Domestic Financial Regulations in Developing Countries: Can They Effectively Limit the Impact of Capital Account Volatility?
This chapter 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. The second set, which can be identified as the ‘pricing-risk-right’ approach, works by providing incentives to financial institutions thereby avoiding excessive risk-taking activities. 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. The main finding of the chapter is that contrary to policy intentions, the first set of regulations — the most commonly used in developing economies — can exacerbate rather than decrease financial sector fragility, especially in episodes of sudden reversal of capital flows. In contrast, the second set of prudential regulation can go a long way in helping developing countries achieving their goals. The chapter advances suggestions for the sequencing of implementation of these regulations for different groups of countries.
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