Bank Supervisor Independence and the Health of Banking Systems Evidence from OECD Countries Steve Donzé London School of Economics

2 Policy Background Just as central bank independence is now fairly ubiquitous, financial supervisor independence has gained momentum, especially in the last decade The need for independence first stressed in the Basel Core Principles for banking supervision (Basel Committee on Banking Supervision 1997) Financial supervisor independence is now a standard policy prescription in the context of IMF- led Financial Sector Assessment Programmes

3 Transmission mechanisms Financial supervisor independence enhances policy credibility by ensuring financial supervisors abide by legal requirements – Government pressure generates time- inconsistent policies, thereby exacerbating risk-taking bias/moral hazard – Industry capture induces lax prudential standards and/or enforcement Downside risk: independent supervisors may not find optimal to act promptly (Kane 1990)

4 Motivation There is limited evidence that bank supervisor independence matters for banking stability. E.g., Barth, Caprio, and Levine (2002); Das, Quintyn, and Chenard (2004) This paper presents new indexes of bank supervisor independence based on national laws and assesses whether the formal adoption of independent supervisory agencies results in sounder banking systems

5 Legal Independence Indexes Set of statutory provisions enabling supervisory agencies to resist political and industry pressures Legal bank supervisor independence from government (LBSIG) summary index –4 sub-indexes (personnel, goal, policy and budget independence) Legal bank supervisor independence from industry (LBSII) summary index –2 sub-indexes (personnel and policy independence)

6 LBSIG Summary Index

7 LBSIG Typology Low personnel independence High personnel independence Low goal, policy and budget independence [Quadrant II] Japan Norway Mexico [Quadrant III] Ireland Korea Spain High goal, policy and budget independence [Quadrant I] Austria Denmark Germany [Quadrant IV] Belgium Finland Poland

8 LBSIG Stylised Facts The most independent supervisors have not been established in the more advanced economies –Full independence is rare. Developed countries discount independence by means of accountability/political control (consistent with Quintyn, Ramirez and Taylor 2006) –Emerging countries implement good practices in monetary and financial policies The higher bank supervisor independence, the less unified financial sector supervision –Politicians tend to fear ‘leviathan’ agencies

9 LBSII Summary Index

10 LBSII Stylised Facts Difference of means between central banks and separate agencies is not significant anymore Common law countries outperform any other legal origin sub-groups –Due in part to the Anglo-Saxon bureaucratic tradition, e.g., transparency in public life Bank-dominated financial systems are more likely to have lesser independent supervisors

11 Empirical Relationships Do banking systems in countries with higher independent supervisory authorities are sounder? Do some dimensions of independence matter more than others? The impact of legal independence is estimated through cross-sectional regressions –OLS with robust standard terms

12 Methodology Small sample size: OECD (30); OECD high- income (24) Basic equation –Dependent variable Average bank financial strength ratings from Moody’s and Fitch –Variables of interest LBSIG summary/individual indexes LBSII summary/individual indexes

13 Methodology There is no single standard way to measure banking sector soundness –Financial statement data –Market data –Financial strength ratings Financial strength ratings –Incorporate more information than any single macro-prudential data –Cross-country comparability

14 Methodology Control variables suggested by existing literature –Bank characteristics (concentration; private credit; foreign/state ownership –Country characteristics Institutions (rule of law; veto players) Macroeconomic (inflation; GDP growth; GDP per capita)

15 Main Regression Results SAIR (dep. var.) OECD (30)High-income (24) (1)(2)(3)(4)(7)(8)(9) LBSIG.255* (1.739).244* (1.683).257* (1.753).367* (1.850).420* (1.932) LBSII.113 (.738).252 (1.220) GDP per capita.691*** (4.706).600*** (3.918).598*** (3.164).520*** (3.303) GDP growth.197 (1.400).370* (1.714) Inflation (-.969) (-.597) Concentration.093 (.634).161 (.747) State ownership -.398** (-2.522) -.440* (-2.054) N R2R2.454***.405***.512***.570***.135* *

16 Results LBSIG summary index is positively correlated with Moody’s/Fitch ratings –Not sensitive to control variables –The impact of LBSIG is stronger at high levels of rule of law, i.e., in high-income countries –An increase in LBSIG summary index by one std. dev. corresponds to 0.62 of a notch at Fitch By contrast, LBSII summary index, although positively correlated, lacks robustness –Capture is not necessarily destabilising

17 Sensitivity Tests Summary indexes were also calculated using random weights instead of equal weights –Results are robust with slight variations Using Moody’s or Fitch measures of banking system soundness yields similar results ‘Mature’ supervisory agencies are associated with stronger banking systems Potential problem –Potential endogeneity of legal independence –Sample size

18 Conclusions Reforms aimed at increasing legal independence from government bring measurable benefits The chosen dependent variables are one of the many possible dependent variables It is understood though that formal independence, as important as the concept is, does not convey the full richness of supervisory agencies’ behaviour in practice –Detailed comparative case studies may add value in this context