INTRODUCTION
Financial institution – such as investment companies, mutual funds, brokerages, insurance companies, pension funds, investment banks and endowment funds – are entities with large amounts to invest. While these institutions have been prominently present in Anglo-Saxon countries since a long time, we provide proof that their importance in Continental Europe has increased dramatically, especially since the second half of the nineties. Specifically, we show an upsurge in the amount of funds that they manage since 1991, which becomes especially striking as of 1995. Simultaneously, institutional investors in Continental Europe on average exhibit a larger appetite for investments in the equity of listed companies during the second half of the nineties. Different studies have investigated the impact of having institutional investors involved in a company’s ownership. Usually, financial institutions are considered to have a positive effect on the stock prices of the firms in which they invest. This effect materializes through different mechanisms: institutional investors reduce information asymmetries between the firm and (other) investors, contribute to the liquidity of the company’s stock and improve the firm’s corporate governance. Nevertheless, the literature has pointed out that some new problems may arise after involving institutional investors in a company’s ownership, such as larger variability in stock prices. Also, specific conflicts of interest may arise between the firm and small shareholders on the one hand and institutional investors on the other. If firms fully understand the positive influences of institutional investors and if benefits are larger than costs, they may do efforts to involve these professional investors in their ownership. In particular, firms that can benefit from the functions performed by institutional investors may wish to attract institutional interest. We apply these ideas in the context of going public, using data on a sample of Belgian initial public offerings (IPOs).[1] The reason why we focus on IPOs is that at the time firms go public, information asymmetries generally are large (the firm has not yet built up a public track record), the liquidity of the firm’s stock has to be assured in order to establish the firm’s credibility (leave a good taste in investors’ mouths) and governance structures usually have to be adjusted to take into account the new (public) ownership structure of the firm. Our results show that firms using the stock market as a financing vehicle are more likely to pre-allocate shares to institutional investors at IPO-time. Such preallocation is found to reduce under pricing and enhance post-IPO stock liquidity.
The Financial Institutions in Bangladesh
The present structure of the financial system in Bangladesh comprises of various types of banks, insurance companies, and non-bank financial institutions. Bangladesh Bank[2] is at the top of the banking system and is accountable for assuring prudential administration and central banking activities for all types of banks operating within the banking industry. On the other hand, the Securities and Exchange Commission (SEC) of Bangladesh is the regulatory body for stock-market related activities. According to the Bangladesh Bank Annual Report (2008-2009), the financial system of Bangladesh consists of 4 state-owned commercial banks, 5 government owned specialized banks, 30 domestic private commercial banks including 7 Islamic banks and 2 denationalized banks, and 9 multinational banks. The financial system of Bangladesh also includes 29 non-bank financial institutions, 298 microfinance institutions, 27 insurance companies, and a number of non-schedule and co-operative banks. Out of 29 non-bank financial institutions one is government owned, 15 are domestic private, and 13 are established under joint venture with foreign participation. Furthermore, Dhaka Stock Exchange Ltd. (DSE) and Chittagong Stock Exchange Ltd. (CSE) are the two stock exchanges operating within the financial system[3]. In addition, there are five trustees of asset-backed securities and mutual funds, seven asset management companies, and six security custodians.
Financial Institution investors and liquidity
Liquidity, i.e. the ease with which an asset can be converted into cash – and especially the lack of it – affects value. The reason why a deficiency in liquidity negatively affects the price of shares is threefold. First of all, if a stock is not regularly traded (in the limit not traded), uncertainty about its underlying value increases (Merton (1987)). For one of the important properties of a stock market is that, as investors assemble information and act upon it, the information [4] becomes reflected into the stock price. Hence the less trading, the less opportunity for information to be (timely) incorporated into the price, and the more uncertainty about the stock’s underlying value. Furthermore, as liquidity decreases, fewer investors are interested in the stock, so that overall information collection tends to decline. Finally, since it is more difficult to find interested buyers, an illiquid stock is more costly to turn into cash. As a consequence, the seller of an illiquid stock will have to accept a discount on the selling price. Consequently, as uncertainty about the underlying value increases, as less investors are interested to buy it and as trading becomes more costly, the share price decreases.
Although there is no perfect agreement yet about how the precise interaction of the factors in the process described above affects value, there is consensus in the academic literature that liquidity has an impact on share prices[5]. For example, Amihud and Mendelson (1986), Reingaum (1990), Eleswarapu and Reingaum (1993), Brennan and Subrahmanyam (1996), Brennan et al. (1998), Eckbo and Norli (2000) provide evidence that stock market liquidity is priced in asset returns. Specifically, they show that illiquid shares require higher (pre-trading cost) returns, which implies a higher cost of equity. In a more direct test of the consequences of liquidity for value, Loderer and Roth (2003) report that the least liquid stocks on Nasdaq and the Swiss Exchange suffer a discount on value of about 30%. Finally, Butler et al. (2002) show for the U.S. that companies with highly liquid shares suffer less issuance costs at the time they raise new share capital and sell these additional shares in the market.
Specifically, companies that count many institutional investors among their investor base tend to have more liquid shares. Of course, institutional investors have a preference for liquid shares (see for example Gompers and Metrick (1998)). Liquidity[6], for example, is valuable when they have to rebalance their portfolios over time. Conversely, as these investors engage in more information collection compared to the average retail investor, liquidity is likely to improve.
On the negative side, it is sometimes claimed that financial institutions contribute to greater stock price variability [7] because of the vast amounts of trading when these investors rebalance their portfolios. That such rebalancing indeed may have important effects can be easily observed by looking at the stock prices of firms that are moved in or out of an important stock market index. As institutional investors commonly have a preference for index stocks, inclusion in (deletion from) a stock market index induces substantial changes in ownership. Whether or not institutional investors actually cause greater stock price variability is as yet not clear. However, some financial institutions – such as momentum traders and hedge funds [8] – tend to trade more aggressively, and these professionals may induce more volatility. For Poland, Bohl and Brzeszczynski (2004) document that since the reform of the Polish pension system in 1999, when privately managed pension funds were established and allowed to invest in the stock market, institutional have become a major investor group.
Impact of financial institutions on underpricing
Pre-allocating shares to financial institutions at IPO-time helps to reduce information asymmetries. Specifically, we examine its impact on IPO-underpricing, which is defined as the percentage difference between the first-day closing price and the offering price, corrected for the stock market return of that day. We find some evidence that firms pre-allocating shares to institutional investors under price their shares to a smaller extent;[9] this finding is consistent with the idea that involving institutional investors in the pricing process through pre-allocating a fraction of the offering induces these investors to invest in information collection and truthfully reveal their opinion. A larger percentage adjustment of the final offering price relative to the mid-price of the initial price range, which in the literature is considered to capture the uncertainty in determining the final price, is associated with higher IPO-under pricing. Finally, when the historical stock market return is large or the IPO takes place in a hot issue market, offerings are underpriced more.
The Impact Of Contractual Savings Institutions On Securities Markets
We assess empirically the impact of contractual savings institutions portfolios (pension funds and life insurance companies) on securities markets, e.g., depth and liquidity in the domestic stock market, and depth in the domestic bond market. We discuss how the institutionalization of savings may modify financial markets through the lengthening of securities’ maturities. Our results are the following. First, an increase in assets of contractual savings institutions relative to domestic financial assets has a positive impact on the depth of stock and bond markets on average. Second, the impact on stock market depth and liquidity is nonlinear: it is stronger in countries where corporate information is more transparent. Third, there is evidence of a significant heterogeneity among countries: contractual savings have a stronger impact on securities markets in countries where: a) the financial system is market based; b) pension funds contributions are mandatory; and c) international transactions in securities are lower. Finally, we do not find that the impact of contractual savings institutions on securities markets is explained by the overall level of development, education, demographic structure or the legal environment. The development of contractual savings institutions provides an institutional framework favoring the accumulation of long-term capital.[10] By increasing the demand for long-term financial assets, it could thus promote financial market development, and improve the capacity to manage financial risks. As long as the levels of nominal debt are too high, long term maturities are not attainable as the credibility of the anti- inflationary stance of the government is undermined.”[11] Conversely, mandatory contributions may have a greater impact on the supply of long-term savings when households would not save long-term
Spontaneously.[12]
Recent decision of Bangladesh Govt. to prop up stock market
Bangladesh will create a US$700 million mutual fund; the country’s biggest ever, in a bid to steady the volatile[13] Dhaka Stock Exchange (DSE), the head of a state-owned investment bank. The plan is part of the government’s drive to restore calm to the market, after sharp falls triggered angry protests by investors in the capital Dhaka and across the country. Eight state-run financial institutions will invest cash to create the planned 50 billion Bangladeshi taka (US$700 million) Bangladesh Fund, said M. Fayequzzaman, chief executive of the Investment Corp of Bangladesh.
“It is the largest ever mutual fund in the country’s history. It is aimed at stabilizing the country’s stock exchange and boosting liquidity in the crisis-hit market,” Fayequzzaman told reporters.
The DSE has shed more than 40 percent in the past three months, wiping over US$16 billion off the share market’s capitalization since its benchmark index hit a record high of 8,918.51 points on Dec. 5 last year..
The fund is in addition to a reform package that includes tighter regulation and other measures announced by the government to prop up[14] the market and boost investor confidence. Anxious to assuage investor anger, the government has also planned a probe into the sharp fall. Experts welcomed the announcement of the Bangladesh Fund, but urged the authorities to use it carefully.
“No doubt, this is some good news for the stock market,” said Mahud Osman Imam, a University of Dhaka finance professor. “A fund of this staggering size will make a positive impact and restore stability that we haven’t seen for months.”
“But it remains to be seen whether the fund is used judiciously. If it is used to buy overheated stocks, there is a possibility that it won’t achieve its goal, but at least it will boost liquidity in the market,” he added[15].
CONCLUSION
We have explored the impact of financial institutions on the development of domestic securities markets. This work complements the existing research on this issue. We show that the institutionalization of savings, as measured by the proportion of financial assets in the economy held by financial institutions, has an impact on the short-term dynamics of securities markets: it increases the depth of stock and bond markets and in some cases increases the stock market liquidity. The impact on the stock market is stronger in countries with a market based financial system and/or countries with mandatory pension contributions, while the impact on the bond market is stronger in countries with a bank based financial system. The link between financial institution and stock market is however weaker the larger the cross-border securities transactions are.
Finally, the analysis suggests that the results are not the consequence of a joint determination of both financial institutions and financial markets by other slow-moving characteristics of the economies. Policies shaping the institutionalization of savings do matter.
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[1] An IPO is a transaction whereby private firms become publicly quoted by selling part
of their shares to the public at large.
[2] According to the Bangladesh Bank Annual Report (2008-2009), “Bangladesh Bank, the central
bank of the country, was established as a body corporate vide the Bangladesh Bank Order, 1972 (P.O.
No. 127 of 1972) with effect from 16th December, 1971. The general superintendence and direction
of affairs and business of the Bank are entrusted to a nine member Board of Directors which consists
of the Governor as chairman, a Deputy Governor, three senior government officials and four persons
having experience and proven capacity in the fields of banking, trade, commerce, industry or
agriculture – all nominated by the government”.
[3] self-tender offer is a transaction whereby the company tenders for its own shares, i.e. a stock repurchase
[4] For a recent overview of the literature on institutional investors and corporate governance, see Gillian and Starks (2003).
[5] As in Pagano et al. (1998), holding companies that concentrate 75% of their assets in a single industrial company are reclassified as belonging to the corresponding industrial sector. Financial firms are kept in the sample as in Belgium, and many other European countries, these firms represent a relatively important subgroup. However, as financial firms may differ from the other sample firms, we have tested the robustness of our results by removing them from the sample. These results, which show that our conclusions are unaffected, can be obtained upon request.
[6] For a recent overview of the literature on institutional investors and corporate governance, see Gillian and Starks (2003).
[7] For the 40 firms on which we have effective share allocation data, we find that on average 49.43% (median of 58.68%) of the shares placed in public are owned by institutional investors.
[8] A hedge fund is a fund that is allowed to use aggressive trading strategies that are unavailable to mutual funds, including short selling, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals.
[9] Firm-commitment IPOs are transactions where the investment banker guarantees the issuing firm that it will purchase all shares of the offering that remain unsold at a price as determined in the firm-commitment contract.
[10] For instance, the existence of transaction costs on capital markets, the ability to diversify risk, and the
long-term commitments of contractual savings institutions explain why they may be more willing to hold
long-term securities than individual investors, and require lower risk and liquidity premia.
[11] Similarly, the use of contractual savings funds as a captive source of finance by governments may signal a
lack of commitment to sound macro-economic policies, thus undermining the development of domestic
financial markets.
[12] Baillu and Reisen (1998) explain how aggregate savings can increase when credit constrained borrowers
(indeed, likely to be the poorer individuals) would not be able to re-shuffle their investment portfolios when
mandated to save through a pension scheme beyond what they would do for precautionary motives. Indeed,
the literature provides us with ambiguous results on the impact on household savings derived from the
introduction of mandatory schemes. Following the literature, the impact on securities markets that we
want to underline in this paper does not stem necessarily from higher savings but from a more efficient
allocation of capital due to institutionalization.
[13] Securities and Exchange Commission, Annual Report 2009-2010, Dhaka, Bangladesh.
[14] This implies that if the offering is highly successful in attracting small retail investors, the portion of shares allocated to the latter may increase to the detriment of institutionals.
[15] Securities and Exchange Commission, Annual Report 2009-2010, Dhaka, Bangladesh.