Role of Government in the Financial Markets

Many countries felt that the government should regulate certain aspects of the financial markets. Based on the history and culture of the individual countries, different countries have different set of regulations for the market. At the rise of capitalism in the late 18th century, the role of government was considered to be that of a "night-watchman", i.e., it was thought that the government should operate on the minimum scale possible, providing only minimal services such as national defense and maintenance of law and order. Later, however, as the government, economy and society matured, the needs of the people became greater and more varied and the role of the government expanded gradually. Today, in most of developed and developing countries of the world, they are supported by the economic activities of both the private and public sectors. In order to have a smooth flow and development without any impediments, the governments devise extensive measures and regulations to closely monitor the performance of various important branches of the financial system from time to time.

Generally financial markets get their support from the government in one form or the other. Governments play an important role in financial markets by passing regulations and closely monitoring the activities of the market through various measures. The financial markets that play an important role in many economies and governments around the world have felt the need to regulate and monitor their functioning and performance vis-à-vis the economy on a continuous basis. The role of institutions, government and other agencies result into cause and effect relationships on the decisions made and rules and regulations formed. Thus, it is not surprising to find that a market's reaction to regulations often prompts a new response by the government. This in turn will have its effect on the various institutions and parties participating in the market who accordingly have to change their behavior or adapt the new rules and regulations. However, the regulations and rules formed by the government vary in degrees from one country to another. While some economies have their markets regulated closely by the government, others have a policy of minimal interference leaving most to the market forces.

Government jurisdiction while regulating the markets will be wide and varied and it can take different forms through its various arms. If the banking sector is allowed to liberalize its norms of lending to brokers it will in turn have its repercussions on the market. There will be some buoyancy in the market and brokers armed with additional funds can play more active role in the market. If the government takes a reverse decision, it may suck out the liquidity from brokers and may dampen the market activity. Governments in developed economies have created elaborate systems of regulations for their financial markets. Various regulatory bodies were established like, for example, SEC in US oversees the financial markets; FSA regulates the banking security and insurance sectors in the UK, etc.

If the market is left to operate freely, the efficient allocation of resources will not take place and distribution of resources at lowest possible cost is also not possible. Also the government offers its help in the areas where the market mechanisms of competition cannot achieve the goals. In other words, it is "market-failure".

Most of the countries have evolved a systematic framework to control the markets. The purposes for which the regulations are made can be classified into the following categories:

• To avoid cheating by investors of security issues without relevant information;
• To bring about transparency and competition in the stock market activities;
• To stabilize the institutional structure in the financial system;
• To avoid taking over of the domestic market by foreign concerns;
• To check the intensity of economic activities.