complex instructions and forms. An added benefit for this approach encompasses the fact that directives are much easier to change than laws. In other words, the disclosure forms and instructions will be far more flexible and adaptive as directives rather than as parts of the law. The directives will continue to develop new information as the Jordanian capital market demands. Disclosures to investors are now required only annually or semi-annually, and even then they are issued long after the year has ended.119 Thus, the information investors receive can 116 Id. article 3.c. 117 See Provisional Securities Law No. 76 of 2002, supra note 11, article 43.b. 118 The U.S. law has, compared with the Jordanian securities law, schedules containing the forms and instructions for disclosure. See Geoffrey A. Manne, The Hydraulic Theory of Disclosure Regulation and Other Costs of Disclosure, 58 Alabama Law Review 473, 488 (2007) (providing examples of disclosure forms such as Form 10-Q and Form 20-F). 119 See Disclosure of Information by Listed Companies, Al Rai Newspaper (in Arabic) (May 25, 2007) (stating that forty-two companies did not submit preliminary reports of their activities for the year 2006 within the specified deadline. In addition, twenty-six companies did not provide the JSC with annual reports for the year 2006 within the specified term). 144 145 be stale on arrival. Moreover, the overall voluntary disclosure is poor.120 The Internet makes it easier for issuers to disseminate timely information for the sake of shareholders and investors. JSC has recognized the importance of the Internet medium to the investment community. Therefore, the Jordanian Securities Law gave issuers guidance concerning the electronic delivery of prospectuses, annual reports and semi-annual report, and other materials.121 For example, now, issuers can provide periodic reports to the investing public via corporate Websites. As a practical matter, electronic disclosure regime may not be readily implemented in Jordan, given the status of issuers' information technology infrastructures. It may be argued that additional costs imposed on issuers as a result of a move to electronic disclosure system could hinder the adoption of such a system. Furthermore, the same features of the Internet that have made it an expedient vehicle for gathering and disseminating information - broad coverage, speed, low costs - could make it an easy vehicle for the perpetration of securities frauds. On a final note, one mechanism can be relied upon for compelling disclosure is ASE. It can impose disclosure requirements on issuers through its ability to condition the right to trade with compliance with certain requirements commonly referred to as listing standards.122 Listing standards typically are split into two categories. Quantitative standards pertain to the trading environment and market process sought by ASE.123 Qualitative standards address 120 See Ayman E. Haddad, Voluntary Disclosure and Stock Market Liquidity: Evidence from the Jordanian Capital Market 10-12 (unpublished manuscript, 2007) (voluntary disclosure is defined as those items of information which are not stipulated by the Jordanian statutory regulations. These items include background information, future and projected information, employee information, and acquisition and disposal information). 121 See Provisional Securities Law No. 76 of 2002, supra note 11, articles 35.b, 37.a, 40 & 43.b, c. 122 Listing standards are the requirements of ASE applicable to securities to be traded on this exchange and to the issuer of such securities. The primary purpose of these standards is generally understood to be the facilitation of the efficient functioning of the exchange by ensuring that there is some baseline method of comparison among companies. 123 Typical quantitative requirements include that a company maintain a minimum net income and aggregate market value of shares (required by most Western exchanges), that the stock be widely held prior to listing, that some minimum percentage of the shares outstanding be owned by outside (i.e., non-management) shareholders and that it maintain a certain monthly trading volume. 145 146 matters that do not pertain directly to liquidity or the underlying market mechanism of an exchange, but to the conduct of the listed companies. For example, qualitative standards typically require Jordanian companies whose securities are to be traded on ASE to agree to make public disclosure of financial data and business information.124 All companies must adhere to minimum disclosure requirements or lose the privilege of the floor. Thus, trading on ASE is regarded as privilege, not a right. By subjecting issuers to various requirements in ASE for listing privileges, it can also protect investors with the result that listings on ASE come to serve as signals of the investment quality of securities listed on it. 3.3 Securities Market Professionals Articles 47-64 of the Securities Law establish the rules governing the activities and oversight of market professionals. The starting point for understanding the JSC jurisdiction over market professionals is defining these professionals. The Securities Law lists as market professionals: brokers, dealers, investment trustees, investment managers, financial advisors, financial services companies, and custodians.125 The basic test for deciding whether a company or an individual is a market professional is whether they are undertaking one of the activities of the listed professionals. These activities include acting as an intermediary in a securities trade, offering securities accounts to others, or placing securities for an issuer. The Securities Law uses an operational definition of market professionals. In other words, one becomes a broker in Jordan by seeking broker status, not acting as a broker. 124 To be considered for listing on the market, an issuer must submit a written application accompanied by documents calling for significant disclosure. In addition, ASE may request additional information from an issuer if needed to enable it to decide whether to admit any security for trading. There is no express limitation on what type of information may be sought. See Directives for Listing Securities on the Amman Stock Exchange of 2004, article5 (July 1, 2004). In the future, Jordan could open an additional trading floor for companies that do not qualify for listing on the main exchange. The new exchange would make more shares accessible to the public but will involve higher risks due to easier listing requirements. To date there has been no action on this type of trading floor. 125 See Provisional Securities Law No. 76 of 2002, supra note 11, article 47. The text of the Jordanian Securities Law borrowed the list of market professionals from a provision in the U.K law covering those individuals who hold themselves out as being engaged in the business of buying and selling securities. See Financial Services Act 1986 (1988), repealed by SI 2001/3649 (taking effect on December 1, 2001) (U.K.). 146 147 Furthermore, the law distinguishes between the different types of market professionals. For example, the law distinguished between brokers and dealers.126 The definitions provided for market professionals impose a balancing act upon them. If a financial advisor undertakes activities of a broker, he automatically becomes an unlicensed broker and could face sanctions. The activities of a broker or dealer must take place in one's commercial capacity.127 Therefore, an individual who is acting for himself and not seeking financial profit through the act of buying and selling securities will not fall within the jurisdictional reach of the Securities Law. Although the Securities Law made a careful distinction between the different categories of market professionals, the mechanics for licensing and ultimate outcome were the same. All market professionals will need licenses from the JSC in order to carry out business. The law forbids any individual or company from undertaking brokerage activities without first acquiring a license, unless it is exempted by the JSC's instructions.128 The JSC will determine the basic requirements and competencies of market professionals.129 The burden is on any company or individual that wishes to undertake securities activities to apply to the JSC for a license. Applications for licensing must be submitted to the JSC for screening.130 The JSC reviews each application fully and must issue a license within sixty days if the application is in order and the applicant meets all of the requisite standards. The licensing requirement is a continuing necessity, mandating periodic recertification of a market professional's licenses.131 126 A financial broker is any person engaged in the business of buying and selling securities for the account of others. While a dealer is any person engaged in the business of buying and selling securities for his own account. See Provisional Securities Law No. 76 of 2002, supra note 11, article 2. 127 The commercial law defines the commercial nature of broker activities. See Mohamed El-Sayed El-Keky, Commercial Law 132-134 (2004) (brokerage acquires a permanent commercial quality for the broker when practiced in the form of a profession or enterprise). 128 See Provisional Securities Law No. 76 of 2002, supra note 11, article 47.c & d. 129 The instructions of the JSC will determine the level of training, experience, competence, testing, and capital requirements. Id. article 47.c. 130 Id. article 48. 131 Id. articles 49 & 59.a. 147 148 While not written in the Securities Law, the process of recertification should include, at the minimum, a review of the market professional's business practices, character, and financial standing, and could include a re-testing of basic skills and knowledge. Given the central role market professionals, such as brokers and dealer, play in a capital market, it may not seem surprising that the Securities Law sets out the duties of these professionals. Market professionals owe duties to their clients. Specifically, market professionals should act with loyalty and dedication to maximize their clients' interests.132 Also, market professionals must refrain from charging clients excessive service fees or commissions, or engaging in deceptive practices. Duties of market professionals include the duty to maintain accounting records and the duty to separate their money and securities from the money and securities of their client.133 Any violation of these duties may result in sanctions by the JSC.134 For example, the JSC could suspend or revoke the license or registration for a market professional who violates the Securities Law or the JSC rules and instructions. It is noticed that the securities law does not create a long list of market professional duties. This list, if adopted, would have hampered the growth of professionalism. Moreover, including all the duties in the law would be impractical since they would be difficult to change at a later date. The current system of regulation allows greater input from market professionals and thereby be able to take advantage of their perspectives and experiences dealing with the law and JSC. Market professionals must file reports as required in the instructions and rules of the JSC. These periodic reports form the regulators' general oversight of market professionals. Furthermore, the JSC has the power to carry out investigations and inspections of any licensed market professional in order to determine if a violation of rules has occurred or is 132 Id. article 57. 133 Id. articles 54.c & 55.a. 134 Id. article 60. 148 149 about to occur.135 This power includes the authority to compel the attendance of witnesses and to take evidence. Also, the JSC must supervise the compulsory or voluntary liquidation of any market professional's business.136 This supervision should allow the JSC to protect investors' interests in these cases. Finally, the JSC has the power to grant an order suspending the license of any broker who is no longer in existence or has not engaged in business as a broker.137 This provision is designed as a housekeeping measure whereby the JSC strikes out from the list of licensed brokers all those who have died or ceased to be brokers. 3.4 Mutual Funds and Investment Companies The second common market professionals that may promote trading are mutual funds and investment companies. Although individuals in Jordan own stock directly, they can also own stock indirectly, through mutual funds and the like. Such institutional arrangements isolate the individual investor from the trading decision. Trading occurs only at the institutional manager's behest. Mutual funds and other investment companies are financial intermediaries which pool money from investors and entrust such money to professional managers to make investments on behalf of the investors. Mutual funds and investment companies offer two primary benefits.138 First, by pooling the financial resources of dispersed investors, they allow investors to gain access to the expertise of professional managers.139 Second, investors gain 135 Id. articles 56 & 68. 136 Id. article 62.a. 137 Id. article 61. The language of this provision is similar to that found in the U.S. Securities laws. See Securities Exchange Act of 1934, 15(b)(5), 48 Stat. 881 (codified as amended at 15 U.S.C. 78o (1999)). 138 Mutual funds and investment companies provide other benefits. In jurisdictions that impose no officially fixed commission rates, mutual funds provide the benefit of lower transaction costs resulting from volume discounts on brokerage commissions. Moreover, to keep attuned to investor needs, mutual fund industries in some countries have adapted and expanded their services to suit investors' needs. For instance, many mutual funds offer automatic reinvestment programs, automatic withdrawal, exchange privileges, and other services. 139 In selecting the securities in which to invest, managers perform extensive economic and financial research. The aim of this research is to develop data so that intelligent decisions can be made about securities in the portfolio. Portfolio managers use sophisticated portfolio management theories (e.g., risk-reward, stock-picking, 149 150 access to the advantages of wide diversification of ownership in the securities market. According to modern finance theory, an efficient portfolio is one that secures the maximum return for a given level of risk.140 Thus, diversification is essential to eliminating what appears to be a risk in taking in specific securities. The Securities Law includes detailed provisions for the regulation of mutual funds. The law defines mutual funds as "funds established to invest in a portfolio of securities or other financial assets for the purpose of providing professional management of collective investment on behalf of holders."141 Thus, the Securities Law recognizes a new class of market professionals - portfolio or investment managers. Although the activities of portfolio managers would technically fall within the definition of "broker," the Securities Law carves out a specific definition and role for them.142 Instead of encumbering either group of market professionals with rules written with the other group in mind, the Securities Law treats each group individually, creating more leeway for specialized treatment for portfolio managers. The JSC acts as the regulator of mutual funds and investment companies. Subjects of regulation include registration requirements for mutual funds and investment companies.143 Registration requirements are arguably the most important part of any legislation addressing investment companies. In that respect, the regulatory scheme of the Jordanian Securities Law follows the ideology of the U.S. law, which requires all investment companies to register.144 A few points in the Jordanian Securities Law with regard to registration requirements demand special attention. First, the Securities Law subjects mutual funds and other efficient market hypothesis and indexation) to conduct securities analysis. See Zvi Bodie, Alex Kane & Alan J. Marcus, Essentials of Investment 98-122 (5th ed., 2004). 140 See Robert N. Rapp, Rethinking Risky Investments for that Little Old Lady: A Realistic Role for Modern Portfolio Theory in Assessing Suitability Obligations of Stockbrokers, 24 Ohio Northern University Law Review 189, 242-244 (1998). 141 See Provisional Securities Law No. 76 of 2002, supra note 11, article 91.b. 142 A portfolio manager is defined as "any person who, on the basis of a contractual arrangement, engages in the business of managing securities portfolios for the account of others, including the management of mutual funds." Id. article 103. 143 Id. article 92. 144 See Investment Companies Act of 1940 § 7(a), 15 United States Code § 80a-7(a) (no company can do business unless registered); id. § 8, 15 United States Code § 80a-8 (registration requirements). 150 151 investment companies to licensing requirements different from those imposed upon broker- dealers and other market participants. In other words, mutual funds and investment companies have their own registration requirements. The approach followed by the Securities Law will not create uniformity in licenses for all market participants and makes it difficult for the JSC, which has yet to acquire expertise, to control the process of licensing. Second, the Securities Law specifies exemptions for certain investment companies from its licensing process.145 The Securities Law also provides that the shares and investment units of an investment company or mutual fund are subject to the registration requirements of the law.146 This provision makes it clear that other registration requirements, as they pertain to the investment companies and its management, do not relieve the company from an obligation to register its securities under the Securities Law. The final licensing requirement pertains to managers of mutual funds and investment companies.147 These persons must be licensed by the JSC. The language of the Jordanian Securities Law most closely parallels section 203 of the U.S. Investment Advisers Act which requires investment advisers to register.148 The purpose of licensing investment managers is to preventing persons with certain criminal records from acting as investment advisers. To that end, for example, a person who has been found guilty of forgery or counterfeiting can be prohibited from being employed as a manager of mutual fund or an investment company. The 2002 Securities Law left the investment companies relatively free to organize in any form they wish. For example, investment companies can be in the form of open joint-stock companies, partnership, or limited liability. A mutual fund and an investment company must include the words "mutual fund" or "investment company" in its name; no other company 145 See Provisional Securities Law No. 76 of 2002, supra note 11, article 94.b. 146 Id. article 105. 147 Id. article 103. 148 See Investment Advisers Act of 1940 § 203, 15 United States Code § 80b-3 (1994). 151 152 may use such designation. This requirement echoes the provisions of general corporation laws that attempt to prevent companies from deceiving the general population by using misleading names. Like ordinary corporations, the mutual fund establishes a hierarchical and centralized management body. The Securities Law requires that "shareholders" elect a board of directors.149 It is important to note at the outset that the description of investors as "shareholders" in the mutual fund suggests that they are entitled to the same set of shareholder rights as corporate shareholders. Their participation rights are based on a preconception of the rights associated with "shareholder" or "owner." The Securities Law also requires that no more than twenty percent of the board of directors be affiliated with the manager.150 This requirement is predicated on the belief that the mutual fund governance system works best when the functions required of independent directors are performed by individuals who are truly independent. The board of directors is principally responsible for reviewing and evaluating the management and distribution arrangements of the manager. Although mutual funds are nominally independent and supervised by their own boards of directors, they are managed by an investment manager pursuant to a contractual arrangement which is subject to general review by its board of directors.151 The directors must annually approve the advisory agreement between the mutual fund and the manager. An investment manager's control over the fund typically includes organizing and promoting the fund, managing the fund's portfolio, and supervising the business operations of the fund.152 The extensive control over the fund wielded by the manager is a matter of necessity, for the fund's directors usually do not possess the expertise needed to manage the fund. Thus, the directors' dependence on the adviser is problematic. 149 See Provisional Securities Law No. 76 of 2002, supra note 11, article 95.a. 150 Id. Affiliation is thus now one of the criteria for whether a director is independent. 151 Id. article 95.b. 152 Id. article 104. 152 153 In addition to the manager, a mutual fund usually contracts with a custodian, a transfer agent, a principal underwriter and other third-party service providers to distribute fund shares. Under the Securities Law, principal underwriting contracts are subject to similar board scrutiny.153 Such contracts and any renewals must be evaluated and approved by the shareholders. The Securities Law envisions two types of investment companies and mutual funds: open and closed.154 An open type of authorized fund of an investment company is a fund that issues securities with an obligation to redeem (buy back) them, and a closed type of authorized fund of an investment company is a fund that does not have such obligation.155 The classification of investment companies under the Jordanian Securities Law is the same as the one used for investment companies in the U.S. in section 5 of the 1940 Act.156 One distinctive feature of mutual funds is the redeemable nature of the claims that investors hold. Investors have the right to redeem their shares at their current average net asset value.157 A redeemable security entitles the holder at his option to receive his pro rata share of the pool's current net assets. Thus, mutual fund investors hold fluctuating claims, not a fixed claim like debt holders. The right to redeem shares is self-enforcing because its enforcement is not dependent on judicial intervention or third-party decisions. The decision of the claim holder to withdraw resources is a form of partial takeover or liquidation which deprives management of control over a portion of the fund's assets. Thus, this control right can be exercised independently by each claim holder. Admittedly, in determining whether to exercise redemption rights investors have to take into consideration factors such as redemption fees and tax consequences. To summarize, the availability of redemption rights 153 Id. article 103.a & b. 154 Id. article 96.a. 155 Id. article 97.a. 156 See Investment Companies Act of 1940 § 5(a)(1), 15 United States Code § 80a-5(a)(1) (open-end companies--those that issue redeemable securities); id. § 5(a)(2), 15 United States Code § 80a-5(a)(2) (closed- end companies--those that issue non-redeemable securities). 157 See Provisional Securities Law No. 76 of 2002, supra note 11, article 100.b. 153 154 within mutual fund would result in high investor mobility and a competitive environment for mutual funds. Investors are the judges of the legal and economic arrangements which they purchase and the Securities Law does not impose any standard with respect to the securities in which investment companies may invest their assets. Nonetheless, the Securities Law restricts the freedom of mutual funds and investment companies to invest in certain transactions.158 The Securities Law prohibits mutual fund and investment companies from conducting any activity other than the business of investment, or activity related to the business of investment. Financial soundness of an investment company is assured by forbidding it to incur debt above the limits prescribed or to invest in securities of one issuer above the limits prescribed.159 A mutual fund or investment company is also prohibited from issuing preferred shares.160 All these restrictions fight potential abuses because of the importance of investment funds and investment companies in the capital market. The Securities Law wanted to make sure that these funds will not undermine public trust in the capital market by engaging in fraudulent practices. As the review of mutual funds and investment companies provisions in Jordan indicate, the Securities Law is a simple and straightforward law. The simplicity of the Securities Law is justified by the conditions of the Jordanian market.161 Securities regulation should be made with an eye toward future developments, but excessively complex regulation could unduly 158 Rather than relying on restrictions to regulate investment companies, the U.S. law relies mainly on disclosure. U.S. investment companies are required disclose to the investing public their investment policies in advance. Investment companies must also seek approval of the majority of shareholders before changing their investment policies. Finally, the U.S. Securities and Exchange Commission is empowered to regulate certain transactions that are deemed to be particularly risky. See Investment Companies Act of 1940 § 8(b)(1)-(3) & 12(a)-(b), 15 United States Code § 80a8(b)(1)-(3) & 15 United States Code § 80a-12(a)-(b) (1994). 159 See Provisional Securities Law No. 76 of 2002, supra note 11, article 102.b. 160 Id. articles 95.a & 100.a. 161 Most of the complexities of the U.S. Investment Companies Act of 1940, which is the longest legislation among all U.S. securities statutes, are inapplicable to the investment vehicles that exist in Jordan. For example, the Jordanian Securities Law does not cover issuers that issue face-amount certificates of the installment type. See Tamar Frankel, The Scope and Jurisprudence of the Investment Management Regulation, 83 Washington University Law Review 939, 979-981 (2005). 154 155 burden the Jordanian market. In sum, even though managers of Jordanian mutual funds and investment companies, unlike their Western counterparts, do not have to deal with all the complexities of modern investment strategies, their primary task of composing a financially sound investment portfolio is basically the same as that of the managers of Vanguard or Fidelity. 3.5 Violations and Sanctions The Securities Law supplies the tools necessary for JSC to enforce its rules. The Securities Law authorizes two approaches to enforcement: public actions and private suits. The law affords the JSC a range of powers to enforce its rules. These powers run from suspension of license to criminal sanctions. Additionally, the law empowers private suits to recover money lost due to the illegal activities of others. The Securities Law empowers the JSC to take public action against anyone who violates the law, the JSC rules, or its decisions. In this case, the JSC has the power to levy a fine not exceeding Jordanian Dinar 100,000 ($141,113) against that person.162 The law also imposes heavy fines not less than twice the amount of profit made or loss avoided against any person responsible for violating the law or any rule. The law imposes public sanctions against anyone operating as a broker without a license. Unlicensed brokers can be imprisoned for up to one year.163 Brokers are paid a commission on every stock transaction they execute, profiting from trades regardless of whether the trading investor profits. They, therefore, have financial incentives to encourage trading. One way brokers can persuade investors to trade is by providing them with imperfect information that suggests that a particular stock or industry sector is significantly under-priced and creates perceived opportunities for speculative profits. Therefore, the law prohibits brokers 162 See Provisional Securities Law No. 76 of 2002, supra note 11, article 110.a. 163 Id. article 110.b.2. 155 156 from using fraud in the sale of securities.164 It is extremely difficult, however, to prove that slanted advice was fraudulent, both because of the evidentiary problems involved in proving intent and the content of brokers' often-verbal representations. The investor who falls prey to an unscrupulous or overoptimistic broker, in the meantime, may have suffered substantial losses from bad trades and brokerage commissions. In addition to public actions, investors in the Jordanian securities market have two causes of action under the Securities Law. The first cause of action is the right of recovery in the event that an investor incurs a loss as a result of the sale of securities.165 The investor must prove that the sale of securities was carried out in manner contrary to the Securities Law, its regulations, and instructions and decision. Further, privity is required.166 In other words, the investor must prove that he incurred the loss as a result of the sale of securities. The second private cause of action is to recover damages resulting from a material misrepresentation in a prospectus.167 The law provides that a material misrepresentation may be an untrue statement of fact or the omission of a necessary, material fact. Materiality is proven by showing that the untrue statement or omission affected the decision of an investor to sell, buy, or continue to hold the securities.168 Under this standard, the effect of the statement or omission on the investor's decision will be determined on a case-by-case basis. The misstatement or omission must exist at the time the prospectus is approved by the JSC for a cause of action to accrue under the law. Issuers, therefore, can make any necessary corrections at any time prior to final approval. However, the law does not state whether there is still a cause of action or not in the case whereby events occur that render the prospectus 164 If the JSC finds that any broker or agent has committed fraud or deceit, it may revoke or suspend the broker's license. Id. article 112. 165 Id. article 111.a. 166 Id. article 111.a.2. 167 Id. article 111.b. This provision of the Jordanian Securities Law closely mirrors the U.S. provision on liability for misrepresentations in a prospectus. See Securities Act of 1933, 48 Stat. 74, 11 (as amended at 15 U.S.C. 77k (1998)). 168 See Provisional Securities Law No. 76 of 2002, supra note 11, article 111.b.1 &2. 156 157 materially misleading subsequent to its approval. Therefore, the JSC will need to issue instructions or rules for publishing corrected prospectus and designating how long an issuer has to act before an uncorrected prospectus becomes subject to suit. Just as in U.S. law, the Jordanian Securities Law provides a list of individuals who may be found liable for misrepresentations.169 Anyone of these individuals may avoid liability upon a showing of due diligence. The Jordanian Securities Law, however, does not detail the standard of due diligence. For example, the law does not state, in showing of due diligence, that an individual demonstrates that after "reasonable investigation," and on the basis of reasonable grounds, he was convinced that that there was no material omission or misstatement. The law does not specify the standard of reasonableness for due diligence.170 In addition, the Securities Law, on its face, is silent as to the knowledge of truth by a purchaser at the time of purchase as a defense to misrepresentation liability. Thus, arguably, an action by a purchaser of securities for false and misleading statements would not be barred if the purchaser knew the truth about the securities, despite the misleading statements. The basic rule in measuring damages under all these private causes of action is the amount of loss suffered or profits foregone. However, the defendants may reduce the measure of the damages by showing that any loss suffered or profit foregone was not caused by the violation in question. The Securities Law provides limitation periods. Suits filed under these two private rights of actions must be instituted within two years.171 Otherwise, private causes of action are 169 This list of individuals is dispersed in several places in the Securities Law. The list includes the issuer, board of directors, executives, general partners, employees, and any auditor or accountant certifying the truthfulness of the prospectus. In harmony with the American model, the signatories to the prospectus are potentially liable. Thus, one can argue that the issuer's counsel is included in the list. Id. articles 42.a & b, 107.c, 110.e. Although not stated expressly in the law, the auditor's liability can be limited only to the sections of the prospectus he actually certified. 170 The standard of reasonableness for due diligence could be that of the prudent man in the management of his property. 171 Id. article 111.c. Most statutes of limitations under the U.S. securities laws allow an action to be brought within one year from discovery of untrue facts but no more than three years from the date of occurrence or 157 158 barred. Parties may not, by an agreement or otherwise, change the duration of the limitations period. The limitations period begins to run from the date of the sale of securities or the effective date of the prospectus. An important provision in the Securities Law provides for speedy trials of securities cases by courts.172 The speedy nature of securities cases does not contradict the notion of due process, rather it is a far better than utilizing Jordan's normal adjudication system which is slow that it precludes effective remedies in fast-moving markets such as the capital markets. Investors should rest easier knowing that all securities disputes will be treated expeditiously. The private right of action for violation of securities laws arises out of specific legislative provisions that expressly give an individual such a right. For example, the Securities Law provides no private right of action for damages against ASE for failure to enforce its rules and regulations.173 The question remains, however, whether, under the Jordanian Securities Law, private right of action may arise out of those provisions of the law that do not expressly give a private plaintiff a right to sue but simply make unlawful certain activities that have injured the plaintiff. Courts of other countries have found an implied private right of action.174 It is difficult to predict whether Jordanian courts will adopt implied private rights of action for violations of the securities law. 3.5.1 Insider Trading and Market Manipulation The offenses of insider trading and market manipulation are those which are most detrimental to the creation of investor confidence in the capital market and thus have been event giving rise to the cause of action. See Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 361 (1991). 172 See Provisional Securities Law No. 76 of 2002, supra note 11, article 113.a. 173 The reason for not holding liable ASE is based on the fact that as ASE is not-for-profit entity with extensive regulatory functions. 174 The U.S. courts have found an implied private right of action under section 10(b) of the Securities Exchange Act. See Superintendent of Ins. of N.Y. v. Bankers Life & Cas. Co., 404 U.S. 6, 13 n.9 (1971). The European Court of Justice implied a private right of action under the Treaty Establishing the European Economic Community, giving a direct effect to the Treaty where the Treaty itself did not provide for such a private right of action. See Case 26/62, Van Gend & Loos v. Nederlandse Administratie der Belastingen [Netherlands Inland Revenue Administration], 1963 E.C.R. 1, [1963] 2 C.M.L.R. 105. 158 159 singled out in the Securities Law.175 Article 108 deals exclusively with insider trading. This article prohibits anyone to capitalize on nonpublic information through the purchase or sale of securities resulting in the unjust enrichment at the expense of others.176 Although the law claims to regulate insider trading, but it is hard to understand how can a single article regulate such a complex matter. The law fails to provide categories of insiders: corporate insiders and temporary insiders.177 The law does not provide details as to the elements of insider trading violation such as whether it is essential that trading on the basis of inside information takes place for the violation to occur, defenses of insider trading, activities of analysts, the presence of scienter, and causation. Anyone who violates insider trading prohibition is may be imprisoned up to three years.178 However, convictions of insider trading in Jordan are rare. The first five years of implementing the provision prohibiting insider trading did not result in any convictions.179 The Securities Law should be amended to provide severe civil penalties. Moreover, the staff of the JSC and prosecutors must have legal and financial background and be adequately trained to handle insider trading offences, which are often very technical in nature. 175 The are several bases for prohibiting insider trading: an ethical base which deems that allowing a select group of investors to acquire advantages simply by virtue of their insider status is inherently unfair; and an economic rationale which deems that unequal access to information will deter investors from entering a risky market, inevitably resulting in the demise of the market. See Jonathan R. Macey, Insider Trading: Economics, Politics, and Policy 25 (1991). See also Emily A. Malone, Insider Trading: Why to Commit the Crime from a Legal and Psychological Perspective, 12 Journal of Law & Policy 327, 338 (2003) (describing insider trading as fundamentally unfair). 176 See Provisional Securities Law No. 76 of 2002, supra note 11, article 110.b.1. The law also provides a definition as to insider information. Insider information is information relating to one or several issuers or to one or several securities which has not been made public and which, if it were made public, would likely affect the price of any such security. Id. article 2. The definition of insider information does not include the debatable issue of tentative information which includes estimates, projections, and opinions. 177 Corporate insiders traditionally include directors, officers and other employees of a company. Temporary insiders are those who perform services for a public company where the relationship entails receipt of inside information that the client expects to be kept confidential. 178 Id. 179 Phone Interview with Rami Salah, Public Prosecutor of Northern Amman, Court of Northern Amman (July 8, 2007). 159 160 The Securities Law dedicates only one article to regulate market manipulation, which is designed to create false market of supply and demand.180 Manipulation not only affects the integrity of the market, but is also contrary to the principles of market economy whereby there is equilibrium between supply and demand. Securities manipulation disrupts this equilibrium by sending false signals that might compel investors to react based on information that will ultimately prove false. The Securities Law provides that anyone who violates market manipulation prohibition is may be imprisoned up to three years.181 A criticism could be directed toward the market manipulation provision in the Securities Law for being too widely drawn. The Securities Law, for example, does not exempt stabilization techniques from market manipulation prohibition.182 Stabilization is important for successful placement of securities. The law should have stipulated such as exemption. In addition, the law should have detailed the requirements for such as an exemption such as the securities that may be stabilized, the stabilizing period, permitted stabilization transactions, and the establishment of stabilization register. Market manipulation cases could overlap with untrue statements of material fact cases. However, there is a distinction between these two cases. While civil liability for both cases requires harm to an investor individual in buying or selling or refraining from buying and 180 Market manipulation occurs through various means such as noisy trade (e.g. rumors or fads). See Provisional Securities Law No. 76 of 2002, supra note 11, article 109. 181 Id. article 110.b.1. 182 Stabilization is described as the buying of a security for the limited purpose of preventing or retarding a decline in its open market price in order to facilitate its distribution to the public. Stabilization thus prevents any price downslide of the securities below issue price during the issue period. As an example, in an IPO in which shares are being sold at a fixed price of $20, the lead underwriter, on behalf of the underwriting syndicate, would stabilize price by maintaining, during the distribution, an offer to buy shares at the offering price. The bid keeps the price of the stock from dropping, if demand is weak, below the offering price, and thus creates the appearance that the issue is more desirable to the market than it actually is. There are several practices associated with stabilization such as creating artificial demand by buy-backs, ramping, and squeezing the shorts. See Jonathan A. Shayne & Larry D. Soderquist, Inefficiency in the Market for Initial Public Offerings, 48 Vanderbilt Law Review 965, 977-980 (1995). 160 161 selling a security, criminal liability for market manipulation does not require any actual harm suffered by any investor; the act itself is the crime. The available literature suggests that the prohibition against market manipulation is rarely implemented. Whether this limited application of the prohibition reflects enforcement difficulties or model market behavior is debatable. Again, qualified personnel and training are paramount for successful implementation of the prohibition against market manipulation. The point to be made here is that the prohibition against market manipulation has not found its way into practice. However, given the way in which the market manipulation provision was drafted, it is hard to see how it can be efficiently implemented. The Securities Law provides punishment for violating insider trading and market manipulation prohibitions in the form of imprisonment for up to three years.183 The Securities Law, in the same provision punishing insider trading and market manipulation, provides also the same punishment for any licensed broker who sells any security without written authorization from its owner.184 Having uniform sanctions for these three violations assumes that they are of the same nature, and thus warrants a uniform sanction. However, the Securities Law fails to take into account the fact that insider trading and market manipulation can harm the market substantially. On the other hand, selling a security by a broker without written authorization does not have the same effect on the market. Moreover, even a single form of violation should not have a uniform sanction as in some cases the violation be intentional or in good faith. The current version of the Securities Law calls for different level of sanctions for insider trading and market manipulation taking into account the gravity of these offences. Finally, the Securities Law does not provide private right of action for insider trading and market manipulation offences. This is not surprising in a law that deals with these 183 See Provisional Securities Law No. 76 of 2002, supra note 11, article 110.b.1. 184 Id. 161 162 complex matters in a single article. Therefore, the Securities Law or its implementing regulations should introduce a private right of action against those who trade while in possession of insider information or affect the price of a security through manipulative practices. 4. Conclusion The Jordanian government enacted the Securities Law of 2002 to jumpstart its market so to attract investment to transform its economy into a main regional player. This was the first step toward regulating the securities market. Much more has to be done to create an appropriate regulatory scheme. Countless regulations need to be adopted to assure proper functioning of the market. Although the internationalization of the Jordanian securities market increases the availability of funds from foreign investors, there could be drawbacks. This internationalization could increase the exposure to investors who would reconsider their portfolio investments if expected returns fall. The Jordanian government should restructure the operation of its stock market. Until now, trading occurs for limited time, from 9:30 a.m. to 12:00 p.m. There is also a trading limit at the opening phase of each day which allows the orderly clearing of outstanding orders prior to fully opening the market. An afternoon session (from 12:30 a.m. to 2:30 a.m.) should be added, and rather expanded later on. Ultimately, the market should have continuous trading from 9:30 a.m. to 3:00 p.m. In this way, Jordan will bring the hours of its securities market more in line with other markets. In short, Jordan should lengthen its trading day. The Securities Law calls for the creation of a central authority which acts pursuant to the legislative authority to control and monitor issuer behavior. This authority is exemplified by the JSC. It enjoys broad regulatory powers. For example, JSC can develop rules on securities 162 163 and oversees industry professionals by issuing broker-dealer and other professional licenses. The powers of the JSC in the enforcement area are, however, less specific. Although the law does contain enforcement provisions, stipulating that the issuer and the issuer's management bodies are responsible for the completeness and reliability of information presented in required documents and subjecting them to civil and criminal action, there is no indication that these provisions will have any immediate impact on actual enforcement efforts. As with the disclosure requirements generally, enforcement provisions are critical and will play an important part in a regulatory scheme in the long run. The JSC should include an enforcement division responsible for market surveillance. This division is to be staffed with inspectors and lawyers adequately trained, with the understanding that their numbers will be increased if necessary as the volume of trading increases. The division will have to take a proactive approach towards enforcement by attending trading sessions at ASE, monitoring public offerings and responding to complaints from investors, among other steps. The ASE, a self-regulatory organization, enables its members of securities industry participants with on-the-ground knowledge to implement the most efficient and effective rules possible. Self-regulation arguably is cost effective because it fosters efficient rules and removes the expensive burden of oversight from the government bureaucracies. However, the self-regulatory nature of ASE could create conflict of interest. There could be lack of enthusiasm for regulation on the part of the group to be regulated and industry participants are inclined to advance their interest through the imposition of poorly anti-competitive restraints as opposed to those justified by regulatory needs. In addition, ASE generates its revenues through the imposition of listing and annual fees. Thus, the financial interest of ASE in continuing to collect fees may lead to decreased regulatory zeal. 163 164 The disclosure requirements are not the last word on the disclosure of material information about securities, rather it is a good start toward creating an efficient securities market. Disclosures to investors are now mandated only annually or semi-annually, and even then are issued long after the year has ended. It appears that detailed and vigorously enforced disclosure requirements can and will assure that the investing public receive all necessary information about the issuer and about the security being issued. While the law defined the materiality concept, it is too vague a concept to serve as the standard that governs the day-to- day conduct of issuers in the real world. Therefore, Jordan should adopt a categorical approach whereby it identifies categories of material events requiring disclosure. In the context of violations and penalties, the Securities Law is silent as to the knowledge of truth by a purchaser at the time of purchase as a defense o misrepresentation liability. Under the Jordanian Securities Law, private right of action arises out of specific provisions. However, it remains unclear whether these provisions implicitly give a private plaintiff a right to sue for making other unlawful activities that have injured the plaintiff. Jordan needs to define specifically, rather than in general terms, manipulative and fraudulent practices. The Jordanian Securities Law or its implementing regulations should provide details as to the elements of insider trading violation and market manipulations. Moreover, the prohibition against insider trading and market manipulation should be implemented effectively. Sanctions against insider trading and market manipulation violations should be increased to commensurate with the seriousness of these violations and the effects they have on the market. The Jordanian Securities Law drew on the expertise of well-known and apparently successful foreign securities laws, specifically those of the U.S. and U.K. For example, securities laws in Jordan and the U.S. have mandatory disclosure requirements on the distribution of securities to the public. In spite of similarities between the securities laws of 164 165 Jordan and the U.S., differences of varying degrees of significance remain. For instance, the regulation of insider trading in Jordan is a much more recent phenomenon than it has been in U.S. Such borrowing from other legal systems is efficient; rather than create a new model from the ground up, Jordan capitalized on lessons already learned in the U.S. and other countries. However, it is dangerous to assume that the regulatory systems appropriate for existing markets in the U.S. and U.K are necessary or sufficient for Jordan. The regulatory structures in use in the U.S and other Western countries are the result of evolution in response to changing conditions. The key is to choose provisions that will permit the Jordanian market to undergo its own evolution. For example, because there is only one viable stock exchange in Jordan, it is not necessary or efficient for broker/dealers to form an independent association at this point as there is little role for such a body to play. As the Jordanian capital market becomes increasingly complex with the introduction of sophisticated financial instruments, and advances in the use of electronic commerce, the regulator risks being marginalized unless it adapts to these changes. An effective regulatory framework must be proactive, with the objective being to strike an appropriate balance between the often-competing interests of protecting the investing public, and allowing market forces to dictate the speed and direction of healthy competition and innovations. However, Jordan should strike the proper balance between over- and under-regulation. Overly zealous regulation will have the counter-effect of scaring off industry professionals, and will ultimately destroy the securities market. There must a sea change in the culture of investing in the securities market in Jordan. The population unfamiliar with the workings of the securities market must gain an understanding of the process and to begin to develop a sense of true risk/reward decisions. Jordanian markets should not be perceived as equivalent to gambling arenas. Investors should come to the market for long-term serious investments but not for the promise of 165 166 quick, extremely advantageous returns. Moreover, excessive speculation in the Jordanian securities market should be constrained through indirect means such as taxation. Certainly, the Jordanian market has a great deal to offer investors. Investors want to maximize return on investment in securities and minimize any risk, and only governmental regulation of the market can give them such benefit. The present regulatory regime and culture in Jordan needs further re-structuring. The process may take a long time, but the legislations and regulations reviewed in this article demonstrate that Jordan is moving in the right direction. 166 167 Jordanian Banks Compliance with Basel II & The Effect on Banks' Capital and Risk Managing Dr. Khalid Al-Zoubi∗ Dr. Murad Atier# Abstract Meeting the requirements of Basel II will mean different things to different Banks and the process of becoming compliant will be dependent on many aspects. The complexity of the rules, their changing detail and the uncertain implementation date make meeting the requirements of Basle II a challenge. Moreover, in recent years, CBJ have increased their focus on the capital adequacy of banking institutions to enhance the stability of the financial system . The purpose of the present paper is to shed some light on whether and how Jordanian Bank react to constraints placed by the regulator on their capital. We used a simultaneous equations model to analyze adjustments in capital and risk at Jordanian banks. Our results indicate that regulatory pressure induce banks to increase their capital, but does not affect the level of risk. ∗ Economic and Administration Sciences Faculty, Hashemite University, Zarka – Jordan. # International Islamic Arab Bank, Irbed Branch Manager, Jordan. 167 168 Jordanian Banks Compliance with Basel II & on Banks' Capital and Risk Managing 1. Introduction Over the last decade two most important facts emerges if we look inside the banking industry. The increasing complexity of financial system in the line with the development and globalization trends has made the banking environment and practice more challenging. Consequently, the banking industries faced new other type of risks different from market and credit risk. Apparently, these includes system security, fraud, expansion of e- commerce, system failure risks, highly automated technology, and many other significant risks such as; the increasing use of outsourcing arrangement, and new risk mitigation like credit derivatives, swaps, and securitization. Overall, these other type of risk can be summarized in one term which is "Operational Risk ". Accordingly, the banking industry all over the world has witnessed a growing number of losses resulted from other type of risks (operational risk). For instance, in 1988 the press reported than US$ 20 billion of operational risk losses in banking industry and the insurance industry (BCBS,2003c). These combined facts brought decision maker in Great Ten Countries (G10) and Bank of International Settlements (BIS), as well as banking and insurance executives to highlight the importance of managing these operational risk and take it more seriously in comprehensive practice compared to the management of credit and market risks (BCBS, 2003c). The definition of operational risk, formulated by the British Bankers’ Association (BBA) and Consultative Document as a supporting document to the new Basel II Accord as Regulatory Treatment of Operational Risk (BCBS,Jan2001), as follows: “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events”. The Committee specified that the abovementioned definition encompasses legal risk but excludes systemic, strategic, and reputational risks for the purpose of a minimum regulatory operational risk capital requirement. The underlying argument or all the appropriate measures is used so that the safety and the soundness of the banking system secured not only that but, because it limits economic downturns related to financial shocks. In addition, it avoids adverse budgetary consequences for the government. However, it is not altogether clear whether the imposition of capital requirements actually reduces risk-taking incentives. It is extraordinarily difficult - if not impossible – for regulators and supervisors to set capital standards that imitate those that would be demanded 168 169 by well informed, undistorted private-market participants. For instance, banks may respond to regulatory pressure by increasing their risk exposure. Moreover, actual capital requirements may increase risk-taking behavior. In a guarded assessment, Thakor (1996) shows the conditions under which risk-based capital requirements increase credit rationing, with negative implications for economic growth. Also, Thakor and Wilson (1995) argue that higher capital requirements may induce borrowers to shift to capital markets and in the process impair capital allocation, while Gorton and Winton (1999) show that raising capital requirements can increase the cost of capital. Thus, theory provides conflicting predictions on whether capital requirements curtail or promote bank performance and stability. My research objective is to investigate the implications of applying Basel II Accord with respect to operational risk capital charge modeling issues with regard Jordanian Banks and CBJ Regulations. Accordingly, this is investigated meanly through questionnaire and in the model that will be used in the Study. More specifically, this Study examines the extent to which the Jordanian Banks could be incorporated into Basel II so that it has the potential to capture the core purpose of imposing the Accord. Generally, the contribution of the Study is that, one may claim that the proposed approach provides incentives is to show if current application is leading Banks to comply with Basel II if so to develop sound operational risk methodologies. Indeed, this Study clearly reveals that operational risk application in which losses are driven by two loss event types - namely, Clients, Products and Businesses Practices on the one hand, and Internal Fraud on the other hand. As a result, the quality of Banks internal control environment appears as a key factor that significantly impacts Banks compliance. As we mentioned later, this will be examined through the distribution of the questionnaire and afterwards the analysis of the questionnaire. 2. Overview of The Banking System in Jordan 2.1 Central Bank of Jordan (CBJ) The Central Bank of Jordan (CBJ) is the entity responsible for regulating and overseeing all banking and money market activities. The CBJ has wide ranging powers and autonomy from the central government, and supervises banking system requirements. The H. K. of Jordan government started preparing to establish the Central Bank of Jordan in the late 1950s. Afterwards, the law of CBJ published on the year 1959, and by the year 1964 the preparation to carry out its duties were finalized to takeover the work of Jordan 169 170 Monetary Committee which established on 1950185. The main objective and responsibilities of CBJ is to: Preserve the stability of money in the H. K. of Jordan and guaranteeing the capability of exchanging the Jordanian Dinar, accompanied by encouraging and assuring the accelerating economic growth in line with the governmental public economic policy. The monetary policy management by the CBJ can be divided into two phases, the first phase from 1964-1989 in which the direct intervention by the CBJ dominated the seen. Moreover, the CBJ depend on the traditional monetary policy tools until the economic and financial crisis in the late 1980s. The second phase started on 1990-till date. As a result of 1988 financial and monetary crisis, the CBJ in cooperation with International Monetary Fund (IMF) and World Bank (WB) started implementing Economic Adjustment Program (EAP). The implementation of the Economic Adjustment Program (EAP) has had a great impact on the banking sector by generating the forces of competition through easing the regulatory restrictions, which previously limited market forces. 2.1.1 CBJ Past Experience The failure of Petra Bank in 1989 has prompted the CBJ to be very strict as regards to capital adequacy. The CBJ is devoted not to see a repeat of the financial and banking crisis, which had been brought about by the Petra Bank collapse. The corrective measures set by CBJ186 and Bank of International Settlement (BIS) in which listed below: Capital adequacy ratios should be set at a higher minimum level than the required 8%. The current BIS capital adequacy ratio has been set at 12%, after having stood briefly at 10%, and has not been following as yet in the rest of the region. At the end of 1997, the CBJ imposed a minimum capital of JD20 million (US$28.2 million) for all banks. This was introduced to encourage consolidation, and there are serious considerations by the CBJ to increase that amount significantly (towards JD50 million or US$70.5 million). The capital to deposit ratio was also set at a minimum of 7.5%. Banks are not to make loans to companies in which they hold more than 10% of the capital. Commercial banks have to place 14% of their deposits in an interest free account at the CBJ. Investment banks are required to place only 9% of their deposits. 185 For more information see the Financial and Banking System in Jordan (CBJ 2005). 186 Central Bank of Jordan review book, Different monthly issues. 170 171 Hence, in spite of some adoption of Basle II capital adequacy regulations. What is not clear from the undependable trends of how these regulations have influenced the capital and risk levels of banks in each Bank in Jordan. To obtain such insight, the need to undertake some empirical analysis is a must. 2.2 Banking System in Jordan The emergence of banking system in Jordan goes back187 to 1927 when the British entity opened in Amman the Ottoman Bank188 and operated as a fiscal agent to the government in the absence of a central bank in that time. The Arab Bank opened a branch in Amman, which became the head office in 1949 after which had its head office in Jerusalem in 1930, the British Bank of the Middle East was next to open its branch in Amman by 1949. The next Jordanian bank that followed Arab Bank was Jordan National Bank in 1956. Accordingly, in 1960, two additional commercial banks were established: Cairo Amman Bank and Bank of Jordan. Remarkably, the Central Bank of Jordan as mentioned before was established in 1964. By the end of 2006, Jordanian-banking system comprised of 23 banks. Figure.1, embodies the banking sector image in which thirteen bank were national commercial banks189, eight foreign banks and two Islamic banks. 190Although, number of working banks in Jordan have maintain acceptable number of banks but it reached high level of sophisticated level of technology , financial tools, service, and products in both retail and corporate. In addition, there were five specialized credit191 institutions, three of which were governmentally owned and two jointly owned by the public and private sector. As for number of bank branches figure.2, it reflects the vast development. Remarkably, the growth in the number of branches is very evident; looking in depth, in 1986 number of bank branches was 254 branches while in late 2006 it reached 515 branch spread all over Jordan registering 100% growth in 20 year. As a part of this ongoing reform by CBJ published new banking law in August 2000 to modernize laws, rules, and regulations to regulate the banking work in Jordan, this law 187 CBJ different annual issues. 188 It was established in 1927 as the Ottoman Bank which has become National and Grindlays Bank in 1969, ANZ Grindlays in 1989, and Standard Chartered Grindlays in 2000 to October 2003. 189 Business Bank merged with Jordan National Bank on January 17, 1997 and Philadelphia Investment Bank merged with Jordan Ahli Bank on July 5, 2005. 190 Before 2002, five national commercial banks were classified as investment banks. 191 These credit institutions are specialized to cover the Governmental Financing in the Public Housing, Industrial and Agricultural Development, and Civil Government. 171 172 aimed to improve and increase the industry’s efficiency, by enhancing banks’ regulations and supervision, and creating large institutions to meet the outcomes of globalization and intensified competition. Accordingly, before year 2000. Jordanian banks rely heavily on traditional banking activities, namely, the extension of direct credit facilities, as a main source of income. Credit facilities offered by banks include loans, discounted bill and overdraft. The year 2000 new law open the door for new working environment to widen the banking work along with new innovations. Generally, this law enabled banks to offer a wide financial services and leads to the concept of comprehensive bank, this include: agency services, financial consultant, investment portfolio, managing and investing customers money, leasing, dealing with open market operations like dealing in futures, forwards, and derivatives. In addition to that, the law allow banks to establish non-banking financial companies like insurance companies. Remarkably, latest indicators available shows that the financial position for working banks in Jordan was distinguished in the following indicators for the year 2006; ROE was 17%, while ROA reached 2%, capital adequacy for all bank combined reached about 20.3% which is equal to twice double minimum requirement set by Basel committee and also by the minimum requirement set by CBJ which is 12%. Moreover, deposits and facilities in banks are reflected in figure 3 above, it's clear that deposit and facilities has increased tremendously. From the figure, if we take 1990 we can notice that it increased from 2.64 Billion JOD to about 14.6 Billion JOD in year 2006. In addition, credit facilities increased from 1.87 JOD Billion in year 1990 to 9.87 JOD Billion in year 2006. Accordingly, coming across the unified balance sheet for licensed banks, from figure.4, it appears that total assets has increased for 4.1 Billion JOD in year 1990 to 24.2 Billion JOD in year 2006. Remarkably, this reflects the improved role of banks work volume and its rule as financial intermediary between savers (Surplus) and investors (Deficit). 172 173 3. Theoretical Foundation and Literature Review 3.1 Theoretical Foundation 3.1.1 Basel Committee on Banking Supervision (BCBS,1988) What is Basel II? Basel II is a capital adequacy framework for banks. It is designed to help banks adopt a more comprehensive, sophisticated and risk-sensitive approach for calculating regulatory capital. The proposals will enable banks to align regulatory requirements more closely with their internal risk measurement and provide incentives to improve operational processes. Basel II also provides banks with a unique opportunity to modernize and upgrade their overall risk practices and risk infrastructure, specifically for credit and operational risk. For these banks, Basel II means more than compliance; rather it denotes the opportunity to achieve distinct competitive advantage in a tough global market. Historical Overview (Basel I ) In July 1988, the Basel Committee on Banking Supervision released its report “International Convergence of Capital Measurement and Capital Standards”. In many regards, the paper that became known as the 1988 Basel Capital Accord. Indeed, for the first time, the Group of Ten (G-10)192 banking supervisory authorities set up an agreed framework for establishing minimum levels of capital, in relation to credit risk, for internationally active banks. Essentially, the 1988 Accord aims at reinforcing the soundness and stability of the international banking system and “diminishing an existing source of competitive inequality among international banks” (BCBS, 1988). Typically, within this new framework, a weighted risk ratio known as the Cooke ratio or risk asset ratio (RAR), requires international banks to have Tier 1 ratio of at least 4% and to hold capital at least equal to 8% ( with the contribution of Tier 2 not exceeding 50%), of their reported risk-weighted assets. In general, three facts underpinned the Committee choice over a more regular gearing ratio methodology and kept as simple as possible the weighting structure by allowing only five weights i.e. 0, 10, 20, 50 and 100 percent: 192 The Basel Committee on Banking Supervision comprises representatives of the central banks and supervisory authorities of the Group of Ten countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom, and United States) and Luxembourg. The Committee meets at the Bank for International Settlements, Basel, Switzerland. 173 174 First, risk ratio facilitates comparisons between heterogeneous international banking systems in that it offers a more adequate basis for assessment. Second, this specific ratio permits off balance-sheet exposures to be included more smoothly into the capital measurement framework. Third, the risk ratio does not prevent banks from holding assets deemed to be low risk such as cash or claims on central governments and central banks. Unfortunately, since 1988, the weaknesses of the simple approach to capital regulation have come to light. As a matter of fact, the 1988 Accord has suffered from many criticisms, the most obvious being that it did not adequately address off-balance sheet exposures on market risk in particular risks associated with the bank’s positions in derivatives and other financial tools. In addition, it did not account for portfolio diversification effects, netting effects and the borrower’s credit rating193. The Development To enhance risk sensitivity, the Committee offers a variety of options for addressing other credit and operational risk. As to credit risk, the range of options includes the standardized approach, a foundation internal ratings-based approach (IRB), and an advanced IRB approach. Regarding operational risk minimum capital requirements, the Committee recommends several approaches that reflect those of credit and market risk. These include three methods in the continuum of increasing sophistication and risk sensitivity (BCBS, 2001): Basic Indicator Approach (BIA), The Standardized Approach (TSA), and Advanced Measurement Approaches (AMA). 3.2 Empirical Academic literature Review 3.2.1 Meeting the requirement of Basel II (The Questionnaire) Meeting the requirements of Basel II will mean different things to different organizations and the process of become accommodating and will be dependent on many factors: Ranging from product and business line. Complexity through size and geographic coverage. Complexity of the rules, and their changing detail. 193 See for more detail CAS,1992. 174 175 Nevertheless, meeting the requirements of Basel II is not simply a question of regulatory compliance. To take advantage of the new system, you will need to review many aspects of banks business activities, including: Risk Management Methodologies and Models. Accessibility and Safeguarding of Data. Systems Infrastructure. Configuration of Process and People. An important innovation of the Basel II applications concerns the introduction of a capital charge for operational risk. To measure the degree of implementation of operational risk management methodologies and models, a Survey on Operational Risk Management will be launched. A questionnaire will be sent to the risk managers of all banking entities in Jordan. The questions will be multiple-choice and focused on the following key areas: Methods for calculating the capital charge for operational risk The development of an Operational Risk Management structure. The content and implementation of operational loss databases. Development of Exposure Indicators, Key Risk Indicators, and Key Performance Indicators. Risk and Control Self Evaluation. 3.2.2 The impact of CARs Literature Review Existing literature suggests that capital adequacy rules (capital regulations), have an impact on bank behavior194 in two main ways: First, it is argued that the introduction of capital adequacy rules will normally strengthen bank capital and, thus, improve the resilience of banks to negative shocks. Second, is the effects concerns banks’ risk behavior in ,other words, to test if the enforcement of capital requirement can effect loans supply. Accordingly if, as it happens, capital adequacy rules establish higher capital standards for loans to the private sector than for credits in comparison with the public sector. Some of the major empirical papers on the impact of capital regulations on risk taking and capital ratios of commercial banks are listed below for both U.S. and outside the U.S. banks. However, we do not discuss all of them in the following review. 194 For more information see Freixas and Rochet (1997). 175 176 The literature begins with Shrieves and Dahl (1992) in which they used several periods of cross section data on commercial banks in the US. Subsequently, Jacques and Nigro (1997) utilized three stage least squire 3SLS of estimation for the US banks. Aggrawal and Jacques (1998, 2001) repeat the analysis of Shrieves and Dahl, employing a cross- sectional of US bank data. Moreover, looking at the UK banks Ediz et al (1998), and the Swiss banks Rime (2001) provide some useful insight from outside the US. Additionally, some authors have also contributed the theoretical case for higher capital standards such as Kim and Santomero (1988), show that capital requirements will introduce changes in the composition of risky part of bank portfolio. Marshall and Prescott (2000), showed that capital requirement directly reduce default of probability and portfolio risks. At the same time, Vlaar (2000) found that capital requirement acted as a burden for inefficient banks when asset of banks assumed to be fixed. In the other hand, regulation increased the profitability of efficient banks. Finally, there is empirical work that explicitly treats the relation between capital requirements and credit supply, which may be classified into two subsets. The first one, which includes Peek and Rosengreen (1995), Furfine (2001), Soares (2001) and Chiuri et al. (2001), analyzes the impact of the adoption of higher capital requirements, comparing credit supply before and after the implementation of Basel Accord 2. The second one, best represented by Van Roy (2003) and Gambacorta and Mistrulli (2004), who assumes that capital regulation as given as it tries to infer its influence on bank lending, basing the empirical tests only in observations after the Accord implementation. 4. The Empirical Model and Methodology 4.1 The Empirical Model A instantaneous model with a partial adjustment framework for capital and risk is used to assess how the banks in the Jordan react to requirements placed by the CBJ on their capital. The model will adopt the work on US banks by Shrieves and Dahl (1992) and in its extensions Jacques and Nigro, 1997; Aggarwal and Jacques, 1997 and 2001; Ediz, et al, 1998; and Rime, 2000; Chiuri, et al, 2001; and VanRoy, 2003. An important aspect of this model is that it recognizes that changes in both capital and risk have an exogenous as well as an endogenous character. Hence, the present study differs from previous studies in three main areas: First, bank capital and risk behavior is modeled explicitly. 176 177 Second, it takes account of the regulatory pressure implied by the minimum capital requirements. Finally, it examines the most banks in the H.K. of Jordan, namely those that have at least five years financial statement throughout the estimation period. It should be stressed that the Jordan banking market has not reached a high level of development and hence sophisticated financial instruments, are not widely available. Generally presenting, to allow for the possibility that capital ratio and risk decisions are determined simultaneously, the analysis of banks’ capital behavior. The simultaneous equations model developed by Shrieves and Dahl (1992). In that model presented below in equation (1) and (2), the observed changes in banks’ capital and risk levels consist of two components, a discretionary adjustment and a change caused by factors exogenous to the bank. d ΔCAP j,t = Δ CAP j,t + E j,t ; (1) d ΔRISK j,t = Δ RISK j,t + S j,t ; (2) In which : ΔCAP j,t : Observed changes in Capital, for bank j in period t. ΔRISK j,t : Observed changes in Risk levels, for bank j in period t. d Δ CAP j,t : Discretionary adjustments in Capital. d Δ RISK j,t : Discretionary adjustments in Risk. E j,t & S j,t : Exogenously determined factor, error term. Generally, banks may not be able to adjust their desired capital and risk levels instantaneously. Thus, following Shrieves and Dahl (1992), the discretionary changes in capital and risk are modeled using the partial adjustment framework such that changes in capital and risk are proportional to the difference between the target levels and the levels existing in period t-1: Δd CAP = α(CAP* - CAP ) ; (3) j,t j,t j,t−1 d (RISK * Δ RISK j,t = β j,t - RISK j,t−1 ) ; (4) Following the work of Jacques and Nigro (1997) and substituting equations (3) and (4) into equations (1) and (2), the observed changes in capital and risk levels can be written as follows: 177 178 = α(CAP* - ) + E ; (5) ΔCAP j,t j,t CAPj,t−1 j,t = β (RISK * - ) + ; (6) ΔRISK j,t j,t RISK j,t−1 S j,t Thus, the observed changes in capital and risk in period t are a function of the target capital and risk levels, the lagged capital and risk levels, and any exogenous factors. The target levels of capital and risk are not observable, but are assumed to depend upon some set of observable variables195. In summery, it is a function of the differences between target level of capital in period t and the previous period actual capital and any exogenous shock. Shrieves and Dahl (1992), pointed out that target level of capital are not observable and could not measures directly. Accordingly, literature argument applies that, the target capital ratio CAP* is influenced by a number of explanatory variables. Specifying variables to explain changes in capital and risk with respect to the target level of capital and risk, we can rewrite equation (5) and (6) as follows: ΔCAPj,t = α 0 + α1SIZE j,t + α 2 ROAj,t + α 3 REG j,t−1 + α 4 ΔRISK j,t + α 5CAPj,t−1 + E j,t ; (7) (8) ΔRISK j,t = β 0 + β1SIZE j,t + β 2 L LOSS j,t + β 3 REG j,t −1 + β 4 ΔCAP j,t + β 5 RISK j,t −1 + S j,t ; Where: SIZEj,t: Is measured as the natural log of bank’s total assets, ⎛ LoanLoss Pr ovisions ⎞ LLOSSj,t : Ratio of new provisions to total assets,⎜ ⎟ , ⎝ PotentialBadLoans ⎠ ⎛ Equity ⎞ ROAj,t : Return on assets proxied by the ratio of ⎜ ⎟ , ⎝ TotalAssets ⎠ 196 REGj,t-1 : Regulatory Pressure Variable to identify undercapitalized bank and must 197 ⎧THR − CARifCAR < THR⎫ fulfill the following condition ; REG = ⎨ ⎬ ⎩ZeroOtherwise ⎭ SIZE is measured as the natural log of bank’s total assets, (ROA) return on assets ⎛ Equity ⎞ peroxide by the ratio of ⎜ ⎟ in which has been used in past literature. Empirical ⎝ TotalAssets ⎠ literature have come up with a number of financial performance measures such as return on 195 Shrieves and Dahl (1992), Jacques and Nigro (1997) and VanRoy (2003). 196 Following VanRoy (2003). 197 THR, represent Threshold level that will have to be chosen in which in Jordan 8%. 178 179 assets (ROA) to find out the relationship between the banks process performance and financial performance. In a similar fashion, the target risk ratio (RISK*) is influenced by size, (LLOSS) approximated with the ratio of new provisions to total assets. Most of these variables were taken from Shrieves and Dahl (1992). In addition, the exogenous factor which could influence bank capital (Ej,t) or risk (Sj,t) is a change in regulatory capital standards, in this case modeled as the degree of regulatory pressure brought about by the risk-based capital standards, these two variable is the error term in which will be tested accordingly in which will fulfill the statistical analysis of the model. The endogenous variables ΔCAPj,t and ΔRISKj,t have been included to recognize the possible simultaneous relationship between changes in capital and changes in risk and to test if there casual relationship between both variables. Empirical estimation of equation (7) and (8) require measures 198of both bank capital and portfolio risk. Because banks must meet the regulatory minimum standards on a continuous basis, the risk-based capital standards may cause these banks to increase their capital ratios or reduce portfolio risk as insulation against any uncertainty regarding whether the bank meets the regulatory minimum. The main emphasis of this study is on the regulatory pressure variable, denoted REG. We focus on the response of banks to the 8% risk-based capital standard. Although, there has been to much debate to the percentage that would be imposed by he central bank of Jordan which range from 8% to 12%. Accordingly, will estimate the model using two measures of regulatory pressure 8% and 12% respectively. 4.2 Methodology 4.2.1 CARs Estimation Methodology Following Jacques and Nigro (1997), Aggarwal and Jacques (1998), and Rime (2000), to estimate the simultaneous system formed by equations (7) and (8). I used two– stage least squares procedure, which recognize the endongeneity of both bank capital ratios and risk levels in a simultaneous equations framework. Unlike ordinary least square (OLS), estimation by 2SLS provides consistent estimates of the parameters. Each equation that is part of recursive system can be estimated separately using OLS. 198The main emphasis of this study is on the regulatory pressure variable, denoted REG. We focus on the response of banks to the 8%and 12% risk-based capital standard. 179 180 In addition to 2SLS estimation technique we will use in our Study another technique available for systems of equations. Three-stage least square (3SLS), which provides a third step in the estimation process that allows for nonzero covariance between the error terms in the structural equations199. It is asymptotically more efficient than 2SLS since the latter ignores any information that may be available concerning the error covariences, and also any additional information that may be contained in the endogenous variables of other equations. 4.2.2 Operational Risk Management Survey Methodology Overview The new Basel II framework consists of three pillars: minimum capital requirements, supervisory review of an institution’s capital adequacy and internal assessment process, and effective use of market discipline as a level to strengthen disclosure and encourage safe and sound banking practices. The Basel II Framework was approved by the central bank governors and bank supervisors of the G-10 as “International Convergence of Capital Measurement and Capital Standards: a Revised Framework”, on June 26, 2004. The Basel Committee intends to have the Framework available for implementation by the individual countries at the early end of 2006 in order to use for the more advanced approaches, on 2007. Description of the Survey The core information that the survey sought to obtain was whether the Jordanian Banks are intended to stick to the Basel II requirements and which approaches to addressing operational risk are to be followed. The survey will be addressed primarily to all Jordanian Banks’ headquarters that are licensed by the Central Bank of Jordan and fulfill the condition of inclusion in the population of the Study200. Occasionally data on Banks branches where excluded since these branches must follow guidelines from their respective head office risk regulator, their risk capital policy cannot differ from the one required in the head office. The survey will be presented for Validation by respective qualified examiner in order to validate the questionnaire. The information provided by the questionnaire survey consists of the following categories: name, type (Local bank, or Foreign Bank), parent name and home country of the bank, whether it is (Large, Medium, or Small sized "Total Assets and Capital"). 199 See Rime (2001) for additional Discussion. 200 The population of the survey is all commercial banks operating in Jordan regardless to any condition 180 181 4.3.1 Measurement of Capital and Risk Two alternative definitions of banks’ capital are used: the ratio of total capital (Tier1+ Tier 2) to risk-weighted assets (RCRWA) and the ratio of capital to total assets (RCTA). Shrieves and Dahl (1992) used the RCRWA definition; which has become more widely used since the introduction of R-RCARS and has been used by Jacques and Nigro (1997), Aggarwal and Jacques (1998) and Ediz, Michael and Perraudin (1998). Hence, CAP is measured as the ratio of total capital (Tier1 + Tier2) to total risk weighted assets. The measurement and definition of banks’ risk is quite problematic and the literature suggests a number of alternatives, all of which are subject to some criticism. In my dissertation, we decide on to go for the ratio of risk-weighted assets to total assets (RWATA) as proposed by Shrieves and Dahl (1992) and used subsequently by Jacques and Nigro (1997) and Aggarwal and Jacques (1998). The rationale for using this measure is that portfolio risk is primarily determined by the allocation of assets across the different risk categories. Hence, the ratio of risk-weighted assets to total assets has been used to measure RISK. 4.3.2 Measurement of Control Variables (Affect Changes in Banks’ Capital and Risk Managing) The control variables are bank size, current profits, current loan losses, regulatory pressure, current profits variable, emphasized by Aggarwal and Jacques (1998), Ediz, Michael and Perraudin (1998), and Rime (2001). In addition to all other variables which has been used in the model have been used by Shrieves and Dahl (1992), with introducing the profit control variables in his study. Bank size is closely related to target risk and capital levels due to its relationship with risk diversification, investment opportunities and access to equity capital. The SIZE is measured by the natural log of total assets and is included in the capital and in the risk equations to capture size effects. SIZE is expected to be inversely related to changes in capital and risk. Current profits measure here as return on assets (ROA201) in which peroxide by the ⎛ Equity ⎞ ratio of ⎜ ⎟ has been used in past literature by Shrieves and Dahl (1992), Jacques ⎝ TotalAssets ⎠ and Nigro (1997), Aggarwal and Jacques (1998), Rime (2001), and VanRoy (2003). The NPAIT 201 In General Return On Assets (ROA) Equals . AverageTotalAssst 181 182 argument behind the use of this ratio because we are trying to highlight the effect of ROA on banks' capital is by deduction if the bank prefers to increase capital through retained earnings, rather than through equity issues, which may convey negative information to the market about the bank’s value in the presence of asymmetric information. ROA is included in the change of capital equation and a negative co-efficient is expected. Bank’s current loan losses affect the ratio of risk-weighted assets to total assets as they lead to a decrease in the nominal amount of the risk-weighted assets, which is the mean component in RISK determination. These losses (LLOSS) are approximated by the ratio of ⎛ LoanLoss Pr ovisions ⎞ new loan loss provisions to total assets,⎜ ⎟ , and therefore included in ⎝ PotentialBadLoans ⎠ the risk equation with an expected negative effect on the change in RISK. 5. The Data Set The empirical work out uses publicly available financial statements published by banks and the CBJ. This study consists of a three dimensional panel data consist of 10 banks presented in table 2, for the period 1992 – 2005, representing a total of 780 observations spaced by bank, complied with Basel II, and year. However, some bank were excluded from banks population because they did not fulfill the condition of at least 7 years of published financial data and the construction of balance sheet and income statement according to CBJ conditions and the type of financial activity. Although, the sample represent 44% of total bank population but the time span is long and number of observation is high. 5.1 Survey Sample The survey sample for my dissertation is the entire population of commercial banks operating in Jordan counting 23 bank in which consist of 13 local bank and 10 foreign bank in which presented in table1. Altogether, 23 bank of interest were identified for the dissertation survey. This number consist of local banks and foreign banks. A total number of 23 bank were contacted directly either by email or questionnaire was sent to headquarter personally. A total of 19 banks and responded to the survey. The response rate for the whole sample was 83%, which is more than ¾ of all banks licensed in Jordan. 5.2 CARs Model Estimation Techniques Following Shrieves and Dahl (1992), Jacques and Nigro (1997), Aggarwal and Jacques (1998), (1998), Ediz, Michael and Perraudin (1998), Rime (2001) and VanRoy (2003), to 182 183 estimate the simultaneous system formed by equations (7) and (8). I used two–stage least squares procedure 2SLS, which recognize the endongeneity of both bank capital ratios and risk levels in a simultaneous equations framework. Unlike ordinary least square (OLS), estimation by 2SLS provides consistent estimates of the parameters. Each equation that is part of recursive system can be estimated separately using OLS. 5.3 Estimation of the Survey The estimation of the survey have beeen done the conventional way by using excel spredsheets. Although, there are various methods you can use to analyse survey data in Excel, but most of them are a real pain, and are likely to produce errors unless we are very, very careful. Excel has different ways of handling nominal variables (questions with answers which don't form a scale - e.g. red, blue, green). To analyse nominal variables, we want to produce frequency distributions and crosstabs. Before we can analyse anything, we have to enter the data from the questionnaires. This is by far the most time-consuming part of the process. Moreover, a cross-tabulation is a table produced when all the answers to one question are compared with all the answers for another question. 6. Emperical Results 6.1 Survey Results Methods for calculating the capital charge for operational risk Choices of the methods for calculating OR capital charges are very diverse, covering the whole scale of available approaches. Branches and subsidiaries of international banks follow the instructions of the group. Banks prefer a single uniform method across business lines. To the extent choices are made in CBJ, the decision makers adopt a reactive approach of following the market and the instructions of the supervisory authorities. Consultation with the regulators is still limited. Status of development of an ORM framework Most of the large banks and foreign banks have developed an operational risk management framework. Moreover half of the small and medium sized banks have developed a method for risk identification. Apart from that, these banks are nearly no where in developing an ORM framework. The designed ORM strategies are business driven, and take into account new products and activities. Small banks haven’t implement risk management approach. While large banks and foreign bank effectively communicated throughout the organization through 183 184 dedicated bulletins supplemented by meetings and live presentations. Most of the strategies don’t yet formally document the risk profile and the extent of risk control of the organization. This applies for few large banks. The operational risk management position is in most cases assumed by Risk Management. Senior management is in charge of the independent ORM & Control process. Policies and procedures have been developed and documented. Internal Audit is informed about these policies and procedures, but not involved in their execution. The reporting flows between the ORM position, senior management and the business lines are clearly defined. Implementation and content of operational loss databases The implementation of loss databases for recording operational losses is already well advanced. The large banks record their operational losses in centralized manner. Almost all banks rather use an interface with some existing systems for collecting loss data. All banks do not yet use their recorded data to measure or verify their operational risks. The majority of the banks have not yet developed initiatives to collect external loss data. Development of Exposure Indicators (EIs), Key Risk Indicators (KRIs) and Key Performance Indicators (KPIs) The vast majority of banks have not yet defined Exposure Indicators (although required under Advanced Measurement Approaches), Key Risk Indicators and Key Performance Indicators. The management information systems of most banks are currently not capable to generate KRI data. The large banks are planning to develop a KRI system. Risk and Control Self Assessments (RCSAs) The large banks and the entities of international banks have developed a well structured process to identify and inventory operational risks; small and medium sized banks have not. Input to the RCSAs is primarily supplied by management of the business units and by business unit personnel. Initiation and co-ordination of the RCSAs is mostly in the hands of Risk Management. The results are also not yet integrated with the KRI system and the loss databases. The results of RCSAs are not yet used to measure performance of a business unit. Operational risks related to outsourced activities are not yet systematically identified and measured. 6.2 Empirical Model Estimation Results 184 185 In this study, the results of estimating equations (7) and (8) are presented in Table 3 and Table 4. The system based on the regulatory pressure gives the following results. In the capital equation, current earnings (ROA) have a significant and positive impact on capital, indicating that improve in capitalization for profitable banks can be done through retained earnings. On the other hand, SIZE has a negative and significant impact on capital, indicating that large banks increased their RCRWA less than other banks; here, a possible explanation is that large banks have to compete on international markets with institutions that are, in general, less capitalized. Regulatory pressure (REG) has a negative and significant impact on the RCRWA. Furthermore, in the risk equation, the regulatory pressure variable has a negative and significant impact on banks’ risk, which indicates that banks increased or decreased the share of RCRWA in their portfolio to approach the minimum capital requirements. SIZE has no significant impact on risk. In the capital equation, there is a significant and positive relationship emerges between changes in capital and changes in risk, where is no significant relationship between changes in capital and changes in risk in risk equation. The estimates obtained using 12% measure of regulatory pressure indicate that the regulatory variable for banks has a positive and significant impact on capital but no significant impact on risk. 6. 3 Conclusions This study has provided new evidence on the effects of rigid enforcement of minimum capital discipline on bank in Jordan. The paper offers a clear support to the general presumption that the credit crunch associated to a strict enforcement of bank capital regulation is more persistent in those countries where the credit channel is more important i.e. where alternatives to bank credit are less developed. This evidence suggests the relevance of a careful phasing in of new capital requirements in order to avoid undesirable macroeconomic side effects. In spite of the general recognition that capital regulation may have different macroeconomic effects according to the different institutional and developmental features of each economy, bank capital regulation has not yet clearly addressed the distinct needs of less developed economies. The paper contributes to the ongoing discussion on the new Basel Capital Accord, stressing the fact that economies, which mostly rely on bank credit, may have to devote particular attention to the process of enforcement of a stricter bank capital discipline. 185 186 Moreover, from the survey result, it appears that Banks working in Jordan are far away from implementing Basel II except for large banks, the consequences immeasurable and distressing and necessary action by the regulator ,CBJ, and banks managements. 186 187 References Aggarwal, R and K. Jacques, 2001, “A Simultaneous Equations Estimation of the Impact of Prompt Corrective Action on Bank Capital and Risk,” Financial Services at the Crossroads: Capital Regulation in the 21st Century, Conference, 26-27 February 1998, Federal Reserve Bank of New York. Aggarwal, R. and K. Jacques, 1997, “The impact of EDICIA and Prompt Corrective Action on bank capital and risk: estimates using a simultaneous equations model.” Journal of Banking and Finance, 25, 1139-1160. Basel Committee on Banking Supervision. (1988). International Convergence of Capital Measurement and Capital Standards, http://www.Bis.Org/publ/bcbs04a.Pdf. Basel Committee on Banking Supervision. (1996). Amendment to the capital accord to incorporate market risks, http://www.Bis.Org/publ/bcbs24. Basel Committee on Banking Supervision. (1999). Operational risk management, http://www.Bis.Org/publ/bcbs42.Pdf. Basel Committee on Banking Supervision. (2001a). The New Basel Capital Accord: An explanatory note, http://www.Bis.Org/publ/bcbsca01.Pdf. Basel Committee on Banking Supervision. (2001b). Operational risk consultative document. Supporting document to the New Basel Capital Accord, http://www.Bis.Org/publ/bcbsca07.Pdf. Basel Committee on Banking Supervision. (2001c). Working paper on the regulatory treatment of operational risk, http://www.Bis.Org/publ/bcbs_wp8.Pdf. Basel Committee on Banking Supervision. (2003c). Sound practices for the management and supervision of operational risk, http://www.Bis.Org/publ/bcbs96.Htm. 187 188 Basel Committee on Banking Supervision. (2004). International Convergence of Capital Measurement and Capital Standards. A Revised Framework, http://www.Bis.Org/publ/bcbsca.Htm. CAS, Casualty Actuarial Society. (1992). Property-casualty risk-based capital requirement. A conceptual framework, http://www.Casact.Org/pubs/forum/92spforum/92sp211.Pdf. Chiuri, M., Giovanni F., and Giovanni M., 2001, “ The Macroeconomic Impact of Bank Capital Requirements in Emerging Economies: Past Evidence to Access the Future,” The World Bank. Ediz, T., I. Michael, and W., Perraudin, (1998), "The Impact of Capital Requirement on US Bank Behavior," Economic Policy Review 1998, Federal Reserve Bank of New York, Oct., 15-22 . FAS Financial Services Authority. (2005). Strengthening capital standards. Consultation paper, http://www.Occ.Treas.Gov/ftp/release/2005-6a.Pdf. Freixas, X., and J. Rochet (1997), Microeconomic of Banking. MIT Press. Furfine, C., (2000), "Evidence on the Response of US Banks to Changes in Capital Requirements," Bank of International Settlements Working Paper, 88. Gorton, G., A. Winton, (1995), "Bank Capital Regulation in General Equilibrium," NBER Working Paper, 5244. IAIS, International Association of Insurance Supervisors. (2002). Principe on capital adequacy and solvency, http://www.Iaisweb.Org/02solvency.Pdf. Jacques, K. and P. Nigro (1997), “Risk-based Capital, Portfolio Risk and Bank Capital: A Simultaneous Equations Approach, Journal of Economics and Business, Vol. 49, pp 533-547. Kim, D., and A. Santomero, 1988, “Risk in Banking and Capital Regulation,” Journal of Finance, 43, 1219-33. 188 189 KPMG, (2002). Commission services study prepared by KPMG on the methodologies to assess the financial position of an insurance undertaking from the perspective of prudential supervision. http://europa.Eu.Int/comm/internal_market/insurance/docs/solvency/solvency2- study-kpmg_en.Pdf. Peek, J., and E. Rosengren, 1995, "Bank Regulation and the Credit Crunch," Journal of Banking and Finance, 19, 679-692. Rime, B., 2001, “Capital Requirements and Bank Behavior: Empirical Evidence for Switzerland,” Journal of Banking and Finance, 25, 798-805. Shrieves, R.E. and D. Dahl (1992), “The Relationship between Risk and Capital in Commercial Banks”, Journal of Banking and Finance, Vol. 16, pp. 439-457. Van Roy, P. 2003, “Impact of the 1988 Basle Accord on bank’s capital ratios and credit risk taking: an international study”, European Center for Advanced Research in Economics and Statistics, Universite Libre de Bruxelles, Working Paper. Vlaar, P. J. , 2000, “Capital Requirements and Competition in the Banking Industry,” Federal Reserve Bank of Chicago, Working Paper, 18. 189 190 Figure 1 Number of Licensed Banks in Jordan from 1995-2006 Number of Banks Working in Jordan 5 5 5 5 5 5 5 5 5 5 8 8 1 1 2 2 2 2 2 2 2 2 2 2 Foreign Bank Islamic Banks 15 Local Commercial Bank 14 14 14 14 14 14 14 14 14 13 13 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: Central Bank of Jordan different publications. Figure 2 Number of Licensed Banks Branches in Jordan from 1964-2006 2006 2003 2000 1997 1994 1991 1988 1985 Year 1982 1979 1976 Number of Banks Branches In Jordan 1973 1970 1967 1964 0 50 100 150 200 250 300 350 400 450 500 550 Numer of Branches Source: Central Bank of Jordan different publications. 190 191 Figure 3 Total Deposit to Total Facilities for Jordanian Licensed Banks from 1964 - 2006 16000.0 14000.0 12000.0 Total Deposit & Total Facilities 10000.0 8000.0 Total Deposit Million JODMillion Total Facilities 6000.0 4000.0 2000.0 0.0 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Year Source: Central Bank of Jordan different publications. Figure 4Total Assets /Liabilities for Jordanian Licensed Banks from 1964-2006 30000.0 25000.0 Banks Total Assets/Liabilities in Jordan 20000.0 15000.0 Millions JOD 10000.0 5000.0 0.0 6 0 8 2 6 6 7 8 9 9 9 9 9 1964 1 1968 19 1972 1974 1976 1978 1980 1982 1984 1986 1 1990 1 1994 19 1996 2000 2002 2004 2006 Year Source: Central Bank of Jordan different publications. 191 192 Table 1: Survey population (Licensed Working Banks in Jordan) 1 Arab Bank 2 Arab Banking Corporation 3 Arab Investment Bank 4 Bank of Jordan 5 Banque Audi/ Sadar Audi Group 6 BLOM Bank 7 Cairo Amman Bank 8 Citibank Group 9 Egyptian Arab Land Bank 10 Export and Finance Bank (Capital Bank) 11 Housing Bank for Trade and Finance 12 HSBC Bank 13 Islamic International Arab Bank 14 Jordan Commercial Bank 15 Jordan Investment and Finance Bank 16 Jordan Islamic Bank for Finance and Investment 17 Jordan Kuwait Bank 18 Ahli Bank 19 National Bank of Kuwait 20 Rafidain Bank 21 Societe Generale De Banque 22 Standards Chartered Bank ANZ 23 Union Bank for Saving and Investment 192 193 Table 2: Dissertation Sample data 1 Arab Bank 2 Arab Banking Corporation 3 Bank of Jordan 4 Ahli Bank 5 Cairo Amman Bank 6 Housing Bank for Trade and Finance 7 Jordan Investment and Finance Bank 8 Jordan Kuwait Bank 9 Union Bank for Saving and Investment 10 Arab Jordan Investment Bank 193 Table 3 Estimation of Eqaution (7) & (8) using 3SLS for the Period from 1993-2005 based on RCRWA REGULATORY MEASURES 8% REGULATORY MEASURES 12% ΔCAP t ΔRISKt ΔCAP t ΔRISKt Coefficient P-Value Coefficient P-Value Coefficient P-Value Coefficient P-Value * REGt-1, 8% 0.0031 0.0023 -0.0014 0.121 * REGt-1 12% 0.0108 0.000 -0.234 0.241 * * ROAt 1.564 0.000 2.108 0.001 LLOSSt -0.0076 0.232 0.0569 0.485 * * * * SIZEt -0.0021 0.002 0.0034 0.000 -0.0035 0.001 0.0036 0.003 ΔCAP t 0.216 0.445 0.124 0.323 ΔRISKt 0.142 0.191 0.098 0.298 * * * * CAPt-1 -0.1311 0.000 -0.0541 0.002 -0.1643 0.000 -0.0544 0.001 Adj-R2 0.187 0.091 0.098 0.082 Statically Significant at 0.05 Level. Table 4 Estimation of Equation (7) & (8) using 2SLS for the Period from 1993-2005 based on Capital to Total Assets REGULATORY MEASURES 8% REGULATORY MEASURES 12% ΔCAP ΔRISKt ΔCAP ΔRISKt Coefficient P-Value Coefficient P-Value Coefficient P-Value Coefficient P-Value * REGt-1, 8% 0.0025 0.000 -0.0011 0.321 * REGt-1 12% 0.013 0.002 -0.346 0.498 * * ROAt 1.411 0.001 1.987 0.000 LLOSSt -0.0076 0.232 0.0569 0.485 * * * * SIZEt -0.0013 0.000 0.0014 0.000 -0.0012 0.000 0.0009 0.000 * * ΔCAP t 0.676 0.004 0.217 0.000 0.108* 0.001 0.159* 0.000 ΔRISKt * * * * CAPt-1 -0.0891 0.002 -0.0389 0.000 -0.1271 0.001 -0.0432 0.000 Adj-R2 0.211 0.189 0.134 0.167 Statically Significant at 0.05 Level 196 196