Relationship Between Privatization and Financial Markets Regulation

7/31/2019 Relationship Between Privatization and Financial Markets Regulation

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Relationship between Privatization and

Developments in Financial Markets RegulationBy

Tomasz Szl zak


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ContentsRelationship between Privatization and Developments in Financial Markets

Regulation...............................................................................................................1

By.......................................................................................................................1

Tomasz Szl zak ...................................................................................................1

Contents ................................................................................................................. 2

Relationship between Privatization and Developments in Financial Markets

Regulation ............................................................................................................... 3

1.0 Privatization ...................................................................................................... 3

2.0 UK .................................................................................................................... 5

2.1 Political and Economic Conditioning .................................................................. 5

2.2 Financial Market Deregulation ........................................................................... 6

2.3 British Telecom; a Case Study ........................................................................... 9

3.0 Developing and Transition Economies ............................................................ 11

3.1 International Aspects of Privatization .............................................................. 12

4.0 Financial Markets and Privatization ................................................................. 14

4.1 Basic Financial Markets Infrastructure ............................................................. 16

4.1.1 Financial Intermediary Activity ..................................................................... 16

4.1.2 Regulatory minimum .................................................................................... 18

5.0 Conclusion ...................................................................................................... 20

6.0 Bibliography and Statutes ............................................................................... 22


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Relationship between Privatization and Developments in

Financial Markets Regulation

1.0 Privatization

According to M. E. Beesley and S.C. Littlechild, privatization can be

described as a process of formation of a Companies Act company and

subsequent sale of the majority of shares previously owned solely by the

government to investors1. Whenever I will use the term privatization in this

essay, I am referring to its meaning according to this definition rather thanother ones. This is due to its reference to the process of moving ownership

from the state to private investors through the means of introducing it to

financial markets2. The above definition observes the legal aspects of

privatization as a process, it fails however to observe the underlying

concepts shaping privatizations and the incentives governments might

have in getting rid of parts of its dominium, that state owned enterprises

are. Below I will try to briefly state the policy governing privatization withreference to examples in order to be able to clarify the underlying

influences it has on financial markets regulation.

It is accepted that privatization is always taken upon as a part of a broader

policy undertaken by the government of a state to realize its goals.

1 See, M. E. Beesley & S.C. Littlechild, Privatization. Principles, Problems and Priorities inPrivatization, Regulation and Deregulation,1997, p. 262 For example, the definition given by R. Sarkar in The Transfer of Ownership or Control of

Enterprises or Assets from Governments to Private Individuals or Entities in DevelopmentLaw and International Finance, 2nd Edition, 2002, p. 185 is too broad for the purposes ofthis essay.


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Privatization is rightfully recognized as a tool in helping the state redefine

its position and responsibilities towards the populace it governs3. I aim in

this section of my essay to define the relationship between privatization and

the regulation of financial markets as a part of government policy, shapedby internal and external factors. The issue that I wish to discuss first is

whether privatization shares a relationship with deregulation of financial

markets in developed economies on the example of the UK experience. The

opposite of this would be the finding that as privatization is carried out, the

regulation of financial markets becomes more stringent in order to assert

the interests of the public in newly formed private monopolies. In the case

of some developing economies that privatized their industries as part of a

policy move towards a market economy the case of deregulation will also be

relevant, as these states have often had no financial markets regulation to

start with4. I will discuss what pushed some states to privatize without

developing infrastructure and financial markets regulation first. I will also

point to some identifiable necessary developments of financial markets

regulation that can be beneficial to privatization.

According to A. Santos, the stake in privatization of previously state owned

industries is the protection of consumers from false share prices or profits in

the markets where private owned monopolies have emerged through

privatization. The author makes a good case that privatization ought to be

followed with liberalization in the market where the newly privatized

company operates5. It is my belief that such statements are often misread

and taken to mean that privatization should be accompanied by a general

withdrawal of the state, allowing financial markets to experience a shock

therapy of deregulation, with the hope that they will emerge from this trial

as stronger. I find that international financial institutions promote this

approach, using it as one of policy conditions for countries with which they

enter into loan agreements.

3 R. Sarkar Development, p. 1864 P. Guislan The Privatization Challenge, World Bank, 1998, p. 69

5 A. Santos, Privatization and State Intervention, in G. Majone Deregulation or Re-reulation? Regulatory Reform in Europe and the United States, Printer Publishers 1990, p.143.


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2.0 UK

2.1 Political and Economic Conditioning

Both economic and ideological answers have been given as to why

privatization was a good idea both in the UK as well as other states. To

name a few of the economic reasons for privatization, it was stated that

moving ownership of companies into public hands on a large scale will

improve the efficiency and governance of those companies, that the overall

costs of providing some services will fall. This was to take place thanks to

enhancing competition in previously monopolistic industries such as public

transport, telecommunications, energy supply and others. It was recognized

that government involvement in the economy and especially systemically

important industries as creating economic inefficiencies whos costs are

effectively moved to the taxpayer6.

I find that the most important factors to introducing privatization programs

within UK were more than the above. Authors make a good case out of

proving that privatization has been used as a society transforming tool,

especially in the UK under the government of Margaret Thatcher. Among

those authors is C. Grey who demonstrates accurately how privatization has

been a tool in achieving the political goals of a movement identified as New

Right in the UK7. This political group accepted the ideas introduced by

political scientists P. Miller and N. Rose who argued that individuals will act

rationally in their interest, given the right set of incentives, in the case of

financial markets the incentive of making a profit and that this concept can

be introduced to the theory of government itself8.

This approach to using economic policy of rolling back state involvement

with the goal of transforming society I find intact with a broader ideology

identified as the neo - liberal movement. However the public sectors

performance was relatively poor to the performance of privately owned

6 See J. Moore, Why Privatise?, in J. Kay, C. Mayer, D. Thompson, Privatisation &Regulation, 1989, p.79-937 C. Grey Suburban Subjects: Financial Services and the New Right, in D. Knights and T.

Tinker Financial Institutions and Social Transformations, 1997, p. 47.8 N. Rose, P. Miller Political Power beyond the State: Problematics of Government, BritishJournal of Sociology, vol. 43, no. 2 p. 201


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industries throughout the 1970s its my opinion that liberal ideology also

had an influence9. The privatization of the telecommunications giant British

Telecom seems to give further evidence to this argument. The launch of

$4.8 billion worth of shares of BT to the market was at first hailed as a greatway for a government to capitalize on assets, but evidence shows the price

of shares in the initial public offering was discounted in proportion to the

actual market value, allowing investors to turn a large margin of profit in a

short time10.

Between the five largest privatizations of the late 1980s the UK has issued

almost fifty billion worth of shares into the public market. This means that

the UK government has found itself in a new position. This position being

that of a regulator of the rapidly expanding capital and financial markets it

has helped inflate through privatizing previously state governed companies.

The task has proven especially difficult and important in sectors such as

capital markets regulation and banking regulation, due to the systemic

importance of these to the rest of the economy11. The amount of capital

pumped into the stock exchange has added liquidity to the financial market,

enhancing companies ability to raise capital more easily, through

introducing new investors to the market and encouraging greater activity on

their part12.

2.2 Financial Market Deregulation

Deregulation of the UK financial services industry followed as part of a move

towards less government involvement. Liberalization of the financial

markets regime in the UK was made, among others, through the

introduction of the amended Financial Services Bill in October 1986. The Bill

was designed to enhance the competitiveness, efficiency and confidence of

9 See. J. Moore The Success of Privatisation, in J. Kay et al. Privatisation, p.94-97 Alsosee, J. Stiglitz Whither Socialism?, abstractand W. Megginson Privatization, ForeignPolicy, 2000, p.1410 The privatisation of BT and the deregulatory movements by the government in relation tothis particular case is well described by J. Vickers and G. Yarrow, Telecommunications:Liberalisation and the Privatisation of British Telecom in J. Kay, C. Mayer, D. ThompsonPrivatisation & Regulation the UK Experience, 1986

11 W. Megginson Privatisation, p.2212 G. Chiesa, G. Nicodano Privatization and Financial Market Development: TheoreticalIssues, 2003, p.6-16 available at: http://ssrn.com.abstract=383460


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the UK financial markets. Self regulation was introduced within the

industry. This meant that regulators would be appointed by members of the

industry, with compulsory membership of all professional firms working on

the financial markets, in one of the seven regulatory bodies. Theoverarching regulatory body was the Securities Investment Board as an

institution that was to regulate the regulators themselves. Compulsory

membership in the organizations took the form of a compulsory contract

between the organization and a member institution, in which the member

stipulated to follow the regulators handbook13. A number of institutions

were dismantled on the grounds that they were isolating Londons market

from the outside world due to their outdated modus operandi14. The

disappearance of some regulatory institutions and substitution with a more

liberal regulatory regime was accepted as a move that would allow Britains

gilt edged and equity financial markets to do a better job in competing

with financial centers of New York and Tokyo15.

The industrys enthusiasm from arriving at a lower level of regulation was

premature. With time the self regulatory bodies produced a level of

regulation that was higher, more complicated and lacked the transparency

of a legalistic approach to regulation which was characteristic of the period

prior to the introduction of the 1986 Financial Services Act. In explaining the

rationale for reform Chancellor of the Exchequer, Gordon Brown, in a note in

May 1997 said that the Government believes the current system is costly,

inefficient and confusing for both regulated firms and their customers16. At

the time of privatization program, the institutional reform was generally

regarded as deregulatory17.

One of the plausible reasons as to why the regulatory approach of the 1986

Act failed is the privatization program itself. The main stimulus for rapid

13 S. Gleeson, Financial Services Regulation: The New Regime, Sweet & Maxwell, 1999,Chapter 1, 1-03.14 I. Kerr, Big Bang, 1986, p. 87-10115 I.Kerr,Big, p. 1516 HM Treasury, Financial Services and Markets Bill: a Consultation Document. Part One.Overview of Financial Regulatory Reform, 1998a, p. 8

17 S. Gleeson, Financial Chapter 1, 1-04. This is because at the time privatization wastaken upon the self regulatory organizations were somewhat fresh and havent yet comeup with their famously long and complicated rulebooks.


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market expansion followed by greater innovation than witnessed before and

higher competitiveness on the markets themselves led the self - regulatory

bodies to come up with an ever growing level of technical regulation in their

rulebooks than anticipated

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. More liquidity introduced to the financialmarkets meant financial institutions that operated on them, as brokers

and/or dealers could make a greater profit and expand their operations,

entering new areas of activity. So, if before the introduction of the 1986 Act,

financial institutions would be mostly bound to one or two areas of activity,

by 1997 they have greatly expanded their operations in sheer volume but

also in area of activity. To a company that deals in more than one area of

financial markets there is a multiplication factor in the weight that

regulation effects on its operations. Therefore, the privatization program of

the previous years helped bring about the regulatory change in the form of

the creation of the Financial Services Authority, or the FSA, and the new

Financial Services Act 200019. A similar view was expressed by Gordon

Brown. In recent years there has been a blurring of the distinctions

between different kinds of financial services business: banks, building

societies, investment firms, insurance companies and others. This has

added further to the complexity of regulation[]We are therefore

establishing a single, statutory regulator for the UK financial services

industry with clearly defined regulatory objectives and a single set of

coherent functions and powers20. It is clear that what at first seemed a

deregulatory step influenced by liberal ideas of self governance has

effectively proven to give the opposite effect21.

Privatization of some of the UKs largest industries including the previously

mentioned British Telecom and a number of others was performed in a

18 I. Kerr, Big, p.79- and onwards, points out the booming response of the financialmarkets to the new form of regulation. S. Gleeson Financial, Chapter 1,1-03-06, pointsout another factor as to why the level of regulation became so cumbersome i.e. The battlebetween the self-regulatory organizations and the Securities and Investment Board as tothe level of compliance of the regulators with the SIBs own rulebook.19 The FSA was created from the framework of the old SIB, through a decision by theChancellor of the Exchequer issued on May 20th 1997. It was gradually granted moreregulatory powers, consolidating its full modern regulatory powers in 2004. Source:www.fsa.gov.uk/Pages/About/Who/History/index.shtml

20 HM Treasury, Financial, p.821 C. Briault, The Rationale for a Single National Financial Services Regulator, FinancialServices Authority Occasional Paper Series, nr. 2, May 1999, p. 6 - 17


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liberal way. But that approach has fallen under criticism on factual grounds.

Those being that its performance failed to strike a balance between the

government withdrawing from certain areas of public life and harmful

deregulation. Harmful in my opinion meaning that by liberalization thegovernment failed to regulate certain aspects of the process of privatization

simultaneously allowing undeserved profits to be made through capital

markets at the cost of the government itself and effectively the general

taxpayer, thus creating additional costs of the privatization process in the

form oflucrum cessans.

2.3 British Telecom; a Case Study

It is my opinion that the privatization of the communications giant BT can be

a showcase example of these shortcomings. Here, shares were launched to

the market in November 1984 at 130p According to J. Vickers and G. Yarrow

as soon as the trading began the price of shares rose by 50p representing a

magnificent rise in share worth in comparison to the 9.35 projected rise of

value projected in the prospectus, and continued raising at a steady rate for

a period of time22. These same authors point out to the failure of the

privatization to achieve two issues. Those two being that the process failed

to bring the government the whole of the benefits that could be generated

by the sale of shares and second that even though the cost of the

privatization was carried by the whole of the tax - paying population, the full

extent of the benefits it brought were enjoyed by few of those who

capitalized on the fast increase in share worth. To dwell more on the case,

the social costs of the privatization have been underestimated as BT, now

being in private hands maintained its highly privileged market position of

dominating company on the telecommunications market23. This creates

competition law issues and potentially causes massive social costs to the

general population, allowing the benefits to be reaped by a minority of BT

22 J. Vickers, G. Yarrow, Telecommunications, p. 22523 Even though the 1984 Telecommunications Act abolished legal privileges to BT and

prescripted that BT like other companies wishing to operate the telecommunicationsmarket had to apply for a license, BTs actual privilege over any other company wishing tooperate the market remained. See, J. Vickers, G. Yarrow Telecommunicatins, p. 239


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shareholders. Even more so as interconnectivity between BT and Mercury

networks, was an issue in the later years24.

To summarize the case of BT it is clear that the governments policy in

privatizing BT materialized as a mixture of both economic and purely

political actions. Throughout the process, the Government acted rationally

in introducing greater competition to the financial markets through

enhancing the liquidity of the stock exchange and deregulating the financial

markets. It must be noted however that on a different level the government

failed in introducing not only formally adequate but also functionally

successful regulation to the telecommunications market allowing a privately

owned monopoly to emerge. This in turn created a distortion on the

financial market as the monopolist position allowed investors to reap

unnatural benefits from share price increase and profit dividend at the

expense of consumers. But this particular failure should not be attributed to

an insufficient level of regulation of the financial markets. Rather, it should

be stated that the move to introduce BTs shares to financial markets came

too early, as regulation aiming to introduce greater competition to the

telecommunications market proved ineffective.

Most importantly, it must be stated that however there were faults in the

process of privatization of the telecommunications giant, these cannot be

attributed to any features of financial markets regulation. As the flotation

attracted new investors and generally deepened the market, it also

demonstrated that the market will respond quickly and efficiently when

discounted instruments are identified, which is in my opinion due to the

existence of well established financial intermediaries. The faults in the

privatization process actually deepened the trust in the ability of the market

to regulate itself as demonstrated by the dynamic increase of price of the

initially under priced shares. It can be stated that in fact the casus of BT

made a strong case for the deregulation and liberalization of financial

markets, proving to a certain extent how investors can use given

opportunities to their advantage. This example shows how well an

24 J. Vickers, G. Yarrow Telecommunications., p. 239


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adequately developed, and open to competition capital market may

embrace a share flotation as large as that of BT. Second, through observing

what happened on the secondary market after the shares have been

released, that investors, given adequate information, will act rationally andefficiently in using any advantage given to their benefit. The success may

be attributed however mostly to how developed and the financial markets in

the UK were. The amount of time the market needed to capitalize on the

discounted share price in relation to the monopolistic position given through

shortcomings of telecommunications laws seems to point out that the

success may be largely attributed to the activity of experienced professional

investors working for financial intermediaries25.

3.0 Developing and Transition Economies

It is vital to recognize that the UK privatization program revolved around a

well established and developed financial system, with many experienced

and sophisticated actors. Ultimately states without such supportive

resources will find themselves in a different position to that described

above. The main issues are that first, such a country might not have a

financial market to start with26. Privatization in this case will have to be

accompanied with legislature setting up such markets, concurrent with

introducing all relevant regulation, as a lack of financial markets will deeply

limit the number of available options to perform privatization for a

government. If this scenario would occur, both enabling and desirable

legislative rules would have to be introduced to the system if a functional

market is to be created in the absence of a prior regime. The disadvantage

of this is that such procedures on the side of the government would

effectively mean that privatization would have to be postponed as lengthy

periods of time are required in order for the legislature to be introduced and

effective27. A further problem is that if a countrys secondary financial

market is too small or disorganized (as in the case of newly established

markets), the investors are faced with the possibility of not being able to

capitalize on their investment in the presence of a general thinness of

25 W. Megginson Privatization, p. 1526 P. Guislan The Privatization, p. 6927 P. Guislan The Privatization, p. 69


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liquidity and a literal absence of sufficient numbers of investors willing to

trade on the secondary markets28.

3.1 International Aspects of Privatization

Why is it then that some countries still choose to privatize on a massive

scale? The answer might lie outside the scope of purely internal political and

economic considerations. Countries such as Poland and Hungary faced

monetary distress in the early stages of their privatization programs in the

1990s. Zambia had a similar situation in the 1980s. The difficulties came

from powerful deficiencies not only in their financial markets but also from

the human resources available. S. Soltysinski points out the fact that

privatization programs were carried out by a mixture of inexperienced

intellectuals and members of the old nomenclature29, also pointing to the

issue of adequate human resources necessary in order to design

privatization and financial markets.

It was natural that such developing or transition economies sought financial

support from international financial institutions, or IFIs, meaning the World

Bank and the International Monetary Fund. Article I of the Articles of

Agreement of the IMF states that one of its purposes is To give confidence

to members by making the general resources of the Fund temporarily

available to them under adequate safeguards, thus providing them with

opportunity to correct maladjustments in their balance of payments30.

Therefore, a certain degree of conditionality is expected upon entering a

credit agreement with the IMF. Those stipulations on behalf of the debtor

vary from country to country in general as each credit contract is entered

upon individually by the parties. I have however found convincing evidence

28A good example of the difficulties such an underdeveloped financial market causes is theintroduction of Bank Slaski to the public market in 1994 during the Polish privatizationprogram. Where the privatization process suffered in this case due to theunderdevelopment of the secondary financial market, where not enough resources wereavailable to actually register the issued shares of the bank, not enough brokers wereemployed by brokerage houses. The shares price would soar thirteen fold on one day andfall greatly the next. See, Financial Times, 7th February 1994, also cited in P. Guislan ThePrivatization, p. 6929 S. Soltysinski, Privatization in Poland: The Legal Framework, Practice and Political

Controversies, FORUM Internationale, no. 15, November 1990, p. 1230 Art. 1 of Articles of Agreement of the International Monetary Fund, available at:http://www.imf.org/external/pubs/ft/aa/aa01.htm


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such correlation in relation to funds achieved from the World Bank34.

Reasearch shows the privatization condition was common in both World

Bank and IMF loan contracts35. It cant be said however, that IFIs promote

privatization out of malice. Insufficient evidence was available at the time toclearly state what is necessary for the process to be successful, indeed after

initially experiencing some trouble most economies have emerged from

privatization stronger. Furthermore, with time revenues from privatization in

transition economies have risen to high levels. It is also true that states that

chose to privatize in a more gradual process, allowing organic growth for

their financial markets to occur, simultaneously introducing preemptive

regulation were more successful than others.

4.0 Financial Markets and Privatization

The disadvantage of possessing underdeveloped financial markets may

hinder the process of privatization in a developing economy. This is because

a lack of adequately developed markets may ultimately mean that the sold

companies dont generate adequate revenue in regards to their net worth.

Adequately developed primary and secondary financial markets will mean

that investors will have better access, not only to the companies sold in

privatization programs but to the market as a whole adding to its liquidity. A

number of actions may be taken to promote investment, ultimately leading

to development of financial markets36. Italy undertook a program of

deepening its financial markets prior to entering upon a privatization

program. The main points of this legal reform entailed authorizing private

pension funds, creation mutual funds was enabled37and banks some

deregulation occurred in the sectors of banking activity38. The above points

34 N. Brune, G. Garett, B. Kogut, The International, p. 235 J. Davis, R. Ossowski, T. Richardson, S. Barnett, Fiscal and Macroeconomic Impact ofPrivatization, 2000, available at:http://www.imf.org/external/pubs/nft/op/194/index.htm#overview36 For example, the Czech and Romanian privatization programs that initially includedvoucher distribution.37 Italian Law no. 344 of August 14 1993

38 Banks were allowed to increase their potential share in non financial companies up to atotal of 15%, through reform of the 1936 Italian Banking Act. See, P. Guislan ThePrivatization, p.70


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are an example of minimum levels of regulation of financial markets and

issues directly related that may be established for a privatization program

to give optimum effect.

Some scholars argue that in the case of some developing countries, where

regulation is weak and capital markets are thin, privatization through capital

markets should not be undertaken. Instead they suggest using joint

ventures and sales through direct placement instead of issuing shares into

public markets. This concept is well founded if we take account of the

volatility of financial markets in some developing countries where lack of

prudential regulation allows the exploitation of small investors. The idea of a

public offering of shares may also be shunned in the case of poorly

performing SOEs that require immediate restructuring. Public flotation of

shares in such cases will produce a large number of weak shareholders, at

the mercy of management, effectively incapable of efficiently restructuring

a company. Such a situation could undermine a whole privatization program

as the newly privatized companies would face issues relating to poor

corporate governance and shareholder supervision39. As the case of BT

demonstrates, privatizations through the means of financial markets tend to

be more successful if the privatized company is healthy, with strong

corporate governance and a general competitive advantage. Authors also

point out that privatizations carried out through means other than public

share offerings, tend to be less transparent and hence breed corruption.

Privatization programs where SOEs were sold through private placement

programs also tend to be regarded as supporting the emergence of

oligopolies40. Therefore it is my opinion that gradual introduction of

regulation with simultaneous privatization through share issuing is

optimum.

39 See, K. Khan, Privatisation and its Legal Aspects in Developing Countries With Special

Reference to Pakistan, 1998, p. 1240 A.Tarasova, Russian Privatization and Corporate Governance: What Went Wrong?,Stanford Law Review 52, 2000, p. 1731 - 1808


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4.1 Basic Financial Markets Infrastructure

P. Guislan suggests that, the success of a privatization program in a

developing country may be enhanced by introducing adequate regulation in

a number of sectors related to the financial sector prior to privatization. Ichoose to agree with him, as many aspects of developing countries legal

systems and economies fall short of providing adequate regulation and

functional infrastructure for large privatization programs to be successful.

Below I describe regulatory issues and institutions that have been proven to

contribute to a beneficial relationship between privatization and financial

markets regulation.

4.1.1 Financial Intermediary Activity

P. Guislan points out adequate banking regulation as a tool that would

encourage financial institutions to increase their efficiency41. This will

normally include stronger banking supervision and introducing

internationally accepted standards to the banking sector regulation.

Furthermore, banks themselves may be privatized, to increase their

efficiency and market activity and decrease their reliance on the state42.

Legislation introducing private pension funds can make a substantial

difference to both the development of financial markets and the overall

success of privatization. Pension funds operate large amounts of capital and

hold sufficient expertise to be valuable institutional investors. Their

privatization would increase the efficiency, stability and liquidity of financial

markets. L. Zingales demonstrates what an important systemic role they

may play on the example of their increased involvement in the US economy.

According to the author the capital held by private pension funds

represented 10% of US GDP in 1930, to 70% today43.

Thirdly, P. Guislan, suggests that legislation enabling the creation of

privatization funds either in a top-down or a bottom up model can

41 P. Guislan The Privatization, p. 71-7242 For example, see Section 18.1, Law no. 69 on financial institutions, November 1991, of

the Republic of Hungary.43 L. Zingales, The Future of Securities Regulation, Centre for Economic Policy Research,no. 7110, 2008, p. 2 and figure 7, p. 48, available at: www.cepr.org/pubs/dps/DP7110.asp


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positively influence both the concerned matters. Privatization programs may

be positively affected due to the creation of risk dispersing intermediaries in

the capital markets, they promote wide dissemination of shares among the

population increasing the number of public shareholders

44

. As to thefinancial markets they encourage development of the financial markets

through encouraging the secondary market. Thirdly they also improve the

corporate governance of privatized companies, through greater

concentration of shareholder powers than in the case when shares have

been simply distributed to a large number of public investors. I find that

their role on the financial markets may be interesting from the point of view

of stabilizing the market, especially in developing countries45. These

financial institutions bring expertise to the market creating jobs for brokers,

dealers, traders. Financial intermediaries such as banks and/or privatization

funds should be in place to protect the market from volatility, decrease

shareholder dispersion, and improve corporate governance of privatized

companies by executing concentrated shareholder rights. Holding big

shares in companies they exercise shareholder rights and place

management under supervision46.

From a corporate governance perspective it is important to note that

financial intermediaries I mentioned provide for some protection of

individual small investors. If the interests of this group are satisfied then

simultaneously market volatility ought to be curbed as individual investors

will be discouraged to from voting with their feet. This is especially

important if a country has weak, or fresh, shareholder rights laws. Above

institutions also provide a valuable service to the market by training highly

skilled professionals who are a framework for all market activity47.

44 P. Guislan, The Privatization, p. 185-186. Also See J. Coffeee in Privatization andCorporate Governance: the Lessons from Securities Market Failure, Journal of CorporateLaw, 25, 1 99-2000, p. 10 - 11 agrees with this also suggesting that the top down model,accepted by Poland proves to be more effective, than bottom up that was introduced inthe Czech Republic.45 As in the casus of the privatization of Bank Slaski in Poland, where shares were issued to800,000 investors. Share prices were extremely volatile in the post privatization period withspreads in value reaching 1300% on a day to day basis. See, Financial Times 14 February1994 , also cited in P. Guislan The Privatization, p. 69

46 P. Guislan The Privatization,p.177 190.47 See Capital Markets Regulation Committee Interim Report, November 30th 2006, p. 21where authors state that the first condition for the successful competitive operation of


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When privatization takes the shape of flotation to public markets, the states

finds itself in the position of the only overarching entity able to regulate the

(sometimes) newly born and expanding financial markets. This constitutes

a new responsibility to the privatizing government. Whereas prior to theshift in ownership structures, the government had a direct stake in the

governance of the companies it controlled. In a post privatization world, a

governments involvement becomes less direct. Market efficiency and

stability in the financial sector cannot be achieved through sheer

contractualism, evidence of this seems to come from the fact that capital

markets are not spot markets that effectively have the possibility of

regulating themselves due to the comprehensive levels of information

possessed by all the parties. A benchmark of regulation must be available to

address these inequalities of information48.

4.1.2 Regulatory minimum

Since a government can no longer have direct say on the corporate

governance of companies operating within its jurisdiction, it must exercise

its goals through other means. This involves regulating financial markets,

thus influencing the behavior of privatized companies, and setting up

corporate governance rules that are more direct and direct the institutional

structures and internal procedures of companies.

The necessity of state involvement in both of the means of influencing the

economy is well illustrated by the failure of the Czech privatization program

which was undertaken through voucher distribution with the expected result

that a secondary capital market will spontaneously emerge in unregulated

conditions49. Some privatized companies were allowed to enter the stock

exchange without issuing a prospectus and without any supervision from a

regulatory body50. In fact the prediction that large public participation will

boost the secondary market proved to be untrue with poor regulation of

financial markets is the availability of trained personnel, with the second condition being afriendly regulatory environment.48 J. Coffee, Privatization, p. 549 J. Nellis, Time to Rethink Privatization in Transitional Economies?, Finance &

Development ,June 1999, p. 16 19. Available at:http://www.imf.org/external/pubs/ft/fandd/1999/06/nellis.htm50 P. Guislan, The Privatization, p. 69, see footnote 40.
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intermediaries and general clogging of the secondary market, leading to

short term losses per one voucher amounting to 90%51. Within less than ten

years of the launch of the Czech privatization program, the economy

entered recession, the revenue generated by financial markets has shrunkand the main share index fell by 60% in one year52 .

J. Coffee attributes this failure to inadequate regulation of financial markets

following a large privatization program. The mentioned author that slower

privatization, introduction of more stringent regulation, and the creation of

privatization funds to prohibit shareholder dispersion could have allowed the

Czech financial markets to expand more naturally, thereby preventing

corporate governance failure on a market wide scale. Alternatively, it can

be argued, that the step of creating privatization funds could have been

foregone, if the Czech legal system would allow greater foreign institutional

investors involvement, as this would functionally allow big investors to

effectively restructure defunct companies. Instead it seems the financial

markets during the privatization program of the early 1990s were

unregulated, but would allow only domestic investors. This case can be

made with the example of Brazil where, hermetic foreign investment laws

blocked access to the financial markets causing initial privatization steps to

be unsuccessful53. In my opinion, whether a country chooses to create

privatization funds or chooses to simply attract foreign investors in order to

prevent shareholder dispersion is more than a policy issue. Both the

mentioned options may be effective in achieving the goal of better

corporate governance in privatized companies54. However as most

developing states inherit the legal systems of previous regimes, opening the

market for foreign investment and effectively attracting capital may prove

51 R. Frydman, A. Rapaczynski, J. Earle et al. The Privatization Process in CentralEurope,1993, p. 87; The authors point out that after initial failings of intermediaries todeliver on their promises new regulation had to be introduced in the form of Act. No.248/1992 on investment Corporations and Investment Funds, of the Republic of Hungary.52 P. Green, Prague Exchanges Failed Reform Efforts Leaves Some Predicting Its Demise,International Herald Tribune, March 17, 199953 See, art. 172 Brazilian Constitution.54 For example in Poland, J. Rajski in Privatization in Poland, in Privatization in Centraland Eastern Europe, ed. by P. Sarcevic, 1992, p. 36, clearly states that in the case of

Poland the effective shape of the Privatization of State Owned Enterprises Act 13th July1990 and its institutions was a battlefield between the clashing opinions of pro socialistand liberal politicians.


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to command large legislative efforts on the side of the government. Legal

systems may be incomprehensible and self - contradictory as in the case of

post Soviet Russia55 or Colombia56, or may straightforwardly bar access to

foreign investors

57

.

Most importantly, the existence of an entry regime for issuers proves to be

important. This regime is based on the idea of ex post disclosure of relevant

financial information prior to the issuing of securities, first to a regulator

then to the general public. Such a regime was first introduced through the

US 1934 Securities Act and proves a good example of stimulating the

market through regulation58.

5.0 Conclusion

It seems to be ironic then, that the developing countries that choose to

privatize are usually those who are trying to make a break from their

previous system. In relation to this issue S. Soltysinski remarks the words of

his colleague J. Przeworski stating that () it is that revolutions are shaped

by the very systems they came to overthrow59. Indeed it is the case that in

many cases the nations that privatize are doomed to either use the prior

legal systems remains60 or pass completely new laws61. Whereas it is clear

that law in books law may be passed and enacted in a matter of months,

it is the law in action that is ultimately responsible for the performance of

financial markets. If the existence of developed financial markets was to be

treated as a sine qua non condition for privatization launch, some programs

might have never taken off. I have demonstrated some factors that have, on

their own, or in a blend pushed some countries governments to discard

55 See, W. Frenkel, Summary of Russian Securities Regulation: The Law And The Practice,Journal of International Banking Law, 1994, p. 1 - 1056 See, D. Schneidermann, Constitutional Approaches to Privatization: An Inquiry Into TheMagnitude Of Neo Liberal Constitutionalism in Law and Contemporary Problems, vol. 63:No.4, 2000, p.9157As Art. 22 of Bulgarias Constitution, banned foreign ownership of land; Art. 5 of theConstitution of Brazil which deters foreign investment by not applying protection ofownership towards them.58 L. James, The Securities Act Of 1933, Michigan Law Review, vol. 32, p. 624-66259 S. Soltysinski Privatization, p. 1460 As in the case of Poland, where the pre - war Companies Act of 1934 was used to

determine shareholder rights.61 As in the case of Hungary where a completely new company law order was created in1988 with the passing of the 1988 Act No. VI on Economic Companies.


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Chancellor Adenauers idea of keine Eksperimenten62, and going ahead

with privatization reforms, simultaneously introducing regulation to the

financial markets. The UK could afford to embrace privatization while

simultaneously relaxing regulation of markets, allowing them to develop.States that embraced a similar approach without introducing adequate

supervision and regulation to the markets have regretted their decision. As

a policy determined at prompting market growth is accepted, secondary

steps must be undertaken by governments to facilitate those changes. I

demonstrated on examples that where no regulatory steps have been

undertaken by governments to increase investor protection, disclosure

standards, and corporate governance of privatized companies, market

participants will not manage to successfully regulate themselves63. Even in

the UKs example an institutional framework was provided by the

government. This lack of regulation in relation with other circumstances

has given suboptimal results. Other states that perhaps sustained initially

more criticism and initially drew less interest due to accepting a different

more wholesome development strategy privatization has proven to be a

success, especially in the final years, when highest yields were gathered. It

is however the countries that have chosen not to privatize their substantial

interests in the economy that proved to be the losers of this global trend.

More research is becoming available allowing the difference between brave

and foolhardy to be observed. With the latter being those who fail to note

that the relationship between privatization and developing regulation of

financial markets is very tight. If privatization shapes financial markets by

broadening them and making capital more available, then financial markets

reciprocate. If adequately regulated and institutionally functional, they

facilitate privatization allowing greater benefits to be reaped. If unsupported

by a sufficient legal framework and underdeveloped, they effectively slow

privatization down and cause inferior revenues to be generated.

62 This refers to a famous quote by Chancellor Adenauer regarding the economic reforms

that he was taking upon West Germany. In relation to his policy of introducing economicreforms he coined the famous mantra of no experiments with the economy.63 Thats in relation to developing countries.


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6.0 Bibliography and Statutes

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Companies Act of 1934 , of the Republic of Poland

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G. Chiesa, G. Nicodano Privatization and Financial Market Development:Theoretical Issues available at: http://ssrn.com.abstract=383460

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& Regulation, 1989

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M. E. Beesley & S.C. Littlechild, Privatization. Principles, Problems and

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from Governments to Private Individuals or Entities in Development Law

and International Finance, 2nd Edition, 2002

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Maxwell, 1999

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Documents

Relationship Between Privatization and Financial Markets Regulation