What is the Government?
The government is very influential in all aspects of the financial world. Government regulations and policies affect the overall economy and directly impact the operations of financial institutions. Government laws and regulations, in fact, affect the financial affairs of every business and every individual.
Governments regulate and influence finances of every kind in several ways. They include central bank operations, taxation, and standards regarding accounting practices.
Central banks, such as the Federal Reserve in the United States, attempt to control the money supply and inflation by setting the country’s base interest rate – the rate at which banks can borrow money from the central bank. The base, or prime, interest rate set by the central bank is the benchmark for the setting of all other interest rates by financial institutions. Banks typically set their standard loan rates, such as the rate for a 30-year mortgage, equal to the prime rate plus a certain percentage that represents their profit on the loan.
The actions of central banks in setting interest rates affect the entire economy of a country. If a central bank unexpectedly raises or lowers the prime rate, the country’s financial markets often react with large price movements in one direction or the other. Higher interest rates usually slow down the economy. Lower rates fuel economic growth as both businesses and individuals can more easily borrow money.
However, higher interest rates may boost the economy by attracting foreign investors from countries with lower interest rates. Central bank interest rates affect the value of a country’s currency relative to other currencies. For example, if deposit accounts in US dollars are earning 3% interest while British banks are only offering 2% interest, it becomes more attractive for investors to hold US dollars rather than British pounds.
The government’s tax policies also affect every aspect of the economy. Tax policy dictates how businesses conduct their business and how investors handle their investments. For example, a lower capital gains tax rate encourages people to invest more. The difference between the short-term and long-term capital gains tax rates may affect how long investors hold onto investments before selling them.
Low corporate tax rates attract businesses to commence operations in a country. Whatever the corporate tax rate and tax policies, businesses must adjust to them. If, for example, the tax authority lowers the amount of money that can be deducted for business travel, businesses are likely to restructure their operations to spend less on travel.
Government Oversight of Financial Markets
Government authorities exercise oversight and have regulatory powers over a country’s financial markets. In the US, the Securities and Exchange Commission (SEC) sets the rules for (stock) market and other investment transactions. In the UK, the Financial Conduct Authority fulfills the same function.
Government financial oversight bodies strive to ensure that financial trading is conducted fairly and honestly. It aims to ensure that investors are protected from fraud or lack of important information. Such objectives are accomplished by setting requirements for financial disclosure by all companies that participate in publicly-traded markets.
Under the SEC, the Financial Accounting Standards Board (FASB) is responsible for setting and maintaining the Generally Accepted Accounting Principles (GAAP) that all companies and accountants must follow in the preparation of financial documents.
Government Laws and Regulations
Governments control the operations of financial institutions through laws and regulations that dictate what banks and other financial institutions can and cannot do. A major piece of legislation that was passed in the US in the aftermath of the 2008 financial crisis was the Dodd-Frank Act. Among other things, the law severely restricted banks in regard to what type of investments they can make. For example, retail banks can no longer invest in hedge funds or private equity investments.
The Dodd-Frank Act extended beyond banking regulations, imposing many restrictions on investments and trading, such as requiring investors to deposit substantially higher amounts of money to hold investment positions.
Government actions also affect the inflow-outflow of goods and services from a country to other countries. By setting tariff rates, governments can either encourage or discourage imports or exports. Governments sometimes set high import tariffs on certain kinds of goods in an effort to protect “home industries” that produce such goods. The high import tariffs discourage suppliers from importing the goods and give them an incentive to purchase the goods domestically.
The invisible hand of government extends to every aspect of the financial world, affecting both businesses and individuals. Through laws, agency regulations, central bank activities, tax policy, and financial oversight bodies, governments affect the way companies do business and the way individuals spend, save, or invest their money.
It is important for financial analysts to stay informed regarding government laws, regulations, and policies that can affect the companies they work for. Changes in government policies can have significant effects on financial models and projections.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: