Financial Systems and Economic Growth: An Evaluation Framework for Policy

Claus, Iris; Jacobsen, Veronica; Jera, Brock Working Paper Financial Systems and Economic Growth: An Evaluation Framework for Policy New Zealand Treasury Working Paper, No. 04/17 Provided in Cooperation with: The Treasury, New Zealand Government Suggested Citation: Claus, Iris; Jacobsen, Veronica; Jera, Brock (2004) : Financial Systems and Economic Growth: An Evaluation Framework for Policy, New Zealand Treasury Working Paper, No. 04/17, New Zealand Government, The Treasury, Wellington This Version is available at: https://hdl.handle.net/10419/205557 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Financial systems and economic growth: An evaluation framework for policy Iris Claus, Veronica Jacobsen and Brock Jera N EW Z EALAND T REASURY W ORKING P APER 04/17 S EPTEMBER 2004 NZ TREASURY WORKING PAPER 04/17 Financial systems and economic growth: An evaluation framework for policy MONTH / YEAR September 2004 AUTHOR Iris Claus The Treasury PO Box 3724 Wellington 6015 NEW ZEALAND Email Telephone [email protected] 64-4-471 5221 AUTHOR Veronica Jacobsen The Treasury PO Box 3724 Wellington 6015 NEW ZEALAND Email Telephone [email protected] 64-4-471 5160 AUTHOR Brock Jera The Treasury PO Box 3724 Wellington 6015 NEW ZEALAND Email Telephone [email protected] 64-4-471 5908 ACKNOWLEDGE MENTS We would like to thank Rienk Asscher, Felicity Barker, Matt Benge, John Bryant, David Carrigan, John Creedy, Nick Davis, Kerryn Fowlie, Ruth Gabbitas, Arthur Grimes, Kirstie Hewlett, Geoff Lewis, Brian McCulloch, Andrew McLoughlin, Duncan Mills, Brendon Riches, Clive Thorp, Bruce White and Ian Woolford for useful comments at various draft stages. Thank you to Bronwyn Croxson for her editorial work. Thanks are also due to Anand Kochunny and Raewyn Peters for research assistance. NZ TREASURY New Zealand Treasury PO Box 3724 Wellington 6015 NEW ZEALAND Email Telephone Website [email protected] 64-4-472 2733 www.treasury.govt.nz DISCLAIMER The views, opinions, findings, and conclusions or recommendations expressed in this paper are strictly those of the authors. They do not necessarily reflect the views of the New Zealand Treasury. The New Zealand Treasury takes no responsibility for any errors or omissions in, or for the correctness of, the information contained in this paper. The paper is presented not as policy, but to inform and stimulate wider debate. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY i Abstract The purpose of this paper is to develop an analytical framework for discussing the link between financial systems and economic growth. Financial systems help overcome an information asymmetry between borrowers and lenders. If they do not function well, economic growth will be negatively affected. Three policy implications follow. First, the analysis underscores the importance of maintaining solid legal foundations because the financial system relies on these. Second, it demonstrates the necessity for reforming tax policy as it applies to investment, as this is demonstrated to significantly affect the operation of the financial system. Finally, given the importance of financial development for economic growth, a more in-depth review of New Zealand’s financial system in the context of financial regulation and supervision would be valuable. JEL CLASSIFICATION G10 - General Financial Markets - General G20 - Financial Institutions and Services - General G38 - Government Policy and Regulation H25 - Public Economics - Business Taxes and Subsidies K20 - Regulation and Business Law - General K34 - Law and Economics - Tax Law O16 - Financial Markets; Saving and Capital Investment KEYWORDS Economic growth, financial development, financial systems, financial regulation; legal system; institutions; tax WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY ii Table of Contents Abstract...............................................................................................................................i Table of Contents ..............................................................................................................ii List of Figures...................................................................................................................iii 1 Introduction ..............................................................................................................1 2 The role of financial systems in the economy.......................................................2 2.1 Provision of liquidity........................................................................................................2 2.2 Transformation of the risk characteristics of assets.......................................................3 2.3 The comparative roles of financial intermediaries and markets.....................................4 3 The link between financial systems and economic growth .................................6 3.1 Capital accumulation ......................................................................................................7 3.2 Technological innovation................................................................................................7 4 The cost of external finance....................................................................................8 4.1 Economic growth and the real rate of interest................................................................8 4.2 The cost of finance in an open economy with perfect information .................................9 4.3 The case of imperfect information ..................................................................................9 5 Assessment of the empirical evidence ................................................................12 5.1 The empirical link between financial systems and economic growth...........................12 5.2 Empirical evidence in the New Zealand context...........................................................13 6 Legal institutions and other policy influences....................................................15 6.1 Legal institutions and financial development................................................................15 6.2 Other policy influences .................................................................................................17 7 New Zealand’s taxation of capital and the effect on the financial system........17 7.1 Development of the current capital-revenue boundary in New Zealand tax policy......18 7.2 Foundations and operation of the current capital-revenue boundary...........................19 7.3 The effect on investment decisions ..............................................................................21 7.4 Growth impacts from present policy implied by an information asymmetry framework ...............................................................................................................................24 8 The role of financial regulation and supervision.................................................27 8.1 Financial instability........................................................................................................27 8.2 Financial regulation and supervision............................................................................29 8.3 Financial regulation and supervision in New Zealand..................................................30 9 Concluding remarks...............................................................................................32 References .......................................................................................................................34 Appendix: Some considerations for the reform of the taxation of financial intermediaries.........................................................................................................39 WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY iii List of Figures Figure 1 – Supply and demand of capital in a small open economy with perfect information............9 Figure 2 – Supply and demand of capital in a small open economy with imperfect information......10 Figure A1 – Consumer and producer surplus...................................................................................42 WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 1 Financial systems and economic growth: An evaluation framework for policy “When an apparently profitable opportunity to a firm, worker, or household is not exploited, the economic approach does not take refuge in assertions about irrationality, contentment with wealth already acquired, or convenient ad hoc shifts in values (that is, preferences). Rather it postulates the existence of costs, monetary or psychic, of taking advantage of these opportunities that eliminate their profitability – costs that may not be easily ‘seen’ by outside observers”. Becker (1976, 111-112) 1 Introduction The purpose of this paper is to develop an analytical framework for discussing the link between financial systems and economic growth. This framework can be used to evaluate policy settings that affect New Zealand’s financial system. The paper does not attempt to assess the adequacy of New Zealand’s financial system in providing financial services. Rather it highlights the importance of financial development for economic growth and identifies key policy priorities. Financial systems, i.e. financial intermediaries and financial markets, are important for economic growth.1 They can lead to a more efficient allocation of resources because they reduce the costs of moving funds between borrowers and lenders, and help overcome an information asymmetry between borrowers and lenders. If they do not function well the economy can not operate efficiently and economic growth will be negatively affected. Information asymmetry arises because borrowers generally know more about their investment projects than lenders. Imperfect information can lead to a lack of market coordination (Akerlof 1970). As financial systems represent the market response to such a possibility, they are crucial institutions. Policy settings are important as they can affect the production and discovery of information, key functions of financial systems. 1 Financial markets refer here to institutions organised for the creation and trade of financial assets, such as a stock exchange. Financial intermediaries are those institutions that carry out the market function of matching providers of funds with users of funds, such as banks, unit trusts or venture capitalists. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 2 The paper proceeds as follows. Section 2 reviews the role of financial intermediaries and markets and their comparative advantages in providing external finance to firms. Section 3 establishes the broad link to economic growth. The cost of external finance is discussed in section 4 and the empirical evidence is reviewed in section 5. Section 6 discusses the importance of the legal environment and other policy influences for financial development and section 7 assesses the potential effects of the New Zealand tax system on the financial system. Section 8 discusses financial regulation and supervision, and the last section summarises and concludes. 2 The role of financial systems in the economy This section discusses the main functions of financial intermediaries and financial markets, and their comparative roles. Financial systems, i.e. financial intermediaries and financial markets, channel funds from those who have savings to those who have more productive uses for them. They perform two main types of financial service that reduce the costs of moving funds between borrowers and lenders, leading to a more efficient allocation of resources and faster economic growth. These are the provision of liquidity and the transformation of the risk characteristics of assets.2 2.1 Provision of liquidity The link between liquidity and economic performance arises because many high return investment projects require long-term commitments of capital, but risk adverse lenders (savers) are generally unwilling to delegate control over their savings to borrowers (investors) for long periods. Financial systems mobilise savings by agglomerating and pooling funds from disparate sources and creating small denomination instruments. These instruments provide opportunities for individuals to hold diversified portfolios. Without pooling individuals and households would have to buy and sell entire firms (Levine 1997). Diamond and Dybvig (1983) show how financial intermediaries can enhance risk sharing, which can be a precondition of liquidity, and can thus improve welfare. In their model, without an intermediary (such as a bank), all investors are locked into illiquid long-term investments that yield high payoffs only to those who consume at the end of the investment. Those who must consume early receive low payoffs because early consumption requires premature liquidation of long-term investments. When agents need to consume at different (random) times, an intermediary can improve risk sharing – by promising investors a higher payoff for early consumption and a lower payoff for late consumption relative to the non-intermediated case. Financial markets can also transform illiquid assets (long-term capital investments in illiquid production processes) into liquid liabilities (financial instrument). With liquid financial markets savers/lenders can hold assets like equity or bonds, which can be quickly and easily converted into purchasing power, if they need to access their savings. 2 The financial system also plays a role in ensuring that payments can be exchanged and settled. This role is largely ignored in this paper. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 3 For lenders, the services performed by financial markets and intermediaries are substitutable around the desired risk, return and liquidity provided by particular investments. Financial intermediaries and markets make longer-term investments more attractive and facilitate investment in higher return, longer gestation investment and technologies. They provide different forms of finance to borrowers. Financial markets provide arms length debt or equity finance (to those firms able to access markets), often at a lower cost than finance from financial intermediaries. 2.2 Transformation of the risk characteristics of assets The second main service financial intermediaries and markets provide is the transformation of the risk characteristics of assets. Financial systems perform this function in at least two ways. First, they can enhance risk diversification and second, they resolve an information asymmetry problem that may otherwise prevent the exchange of goods and services, in this case the provision of capital (Akerlof 1970). Financial systems facilitate risk-sharing by reducing information and transactions costs. If there are costs associated with the channelling of funds between borrowers and lenders, financial systems can reduce the costs of holding a diversified portfolio of assets. Intermediaries perform this role by taking advantage of economies of scale, markets do so by facilitating the broad offer and trade of assets comprising investors’ portfolios. Financial systems can reduce information and transaction costs that arise from an information asymmetry between borrowers and lenders.3 In credit markets an information asymmetry arises because borrowers generally know more about their investment projects than lenders. A borrower may have an entrepreneurial “gut feeling” that can not be communicated to lenders, or more simply, may have information about a looming financial risk to their firm that they may not wish to share with past or potential lenders. An information asymmetry can occur ex ante or ex post. An ex ante information asymmetry arises when lenders can not differentiate between borrowers with different credit risks before providing a loan and leads to an adverse selection problem. Adverse selection problems arise when lenders are more likely to make a loan to high-risk borrowers, because those who are willing to pay high interest rates will, on average, be worse risks. The information asymmetry problem occurs ex post when only borrowers, but not lenders, can observe actual returns after project completion. This leads to a moral hazard problem. Moral hazard problems arise when borrowers engage in activities that reduce the likelihood of their loan being repaid. They also arise when borrowers take excessive risk because the costs may fall more on lenders compared to the benefits, which can be captured by borrowers. The problem with imperfect information is that information is a “public good”. If costly privately-produced information can subsequently be used at less cost by other agents, there will be inadequate motivation to invest in the publicly optimal quantity of information (Hirshleifer and Riley 1979). The implication for financial intermediaries is as follows. Once financial intermediaries obtain information they must be able to obtain a market return on that information before any signalling of that information advantage results in it being bid away. If they can not prevent information from being revealed prior to obtaining that return, they will not commit the resources necessary to obtain it. One reason financial intermediaries can obtain information at a lower cost than individual lenders is that financial intermediation avoids duplication of the production of information faced by 3 When markets do not operate costlessly, firms arise if they can reduce market transaction costs by organising resources more cheaply within the firm (Coase 1937). WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 10 lead to “agency costs” that increase the cost of external financing (Bernanke and Gertler 1989). With imperfect information, capital is only available at a higher real interest rate. The supply curve may even become positively sloped at some point as the level of external financing increases. In other words, the supply of capital may no longer be infinitely elastic in a small open economy. This is because greater reliance on external funds lowers the equity stake of borrowers, which gives them more incentive to engage in risky investment projects and increases lenders’ potential losses from adverse selection. To compensate for these additional risks lenders will demand a higher rate of return. With imperfect information the supply of capital curve may also become backward bending or downward sloping, i.e. lenders reduce their supply of funds as interest rates increase (Figure 2). The supply curve becomes backward bending when there exists an interest rate that maximises the expected return to lenders and beyond which they will be unwilling to supply funds to some borrowers. This is because adverse selection increases the likelihood that loans will be made to bad credit risks, while moral hazard lowers the probability that a loan will be repaid. As a result, lenders may decide in some circumstances that they would rather not make a loan and credit rationing may occur. Figure 2 – Supply and demand of capital in a small open economy with imperfect information r k D O S S' r* There are two forms of credit rationing: some loan applicants may receive a smaller loan than they applied for at the given interest rate, or they may not receive a loan at all, even if they offered to pay a higher interest rate. Jaffee and Russell (1976) develop a theoretical model in which imperfect information and uncertainty can lead to rationing in loan markets, where some agents do not receive the loan they applied for. Stiglitz and Weiss (1981) develop a model of credit rationing, where some borrowers receive loans and others do not. The empirical evidence on credit rationing is discussed in the next section. Higher financing costs lower investment and economic growth. However, the effects are difficult to measure. It has been empirically shown that real (i.e. inflation adjusted) interest rates (of different maturities) and the cost of capital have only quantitatively small effects on total spending and investment. Moreover, it is difficult to explain the timing and composition of economies’ responses to changes in interest rates solely in terms of cost of capital effects (Bernanke and Gertler 1995). However, these aggregate effects can hide an unequally distributed impact that can harm smaller firms more extensively than larger firms. For example, Gertler and Gilchrist (1994) found that small firms account for a WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 11 significantly disproportionate share of the manufacturing decline and slowdown in inventory demand that follows a tightening of monetary policy. The empirical finding of quantitatively small effects of the cost of borrowing on total economic activity is supported by the results from theoretical general equilibrium models (see, for example, Claus 2003). What seems crucial though is the effectiveness of financial systems in allocating resources to best uses, i.e. the degree to which financial systems overcome information asymmetry between borrowers and lenders. Using a general equilibrium model that is calibrated for New Zealand, Claus (2004) shows that a decline in the degree of information asymmetry increases the long-run level of steady state investment, capital and output. Asymmetric information and other credit market frictions also amplify and propagate conventional interest rate effects, underscoring the importance of financial institutions in minimising the imperfect information problem. Asymmetric information may be of greater significance in small open economies than in large closed economies. This is because small economies tend to have a large number of small firms (in terms of the size of their balance sheets). Small firms are more affected by asymmetric information than large businesses because of economies of scale in acquiring and monitoring information. Moreover, in small economies financial markets may be less liquid and savers/lenders may not be able to quickly and easily convert assets into purchasing power, if they need to access their savings. In open economies additional information asymmetries may arise between domestic and foreign borrowers and lenders. If the degree of information asymmetry is large in small open economies, the reliance on bank borrowing, all else equal, should be large as well. This is because financial intermediaries are better able to overcome the imperfect information problem than financial markets. The New Zealand data provide some support of this hypothesis. For example, in a study of business practices and performance, Knuckey et al (2002) found that 51 percent of firms in New Zealand in 2002 “used banks to fund some proportion of their innovation of expansion activities in the three years prior to the survey, with 22 percent of respondents using banks to fund more than 50 percent of their activities”. Moreover, firms facing substantial asymmetric information can be expected to issue the “safest” security first, i.e. the one whose value changes least when inside information is revealed to the market. That is, firms will choose to issue debt and, only as a last resort, equity (Denis and Mihov 2003). The proposition suggests that the Modigliani and Miller (1958) theorem that firms are indifferent between issuing debt or equity does not hold.16 Finally, imperfect information may be an impediment to international capital mobility. With imperfectly integrated capital markets, domestic interest rates will be influenced by factors, such as the depreciation rate of the domestic capital stock, productivity and labour force growth and the domestic savings rate, in addition to foreign interest rates and changes in the exchange rate. Observed “home bias” in investment portfolios (i.e. investors holding less of their wealth in foreign assets than is optimal for diversification) suggests that there may be some barriers to capital mobility. However, the empirical evidence suggests that smaller countries may be somewhat less affected by home bias, which seems to be the case for New Zealand.17 16 The Modigliani and Miller (1958) theorem assumes that there are no information or transaction costs. 17 See Claus, Haugh, Scobie and Törnquist (2001). WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 12 5 Assessment of the empirical evidence There are several sources of empirical evidence to draw upon in assessing the extent to which countries and firms in general, and New Zealand in particular, are affected by information asymmetries and the development of financial systems to reduce them. There is a literature drawing on the connection between a country’s financial development and its rate of economic growth; a literature evaluating whether a shift to financial markets or intermediaries affects growth rates; and a body of research assessing the importance of financing constraints. Each of these areas of research is discussed in this section. 5.1 The empirical link between financial systems and economic growth The interaction between financial systems and real activity has been investigated empirically since at least Gurley and Shaw (1955), who conjecture that financial systems play an important role in improving the efficiency of intertemporal trade and economic growth. Their conclusion is based on an observed correlation between economic development and financial systems. That is, developed countries tend to have highly organised and broad financial systems to facilitate the flow of loanable funds between borrowers and lenders, while in developing countries the financial system is much less evolved. The empirical literature on the financial systems and economic growth nexus has expanded rapidly since Gurley and Shaw and the following conclusions seem to emerge.18 Countries with better developed financial systems tend to grow faster than countries with smaller banking systems and less liquid financial markets. Also, industries and firms that rely on external financing tend to grow faster in countries with well developed financial systems than countries with poorly functioning financial systems (Levine 2003). These results are based on estimations using different statistical procedures and data sets (cross country, panel data, firm and industry level and time series data). However, conclusions about the empirical link between finance and economic growth and the quantitative significance of financial development need to be drawn cautiously. This is because of two main problems with the estimations. First, financial development can not be directly measured and must be approximated. Second, the estimations are subject to a simultaneity bias, i.e. financial development and economic growth are likely to be simultaneously determined. Financial development affects economic growth and vice versa. The simultaneity bias can be overcome with the use of instrumental variables if appropriate instruments are available. Limited data on financial development unfortunately means that instruments are even more difficult to find.19 As a result, answering this question presently requires extrapolation from more specific quantitative research. The empirical link, at a country level, between economic growth and the degree to which countries’ financial systems are intermediary or market based is investigated in Levine (2002). Measuring financial structure is difficult and Levine uses a range of indicators for the size, activity and efficiency of various components of the financial system, including banks, securities markets and non-financial intermediaries. The cross-country 18 For a useful survey see Levine (1997). For a comprehensive analysis see Graff (2000). For a historical perspective on financial development and economic growth see also Rousseau (2003). 19 For an assessment of the direction of causality between financial development and economic growth see Calderon and Liu (2003). WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 13 comparisons do not reveal significant differences between the economic growth of countries with more market based or more intermediary based financial systems. The results show that specific laws and enforcement mechanisms that govern debt and equity transactions are more important in explaining economic growth than the indicators as to whether a system is intermediary or market based. This result is robust to different specifications. Levine’s (2002) data set comprises data series for 48 countries for the period 1980 to 1995 and includes New Zealand. According to Levine’s measures, financial intermediaries and markets are both important in New Zealand with a slight predominance of financial markets. The finding of a slightly greater importance of financial markets is somewhat surprising and in contrast with other evidence which suggests that New Zealand is a more intermediary based system. For, example, a recent report by the International Monetary Fund (IMF) on financial system stability in New Zealand noted that the non-bank financial sector accounts for only a quarter of financial system assets.20 Levine’s (2002) finding probably warrants further investigation. The question of access to finance is generally assessed at the firm level. The empirical work shows that access to finance for particular types of firm is constrained in some circumstances. Financing constraints seem to exist for some firms even in countries with highly developed financial systems like the United States. The propensity of smaller firms to cut work hours and production in response to cash flow constraints by more than larger firms, which are more likely to increase short-term borrowing, provides evidence that small firms are constrained in their ability to increase borrowing (Bernanke and Gertler 1995 and Gertler and Gilchrist 1994b). This view that firms’ access to external finance may be limited in some circumstances is supported by the existence of an economically significant non-bank lending sector providing finance for high risk firms unable to obtain bank credit (Denis and Mihov 2003). That younger firms more often resort to the use of expensive trade credit relative to more established firms has also been taken to demonstrate the existence of credit rationing by banks (Petersen and Rajan 1994). Finally, Faulkender and Peterson (2003) find that firms with access to public debt markets have significantly higher leverage ratios than firms without such access.21 Their finding can be interpreted as evidence of a financing constraint – firms without access to public debt markets are constrained as to the amount of external finance they can obtain. Each of these conclusions suggests the existence of credit limitations, often particularly for smaller or younger firms, consistent with an information asymmetry hypothesis. 5.2 Empirical evidence in the New Zealand context A key factor in firms’ decisions to undertake an investment project is the cost of finance relative to the rate of return for the investment project. Another factor is access to external financing when firms require additional funds to undertake an investment project. New Zealand research on the cost of capital, the rate of return to investment and access to financing has been limited, and has focused particularly on aggregate and survey data or case studies. Limited analysis has been conducted on the cost of finance below the 20 The report can be found at www.imf.org/external/pubs/ft/scr/2004/cr04126.pdf . 21 The differences do not seem to be explained by different firm characteristics. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 14 aggregate level as virtually no information is available at the firm or industry level, or on the effect of aggregate measures on particular instruments.22 Lally (2000) compares the real (inflation-adjusted) cost of capital in New Zealand, Australia and the United States. He finds that the New Zealand real government bond rate over the second half of the 1990s was comparable with Australia’s, but significantly higher than in the United States. The New Zealand term premium for equity capital is similar to that for government bonds. Lally’s findings are in line with the results in Hawkesby, Smith and Tether (2000), who find that over the 1990s the term premium in New Zealand’s interest rates versus interest rates in the United States was quite large but much smaller versus Australian rates. Using a panel of OECD countries, Plantier (2003) also finds a persistent although declining margin between real interest rates in New Zealand and the rest of the world. His results provide some support for the hypothesis that the cost of borrowing has been higher in New Zealand because of greater reliance on foreign borrowing. A study by Conway and Orr (2002) of interest rate differentials across a number of currencies suggests that the lower liquidity of the New Zealand dollar may also have been a contributing factor. These analyses use government bond rates, and focus on the potential cost of finance for larger firms, which may not be a good proxy for the cost of capital for a number of New Zealand firms.23 To date, no information is available on the proportion of firms that can actually borrow at this near risk free rate. Given the potential importance of bank lending in New Zealand, a useful first step may be to extend the analysis to incorporate the cost of bank borrowing, for which aggregate data are available. Limited information is available on the rate of return to investment (capital) in New Zealand. Aggregate data suggest that the rate of return to capital, measured by the share of gross operating surplus in value added, is high in New Zealand compared to other OECD countries (Claus and Li 2003).24 However, this measure of rate of return does not adjust for risk. The concept of economic value added (EVA) attempts to adjust for risk. It is an estimate of the amount by which earnings exceed (fall short of) the required minimum rate of return that lenders could achieve by investing in other securities of comparable risk.25 In 2000, the ANZ Bank undertook a study on the economic value added of firms listed on the New Zealand stock exchange (Healy 2000). The results show that economic value added has been negative for several New Zealand companies over the 1990s. Economic value added may be low if rates of return adjusted for risk are low or if firms’ cost of borrowing is high. Further research is probably required on the risk adjusted rate of return and cost of capital in New Zealand. The concept of economic value added presents a promising avenue for future work. The question of access to finance domestically has primarily been addressed through the use of business surveys. Available New Zealand evidence does not generally suggest that respondents believe there are problems with access to finance (Fabling and Grimes 2004 and Knuckey et al 2002). The literature reviewed in the previous section, which is based on quantitative studies conducted overseas, suggests that finance constraint issues are endemic and that certain types of firm are more likely to be affected. 22 See Fowlie (2003) for a more comprehensive review. 23 The analyses also do not take into account differing equilibrium real rates. As discussed in the previous section real rates of return may not be equalised across countries if there are information asymmetries and/or other distortions that impede perfect capital mobility. 24 See also Hall and Scobie (2004). 25 For a more detailed discussion of economic value added see Healy (2003). WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 15 Reconciling these streams of work depends to some extent on how one interprets the meaning of survey respondents’ answers and how one views potential issues associated with the use of survey evidence in this context. Without further quantitative work along the lines conducted overseas, we would hesitate to draw the conclusion that New Zealand’s experience is different.26 As a result, further New Zealand specific quantitative study would be valuable. A forthcoming survey of business finance conducted by Statistics New Zealand on behalf of the Ministry of Economic Development will provide valuable insights into firms’ access to finance and their use of different instruments. 6 Legal institutions and other policy influences 27 There are several areas where government policy affects financial systems. The remainder of the paper focuses on three: (i) the legal environment and other policy influences, (ii) taxation and (iii) financial regulation and supervision. This section discusses the importance of the legal environment and other policy influences. 6.1 Legal institutions and financial development The law and finance theory focuses on the role of legal institutions in explaining differences in financial development across countries. In particular, it addresses questions such as why some countries have well developed growth enhancing financial systems and others do not, and why some countries have well developed investor protection laws and contract enforcement mechanisms to support financial systems and others do not (Beck and Levine 2003). There are two main hypotheses of the law and finance theory with respect to the importance of legal institutions for financial development. First, the legal based view conjectures that countries have better developed financial intermediaries and markets, where legal systems enforce property rights, support private contractual arrangement and protect the legal rights of outside investors, than countries where these mechanisms are absent. The argument is that finance can be viewed as “a set of contracts” (Levine 2002) and the functioning of a country’s financial system will be determined by its contract, company, bankruptcy and securities laws and the enforcement of these codes and regulations. Also important are accounting and governance standards, and auditing practices (Wachtel 2001). The second hypothesis of the law and finance theory is that legal origin may influence financial development. In particular, there are two channels through which legal origin can affect financial systems: the political mechanism and the adaptability mechanism. The political channel concerns the power of the State while the adaptability channel focuses on differences in the ability of legal systems to evolve with changing conditions. 26 The existence of access to finance problems generally would not imply that a government policy to subsidise access to finance would be valuable. The information asymmetry framework suggests that providing funds to a borrower can change that borrower’s behaviour, perhaps negatively. As a result, attempts to overcome an ex ante information asymmetry by increasing a flow of funding, without reducing that information asymmetry has the potential to exacerbate an ex post information asymmetry (moral hazard) problem. While such a policy may get money into the hands of a constrained firm, it may increase the temptation to make risky investments or worse, to take the money and run. 27 The discussion in this section partly follows Beck and Levine (2003). WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 16 The political mechanism is based on two premises. First, legal systems differ in the emphasis they put on protecting the rights of private investors versus protecting the rights of the State. The second premise is that the fundamental basis for financial development is the protection of private property rights. The law and finance view conjectures that countries with Civil law will have weaker property rights protection and lower levels of financial development than countries with Common law. This is because Civil law tends to support the rights of the State, whereas Common law tends to support private property rights. The second mechanism that links a country’s legal origin with its financial development is the adaptability channel. This channel is built on the view that legal systems differ in their adaptability to adjust to changing circumstances. The implication for financial development is that if a country’s legal system adapts only slowly, then gaps can arise between the financial needs of an economy and the ability of the legal system to support those needs. Legal systems that use case law and judicial discretion tend to be more responsive to changing (financial) conditions than legal systems that follow rigid and formalistic procedures and rely on statutory law (Posner 1998). This is because statutory law is slow and costly to change and the absence of jurisprudence tends to hinder the efficiency with which laws adapt to changing conditions. New Zealand is generally regarded as a “settler colony”, i.e. immigrants settled in New Zealand and created institutions to support private property and limit the power of the State (Acemoglu, Johnson and Robinson 2001).28 The legal system is based on the British Common law. This system is thought to be more supportive to financial development than other legal traditions because of its emphasis on private property protection rather than protection of the rights of the State. Moreover, under the British Common law judges generally have broad interpretation powers and courts can modify and create laws as circumstances change. The British Common law also typically imposes less rigid and formalistic requirements throughout judicial processes. The British Common law system should therefore better be able to respond to changing needs. This adaptability and flexibility of the legal system may be of particular importance for the financial sector given the vast and rapid changes due to growing volumes of international financial transactions, the increased complexity of financial instruments and advances in information technology. Specific aspects of the legal environment also affect financial development and economic growth. They include measures such as banking regulation and investor protection, which typically interact with one another and reflect broader norms, values and institutional arrangements on the protection of private property and the operation of the free market. The role of financial regulation and supervision is discussed further in section 8. The effects of legal origin on financial development are investigated by Beck, Demirgüç- Kunt and Levine (2003). Using a cross-country analysis of a sample of up to 115 countries with French Civil, German Civil, Scandinavian Civil and British Common law origins, they find that the adaptability of the legal system matters because it allows the legal system to adjust efficiently to changing socio-economic conditions. The adaptability of the legal system helps explain cross-country differences in the development of financial intermediaries, the stock market and private property rights.29 A legal system that 28 At the other end of the spectrum are “extractive colonies”, where settlers did not create institutions to support private property rights, but to empower the elite to extract gold, silver, etc. Examples include Congo, Ivory Coast and much of Latin America (Beck and Levine 2003). 29 The estimation controls for the effects of political mechanisms. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 17 responds to the financial needs of the economy fosters financial development more effectively than a more rigid legal system. Maintaining solid legal foundations is important because the financial system relies on these. A comparison between New Zealand’s legal system and that of other like countries may provide a valuable benchmarking exercise. The legal indicators considered by Beck and Levine (2003) would be a useful starting point. 6.2 Other policy influences There are several other areas where government policy can impact on financial systems. Government policy can affect financial systems through the types of financial instrument it creates and stands in the market with. Examples include the government bond market, and policy choices over whether inflation indexed debt or longer maturity debt should be issued. Government bonds in New Zealand play an important role in the risk management operations of market participants. Yield curves provide a reference for pricing, and government bonds are regularly used by financial intermediaries and other market players for hedging purposes. “Having access to a liquid instrument for (hedging) purpose(s) is (particularly) important in New Zealand as the futures market has not developed as a viable hedging alternative” (Turner 2002).30 There are also various types of financial instrument (such as state-contingent securities and claims on national income) that it has been proposed a government could issue to improve the allocation of risk throughout the economy. Other policy choices about government financial instruments (such as their liquidity and the transparency with which they are traded) also affect the operation of financial systems. Crown guarantees and indemnities are another category of financial instrument that are used from time to time to facilitate the operation of financial systems. In New Zealand government policy also has a direct influence on governance arrangements for some financial institutions. This is because of the Crown’s ownership of and/or contributions to the New Zealand Superannuation Fund, the Accident Corporation Company (ACC), venture capital funds, the Export Credit Office and Kiwibank, for example. 7 New Zealand’s taxation of capital and the effect on the financial system This section discusses the effects of the New Zealand tax system on the financial system. It first reviews the taxation of capital gains and then outlines how New Zealand’s tax system, which classifies some capital gains as taxable income while exempting others, acts to distort the investment patterns toward direct investments in larger and less risky firms or toward passive indexing tracking funds. The information asymmetry framework is then used to assess the potential impact of these distortions on investment decisions and economic growth. 30 During the 1990s corporates and fund managers have increasingly used swaps as a risk management tool. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 18 7.1 Development of the current capital-revenue boundary in New Zealand tax policy New Zealand considers itself to be a country without a capital gains tax (CGT), with the common assumption being that gains from the sale of assets that have appreciated in value are not taxable. 31 In practice a significant amount of capital gain in New Zealand is classified as taxable income, and the difference between what gains are or even should be taxable is a contested issue. As a result, the question of whether to adopt a comprehensive capital gains tax is a beehive that is prodded every so often in New Zealand. In each instance, after the buzzing has died down, New Zealand has remained “CGT-free”. While a comprehensive capital gains tax may or may not be optimal tax policy (a separate issue with a substantial dedicated literature), a country without a capital gains tax does not escape the need to police the difficult boundary issue as to whether a particular sum received should be classified as income or capital (Oliver 2000). These boundary issues arise because of the substantial return to reclassifying income streams (taxed at marginal tax rates) as capital gains (untaxed). Indeed, New Zealand currently faces many of the challenges associated with capital gains taxes because of the practical operation of the capital-revenue boundary which polices against this type of reclassification. As a result, the debate on a capital gains tax has remained a staple of New Zealand tax policy.32 Underneath this unresolved debate remains an approach to taxing capital with serious deficiencies that are likely to affect the country’s growth potential. The boundary between capital and revenue is a core element of the New Zealand tax system.33 It seems straightforward to suggest that proceeds from the sale of capital items are generally untaxed, while sums obtained on the revenue side of the boundary are defined as income and so are typically taxed at full marginal rates. In practice the boundary generates widespread uncertainty.34 The history of New Zealand tax law related to capital gains may seem odd to some. While New Zealand’s income tax legislation provides inclusive guidance, it does not define the central term “income”. Judges, when faced with the question of what constitutes income, have borrowed concepts from trust law, which predates income tax law and is inherited by New Zealand’s historical connection with the United Kingdom. The purpose of these trust law concepts is to “differentiate the interests of the life tenant (entitled to income) from the interests of the remainderman (entitled to capital and so to the realisation of capital assets of the trust)” (Royal Commission on Social Policy 1988: 450). 31 Tax systems typically distinguish between income and capital gains. Capital gains, when they are not counted as income, are often taxed by an explicit capital gains tax, which is often set at a different rate than the tax on income. When capital gains are considered to be regular income, as is the case for some gains in New Zealand, then normal personal tax rates apply to those gains. 32 While there has not been recent high level advocacy of a capital gains tax, the 2001 McLeod Tax Review proposed a Risk-Free Return Method (RFRM) approach as one tool that may address some of the issues inherent in the definition and taxation of capital. The debate on this issue is beyond the scope of this paper (see Burman and White 2003 and The Treasury and Inland Revenue 2003). It is sufficient to say here that RFRM may improve or exacerbate issues associated with this boundary, as RFRM is a tool that can be implemented in a number of ways to differing effect. Many of these options will not represent an effective solution to the problems described in this paper, so careful consideration is advised. This paper provides some guidance on potential growth impacts of any reform of the current capital-revenue boundary. 33 This storied history even extends to the argument by some that one of the first significant revenue raising devices in New Zealand, a tax on land purchases from Maori from 1840-1859, was in fact “a capital gains tax in substance” (Hooper and Kearins 2002). 34 Sir Ivor Richardson has declared that drawing the boundary is “an intellectual minefield in which the principles are elusive and the analogies treacherous” CIR v Thomas Borthwick & Sons (Australasia) Ltd (1992) 14 NZTC 9,101. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 19 The jurisprudence which has evolved from these concepts has created a definition of income focusing on particular tests, such as whether a sum received is more in the character of a flow (income) or of a one-off payment (capital), and it is tied to analogies such as that of the tree (capital) and the fruit (income). These have been, and will continue to be useful tools to guide difficult judgements before the courts. With respect to the financial system however (for savers and those managing the funds of savers in particular), judicial and policy interpretations of the capital-revenue boundary have generated a substantial degree of uncertainty. The inability to clearly understand the outcome of transactions is likely to provide an additional hurdle to effective contracts. Attempts to generate definitive guidance for superannuation funds and others by reference to test cases have met with limited success.35 This situation is not particularly unique in the evolution of the capital-revenue boundary in New Zealand. A decision by the courts that a particular transaction represents capital means that it is untaxed in New Zealand, while similar decisions by courts overseas may simply determine what rate of tax should apply. Policy concerns have dictated that legislation at times clarify or shape this boundary where reliance on existing case law alone does not provide a satisfactory outcome. With respect to taxation of the financial system, the task is to determine what tax policy is attempting to achieve, what costs arise from the current approach and whether legislative change is the best remedy. An analysis of the current system’s workings and its underlying logic is a necessary first step. 7.2 Foundations and operation of the current capitalrevenue boundary The case law on the capital-revenue boundary has developed to assist decisions before the courts on a range of issues, the origin being a question of the ultimate ownership of the assets of a trust. On their own, the tests and analogies evolving from case law are not robust enough to in all cases definitively determine the approach by which a government should base its tax treatment of capital gains. Parsons (1986) expressed this notion best: “A principle of trust law that would direct that in the circumstances an item should be allocated to the remainderman, because this was the presumed intention of the creator of the trust, seems a strange basis for a conclusion that the item is not one in which the State should share through a tax.”36 Tax legislation based on the legal approach to the distinction between capital and income immediately faces a tension with the conception of comprehensive income held by economists, which includes changes in net wealth broadly defined.37 In practice, comprehensive income can not fully be taxed, with practical considerations requiring on balance decisions to be made to account for the imperfect real world in which tax systems operate. This is often the crux of the argument for supporters of a capital gains tax, who 35 For example, consider Alexander & Alexander Pension Plan v. CIR (1995) 19 TRNZ 884, reported also as Piers v. CIR, meant to function as a test case but which ultimately did not provide the certainty that the industry had hoped. 36 Note that while the capital-revenue boundary for tax purposes does not claim a grounding in economic theory on the income side, there is a better claim to economic substance on the expenditure side, where expenditure on revenue account is immediately deductible whereas expenditure on capital account must be deducted over time to reflect (and match) the economic benefit resulting from that expenditure. It can be argued that there is some degree of inconsistency in a tax system that allows depreciation but only imperfectly captures associated capital gains. 37 Comprehensive income is defined as the sum of the change in an individual’s net wealth and the value of consumption, (typically called Haig-Simons income). In theory changes in net wealth and consumption would include even such hard to value aspects such as changes in wealth from human capital and the total personal utility from consumption. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 26 There are several types of firm and reasons why firms, in particular circumstances, might choose to obtain equity investment via financial intermediaries. Small or fast growing firms may find that typically available debt contracts are not ideal due to volatilities in their cash flow that make servicing debt obligations a poor choice compared with other uses of retained earnings. Another reason that firms may seek equity through financial intermediaries is to obtain the expertise that investors often bring along with their investment capital. Firms may also wish to avoid debt at a certain stage of development in order to preserve their ability to access such finance at a later stage, perhaps to finance a future project where other types of finance might not be as forthcoming.46 The ability of firms to obtain equity finance from intermediaries may increase access to additional finance or lower their cost of finance in the future, providing an additional benefit to the information discovery provided by the equity financier. In addition to funding otherwise foregone projects, finance by financial intermediaries has value in providing efficient and effective monitoring (Denis and Mihov 2003). As a relationship deepens with a financial intermediary, and if that intermediary obtains positive information about a firm that is durable and not easily transferred (assuming scale economies in information production) then the cost of capital extended to that firm may decrease over time. This effect of relationship building has been shown in the case of bank lending relationships (Faulkender and Petersen 2003 and Petersen and Rajan 1994), and it may exist to some degree for firms developing relationships with other financial intermediaries. Evidence from overseas banks that participate in venture capital suggests that making an investment as a venture capitalist increases a bank’s likelihood of providing a loan to a firm (Hellman, Lindsey and Puri 2004).47 Firms’ ability to access external financing may be further enhanced if firms’ net worth and cash flow improve as a result. Cash flow and net worth (firms’ market value) are important signals for lenders who are attempting to assess agency costs and they are thus good predictors of the availability of finance to a firm (Bernanke, Gertler and Gilchrist 1999, Petersen and Rajan 1994 and Walsh 1998). Equity investment that improves these measures for a particular firm would affect well established mechanisms by which banks determine the credit risk associated with a firm. Essentially, private equity investment in a firm would act as a signal reducing information asymmetry associated with that firm, increasing the market value of the firm and thus strengthening the firm’s balance sheet. These measures flow back to the ability to obtain debt finance. This result in particular has potential significance in the presence of AIL, which results in low tax rates on debt investments to New Zealand from abroad. This type of investment represents much of the foreign capital imported into New Zealand through financial intermediaries. An enhancement in the discovery of information through private equity investment, if it improves the subsequent ability of banks to provide debt finance could provide reinforcing increases in access to capital and reductions in the cost borrowing. The tax distortion that affects intermediaries also has an impact on the functioning of financial markets. This is because investors in financial markets rely to some degree on other investors to discover information about firms and to perform the costly monitoring required to promote good governance of listed firms. New Zealand tax policy may undermine this function by biasing investors to hold direct investments for longer periods of time. A passive index tracking fund that deviates from that practice to act on information revealed may result in the taxation of the broader investments of the particular 46 Deviations from the pecking order hypothesis in such cases have been explained by the use of multi-period models such as in Viswanath (1993). 47 Note that the authors also caution against relying on banks for the development of a venture capital industry. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 27 investment fund in addition to investments directly affected by any information obtained. A bias against the use of intermediaries will increase the costs of acting on information obtained for a class of decision makers that is likely to uncover information about listed companies.48 As a result, there is likely to be a decrease in the check on firm governance provided by financial markets and a decrease in the confidence regarding firms on those markets. 8 The role of financial regulation and supervision Policy influences the operation of financial systems through financial regulation and supervision. This section discusses the main sources of financial instability. It reviews the role of financial regulation and supervision and briefly examines the regulatory and supervisory approach in New Zealand. 8.1 Financial instability 49 The need for regulation and supervision of the financial system arises because financial intermediaries and markets, like firms, are subject to asymmetric information. A key objective for financial regulation and supervision is to increase the effective functioning of the financial system in order to enhance the ability to absorb shocks and maintain financial stability. Financial instability occurs when shocks to the financial system interfere with the payment system and impact on the ability for normal business and trade to occur. It may be caused by the collapse of a systematically important financial intermediary or other shocks. Any disruption in the financial system can potentially have severe real economic effects.50 During the Asian crisis in the second half of the 1990s, for example, the disruption in the supply of credit was a major factor in the recessions experienced by the affected countries. An economic downturn may be exacerbated by falling prices (Fisher 1933). Given that (most) debt contracts are written in nominal terms, a fall in prices increases real debt burdens and reduces firms’ ability to borrow, adding further to the decline in economic activity. The problem of falling prices is particularly acute for debt contracts of fairly long duration.51 There are four main factors that can initiate financial instability: (i) increases in interest rates, (ii) increases in uncertainty, (iii) negative shocks to firms’ balance sheets, and (iv) a deterioration in financial intermediaries’ balance sheets (Mishkin 1997). Increases in interest rates In some circumstances increases in interest rates can potentially lead to large declines in lending or even a collapse in the loan market if some form of credit rationing occurs as a result. Credit rationing can occur because changes in interest rates worsen the adverse selection and moral hazard problems of imperfect information (Stiglitz and Weiss 1981). The adverse selection effect of interest rates is a consequence of different borrowers 48 Recall that financial markets provide an incentive to uncover information about listed firms because of the liquidity of the securities such firms offer. Intermediaries commonly use traded securities to provide such liquidity to their clients. 49 Sections 8.1 and 8.2 partly draw on Mishkin (1997). 50 The role of government in preventing or mitigating the worst effects of a financial collapse has been a dominating theme in Minsky’s published writings. See, for example, Minsky (1975 and 1986). 51 Generally, debt contracts are of fairly long duration in countries where inflation has been moderate (Mishkin 1997). WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 28 having different probabilities of repaying their loans. The interest rate an individual is willing to pay may act as a screening device. Those who are willing to pay high interest rates may, on average, be worse risks. They are willing to borrow at high interest rates because they perceive their probability of repaying the loan to be low. As a result there exists an interest rate that maximises financial intermediaries’ expected return and beyond which they will be unwilling to supply funds, making the supply of loans curve bend backwards and downward sloping (see Figure 2). A change in interest rates can also affect financial intermediaries’ expected return from loans through the moral hazard effect by changing the behaviour of borrowers. Higher interest rates induce firms to undertake projects with lower probabilities of success but higher payoffs when successful. Increasing the rate of interest raises the relative attractiveness of riskier projects, for which the return to the bank may be lower because of increased default risk.52 As the interest rate rises, the average riskiness of those who borrow increases and the moral hazard effect reinforces the adverse selection problem. Financial intermediaries and markets therefore have an incentive, in some circumstances, to ration credit. Increases in uncertainty The functioning of financial systems may be affected by substantial increases in uncertainty, due to, for example, the failure of a large financial or non-financial institution, a severe recession, political instability or a stock market crash. Increased uncertainty reduces the ability of financial systems to screen borrowers and may result in credit rationing. Negative shocks to firms’ balance sheets Information asymmetries and the inability of lenders to monitor borrowers costlessly lead to agency costs, creating a wedge between the costs of internal and external financing for a firm. Firms’ market value (or net worth) is an important determinant of agency costs and hence the cost and availability of finance. Adverse shocks to firms’ balance sheets and net worth due to natural disaster or a stock market crash, for example, affect their ability to borrow and can have severe real economic effects.53 This is because shocks that lower the market value of firms reduce the value of assets that firms can use as collateral. As a result, financial intermediaries and markets may be less willing to lend to firms because the reduction in collateral increases their potential losses from adverse selection: owners will have a lower equity stake in their firms, which gives them more incentive to engage in risky investment projects. The decline in collateral may lead to loans not being extended upon maturity or being recalled, i.e. to forms of credit rationing. A deterioration in financial intermediaries’ balance sheets Adverse shocks to financial intermediaries’ balance sheets may affect their willingness to lend. A deterioration in financial intermediaries’ balance sheets may be caused, for example, by an increase in interest rates, a stock market crash or an unanticipated decline in inflation. Weak bank balance sheets may also be the result of inadequate financial regulation and/or supervision. Adverse shocks to financial intermediaries’ balance sheets can have severe economic real effects if the financial institution affected is systemically important either directly or indirectly. A deterioration in financial intermediaries’ value of equity can affect lending. If banks, for example, are required by regulators or depositors to retain some minimum capital ratio (defined as the value of 52 Higher interest rates may also increase the default risk of existing loans. 53 Negative shocks to firms’ balance sheets would need to both be significant and widespread to bring down a financial system. A sever recession could be another factor that could cause this. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 29 banks’ equity as a percent of the value of loans outstanding), they will have to either reduce their supply of loanable funds or raise new equity. However, because it takes time to raise equity and also because the cost of new capital has increased due to a lower market value of banks, the typical initial response is a contraction in lending. Financial regulation and supervision (discussed next) can help increase the effective functioning of the financial system and maintain financial stability. Other factors that are important contributors are a flexible exchange rate regime and a low inflation environment. A sharp depreciation in the exchange rate, for example, may be an early warning to policy makers that their policies may need to be adjusted. Price stability is important because it means that a central bank/government can more credibly take action if required. Sustained low and stable inflation and credible commitment to price stability mean that a central can ease monetary policy or engage in lender of last resort activities (discussed further below) to prevent a financial crisis or promote recovery from it without leading to rapid rises in expected inflation (Mishkin 1997). 8.2 Financial regulation and supervision Financial instability is caused by asymmetric information and disrupts the efficient functioning of the financial system during periods of distress. Minimising information asymmetry and hence lowering the risk of financial instability is important and requires the production of information through screening and monitoring. Governments can encourage information production by imposing regulations on the financial system. For example, governments typically require financial institutions or firms issuing securities to adhere to standard accounting principles and disclose a wide range of information about their balance sheets. Moreover, governments impose strict penalties for fraud such as hiding information or stealing profits. Disclosure requirements increase the amount of information available. However, they do not overcome the public good problem of information, leading to socially sub-optimal monitoring and screening of financial intermediaries by the individuals, who provide them with funds. As a result, governments impose further restrictions on the asset holdings of financial intermediaries or capital requirements, for example, to prevent them from taking too much risk. Demirgüç-Kunt, Laeven and Levine (2003) examine the impact of banking regulations on net interest margins and overhead costs across 72 countries. They find that tighter regulations increase the cost of financial intermediation and do not create countervailing benefits. However, bank regulation must be seen as part of the overall institutional framework, as its effects become insignificant when broader institutional factors such as property rights protection and economic freedom are taken into account. A second role generally of governments is to provide a safety net. Providing a safety net is important for the banking sector for three main reasons. First, banks are important because they hold and issue a large amount of demand deposits and private loans. Second, banks often provide credit to borrowers who would not otherwise be able to obtain external funding. Third, banks may be subject to contagion, or the risk of spill-over of the effects of shocks from one or more banks to other financial intermediaries or markets, due to interbank exposure.54 54 The problem of contagion is somewhat reduced with real time gross settlement. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 30 As Diamond and Dybvig (1983) show banks are vulnerable to bank runs. Bank runs occur when depositors panic and withdraw their deposits immediately, including even those who would prefer to leave their deposits in the bank if they were not concerned about the bank failing. Bank runs cause real economic problems because even “healthy” banks can fail, leading to a recall of loans and the termination of productive investment. In Diamond and Dybvig’s (1983) model, when normal volumes of withdrawals are known and not stochastic, suspension of convertibility of deposits allows banks to prevent bank runs and provide optimal risk sharing. In the more general case (with stochastic withdrawals), deposit insurance can rule out runs without reducing the ability of banks to transform assets. A central bank as a lender of last resort can provide a service similar to deposit insurance under the assumption that banks can not select the risk of their loan portfolios. However, when there is a trade-off between optimal risk and proper incentives for portfolio choice, the lender of last resort may not be as effective as deposit insurance. This is because if the lender of last resort were always required to bail out banks with liquidity problems, there would be perverse incentives for banks to take on risk. Deposit insurance on the other hand is a binding commitment that, in theory, can be structured to retain punishment in the case of bank runs. However, implementing deposit insurance in practice can be difficult (see, for example, Demirgüç-Kunt and Kane 2002) because it may encourage risk taking by financial institutions and by those who hold funds in them.55 Safety nets are important in reducing the real effects of financial instability. However, a serious problem arises from moral hazard when depositors expect that they will not suffer losses if a bank fails and are less likely to withdraw their deposits when they suspect that a bank is taking on too much risk. As a result, central banks as lenders of last resort often engage in “constructive ambiguity”; that is, “central banks reserve the right to intervene to preserve stability but give no assurances, explicit or implicit, to individual institutions” (Crockett 1997). Financial supervision ensures compliance with government regulations. The most supervised institutions are banks. Banking supervision generally consists of regular bank examinations to monitor banks’ compliance with capital requirements and restrictions on asset holdings. Moreover, bank examiners try to assess whether banks maintain proper management controls. One difficulty of regulation and supervision is that it creates a principal-agent problem; that is, the agent (politician or regulator) may not have the same incentives to minimise the costs to the economy as the principal (the taxpayer). To act in taxpayers’ interests, regulators must impose restrictions. But because of the principal-agent problem they have an incentive to engage in regulatory forbearance. 8.3 Financial regulation and supervision in New Zealand 56 New Zealand’s financial system is dominated by foreign-owned banks, with the four systemically-important banks Australian-owned. Non-bank financial institutions are not systemically important and allowed to compete with banks in all areas of business. New Zealand’s regulatory system in the non-bank area is based on a disclosure regime, and disclosure plays an important role in the regulation and supervision of banks as well. 55 For the latest Reserve Bank of New Zealand comments on the topic see http://www.rbnz.govt.nz/banking/regulation/0154814.html. 56 For an overview of the financial regulation and supervision in New Zealand see http://www.rbnz.govt.nz/banking/Regulation/index.html and http://www.rbnz.govt.nz/banking/supervision/index.html. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 31 Outside of banking, authorities mainly rely on requirements to disclose financial and prudential information and less emphasis is put on merit regulation. Merit regulation involves the authorities applying, monitoring and enforcing prudential standards. Merit regulation includes a gate-keeper role, where the gate-keeper enforces standards to be met in order to obtain and keep a licence to operate in the financial system.57 The preference for a disclosure based regime for the non-bank parts of the system in New Zealand over merit regulation reflects a view that with a disclosure based regime well-informed markets can develop their own solutions to many of the problems caused by asymmetric information and that more direct merit regulation can undermine those market solutions. The core, non-bank regulatory regime is provided by the Securities Act 1978 and accompanying Securities Regulations 1983 and the Securities Markets Act 1988. Both acts are administered by the Securities Commission. The Securities Act is a disclosure based regime and applies to all classes of entity raising funds from the public, except for registered banks, and irrespective of the form of the instrument (deposits, debt, equity, syndicate participations, etc). The Securities Markets Act provides for ongoing disclosure by public entities, disclosure by directors and officers and people with substantial security holdings, the regulation of securities exchanges and insider trading. Oversight of much of the non-bank sector and securities markets is undertaken by the Securities Commission, the Registrar of Companies, the Government Actuary and Insurance Savings Unit and the National Enforcement Unit. To strengthen the regulatory framework in order to encourage investment and enhance the performance of the New Zealand market, a programme of reform has been in progress since 2000. The programme has resulted in the introduction of the Takeovers Code and the passing of the Securities Markets and Institutions Bill. The Securities Trading Law Reform Bill, which implements a new insider trading and market manipulation regime, provides for greater general enforcement and oversight of securities trading law by the Securities Commission and enhanced disclosure. Greater enforcement by the Securities Commission of investment adviser disclosure law will be introduced by the end of the year and a review of the Securities Act 1978 will be commenced later next year. A specialised regime applies to financial institutions that represent themselves as “banks”.58 It is administered by the Reserve Bank of New Zealand and is merit based, albeit with a heavy reliance on disclosure. Moreover, it is supplemented by active home country supervision of New Zealand’s largest banks. To maintain the soundness of the financial system the central bank may also act as a lender of last resort and engages in failure management of financial institutions. New Zealand’s approach to regulation and supervision has been effective in promoting financial stability over the past decade, at a time of significant financial turmoil in other countries (e.g. the Asian financial crisis, the Russian government’s default on its debt and the failure of a major hedge fund). The general soundness of New Zealand’s financial system has been confirmed in the IMF’s recent assessment of financial system stability. However, the IMF report does recommend improvements in some areas of bank and nonbank supervision and securities market regulation, which are currently being considered. 57 Financial regulation is supplemented by self regulation and reporting and internal management incentives. See http://www.med.govt.nz/buslt/bus_pol/bus_law/corporate-governance/financial-reporting/partone/index.html for a review of the Financial Reporting Act that is currently being undertaken by the Ministry of Economic Development. 58 Technically, it is institutions that wish to include the word bank in their name or voluntarily choose to be covered by this regime instead of the Securities Act regime. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 32 9 Concluding remarks This paper developed an analytical framework for discussing the link between financial systems and economic growth. The first part of the paper reviewed the role of financial systems, their importance for economic growth and the cost of external finance. The second part focused on areas where policy affects financial systems: the legal environment and other policy influences, taxation and finally, financial regulation and supervision. Existing theory suggests a clear link between financial systems and economic growth. Financial intermediaries and markets can help overcome an information asymmetry in credit markets. They reduce information and transaction costs and improve the allocation of resources, leading to increased capital accumulation and faster economic growth. Empirical evidence suggests that information asymmetries are important and affect firms’ access to finance and their cost of borrowing. Removing regulatory or tax distortions that prevent/lower the production and discovery of information will lead to increased investment and output. The magnitude of these effects is uncertain but possibly significant. The economic benefit could be substantial if resolving existing distortions would increase firms’ ability to borrow in future. Moreover, additional investment may lead to technological innovation. The existence of information asymmetry has implications for policy. Policy makers should be aware that different types of financial intermediary are likely to be providing finance to different classifications of firm or different sectors of the economy. This means that distortions arising from policy which create biases against the use of certain segments of the financial system can have impacts that are concentrated amongst particular types of firm. This paper demonstrated one way in which present tax policy may have such an impact. Given the importance of financial development for economic growth a resolution of the tax distortions should be a priority.59 When considering issues of cost or access to finance, policy makers should be aware that the existence of finance constraints for some firms may represent the optimal response by financial markets and intermediaries to information asymmetries. Policy that affects the production of information, the effective monitoring of firms, the enforcement of contracts, or institutions that carry out these functions can often have a more pronounced effect for firms than actions aimed at high level measures of capital availability. Because receiving finance can change the behaviour of the borrowing firm and because there is a moral hazard risk from extending funds when information asymmetry issues have not been resolved, increasing the flow of funds to some firms in response to apparent finance constraints can do more harm than good. Encouraging the production of information or removing impediments to effective firm monitoring in such cases would more closely address the cause of finance constraint for many firms. The financial environment is one of growing global integration, rapid changes in financial practice and increasing complexity of financial contracts. A better understanding of the financial instruments available to New Zealand firms would assist our assessment of the cost and access to finance and the impact of New Zealand’s financial system on economic growth. 59 A review of the taxation of investment has been announced, with a report on a consultation process chaired by Craig Stobo due in October 2004. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 33 Finally, a comprehensive assessment and evaluation of the recommendations in the IMF’s report should be of high importance. A number of reviews are currently being undertaken in relation to the financial system. Within the context of these reviews it will be important to consider the IMF’s recommendations, ensure that the regulatory regime has the flexibility to meet the financial needs of the New Zealand economy and that any changes to the financial system are considered within developed frameworks on how they can impact on economic growth. 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Gertler, Mark and Simon Gilchrist (1994a) "Monetary policy, business cycles, and the behavior of small manufacturing firms." Quarterly Journal of Economics 109(2): 309-340. Gertler, Mark and Simon Gilchrist (1994b) "Monetary policy, business cycles, and the behavior of small manufacturing firms." Quarterly Journal of Economics 109(3): 309-340. Graff, Michael (2000) Finanzielle Entwicklung and reales Wirtschaftswachstum. (Tübingen: Mohr Siebeck Verlag). Gurley, John G and Edward S Shaw (1955) "Financial aspects of economic development." American Economic Review 45(4): 515-538. Hall, Julia and Grant M Scobie (2004) "The concept and measurement of capital shallowness: An initial analysis." Wellington, New Zealand Treasury, mimeo. WP04/17 FINANCIAL SYSTEMS AND ECONOMIC GROWTH: AN EVALUATION FRAMEWORK FOR POLICY 42 serves to limit certain types of abuses of the tax base, and so any move to change in this era would have to evaluate potential impacts on the tax base. Figure A1 – Consumer and producer surplus With respect to non-controlled share purchases by savers through a financial intermediary, net fee for service may be the appropriate tax base for that transaction. It does not follow that the appropriate tax base is the same for investments made by financial intermediaries for the benefit of themselves, their owners or their shareholders. With regard to these transactions, where the intermediary is conducting services on their own behalf the current taxation of capital gains appears to be appropriate in those cases. This framework considers the appropriate tax treatment of investment income obtained by an intermediary for the benefit of a saver. The financial system includes a broad range of transactions and tax issues. As a result, this is a brief overview of an area where further work is recommended rather than a detailed policy proposal. Several initial questions of detail are raised by this alternative approach, just as a number of detailed questions remain unresolved about the current tax system in this area. If it is determined that the capital-revenue boundary is an issue worthy of policy attention, this brief outline provides one starting point for a reform process. One benefit of taxing capital gains and distributions of intermediaries as companies is that it restricts their incentives to participate in certain attempts to circumvent the capitalrevenue boundary through lease inducement payments, capital contribution payments, and the like. Any such gains would be clawed back at present when they were passed back to savers as dividends. Any policy movement along the lines suggested in this paper would require that the objective of economic growth be balanced against any potential base maintenance concerns. An important consideration as to whether a change in the basis of taxation for financial intermediaries would be worthwhile is the level of economic cost associated with the current tax regime. The information asymmetry framework used in this paper suggests those costs may be substantial. Demand Supply-Post Tax Pre Tax Market Price Quantity a b Price a = Consumer Surplus b = Producer Sur p lus Tax Price Increase Supply-Pre Tax