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Financial Sector Legal and Regulatory Toolkit : Part Two: Preconditions and Infrastructure for Financial Sector Development : I. Preconditions for Financial Sector Development
A. Foundations of Financial Development and Economic GrowthAlthough no overall international consensus has evolved in respect of these preconditions, it is generally agreed that there must be a system of governance which provides for property rights and enforcement of contracts, as well as supports the development of human capital. Clearly defined property rights constitute a fundamental precondition to financial development and transition. A regime that supports binding and enforceable contracts is necessary in order for financial activity to develop beyond close networks and instantaneous transactions. Investment is predicated on binding and enforceable contracts, without which parties cannot effectively structure their transactions. The governance system should also support long-term development of human capital. In addition to a sound public law regulatory framework, private law must provide individual investors with a means for participating in financial transactions and for enforcing their rights with respect to their investments. This is discussed further in Part Three. The basic functions of the legal/judicial framework in supporting the financial system are
All of these have the effect of reducing transaction costs and market failures.
Issues of governance and appropriate political structure have been of central concern probably since the development of the first settled, agricultural civilizations. While politics and economics became quite separate disciplines across the 20th century, by the end of the 20th century, the interactions between governance and economics were once again being addressed, at least partially as a result of the lessons learned while transitioning from centrally planned to market economies, as well as from failures of development models focusing largely on economic policy. In the 20th century there was a battle of ideas between two different models of the role of the government in the economy, with the capitalist models focusing on the fundamental role of markets with limited government involvement and the communist models focusing on central planning combined with state-ownership and control. (Yergin & Stanislaw, 1998) By the beginning of the 1990s, there emerged a general consensus on the superiority of a model where the market economy operates within an appropriate regulatory system, which addresses the interests of the society as a whole through the provision of public goods. Nonetheless, there are many differences between the various economic and governance models around the world. The question naturally arises as to what are the best choices among the options available. Regardless of its ideological basis and consequent form, however, the governance system needs to provide for two fundamental features in order to support a market economy. First, the governance system needs to provide for clear and useable property rights. Second, the governance system needs to provide for a system to enforce contracts. Both are necessary in the context of imperfect markets where transaction costs exist. In the classic analysis, property is described as a "bundle of rights": the rights to hold, use, transfer, and destroy. Questions of degree and time relate to all the various rights. In addition, property can be real or personal, tangible or intangible. The more complex the system of property rights, the more effectively they can be used in the context of finance. In The Mystery of Capital, Hernando de Soto argues that capital is the engine of a market economy and that property rights provide the mechanism. Poor countries cannot produce the capital necessary for economic development because of failings in their property systems. He postulates five essential "mysteries" of capital: First, poor societies do have massive amounts of capital; unfortunately, it is "dead" capital, (i.e., property that cannot be used as capital). Second, capital itself is difficult to define. Third, governments around the world have missed the importance of the first two which is now changing and needs to change faster. Fourth, the process which is taking place in emerging, transition, and developing economies around the world has in fact taken place in the developed countries, but has been poorly understood and documented. Fifth, laws have to reflect existing circumstances in order to function effectively to transform assets into capital. De Soto argues that formal property systems should produce six effects in order to allow their citizens to generate capital: Property rights and their identification and protection are therefore essential to a market economy. Unfortunately, as de Soto suggests, property rights have evolved over a long period of time in the developed economies and, therefore, it is difficult to discern how they are established and function. As a result, it is difficult to transport these experiences and system to other economies. To do these, de Soto suggests a capitalization process which is divided into two main strategies: (i) discovery strategies; and (ii) political and legal strategies.
In an environment of imperfect markets where transaction costs exist, parties will seek to reach efficient results through contracting. Unfortunately, transaction costs extend to costs of enforcement and if enforcement is not possible, then contracts cannot produce solutions to imperfections nor lead to longer-term outcomes. Rather, transactions will be limited to instantaneous transactions. This is why enforcement of contracts is important and as such a governance system which enforces contracts is required for a basic market economy and simple financial markets to develop beyond single instantaneous transactions. In addition to property rights and contract enforcement, a governance system also needs to support development of human capital. However, human capital development without property rights and enforcement of contracts is not sufficient for economic development. This issue, however, is beyond the scope of this toolkit. Office of the General Counsel
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