Rethinking Bank Regulation James Barth Gerard Caprio Ross Levine

Overview 1.Some findings 2.Some weaknesses, and strengths 3.A plea  For epistemological modesty  Against faith-based policy advising

Some Findings: Conceptual framework 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, 1788 Bankers are not angels Politicians (& some bank supervisors) are not angels. Politics shapes bank regulatory choices and the effects of those choices. BCL, 2006

What does this actually mean for policy? Capital regulations, entry restrictions, activity restrictions, deposit insurance, government ownership, etc. Capital regulations, entry restrictions, activity restrictions, deposit insurance, government ownership, etc. Needed to overcome market failures … predictions. Needed to overcome market failures … predictions. In some political systems, protects elite … predictions. In some political systems, protects elite … predictions. Strong official supervisory oversight Strong official supervisory oversight Needed to overcome market failures …. predictions. Needed to overcome market failures …. predictions. In some political systems, protects elite … predictions. In some political systems, protects elite … predictions. Private monitoring, transparency, market discipline Private monitoring, transparency, market discipline Insufficient to overcome market failures … predictions. Insufficient to overcome market failures … predictions. Reduces discretion of elite … predictions. Reduces discretion of elite … predictions.

Results: What Works Best? Results: What Works Best? “Works” “Works” Bank development Bank development Efficiency Efficiency Stability Stability Corruption in lending Corruption in lending

Results: Measuring regulation Results: Measuring regulation “Every rule” vs. “Broad index”? “Every rule” vs. “Broad index”? Countries choose strategies! Countries choose strategies! Not a smorgasbord of rules Not a smorgasbord of rules So, we use broad indexes So, we use broad indexes

Correlations Correlations Govt ownership  more entry restrictions & less reliance on private sector No simple tradeoffs with generous deposit insurance Private monitoring associated with fewer regulatory restrictions on entry / competition

Bank development 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

Some findings: Bank efficiency  Interest margins  Overhead costs

Also includes bank-level variables: Market share, total assets, liquidity, bank equity, etc.

Some findings: Stability Past work shows: Past work shows: Increases in deposit insurance generosity Increases in deposit insurance generosity Increase moral hazard Increase moral hazard Increases fragility Increases fragility But, do supervision and regulation help? But, do supervision and regulation help?

NO!: Moral hazard mitigated by broad institutions, NOT standard regulations Constant Restrictions on Bank Activities ** Entry into Banking Requirements Capital Regulatory Index-1.035* **-1.026**-1.201* Official Supervisory Index Government-Owned Banks Inflation Moral Hazard Index 0.719**1.442**2.132**0.716** ** 0.769** Moral Hazard Index*Political Openness ** Political Openness0.762 Moral Hazard Index*Rule of Law ** Rule of Law Moral Hazard Index*Official Supervisory Power Moral Hazard Index*Capital Regulatory Index N

Results: so far … Inconsistent with … Inconsistent with … Laissez-faire Laissez-faire Angelic regulators Angelic regulators Consistent with … Consistent with … Private interest view Private interest view Market discipline Market discipline But, corruption? But, corruption?

Some more findings: Corruption in lending Corruption Obstacle i,k = a[F i,k ] + b[C i ] + c[S i ] + u i,k F i,k : Firm-specific traits C i : Country-specific traits S i : Supervision/Regulatory indicators Official supervisory power Official supervisory power Private monitoring Private monitoring 4812 firms across 49 developed and developing countries 4812 firms across 49 developed and developing countries

Some findings: corruption in lending

More Controls...

Some findings: Political institutions Why don’t countries choose good regulations? Why don’t countries choose good regulations? Good for whom? Good for whom? Politics matters! Politics matters!

Political differences explain sup. & reg. (This table summarizes the results from 20 regressions.) This holds when using instrumental variables for the political system (e.g., initial political system, religious differences, endowments, independence, legal origin. Or when including these instruments directly in the regression

How Do Countries Choose? Open, competitive, democratic institutions: Open, competitive, democratic institutions: Foster private monitoring, transparency. Foster private monitoring, transparency. Less likely to limit bank entry, activities. Less likely to limit bank entry, activities. Less likely to have state banks. Less likely to have state banks. Closed, uncompetitive, autocratic institutions: Closed, uncompetitive, autocratic institutions: Do NOT favor transparency (surprise!). Do NOT favor transparency (surprise!). Limit bank entry, activities. Limit bank entry, activities. Tend to have state banks. Tend to have state banks.

Findings so far... Until angels govern … Until angels govern … Avoid relying only on official oversight, restrictions, etc. Avoid relying only on official oversight, restrictions, etc. Emphasize private monitoring / incentives Emphasize private monitoring / incentives Stress Basel II’s 3 rd pillar Stress Basel II’s 3 rd pillar 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 “Best practices” depend on political system. “Best practices” depend on political system.

2. Analytical Weaknesses But, confirmatory evidence

Weaknesses, but... Limitations Limitations 1. Survey errors 2. Implementation 3. Cross-country shortcomings Response 1. Survey errors Errors, but bias? Do better surveys! 2. Implementation Recent FSAP work Do better surveys! 3. Cross-country shortcomings But, case-studies Where is the countervailing evidence??

3. A plea... For Epistemological modesty For Epistemological modesty Surveys have problems Surveys have problems Regressions have problems Regressions have problems Case studies have problems Case studies have problems Expert guidelines have problems Expert guidelines have problems Against Faith-based policy advising These policies are very important For growth For poverty alleviation For equality of opportunity Need to assess competing views systematically