As the GFC demonstrated, governments may feel compelled to commit public funds to rescue failing banks in order to limit the systemic damage from such events. The presence of externalities means that, in the absence of prudential regulation, banks may take on greater risk than is appropriate from the point of view of the broader economy and society.
The prudential framework reinforces incentives for banks and their creditors to understand and manage the risks they take. In some areas, incentives alone are insufficient and we have imposed direct regulatory requirements.