Prudential Regulation

Prudential regulation focuses on the safety and soundness of financial institutions. It contrasts with conduct regulation, which focuses on how firms treat their customers and behave in markets.

Key tools of prudential regulation include capital requirements, which require firms to hold enough capital to absorb losses; liquidity requirements, which require them to hold enough liquid assets to meet withdrawals and other outflows; limits on large exposures; stress testing; and requirements for risk management, governance and recovery planning.

For example, under the Basel framework, banks must maintain minimum ratios of capital to risk-weighted assets. Insurers in the European Union and United Kingdom must meet capital requirements under Solvency regimes.

Microprudential regulation focuses on individual firms, while macroprudential regulation focuses on risks to the financial system as a whole. In the UK, prudential regulation is carried out by the Prudential Regulation Authority, part of the Bank of England. In the United States, responsibilities are shared among the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency and state regulators.