The first note of this series described how banks collect savings and make loans to businesses and households.
The second important use of savings is the capital market.
The establishment of the capital market is perhaps the most important development of human economic organizations and is the real source of the successful development of capitalism. (I deem Capitalism successful as all of the advanced economics are based on capitalism and no state organized on socialist principles has come anywhere near the level of wealth of the advanced economies.)
If a businessman takes a loan from a bank he is usually asked to agree that all of his assets can be taken to recover the loan.
The personnel wealth of the borrower is part of the collateral.
If the businessman takes a partner then both partners’ personal wealth becomes part of the collateral of any borrowing by the partnership.
The invention of the “limited” company changed all of this.
Under the laws governing limited companies a group can join together and co-mingle their money to establish a new company.
Everyone who joins the group gets “shares” in return for money paid to the firm.
When the limited company takes a loan from a bank, in the case of default the bank cannot take the assets of the owners.
Collateral comprises assets owned by the limited company, not the investors.
“Limited” means that the greatest loss an investor can experience is the amount he invests.
It then becomes possible for the owner of shares to sell them to someone else.
Stock markets then became established where shares are traded freely, the value determined by participating individuals.
This secondary share market does not provide financial resources to the company, rather ownership interests are traded at a price for the share established that may be quite different from the nominal face value of a share.
A company gets started by issuing shares to the public (initial public offering).
The funds raised are used by the company to expand or rearrange the finances of the company.
The person who places savings in a bank deposit passes the choice of where to invest to the bank.
The saver who buys shares either in an IPO or in the stock market makes his own choice of how to place the investment.
Other channels
There are other channels for the investor to place his savings: The non-bank financial institutions take only large deposits and make riskier loans at higher interest rates (to cover the greater risk).
A person who deposits his savings in an NBFI is taking a greater risk while hoping for a better return.
The restriction to large size deposits assumes that the wealthy individual can take responsibility for his own investment choices and the level of risk that he finds acceptable.
There are also asset management companies (AMC) that function as investment experts who take savers money and invest in a group of stocks.
Mutual funds are one product of AMCs.
Such companies need very careful supervision by the BSEC.
The idea here is that the manager of the investments can do a better job than the individual in selecting a group of stocks.
In fact, this idea turns out to be wrong.
No matter how much expertise is claimed the specialist investor cannot on the average do better than the average for the entire market.
AMCs can invest in a very broad part of the market, e.g. all energy stocks, then the individual can choose to invest in such a fund if he believes the energy sector is going to do very well.
There is also potential for issuance of bonds by private companies but this remains very limited and has not been included in the numerical estimates at the end of this article.
Effective capital market
To have an effective capital market there must be trust between the holder of the stock and the company.
Enforcing trust is the main task of the Bangladesh Securities and Exchange Commission (BSEC).
There are many difficulties in building investor trust in limited companies.
The BSEC works steadily to ensure a valid trust relationship.
These problems remain: (1) Audited accounts of listed companies are often questioned. One signal of this problem is foreign investors in the market are heavily concentrated in stocks where the audit is done by a local chartered accountant associated with a first-class international auditor. (2) The BSEC sometimes interferes in the market to prevent share prices from falling. It is not the business of the SEC to encourage or force a rising index of share prices. Such interventions will cause investors to walk away from the market. (3) There are many listed companies that are bankrupt and should be liquidated, but there is little progress in cleaning out all of the trash. (4) There are occasional instances of the share price of a bankrupt company suddenly rising when there is no business reason. This clearly signals some sort of price manipulation. (5) The commercial banks are encouraged to put their funds into the share market.
This is a very bad idea: it shifts funds away from the loan market; the BSEC would improve the capital market by having the commercial banks exit the share market and focus on their main task of collecting deposits and making loans.
Building up the reputation of the capital market takes years.
Small capital markets are often the target of manipulation through ramping up the share price of a company and then selling when the price begins to rise.
Such performance is relatively easy to detect and to identify the persons engaged in such political actions.
Unfortunately, the SEC has been unsuccessful in prosecuting such manipulators.
Such scams have a serious negative impact on investing in the capital market.
It is widely believed by persons knowledgeable about Bangladesh’s capital market that this type of scam is common and has a strong influence on the rise and fall of the market price index.
The most important tasks that the BSEC should now emphasize are to seek more institutional investment, to increase small investors' use of mutual funds, to encourage AMCs to manage retirement funds and portfolios covering particular sectors of the economy.
To bring more investors to the capital market the BSEC must create trust. There have definitely been improvements but there is a long way to go.
Supervision of AMCs has been lax to the detriment of the investors and the benefit of the managers. IPOs bordering on the fraudulent have been approved.
Many investors suspect that the BSEC supports the issuers of shares, not the investors who buy these shares.
BSEC must act from the assumption that listed companies will try to conceal their shortcomings.
What does it all mean?
This second note ends by putting into perspective the significance of the banks and the capital market.
My rough estimate is that over the past 11 years from June 2010 to June 2021 there has been Tk46 trillion invested by the private sector.
Of this the banks and non-bank financial institutions have financed Tk24 trillion and the capital market Tk1 trillion.
About Tk0.6 trillion has been financed from abroad.
The NGOs have invested about Tk1 Trillion and the remainder Tk19 trillion has been financed from the retained earnings of enterprises or by households directly.
The total capitalization in the share market suggests that Tk3 trillion has been invested from retained earnings of listed companies.
In brief, about 52% is funded through the banking system and 2.2% through the capital market, or 55% of private investment passes through the financial system (excluding the NGOs).
Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics.