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Levine, Ross

Article Bank regulation and supervision

NBER Reporter Online

Provided in Cooperation with: National Bureau of Economic Research (NBER), Cambridge, Mass.

Suggested Citation: Levine, Ross (2005) : Bank regulation and supervision, NBER Reporter Online, National Bureau of Economic Research (NBER), Cambridge, MA, Iss. Fall 2005, pp. 9-12

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Ross Levine*

A large body of research suggests World Bank, and other international the world. In terms of defining “sound that banks matter for human welfare. agencies have developed extensive banking,” many take for granted that Most noticeably, banks matter when checklists of “best practice” recommen- stability is the primary objective of they fail. Indeed, the fiscal costs of dations that they urge all countries to bank regulation. While we study stabili- banking crises in developing countries adopt. Most influentially, the Basel ty, my co-authors and I also examine the since 1980 have exceeded $1 trillion, Committee on Bank Supervision recent- impact of banking policies on bank and some estimates put the cost of ly revised and extended the 1988 Basel development, efficiency, corruption in Japan’s banking problems alone over Capital Accord. lending, and corporate governance of this threshold.1 Recent research also banks. Banks are not simply safe places finds that banks matter for economic Data to stash funds. Banks play pivotal roles growth.2 Banks that mobilize and allo- in mobilizing and allocating resources, Until recently, the absence of data cate savings efficiently, allocate capital monitoring firms, and providing liquid- on bank regulation and supervision to endeavors with the highest expected ity and risk management services. Thus, made it impossible to conduct broad social returns, and exert sound gover- bank regulation and supervision should cross-country studies of which regula- nance over funded firms foster innova- be judged by more criteria than stability tions and supervisory practices pro- tion and growth. Banks that instead alone. mote sound banking. While analysts funnel credit to connected parties and used models, country-studies, and the the politically powerful discourage A Political Economy Approach experiences of supervisors to make pol- entrepreneurship and impede economic icy recommendations, there were simply Consistent with research on the development. Recent work further insufficient data with which to conduct political economy of banking policies, shows that banks matter for poverty extensive international comparisons the patterns we observe in the data sug- and income distribution.3 Well-func- and to test the validity of Basel II or gest that countries do not choose indi- tioning banks that extend credit to other proposals for reform. Clearly vidual regulations in isolation; rather, those with the best projects, rather than expert advice and evidence from indi- individual choices reflect broad to the wealthy or to those with familial, vidual countries should inform banking approaches to the role of government political, or corrupt connections, exert policies; but just as clearly, cross-coun- in the economy.5 Some governments an equalizing affect on the distribution try econometric evidence can provide a choose an active, hands-on approach, of income and a disproportionately valuable input. where the government owns much of positive impact on the poor by de-link- Consequently, James Barth, Gerard the banking industry, restricts banks ing good ideas and ability from past Caprio, and I assembled an internation- from engaging in non-lending activities accumulation of wealth and associa- al database on banking policies. We con- such as securities underwriting, insur- tions. ducted two surveys. The first was con- ance, real estate, and non-financial serv- The important relationship between ducted in 1998–9 and involved over 100 ices, limits the entry of new banks, and banks and economic welfare has led countries and included information on creates a powerful supervisory agency researchers and international institutions almost 200 regulations and supervisory that directly oversees and disciplines to develop policy recommendations con- practices. The second covered 2003–4 banks. Other countries rely substantial- cerning bank regulation and supervision. and included 50 more countries and 100 ly less on direct government control of The International Monetary Fund, additional questions, many of which banks. These countries place compara- were recommended by users of the first tively greater emphasis on forcing * Levine is a Research Associate in the survey.4 banks to disclose accurate information NBER's Program on International Finance Using these data, I am working with to the public as a mechanism for facili- and Macroeconomics and the Curtis L. Carlson others to assess which banking sector tating private sector governance of Professor of Finance at the University of policies promote sound banking around banks. Thus, some of my research can Minnesota. His profile appears later in this issue.

------NBER Reporter Fall 2005 9 be viewed as using the laboratory of regulation of bank activities and direct, Thorsten Beck, Asli Demirgüç-Kunt, bank regulation and supervision to hands-on influence over banks is and I estimate that the probability that a assess the historic debate about the unlikely to promote sound banking. firm reports bank corruption as a major proper role of government in the econ- Rather, the private interest view holds obstacle to firm growth would decrease omy. that the most efficacious approach to by over half if a country moved from Given these observations, my coau- bank supervision relies on using gov- the 25th percentile of our measure of thors and I have framed our initial inter- ernment regulations and institutions to the degree to which regulations force national investigations of bank regula- empower private monitoring of banks. information disclosure and foster pri- tion and supervision within the context Specifically, the private interest vate sector monitoring to the 75th per- of two views of government. The pub- approach advocates effective informa- centile.7 Furthermore, information dis- lic interest approach stresses that mar- tion disclosure rules and sound contract closure rules have a particularly strong ket failures — information and contract enforcement systems so that private effect on reducing corruption in lend- enforcement costs — interfere with the investors can use this information to ing in countries with well-functioning incentives and abilities of private agents exert sound corporate governance over legal institutions. Thus, private investors to monitor and discipline banks effec- banks with positive ramifications on need both information and legal tools tively. From this perspective, a powerful bank operations. This is not a laissez- to exert sound governance over banks. supervisory agency that directly moni- faire approach. To the contrary, the pri- Results on banking system crises tors and disciplines banks can improve vate interest approach stresses that also advertise the importance of the bank operations. The public interest strong legal and regulatory institutions incentives facing private investors. approach assumes that there are market are necessary for reducing information While we do not find a relationship failures and official supervisors have the and contract enforcement costs. My between information disclosure rules incentives and capabilities to ameliorate research is beginning to provide cross- and bank fragility, there is a strong link those market failures by directly over- country empirical evidence on these dif- between deposit insurance design and seeing, regulating, and disciplining ferent approaches to bank regulation crises. The results are consistent with banks. and supervision, including analyses of the view that generous insurance The private interest view, however, the role of legal and political institu- schemes reduce the incentives of pri- questions whether official supervisory tions in determining the effectiveness of vate investors to monitor banks and this agencies have the incentives and ability different banking sector policies. increases the ability of bank owners to to fix market failures and enhance the take on excessive risks, increasing the socially efficient operation of banks. Initial Results on What Works probability that the country suffer a sys- The private interest view holds that and What Does Not temic crisis.8 For example, James R. politicians and government supervisors Barth, Gerard Caprio, and I estimate Using different cross-country, do not maximize social welfare; they that if Mexico changed its very gener- bank-level, and firm-level datasets and maximize their own welfare. Thus, if ous deposit insurance to the sample employing different econometric tech- bank supervisory agencies have sub- average, then its probability of suffering niques, the initial results are broadly stantial influence over bank decisions, a systemic crisis would drop by 12 per- consistent with the predictions from a then politicians and supervisors may centage points.9 private interest view of bank regulation. abuse this power to force banks to In contrast, the results across a Bank regulations and supervisory prac- divert the flow of credit to ends that range of studies do not support the tices that force banks to disclose accu- satisfy the private interests of politi- public interest view of regulation and rate information to the public tend to: cians and supervisors, not the interests raise a cautionary flag regarding reliance 1) boost the development of the bank- of the broader public. Thus, strength- on direct official oversight of banks, ing system as measured by private cred- ening official oversight of banks might government ownership of banks, regu- it relative to Gross Domestic Product; reduce bank efficiency and intensify lations restricting bank activities, and 2) increase the efficiency of intermedia- corruption in lending. impediments to the entry of new tion as measured by lower interest mar- According to the private interest domestic and foreign banks. We never gins and bank overhead costs; and 3) view, most countries do not have politi- find that giving official supervisors reduce corruption in lending as meas- cal and legal systems that induce politi- greater powers (to force a bank to ured by survey information from firms cians and government officials to act in change its internal organizational struc- around the world.6 For example, the best interests of society. Thus heavy ture, suspend dividends, stop bonuses,

10 NBER Reporter Fall 2005 ------halt management fees, force banks to sistent with the private interest predic- efficacy of Basel II’s third pillar: market constitute provisions against actual or tion that regulatory restrictions on discipline. Regulations that require potential losses as determined by the activities, impediments to entry, limits informational transparency and that supervisory agency, supersede the legal on investing abroad, government own- strengthen the ability and incentives of rights of shareholders, remove and ership, and strengthening the discre- the private sector to monitor banks tend replace managers and directors, obtain tionary power of official supervisors to promote sound banking. information from external auditors, and increase cronyism, corruption, and col- take legal action against auditors for lusion with adverse ramifications on the Extensions negligence) enhances bank operations efficiency and effectiveness bank inter- Finally, I have also begun to exam- or reduces bank fragility. Similarly, mediation. In analyses, however, we ine the determinants of bank supervi- greater government ownership of find that well-functioning political and sory and regulatory choices.12 Perhaps banks, regulatory restrictions on bank legal institutions negate the negative not surprisingly, the data indicate that activities, or limitations on the entry of effects of empowering direct official countries with more open, competitive, new banks never has positive effects. oversight of banks. But even in these democratic political systems that have While some theories predict that cases, the results do not indicate that effective constraints on executive power strengthening direct official oversight empowering direct official oversight tend to adopt an approach to bank and regulation of banks will promote improves bank operations. supervision and regulation that relies social welfare in countries with well more on private monitoring, imposes functioning political and legal institu- Basel II and Beyond fewer regulatory restrictions on bank tions, we do not find support for this This research has implications for activities and the entry of new banks, hypothesis either.10 the three pillars of Basel II. Regarding and has less of a role for government- Across the different studies that I pillar one, my coauthors and I did not owned banks. In contrast, countries have conducted thus far, the bulk of find a significant impact of capital reg- with more closed, uncompetitive, auto- “hands on” government policies lowers ulations on bank development, efficien- cratic political institutions that impose bank development, induces less effi- cy, stability, or corruption. Many factors ineffective constraints on the executive cient banks, exacerbates corruption in may explain this result. The harmoniza- tend to rely less on private monitoring, bank lending, and intensifies banking tion of national capital regulations impose more restrictions on bank activ- system fragility. Specifically, countries makes it difficult to find a relationship ities and new bank entry, and create a that grant their official supervisors between capital regulations and bank bigger role for government banks. greater disciplinary powers have lower performance. Or, the lack of clear evi- These findings underscore the difficulty levels of bank development and greater dence on the beneficial effects of cur- in deriving uniform best practice guide- corruption in lending. Governments rent capital regulations may reflect the lines for countries around the world. that heavily regulate bank activities and inadequacy of the Basel I capital regula- Much work remains, though. We have restrict entry into banking have banks tions and the need for implementing not exploited all aspects of the database with bloated interest rate margins and Basel II. Or, banks may evade capital on bank regulation and supervision and larger overhead costs. For example, regulations. considerably more research is needed Demirgüç-Kunt, Luc Laeven, and I The findings support Basel II’s on designing strategies for reforming compute that if Mexico had the same third pillar, but not its second. For most banking policies in ways that enhance level of restrictions on bank activities as countries, the data indicate that the operation of banks and improve Korea, its interest rate margins would strengthening official supervisory pow- social welfare. be a full percentage point lower.11 ers will make things worse, not better. Furthermore, countries with greater 1 Unless the country is “top ten” in terms J. Barth, G. Caprio, and R. Levine, government ownership of the banking of the development of its political insti- Rethinking Bank Regulation: Till Angels industry have less banking system Govern, Cambridge University Press, forth- tutions, the evidence suggests that development. We also find that restrict- coming. strengthening official supervisory pow- 2 ing banks from diversifying into non- R. Levine, “Finance and Growth: Theory ers hurts bank development and leads and Evidence,” NBER Working Paper No. lending activities and prohibiting banks to greater corruption in bank lending 10766, September 2004, and Handbook of from lending abroad increases banking without any compensating positive Economic Growth, Philippe Aghion and system fragility. effects. Instead, the results advertise the Steven Durlauf eds., forthcoming. Thus, the evidence is broadly con- 3 T. Beck, A. Demirgüç-Kunt, and R. Levine,

------NBER Reporter Fall 2005 11 “Finance, Inequality, and Poverty: Cross- Regulation and Supervision: What Works Journal of Banking and Finance, forth- Country Evidence,” NBER Working Paper Best?”, and Rethinking Bank Regulation: coming. No. 10979, December 2004; and T. Beck, Till Angels Govern,. 9 J. Barth, G. Caprio, and R. Levine, “Bank A. Demirgüç-Kunt, L. Laeven, and R. 6 J. Barth, G. Caprio, and R. Levine, “Bank Regulation and Supervision: What Works Levine, “Finance, Firm Size, and Growth,” Regulation and Supervision: What Works Best?” NBER Working Paper No. 10983, Best?”; A. Demirgüç-Kunt, L. Laeven, and 10 G. Caprio, L. Laeven, R. Levine, December 2004. R. Levine, “Regulations, Market Structure, “Governance and Bank Valuation,” NBER 4 J. Barth, G. Caprio, and R. Levine, Institutions, and the Cost of Financial Working Paper No. 10158, December 2003; “Banking Systems Around the Globe: Do Intermediation,” NBER Working Paper No. J. Barth, G. Caprio, and R. Levine, “Bank Regulation and Ownership Affect Performance 9890, August 2003, and Journal of Money, Regulation and Supervision: What Works and Stability?” in Financial Supervision Credit, and Banking, 36 (2004), pp. Best?”; A. Demirgüç-Kunt, L. Laeven, and and Regulation: What Works and What 593–622; T. Beck, A. Demirgüç-Kunt, and R. Levine, “Regulations, Market Structure, Doesn’t, F. Mishkin ed., Chicago, IL: R. Levine, “Bank Supervision and Corporate Institutions, and the Cost of Financial Chicago University Press, (2001), pp. 31–88; Finance,” NBER Working Paper No. 9620, Intermediation”; T. Beck, A. Demirgüç-Kunt, “The Regulation and Supervision of Banks April 2003, and “Bank Supervision and and R. Levine, “Bank Supervision and Around the World: A New Database,” in Corruption in Lending,” mimeo (June 2005). Corporate Finance”; T. Beck, A. Demirgüç- Robert E. Litan and Richard Herring, eds., 7 T. Beck, A. Demirgüç-Kunt, and R. Levine, Kunt, and R. Levine, “Bank Supervision and Integrating Emerging Market Countries “Bank Supervision and Corruption in Corruption in Lending”; T. Beck, A. into the Global Financial System, Lending”. Demirgüç-Kunt, and R. Levine, “Bank Brookings-Wharton Papers on Financial 8 A. Demirgüç-Kunt and E. Enrica Concentration and Crises”; and J. Barth, G. Services, Washington, DC: Brookings Detragiache, “Does Deposit Insurance Caprio, and R. Levine, Rethinking Bank Institution Press (2001), pp. 183–241; Increase Banking System Stability? An Regulation: Till Angels Govern. “Bank Regulation and Supervision: What Empirical Investigation,” Journal of 11 A. Demirgüç-Kunt, L. Laeven, and R. Works Best?” NBER Working Paper No. Monetary Economics, 49, (2002), pp. Levine, “Regulations, Market Structure, 9323, November 2002, and Journal of 1373–406; and T. Beck, A. Demirgüç-Kunt, Institutions, and the Cost of Financial Financial Intermediation, 13, (2004), pp. and R. Levine, “Bank Concentration and Intermediation”. 205–48; and Rethinking Bank Crises,” NBER Working Paper No. 9921, 12 J. Barth, G. Caprio, and R. Levine, Regulation: Till Angels Govern. August 2003, and “Bank Concentration, Rethinking Bank Regulation: Till Angels 5 J. Barth, G. Caprio, and R. Levine, “Bank Competition and Crises: First Results,” Govern.

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