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Relationship between Privatization and Developments in Financial Markets Regulation

By Tomasz Szlzak

Contents
Relationship between Privatization and Developments in Financial Markets Regulation...............................................................................................................1 By.......................................................................................................................1 Tomasz Szlzak...................................................................................................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

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 than other 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 governments might privatization as a process, it fails however to observe the underlying concepts shaping privatizations and the incentives 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 with reference 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 in Privatization, Regulation and Deregulation,1997, p. 26 2 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 Development Law and International Finance, 2nd Edition, 2002, p. 185 is too broad for the purposes of this essay.

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, shaped by 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 4

R. Sarkar Development, p. 186 P. Guislan The Privatization Challenge, World Bank, 1998, p. 69 5 A. Santos, Privatization and State Intervention, in G. Majone Deregulation or Rereulation? Regulatory Reform in Europe and the United States, Printer Publishers 1990, p. 143.

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.79-93 7 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, British Journal of Sociology, vol. 43, no. 2 p. 201

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 great way 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 Also see, J. Stiglitz Whither Socialism?, abstract and W. Megginson Privatization, Foreign Policy, 2000, p.14 10 The privatisation of BT and the deregulatory movements by the government in relation to this 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. Thompson Privatisation & Regulation the UK Experience, 1986 11 W. Megginson Privatisation, p.22 12 G. Chiesa, G. Nicodano Privatization and Financial Market Development: Theoretical Issues, 2003, p.6-16 available at: http://ssrn.com.abstract=383460

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. The overarching 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. 87-101 15 I.Kerr,Big, p. 15 16 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 was taken upon the self regulatory organizations were somewhat fresh and havent yet come up with their famously long and complicated rulebooks.

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 anticipated18. More liquidity introduced to the financial markets 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 financial markets to the new form of regulation. S. Gleeson Financial, Chapter 1,1-03-06, points out another factor as to why the level of regulation became so cumbersome i.e. The battle between the self-regulatory organizations and the Securities and Investment Board as to the 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 the Chancellor of the Exchequer issued on May 20th 1997. It was gradually granted more regulatory 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.8 21 C. Briault, The Rationale for a Single National Financial Services Regulator, Financial Services Authority Occasional Paper Series, nr. 2, May 1999, p. 6 - 17

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 the government 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 of lucrum 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 23

J. Vickers, G. Yarrow, Telecommunications, p. 225 Even though the 1984 Telecommunications Act abolished legal privileges to BT and prescripted that BT like other companies wishing to operate the telecommunications market had to apply for a license, BTs actual privilege over any other company wishing to operate 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 and efficiently 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 26 27

W. Megginson Privatization, p. 15 P. Guislan The Privatization, p. 69 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
28

A good example of the difficulties such an underdeveloped financial market causes is the introduction of Bank Slaski to the public market in 1994 during the Polish privatization program. Where the privatization process suffered in this case due to the underdevelopment of the secondary financial market, where not enough resources were available to actually register the issued shares of the bank, not enough brokers were employed by brokerage houses. The shares price would soar thirteen fold on one day and fall greatly the next. See, Financial Times, 7th February 1994, also cited in P. Guislan The Privatization, p. 69 29 S. Soltysinski, Privatization in Poland: The Legal Framework, Practice and Political Controversies, FORUM Internationale, no. 15, November 1990, p. 12 30 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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in the work of N. Brune, G. Garret and B. Kogut that the IMF has used conditionality as a means of exerting pressure on countries to embrace privatization contracts. The authors point out that whereas the biggest net revenues were generated by privatizations, among others, in the UK and Japan, which were not indebted to the IMF at the time. Countries such as Bolivia, Hungary or Portugal have all privatized assets worth more than 30%of their GDP. The revenues generated by the privatizations of those countries are small in proportion to the numbers of transactions in those years. However they rise notably as time passes31. The role of the IFIs lending in transitional and developing economies may vary but is generally regarded as important. This is because they provide loans in foreign currency, fixing fiscal imbalances in a states budget and providing expertise and advice on policies that should be enacted. In the period between 1980 to 1999 the IMF and World Bank were very popular institutions among low income countries32. It has been argued that IFI, and particularly IMF policy condition programs work as catalytic devices that help signal good housekeeping, increasing attractiveness for investors33. In the period of the 1980s to 1990s there was substantial evidence that privatization in countries such as the UK has been a success in attracting liquidity to financial markets and attracting foreign investment. However, there was no such evidence in the case of developing countries. With only speculative research available, some IFIs, especially the IMF have urged states to privatize, calculating that as in the explained case of the UK, privatization would add to a governments credibility and act as a catalyst. As a result of this policy, it has been found that governments were urged to privatize, even if their financial markets were in poor condition. Empirical studies have found interesting data. It was found that where a state has borrowed money from the IMF, per every dollar that was borrowed, the state would on average privatize assets worth 50 cents. There has been no
31

See, N. Brune, G. Garrett, B. Kogut The International Monetary Fund and Global Spread of Privatization, UCLA Occasional Paper Series, 2003, available at: http://repositories .cdlib.org/international/ops/brunegarrettkogut 32 N. Brune et al The International , Table 2 33 D. Saravia, A. Mody, Catalyzing Capital Flows: Do IMF Programs Work as Commitment Devices?, 2003, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=688043

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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 to clearly 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 35

N. Brune, G. Garett, B. Kogut, The International, p. 2 J. Davis, R. Ossowski, T. Richardson, S. Barnett, Fiscal and Macroeconomic Impact of Privatization, 2000, available at: http://www.imf.org/external/pubs/nft/op/194/index.htm#overview 36 For example, the Czech and Romanian privatization programs that initially included voucher 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 a total of 15%, through reform of the 1936 Italian Banking Act. See, P. Guislan The Privatization, 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 optimum. with simultaneous privatization through share issuing is

39

See, K. Khan, Privatisation and its Legal Aspects in Developing Countries With Special Reference to Pakistan, 1998, p. 12 40 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. I choose 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 42

P. Guislan The Privatization, p. 71-72 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 shareholders44. As to the financial 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 and Corporate Governance: the Lessons from Securities Market Failure, Journal of Corporate Law, 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 in the Czech Republic. 45 As in the casus of the privatization of Bank Slaski in Poland, where shares were issued to 800,000 investors. Share prices were extremely volatile in the post privatization period with spreads in value reaching 1300% on a day to day basis. See, Financial Times 14 February 1994 , 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. 21 where 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 the shift 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 a friendly regulatory environment. 48 J. Coffee, Privatization, p. 5 49 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.htm 50 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 shrunk and 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 Central Europe,1993, p. 87; The authors point out that after initial failings of intermediaries to deliver 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, 1999 53 See, art. 172 Brazilian Constitution. 54 For example in Poland, J. Rajski in Privatization in Poland, in Privatization in Central and 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 July 1990 and its institutions was a battlefield between the clashing opinions of pro socialist and 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 investors57. 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 - 10 56 See, D. Schneidermann, Constitutional Approaches to Privatization: An Inquiry Into The Magnitude Of Neo Liberal Constitutionalism in Law and Contemporary Problems, vol. 63: No.4, 2000, p.91 57 As Art. 22 of Bulgarias Constitution, banned foreign ownership of land; Art. 5 of the Constitution of Brazil which deters foreign investment by not applying protection of ownership towards them. 58 L. James, The Securities Act Of 1933, Michigan Law Review, vol. 32, p. 624-662 59 S. Soltysinski Privatization, p. 14 60 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 in 1988 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 economic reforms 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

A. Santos, Privatization and State Intervention, in G. Majone Deregulation or Re-reulation? Regulatory Reform in Europe and the United States, Printer Publishers 1990 A.Tarasova, Russian Privatization and Corporate Governance: What Went Wrong?, Stanford Law Review 52, 2000 Act No. VI, 1988, On Economic Companies, Republic of Hungary Act. No. 248/1992 on investment Corporations and Investment Funds, of the Republic of Hungary Articles of Agreement of the International Monetary Fund, available at: http://www.imf.org/external/pubs/ft/aa/aa01.htm C. Briault, The Rationale for a Single National Financial Services Regulator, Financial Services Authority Occasional Paper Series, nr. 2, May 1999 C. Grey Suburban Subjects: Financial Services and the New Right, in D. Knights and T. Tinker Financial Institutions and Social Transformations, 1997 Capital Markets Regulation Committee Interim Report, November 30th 2006 available at: http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf Companies Act of 1934 , of the Republic of Poland Constitution of The Republic of Brazil Constitution of the Republic of Bulgaria D. Saravia, A. Mody, Catalyzing Capital Flows: Do IMF Programs Work as Commitment Devices?, 2003, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=688043 D. Schneidermann, Constitutional Approaches to Privatization: An Inquiry Into The Magnitude Of Neo Liberal Constitutionalism in Law and Contemporary Problems, vol. 63: No.4, 2000 Financial Services Authority, history of the UK regulatory order reforms, available at: www.fsa.gov.uk/Pages/About/Who/History/index.shtml

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G. Chiesa, G. Nicodano Privatization and Financial Market Development: Theoretical Issues available at: http://ssrn.com.abstract=383460 HM Treasury, Financial Services and Markets Bill: a Consultation Document. Part One. Overview of Financial Regulatory Reform, 1998a I. Kerr, Big Bang, 1986 J. Coffeee in Privatization and Corporate Governance: the Lessons from Securities Market Failure, Journal of Corporate Law, 25, 1 99-2000 J. Davis, R. Ossowski, T. Richardson, S. Barnett, Fiscal and Macroeconomic Impact of Privatization, 2000, available at: http://www.imf.org/external/pubs/nft/op/194/index.htm#overview J. Moore The Success of Privatisation, in J. Kay et al. Privatisation & Regulation 1989 J. Moore, Why Privatise?, in J. Kay, C. Mayer, D. Thompson, Privatisation & Regulation, 1989 J. Nellis, Time to Rethink Privatization in Transitional Economies?, Finance & Development ,June 1999, available at: http://www.imf.org/external/pubs/ft/fandd/1999/06/nellis.htm J. Rajski in Privatization in Poland, in Privatization in Central and Eastern Europe, ed. by P. Sarcevic, 1992 J. Stiglitz, Whither Socialism?, 1994 J. Vickers and G. Yarrow, Telecommunications: Liberalisation and the Privatisation of British Telecom in J. Kay, C. Mayer, D. Thompson Privatisation & Regulation the UK Experience K. Khan, Privatisation and its Legal Aspects in Developing Countries With Special Reference to Pakistan, 1998 L. James, The Securities Act Of 1933, Michigan Law Review, vol. 32 L. Zingales, The Future of Securities Regulation, Centre for Economic Policy Research, no. 7110, 2008 Law no. 344 of August 14 1993 Italian Republic Law no. 69 on financial institutions, November 1991, of the Republic of Hungary

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M. E. Beesley & S.C. Littlechild, Privatization. Principles, Problems and Priorities in Privatization, Regulation and Deregulation, 1997 N. Rose, P. Miller Political Power beyond the State: Problematics of Government, British Journal of Sociology, vol. 43, no. 2 P. Green, Prague Exchanges Failed Reform Efforts Leaves Some Predicting Its Demise, International Herald Tribune, March 17, 1999 P. Guislan The Privatization Challenge, World Bank, 1998 Privatization of State Owned Enterprises Act 13th July 1990, of the Republic of Poland R. Frydman, A. Rapaczynski, J. Earle et al. The Privatization Process in Central Europe,1993 R. Sarkar in The Transfer of Ownership or Control of Enterprises or Assets from Governments to Private Individuals or Entities in Development Law and International Finance, 2nd Edition, 2002 S. Gleeson, Financial Services Regulation: The New Regime, Sweet & Maxwell, 1999 S. Soltysinski, Privatization in Poland: The Legal Framework, Practice and Political Controversies, FORUM Internationale, no. 15, November 1990 See, N. Brune, G. Garrett, B. Kogut The International Monetary Fund and Global Spread of Privatization, UCLA Occasional Paper Series, 2003, available at: http://repositories .cdlib.org/international/ops/brunegarrettkogut See, W. Frenkel, Summary of Russian Securities Regulation: The Law And The Practice, Journal of International Banking Law, 1994 W. Megginson Privatization, Foreign Policy, 2000