Financial Policy and the Role of the State

Published: 29th November 2011
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Does financial liberalization mean that LDC governments have no role to play in the financial sector? In an effort to identify how these governments can work effectively within the context of liberalized financial markets, some economists isolated seven major market failures that imply a potential role for state intervention. Their basic argument is "that (LDC) financial markets are markedly different from other markets", "that market failures are likely to be more pervasive in these markets" and that "much of the rationale for liberalizing financial markets is based neither on a sound economic understanding of how these markets work nor on the potential scope for government intervention". The seven market failures economists identified are the following:

(1) The "public good" nature of monitoring financial institutions: Investors need information about the solvency and management of financial institutions. Like other forms of information, monitoring is a public good - everyone who places savings in a particular financial institution would benefit from knowing that the institution was prospering or close to insolvency. But like other public goods in free-market economies, there is an undersupply of monitoring information, and consequently, risk-averse savers withhold their funds. The net result is fewer resources allocated through these institutions.

(2) Externalities of monitoring, selection, and lending: Benefits are often incurred by lenders who learn about the viability of potential projects from the monitoring, selection, and lending decisions of other lenders. Investors can also benefit from information generated by other investors on the quality of different financial institutions. Like other positive (or negative) externalities, the market provides too little information, and resources are under allocated or over allocated.

(3) Externalities of financial disruption: In the absence of government insurance (whether or not an explicit policy has been issued), the failure of one major financial institution can cause a run on the entire banking system and lead to long-term disruptions of the overall financial system.

(4) Missing and incomplete markets: In most developing countries, markets for insurance against a variety of financial (bank failure) or physical (e.g., crop failure) risks are missing. The basic problem is that information is imperfect and costly to obtain, so an LDC government has an important role in reducing these risks. It can, for example, force membership in insurance programs or require financial institutions as well as borrowers to disclose information about their assets, liabilities, and creditworthiness.

(5) Imperfect competition: Competition in the banking sector of most developing countries is extremely limited, meaning that potential borrowers usually face only a small number of suppliers of loanable funds, many of which are unwilling or unable to accommodate new and unknown customers. This is particularly true of small borrowers in the informal urban and rural sectors.

(6) Inefficiency of competitive markets in the financial sector: Theoretically, for perfectly competitive markets to function efficiently, financial markets must be complete (without uninsured risks) and information must be exogenous (freely available to all and not influenced by any one participant's action in the market). Clearly, there are special advantages to individuals or entities with privileged information in LDC financial markets, and risk insurance is difficult, if not impossible, to obtain. As a result, unfettered financial markets may not allocate capital to its most profitable uses, and there can be substantial deviations between social and private returns to alternative investment projects. In such cases, direct government intervention - for example, by restricting certain kinds of loans and encouraging others - may partly or completely offset these imbalances.

(7) Uninformed investors: Contrary to the doctrine of consumer sovereignty, with its assumption of perfect knowledge, many investors in LDCs lack both the information and the appropriate means to acquire it in order to make rational investment decisions. Here again, governments can impose financial disclosure requirements on firms listed on local stock exchanges or require banks, for example, to inform customers of the differences between simple and compound interest rates or of the nature of penalties for early withdrawals of savings.

LDC governments have a proper role to play in regulating financial institutions, creating new institutions to fill gaps in the kinds of credit provided by private institutions (e.g., micro loans to small farmers and trades people), providing consumer protection, ensuring bank solvency, encouraging fair competition, and ultimately improving the allocation of financial resources and promoting macroeconomic stability. As in other areas of economic development, the critical issue for financial policy is not about free markets versus government intervention but rather about how both can work together (along with the NGO sector) to meet the urgent needs of poor people.


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Rashid Javed is an Asian author. He writes articles about various topics of accounting and economics such as elasticity of demand and cash book.

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