A Network Model of Frontier Capital Markets

Finance session

Margaret Moten (West Point), Daniel Evans (West Point)
A Network Model of Frontier Capital Markets

Economic background

Extensive research has recognized that well-functioning financial markets are associated with economic growth. However, the basic assumptions underlying macro-economic and financial theory are increasingly subject to debate including rational expectations, representative agent, and efficient markets theories. Economic research focused on modeling the behavior of networked, diverse economic agents is emerging to address limitations in traditional economic theoretical foundations.

Understanding the structure, dynamics, and unique characteristics of the capital market network in which individuals operate is vital to analyzing how capital markets evolve, especially in developing economies where individuals make reciprocal exchanges and clan or family interests are as important as individual self-interest or social norms, institutions and legal frameworks. Our network approach should reveal existing qualities of market behavior that do not adhere to traditional economic assumptions providing insights to the study of network science, economics and capital markets.

Capital markets and development

Well-functioning capital markets are an extremely important component of capitalism. Companies require funds to expand, develop new products and services, and construct facilities. Governments use capital market funding to develop infrastructure, for government projects and initiatives, and deficit financing. Few foreign investors participate in a frontier or emerging market unless they know they can sell their shares easily in well-regulated markets. Investors require transparency – reliable financial and management information. Government stability, economic policies, taxation, and the ability to repatriate capital influence an investor’s risk perception.

Successful economic development requires that local entrepreneurs have access to the capital necessary for business expansion, but little is understood about the types and functions of capital markets in the world’s less-developed countries. These capital markets, often termed “frontier markets” are ones in which social connections play a much more critical role than in developed capital markets calling for a network approach to evaluating and classifying these markets. Network analysis can inform behavioral, financial and development economists seeking to understand the essential characteristics that foster capital market development in countries where social capital can be as important as financial capital. As Stiglitz and Gallegati (2011) note, “Some network designs may be good at absorbing small shocks, when there can be systemic failure when confronted with a large enough shock. Similarly, some typologies may be more vulnerable to highly correlated shocks.” Goyal (2007) found that, “Network structure has significant effects on individual behavior and on social welfare.” He concluded that some networks are better than others in promoting socially desirable outcomes, and both the quality and quantity of the links in the networks are important. Understanding the personal, corporate, and information networks that underlie developing capital markets is a critical component for developing programs that expand economic opportunities.

Frontier market networks

Financial analysts classify capital markets as Developed, Emerging, or Frontier. We focus on Frontier Markets, the smallest, less developed, less liquid investable markets. Functioning capital markets enable developing economies to attract domestic and international investment needed to support entrepreneurs, expand economic opportunities, and foster economic growth. Frontier Markets have smaller scope and fewer institutional controls, and social relations and human behavior have a greater impact. Thus, the study of Frontier Capital Markets provides a unique opportunity to examine the network-based intersection of human behavior and economics. The individual motivations, information availability, transaction systems, and cultural realities in these markets provide a rich context.

A social network analysis reveals interesting insights about how interrelationships among actors and organizations affect market operations and development. Network analysis provides both a visual and mathematical analysis of the relationships and information flows between people, organizations, and knowledge entities enabling us to describe capital market structure and function in innovative ways. Initial research focuses on the capital markets in three frontier markets, Ghana, Tanzania and Trinidad and Tobago. We collected extensive data about the actors in the markets using mathematical techniques to identify and evaluate the nodes in the network. Initially focusing on stock exchange personnel and government regulators, we expanded the network to encompass public companies, banks, brokers, and key personnel in government.

We recorded individual résumé data including the businesses, clubs and professional associations with which they were associated. We documented nationality, educational attainment and university affiliations, and conducted interviews with key “nodes” at the stock exchanges, banks, brokerage firms, and government organizations. We then assigned individuals up to three functions, such as commercial banking, conglomerate, or parastatal, that best described their expertise. Using ORA network analysis software, we constructed functional networks for each country depicting how functions are connected with other functions through individuals and generated descriptive statistics and typologies of the networks. We identified which functions, individuals and organizations serve as central hubs and power brokers. We also noted potential points of failure, the nodes on the shortest paths between nodes that exhibit the most influence on other nodes, and the nodes on the periphery, lacking information or resources. These network typologies enable us to classify, compare and contrast capital market networks.

Conclusions

Our preliminary research generated functional network typologies and descriptive statistics for three frontier capital markets. Future research will focus on refining the functions and assignment process, conducting sensitivity analysis, and weighting the functions and links. We are also conducting a network analysis of an emerging market, the Czech Republic, to enable a vertical comparison. Such a comparison will reveal similarities and differences in the network structure of developing versus emerging markets furthering our understanding of the types of social networks that have fostered economic growth. Our models will offer insights to economists seeking to understand the interconnections between economic actors and their effects on financial markets, risk, and economic conditions. This research will also provide governmental and nongovernmental organizations with a playbook when creating economic development policies enabling decision-makers to focus on aspects of the network that will generate results efficiently.

1 Stiglitz, Joseph E. and Mauro Gallegati, “Heterogeneous Interacting Agent Models for Understanding Monetary Economics,” Eastern Economic Journal, Volume 37, Winter 2011, Bloomsburg, PA, Eastern Economic Association, p. 37.

2 Goyal, Sanjeev (2007). Connections: An Introduction to the Economics of Networks, Princeton: Princeton University Press, pp. 54, 27.