Prudential Norms: Meaning, Importance and Challenges

Prudential Norms: Importance and Challenges

This article covers the introduction, major importance, and challenges of prudential norms or regulations in banking system.

Introduction to prudential norms:

Prudential norms are the standards set by the regulatory body to maintain financial discipline in the bank and financial institutions. These standards help to identify and measure the risk inherent in banking business and helps to mitigate and control those risks. The main objective of the prudential norms is to create a resilient banking system and maintain financial stability. It also helps to protect the interest of depositors and shareholders which ultimately build trust among the public towards the banking and financial sectors.

 

Importance of Prudential Norms in Banking System:

Prudential norms are necessary in banking business for overall financial stability and soundness of the financial sector. The main importance of prudential norms is pointed below:

• It helps to maintain financial strength through capital adequacy and adequate liquidity,
• It helps to manage risk inherent in banking business especially focus on credit risk, liquidity risk, operational risk, market risk,
• It helps to protect the interest of depositors and shareholders,
• It helps to make sustainable profit through sound financial operation,
• It helps to show the path of investment which makes it secure and systematic,
• It promotes consortium financing which helps to expand the investment in quality project,
• It helps to manage liquidity risk raised from liquidity fluctuations,
• It helps to control interest rate fluctuation by matching the maturity of interest rate of deposit and loans,
• It helps to match the maturity of assets and liabilities,
• It helps to enhance the trust towards banking sector among the public,
• It helps to reduce unhealthy competition through proper arrangement of merger and acquisition,
• It helps to maintain transparency of banking activities,
• It helps to maintain good corporate governance and enhance internal control system in the banks,
• It helps to utilize resources of banks efficiently and effectively,
• It helps to reduce financial risk by creating an environment of investment diversification,
• It helps to strengthen the corresponding banking relationship through ethical banking practices,
• It helps to prevent money laundering and terrorist financing through collecting sufficient documents for customer identification.

So, these are the main benefits of prudential norms in banking system.

 

Challenges and Limitations of Prudential norms:

Even there are lots of significant of prudential norms in banking, there are some challenges and limitations. Some of the major challenges and limitations of prudential norms are as follows:

• It is costly to implement and comply all those standards,
• Different banks may have different risk, it ignores this possibility,
• Stress test may not always accurately depict the liquidity and solvency position of banks,
• Different regulations in different countries may affect the corresponding relationship,
• Tight regulations prevent banks to apply the business strategies and force them to change their strategies,
• During loose credit control of regulator while excess liquid situation, bank may expand the credit, this makes difficult to recover those credit and ultimately non-performing loan will be increased,
• Prudential norms couldn’t be covering the non-financial risk such as cyber-attack, environmental impact etc. which may significantly impact the banking business.

So, these are the major challenges and limitations of prudential norms.