This paper identifies two alternative forms of prudential regulation. The first set is formed by regulations that directly control financial aggregates, such as liquidity expansion and credit growth. An example is capital requirements as currently incorporated in internationally accepted standards, namely, capital requirements with risk categories used in industrial countries. The second set, which can be identified as the "pricing-risk-right" approach, works by providing incentives to financial institutions to avoid excessive risk-taking activities. A key feature of this set of regulations is that they encourage financial institutions to internalize the costs associated with the particular risks of the environment where they operate. Regulations in this category include ex-ante risk-based provisioning rules and capital requirements that take into account the risk features particular to developing countries. This category also includes incentives for enhancing market discipline as a way to differentiate risk-taking behavior between financial institutions.
The main finding of the paper is that the first set of regulations—the most commonly used in developing economies—have had very limited usefulness in helping countries to contain the risks involved with more liberalized financial systems. The main reason for this disappointing result is that, by not taking into account the particular characteristics of financial markets in developing countries, these regulations cannot effectively control excessive risk-taking by financial institutions. Moreover, the paper shows that, contrary to policy intentions, this set of prudential regulations can exacerbate rather than decrease financial sector fragility, especially in episodes of sudden reversal of capital flows.
In contrast, the second set of prudential regulations can go a long way in helping developing countries achieve their goals. The paper advances suggestions for how to sequence the implementation of these regulations for different groups of countries.