Financial markets play an important role in the efficiency and growth of the economy. They mobilise savings but also pool capital, select projects, monitor and enforce contracts, and manage risks. Obtaining, processing and managing information is fundamental to well-functioning financial markets. This means that market failures are – arguably – more likely in financial markets than for many other goods and services.
Governments have always played a role in financial markets. Most obviously, the state steps in during financial crises – such as the 2007 Crash, when governments around the world intervened to prevent bank collapses and stimulate the supply of credit. In recent years governments have also used financial tools – such as loans and tax breaks – to stimulate growth in high-value sectors of the economy.
Market failures provide the rationale for government intervention in business finance markets. While many businesses can obtain the finance they need, there are a number of structural market failures affecting the supply of both debt and equity finance to certain businesses such as start-ups, micro enterprises and Small and Medium Sized Enterprises (SMEs). This leads to some potentially viable businesses being refused finance, which may be sub-optimal for economic growth.
These market failures mainly relate to imperfect or asymmetric information. When future profitability is hard to predict it may be difficult to distinguish between good and bad prospects. Those firms most keen to borrow may be least likely to pay back. Even highly informed lenders such as venture capital firms find that only about 6% of investments pay off more than five times their initial stake. High street lenders, who operate across a much broader pool of clients, typically respond to these challenges by ‘profiling’ borrowers into blocks, then adjusting the cost of borrowing and/or restricting supply.
In economists’ jargon, this makes markets ‘incomplete’ – lenders respond to uncertainty and risk by reducing the supply of finance below what the market demands. For these reasons there is often limited competition in the market: ‘riskier’ borrowers may find that only a few lenders will actually do business with them. These information failures may also become exacerbated in uncertain economic conditions (such as recessions) when lenders become more risk adverse and there is greater uncertainty.
In addition, there are information market failures affecting the demand side for businesses seeking finance. Some entrepreneurs and businesses may not fully understand the potential benefits to their business of raising finance or their likely chance of success in gaining finance, which ultimately means they do not apply. This may restrict the growth of businesses. Business owners can also lack knowledge of funding sources available or lack the skills to present themselves as strong opportunities to investors.
Financial markets also typically disregard social returns. Banks and other lenders fund projects with the highest private returns. But society may benefit from other projects being funded. For example, investing in early stage innovative businesses can lead to a number of positive spill-over effects – through innovation and knowledge transfers – to other parts of the economy. Private investors do not take this into account when making a decision to invest, meaning they may not fund such firms at all.
In recessions wider factors also apply: sustaining firms’ viability and preventing job losses is important for preventing negative spillovers across the economy. In some countries (and cities) there may also be a shortage of private sector specialist finance such as angel investors or venture capital firms.
In theory, then, there are public interventions in financial markets that can make everyone better off. Through legal powers and scale, governments can compel the disclosure of information, pool risk and handle externalities (for example, acting as a public venture capitalist). At a basic level, government can:
- Provide information
- Provide incentives to lenders (e.g. tax breaks)
- Indirectly provide finance (e.g. loan guarantees, or ‘funding for lending’ type schemes)
- Directly provide finance (e.g. loans).