Meaning and Reasons of Regulations of Financial System

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Meaning and Reasons of Regulations of Financial System

Regulation of Financial System

We discussed earlier different types of financial markets and financial intermediaries. Financial markets and financial intermediaries play a key role in – mobilizing the funds from surplus units to deficit units in the economy. The concerned government needs to enforce the acts and regulations to issue financial instruments, operate the financial markets, incorporate and license financial institutions, and protect the investors’ interests. In addition, strong regulatory authority is necessary to enforce the concerned act and regulation, protect the investors’ interest, and build up public confidence in the financial system of the country. Thus, the financial system refers to the collective form of financial markets, institutions, laws, regulations, and methods through which interest rates are determined, and financial products are produced and traded around the world. The major components of the financial system are financial assets, financial markets, financial institutions, relevant acts and regulations, and monetary authorities.

Reasons for Regulation of Financial System

Meaning and Reasons of Regulations of Financial System

Regulation is a process of regulating regulating of financial system is the of regulating financial system of the country. In every country, the financial system is heavily regulated sector. An unsound financial system brings a financial crisis that may have an intensive and extensive effect on the domestic and international economies. For example, the East Asian financial crisis of early 1997 badly hit East Asian countries such as South Korea, Thailand, and Indonesia. The contagious effect of this crisis spread over other south-east countries also. The fundamental reasons for heavy regulation of the financial system are to increase the information available to investors and maintain the sound health of the financial system of the country. We discuss these two reasons in the ensuing section.

Increase Information Available to Investors

We discussed earlier about the asymmetric information. There is the risk of adverse selection and moral hazard due to the asymmetric information about the information about the investment. Insiders (management) have more performance of the company and outsiders (shareholders and lenders) have less information about the performance and financial condition of the company. Full disclosure of relevant information reduces the risk caused by adverse selection and moral hazard. The government enforces the regulation that empowers the monitoring authorities to force the financial markets and financial institutions to disclose financial information.

In Nepal, financial institutions licensed by Nepal Rastra Bank have to disclose their financial condition and operation condition quarterly. In Nepal, licensed financial institutions have to disclose the information as per the provision made in the Company Act, 2006 (2063), Securities Registration and Issuance Regulation 2016 (2073), Bank and Financial Institution Act, 2017, and directives of Nepal Rastra Bank. Enforcement of all these acts, regulations, and directives issued by Nepal Rastra Bank and other regulatory authorities such as the Securities Board of Nepal and Beema Samiti have increased the financial information to investors.

Ensure the Sound Health of Financial Intermediaries

The sound health of financial intermediaries is vital to protect the public and economy of the country. Asymmetric information causes the bank collapse which is referred to as financial panic. The unsound financial health of financial intermediaries causes an adverse effect on the confidence of the public in the financial systems especially in financial intermediaries and the economy of the country which may contaminate the economy of other countries. We can take the example of the Asian Financial Crisis which started in Thailand in July 1997. The public withdraws their money and they take their capital out of the country if they doubt the soundness of the financial intermediaries. Thus, the unsound health of financial intermediaries may bring in the bank run and crisis in the foreign exchange market which in turn affects the overall financial system.

The government of the concerned country enforces different types of regulation to protect the interest of the public and the economy of the country. Broadly, the regulations enforced by the government of any country are categorized into six categories:

  1. Restriction on entry,
  2. Disclosure,
  3. Deposit insurance,
  4. Restriction on interest rates.
  5. Restriction on assets and activities,
  6. Limit of competition, and

Restriction on entry.

The degree of restriction on the entry of financial intermediaries depends on the economic policy of the concerned government. The entry of financial institutions is relatively easy in a country where financial policy is liberal. In Nepal, the financial sector was not open to the private sector before financial liberalization which was started in the latter half of the 1980s. After 1990, the government became very liberal in granting the license to financial intermediaries. In order to restrict entry, the concerned government enforces the acts and regulations and establishes the regulatory authorities. In Nepal, Nepal Rastra Bank licenses the depository financial intermediaries and restricts their entry and exit into the financial system. Beema Samiti restricts the entry of insurance companies through the licensing provision and the Securities Board of Nepal controls the entry of investment banks and securities dealers and brokers.

Thus, the government restricts the entry of financial intermediaries by making the provision of licensing. The government makes the licensing provision more stringent if the existing number of financial intermediaries is sufficient and makes a more lenient policy for licensing if more financial intermediaries are required to run the financial system. Regulating the entry of financial intermediaries is necessary to keep up the healthy competition in the markets.


Financial intermediaries should disclose all financial information important to the investors and the general public. Financial institutions should prepare the financial statements in the statutory format following the Nepal Financial Reporting Standard (NFRS) and should publish the final report for public knowledge. Financial institutions should prepare interim financial reports and publish them quarterly for public knowledge.

Restriction on assets and activities.

We discussed earlier that regulation of financial intermediaries is necessary to protect the public. Regulatory authorities fix the limit of holding certain assets. For example, Nepal Rastra Bank has issued a directive restricting financial institutions not to invest more than 25 percent of their total loans in real estate loans. Similarly, it has issued directives to the licensed financial institutions regarding the position limit of loans. It has restricted financial institutions from investing more than 25 percent of their core capital in one sector or one party or interlinked parties. Financial institutions may invest the funds in risky activities and depositors’ money may be exposed to risk. Monitoring authorities may put restrictions on financial intermediaries to invest in risky projects. In the case of the insurance industry, insurance companies are restricted to purchase the stock of risky companies.

Deposit insurance.

The government can ensure the people’s deposits by ensuring the deposits. Depositors may lose the money deposited in the financial intermediaries if financial intermediaries go into liquidation. The only way of ensuring the deposits to get back is deposit insurance. In the USS, the Federal Deposit Insurance Corporation ensures the deposits. In Nepal, Deposit and Credit Guarantee Funds (DCGF) provides insurance for deposits received by its member financial institutions. DCGF provides a deposit guarantee of up to Rs 3,00,000 per natural individual depositor per member institution applicable on a combination of savings and fixed deposit. All licensed depository financial institutions are members of DCGF and DCGF charges 0.16 percent on guaranteed deposits to all member financial institutions.

Limits on competition.

Exit and entry of financial intermediaries are more frequent if there is high competition in the financial markets. So, unbridled competition among financial intermediaries promotes the failure of financial intermediaries. Failure of financial institutions harms the public in terms of loss of deposits and loss of investment in equity. However, the evidence of this effect of unbridled competition among the financial intermediaries is very weak. Government restricts the incorporation of new financial intermediaries and the opening of new branches in the same location.

Restriction on interest rates.

In liberal and open financial markets interest rate on a different product is determined by the supply of and demand for funds in the financial markets. However, the central bank controls the interest rate on different products of financial intermediaries. In the financial markets like ours, there may be unfair competition among financial intermediaries. But bankers’ syndicate influences interest rates in Nepalese financial markets. So, it is necessary to regulate the interest rate.

Regulation of capital.

The capital of financial institutions has a vital role in keeping up the sound health of financial intermediaries. So, regulatory authority regulates the capital and ensures the minimum capital of financial intermediaries. Regulation of capital is the measurement of different components of capital and minimum capital required for different types of financial intermediaries. In Nepal, Nepal Rastra Bank issues the directive on the measurement of each component of licensed financial institutions and a minimum standard of capital. It regulates constantly the capital of licensed financial institutions to ensure the adequacy of capital as directed by it.

What is a Financial System?

Financial System refers to the collective form of financial markets, institutions, laws, regulations, and methods through which interest rates are determined, financial products are produced and traded around the world.

1 thought on “Meaning and Reasons of Regulations of Financial System”

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