6  Legal institutions and other policy influences

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.

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 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.