Prudential Regulation of Banks in Less Developed Economies

This article argues that developing countries face inherent obstacles in setting up efficient financial regulation, and building up a sound banking sector: the presence of multiple tasks and multiple principals, poor institutions, lack of economies of scale in the banking sector as well as regulatory supervision, and the lack of reputation. Developing countries 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 sector. The article concludes with a list of policy options whose appropriateness is judged by their ‘friendliness’ with local circumstances.