Prudential Regulation

Topic :

This short briefing paper notes that experience in emerging markets has demonstrated that financial crises can be highly damaging for economies, government budgets and living standards. This realisation, it argues, has reinforced interest in improving financial sector regulation and supervision. The objective of prudential regulation is to protect the stability of the financial system and protect deposits so its main focus is on the safety and soundness of the banking system and on non bank financial institutions that take deposits.

The brief aims to answer the question – why have the prudential reforms already implemented in developing countries not been more effective in preventing banking crises and how can prudential systems be made more effective? In doing so, the following topics are covered:

  • Weak regulations and gaps in regulation
  • Weak enforcement of regulations
  • Supervisory capacity constraints
  • Strengthening prudential regulations
  • Better bank intervention policies
  • Improving the institutional environment for regulation
  • Risk based supervision
  • Market based approaches to regulation
  • Deposit insurance

In its analysis, the brief highlights the following as the main points:

  • Developing countries have made much progress in strengthening their prudential systems since the 1980s. Banking legislation has been upgraded and supervisory capacities expanded
  • Important weaknesses remaining include lax bank licensing, weaknesses in prudential regulations and poor enforcement of regulations
  • In most cases of bank insolvency, unless a systemic risk to the banking system is involved, the bank should be closed down
  • Bank regulators need stronger incentives to undertake effective regulation and supervision in the public interest. They need to be made more accountable to a body representing the public interest
  • Bank regulators also need proper protection from political interference
  • Risk based supervision can help make best use of scarce supervisory resources and help regulators deal with the increasingly complex financial services now evolving
  • Relying on market based supervision is unlikely to be feasible for many low income developing countries

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