Prudential Control

Why is Prudential Control important in an economy?

The central bank (or another government institution) is expected to protect the economy from suffering the effects of a financial crisis.

It is widely accepted that the banking system has a unique position in the national economy. A widespread collapse can lead to a decline in the intermediation , money transmission and liquidity services supplied by banks, which will, in turn, contribute to an inefficient allocation of resources in the economy.

There are additional macroeconomic ramifications if there is a continuous reduction in the money supply growth rate or rise in interest rates.A bank run begins when customers withdraw their deposits because they fear the bank will fail. Immediately, the bank finds it is unable to supply one of its key services: liquidity. The banking system is vulnerable to contagion effects: a lack of confidence associated with one poorly performing bank spreads to other, healthy, banks because agents know that once a run on deposits begins, liquidated bank assets will decline in value, so everyone will want to withdraw their deposits before the run gains some momentum. In the absence of perfect information about the quality of each bank, the sudden collapse of one bank often prompts runs on another, healthy, banks.

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