The Effectiveness of Prudential Regulations for Banks : Global Perspective and Indian Context

Banking regulations intend to protect the interest of depositors, reduce the risk of bank failures, minimize the moral hazard, and strengthen the financial stability by controlling the behavior of financial system participants and by building financial buffers. In countries like India, where banks dominate the financial sector, banking regulations assume added significance. This paper provides a global perspective on the prudential regulations and examines the extent to which the regulations could mitigate the risk of financial crises. It also analyses the role of macro-prudential regulations in achieving financial stability and its interaction with micro-prudential regulations. It further delves into the role of regulations in catalyzing financial innovations and hence, indirectly contributing to irrational exuberance and excessive risk-taking in the financial system. Certain other issues deliberated upon in this paper include a need to closely look at the nature and design of prudential regulations with a view to reducing complexities in regulatory and supervisory processes, and evaluation of the role of regulations in growth, governance, and performance of banks in India. The paper looks at the movement of credit to GDP ratio, the GDP growth trajectory, and a periodic emergence of credit gap in the Indian context, and discusses the utility of credit gap as an indicator for macroprudential policy in India. This paper also analyses the pattern and movement of gross and net NPAs of the Indian banks and its relations with regulatory forbearance and supervisory processes. It suggests a continual need for strengthening institutional credibility for improving the effectiveness of regulatory and supervisory processes so as to achieve stability, transparency, and robustness in financial institutions and financial markets