Delivering a lecture on `Principles of Financial Regulation in Developing Countries,' organised by the National Council of Applied Economic Research, here on Tuesday, Stiglitz stressed that regulation should embrace all financial institutions. "If restrictions on banks become too severe, then funds will flow to the less regulated non-bank financial institutions," he said.

"Regulators need to recognise that capital adequacy standards by themselves may actually induce banks to engage in riskier behaviour," the noted economist said. "As they seek returns to offset their higher costs, they engage in increased risk-taking, partly offsetting the benefits of the capital adequacy standards."

There are two approaches to bank regulation--altering incentivesand imposing constraints. "The major way that incentives are improved is through increased capital, so those banks have more to lose if they gamble."

Stiglitz pointed out that the enthusiasts of capital adequacy standards ignore the fact that increasing capital requirements lowers the franchise value of the bank, so that the net benefit is much less than that would seem to be the case. And this may lower the overall capital value of the bank, thus actually adversely affecting incentives.

"Capital adequacy standards are only one way to enhance incentives," he said. Other ways entail strategies that increase franchise value like restrictions on deposit rates, lending rates and entry.

The simplest constraint that can be imposed on banks is not to allow them engage in risky lending, and to ensure that when such lending occurs, the bank is adequately compensated with a high interest rate, that it has an adequate capital buffer to absorb losses, and it promptly sets aside reserves when loans becomenon-performing, the World Bank chief economist said.

There are, however, limitations in implementing regulatory incentives and constraints. The limitations could be when capital is imperfectly measured and when constraints are imperfectly monitored. These imperfections are greatly affected by the regulatory regime.

The well-known economist cautioned liberalisers that they must be "cognizant of the scarcity of trained human resources." Often, in pre-liberalisation era, banks were directed to lend loans by governments. Hence "they are not engaged in central functions of banking--screening and monitoring of loans."

Stiglitz also cautioned against too much regulation. "The problem is that all too often, regulation goes beyond the confines of attempting to enhance the safety and soundness of banking systems. There are, for instance, frequent attempts to repress competition."

He added, "Countries like India, which have had a long history of government intervention in many sectors of the economy, need to beespecially sensitive to these self-serving arguments. Competition, by and large, is the most efficient mechanism for encouraging efficiency and innovation."