Banking on the Principles: Compliance with Basel Core Principles and Bank Soundness

1. Banking on the Principles: Compliance with Basel Core Principles and Bank Soundness byAslı Demirgüç-Kunt, Enrica Detragiache, and Thierry Tressel September 2006

2. Motivation • Everybody agrees that to make banks more stable countries need to “strengthen prudential regulation and supervision” • But how ??? • What exactly is good regulation and supervision? • How can countries do it with limited resources? • What should reforms focus on?

3. Motivation • In 1997, the Basel Committee issued the Basel Core Principles (BCPs) of Effective Bank Supervision and Regulation • Beginning in 1999, assessments of compliance with BCPs carried out by IMF and WB in FSAPs

4. Basel Core Principles • Chapter 1: Preconditions for effective banking supervision • Chapter 2: Licensing and Structure • Chapter 3: Prudential Regulations and Requirements • Chapter 4: Methods of On-Going Supervision • Chapter 5: Information Requirements • Chapter 6: Formal Powers of Supervisors • Chapter 7: Cross-Border Banking

5. The Questions • Is compliance with BCPs associated with a sounder banking sector? • Are any principles more important than others, so that they should be the focus of reform efforts?

6. Literature review • Barth, Caprio, Levine (2001, 2004, 2006): survey data on supervisory approaches around the world • What works best is empowering the market • accurate information disclosure • foster incentives for private sector to monitor and exert corporate control

7. Literature review • Sundararajan, Marston, and Basu (2001): BCP compliance data for 25 countries. No effect of BCP compliance on NPLs and loan spreads. • Podpiera (2004): BCP compliance for 65 countries. BCP compliance lowers NPLs.

8. This paper: • Do banks in countries with better BCP compliance get a higher financial strength rating from Moody’s? • Do some BCP chapters matter more than others?

9. Pros and Cons of using ratings: • Pros of using ratings to measure bank soundness • Ratings have more information than just accounting data • Ratings should be comparable across countries • Safety net differences do not matter for these ratings

10. Pros and Cons of using ratings: • Cons of using ratings to measure bank soundness • Restricts the sample (no small banks; few banks from low income countries) • Subjective assessment could introduce biases • Rating agencies did not do a good job at warning of crises We also use Z-scores (based on accounting measures) as robustness check

11. Methodology: • Sample: 203 banks, 39 countries • Basic equation: • Dependent variable: bank rating (scale 1-15) Variable of interest: • BCP compliance overall index (scale 1-4) • BCP compliance with individual chapters • Ordered probit with errors clustered by country

12. Methodology: • Control variables • Bank characteristics (foreign/state-owned; size; capitalization; profitability; loans/assets) • Country characteristics; • Institutions (rule of law; GDP per capita) • Macro (sovereign rating; inflation; growth; depreciation;...)

13. Potential Concerns • BCP compliance may proxy for the overall quality of the institutional environment • Institutional quality, sovereign ratings.. • Endogeneity of BCP compliance • IV estimation • Moody’s ratings may also reflect institutional quality rather than soundness • Z-scores

15. Results : • The overall index of BCP compliance is positively correlated with Moody’s ratings, but sensitive to controlling for the institutional quality of the country and the exclusion of outliers.

17. Results : • When we consider individual chapters, Chapters 2 (licensing and structure), Chapter 5 (information requirements), and Chapter 1 (preconditions) are significant • However: when we test robustness excluding one country at a time and/or controlling for aggregate indexes that exclude the individually included chapters, the only one that survives is Chapter 5

19. Chapter 5 remains significant • Excluding developed countries or extreme observations • Including • Macro controls (exchange rate depreciation, inflation and its volatility, real credit growth, read GDP per capita growth..) • Frequency and timeliness of macroeconomic data release • Other indexes of discipline, information disclosure, auditing requirements and lack of banking restrictions

20. Endogeneity : • Individual bank data makes reverse causality less of a concern • Nonetheless, instrumental variable estimation using legal origin as instrument for compliance leaves the results unchanged

22. Measuring Bank Risk with Z-scores: • Z-score definition (Boyd and Runkle, 1993) (mean return on assets+equity/assets)/ standard deviation of returns A higher score indicates a more stable bank Using this measure again the only element of compliance that seems to matter for bank soundness is compliance with information requirements

23. Conclusions : • It is important to ensure broad, frequent, and accurate information disclosure both to supervisory authorities and to the markets. • When allocating limited resources, and considering reforms to strengthen their regulatory and supervisory systems, countries should give priority to transparency