Prudential regulatory policy has been characterised by inserting best practices as defined by the Basle Accord into Indian banking. This approach has the weakness that it requires substantial reliance on supervision. Second, the best practices were introduced without bank behavioural responses to them being well understood. Third, diversification as a means of making the banking system safer has not been explored. It is argued that the introduction of prudential regulation turned a credit liberal regime spawned by implicit government guarantees of bank safety and stability into a credit constrained regime. This regime is characterised by a reduction in lending and change in the composition of lending towards assets with a lower risk weighting such as government securities which is a temporary stock adjustment response by banks as they seek more sustainable balance sheet positions. Shifting from an emphasis on supervision towards more reliance on incentives to ensure safe and sound banking it is argued can be achieved by introducing contingent liability, structured supervision, and diversification.
