FinRiskAlert

Developed and deep capital markets can play a key role in financing economic growth as well as influencing financial stability and the transmission of monetary policy. As economies develop and investment projects become larger and more complex, efficient resource allocation and risk-sharing are facilitated by the information aggregation activity and variety of financial claims provided by capital markets. Moreover, capital markets have played an important role in financing the recovery from the Great Financial Crisis (GFC), a reminder of their “spare tyre” role in the financial system.

Consistent with the mandate of the Committee on the Global Financial System to further the understanding of financial markets’ underpinnings and promote improvements to their functioning and stability, this report assesses recent trends in capital market development and identifies both key drivers in the enabling environment and other factors more specific to capital market functions. It concludes by providing policy recommendations that aim to enhance the effectiveness of capital markets in serving the real economy. The breadth of the recommendations reflects the broader role of central banks in promoting capital market development in addition to their direct regulatory responsibilities.

There still remain significant differences in the size of capital markets across economies. Indicatively, the largest equity, government bond and corporate bond markets relative to GDP in advanced economies (AEs) are approximately twice the size of those at the 75th percentile, which in turn are twice the size of those at the 25th percentile. A similar pattern holds across markets in emerging market economies (EMEs).

Fixed income markets have seen strong growth over the past two decades, bringing current amounts outstanding closer to equity market capitalisation. In terms of market functioning, market participants report the least concerns about government securities markets and the greatest concerns about markets for corporate bonds, with equities somewhere in between.

EME capital markets are catching up, but a gap relative to AE markets remains. In EME government securities markets, the instrument mix and liquidity have improved. At the same time, EME corporate securities markets have experienced a broad deepening. However, they remain on average smaller than those in AEs and their growth has been somewhat flattered by issuances from state-owned firms and companies with large insider holdings. Moreover, EME corporates still have less access to longer-maturity, local currency debt securities; and compared with AEs, fewer small firms access EME equity markets. Overall, EME markets still appear less resilient to volatility than AE markets.

This diversity in capital market development across AEs and EMEs and capital markets’ evolution over time is explained by a number of factors. Underlying much of the heterogeneity in capital market development are differences in the strength of the enabling environment. An environment of low and stable inflation and sustainable fiscal management contributes to lowering the costs of capital market finance for both public and private sector issuers. Market autonomy to determine allocations, free from repressive policies such as excessive requirements to hold government securities or paternalistic management of stock prices through initial public offering (IPO) quotas, facilitates information creation and investor base diversity.

A supportive legal environment ensures the efficient and fair enforcement of arm’s length financial contracts and transactions, while efficient and predictable insolvency regimes provide greater assurance about the recovery value of distressed assets. Finally, independent regulators with well defined objectives, adequate resources and credible enforcement powers are better able to protect investors, lower issuance costs and ensure that capital markets are fair, effective and transparent.

Beyond the enabling environment, there are other drivers which are more closely linked to capital market-specific functions. High quality and timely information is the lifeblood of effective and viable capital markets. Thus, the provision of high-quality information at low cost through well developed disclosure regimes gives investors the means to value securities. A broad and diversified investor base provides a source of stable demand that supports liquidity, depth and stability. Greater bi-directional openness to international investors and issuers expands the pool of savings and investment products as well as promoting implementation of international best practices and standards.

But openness may also increase the sensitivity of domestic capital markets to global spillovers. Deeper complementary markets such as those for derivative, repo and securities lending spur liquidity and broader participation by facilitating the hedging and funding of capital market positions. Finally, robust and efficient market infrastructures with fair and open access boost liquidity by making it safer and cheaper to trade, hold and value capital market securities.

The report concludes with six broad policy recommendations. The relevance of these policy takeaways varies by economy, and some of them fall outside direct central bank control. Nevertheless, they impact the vibrancy of capital markets and central banks’ ability to meet their objectives. The broad range of drivers identified also suggests that comprehensive initiatives that take into account the range of dimensions identified are likely to prove more successful in developing viable capital markets.

First, greater market autonomy would enhance capital market pricing and funding allocations. In particular, policymakers need to address vestiges of financially repressive policies and fix market failures. These include policies that create preferential financing terms for the public sector as well as paternalistic policies that override private allocations. In many cases, repressive measures exacerbate market volatility by reducing investor diversity and suppressing securities issuance.

Second, capital market development can be placed on firmer foundations by strengthening legal and judicial systems for investor protection. Policies that ease access to legal recourse lower the cost of private contract enforcement and sanctioning breaches of duty. In addition, raising the efficiency, consistency and fairness of legal proceedings, eg through the creation of specialised financial courts, could usefully boost investor protection, as would policies that raise the predictability and efficiency of insolvency procedures.

Third, enhancing regulatory independence and effectiveness is a key factor in striking a balance between investor protection and issuer costs. Clear and well focused objectives and strong governance frameworks for regulators strengthen operational autonomy, thereby protecting against unwarranted influence. Enhancing investigative powers as well as ensuring the adequacy of resources would facilitate effective enforcement of regulations and timely diagnosis of market failures and vulnerabilities. Regulators can also strengthen investor protection by raising accounting and disclosure standards, and promoting best practices in corporate governance. In addition, authorities can supplement regulatory efforts by encouraging the private sector to develop standards and codes that may help market practices keep pace with evolving market innovations.

Fourth, many economies have scope to increase the depth and diversity of the domestic institutional investor base. Policies to promote greater penetration on the part of institutional investors such as pension funds and insurance companies can dampen volatility as well as create a domestic constituency that raises corporate governance standards and the broader efficiency of capital markets. Achieving greater financialisation of household savings by facilitating cost-effective, transparent and well regulated collective investment products and fostering greater financial literacy would further boost capital market development.

Fifth, a broad and bi-directional opening of capital markets can exert a general positive influence on domestic capital market development. But to reap the benefits, policymakers need to actively engage with potential market entrants and prepare for spillover risks. Calibrating the pace and sequencing of opening and creating macro policy buffers can help contain the associated risks and provide margins for coping with volatility.

Finally, enhancing market ecosystems by developing deep complementary markets for derivative, repo and securities lending requires a coordinated effort along multiple dimensions. These include a supportive legal and regulatory environment, regulatory coordination to broaden the investor base in these markets, and robust and efficient market infrastructures such as central counterparties and trade repositories to manage potential financial stability risks.