The Role of Government in Financial Systems

In the previous articles, we have already established that the financial system of any country is the key to its economic prosperity. It is for this reason that these financial systems need to be appropriately maintained.

The government is the party that is most suited to this maintenance of financial systems. However, too much government intervention is not desirable since it interferes with the laissez-faire policy, which is important for financial markets.

Therefore, the government has a challenging role. It is supposed to ensure the proper functioning of the financial systems. However, it is supposed to do so without direct intervention.

In this article, we have enumerated some of the steps which governments take in order to indirectly influence the financial system and create a positive environment of growth in the economy.

Interest Rates and Loanable Funds: The central bank, which is a quasi-government body, decides the level of interest rates in an economy. The interest rate is a very important number for the economy. This is because the interest rate decides the time preference of people.

If the interest rate is high enough, people will postpone their consumption for a future date. However, if the interest rate is low, people will consume immediately, and the savings rate will reduce.

Hence, interest rates have a direct impact on the amount of loanable funds in the economy. These loanable funds, on the other hand, have a direct impact on capital formation and the entire economic process.

Reserve Requirements: Apart from interest rates, the central bank of any country can also alter the supply of loanable funds by altering the reserve requirements. The modern banking system is based on the concept of fractional reserve banking.

This means that modern banks need to keep a fraction of their reserve with the central bank before they lend out the rest of the money. Hence, if the proportion of funds which they need to keep with the central bank increases, the amount of loanable funds decreases correspondingly, the government can increase or decrease the reserve requirement in order to regulate the money supply.

Minting of Money: The government is the only agency which is authorized to create money supply in a country. Therefore, it is the responsibility of the government to ensure that excess money is not printed and flooded in the market.

Financial systems tend to fail if there is excessive inflation in the economy. Countries like Zimbabwe provide good examples to study this fact.

Fiscal Policy: The government can also regulate the functioning of the financial system with its fiscal policy.

Normally, countries where governments spend most of the money, do not have well developed financial systems. This is because there is already infrastructure in place to sell government-backed securities.

However, if capital does not flow into private hands via the equity market and bank loans, other channels of financing remain underdeveloped. Also, if the government starts undertaking the bulk of viable projects, then the financing channels for the private sector do not grow as fast as they should. The government must ensure that a balance is struck between the public sector and private sector funding.

Transaction Costs and Taxes: Governments can severely impact the functioning of credit markets if they start levying excessively high transaction costs. A transaction cost creates friction in the financial market. They deter investors from trading more often.

Hence, it is the job of the government not to treat financial markets as a source of revenue. The taxes and charges imposed on the financial markets should be minimal as a turnaround in the financial markets means that there is more liquidity in the financial system. Liquidity is a desirable quality since it promotes investments and increases economic growth as well as prosperity.

Deposit Insurance: The government also has the responsibility to stabilize the banking system. Usually, this is done by providing deposit insurance.

Governments all over the world guarantee the safety of depositor funds up to a certain amount. This is a very important function since, without this function, the funds which are deposited with banks would reduce drastically. As a result, the flow of funds from the idle to the industrious would be impacted.

Regulatory Role: Last but not least, it is the job of the government to ensure that each type of financial institution has its own regulator. This regulator must prevent malpractices.

Malpractices can be practices that jeopardize the safety of investor funds. Alternatively, they can be practices that suppress competition in the sector. Fortunately, frameworks that define the role of regulators are already well developed in most nations. The present task of governments is just to keep pace with the technology, which in itself is quite challenging.

It would be fair to say that the government is directly in charge of the growth of the financial system. The above-mentioned steps are just an indication of how much depends upon the actions of the government. This is also the reason why sometimes a change in government has an immediate and negative effect on the functioning of the entire financial system.

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