Welcome to the second module of The Role of Global Capital Markets. In the previous module, we've given an overview of the financial and capital markets of most importance to corporations. Now we will take a closer look at what the value proposition of these markets is. We'll talk about the Flow of Funds. How corporations access financing for their investment projects. We'll talk about Price Discovery. Market value of the assets and the liabilities that we saw listed in the financial statements. We'll talk about Optimal Allocation of Funds. Which investment project should be provided with funds and which ones shouldn't. We'll talk about Portfolio Diversification. How do markets achieve a good spreading, a good diversification of risk. And we will briefly touch on the cooperate governmenance role performed by markets. So consider a world without markets. What would be the economic costs? Well first and foremost, the search cost would rise dramatically. Any party who wants to sell an asset, a share in a corporation, a bond, a commodity would have to start looking on their own accord for a counter party interested in buying that asset. That's going to be a costly process. Not only that but every time the next transaction occurs, the same surge would have to start again. Information would not be pulled. Some information, only of relevance to a particular bi-lateral transaction, would be available. But the broader availability of the asset, demand for the asset, that kind of information would not necessarily be available in any particular transaction. Risk would not be pooled. Every transaction would have its own unique risk attached to it. Without the opportunity to spread that risk across many transactions. Default risk would be high. There would be a high likelihood, or a high possibility that a counter-party would not come to the party, would not honor their obligations. Risk premiums would drive up prices, to cover for default risk, for example. Regulation and contract enforcement would be very difficult on a contract by contract basis. And very costly, as a matter of fact. Ultimately the outcomes would be distorted by possible local market power. In any particular transaction, either the buyer or the seller might have a dominant position. And thereby influence price discovery, leading to a unfair outcome for the other party. All of those add up to the economic costs in a world without markets. So maybe we can turn that around and look at the benefits of the markets. So is it truly a coincidence that developed economies do in fact have very developed and efficient markets. The purpose of the market is to make capital available to corporate investment and to allocate it optimally. That outcome would then drive economic growth. By pooling risky transactions we're able to spread or diversify as we call it, the risk in individual transactions. That would make the investment in risky projects all of the sudden feasible. On a stand alone basis, investors would shy away from investing in risky projects, but if they have an opportunity to pull that risk across many transactions in a market, then all of a sudden, the risk becomes palatable. Ultimately economic growth requires investments in risky projects. So markets will increase the likelihood of economic growth. But what truly is the causality? Is it the fact that markets have grown very strongly? Look at China. Or is it the fact that markets were very well developed first, and economic growth followed? The answer to that question is not trivial. The World Bank has got the following to say on that matter. Countries with better developed financial intermediaries including markets experience faster declines in measures of both poverty and income inequality. And these results they found to be truly robust against reverse causality. So the World Bank, seems to conclude, that better financial markets, better financial intermediaries, lead economic growth. So knowing that, can't we then ask the question, can't financial services, simply be imported by countries? Why do countries have to develop their financial markets, their own financial system first, before they can reap the benefits of economic growth? That's a question that we will address in the next two modules. To make a market, requires what we would label as Infrastructure. And the infrastructure, of course, is the physical assets of running a market, the service on which an automated trading platform runs, but it also includes the market participants. For markets to be truly efficient in allocating capital to economic investment projects, requires the participation of financial institutions, institutional investors, corporations. But it also requires the government and regulators doing their part. And of course, the arbitrageurs and speculators that we referred to in the previous module. All of these bodies need to be present to truly lead to an efficient market outcome. After we discuss the many benefits of efficient markets, we'll take stock and also consider some of the challenges confronting global capital markets today. Most of that discussion will take place in modules three and four. We'll talk about the unregulated, those new markets that are popping up all the time that do not quite fit the current system that regulators focus on. So P2P lending is one example here. Crowdfunding or microfinance are other examples of what we would label as the Unregulated Capital Markets. We've also seen a series of market crashes. And these market crashes seem hard to deal with the benefits, the alleged benefits of a well-functioning, efficient capital market. Bubbles, irrational exuberance by those market participants. Flash crashes seem to happen too frequently to justify the benefits of global capital markets. In the last module we will discuss, in quite some detail, financial crisis. And a suggestion that is not all good what capital markets, what financial markets deliver to the economic system and to corporations. We'll talk in particular about the global nature of these markets. And how that is posing challenges to regulation which is typically on a national basis. So we'll talk about contagion, and we'll talk about the risk that some of the market failures could potentially lead to recessions.
