INTRODUCTION

Few advocates of financial liberalization ever envisaged a complete dismantling of prudential regulation of financial intermediaries. Many of the banking regulations that were liberalized had been directed to economic or sectoral objectives other than prudence. Besides, many had become ineffective or dysfunctional, often outflanked by technological change or subverted by special interests. Furthermore, the old regime often masked endemic banking insolvency, notably where government had diverted banking resources for quasifiscal purposes. But, by mechanically limiting the scope of banking activities and by conveying valuable franchises, many of the old rules had incidentally served to reduce the incidence of crashes.

In response, international efforts have focused on codifying accounting rules and harmonized capital requirements, and there has been stepped-up supervision at the national level. But parallel financial innovation has complicated the traditional work of the regulator, and enforcement has, in practice, been weak. The fashionable response – a minimalist retreat into indirect prudential regulation relying largely on assessing intermediaries' risk control procedures and requiring only a moderate risk-adjusted minimum of accounting capital – seems dangerously complacent for developing countries. For example, it neglects just how imperfectly bank capital is measured and the fact that bank management may have an incentive to increase the measurement difficulties. It overrates the accuracy of the risk adjustments, potentially encouraging banks to increase their assumption of underpriced risk. Finally, it overemphasizes accounting measures of capital, neglecting the economically relevant aspects of franchise value.

By contrast, this chapter considers the economic case for a more robust approach to financial restraint.