Legal institutions in the financial market - Free Essay Example

Sample details Pages: 8 Words: 2476 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? Legal Institutions and rules are essential to building up strong and vibrant financial markets. Do you agree? As has been acknowledged by many writers, financial markets rely on laws and regulations to ensure that financial transactions occur in predictable ways. This is important for the efficient functioning of markets, as the more confident the participants in said markets are in the laws governing transactions, the more likely they will be to invest, and the more significant their investments. Indeed, given that any free market economy is dependent on the repeated actions and interactions between buyers and sellers of goods and services, some legal protection for both will be vital to ensure that markets remain stable in the long term. However, the generally accepted view is that the law has historically needed to be well developed and consistently applied in order to generate this long term stability. Indeed, as early as the 18th century, Adam Smith (1776) argued that, in order to function properly, markets needed to be guided and regulated to avoid exploitation. Whilst Adam Smith is often cited as promoting minimal outside interference in markets, he nevertheless realised that the à ¢Ã¢â€š ¬Ã‹Å"Invisible Handà ¢Ã¢â€š ¬Ã¢â€ž ¢ needed a strong legal framework and basis in order to be effective. However, Chase (1971) argues that there are numerous laws and regulations which actually interfere with the efficient operation of many intermediaries in financial markets. Whilst Chaseà ¢Ã¢â€š ¬Ã¢â€ž ¢s (1971) work mainly focuses on laws affecting the depositing of funds, the laws as a whole place significant restrictions on new firms entering financial markets, place restrictions on mergers and acquisitions, restrict investment portfolio regulations, and often include mandatory, and inefficient, insurance programs to reduce the risk to external participants. Whilst supporters of these laws claim that they reduce the tendency for interna l participants to take excess risks with external participantsà ¢Ã¢â€š ¬Ã¢â€ž ¢ investments, Chase (1971) argue that they also reduce competition and innovation, thus acting to redcue the performance of markets. Hence, whilst they may increase the security and reliability of transactions, this is not necessarily good for investors who wish to voluntarily sacrifice security for additional performance. Further to this, Strahilevitz (2007) argues that laws and legal interventions can actually pose a threat to the development of more advanced forms of market activity, such as social production. Indeed, this argument is based on the fact that the existing legal and institutional framework actually acts to maintain the status quo, hence reducing the chance that initiatives such as social production will increase market participation and help reduce the gap between the rich and the poor. However, Walker (2000) makes the point that, whereas traditional markets involve exchanging goods o r services for payment, financial markets are fundamentally based on exchanging money in expectation of future rewards. These rewards may be interest, potential capital appreciation, or a right to future corporate earnings, but the key factor is that the promised returns must be creditable. As such, legal rules and frameworks such as bankruptcy provisions and loan securities, together with recourse to the courts should there be a dispute over a debt or a contract, are vital for ensuring this credibility. In particular, Walker cites and analyses the Asian financial crisis as an example of how inadequate security and creditworthiness in the global financial market triggered a major crisis. However, whilst Walker (2000) argues that the legal and regulatory framework should develop with the market, in order to support ongoing financial stability; this is often not what occurs in real life. Instead, regulations such as Basel II and Sarbanes-Oxley were created and enacted only in response to issues, such as the Enron fraud, as said issues arose. Indeed, there are growing arguments in favour of embracing the concept of the social market economy, whereby the market is regulated by social cohesion, with only a basic framework of legal rules and regulations. As such, the normalisation of transactions in the market is driven by shared cultural values and common interpretations of fairness and reliability. There is still recourse to the courts for any major issues encountered in the markets, but the spirit of the agreements between buyers, sellers and intermediaries is considered, rather than the letter of the agreements. As such, the market has more of a constitutional status than a legal and regulatory focus (Ebner, 2006). Whilst this type of market will likely require more conceptual development before it can be made viable on a large scale, it offers the chance to move away from constricting and reactive legal and regulatory frameworks and towards a more holistic m odel of the market. However, in the short term, it is clear that legal rules are still a vital component of a well functioning market economy. Gianetti (2003) argues that legal rules, along with firm characteristics and financial development, are vital factors in the raising of corporate finance; which in itself is a vital part of any financial market. As part of this argument, Gianetti (2003) demonstrates that rules providing a good level of protection for creditors increase the flow of capital within the market, particularly for unsecured loans or firms operating in volatile sectors. This is particularly important in developing nations, where their stock market is less advanced; as the majority of firms will unlisted and thus will need to raise more finance from debt, rather than equity. In addition, providing legal rules which support the rights of creditors, and provide functioning enforcement mechanisms, tends to increase the amout of long term debt available to firms (Giann etti, 2003). However, Bar-Gill and Fershtman (2004) argue that legal rules have a more important role than simply incentivising markets; rather the rules actually change participantsà ¢Ã¢â€š ¬Ã¢â€ž ¢ preferences and behaviours. As such, given that free markets invariably encourage participantsà ¢Ã¢â€š ¬Ã¢â€ž ¢ self interests, it is necessary to understand how laws and regulations affect preferences and behaviour, as well as how they affect outcomes. As such, Bar-Gill and Fershtman (2004) argue that legal rules must be created to address all individual concerns, particularly their concerns around being treated fairly, in order to encourage efficient and productive behaviour by market participants. As such, legal rules such as enhancing the remedies available to participants for breaches of contract will likely reduce the equilibrium preferences for fairness, as the participants seek contracts which are more advantageous for themselves. However, Kerwer (2005) argues that the e fficient regulation of financial markets needs to move away from rigid legal rules, and towards more voluntary and alternative options such as best practice rules and standards. This is based on the claim that, where these standards can be agreed, they can be highly effective in moderating behaviour, to a greater extent than rigid legal rules. In particular, standards have influence because they are based on the knowledge and expertise of the market participants, rather than being driven by outside institutional agencies, and will thus be more acceptable for states which want to maintain their regulatory autonomy. For example, the Sarbanes-Oxley legislation was passed by the US Senate, and thus creates problems for firms looking to do business in the United States, whilst being based in a nation which has not adopted the Sarbanes-Oxley requirements. In addition, Kerwer (2005) argues that global standard setters can often be held more accountable than regulatory institutions setting legal rules, as the standard setters will answer to the market, not to the government. This implies that standards could play an important future role in market regulation. Rodrik and Subramanian (2003) argue that institutions are vital to the development, regulation and maintenance of stable financial markets. However, they acknowledge that there is no one institutional framework which will be suitable for all settings, with many different nations having different institutional frameworks with varying degrees of success. Indeed, this is supported by Stephen et al (2005) who argue that whilst institutions are important in promoting entrepreneurial activity in both developing and developed nations, nations need to take a contingent approach to the development of said institutions. Stephen et alà ¢Ã¢â€š ¬Ã¢â€ž ¢s (2005) work supports the fact that legal rules and institutions need to protect creditors and investors, in order for financial markets and economies to grow. However, th ere are no such prescriptive solutions for the nature of the institutions needed to support this growth. This argument is further developed by Teubner (2002) who argues that the process of globalisation is deconstructing the traditional framework of legal and institutional norms; making pluralism a driving force in formation of global markets. As such, a new framework for legal and regulatory institutions is required if said institutions are to remain relevant in the modern global economy. A similar argument has led Ramirez (2007) to argue that the legal structure underlying corporate governance standards in the United States, and the wider world, needs to be altered to reflect this changing nature. In particular, the inherent nature of corporate governance implies that it should be based upon the verdicts and influence of the market. This implies that corporate governance best practice and à ¢Ã¢â€š ¬Ã‹Å"scienceà ¢Ã¢â€š ¬Ã¢â€ž ¢ should be used to largely replace the current ins titutional framework, as these institutions are largely driven by political concerns and are thus poorly equipped to impose relevant standards (Ramirez, 2007). In spite of the growing backlash against the institutional dominance of the financial markets, many academics continue to argue that legal and regulatory institutions are essential to maintain strong financial markets. This is largely due to the fact that institutions set up to protect investors have been shown to increase the strength of markets by reducing and controlling information asymmetries (Black, 2001). In addition, Musacchio (2008) argues that institutions are vital in ensuring continued creditor protections and the enforcement of financial contracts such as bond contracts. However, Musacchio (2008) also argues that institutions are somewhat constrained by past legal traditions, and thus have an inherent tendency to be backwards looking when attempting to regulate markets. Oà ¢Ã¢â€š ¬Ã¢â€ž ¢Driscoll and Hoskins (2006) also recognise this backwards looking tendency, however they argue that this is largely restricted to government institutions. As such, they claim that markets are characterised and governed by both prices, and by market rules and institutions, with government institutions often undermining the existing system of market based regulation. However, it is important to recognise that some institutions do not always act to support the economy; rather they use the legal frameworks and existing institutions to act against the market for their own self interest. By far the most well known of these institutions are the trade unions, who have been argue to both promote and reduce levels of economic efficiency and social welfare in markets (Kaufman, 2005). This is because the trade unions are well versed in the rigid legal rules and regulations, and thus are able to use them to their advantage by arguing that the laws they are using are designed to increase social welfare. They also take advantage of the fact that many lawyers will be systematically optimistic about their ability to use the legal frameworks to their advantage in court. As such, they will frequently use the threat of litigation, and its associated costs, to force any opponents into a favourable settlement (Bar-Gill, 2006). This is argued to be due to the current design of the legal and institutional framework, which serves to support any court action against market participants, thus arguably decreasing the efficiency of the markets and placing a financial burden on participants. As such, it is clear from both sides of the argument that legal rules and institutions are essential components of a strong market. Without them, unscrupulous participants would be able to operate with impunity, breaking contracts and failing to repay loans. Whilst internal market regulations could impose penalties on these participants, without the backing of legal rules and institutions, there would be no effective way of enforcing these penalties. However, whilst there is a strong argument in favour of a strong, basic legal framework to protect creditors and enforce contracts, there is also an argument that any further regulation is better performed by market based institutions, rather than legal rules and government institutions. In particular, critics of legal regulation argue that the Sarbanes-Oxley Act in the United States has damaged the American financial markets, whilst the market based Financial Services Authority in the UK has helped increase the UK marketà ¢Ã¢â€š ¬Ã¢â€ž ¢s competitiveness by providing a more market based form of regulation (Bloomberg and Schumer, 2007). This market driven regulation also helps reduce the occurrence of corporate lawsuits in the UK, thus further reducing the burden on market participants. As such, whilst legal rules and institutions are vital parts of strong, stable markets, it is important to recognise that they should only form part of the overall market framework, and should not be used to the exclusion of other factors such as best practice, market standards and market based institutions. References Bar-Gill, O. (2006) The Evolution and Persistence of Optimism in Litigation. Journal of Law, Economics Organization; Vol. 22, Issue 2, p. 490-507. Bar-Gill, O. and Fershtman, C. (2004) Law and Preferences. Journal of Law, Economics Organization; Vol. 20, Issue 2, p. 331-353. Black, B. S. (2001) The Legal And Institutional Preconditions For Strong Securities Markets. UCLA Law Review; Vol. 48, Issue 4, p. 781. Bloomberg, M. R. and Schumer, C. E. (2007) Sustaining New Yorkà ¢Ã¢â€š ¬Ã¢â€ž ¢s and the USà ¢Ã¢â€š ¬Ã¢â€ž ¢ Global Financial Services Leadership. City of New York / United States Senate. Chase Jr., S. B. (1971) Financial Structure and Regulation: Some Knotty Problems. Journal of Finance; Vol. 26, Issue 2, p. 585-597. Cranston, R. (2003) Principles of Banking Law: 2nd Edition. Oxford: Oxford University Press. Ebner, A. (2006) The intellectual foundations of the social market economy. Journal of Economic Studies; Vol. 33, Issue 3, p. 206-223. Giannetti, M. (2003) Do Better Institutions Mitigate Agency Problems? Evidence from Corporate Finance Choices. Journal of Financial Quantitative Analysis; Vol. 38, Issue 1, p. 185-212. Kaufman, B. E. (2005) Historical Insights: The Early Institutionalists on Trade Unionism and Labor Policy. Journal of Labor Research; Vol. 26, Issue 1, p. 1-32. Kerwer, D. (2005) Rules that Many Use: Standards and Global Regulation. Governance; Vol. 18, Issue 4, p. 611-632. Musacchio, A. (2008) Can Civil Law Countries Get Good Institutions? Lessons from the History of Creditor Rights and Bond Markets in Brazil. Journal of Economic History; Vol. 68, Issue 1, p. 80-108. ODriscoll Jr., G. P. and Hoskins, L. (2006) The Case For Market-Based Regulation. CATO Journal; Vol. 26, Issue 3, p. 469-487. Ramirez, S. A. (2007) The End of Corporate Governance Law: Optimizing Regulatory Structures for a Race to the Top. Yale Journal on Regulation; Vol. 24, Issue 2, p. 313-359. Rodrik, D. and Subramanian, A. (2003) The Primacy of Institutions. Finance and Development; Vol. 40, Issue 2, p. 31-34. Smith, A. (1776) An Inquiry Into The Nature And Causes Of The Wealth Of Nations. London: The Adam Smith Institute. Stephen, F. H. Urbano, D. and van Hemmen, S. (2005) The impact of institutions on entrepreneurial activity. Managerial Decision Economics; Vol. 26, Issue 7, p. 413-419. Strahilevitz, L. J. (2007) Wealth Without Markets? Yale Law Journal; Vol. 116, Issue 7, p. 1472-1516. Walker, J. L. (2000) Building the Legal and Regulatory Framework. Building an Infrastructure for Financial Stability, Conference Series No. 44, Rosengren, E. S. and Jordan, J. S. (Eds) Paper presented at the Conference of the Federal Reserve Bank of Boston; June 2000, p. 31-66. Don’t waste time! Our writers will create an original "Legal institutions in the financial market" essay for you Create order