CFA Institute Journal Review summarizes "Finance and Development: Rethinking the Role of Financial Transparency," by Burak R. Uras, published in Journal of Banking & Finance, Vol. 111, No. 2 (February 2020).
Using both a theoretical framework and cross-country empirical evidence to support his findings, the author shows that in a financially underdeveloped economy, increasing transparency might have negative effects.
What Is the Investment Issue?
Developing-country asset markets lack both liquidity and information in the sense of disclosures. As a result, asset originators can hide information, resulting in adverse selection issues. Increasing financial transparency therefore seems a logical solution to increase market efficiency, and indeed, cross-country data show a positive relationship between transparency and macro development.
Accordingly, policymakers have pressed to increase information availability in developing countries. The World Bank Group’s Doing Business report indeed shows an increase in asset market transparency for developing countries over the 2005–17 period. However, past literature did not consider that originators might be unsure about the quality of their project at initiation and could therefore increase ex ante long-term investing. With limited spot market liquidity and uncertain investment returns, asset prices are not adjusted appropriately, which provides long-term investors a better return, resulting in a higher allocation of long-term investments.
How Did the Author Conduct This Research?
The author develops a general equilibrium model that includes consumption risk, investment uncertainty, adverse selection, and liquidity limitations. Furthermore, the assumption is made that imperfect insurance against consumption shocks exists in developing countries. Asset originators receive private news about future asset returns not at the start of the investment but at the interim date. Also, consumption shocks are conveyed as private news; consequently, the market cannot determine whether the asset originator wants to trade based on information or on liquidity needs. The author shows that, by itself, imperfect insurance against consumption always has a negative macro effect, though in combination with investment return uncertainty and private news, it might have a positive macro effect.
The author checks his model outcome with different sets of model specifications, such as asset type choice, and an improvement of liquidity of the spot market. Via an empirical analysis of cross-country data, he reveals a positive relationship between disclosure standards and GDP per capita and a negative one between disclosure standards and illiquidity with GDP per capita.
Previous studies have shown that a negative relationship between borrowing capacity and economic growth can exist and have assessed the impact of an oversized financial sector. This study adds the elements of information frictions, limited consumption insurance, and investment uncertainty. In addition, previous studies have examined the relationship between economic growth and accounting standards, the latter being a consequence of disclosure rules, and have demonstrated that transparency does not always imply economic growth. The author indicates that a negative relationship might exist between market liquidity and transparency. Finally, this article may provide insights into the social return of information on financial markets. In shallow markets, more information could reduce asset returns. This study differs in that it focuses on private information and decision making and on when asset swaps are sensible in opaque markets, even with risk-neutral decision makers.
What Are the Findings and Implications for Investors and Investment Professionals?
When asset transparency is lacking, the market cannot observe different levels of asset quality. Instead, asset originators receive private news about asset quality. As a result, originators invest more in the market because they are able to switch to other assets, depending on the information. Adding a social planner to the equation does not make a difference, given that the private agents’ choice and social choice coincide.
The author’s model thus shows that adverse selection can have a positive effect on economic welfare. This conclusion is supported by empirical analyses demonstrating that while a significant positive relationship can be seen between transparency and economic development, a negative and significant relationship can be seen between an illiquid stock market and disclosure. Variables such as property rights and education are also significant, whereas others, such as legal rights and market liquidity, are not.
The author’s findings are as relevant for policymakers as they are for investors. Policymakers should be aware that increasing security transparency will not necessarily result in economic progress, while investors should be aware that the lack of transparency in developing countries might not be a real issue from an asset return perspective.
Investors commonly believe that increased transparency benefits investors by reducing principal–agent problems. However, this principle works well only in liquid markets, where assets can easily be sold. In less liquid markets, asset sales are more cumbersome and returns might be negatively affected by bid–ask spreads or market timing. The author provides a new and interesting perspective on the need for transparency in developing countries, thereby shedding new light on mainstream thinking. The addition of empirical data strengthens the author’s case and shows that developing countries need more than just transparency to improve their prospects.