The financial system is among the most heavily regulated sectors across economies. There are two or three main reasons why different governments regulate the financial markets, namely to increase the information available to investors, ensuring the soundness of the financial system, and improving the control of monetary policy.
- Improving the availability of information – lack of information in the financial markets leads to the problem of asymmetric information which also leads to the problems of moral hazard and adverse selection. The existence of a moral hazard and adverse selection lead to inefficiency in the financial markets and keep investors out of the market. As a result, the government may intervene in the market and reduce moral hazard and adverse selection by increasing the amount of information available to investors. Various ways through regulation that can be used to improve the availability of information include the following;
- Disclosure requirements – the government will require financial intermediaries to disclose information about their sales, assets, and earnings to the public and restrict trading by the largest stockholders in the corporation. This will assist in reducing problems of insider trading and window dressing that can be used to manipulate the financial statement of the organization and stock prices.
- Avoiding financial panic – another reason why governments regulate the financial markets arise from the need to avoid the widespread collapse of the financial intermediaries that are sometimes called financial panic. Financial panic leads to a massive withdrawal of funds from both sound and unsound institutions and can lead to serious damage to the overall economic performance. In order to protect the public and the economy from financial panics, different governments implement various types of regulations with the following examples:
- Restriction of entry – this kind of regulation restricts the entry of the new firms in the market through laws that selects individuals and companies that enter and engage as financial intermediaries. In SA the Financial Service Board is responsible for regulating this. Disqualified directors cannot start or run financial intermediaries, the institutions that provide financial services should appoint Key Individuals for them to the operator and comply with this regulation.
- Restrictions on assets and activities – this regulation restricts the financial intermediaries from dealing and holding a certain type of assets. Regulators may restrict financial intermediaries from hold risky assets. For example, Banks and other depository institutions are not allowed to hold common stock because stock prices tend to fluctuate rapidly. On the other hand, insurance companies are allowed to hold common stock but the value of the ownership in the common stock should not exceed a certain fraction of the total assets of that particular insurance company.
- Deposit insurance – this calls for the creation of and ensuring the individual’s deposits such that in the event of financial loss by a financial intermediary the depositors will be protected.
- Limits on competitions – restriction on the establishment of more banks especially licensing of foreign banks in the local market is another way used by the government to regulate the financial intermediaries.
