GOVERNMENT AND FINANCIAL MARKET

SUBMITTED TO

Bishal Poudel

Lecturer

Boston International College

Submitted by:

Bipana Thapa

January, 2019
 Every week, homes across the nation receive advertising fliers from local businesses advising of
weekly specials. Both customer and seller benefit from the price-reduced items. For the customer,
it’s time to stock up, while the business gains important feedback from the market about actual
demand for certain goods. That feedback reduces waste and allows the business to provide enough
products to meet market demand. It results in store shelves being sufficiently stocked while
minimizing an excess of perishable goods in the stockrooms.

The financial market is a broad term describing any marketplace where trading of securities
including equities, bonds, currencies and derivatives occur. Basically, consumers spend more
during bull markets because they feel wealthier when they see their portfolios rise in value. During
bear markets, they pull back on spending, fearing the loss of wealth and purchasing power as the
value of their investment’s contracts. A rising stock market signals investor confidence, as buying
activity pushes up prices. When stocks rise, people invested in the equity markets gain wealth.
Increased wealth often leads to increased spending, as consumers buy more goods and services
when they're confident they are in a financial position to do so. When consumers buy more,
businesses that sell those goods and services benefit in the form of increased revenues. Stock
market losses cause wealth erosion. A consumer who sees his portfolio drop in value is likely to
spend less. This reduction in spending negatively affects businesses – particularly ones that sell
non-necessity goods and services, such as luxury cars and entertainment, that customers can live
without when money is tight.

The first primary undertaking regarding the role of the government in the financial markets
concerns the degree of oversight. The government must both regulate the financial markets
initially, as well as intervene in the markets when need be. The goal is perfect regulation, resulting
in the need for little or no intervention. One must assume, however, that human nature will suggest
that there will never be perfect regulation, and thus some intervention will likely always be
necessary in order to respond to emotional actions. By recognising this failing of human emotion,
strict regulatory controls over money can be instituted with some ease, resulting in scant need to
unduly intervene in the financial markets with knee-jerk pastiche reactions.

GLOBAL financial markets are currently perceived to be in crisis. Debate over regulatory reform
in the financial sector has, consequently, assumed national prominence. Institutionalists have
traditionally argued for government intervention when the market fails to produce a socially
desirable outcome. While these arguments cannot be denied, it may be suggested that the
technological change inherent in a financial innovation can, in fact, promote a progressive
institutional change that enhances social welfare.The problems of inefficiency or inequity in the
financial sector may, consequently, be ameliorated by technological change. This implies that
government regulatory intervention may not always be necessary in the event of a failure of the
market to provide an optimum outcome.

Governance is that broad field of economics which concern the design of institutions through
which exchange is conducted.
The economic theory of regulation, a subfield of governance, most often examines how collective
action by individuals, through the auspices of government, affects the incentives of participants in
private markets. The theory of governance, and area of commonality between certain aspects of
institutional and neoclassical economics, also examines how economic institutions evolve, both
through technological innovations and bargaining between coalitions of individuals whose welfare
depends on the pattern of trade within these institutions. Regulation of financial markets is best
examined within this context. Institutional structure, which includes legal restrictions, traditional
practices, and regulatory policy, constitutes the technology of exchange.

Alternative structures may, at any particular time, vary widely in terms of their economic
efficiency.

The institutional approach to regulation more explicitly considers broader issues of governance
and institutions as the technology of exchange. The basic postulates of the institutionalist approach
to regulation are:

The need for government intervention exists because industrialised societies give rise to
concentration of power, increased uncertainty, performance failures, uncompensated costs, and
adverse distributional effects.

Regulation must endeavour to promote public interest or social values that cannot be derived
exclusively from monetary or market-oriented measures.

When properly applied, regulation seeks to promote higher levels of efficiency and greater
individual choice. Regulation can convert emergent values into allocative decisions that better
reflect social wants.

Strategies of actors in the regulatory process can have a significant impact on the outcome.

Since the evolutionary process makes any set of goals and methods provisional and
intermediary, it follows that the form of regulatory intervention may change over time.

The twin objectives of efficiency and equity may, however, often be mutually incompatible in
practice. The traditional neoclassical theory of regulation focusses on how these objectives can be
attained through government intervention, and much of that theory involves an examination of the
relative costs of the state pursuing such goals. The choice of policy instruments is directly related
to the choice of regulatory objectives and involves the means by which the incentives of individual
market participants are influenced by government in order to achieve specific goals. These means
can range from direct legal edicts or command and control procedures to broad regulations
incorporating a role for market incentives.

The role of government in financial markets must be to contribute to the development of an

efficient system for financial governance, which includes the organisation of a reliable payments
system and clearing mechanism, standardised accounting procedures, and a uniform legal code
through which financial contracts can be enforced. Appropriate public policy involves measures
which insure that these market incentives are indeed operative and, more particularly, that
information germane to financial exchange is produced and disseminated to the most efficient
extent possible. One role for government in establishing an efficient structure for public financial
governance involves the standardisation and refinement of techniques for financial accounting.
Conventional or generalised accounting procedures are static in nature, focussing on realised
values of elements of the random income streams comprising most marketable financial assets.A
second role for government lies in reducing transactions costs in financial markets, especially the
costs of enforcing financial contracts.

These costs, such as those involved in lending, may be relatively high owing to both legal
restrictions on lenders taking contingent positions in the investments of their borrowers and the
legal costs associated with the liquidation of collateral assets in the event of borrower default. The
government should also seek to ensure the continuous disclosure of portfolio holdings by
intermediaries. By creating the opportunity for competing intermediaries to credibly commit to
such strategic disclosure, in the context of an imperfectly competitive credit market, internalities
will be reduced and incentives for prudent financial management enhanced. The disclosure of
information relevant to private financial exchange, which also includes the trading strategies of
the central bank and fiscal budgeting of government agencies, such as the UTI in India, active in
private credit markets, can help coordinate investment planning among private individuals and
firms in the nascent or thin domestic credit markets, such as those for community-based lending.
Another role for government involves measures to mitigate the adverse incentive effects created
by its inability to credibly refrain from offering loan guarantees which insure the debt of large and
politically influential intermediaries.

Traditional regulatory methods involve restricting the strategies available to such intermediaries
by:

imposing capital adequacy requirements;

restricting ownership between intermediaries and certain classes of borrowers, such as

manufacturing firms, and;

imposing restrictions on yields paid on the deposit liabilities of these intermediaries.

These measures are intended to inhibit the incentives that bank managers have to increase the
volatility of earnings, by insuring that equity-holders in any financial institution have and
appreciable portion of their own wealth exposed to the risk of insolvency, rather than relying
primarily on that of depositors or, through mis-priced government loan guarantees, that of the
general public.

A final role for government in developing economies is to address the difficulties posed to
uninformed or neophyte traders by their participation in private financial markets. Incentives,
possibly including subsidised educational programmes, could be offered to such traders to acquire
and maintain sufficient expertise to infer and evaluate the risks they are facing. Given the current
state of knowledge about financial markets, as well as the obvious difficulties in devising and
implementing an effective policy of monitoring and enforcing compliance, the social costs posed
by refining traditional forms of financial regulations, such as capital requirements, may exceed the
benefits to such refinement. Vital directions for future theoretical and empirical research into
efficient financial governance must focus on both the costs of implementing financial regulations
and the capacity for the endogenous resolution of extant inefficiencies by private financial
institutions through the process of financial innovation.

In summary the role of government can be enlisted as below:

 Designer of economy
 Role of controller
 Role of developer of an efficient system for financial governance
 Policy formulator
 Role to reduce transactions costs in financial markets
 Role of monitor.
 To address the difficulties posed to uninformed or neophyte traders by their participation
in private financial markets.

Thus, government should play all above roles in addressing or regulating financial markets.