Rethinking Bank Regulation: Rethinking Bank Regulation: Till Angels GovernTill Angels Govern

James BarthJames Barth

Gerard CaprioGerard Caprio

Ross LevineRoss Levine

““Narrow” MotivationNarrow” Motivation

Banks matterBanks matter– Growth, Income Distribution, & Poverty AlleviationGrowth, Income Distribution, & Poverty Alleviation– Crises ($1 trillion in DCs), which hurt poorCrises ($1 trillion in DCs), which hurt poor

BIS / IMF / WB matter BIS / IMF / WB matter best practice recommendations best practice recommendations– ““If countries adopt sound policies …”If countries adopt sound policies …”– Apply “checklist” of best practices around the worldApply “checklist” of best practices around the world– An FSAPAn FSAP

Is there any support for these recommendations? Is there any support for these recommendations?

““Broader” MotivationsBroader” Motivations

Epic debates about the role of governmentEpic debates about the role of government– Public interest view vs. Private interest viewPublic interest view vs. Private interest view

Why countries choose different policies?Why countries choose different policies?– If political institutions matter, then this should change If political institutions matter, then this should change

the approach to reformthe approach to reform

Bank regulation seems like a boring, technical subfield of finance, But …

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, Number 51

Our Contributions:Our Contributions:

Collect Collect new datanew data and assess … and assess …

Which Regulatory Policies Works Best?Which Regulatory Policies Works Best?

Public vs. Private Interest Theories?Public vs. Private Interest Theories?

Do Political Institutions Shape Regulations?Do Political Institutions Shape Regulations?

Debate about government’s roleDebate about government’s rolePublic interest viewPublic interest view

Gov’t maximizes social welfareGov’t maximizes social welfare

Gov’t has incentives / ability to Gov’t has incentives / ability to ameliorate market failuresameliorate market failures

If we identify “best practices,” If we identify “best practices,” countries will change.countries will change.

Private interest viewPrivate interest view

Gov’t maximizes Gov’t welfareGov’t maximizes Gov’t welfare

Gov’t does not necessarily have Gov’t does not necessarily have incentives / ability to fix failuresincentives / ability to fix failures

Need more than “best practices”:Need more than “best practices”:

Laissez-Faire : Market failures minor no need for government

Private vs. Public interest: Different predictionsPrivate vs. Public interest: Different predictions

Entry restrictions, bank activity restrictions, etc.Entry restrictions, bank activity restrictions, etc.– Needed to overcome market failures … Needed to overcome market failures … predictionspredictions..– Used to protect elite … Used to protect elite … predictionspredictions..

Strong official supervisory oversight and state-owned banksStrong official supervisory oversight and state-owned banks– Needed to overcome market failures …. Needed to overcome market failures …. predictionspredictions..– Used to protect elite … Used to protect elite … predictionspredictions..

Private monitoringPrivate monitoring– Insufficient to overcome market failures … Insufficient to overcome market failures … predictionspredictions..– Necessary to protect against control by elite … Necessary to protect against control by elite … predictionspredictions..

Aside: Debate about BaselAside: Debate about Basel

Basel II assumes public interest Basel II assumes public interest incentives and focuses on ...incentives and focuses on ...

1.1.Capital Capital

2.2.Official Supervisory OversightOfficial Supervisory Oversight3.3. Market DisciplineMarket Discipline

Thus, our work provides the first cross-country Thus, our work provides the first cross-country evaluation of the validity of the Basel approach and its evaluation of the validity of the Basel approach and its specific recommendationsspecific recommendations

Institutional EnvironmentDemocratic, Political Structure/System

Technology, Information Infrastructure

Judi

cial

, Leg

al,

Reg

ulat

ory

Env

iron

men

tM

arket Structure

Media

The Market:Depositors,creditors,

rating agencies

Politicians

Regulators andsupervisors

Borrowers, counterparties

Corruption

corruption Banks

The Public

corruption

DataData

There are 150 pages of data There are 150 pages of data description in the book!description in the book!

DataData

Structure, scope, Structure, scope, independence of independence of regulatory agencyregulatory agencyBank activitiesBank activitiesEntry requirementsEntry requirementsCapital requirementsCapital requirementsSupervisory powersSupervisory powers

Deposit insuranceDeposit insurance

Private monitoringPrivate monitoring

External governanceExternal governance

OwnershipOwnership

Data are online.

Regulatory restrictions on activitiesRegulatory restrictions on activities

36

13 11

31

40

4220

34

33

18

21

26

46

3231

41

7

97 4

0

20

40

60

80

100

Securities Insurance Real estate Bank ownership of nonfinancial

firms

Nonfinancial firm

ownership of banks

PercentUnrestricted Permitted Restricted Prohibited

Entry Entry

ForeignForeign1.1. limitations on foreign entry/ownershiplimitations on foreign entry/ownership

2.2. % of entry applications denied% of entry applications denied

DomesticDomestic1.1. summary indicator of rules to obtain a licensesummary indicator of rules to obtain a license

1.1. draft by-laws, organizational chart, financial projections, draft by-laws, organizational chart, financial projections, financial background information on major owners, financial background information on major owners, background of directors/managers, sources of capital, etc.background of directors/managers, sources of capital, etc.

2.2. % of entry applications denied% of entry applications denied

Official supervisionOfficial supervision

Supervisory powerSupervisory power– Power to take legal action against auditors, director, Power to take legal action against auditors, director,

officersofficers– Force bank to provision, change organizational structureForce bank to provision, change organizational structure– Power to suspend dividends, bonuses, management feesPower to suspend dividends, bonuses, management fees– Legal power to declare insolventLegal power to declare insolvent– Power to supercede shareholder rights, remove/replace Power to supercede shareholder rights, remove/replace

managers, directorsmanagers, directors

Private monitoringPrivate monitoring

Certified audit requiredCertified audit required

Percent of 10 biggest banks rated by Percent of 10 biggest banks rated by international rating agenciesinternational rating agencies

Accounting disclosure and liabilityAccounting disclosure and liability– accrued but unpaid interestaccrued but unpaid interest– consolidated statements consolidated statements – liability of directorsliability of directors

No deposit insuranceNo deposit insurance

! Private monitoring ≠ Laissez-Faire

Private monitoring involves “strong” supervision

Government-owned BanksGovernment-owned Banks

Percentage of banking system assets Percentage of banking system assets held by banks that are 50% or more held by banks that are 50% or more owned by the government.owned by the government.

Correlations (ignores within category corr’s!)Correlations (ignores within category corr’s!)Entry

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**

Gov’t ownership more entry restrictions & less reliance on private sector

Few tradeoffs with generous deposit insurance

Private monitoring associated with fewer regulatory restrictions on entry / competition

What Works Best?What Works Best?What “works”What “works”

– Bank development (country-level)Bank development (country-level)– Efficiency (bank-level data)Efficiency (bank-level data)

Net interest marginsNet interest margins Overhead costsOverhead costs

– Integrity (firm-level data)Integrity (firm-level data)– Stability (country-level data)Stability (country-level data)

Systemic crisesSystemic crises Non-performing loansNon-performing loans

– Bank governance: Market valuations (bank-level)Bank governance: Market valuations (bank-level)

Results on Bank DevelopmentResults on Bank Development

Basel IIBasel II– Capital requirements: ?Capital requirements: ?– Official supervisory power: hurtsOfficial supervisory power: hurts

But, not if high level of democracy (“top 10”)But, not if high level of democracy (“top 10”)– Private monitoring: helpsPrivate monitoring: helps

SOBs are bad. SOBs are bad.

Entry & Activity Restrictions: hurtEntry & Activity Restrictions: hurt

These results are more consistent with private rather than a public interest view

-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 (Confirmed using Net Interest Margin)

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

Economic SizeEconomic Size

If Mexico had Private Monitoring as the U.S. If Mexico had Private Monitoring as the U.S. (0.97 instead of –0.43) …(0.97 instead of –0.43) …

This would reduce the average Overhead Costs This would reduce the average Overhead Costs of Mexican banks from 6 to about 5. of Mexican banks from 6 to about 5.

This would reduce the difference between This would reduce the difference between Mexico & U.S., where Overhead Costs average Mexico & U.S., where Overhead Costs average a little over 3.a little over 3.

-1 -2 -3 -4 -5 -6 -7 -8

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

O fficial Power

0.144*** 0.131*** 0.161*** 0.076*** 0.172*** 0.143*** 0.117*** 0.144***

Private Monitoring

-0.271*** -0.231*** -0.106** -0.174*** -0.298*** -0.232*** -0.136*** -0.295***

GDP Growth

-12.052*** -8.183*** -0.582 -4.153** -13.104*** -9.854*** -5.402** -4.181*

Political Violence

-0.137** 0.674*** 0.632***

Political Voice

-0.403*** -0.674*** -0.735***

Corruption -0.245*** -0.165*** -0.179***

Gov't Banks

0.226* 0.32** 0.499***

Firm O bstacles

0.262*** 0.23*** 0.225***

GDP per Capita

0.16***

firms 2259 2259 2259 2259 2124 2259 2124 2124

countries 33 33 33 33 31 33 31 31

Results on Corruption in Lending

Controls for firm level traits: foreign, exporter, government, manufacturing, services, sales, & competitors

SummarySummary

Bank Development

EfficiencyStability/Loan

QualityLending Integrity

Capital Regulation +Supervisory Power - - (*) - - -Private Monitoring ++ ++ ++Activity Restrictions - - - - / - -Entry Restrictions - - -Government Banks - - - - -

Basel II: Remember Pillar III Private vs. Public interest: Private vs. Public interest: Suggests wariness of relying Suggests wariness of relying on official interventionon official intervention

Choosing policiesChoosing policies

Q1: Why do some countries choose policies that foster sound Q1: Why do some countries choose policies that foster sound banking, while others choose policies that encourage banking, while others choose policies that encourage

inefficiencies and corruption? inefficiencies and corruption?

Q2: What does the answer imply about the usefulness of Q2: What does the answer imply about the usefulness of identifying what works best?identifying what works best?

An example from Stephen HaberAn example from Stephen Haber

Mexico-Diaz (1876)Mexico-Diaz (1876)– Porfirio Diaz consolidates powerPorfirio Diaz consolidates power– Loans Loans Bank Charter Bank Charter– 2 banks / They write regulations!2 banks / They write regulations!– Directors of Banamex: Directors of Banamex:

President of Congress, Under-President of Congress, Under-Secretary of the Treasury, Senator Secretary of the Treasury, Senator for the Federal District, President’s for the Federal District, President’s Chief of Staff, brother of the Chief of Staff, brother of the Secretary of the TreasurySecretary of the Treasury, etc., etc.

ALL loans ALL loans directors directors

– Self-reinforcing – durable Self-reinforcing – durable

U.S. States post 1789U.S. States post 1789– States short of revenuesStates short of revenues– Loans Loans Bank Charter Bank Charter– Links: federalists-banks!Links: federalists-banks!– But:But:

Political competitionPolitical competition– PhiladelphiaPhiladelphia– NYNY– JeffersonJefferson

Competition for peopleCompetition for people– SuffrageSuffrage– Free bankingFree banking

Political system mattered for bank regulation

Social conflict view: PredictionsSocial conflict view: Predictions

Regimes that are uncompetitive with unconstrained executivesRegimes that are uncompetitive with unconstrained executives: : – Avoid: transparency and private monitoring, state banksAvoid: transparency and private monitoring, state banks– Construct: barriers to entry & perhaps restrictions on Construct: barriers to entry & perhaps restrictions on

activitiesactivities– ?: official supervisory power?: official supervisory power

Regimes that are competitive, democratic, constrained Regimes that are competitive, democratic, constrained executivesexecutives: : – Construct: transparency and private monitoringConstruct: transparency and private monitoring– Avoid: barriers to entry / restrictions on activities, state Avoid: barriers to entry / restrictions on activities, state

banksbanks– ?: official supervisory power?: official supervisory power

Alternative viewAlternative view

Govts maximize social welfare, but Govts maximize social welfare, but

– … … have limited informationhave limited information

– … … make and inherit mistakes / accidentsmake and inherit mistakes / accidents

So, “ what works best” So, “ what works best” reform reform social welfare. social welfare.

But, Argentina believes this optimism:But, Argentina believes this optimism:

“The Argentines alter their currency almost as frequently as they change presidents”

British Observer, 1899 !!

5. Political differences explain sup. & reg.5. 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). Control for legal origin. Or, simply run reduced form.

How Do Countries Choose?How Do Countries Choose?

Key results Key results – Open, competitive, democratic political institutions:Open, competitive, democratic political 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 political systems:Closed, uncompetitive, autocratic political systems:

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.

Qualified ConclusionsQualified ConclusionsUntil angels govern, need to rethink to bank regulation …Until angels govern, need to rethink to bank regulation …– Basel II is likely to be ineffective and may be harmfulBasel II is likely to be ineffective and may be harmful– Avoid relying excessively on official oversight, restrictions, & ownershipAvoid relying excessively on official oversight, restrictions, & ownership– Emphasize private monitoring / incentives (deposit insurance)Emphasize private monitoring / incentives (deposit insurance)

Confirmation of the private interest theory of regulation. No Confirmation of the private interest theory of regulation. No support for the public interest viewsupport for the public interest view

Political institutions influence bank regulatory choicesPolitical institutions influence bank regulatory choices– Reform will require customization: F{ political institutions }Reform will require customization: F{ political institutions }– Standardized “best practice” recommendations are unlikely to foster Standardized “best practice” recommendations are unlikely to foster

socially efficient reform.socially efficient reform.