Role of Government

Summary of “Role of Government in Capital Market Development”¹

Policy makers have traditionally focussed on creating a sound framework within which capital markets can operate effectively and efficiently. This generally includes implementing ‘good fundamentals’ such as sound tax policy, efficient and effective regulation of securities issuance, securities exchanges, market conduct etc. and sound commercial law (e.g. protection of property rights) more generally as well as an efficient payment, settlement and clearance system. Increasingly though, policy makers are considering other ways in which government can influence development through its participation in capital markets. The Capital Market Development Taskforce asked Nick Davis of MartinJenkins to develop a high-level framework for considering the role of government in capital market development.

What role does government currently play in the capital markets?

The Government (through a range of different institutions including the Reserve Bank, Debt Management Office, and the four large Crown financial institutions) is a significant participant in capital markets, borrowing funds, investing in assets, and transforming the risk characteristics of financial portfolios through derivatives. 

The Government is also currently active in promoting capital market development and financial innovation (e.g., Venture Investment Fund), in regulating capital markets (e.g., Securities Act), in negotiating international agreements that improve the international integration of capital markets (e.g., Trans Tasman Mutual Recognition of Securities Offerings).  A wide range of other government policy decisions, such as the provision of New Zealand Superannuation, also have implications for capital markets.

Framework for thinking about the role of government

Drawing on work by Robert Merton, Joseph Stiglitz, and Dani Rodrick, Nick Davis describes the following roles for government in capital markets:

Government as market participant
The Government is a significant direct participant in capital markets, as a borrower, investor, owner of commercial companies, and through its risk management activities. There are a number of ways that the Government could potentially leverage its participation in capital markets to foster their further development:

In borrowing, it can be strongly argued that Government should develop a deep, liquid market for government securities. Issuing liquid benchmark securities at different terms and maturities underpins the development of the risk-free yield curve, which in turn improves the pricing of other securities such as corporate bonds or annuities. The literature is mixed, but recent studies appear to support the notion that issuance of sovereign bonds lowers corporate yields and bid-ask spreads.

Government as a financial innovator
Government also has a potential role to address the problem of missing or incomplete markets by issuing new or novel securities that the market cannot provide.  The Government has a distinct advantage in that it is long-lived, has the power to tax, and can credibly issue securities that the private sector cannot.  It also has the ability to alter the inter-generational distribution of risk.  However, the creation of new markets involves costs, and careful analysis of these costs as well as the possible benefits of government financial innovation is required.

Government as regulator
Capital market regulation is central to market development. The laws surrounding the conduct of capital market transactions must be seen to be robust and fair to market participants while not imposing undue compliance costs. As emphasised by Stiglitz, a key market failure that gives rise to government regulation is informational problems that make it costly, if not impossible, for participants to effectively monitor the behaviour or situation of others.  Information asymmetries between the buyers and sellers of financial products provide the basis for a raft of legislation aimed at reducing undesirable incentive effects, such as moral hazard and adverse selection, deterring and prosecuting unfair or fraudulent conduct, promoting transparency and contestability, ensuring fairness of treatment of different classes of market participant and, more generally, promoting investor confidence in the markets.

Government as international negotiator
This role is principally concerned with the development of international agreements relating to tax and regulation, with a view to improving integration of capital markets. A key question is whether the New Zealand Government can negotiate with other governments to improve the functioning of its capital markets. As discussed in Boyle (2009), there are many benefits (as well as risks) from greater integration of capital markets, although the potential size of these is uncertain. It is therefore likely that further integration would be beneficial in some areas while imposing net costs in others. It is also important to recognise that in many areas, New Zealand will effectively need to follow trends in Australia (and larger global markets) if we wish to pursue further integration, and there will be costs as well as benefits associated with the adoption of other countries regulations.

Government as industry policy maker
This role relates to the development and implementation of policies that aim to maximise the contribution of capital markets to economic growth.  A number of countries have adopted policies aimed at capturing a share of the global market for financial services.  In addition, governments intervene to address specific problems in parts of the capital markets.  There are many examples of policies that do not appear to work.  One area where arguments for government intervention appear reasonably well founded relates to early stage equity capital markets, in particular policies to spur venture capital.  Other possible roles of government relate to improving the information environment surrounding the capital markets, offering subsidised information and brokerage services to small growing firms, promoting a stronger saving and investment culture, and improving financial literacy. 

Wider government roles
Governments may unintentionally influence capital market development through the implementation of a wide range of seemingly unrelated policies. The provision of New Zealand Superannuation, for example, can be expected to influence incentives for private households to save, in turn affecting the development of the capital markets.  Other government policies with reasonably direct impacts on capital markets include debt management policy, tax policy and the retail deposit guarantee scheme recently introduced by the Government.  The policy implication is that, amongst other things, potential capital market impacts should be considered as part of the policy analysis process.

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