Disciplining stock markets
The stock markets of Bangladesh recently witnessed wild volatility. The general index of Dhaka Stock Exchange stood at 4,535 at the end of December 2009, nearly doubled in less than a year to 8,912 on December 5, 2010, suffered drastic loss of more than 1,200 points over a period of two days to dip to 6,499 on January 10, and then regained more than 500 points the next day to reach 7,512 following some policy pronouncements by Securities and Exchange Commission (SEC) and Bangladesh Bank. The index was 7,378 on 17.
In an earlier paper (DS March 25 2009) I noted that certain inherent characteristics of the financial markets expose them to wide volatility. Those include asymmetry of information, adverse selection, herd behaviour by investors and moral hazard. These factors appear to have afflicted our stock markets with vengeance in recent times.
"Asymmetry of information" in the context of stock markets implies that the investors know much less about the inherent worth of the companies' shares which they are buying/selling compared to the managers and sponsors of those companies. Investors' decisions, therefore, may not be based on rational considerations. Perhaps even more importantly, the incapacity or unwillingness to process available information has contributed to large swings.
The investors have not taken into consideration well-known criteria such as net asset value per share and/or price-earning ratio in their decisions even though information regarding these criteria is readily available on the websites of stock exchanges. As a result, all share prices rose or fell more or less in unison, irrespective of differences in fundamentals.
This is also a reflection of "herd behaviour" in the sense that when some investors started buying/selling some shares, others joined in droves to follow suit without discriminating among shares on the basis of their intrinsic worth. "Herd behaviour" has been intensified by the entry of many new investors.
The number of B.O. account holders has skyrocketed to 33 lakhs, many of them having been allured into the stock market by brokers who have opened many branches outside the major cities. Most of these new investors from outlying districts have hardly any knowledge about the basic principles that should guide decisions regarding investment in stock markets. It is regrettable that even institutional investors behaved in a herd-like manner. Both irrational exuberance and irrational pessimism became pervasive.
"Adverse selection" also came into play to cause instability. The banks as well as non-bank financial institutions generously provided credit to investors in stocks (which are inherently high-risk, but potentially high-yield investments) who probably offered to pay higher interest, depriving investors in the real sectors of the economy.
In addition, the banks themselves invested in stocks and there was diversion of funds ostensibly borrowed for industrial term credit or working capital into the stock market. Subsequently, sale pressure gathered momentum as the investors began to realise that the indices had reached unsustainable levels. This scenario brought into question the effectiveness of monitoring and supervisory role of Bangladesh Bank.
"Moral hazard" implies that regulators would rescue the investors though their losses were the consequence of irrational investment decisions. This perception encourages assumption of high risk. In the context of our stock markets, moral hazard has been reflected in changes in policy stance by Bangladesh Bank with regard to exposure of banks to stock markets and frequent changes by SEC in respect of loan margin ratio and the methods of calculating the ratio. Moral hazard seems to have become entrenched, especially because regulatory authorities have often relaxed their standards in response to destructive activities of a limited number of disgruntled investors.
In addition to the above factors, market manipulation has also been cited as a cause of instability. This is an issue which deserves urgent probe by the Securities and Exchange Commission whose primary duty is to ensure fair trading.
To ensure stability of stock markets would require actions on a number of fronts. Some of these are suggested below:
* Increase in the number of scrips: There has been an explosion of market capitalisation on the basis of price inflation of existing scrips. There have not been many new issues of initial public offering (IPO) over the last couple of years from the private sector, with the notable exception of Grameen Phone. The promised off-loading of shares of 26 state-owned enterprises has not materialissed. A large number of shares issued by companies from different sectors would help bring about better balance between demand and supply and enable investors to pick and choose on the basis of fundamentals rather than zooming on a limited number of existing shares, thus excessively inflating their prices and creating conditions for eventual downslide. Furthermore, adverse impact of manipulation by any errant market actor with respect to a few shares would be minimised.
* Coordinated role of regulators: Bangladesh Bank and SEC should regularly exchange notes and adopt policies with due regard to interactions between money market and capital market. Policies, once adopted on the basis of mutual consultations between the two regulatory authorities as well as between them and other stake holders, should be implemented rigorously without being subservient to extraneous influences and should not be changed frequently.
Investor's education: The coverage of existing investor's education programmes conducted by the stock exchanges and SEC is limited. These programmes need to be expanded. Cooperation of both print and electronic media should be sought to educate investors about the considerations that should guide investment decisions. It should also be made abundantly clear to them that they have to bear the losses of wrong decisions themselves and should not expect regulators to undertake salvage operations. They should be made aware that stock prices can not go on rising till eternity.
* Strengthening monitoring and surveillance: SEC should strengthen monitoring and surveillance over all direct and indirect market actors. Those include banks, non-bank financial institutions, merchant banks, mutual funds, brokers, the stock exchanges, issuer companies, auditors etc. Appropriate actions should be taken against violators of relevant laws, rules and regulations.
* Demutualisation: Our stock exchanges have reached a stage where demutualisation over the next three to five years should be seriously considered. Stock exchange authorities are the front line soldiers for ensuring market stability. A situation of conflict of interest arises when the brokers exclusively serve as members of the Board of Directors of stock exchange and assume the role of primary regulators. Many exchanges around the world have been demutualised to resolve such conflict of interest.