ABSTRACT
Financial sectors thrive on trust. When the modern financial system started taking shape in the era of industrialisation, the most important challenge was how to mitigate the problem of moral hazard and adverse selection. Slowly, financial institutions were developed around a key financial regulator (mostly a central bank) and it came to be a common understanding that financial institutions (especially banks) should be deliberately cut off from the real economy. It was also thought prudent to keep the risk of a financial burden on the shareholders and promoters of financial institutions, and general savers and the public at large should be protected. Deposit insurance was also introduced to provide a further cushion and increased trust of the general public. Interest (reward for saving) was first introduced on the liability side and then to the asset side to keep the financial system aloof from the real economic burdens. Financial sector regulators also extended some other favours, like interest being treated as tax deductible, which ensured regular and continuous business for the financial institutions.
