Market Failure - Case Study Example

I. II. Thesis: The reasons for market failure due to failure in banking system and steps taken to overcome it. III. Market Failure A. Supervision B.Financial System C. Export Information Collection and Use in Decision-Making Khalifa Al-Qubaisi Dr.Martin H.Saboo Micro Economics 1-5-2009 Market Failure The stock markets are not for the chicken hearted. They can take an individual or an economy on a roller coaster ride from huge profits to deep losses. The year 2008 was marked by volatility in the world stock market due to subprime mortgage crisis. From January to October, 2008, the U.S markets had to face a huge downturn , with a loss of 770 points in a single day. This loss translated into approximately $1.2 trillion value on the Dow Jones. These market fluctuations in the US exerted a profound influence on world markets. There were times when no satisfactory explanation could be found for the fluctuation in prices. Once the US market tumbled the markets around the world followed suit. Some Asian markets even lost 40% (China)while others lost almost 60% (India) in a matter of months. Most analysts hold the subprime lending crisis as the root cause for the current economic slowdown. In their enthusiasm to outdo other banks and get the maximum number of customers, banks were ready to lend any amount to anyone, without even verifying their credit worthiness properly. As a result, many banks had to close shop, including big names like Citibank and Merryl Lynch. Thousands of people the world over lost jobs, companies had to be bailed out and even turn to government support for their functioning and existence. The latest victim is the automobile giant, General Motors. After being the iconic company that it was, it had to declare bankruptcy and carry out a sale to the U.S government. The U.S and other governments have doled out various impromptu financial packages to help their countries struggle through this economic crisis created by the financial institutions lacking foresight. The subprime lending crisis does not seem to be an isolated one in the financial world. Persistent industrial loan defaults and massive loan losses have become a regular feature in developing countries. According to Hoque (2004) and the World Bank (1993), 150 development banks in 33 developing countries have been haunted by massive debt default and loan loss. The present subprime mortgage crisis that hit the credit markets and banking systems is due to the massive increase in loan defaulters, thus forcing the banks to go bankrupt. Industrial Development Finance Institutions (IDFIs) form the backbone of the economy in both developing and developed countries. These institutions are expected to stimulate industrial investment in both private and public sectors in the country. They play the key role of injecting capital into the system. However, a job bigger than that is to blend capital with entrepreneurial skills to support industrial advancement in an underdeveloped economy. This is precisely what IDFIs are doing in a majority of the countries. A great number of IDFIs have been established in the developed and developing countries since 1945, many following independence in the late 1950s and 1960s of former British and French colonies, to provide both medium- and long term loans to industrial and agricultural projects. In South Africa, it is IDC or Industrial Development Bank, while in Nigeria, it is the Bank Of Industry and in India, it is called IDFC (Industrial Development and Finance Corporation). There is hardly any developing country where there is not at least one development bank. Irrespective of their size or functional roles, a large number of development banks in Asia, Africa and Latin America are now plagued by persistent bad debts. However, in developing countries like India and China a few IDFIs have not been adversely affected by persistent debt defaults. It is logical to assume that debt default occurs due to the borrower’s inability or unwillingness to repay debt. The fact could be that there are borrowers who are willing, but not in a position to repay debt. Again, there are borrowers who are able, but not willing to repay debt — debt default arises in both cases. However, this chapter deliberates on the borrowers’ inability to repay industrial debt, rather than willingness to repay industrial debt. The ability or rather inability to repay industrial debt is influenced by a number of factors relating to industrial financing. In particular, the following factors influence the type of industrial projects financed and the loan repayment capacity: Selection of project to be financed i.e type of project How it is financed; Stages of involvement of IDFI from the set up stage to loan liquidation While all the above factors are very important in deciding the loan repayment, the development bank must, of necessity, restrict itself to financing only those development projects that are bankable. The choice of a project lies within the developmental role of a bank. As a development institution, a commercial institution or an IDFI should deal with those projects with the highest ranking on the development-impact scale and as a banking institution, it should finance those projects with the highest ranking on the interest-rate scale. It means that a bankable project should satisfy both developmental and financial criteria, unlike a commercial bank that stresses the financial role rather than the developmental role. It appears from the above that debt default may arise if the development bank finances non-bankable projects that are not capable of generating enough income within a reasonable time to cover the costs of operation, repay the principal debt, meet costs of borrowing and earn enough profit to motivate its promoters to remain in operations. The role of a development bank, particularly a public industrial development bank, is not solely confined to the supply of medium- and long-term loans and/or equity. Unlike other financial institutions such as trading or commercial banks, development banks are expected to direct and guide the use of loans, to nurse an enterprise, and to play a developmental or promotional role in addition to their financial role. The developmental or promotional role of an industrial development bank implies that the bank has to get itself involved in the formulation, initiation and organization of industrial development; acting not just as a bank, but as an entrepreneur who, perceiving or seeking out profitable investment opportunities, actually takes the initiative and leadership to conceive, formulate proposals and organize finance for the enterprise and actually executes them. To put it simply, it involves the entrepreneurial activity of taking the initiative of shaping up a business and getting it started. Development banks are also expected to provide guidance to budding or new generation entrepreneurs in selecting viable projects consistent with country’s industrial development objectives. Thus, it would be prudent for a development bank to examine the ability and integrity of the top management of the enterprise while selecting industrial projects. Supervision Supervision of an enterprise, both at the initial developmental stage and at the operational stage, constitutes part of the developmental role. The commercial or economic environment within which an enterprise operates changes from time to time and inexperienced management of the enterprise may not be able to withstand such changes. This may affect the profitability of the operations of the enterprise. Enterprise supervision places a development bank in a position by which it can foresee imminent or emerging problems of an enterprise. In changing circumstances, it can provide timely and appropriate suggestions to the entrepreneurs so they can overcome them successfully. Financial System Changes in the international capital markets and deregulation of 1980s in US opened new possibilities for raising capital, investing and hedging risk. The U.S has a highly developed financial sector. Historically, US was viewed as a commodity-based economy but has subsequently become a services-based economy in the past decade. The Banks, investment bankers, insurance industry, capital markets, foreign exchange market, equities market, debt securities market and the derivatives market constitute the U.S financial markets. U.S is a key center in the world economy for any sort of activity in the capital market. U.S markets have high exposure to foreign exchange, equities, debt and derivatives markets. US markets have benefited from the timely deregulation and high quality of institutional and operational infrastructure, supported by a highly skilled workforce. Export Information Collection and Use in Decision-Making Intelligence generation or knowledge capital is the first component of market orientation, and the knowledge gained from these activities is seen as being inextricably linked to the adoption of the marketing concept. Whatever is done, whatever decision is made: small or big, should have a market-oriented approach, especially if the industry is export oriented. Also, a commercial approach from the management’s side is likely to improve performance. Recent research and analysis has extended and adapted the market orientation construct into an exporting context. It follows, therefore, that the collection and use of export market intelligence is likely to be an important element in successful export performance. At the same time, the limited capacity of SMEs to acquire and use market information is seen as a key factor in explaining the poor performance of a number of these companies. The fieldwork comprised a qualitative followed by a quantitative study. The aim of the qualitative investigation was to explore the nature and effect of managerial background on export market information collection and use. Groups of export behaviors relating to marketing intelligence were initially derived from previous literature in the area. BIBLIOGRAPHY English J.W, Udell G.G. A preliminary innovation evaluation system for economic development systems. Journal of New Business Ideas and Trends, University of Ballarat, 2004, 2, 11–20. Udell G.G. Exploring the Rewards and Risks of Invention and Innovation. WIN Innovation Center, Southwest Missouri State University, Missouri. 2002. Knotts T.I., Jones S.C., Udell, G.G. Small business failure: the role of management practices and product characteristics. Journal of Business and Entrepreneurship, New Mexico State University, 2003, 15, 8–16. Kitchen, R.L. Finance for Developing Economies, John Wiley and Sons, New York. 1986. Kane J A. Development Banking, Lexiton, London. 1975. Hoque M Z. Flawed working capital loan policy and loan default : Evidences from Bangladesh, Journal of Accounting, Business and Management, Vol.11, No. 2, 2004, pp.202-213. Berger, B. The Culture of Entrepreneurship, Transnational Publishers, New York. 1991. World Bank, The. World Development Report, Oxford University Press, New York. 1993. Read More