Ebook The Virtues of Prudential Regulation in Financial Markets
The potential of properly regulated financial system to dampen rather than exacerbate shocks to developing economies has too often been overlooked. This chapter explores the potential of prudential regulations to dampen international capital flows, limit certain kinds of risk taking and help guard against systemic failures and international contagion.
Macroeconomics tends to focus on the policy efficiency of government budgets and central bank interventions to respond to economic shocks. This narrow focus has lead the policy debate to focus on such matters as capital controls and transaction taxes.
This chapter analyzes a set of regulatory proposals that are designed for developing countries to remedy financial market short-comings and make financial markets and overall economies more efficient as well as less vulnerable to financial sector disruptions and distortions. In doing so that shape the composition and volume of international capital flows to developing countries so as to better meet the needs of development, and they encourage the use of derivatives for risk management purposes while discouraging their use in unproductive pursuits that might create dangerous levels of exposure to market risk as well as credit risk or lead to reverse capital flows.
These prudential regulatory proposals are of three basic types. The first type relates to reporting and registration requirements and is designed to improve the transparency and thus the pricing efficiency in the markets. Reporting requirements also enable the government, and other market surveillance authorities such as exchanges, to better detect and deter fraud and manipulation. Registration requirements are especially useful in preventing fraud.
The second type of prudential regulatory measures involves capital requirements and collateral requirements. Capital requirements function to provide both a buffer against the vicissitudes of the market and a governor on the tendency of market competition to drive participants towards seeking high returns and thus higher risks.
Collateral requirements have basically the same effect, although collateral requirements apply to transactions in particular and not institutions. Thus non-financial institutions that would not otherwise be subject to capital requirements would be subject to collateral requirements on their derivatives transactions.
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