Bank Regulation Is Changing: But for Better or Worse? Gerard Caprio Williams College

If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. James Madison, Federalist Papers, Number 51

Institutional Environment Democratic, Political Structure/System Technology, Information Infrastructure Judicial, Legal, Regulatory Environment Market Structure Media The Market: Depositors,creditors, rating agencies Politicians Regulators and supervisors Borrowers, counterparties Corruption corruption Banks The Public corruption A Framework for Bank Regulation

2. Debate about government’s role Public interest view Gov’t maximizes social welfare Gov’t maximizes social welfare Gov’t has incentives / ability to ameliorate market failures Gov’t has incentives / ability to ameliorate market failures If we identify “best practices,” countries will change. If we identify “best practices,” countries will change. Private interest view Gov’t maximizes Gov’t welfare; so do regulatees Gov’t does not necessarily have incentives / ability to fix failures Need more than “best practices”: Combination of incentives for regulators and regulatees will not maximize social welfare Laissez-Faire : Market failures minor  no need for government

3 Surveys 3 Surveys 1 st : st : countries 107 countries 175 questions 175 questions 2 nd : nd : countries 152 countries 275 questions 275 questions 3rd: rd: countries 142 countries 300+ questions 300+ questions 3. Collecting the data...

Size of Banking Systems Differs Widely Vanuatu 14,342% Germany 361% Japan 159% Mexico 28% Russia 34% United States 64% Argentina 45% Singapore 117% Sudan 14% Bank Assets/GDP Median=68%

14% 64% 361% Ratio of Bank Assets to GDP Ratio of Bank Assets to GDP

Government-Owned Banks

Government Ownership of Banks Differs Widely Median = 5%

Government-Owned Bank’s Share of Total Bank Assets 78 Percent 68 Percent

Foreign Ownership of Banks Differ Widely Median = 39%

11 Percent 98 Percent Foreign-Owned Banks’ Share of Total Bank Assets

Grouping and Aggregating Data to Assess What Works Best Structure, scope, independence of regulation and supervision Structure, scope, independence of regulation and supervision Bank activities Bank activities Entry requirements Entry requirements Capital requirements Capital requirements Deposit Insurance Deposit Insurance Supervisory powers Private monitoring External governance Ownership characteristics All the data is online in the hopes of lowering the entry barriers to conducting better research.

How Many Bank Supervisory Authorities Do Countries Have?

Is the Central Bank a Supervisory Authority?

Who Funds Supervision in Countries?

What Is a Bank? Regulatory Restrictions on Activities SecuritiesInsurance Real estateBank ownership of nonfinancial firms Nonfinancial firm ownership of banks Percent UnrestrictedPermittedRestrictedProhibited

Entry Foreign Foreign limitations on foreign entry/ownership limitations on foreign entry/ownership % of entry applications denied (foreign & domestic) % of entry applications denied (foreign & domestic) Domestic Domestic summary indicator of rules to obtain a license summary indicator of rules to obtain a license draft by-laws, organizational chart, financial projections, financial background information on major owners, background of directors/managers, sources of capital, etc. draft by-laws, organizational chart, financial projections, financial background information on major owners, background of directors/managers, sources of capital, etc.

Capital Summary measure of initial and general capital stringency Summary measure of initial and general capital stringency Basel C/A Basel C/A Capital varies with market risk Capital varies with market risk loan securities, FX losses deducted from capital loan securities, FX losses deducted from capital initial capital only with cash and government securities initial capital only with cash and government securities borrowed funds for initial capital borrowed funds for initial capital verify capital sources verify capital sources

Are Countries Planning on Adopting Basel II?

Which Approach Do Countries Plan to Adopt? Standardized Approach Foundation IRB Approach Advanced IRB Approach

Deposit Insurance Generosity Explicit Explicit Level of coverage Level of coverage Coinsurance Coinsurance Coverage (e.g., FX, interbank deposits) Coverage (e.g., FX, interbank deposits) Funding (source; flat or risk based) Funding (source; flat or risk based) Management Management Membership Membership

Do Countries Have Explicit Deposit Insurance Schemes? Survey III 143 Countries Survey II 152 Countries Countries recently adopting deposit insurance: Armenia, Hong Kong, Malaysia, Moldova, Russia, Singapore, Tajikistan, Uruguay, and Zimbabwe

Percent of the Commercial Banking System’s Assets Funded by Deposits

Percent of the Commercial Banking System’s Assets Funded with Insured Deposits 62 countries with no assets funded with insured deposits Angola, Anguilla, Antigua and Barbuda, Australia, Belize, Benin, Bhutan, Bolivia, Botswana, British Virgin Islands, Burkina Faso, Burundi, Cameroon, Cayman Islands, Central African Republic, Chad, China, Congo, Cook Islands, Costa Rica, Cote d'Ivorie, Dominica, Dominican Republic, Equatorial Guinea, Ethiopia, Fiji, Gabon, Ghana, Grenada, Guernsey, Guinea Bissau, Guyana, Jersey, Kosovo, Kuwait, Kyrgyz Republic, Lesotho, Macau, China, Malawi, Maldives, Mali, Mauritius, Montserrat, Mozambique, New Zealand, Niger, Pakistan, Panama, Papua New Guinea, Senegal, Seychelles, South Africa, Sri Lanka, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, Syria, Thailand, Togo, Vanuatu

Official Supervision Supervisory power Supervisory power Power to take legal action against auditors, director, officers Power to take legal action against auditors, director, officers Force bank to provision, change organizational structure Force bank to provision, change organizational structure Power to suspend dividends, bonuses, management fees Power to suspend dividends, bonuses, management fees Legal power to declare insolvency Legal power to declare insolvency Power to supercede shareholder rights, remove/replace managers, directors Power to supercede shareholder rights, remove/replace managers, directors Forbearance discretion Forbearance discretion Loan classification and provisioning stringency Loan classification and provisioning stringency Diversification: domestically and abroad Diversification: domestically and abroad Supervisory resources Supervisory resources

What Powers Do Supervisors Possess?

Are Courts Supervisory Authorities Too?

3. Private monitoring Certified audit required Certified audit required Percent of 10 biggest banks rated by international rating agencies Percent of 10 biggest banks rated by international rating agencies Accounting disclosure and liability Accounting disclosure and liability accrued but unpaid interest accrued but unpaid interest consolidated statements consolidated statements liability of directors liability of directors No deposit insurance No deposit insurance Private monitoring ≠ Laissez-Faire Private monitoring involves supervision

Do Countries Require a Simple Leverage Ratio?

4. What Works Best? What “works” Bank development Bank development Efficiency Efficiency Integrity Integrity Stability Stability Bank governance? Bank governance?

4. Bank development s = Supervisory/regulatory indicators s = Supervisory/regulatory indicators X = Exogenous determinants of Bank Development, identified by existing research (legal origin, ethnic diversity, settler mortality, etc.) X = Exogenous determinants of Bank Development, identified by existing research (legal origin, ethnic diversity, settler mortality, etc.) Z = Instrumental variables for the bank supervision and regulation variables (religious orientation, endowments, latitude) Z = Instrumental variables for the bank supervision and regulation variables (religious orientation, endowments, latitude) u and  are error terms u and  are error terms , , , and  are the estimated parameters , , , and  are the estimated parameters Bank Development =  +  s +  X + u s =  Z +  s =  Z + 

Private monitoring boosts bank development

Official supervisory power lowers bank development

4. Summary Basel II: Remember Pillar III Private vs. Public interest: Suggests wariness of relying on official intervention

Changes in Restrictions on Banks

Impact of Changes in Restrictions

Changes in Entry Requirements

Impact of Entry Changes

Impact of ‘Improved’ Supervision

Impact of Private Monitoring

Impact of Diversification

6. Qualified Conclusions Until angels govern, the data suggest … Until angels govern, the data suggest … Avoid relying on official oversight, restrictions, & ownership Avoid relying on official oversight, restrictions, & ownership Emphasize private monitoring / incentives (deposit insurance) Emphasize private monitoring / incentives (deposit insurance) Stress Basel II’s 3 rd pillar (not capital and official oversight) Stress Basel II’s 3 rd pillar (not capital and official oversight) Supervisors have crucial role Supervisors have crucial role Support market discipline, not supplant it Support market discipline, not supplant it Foster / force information disclosure Foster / force information disclosure Do not fax “best practices to countries! Do not fax “best practices to countries! Empiricists / Researchers deserve a seat at the regulatory reform table

What to do? Data say that capital and supervision do not work Data say that capital and supervision do not work Implications: Implications: Emerging markets need to emphasize infrastructure first, with better information, incentives to use it Emerging markets need to emphasize infrastructure first, with better information, incentives to use it Look to why supervision has not been working (politics). Look to why supervision has not been working (politics). Focus on private sector incentives and diversify Focus on private sector incentives and diversify State guarantees (deposit insurance) and/or state ownership reduces monitoring State guarantees (deposit insurance) and/or state ownership reduces monitoring Limits on activities are bad Limits on activities are bad Diversification (activities, portfolios) is essential Diversification (activities, portfolios) is essential Foreign entry matters, esp. for small countries Foreign entry matters, esp. for small countries Go slow on Basel II (wait for version II.x, or later) Go slow on Basel II (wait for version II.x, or later) Emphasize pillar 3…Till Angels Govern. Emphasize pillar 3…Till Angels Govern.

Our Limitations Our Limitations Measurement Measurement Errors, omissions, time-series in measuring supervision / regulation? Errors, omissions, time-series in measuring supervision / regulation? Impact of supervision on the ground (only have proxies) Impact of supervision on the ground (only have proxies) Better aggregate indexes of approaches to supervision / regulation? Better aggregate indexes of approaches to supervision / regulation? Solution: get better data Solution: get better data Gauging Government Role Gauging Government Role Policies may work differently in different political / institutional regimes Policies may work differently in different political / institutional regimes Do we capture these nuances? Do we capture these nuances? Solution: add case studies Solution: add case studies Regulatory choices Regulatory choices Does X-C evidence add much? Does X-C evidence add much? Solution: add time series data Solution: add time series data

Our Limitations Our Limitations Measurement Measurement Errors, omissions, time-series in measuring supervision / regulation? Errors, omissions, time-series in measuring supervision / regulation? Impact of supervision on the ground (only have proxies) Impact of supervision on the ground (only have proxies) Better aggregate indexes of approaches to supervision / regulation? Better aggregate indexes of approaches to supervision / regulation? Solution: get better data Solution: get better data Gauging Government Role Gauging Government Role Policies may work differently in different political / institutional regimes Policies may work differently in different political / institutional regimes Do we capture these nuances? Do we capture these nuances? Solution: add case studies Solution: add case studies Regulatory choices Regulatory choices Does X-C evidence add much? Does X-C evidence add much? Solution: add time series data Solution: add time series data

Percent of the Commercial Banking System’s Assets Denominated in Foreign Currency

Percent of the Commercial Banking System’s Liabilities Denominated in Foreign Currency

Percent of the Commercial Banking System’s Assets in Government Securities