Rethinking Bank Regulations Till angels govern (but who are the angels?)

1. Rethinking Bank RegulationsTill angels govern(but who are the angels?) Comments Roberto Rocha, FPDFS

2. Overview of Objectives, Methodology, and Conclusions • Main objective: identify which approaches to bank regulation and supervision lead to better outcomes • Outcomes defined by banking development, stability, efficiency, integrity • Methodology: Large questionnaire (275 questions) sent to 150 countries • Answers combined to produce large number of indices • Indices used as regressors • Outcomes (dependent variables) measured by private credit/GDP, interest margin, crisis index, lending corruption index

3. Overview of Objectives, Methodology, and Conclusions • Main Conclusions: • Strong direct official supervision and capital standards (pillars 1 and 2) do not generate positive results • In contrast, policies that facilitate private monitoring of banks (pillar 3) produce much better outcomes • Boost bank development • Improve bank efficiency • Reduce corruption in lending • Lower bank fragility

4. Overview of Objectives, Methodology, and Conclusions Some of the arguments used to substantiate conclusions: • Capture of politicians/supervisors by control groups, (corruption); powerful supervision aimed at favoring the privileged. These actors are no angels. • Regulators in high income countries take the view that their approach is best for other countries. • Results show that policies that facilitate private sector monitoring work best; it is essential to empower private actors through: • Disclosure of reliable, comprehensive, timely information • Incentives to monitor • Laws that strengthen the rights of private investors

5. General Comments • General concept and objectives of the exercise are very attractive, could generate important policy lessons • However, methodological problems are not trivial • Potential differences between statutory parameters and the reality of supervision is acknowledged by the authors; • The questionnaire may not capture the reality of bank regulation and supervision, differences across countries: • Several questions are too general/vague • No guidelines clarifying objectives of each question, and minimizing differences in interpretation • Important questions missing • Definitions/criteria used for building the indices from the answers are arbitrary, not clear • Main problem: measurement errors on the right hand side of the equation, but also other methodological issues

6. General Comments • Scores and rankings (and the regression results) are very sensitive to definitions/criteria used to build the indices • Example: Correlation of BCL index of central bank independence, with another index by Arnone, Laurens and Segalotto (ALS) (IMF2007) is only 0.1 • ALS index is more comprehensive, capturing more aspects of central bank independence • Some indices are inconsistent with evidence produced by the questionnaire itself • Example: CEE countries are the most open countries, as indicated by highest shares of foreign ownership; yet most restrictive according to the entry restrictions index (almost all countries scored max of 8) • Bona fide foreign investors could easily meet the 8 requirements in the index; In fact, correlation of index with share of foreign investors is positive (0.2) • At the same time, real statutory restrictions not captured in the index

7. General Comments • Country rankings are too counter-intuitive in many cases • Examples: Nigerian supervisor more independent than Chilean; Brazil as open as New Zealand; accounting/auditing standards very similar across countries • Some answers reflect lack of guidelines • Example: Australia classified as multiple supervisor and UK as unified supervisor • Questionnaire and regression results produce a main hero and a main villain: • Main hero: Private Monitoring Index (pillar 3) • Main villain: Official Supervisory Power Index (pillar 2) • More detailed analysis of these two indices is warranted

8. The Main Hero: Private Monitoring Index • What should the index capture: • The disclosure of reliable, comprehensive, timely information • Incentives for private agents to monitor banks, both positive and negative • How would the index capture these elements • Quality of bank accounting • Quality/integrity of external auditing • Quality of disclosure rules • Existence of subordinated debt • Existence of effective rating industry • Existence of de facto deposit insurance • Legal liabilities of pillar 3 players: directors, auditors, raters • Existence of effective, clean judicial system

9. The Main Hero: Private Monitoring Index Index probably does not reflect effectiveness of pillar 3 and differences across countries: • Assessment of the quality and integrity of external auditing is too shallow; no differences across countries • One single, trivial, aspect: existence of certified bank audits • Except for China, Italy, all countries got a 1 • Albania, Burkina, Bolivia, Central Afr. Republic, Honduras, Zimbabwe have the same auditing score as the US and the UK • Some important audit information used in other indices but not in this one (e.g., scope of audit, relations with supervisor) • Evidence from questionnaire on de facto absence of legal liability of auditors is ignored • Key aspects of auditing function missing in the questionnaire (e.g., scope, independence, conflicts of interest, SRO)

10. The Main Hero: Private Monitoring Index • Assessment of quality of accounting too shallow, not capturing differences across countries either: • Question on whether accrued interest on NPLs enters the income statement disregards quality of loan classification • Questions on elements of disclosure (off-balance sheet items, risk management) too vague, especially second - yes or no. • Bank directors in all countries are liable for disclosing wrong information: disregards evidence of lack of enforcement due to judicial corruption in ECs • Answers on % of 10 top banks rated are revealing: some supervisors were not certain, no domestic raters in most countries • Except for Germany, Tunisia, all countries got 3s and 4s (1-4) • Quality of accounting in Egypt, Nigeria, Paraguay, Russia, Rwanda equal to US, UK, higher than France, Germany, Sweden

11. The Main Hero: Private Monitoring Index • Assessment of the existence of moral hazard through provision of deposit insurance does not capture the reality of many countries: • Question relies on existence of explicit deposit insurance • In many countries deposits are insured by the government, no depositor has lost a cent, despite absence of explicit insurance • Examples: Egypt, Kuwait, Saudi Arabia, other Gulf countries • Egypt example: Bank restructuring program has entailed exit of 20 weak banks (out of 50) in the past 3 years, through organized mergers and acquisitions. • Question would need to be reformulated

12. The Main Hero: Private Monitoring Index • Final result: compressed scores, ranging from 5 to 11; average 7.8, SD = 1.4; unlikely to reflect actual differences across countries • Only 2 countries scored 11: Canada and Kuwait • Egypt and Gulf countries (Kuwait, Oman, Saudi Arabia, Oman, UAE) got high scores, average = 10, reflecting inter alia, absence of explicit deposit insurance • Different reality, strong (implicit but well-known) deposit insurance by Government • Index should be revised, robustness of results tested: • Elements from the existing questionnaire should be included • Several questions reformulated, some dropped • Additional questions included • Guidelines/instructions explaining objectives

13. The Main Villain: Official (Direct) Supervisory Power Index • Index presumably measures statutory enforcement powers, based on 14 questions: • 3 questions relate to relations with auditor (presumably important for the effectiveness of audit function and pillar 3) • 11 questions on enforcement, of which: • 3 deal essentially with the same supervisory action: • Whether supervisor can suspend dividends, bonuses, fees • 5 questions on enforcement check/compare power of supervisor, other agencies, courts to enforce key actions • Court involvement implies weaker powers, lower scores • 1 question deals with a basic reporting requirement (whether off-balance sheet items are disclosed to supervisor)

14. The Main Villain: Official (Direct) Supervisory Power Index Very difficult to assess this index • Index is not highly correlated with the supervisory independence index (corr. = 0.2) • Questionnaire does not capture regulatory powers (i.e. power to issue binding secondary regulation) • Questionnaire does not deal with the supervisory process • No information on basic numbers (e.g. numbers, salaries) • No information on on-site and off-site procedures • Index seems restricted to some specific statutory aspects of enforcement • Therefore, index captures very limited aspects of pillar 2; and even these aspects may not be sufficiently addressed

15. The Main Villain: Official (Direct) Supervisory Power Index • Not clear whether the three questions dealing with the auditor relate more to pillar 2 than pillar 3 • Many countries answered yes to whether supervisor can take legal action for auditor negligence but most of these also answered that this has not happened • Either auditors are doing a very good job, or the supervisor is a lion without teeth • Second information is not used at all in the exercise • Absence of de facto legal liability could make all these three questions irrelevant

16. The Main Villain: Official (Direct) Supervisory Power Index • Question on whether off-balance items are reported to supervisor is too basic – all countries answered yes. • Almost all countries also answered that supervisor have powers to order management to build provisions • Final result: Slightly wider differences across countries relative to private index (average 10.9, SD = 2.6), but is it capturing effectiveness of pillar 2? • One difficult but critical issue not sufficiently examined: the questions dealing with court involvement disregard the effectiveness of the judicial system

19. Other Methodological Issues • Measurement errors in the dependent variables • Variable measuring banking crisis: what was the treatment of countries where banks were deeply insolvent but there was never an open crisis, and where large stock of NPLs was never shown before the main restructuring program? • Specification problems • Many, more important factors, affecting dependent variables such as stock of private credit/GDP: inflation history, timing of recapitalization program with massive carve-outs • Endogeneity • Are there instruments to address response of regulatory and supervisory actions to shocks?

20. Summing Up Methodology • Most serious problem: measurement errors in the independent variables (indices built and used) • Errors are probably of such a magnitude that cannot be addressed by any of the available techniques • Specification problem in some of the regressions • Overall, robustness of results is questionable

21. Summing Up Policy Messages • Message that pillar 3 is important would find support • Message that pillar 2 is always ineffective, leading to corruption, and that only hope is pillar 3 would not • Directors, auditors, raters, courts are no angels either • Exercise provides a very basic message, does not provide sufficient guidance to policy-makers: • No pillar 2 at all?; Some pillar 2, ma non troppo? (Are there non-linearities?); If so, what type of pillar 2? • What are the building blocks for an effective pillar 3? • In particular, how to deal with judicial corruption?

22. Summing Up Proposal for next steps could include: • Revising the questionnaire, elaborating guidelines • More inputs from bank supervisors, auditing/accounting experts • Greater use of available material, ROSCs • Objective: build more reliable indices • Combine cross-country regressions with analysis of individual cases • Greater effort to identify policy lessons • Work program on Pillar 3 • What are the pre-conditions/building blocks for an effective pillar 3?