March 2002 Insights Issue #40

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Prudence pays?
Regulating the financial sector

A strong banking system is the backbone of a robust financial sector. Research by the United Nations University's World Institute for Development Economics Research identified four main obstacles to efficient banking regulation in LDCs:

1. serious information (data on many aspects of the economy is unavailable), contracting and monitoring problems
2. a paucity of well-paid, qualified officials and infrastructure for adequate supervision
3. high operation costs and a limited choice of financial assets for diversification purposes curtails profitability
4. poor credibility of government agencies.

What policies would work best to strengthen the banking sector and restrain irresponsible bank behaviour?

Restraints on input: capital adequacy (having enough capital is a minimum banking regulation), liability composition (types of assets banks are allowed to hold) and tests for bank managers are generally considered the least effective measures but with the lowest verification costs. Critics say, however, that two banks with the same capital adequacy ratio and using similar risk management procedures, may have completely different risk profiles if bank owners and managers' interests diverge.

Direct control and impact on output: such as ceilings on risky assets and on total asset growth and lending rates. While direct controls may prevent countries from experiencing crises, they are usually at the expense of financial sector performance - important for stimulating general economic activity. Restraints on output can also lose effectiveness as a result of financial innovation and if the incentives driving bankers' actions are ignored.

Controls on process or supervision: Prudential restraint such as overseeing and influencing banks' risks policy framework, internal reporting standards, or market and credit risk management procedures would result in the least crisis-prone financial sector, but are complex and expensive to implement in countries where rent seeking activities such as corruption, bribery, and lobbying are commonplace.

Increasing bankers' liability limits - a powerful incentive to bank owners to stay prudent if liability is extended to personal wealth, although penalties for risk-taking may become too high.

While raising capital ratios and liability limits might be suggested to countries with insufficient supervisory skills, both policy tools could induce either banking disintermediation. To guarantee profitability, limiting entry could be a solution, although rent-seeking activities may emerge.

LDCs need a regulatory framework that rewards prudent risk-taking and punishes misconduct: possible policy options are summarised in the table below.

S Mansoob Murshed
Institute of Social Studies (ISS)
PO Box 29776
2502 LT The Hague
Netherlands

Murshed@iss.nl

See also

'Prudential regulation of banks in less developed countries', Finance and Development Research Programme Working Paper #19: IDPM, University of Manchester by S.M. Murshed and D. Subagjo, 2000

http://idpm.man.ac.uk/idpm/fdwp19abs.htm