The PNG University of Technology

Department of Business Studies

AC422 (Financial Risk Management)
Dr. Luis R. Alamil, CPA, FFA-Aus., Ph.DBA
Course Facilitator
===============================================================
Lecture/Reading Materials
on
(Chapter 5)
MARKET MECHANISMS AND EFFICIENCY

When you place money in the stock market, the goal is to generate a return on the capital
invested. Many investors try not only to make a profitable return, but also to
outperform, or beat, the market.1

Learning Outcomes
After studying this chapter, you shall be able to:
1. Define market efficiency.
2. Explain the efficient market theory and its implications to portfolio management and
market regulation.
3. Analyze the causes of market failure.
4. Analyze market liquidity and its importance in business and apply the measures towards
liquidity.
5. Explain financial development and role of financial intermediaries in risk management.

5.1 MARKET EFFICIENCY2

Market efficiency refers to a market where prices represent all relevant financial information
about an underlying asset or security. The more information that all market players will have, the
more efficient the market is. It, thus, provides an equal opportunity for buyers and sellers to
execute trades and make profits while minimizing transaction costs.
When you place money in the stock market, the goal is to generate a return on the capital
invested. Many investors try not only to make a profitable return, but also to outperform, or beat,
the market. However, market efficiency suggests at any given time, prices fully reflect all
available information about a particular stock and/or market3.
The above concept is connected with the market efficiency hypothesis (EMH), which is based
on asset price changes due to the availability of relevant information. Since all traders have
access to the same data, they cannot predict prices and outperform the market. Therefore, it
plays a significant role in running the asset trade cycle in highly competitive financial markets.

1 Mary Hall (2022). :Market Efficiency: Effects and Anomalies”. https://www.investopedia.com.

2 Market Efficiency – Explained, The Business Professor, https://www.thebusinessprofessor.com.
3 The Nobel Prize. "Eugene F. Fama: Biographical. https://www.novelprize.org.

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 The Effect of Efficiency: Non-Predictability4

The nature of information does not have to be limited to financial news and research alone.
Indeed, information about political, economic, and social events, combined with how investors
perceive such information, whether true or rumored, will be reflected in the stock price.
According to the EMH, as prices respond only to information available in the market, and
because all market participants are privy to the same information, no one will have the ability to
out-profit anyone else.
In efficient markets, prices become not predictable but random, so no investment pattern can
be discerned. A planned approach to investment, therefore, cannot be successful. This random
walk of prices, commonly spoken about in the EMH school of thought, results in the failure of
any investment strategy that aims to beat the market consistently. In fact, the EMH suggests
that given the transaction costs involved in portfolio management, it would be more profitable
for an investor to put his or her money into an index fund.

How Does a Market Become Efficient?5

For a market to become efficient, investors must perceive the market is inefficient and possible
to beat. Ironically, investment strategies intended to take advantage of inefficiencies are
actually the fuel that keeps a market efficient.
A market has to be large and liquid. Accessibility and cost information must be widely available
and released to investors at more or less the same time. Transaction costs have to be cheaper
than an investment strategy's expected profits. Investors must also have enough funds to take
advantage of inefficiency until, according to the EMH, it disappears again.

5.2 THE EFFICIENT MARKET THEORY (EMT)6

Efficient Market Theory or EMT (also known as Efficiency Market Hypothesis [EMH]) is a
concept in finance that asserts that financial markets are highly efficient and that prices of
assets fully reflect all available information. EMT has been a prominent topic of debate among
finance academics and practitioners since its inception. It has been a widely studied and
researched topic for decades, and its applications have had significant implications for
investment decision-making, portfolio management, and market regulation. According to the
EMH, no investor has an advantage in predicting a return on a stock price because no one has
access to information not already available to everyone else.
The concept of EMT has its roots in the works of Eugene Fama who introduced it in 1965. EMT
is grounded in the notion that market participants are rational and have access to all relevant
information. Therefore, in an efficient market, prices of securities are determined by market
forces, and any new information is immediately incorporated into prices. This implies that it is
impossible to outperform the market consistently, as prices already reflect all available
information.

4 Ibid (Mary Hall, 2022).

5 The Nobel Prize. "Eugene F. Fama: Biographical. https://www.novelprize.org
6 Ibid (The Nobel Prize).

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The same theory finds relevance in business and stock market situations. It is the most effective
technique for investors who spend a large sum of money on financial instruments that provide
risk-free profits. However, they cannot estimate asset price swings and out-profit others
because prices are random and no assets or securities are overpriced or undervalued.
EMT is commonly categorized into three forms. These are:
i. Weak Form: The weak form of EMT asserts that all past prices of securities are reflected in
current prices, and it is impossible to use past prices to predict future prices.
ii. Semi-strong Form: The semi-strong form of EMT suggests that current prices reflect all
publicly available information, including financial statements and other disclosures.
iii. Strong Form: The strong form of EMT suggests that current prices reflect all available
information, including public and private information. In this case, insider trading would not
be profitable, as prices already reflect all available information
Several authors have expanded further the content of the EMT forms, as follows:
 Weak: This form reveals all past information about asset or security pricing. However,
past pricing details reflected in current prices are insufficient to assist investors in
determining correct future trading prices. As a result, the weak form market efficiency will
only result in asset undervaluation or overvaluation, affecting trade decisions.
 Semi-Strong: It indicates that current prices consider all publicly available information
about an asset or security. It also offers previous price details. As a result, it discourages
investors from benefitting above the market by trading on the inside information.
 Strong: It is the result of combining weak and semi-strong forms. This form
shows market prices based on all accessible information (public, insider, and private).
This insider knowledge, however, is neutral and available to all traders. As a result,
despite having access to insider information, it ensures that all investors profit equally.
Let us consider the following market efficiency examples to understand EMT well:
Example #1: Assume that companies A and B are up for takeover. These companies’ stock
values are lenient and stable for a few days, with only minor fluctuations. However, as soon as it
was announced that a well-known corporation would be taking over both of them, their stock
prices jumped.
In this instance, the takeover announcement adds new information to the current data for the
companies’ stocks, resulting in a price change. As a result, the rise in stock prices indicates new
positive information to the companies.
Example #2: Mary, a trader, is looking forward to purchasing stocks at a reduced price on one
market and selling them at a higher price on another market. This type of trading, known as
arbitrage, is the process of profiting from a pricing discrepancy. Unfortunately, even though an
arbitrager can make a risk-free return in this situation, the market’s overall efficiency suffers. As
a result, markets prohibit arbitrage and impose restrictions on acts that impede market
efficiency.

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 Empirical Evidence supporting Efficient Market Theory7
Numerous empirical studies have been conducted to test the validity of EMT.
i. Stock Prices Follow Random Pattern: One of the earliest and most influential studies was
conducted by Fama himself. In his study, he found that stock prices in the United States
followed a random walk pattern and were not predictable.
ii. Market Prices Are Unpredictable: Other studies have found similar results, suggesting that
market prices are unpredictable and follow a random walk pattern.
iii. Actively Managed Funds Underperform: In addition, some studies have found that
actively managed funds, which seek to outperform the market, often underperform the
market after accounting for fees and transaction costs.
Investors can profit in an efficient market because they have access to all essential information.
Furthermore, they do not have to pay higher transaction cost for trading financial instruments.
As a result, it reduces arbitrage or above-market gains in a large, liquid, and highly competitive
market.
Financial news, research, social, political, and economic factors, rumors, etc., can influence the
current value of an asset or security. In market efficiency, the amount of information accessible
about security or asset is eventually reflected in its price. In reality, even if the market appears
inefficient, portfolio managers should consider it efficient since it keeps them active throughout
the process.
The Sarbanes-Oxley Act of 2002 promoted this trading component and improved the reliability
of the information. It gave investors more confidence in security pricing. The market became
more efficient as a result.
The salient features of the empirical studies are:
i. Investors cannot use any new information about a security or asset for their benefit.
ii. The price of an asset or security represents all important information, making it available
to all investors trading on various exchanges.
iii. It is always possible that one market is efficient for a few investors but inefficient for
others.
iv. It provides free access to accurate and comprehensive asset-related data.
v. The amount of time it takes for trading to affect asset value reflects the efficiency of a
market.
vi. Investors interested in passive portfolio management select index funds that reflect the
stock market’s overall performance.
vii. Transparency in the financial market makes it more efficient.

Implications of Efficient Market Theory (EMT)

EMT has significant implications on the following:

7 Mary Hall (2022). :Market Efficiency: Effects and Anomalies”. https://www.investopedia.com.

4
 i. Portfolio Management: EMT suggests that it is impossible to outperform the market
consistently, and as such, active portfolio management strategies, such as stock picking
and market timing are unlikely to be successful in the long run. Instead, EMT suggests
that investors should focus on passive investment strategies such as index funds that
aim to replicate market performance.
ii. Market Regulation: The implications of EMT for market regulation are also significant. If
prices are always efficient, then it may not be necessary to regulate markets to ensure
that prices are fair. However, some argue that regulation is still necessary to prevent
fraud and market manipulation, which can lead to market inefficiencies and undermine
investor confidence.
Alternatives to Efficient Market Theory
There are several alternative theories and perspectives to EMT:
i. Technical Analysis: A popular approach to investing that involves analyzing past
market data, such as price and volume, to predict future price movements.
ii. Fundamental Analysis: This involves analyzing a company's financial statements,
industry trends, and macroeconomic factors to determine its intrinsic value.
iii. Value Investing: This strategy involves identifying undervalued securities and investing
in them with the expectation that their value will increase over time
Bottom Line
In the real world, markets cannot be absolutely efficient or wholly inefficient. It might be
reasonable to see markets as essentially a mixture of both, wherein daily decisions and events
cannot always be reflected immediately in a market. If all participants were to believe the market
is efficient, no one would seek extraordinary profits, which is the force that keeps the wheels of
the market turning.
In the age of information technology (IT) however, markets all over the world are gaining greater
efficiency. IT allows for a more effective, faster means to disseminate information, and
electronic trading allows for prices to adjust more quickly to news entering the market. However,
while the pace at which we receive information and make transactions quickens, IT also restricts
the time it takes to verify the information used to make a trade. Thus, IT may inadvertently result
in less efficiency if the quality of the information we use no longer allows us to make profit-
generating decisions.

5.3 MARKET EFFICIENCY AND MARKET FAILURE

Market efficiency also plays a crucial role in allocating resources to produce consumer-friendly
goods. Resource allocation efficiency refers to a market where the value obtained for goods is
equivalent to the predicted value.
Market failure, on the contrary, occurs when resource allocation efficiency is not attained. The
market is likely to fail when the price mechanism fails to account for all costs and advantages
essential for consumers when buying and using an item. In other words, when price and quality
do not match, the market fails. To address market failure, the government enacts legislation,

5
imposes taxes, gives subsidies, offers tradable permits, etc., depending on the nature of the
market.
How are market efficiency and market failure related?
Market efficiency influences the allocation of resources to generate consumer-friendly items. It
refers to a market in which the value gained for commodities is equal to the value projected. On
the other hand, market failure happens when resource allocation efficiency is not achieved. For
example, the market is likely to fail when the price mechanism fails to account for all costs and
benefits required for consumers to buy and utilize an item. In other words, the market fails when
price and quality do not match.

5.4 MARKET LIQUIDITY8

Liquidity refers to the efficiency or ease with which an asset or security can be converted into
ready cash without affecting its market price. The most liquid asset of all is cash itself. The more
liquid an asset is the easier and more efficient it is to turn it back into cash. Less liquid assets
take more time and may have a higher cost.
The term “liquidity” is, however, frequently used loosely and it is often difficult to disentangle
precisely what concept is meant in this respect. It is useful to recall that economic theory offers
at least two different concepts of liquidity.9
The first concept is called monetary liquidity and it pertains to the quantity of liquid assets in the
economy, which is in turn related to the level of interest rates. A second concept is market
liquidity, which is generally seen as a measure of the ability of market participants to undertake
securities transactions without triggering large changes in their prices. These two concepts are
quite distinct from one another and although there can be relationships between them they are
rather complex and by no means direct.10
From a financial stability perspective, it is important to identify the sources of financial market
liquidity because if there are risks associated with the durability of the factors driving it; this
could leave asset prices vulnerable to abrupt changes in market liquidity. Focusing on the
second concept, this box introduces an indicator designed to gauge patterns in euro area
market liquidity, it assesses some of the explanations commonly offered for perceptions of
abundant market liquidity and it draws some financial stability conclusions.
Importance of liquidity
Liquidity describes the degree to which an asset can be quickly bought or sold in the market at a
price reflecting its intrinsic value. If markets are not liquid, it becomes difficult to sell or convert
assets or securities into cash. You may, for instance, own a very rare and valuable family
heirloom appraised at $150,000. However, if there is not a market (i.e., no buyers) for your
object, then it is irrelevant since nobody will pay anywhere close to its appraised value—it is
very illiquid. It may even require hiring an auction house to act as a broker and track down
potentially interested parties, which will take time and incur costs.

8
Adam Hayes, (2023). Understanding Liquidity and How to Measure It. https://www.investopedia.com › terms › liquidity
9
ECB (2007). The Euro Area Financial System, Box 9 - Understanding Financial Market Liquidity, Financial Stability Review.
10
Ibid.

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Liquid assets, however, can be easily and quickly sold for their full value and with little cost.
Companies also must hold enough liquid assets to cover their short-term obligations like bills or
payroll; otherwise, they could face a liquidity crisis, which could lead to bankruptcy.
What are the most liquid assets or securities?
Cash is the most liquid asset, followed by cash equivalents, which are things like money market
accounts, certificates of deposit (CDs), or time deposits. Marketable securities, such as stocks
and bonds listed on exchanges, are often very liquid and can be sold quickly via a broker. Gold
coins and certain collectibles may also be readily sold for cash.
Cash is universally considered the most liquid asset because it can most quickly and easily be
converted into other assets. Tangible assets, such as real estate, fine art, and collectibles, are
all relatively illiquid. Other financial assets, ranging from equities to partnership units, fall at
various places on the liquidity spectrum.
For example, if a person wants a $1,000 refrigerator, cash is the asset that can most easily be
used to obtain it. If that person has no cash but a rare book collection that has been appraised
at $1,000, they are unlikely to find someone willing to trade them the refrigerator for their
collection. Instead, they will have to sell the collection and use the cash to purchase the
refrigerator. That may be fine if the person can wait for months or years to make the purchase,
but it could present a problem if the person only had a few days. They may have to sell the
books at a discount, instead of waiting for a buyer who was willing to pay the full value. Rare
books are an example of an illiquid asset.
What are some illiquid assets or securities?
Securities that are traded over the counter (OTC), such as certain complex derivatives, are
often quite illiquid. For individuals, a home, a time-share, or a car are all somewhat illiquid in
that it may take several weeks to months to find a buyer, and several more weeks to finalize the
transaction and receive payment. Moreover, broker fees tend to be quite large (e.g., 5% to 7%
on average for a real estate agent).
Why are some stocks more liquid than others?
The most liquid stocks tend to be those with a great deal of interest from various market actors
and a lot of daily transaction volume. Such stocks will also attract a larger number of market
makers who maintain a tighter two-sided market.
Illiquid stocks have wider bid-ask spreads and less market depth. These names tend to be
lesser known, have lower trading volume, and often have lower market value and volatility.
Thus, the stock for a large multinational bank will tend to be more liquid than that of a small
regional bank.

5.5 THE MAIN MEASURES OF LIQUIDITY11

There are two main measures of liquidity: market liquidity and accounting liquidity.

11
Ibid (Adam Hayes, 2023).

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 Market Liquidity
Market liquidity refers to the extent to which a market, such as a country’s stock market or a
city’s real estate market, allows assets to be bought and sold at stable, transparent prices. In
the example above, the market for refrigerators in exchange for rare books is so illiquid that, for
all intents and purposes, it does not exist.
The stock market, on the other hand, is characterized by higher market liquidity. If an exchange
has a high volume of trade that is not dominated by selling, the price that a buyer offers per
share (the bid price) and the price that the seller is willing to accept (the ask price) will be fairly
close to each other.
Investors, then, will not have to give up unrealized gains for a quick sale. When the spread
between the bid and ask prices tightens, the market is more liquid; when it grows, the market
instead becomes more illiquid. Markets for real estate are usually far less liquid than stock
markets. The liquidity of markets for other assets, such as derivatives, contracts, currencies, or
commodities, often depends on their size and how many open exchanges exist for them to be
traded on.
Accounting Liquidity
Accounting liquidity measures the ease with which an individual or company can meet their
financial obligations with the liquid assets available to them—the ability to pay off debts as they
come due. In the example above, the rare book collector’s assets are relatively illiquid and
would probably not be worth their full value of $1,000 in a pinch. In investment terms, assessing
accounting liquidity means comparing liquid assets to current liabilities, or financial obligations
that come due within one year.
There are a number of ratios that measure accounting liquidity, which differ in how strictly they
define liquid assets. Analysts and investors use these to identify companies with strong liquidity.
It is also considered a measure of depth.
Measuring Liquidity
Financial analysts look at a firm’s ability to use liquid assets to cover its short-term obligations.
Generally, when using these formulas, a ratio greater than one is desirable.
Current Ratio: The current ratio is the simplest and least strict. It measures current assets
(those that can reasonably be converted to cash in one year) against current liabilities. Its
formula would be:
Current Ratio = Current Assets ÷ Current Liabilities
Quick Ratio (Acid-Test Ratio): The quick ratio, or acid-test ratio, is slightly more strict. It
excludes inventories and other current assets, which are not as liquid as cash and cash
equivalents, accounts receivable, and short-term investments. The formula is:
Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts
Receivable) Current Liabilities
Acid-Test Ratio (Variation): A variation of the quick/acid-test ratio simply subtracts inventory
from current assets, making it a bit more generous:

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 Acid-Test Ratio (Variation) = (Current Assets - Inventories - Prepaid Costs)
Current Liabilities
Cash Ratio: The cash ratio is the most exacting of the liquidity ratios. Excluding accounts
receivable, as well as inventories and other current assets, it defines liquid assets strictly as
cash or cash equivalents.
More than the current ratio or acid-test ratio, the cash ratio assesses an entity’s ability to stay
solvent in case of an emergency—the worst-case scenario—on the grounds that even highly
profitable companies can run into trouble if they do not have the liquidity to react to unforeseen
events. Its formula is:
Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities
Liquidity Example
In terms of investments, equities as a class are among the most liquid assets. But not all
equities are created equal when it comes to liquidity. Some shares trade more actively than
others on stock exchanges, meaning that there is more of a market for them. In other words,
they attract greater, more consistent interest from traders and investors.
These liquid stocks are usually identifiable by their daily volume, which can be in the millions or
even hundreds of millions of shares. When a stock has high volume, it means that there are a
large number of buyers and sellers in the market, which makes it easier for investors to buy or
sell the stock without significantly affecting its price. On the other hand, low-volume stocks may
be harder to buy or sell, as there may be fewer market participants and therefore less liquidity.
For example, on March 13, 2023, 69.6 million shares of Amazon.com Inc. (AMZN) traded on
exchanges. By comparison, Intel Corp. (INTC) saw a volume of just 48.1 million shares,
indicating it was somewhat less liquid. But Ford Motor Co. (F) had a volume of 118.5 million
shares, making it the most active, and presumably most liquid, among these three stocks on
that day.
In addition to trading volume, other factors such as the width of bid-ask spreads, market depth,
and order book data can provide further insight into the liquidity of a stock. So, while volume is
an important factor to consider when evaluating liquidity, it should not be relied upon
exclusively.
Factor for financial market liquidity12
A key factor for financial market liquidity has been the remarkable structural changes which
have been taking place in financial markets. These have included the liberalisation of
international capital flows, the securitisation of loans and the development of new financial
products (e.g. credit derivatives). At the same time, the emergence and growing presence of
highly active participants, such as investment funds and hedge funds in particular, in financial
markets has probably significantly enhanced market liquidity.
The above developments have increased the number and diversity of market participants in
financial markets and, generally speaking, the greater the degree of heterogeneity of investors

12 ECB. The Euro Area Financial System, Box 9 - Understanding Financial Market Liquidity, Financial Stability Review. June 2007.

9
in a market, the higher the number of buyers and sellers willing to trade under different market
conditions will be. At the same time, there can be feedbacks as an increasing number of buyers
and sellers who are willing to trade regardless of the direction of markets may explain why the
number and frequency of financial market transactions has been increasing.

5.6 FINANCIAL DEVELOPMENT AND THE FINANCIAL SECTOR13

Financial sector is the set of institutions, instruments, markets, as well as the legal and
regulatory framework that permit transactions to be made by extending credit. Fundamentally,
financial sector development is about overcoming “costs” incurred in the financial system. This
process of reducing the costs of acquiring information, enforcing contracts, and making
transactions resulted in the emergence of financial contracts, markets, and intermediaries.
Different types and combinations of information, enforcement, and transaction costs in
conjunction with different legal, regulatory, and tax systems have motivated distinct financial
contracts, markets, and intermediaries across countries and throughout history.
The five key functions of a financial system are:
i. producing information ex ante about possible investments and allocate capital;
ii. monitoring investments and exerting corporate governance after providing finance;
iii. facilitating the trading, diversification, and management of risk;
iv. mobilizing and pooling savings; and
v. easing the exchange of goods and services.

Financial sector development thus occurs when financial instruments, markets, and
intermediaries ease the effects of information, enforcement, and transactions costs and
therefore do a correspondingly better job at providing the key functions of the financial sector in
the economy.
Importance of financial development
A large body of evidence suggests that financial sector development plays a huge role in
economic development. It promotes economic growth through capital accumulation and
technological progress by increasing the savings rate, mobilizing and pooling savings,
producing information about investment, facilitating and encouraging the inflows of foreign
capital, as well as optimizing the allocation of capital.
Countries with better-developed financial systems tend to grow faster over long periods of time,
and a large body of evidence suggests that this effect is causal: financial development is not
simply an outcome of economic growth; it contributes to this growth. Additionally, it reduces
poverty and inequality by broadening access to finance to the poor and vulnerable groups,
facilitating risk management by reducing their vulnerability to shocks, and increasing investment
and productivity that result in higher income generation.
Financial sector development can help with the growth of small and medium sized enterprises
(SMEs) by providing them with access to finance. SMEs are typically labor intensive and create
more jobs than do large firms. They play a major role in economic development particularly in

13
World Bank (2016). Financial Development. https://www.worldbank.org.

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emerging economies. Financial sector development goes beyond just having financial
intermediaries and infrastructures in place. It entails having robust policies for regulation and
supervision of all the important entities. The global financial crisis underscored the disastrous
consequences of weak financial sector policies. The financial crisis has illustrated the potentially
disastrous consequences of weak financial sector policies for financial development and their
impact on the economic outcomes. Finance matters for development‐‐both when it functions
well and when it malfunctions.
The crisis has challenged conventional thinking in financial sector policies and has led to much
debate on how best to achieve sustainable development. Reassessing financial sector policies
after the crisis is an important step in informing this process. To help achieve this, publications
such as the World Bank’s Global Financial Development Report can play a role. Chapter 1 and
the Statistical Appendix of the report present data and knowledge on financial development
around the world.
Measurement of financial development
A good measurement of financial development is crucial to assess the development of the
financial sector and understand the impact of financial development on economic growth and
poverty reduction. In practice, however, it is difficult to measure financial development as it is a
vast concept and has several dimensions. Empirical work done so far is usually based on
standard quantitative indicators available for a long time series for a broad range of countries.
Examples of the works are: ratio of financial institutions’ assets to GDP; ratio of liquid liabilities
to GDP; and, ratio of deposits to GDP. Nevertheless, as the financial sector of a country
comprises a variety of financial institutions, markets, and products, these measures are rough
estimation and do not capture all aspects of financial development.
The World Bank’s Global Financial Development Database developed a comprehensive yet
relatively simple conceptual 4x2 framework to measure financial development around the
world.14 This framework identifies four sets of proxy variables characterizing a well-functioning
financial system: financial depth, access, efficiency, and stability. These four dimensions are
then measured for the two major components in the financial sector, namely the financial
institutions and financial markets.
The framework is described below.

Financial Institutions Financial Markets

 Stock market capitalization and
 Private Sector Credit to GDP
outstanding domestic private debt
 Financial Institutions’ asset to securities to GDP
GDP
 Private Debt securities to GDP
Depth  M2 to GDP
 Public Debt Securities to GDP
 Deposits to GDP
 International Debt Securities to GDP
 Gross value added of the
 Stock Market Capitalization to GDP
financial sector to GDP
 Stocks traded to GDP
Depth  Private Sector Credit to GDP  Stock market capitalization and

14
World Bank (2016). Financial Development. https://www.worldbank.org.

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 Financial Institutions
 Financial Institutions’ asset to
GDP
 M2 to GDP
 Deposits to GDP
 Gross value added of the
financial sector to GDP
 Accounts per thousand
adults(commercial banks)
 Branches per 100,000 adults
(commercial banks)
 % of people with a bank
Access
account (from user survey)
 % of firms with line of credit
(all firms)
 % of firms with line of credit
(small firms)
 Net interest margin
 Lending-deposits spread
 Non-interest income to total
income
 Overhead costs (% of total
Efficiency assets)
 Profitability (return on assets,
return on equity)
 Boone indicator (or Herfindahl
or H-statistics)
 Z-score
 Capital adequacy ratios
 Asset quality ratios
Stability
 Liquidity ratios
 Others (net foreign exchange
position to capital etc.)
12
Financial Markets
outstanding domestic private debt
securities to GDP
 Private Debt securities to GDP
 Public Debt Securities to GDP
 International Debt Securities to GDP
 Stock Market Capitalization to GDP
 Stocks traded to GDP
 Percent of market capitalization outside
of top 10 largest companies
 Percent of value traded outside of top 10
traded companies
 Government bond yields (3 month and
10 years)
 Ratio of domestic to total debt securities
 Ratio of private to total debt securities
(domestic)
 Ratio of new corporate bond issues to
GDP
 Turnover ratio for stock market
 Price synchronicity (co-movement)
 Private information trading
 Price impact
 Liquidity/transaction costs
 Quoted bid-ask spread for government
bonds
 Turnover of bonds (private, public) on
securities exchange
 Settlement efficiency
 Volatility (standard deviation / average)
of stock price index, sovereign bond
index
 Skewness of the index (stock price,
sovereign bond)
 Vulnerability to earnings manipulation
 Price/earnings ratio
 Duration
 Ratio of short-term to total bonds
(domestic, int’l)
 Correlation with major bond returns
(German, US)