Rethinking Bank Regulation

1. Rethinking Bank Regulation James Barth Gerard Caprio Ross Levine

2. Overview • Some findings • Some weaknesses, and strengths • A plea • For epistemological modesty • Against faith-based policy advising

3. 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 angels Politicians (& some bank supervisors) are not angels. Politics shapes bank regulatory choices and the effects of those choices. BCL, 2006 Some Findings: Conceptual framework

4. What does this actually mean for policy? • Capital regulations, entry restrictions, activity restrictions, deposit insurance, government ownership, etc. • Needed to overcome market failures … predictions. • In some political systems, protects elite … predictions. • Strong official supervisory oversight • Needed to overcome market failures …. predictions. • In some political systems, protects elite … predictions. • Private monitoring, transparency, market discipline • Insufficient to overcome market failures … predictions. • Reduces discretion of elite … predictions.

5. Results: What Works Best? “Works” Bank development Efficiency Stability Corruption in lending

6. Results:Measuring regulation • “Every rule” vs. “Broad index”? • Countries choose strategies! • Not a smorgasbord of rules • So, we use broad indexes

7. Correlations 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

8. Bank development Bank Development =  + s + X + u s = Z +  • s = Supervisory/regulatory indicators • X = Exogenous determinants of Bank Development, identified by existing research (legal origin, ethnic diversity, settler mortality, etc.) • Z = Instrumental variables for the bank supervision and regulation variables (religious orientation, endowments, latitude) • u and  are error terms • , , , and  are the estimated parameters

9. Private monitoring boosts bank development

10. Official supervisory power lowers bank development

11. Some findings: Bank efficiency Interest margins Overhead costs

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

13. Some findings: Stability • Past work shows: • Increases in deposit insurance generosity • Increase moral hazard • Increases fragility • But, do supervision and regulation help?

14. NO!: Moral hazard mitigated by broad institutions, 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 -0.031 Moral Hazard Index*Capital Regulatory Index -0.131 N 43 40 41 43 43

15. Results: so far … • Inconsistent with … • Laissez-faire • Angelic regulators • Consistent with … • Private interest view • Market discipline • But, corruption?

16. Some more findings: Corruption in lending Corruption Obstaclei,k = a[Fi,k] + b[Ci] + c[Si] + ui,k Fi,k: Firm-specific traits Ci: Country-specific traits Si: Supervision/Regulatory indicators • Official supervisory power • Private monitoring • 4812 firms across 49 developed and developing countries

17. Some findings: corruption in lending

18. More Controls ...

19. Some findings: Political institutions • Why don’t countries choose good regulations? • Good for whom? • Politics matters!

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

21. How Do Countries Choose? • Open, competitive, democratic institutions: • Foster private monitoring, transparency. • Less likely to limit bank entry, activities. • Less likely to have state banks. • Closed, uncompetitive, autocratic institutions: • Do NOT favor transparency (surprise!). • Limit bank entry, activities. • Tend to have state banks.

22. Findings so far ... • Until angels govern … • Avoid relying only on official oversight, restrictions, etc. • Emphasize private monitoring / incentives • Stress Basel II’s 3rd pillar • Supervisors have crucial role • Support market discipline, not supplant it • Foster / force information disclosure • “Best practices” depend on political system.

23. 2. Analytical Weaknesses But, confirmatory evidence

24. Limitations Survey errors Implementation Cross-country shortcomings Response Survey errors Errors, but bias? Do better surveys! Implementation Recent FSAP work Do better surveys! Cross-country shortcomings But, case-studies Weaknesses, but ... Where is the countervailing evidence??

25. For Epistemological modesty Surveys have problems Regressions have problems Case studies have problems Expert guidelines have problems Against Faith-based policy advising These policies are very important For growth For poverty alleviation For equality of opportunity Need to assess competing views systematically 3. A plea ...