Working Paper
Prudential Regulation of Banks in Less Developed Economies

Beginning with an empirical analysis of banking crises using a logit econometric model covering a sample of developed and developing countries between 1980-97, the paper suggests that crises are more likely in years of low growth and high real interest rates. Private sector credit as a percentage of GDP, lagged credit growth and tight liquidity in the banking sector are also strongly related with banking crises. The results call for more robust financial regulation. The paper argues that less developed countries (LDCs) face inherent obstacles in setting up efficient regulation, and building up a sound-banking sector. These are related to the presence of multiple tasks and multiple principals, poor institutions, lack of economies of scales in banking sectors as well as regulatory supervision, and the lack of reputation. LDCs need a regulatory framework that rewards prudent risk taking, but punishes misconduct. This is likely to involve a combination of input based measures impacting on bankers' incentives, with a few direct controls on the output of the banking sector. The paper concludes with a list of policy options whose appropriateness is judged by the 'friendliness' with the circumstances in LDCs.