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Home > Opinions Last Updated: 09:28 05/21/2007
May 21, 2007

Integrity is Indispensable for Capital Market Development

Kazuhito IKEO (Professor, Keio University)

As capital market liberalization has been progressing in Japan for the last few years, we have regrettably seen a number of misconducts, which could be considered the abuse of freedom. However, the capital market should not be such a place that any kind of behavior would be permitted so long as it does not violate the law.

For the development of the capital market, "integrity" is an indispensable element. This statement can be derived not just from the normative viewpoint, but from the positive viewpoint of realizing sustainable returns, as recently pointed out by Professor Michael Jensen (see the Reference). There is always a certain cost (time and effort) incurred in market transactions in general, and in the capital market in particular. It is called "transactions cost" in economics, and consists of "search cost" to find appropriate counterparts for transactions, "bargaining cost" to reach agreements on conditions for transactions, and "enforcement cost" to secure the execution of agreements.

If your counterpart is a kind of individual who is egoistic and thinks that he can do whatever he likes so long as it is not against the law," you would have to spend a tremendous time and effort in market transactions. That is because it would be necessary for you to make sure whether your counterpartís statements could possibly contain any lies, any strategic intent, or any concealed information. Without such confirmation, you might be forced to accept quite disadvantaged conditions.

Furthermore, you might have to pay a very high cost in materializing the content of agreements (securing their proper execution), because you would need to take every precaution not to overlook any possibility of cheating (opportunistic behavior) and take every countermeasure against a possible violation of your benefits or rights.

Unless you are a rational economic agent with a very high capacity of computation and information processing, such a situation would be too burdensome. In other words, smooth economic transactions cannot be realized when costs for bargaining and enforcement are too high. In order to contain bargaining and enforcement costs within a permissible range, there should be moral and ethical norms internalized in each individual to keep promises and not to lie, and as a result, individuals may act in the atmosphere of mutual trust, at least to a certain degree.

Integrity is a basis for the formation of such mutual trust and is indispensable for the establishment of the market economy. This is especially true with the financial and capital markets in which trade takes place for a very abstract kind of merchandise such as "promises" to deliver incomes under certain conditions in the future. In short, integrity is needed to reduce transactions cost.

Therefore, for the purpose of developing Japanís capital market further, it is imperative that every market participant behave on the basis of real integrity beyond the mere compliance of the law (which is a matter of course). By doing so, we must eliminate all possible misconducts arising from the lack of ethical norms, and create a kind of market environment in which participants can trade based on mutual trust.

Jensen, Michael C., "Putting Integrity into Finance Theory and Practice: A Positive Approach (pdf of Keynote slides)" (Oct. 2006), Harvard NOM Working Paper No. 06-06, available at SSRN:

(The original Japanese article appeared in the May 12, 2007 issue of Weekly Toyo Keizai)

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