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	Table of Contents
p. 30 of 58 BACK | NEXT Purpose and Structure of the Toolkit Part One: Introduction and Overview Part Two: Preconditions and Infrastructure for Financial Sector Development Part Three: Financial Regulation and Supervision I. Financial Stability, Development and Institutional Design II. Financial Regulation: General Principles III. Financial Regulatory Structure IV. Banking Regulation A. International Standards B. Guidance and Recommendations V. Bank Insolvency and Depositor Protection VI. Securities and Derivatives Regulation VII. Insurance and Pensions Regulation VIII. Regulation of Financial Conglomerates Part Four: Regional Financial Integration Part Five: ADB's Intervention in the Financial Sector Bibliography Glossary and List of Abbreviations Acknowledgements

Financial Sector Legal and Regulatory Toolkit : Part Three: Financial Regulation and Supervision

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IV. Banking Regulation

In general, banking institutions in a market economy provide basic payment, clearing, and settlement services; serve as the main conduit for the mobilization of private savings and other capital resources and for their employment in productive uses, in the form of loans to commercial and industrial enterprises; and have a vital function in the creation of the money supply upon which the growth of an economy depends. For these reasons, banks and securities markets are not only complementary in that both serve to mobilize savings and allocate investment, thereby increasing the size of the financial system, but also competitors in that both seek to attract the same resources (namely scarce savings) and direct such resources to their most efficient uses, earning their profits from the provision of their respective financial intermediation mechanisms.

However, in most emerging market, developing, and transition economies, banks, more often than securities markets, are the major suppliers of funds to new and old enterprises. Banks have a major role to play as the predominant savings outlet in such countries.

It is important to create a legal and regulatory framework that allows banks to channel savings to enterprises in an efficient manner while also minimizing the system's exposure to corruption and instability. Prudential oversight in banking provides a measured alternative to the disruptive discipline of bank runs and is often accompanied by government provision of deposit guarantees.

Prudential standards that apply to banks commonly cover the following areas:

1. Entry requirements
2. Ownership and control structures, including the position of banks in groups of corporations
3. Bank governance requirements
4. Prudential standards, including capital adequacy and liquidity requirements, risk management and control systems, and various credit limits
5. Prevention of crime such as money laundering and the financing of terrorism
6. Accounting and reporting requirements
7. Special criteria for the licensing, prudential supervision, and liquidation of branch and representative offices of foreign banks in cooperation with foreign bank regulators
8. Systems for closure and exit
9. Customer support schemes (such as deposit insurance and industry guarantee funds)

Prudential regulation also relates closely with regulation addressing systemic stability, which traditionally includes

1. sustainable macro-economic environment,
2. prudentially sound system of financial institutions,
3. lender of last resort facility, and
4. direct regulation of the payments system.

In market economies, banking crises have tended to occur when financial markets were recently liberalized but supervision and regulation were not upgraded to cope with expanded activity. The series of financial crises in the 1980s and the 1990s that left many enterprises and banks insolvent and resulted in persisting banking crises despite development and transition advances, illustrate the need for prudential regulation. Pervasive connected lending by banks has been a common factor; new (or recently privatized) financial institutions rapidly expanding their activities have been another. Problems with foreign currency borrowing and on-lending in local currencies, especially for property and infrastructure development (or speculation) have been other common factors. In the current global financial crisis, lax regulation and regulatory gaps especially in global financial institutions and markets were important underlying causes. In each episode, there were serious gaps in the prudential regulation and supervision of banks that allowed imprudent exposures or fraud to go unchecked.

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