Rethinking Bank RegulationRethinking Bank Regulation

James BarthJames Barth

Gerard CaprioGerard Caprio

Ross LevineRoss Levine

OverviewOverview

1.1. Some findingsSome findings

2.2. Some weaknesses, and strengthsSome weaknesses, and strengths

3.3. A pleaA plea For epistemological modestyFor epistemological modesty Against faith-based policy advisingAgainst faith-based policy advising

Some Findings: Conceptual frameworkSome Findings: Conceptual framework

If men were angels, no government would be necessary.

If angels were to govern men, neither external nor internal controls would be necessary.

In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.

James Madison, Federalist Papers, 1788

Bankers are not Bankers are not angelsangels

Politicians (& some Politicians (& some bank supervisors) bank supervisors) are not angels.are not angels.

Politics shapes Politics shapes bank regulatory bank regulatory choices and the choices and the effects of those effects of those choices.choices.

BCL, 2006BCL, 2006

What does this actually mean for policy?What does this actually mean for policy?

Capital regulations, entry restrictions, activity Capital regulations, entry restrictions, activity restrictions, deposit insurance, government ownership, restrictions, deposit insurance, government ownership, etc.etc. Needed to overcome market failures … Needed to overcome market failures … predictionspredictions.. In some political systems, protects elite … In some political systems, protects elite … predictionspredictions..

Strong official supervisory oversightStrong official supervisory oversight Needed to overcome market failures …. Needed to overcome market failures …. predictionspredictions.. In some political systems, protects elite … In some political systems, protects elite … predictionspredictions..

Private monitoring, transparency, market disciplinePrivate monitoring, transparency, market discipline Insufficient to overcome market failures … Insufficient to overcome market failures … predictionspredictions.. Reduces discretion of elite … Reduces discretion of elite … predictionspredictions..

Results: What Works Best?Results: What Works Best?

“ “Works” Works” Bank developmentBank development EfficiencyEfficiency StabilityStability Corruption in lendingCorruption in lending

Results:Results:Measuring regulationMeasuring regulation

““Every rule” vs. “Broad index”?Every rule” vs. “Broad index”?

Countries choose strategies! Countries choose strategies! Not a smorgasbord of rulesNot a smorgasbord of rules So, we use broad indexesSo, we use broad indexes

CorrelationsCorrelationsEntry

Applications Denied

Capital Regulatory

Index

Activities Restrictions

Private Monitoring

Index

Moral Hazard Index

Official Supervisory

Power

Limitations on Foreign Bank

Entry/Ownership

Capital Regulatory Index -0.49*** 1

Activities Restrictions 0.27 -0.20 1

Private Monitoring Index -0.55*** 0.24** 0.22* 1

Moral Hazard Index -0.17 0.32** -0.18 0.18 1

Official Supervisory Power 0.12 -0.07 -0.05 -0.11 -0.02 1

Limitations on Foreign Bank Entry/Ownership

0.30*** -0.06 -0.01 -0.23** -0.18 0.08 1

Government Owned Banks 0.40*** -0.20 -0.03 -0.39*** -0.03 -0.01 0.28**

Govt ownership more entry restrictions & less reliance on private sector

No simple tradeoffs with generous deposit insurance

Private monitoring associated with fewer regulatory restrictions on entry / competition

Bank developmentBank development

s = Supervisory/regulatory indicatorss = Supervisory/regulatory indicators

X = Exogenous determinants of Bank Development, identified X = Exogenous determinants of Bank Development, identified by existing research (legal origin, ethnic diversity, settler by existing research (legal origin, ethnic diversity, settler mortality, etc.)mortality, etc.)

Z = Instrumental variables for the bank supervision and Z = Instrumental variables for the bank supervision and regulation variables (religious orientation, endowments, regulation variables (religious orientation, endowments, latitude)latitude)

u and u and are error terms are error terms , , , , , and , and are the estimated parameters are the estimated parameters

Bank Development = Bank Development = + + s + s + X + uX + u s = s = Z + Z +

Private monitoring boosts bank developmentPrivate monitoring boosts bank development

Official supervisory power lowers bank Official supervisory power lowers bank developmentdevelopment

Some findings:Some findings:

Bank efficiencyBank efficiency Interest marginsInterest margins Overhead costsOverhead costs

-1 -2 -3 -4 -5 -6

O verhead Costs

O verhead Costs

O verhead Costs

O verhead Costs

O verhead Costs

O verhead Costs

O fficial Power -0.121 -0.203 -0.148 -0.151 -0.084 -0.123

Private Monitoring -0.713*** -0.743*** -0.631*** -0.744*** -0.576*** -0.642***

Activity Restrictions 0.154 -0.187 -0.006 0.473 0.207 0.539

GDP Growth -0.166** -0.131 -0.162** -0.215** -0.16** -0.248*

Political Violence -0.591** -0.933**

Political Voice -0.281 0.108

Corruption -0.03 0.338

Government Banks 0.553 -0.36

banks 1383 1376 1383 1214 1208 1063

countries 70 67 70 48 62 42

Results on Bank Efficiency (overhead costs or interest margin)

Also includes bank-level variables: Market share, total assets, liquidity, bank equity, etc.

Some findings: StabilitySome findings: Stability

Past work shows:Past work shows: Increases in deposit insurance Increases in deposit insurance

generositygenerosity Increase moral hazardIncrease moral hazard

Increases fragilityIncreases fragility

But, do supervision and regulation But, do supervision and regulation help?help?

NO!: Moral hazard mitigated by broad NO!: Moral hazard mitigated by broad institutions, NOT standard regulationsinstitutions, NOT standard regulations

Constant -0.314 -1.409 1.760 -0.308 -0.094

Restrictions on Bank Activities 0.647 1.880** 0.735 0.656 0.627

Entry into Banking Requirements 0.125 0.398 0.249 0.127 0.164

Capital Regulatory Index -1.035* -1.268 -1.075** -1.026** -1.201*

Official Supervisory Index -0.243 -1.190 -0.222 -0.246 -0.241

Government-Owned Banks 2.846 9.477 3.963 2.761 2.869

Inflation 0.031 0.025 0.023 0.031 0.030

Moral Hazard Index 0.719** 1.442** 2.132** 0.716**** 0.769**

Moral Hazard Index*Political Openness -0.513**

Political Openness 0.762

Moral Hazard Index*Rule of Law -0.288**

Rule of Law -0.295

Moral Hazard Index*Official Supervisory Power -0.031Moral Hazard Index*Capital Regulatory Index -0.131

N 43 40 41 43 43

Results: so far …Results: so far …

Inconsistent with …Inconsistent with … Laissez-faireLaissez-faire Angelic regulatorsAngelic regulators

Consistent with …Consistent with … Private interest viewPrivate interest view Market disciplineMarket discipline

But, corruption?But, corruption?

Some more findings: Some more findings: Corruption in lendingCorruption in lending

Corruption ObstacleCorruption Obstaclei,ki,k = a[F = a[Fi,ki,k] + b[C] + b[Cii] + c[S] + c[Sii] + u] + ui,ki,k

FFi,ki,k: Firm-specific traits : Firm-specific traits

CCii: Country-specific traits: Country-specific traits

SSii: Supervision/Regulatory indicators: Supervision/Regulatory indicators Official supervisory powerOfficial supervisory power Private monitoringPrivate monitoring

4812 firms across 49 developed and developing countries4812 firms across 49 developed and developing countries

Some findings: corruption in lendingSome findings: corruption in lending

Inflation 1.023 1.477*** 1.52* 1.67**

Growth 0.035 0.183 0.222 0.276*

Priv -6.17 -7.628 -4.999 -2.896

Supervisory Power 0.165** 0.151*** 0.155***

Private Monitoring -0.386*** -0.368*** -0.347***

General Financing Obstacle 0.298***

Observations 2510 2510 2510 2510

More Controls ...More Controls ...

Supervisory Power 0.132** 0.146*** 0.143** 0.187*** 0.149** 0.17*** 0.182*** 0.093

Private Monitoring -0.297* -0.337*** -0.422*** -0.366** -0.512*** -0.37** -0.23* -0.292***

GDP per capita -0.113

Banking Freedom -0.145

State ownership 0.407

Banking crisis 0.078

Creditor rights -0.019

Shareholder rights -0.164***

Political Voice -0.453***

Corruption -0.277***

Observations 2510 2510 2340 2010 1925 1985 2510 2510

Some findings: Political institutionsSome findings: Political institutions

Why don’t countries Why don’t countries choose good choose good regulations?regulations? Good for whom?Good for whom? Politics matters!Politics matters!

Political differences explain sup. & reg.Political differences explain sup. & reg.(This table summarizes the results from 20 regressions.)(This table summarizes the results from 20 regressions.)

Private Monitoring

Entry Applications

Denied

Official Supervisory

Power

Activity Restrictions

Government Owned Banks

Executive Constraints

0.38*** -0.126*** -0.14 -0.468*** -0.055**

Executive Openness

0.78*** -0.23** -0.156 -0.98*** -0.108*

Executive Competition

0.84*** -0.264*** -0.189 -1.057*** -0.123**

Voice & Accountability

0.661*** -0.206*** -0.358* -0.827*** -0.093**

This holds when using instrumental variables for the political system (e.g., initial political system, religious differences, endowments, independence, legal origin. Or when including these instruments directly in the regression

How Do Countries Choose?How Do Countries Choose?

Open, competitive, democratic Open, competitive, democratic institutions:institutions:

Foster private monitoring, transparency.Foster private monitoring, transparency. Less likely to limit bank entry, activities.Less likely to limit bank entry, activities. Less likely to have state banks.Less likely to have state banks.

Closed, uncompetitive, autocratic Closed, uncompetitive, autocratic institutions:institutions:

Do NOT favor transparency (surprise!).Do NOT favor transparency (surprise!). Limit bank entry, activities.Limit bank entry, activities. Tend to have state banks.Tend to have state banks.

Findings so far ...Findings so far ...

Until angels govern …Until angels govern … Avoid relying only on official oversight, restrictions, etc. Avoid relying only on official oversight, restrictions, etc. Emphasize private monitoring / incentivesEmphasize private monitoring / incentives Stress Basel II’s 3Stress Basel II’s 3rdrd pillar pillar

Supervisors have crucial roleSupervisors have crucial role Support market discipline, not supplant itSupport market discipline, not supplant it Foster / force information disclosureFoster / force information disclosure

““Best practices” depend on political system.Best practices” depend on political system.

2. Analytical Weaknesses2. Analytical Weaknesses

But, confirmatory evidenceBut, confirmatory evidence

Weaknesses, but ...Weaknesses, but ...

LimitationsLimitations1.1. Survey errorsSurvey errors

2.2. ImplementatioImplementationn

3.3. Cross-country Cross-country shortcomingsshortcomings

ResponseResponse1.1. Survey errorsSurvey errors

Errors, but bias? Errors, but bias? Do better surveys!Do better surveys!

2.2. ImplementationImplementation Recent FSAP workRecent FSAP work Do better surveys!Do better surveys!

3.3. Cross-country Cross-country shortcomingsshortcomings But, case-studiesBut, case-studies

Where is the countervailing evidence??Where is the countervailing evidence??

3. A plea ...3. A plea ...

For Epistemological For Epistemological modestymodesty Surveys have Surveys have

problemsproblems Regressions have Regressions have

problemsproblems Case studies have Case studies have

problemsproblems Expert guidelines Expert guidelines

have problemshave problems

Against Faith-based Against Faith-based policy advisingpolicy advising These policies are These policies are

very importantvery important For growthFor growth For poverty For poverty

alleviationalleviation For equality of For equality of

opportunityopportunity Need to assess Need to assess

competing views competing views systematicallysystematically