Financial Regulations in Developing Countries: Can they Effectively Limit the Impact of Capital Account Volatility?
AbstractThis 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 paper claims, the second set of prudential regulation can go a long way in helping developing countries achieving their goals. The paper advances suggestions for the sequencing of implementation of these regulations for different groups of countries.
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Bibliographic InfoPaper provided by Center for Global Development in its series Working Papers with number 59.
Length: 52 pages
Date of creation: May 2005
Date of revision:
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Web page: http://www.cgdev.org
regulation; liquidity; credit growth; pricing-risk-right; financial institutions; capital flows; developing countries;
Find related papers by JEL classification:
- O16 - Economic Development, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
- F30 - International Economics - - International Finance - - - General
- F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
- F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
- F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
- F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies
- H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-08-26 (All new papers)
- NEP-BAN-2006-08-26 (Banking)
- NEP-DEV-2006-08-26 (Development)
- NEP-FMK-2006-08-26 (Financial Markets)
- NEP-IFN-2006-08-26 (International Finance)
- NEP-PBE-2006-08-26 (Public Economics)
- NEP-REG-2006-08-26 (Regulation)
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