Re-Rethinking Bank Regulation F. Montes-Negret Director, ECSPF October, 2007

2 Dubious Policy Conclusion & Data “Across the different statistical approaches, we find that empowering direct official supervision of banks and strengthening capital standards do not boost bank development, improve bank efficiency, reduce corruption in lending, or lower banking system fragility. Indeed, the evidence suggests that fortifying official supervisory oversight and disciplinary powers actually impedes the efficient operation of banks, increases corruption in lending, and therefore hurts the effectiveness of capital allocation without any corresponding improvement in bank stability” (p.12).  Yes, supervision is deficient and yes, there is no “silver bullet”, but abolishing the “police force” can be extremely costly!. Bankers driven by balance between greed & fear (of loss) and by supervisors constraints on behavior!!.

3 A Policy Recommendation Nobody Can Disagree With -“In contrast to these findings on capital regulations and direct supervisory oversight of banks, bank supervisory and regulatory policies that facilitate private sector monitoring of banks improve bank operations, which endorses Basel’s II third pillar”.  But how do we get there?  Which are the pre-conditions to make it work?  Who provides the market discipline and how?  Do you still trust the private rating agencies?

4 Need for a more nuanced approach  The first conclusion is entirely anchored in a model of complete “regulatory capture” (private interest approach to regulation), where the interests of the public are totally subordinated to the different interests of industry and corrupt politicians  the back-door privatization of the State by the “oligarchs”. –“ All politics is business in Russia today, and all business is acutely political”, Quentin Peel, “Between the Lines”, FT. –If all institutions fail, bank supervision also fails: Anything new or surprising?. Failure of the State!.  Need for a more nuanced approach;

5 Need for a more nuanced approach  No disagreement wit the second conclusion, but most likely if the authors’ first conclusion holds, the second one cannot be implemented!.  Captured public sectors are often correlated with weak, also captured private mechanisms to oversee banks! (no independent press, etc..).  Real dilemma is how to enhance the (internal) check & balances (independent supervisors) and (external) effective market discipline (absence of moral hazard and preconditions for effective market enforcement).

6 How does an Efficient & Effective Supervisory System Look Like? *  It must create financial stability and a dynamic and competitive sector;  The supervisory structure must be cost efficient;  It must be competitively neutral (leveled playing field);  It must be transparent;  It must provide an effective crisis management framework;  It must foster market integration and efficiency; and  It must have political accountability;  Asking too much? * “Towards a new structure for EU financial supervision”, Deutsche Bank Research, August 22, 2007

7 Four Very different Classes of Capitalism One Common Element: Private Ownership*  State-Guided Capitalism  Colbert & Picking winners  public banks a problem;  Oligarchic Capitalism  Privatizing the KGB. Irrelevance of the “public interest”;  Big Firm Capitalism  GM/GE runs the place;  Entrepreneurial Capitalism  Schumpeterian Competitive markets,  Impossibility of having an independent supervisory function in the first three classes! * Good Capitalism, Bad Capitalism and the economics of growth and prosperity, W. Baumol et. al., Yale, 2007.

8 Is Pillar 3 only enough?  While there has been successful cases of laissez- faire approaches to banking regulation (ex. the Scottish free banking era), such approaches are not feasible today.  The terrifying counterfactual: abolishing the police!.  Need to accept the imperfections of regulations, maybe limit its scope, but hard to agree with the book’s conclusions: Abolish supervision and believe Pillar 3 measures will solve all problems!

9 A new regulatory model is emerging  Meta-Regulation  Devolution of responsibilities to Sr. bank Managers and Boards of Directors, while regulators focus on the adequacy of banks’ governance ( integrity of internal controls, avoidance of conflicts of interests, accountability, incentives, etc.) and enforcement.

10 The Dangers of Excessive Empiricism  Simple questions for complex topics not advisable – Credibility of self assessments;  Quality of data: Dubious?  Comparability across countries?  Methodology: –Discrete questions: events versus processes;

11 Concluding Remarks Dangerous for the WB to give non-nuanced and unqualified policy advice:  “strengthen official supervision and regulation” (traditional WB advice with vague meaning) or  “regulation and supervision are counterproductive” (Caprio et. al.). => Crisis of the supervisory framework or crisis of the State?

12 No Easy Solutions  Greed > Fear => bubbles, speculation, etc. validated by lax M&F policies.  Greed recessions, risk-aversion, higher unemployment, etc. validated by tight M&F policies.  Difficulty of allocating losses to the “guilty parties”.  Importance of institutional development, good governance and disclosure.