Controversial issues of prudential banking regulation

Abstract

The paper addresses conceptual issues in prudential banking regulation. Prevailing regulatory frameworks are largely grounded in approaches to bank risk management, which primarily emphasize exogenous sources of banking risk and often insufficiently account for the specific objectives of regulators. The analysis substantiates the argument that endogenous mismanagement risk constitutes the principal threat to bank stability. Furthermore, the study contends that there is no measurable relationship between the stringency of prudential standards and the degree of bank stability, suggesting that the perceived sensitivity of such norms to stability risk is largely illusory. The paper critiques the excessive emphasis placed on regulation within the prudential framework and proposes refinements to the underlying conceptual approach. Specifically, it is recommended that the risk of mismanagement be recognized as the central focus of prudential regulation. Such a focus would clarify the objectives of prudential policy and optimize the selection of policy instruments. The adoption of a compliance-based approach, utilizing straightforward calculation methods and expert-defined threshold values, is advocated for the construction of mandatory prudential ratios. The paper also presents an approach for detecting mismanagement risk and clarifies the distinct roles and responsibilities of banking regulation, supervision, and governance in the process of regulatory change.