Measuring Bank Regulation and Supervision: Lessons from Economic History Stephen Haber Stanford University Presented at the World Bank, October 26, 2007

What is Agreed Upon: There is a causal relationship between financial development and economic growth: King and Levine 1993; Levine 1997, 1998, 2005; Levine and Zervos 1998; Levine, Loayza, and Beck 2000; Rajan and Zingales 1998; Gerschenkron 1962; Rousseau and Sylla 2003.

What is not agreed upon: How do we encourage financial development?. 1. Stronger supervision and regulation? 2. Reforms to basic institutions? Might #1, in the absence of #2, actually make things worse?

Barth, Caprio, and Levine are in the last camp

Does the BCL view hold when we look at variance within countries over time

How can we know whether the BCL regressions are detecting causal relationships? One method is to use history as a natural laboratory, to see if the hypothesized causal relationships can be seen to operate in real world cases. I am therefore going to focus on a single case—but that that has had five separate experiments in the creation of a banking system: Mexico,

Mexico’s first experiment: The Porfirio Diaz dictatorship, Getting bankers to deploy their capital meant A. centralizing supervision B. granting special privileges C. Limiting entry. The results: A. segmented monopolies. B. rent sharing with politicians.

Bank Shareholders Earned Rents

Mexico’s Banking System Grew

Bankers lent to themselves Percent of non-government loans made to banks’ own boards of directors: Banamex 1886 to % Mercantil de Veracruz % Coahuila, % Durango, % Mercantil de Monterrey, % Nuevo León, %

Limits on bank entry created barriers to entry in downstream industries

The experiment ended with a revolution—and a bank expropriation using the supervisory powers of the new government

Mexico’s second experiment: Banking under the PRI Getting bankers to deploy their capital meant: A. Allowing them to write the banking laws B. Limiting entry. C. Giving them voice in the supervisory body— the CNB. D. Creating a government owned commercial bank, Banxico, that made loans to the private banks and to powerful politicians.

The lack of limits on government meant that the rules were soon changed In 1932 Banxico was made a central bank. In 1936 the government required that private banks hold deposit reserves in Banxico, and bank supervision was transferred to Banxico.

In the 1970s, the government used the supervisory powers of Banxico to expropriate deposits, and then the government expropriated the banks in 1982

Mexico’s Third Experiment: The Privatization of Bankers faced expropriation risk. 2.Government wanted to maximize price on offer. 3.Government aligned the incentives of the bankers by regulating entry 4.Bankers were also allowed to buy the banks with borrowed funds—some of it from the same banks they were buying. 5.Bankers therefore had weak incentives to be prudent, which in turn required that depositors be protected with unlimited deposit insurance, removing their incentives to monitor.

So, Bankers Plunged into Credit Markets

Made lots of bad loans, and got bailed out

Mexico’s Fourth Experiment: Bank Regulation in an Emerging Democracy, In 1997: A. Accounting standards rewritten. B. Related lending made more difficult. C. Deposit insurance agency made independent. D. Foreign banks permitted to buy Mexican banks. In : A. Bankruptcy laws reformed; B. Programs to improve property registers. C. Expansion of non-bank banking sector. In 2006: A. Bank charters granted to large retailers.

Bank Lending to Households and Business Enterprises, by type, as % GDP

Conclusions 1.Broadly speaking, BCL’s main conclusions from cross sectional evidence are consistent with case study. 2.When government’s authority and discretion were not limited, supervision was used to either expropriate banks (1916 & 1982), create government owned banks ( ), behave opportunistically toward banks (1970s, early 1990s). 3.When government’s authority and discretion were limited ( ), prudent supervision produced financial development—but starting from a low base.

These results extend beyond Mexico Time constraints prevent us from discussing other cases. Nevertheless, the analysis of other cases—Brazil, Colombia, the United States—produces broadly similar results Supervision can be used opportunistically by governments against private banks—and the more unconstrained the government is, the more opportunistic it can be.