Managing Risks to Financial Markets from Volatile Capital Flows: the Role of Prudential Regulation.

Prudential regulation is intended to channel capital inflows through institutions most likely to make sound investment decisions. The paper presents examples of prudential regulation in two countries, Mexico and Hong Kong, where capital was suddenly withdrawn in a test of the financial system. Especially under modern conditions, a risk-taking bank can avoid prudential regulation, which on paper is near the industrial country standard; and the case of Mexico shows how even the best intended regulation can be avoided and can even produce a result that is the opposite of their intent. The existence of offshore markets, particularly OTC derivative markets, makes on-shore regulation problematic in the absence of stringent, consolidated supervision. In addition, they have rendered meaningless the subaccounts of the standard balance of payments capital accounts. [ABSTRACT FROM AUTHOR]