Rethinking Bank Regulation: Till Angels Govern James Barth Gerard Caprio Ross Levine

“Narrow” Motivation Banks matter –Growth, Income Distribution, & Poverty Alleviation –Crises ($1 trillion in DCs), which hurt poor BIS / IMF / WB matter  best practice recommendations –“If countries adopt sound policies …” –Apply “checklist” of best practices around the world –An FSAP Is there any support for these recommendations?

“Broader” Motivations Epic debates about the role of government –Public interest view vs. Private interest view Why countries choose different policies? –If political institutions matter, then this should change the approach to reform Bank regulation seems like a boring, technical subfield of finance, But …

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

Our Contributions: Collect new data and assess … Which Regulatory Policies Works Best? Public vs. Private Interest Theories? Do Political Institutions Shape Regulations?

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

Private vs. Public interest: Different predictions Entry restrictions, bank activity restrictions, etc. –Needed to overcome market failures … predictions. –Used to protect elite … predictions. Strong official supervisory oversight and state-owned banks –Needed to overcome market failures …. predictions. –Used to protect elite … predictions. Private monitoring –Insufficient to overcome market failures … predictions. –Necessary to protect against control by elite … predictions.

Aside: Debate about Basel Basel II assumes public interest incentives and focuses on Capital 2. Official Supervisory Oversight 3. Market Discipline Thus, our work provides the first cross-country evaluation of the validity of the Basel approach and its specific recommendations

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

Data There are 150 pages of data description in the book!

Data Structure, scope, independence of regulatory agency Bank activities Entry requirements Capital requirements Supervisory powers Deposit insurance Private monitoring External governance Ownership Data are online.

Regulatory restrictions on activities SecuritiesInsurance Real estateBank ownership of nonfinancial firms Nonfinancial firm ownership of banks Percent UnrestrictedPermittedRestrictedProhibited

Entry Foreign 1.limitations on foreign entry/ownership 2.% of entry applications denied Domestic 1.summary indicator of rules to obtain a license 1. draft by-laws, organizational chart, financial projections, financial background information on major owners, background of directors/managers, sources of capital, etc. 2.% of entry applications denied

Official supervision Supervisory power –Power to take legal action against auditors, director, officers –Force bank to provision, change organizational structure –Power to suspend dividends, bonuses, management fees –Legal power to declare insolvent –Power to supercede shareholder rights, remove/replace managers, directors

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

Government-owned Banks Percentage of banking system assets held by banks that are 50% or more owned by the government.

Correlations (ignores within category corr’s!) Gov’t ownership  more entry restrictions & less reliance on private sector Few tradeoffs with generous deposit insurance Private monitoring associated with fewer regulatory restrictions on entry / competition

What Works Best? What “works” – Bank development (country-level) – Efficiency (bank-level data) Net interest margins Net interest margins Overhead costs Overhead costs – Integrity (firm-level data) – Stability (country-level data) Systemic crises Systemic crises Non-performing loans Non-performing loans – Bank governance: Market valuations (bank-level)

Results on Bank Development Basel II –Capital requirements: ? –Official supervisory power: hurts But, not if high level of democracy (“top 10”) –Private monitoring: helps SOBs are bad. Entry & Activity Restrictions: hurt These results are more consistent with private rather than a public interest view

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

Economic Size If Mexico had Private Monitoring as the U.S. (0.97 instead of –0.43) … This would reduce the average Overhead Costs of Mexican banks from 6 to about 5. This would reduce the difference between Mexico & U.S., where Overhead Costs average a little over 3.

Controls for firm level traits: foreign, exporter, government, manufacturing, services, sales, & competitors

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

Choosing policies Q1: Why do some countries choose policies that foster sound banking, while others choose policies that encourage inefficiencies and corruption? Q2: What does the answer imply about the usefulness of identifying what works best?

An example from Stephen Haber Mexico-Diaz (1876) –Porfirio Diaz consolidates power –Loans  Bank Charter –2 banks / They write regulations! –Directors of Banamex: President of Congress, Under- Secretary of the Treasury, Senator for the Federal District, President’s Chief of Staff, brother of the Secretary of the Treasury, etc. ALL loans  directors –Self-reinforcing – durable U.S. States post 1789 –States short of revenues –Loans  Bank Charter –Links: federalists-banks! –But: Political competition –Philadelphia –NY –Jefferson Competition for people –Suffrage –Free banking Political system mattered for bank regulation

Social conflict view: Predictions Regimes that are uncompetitive with unconstrained executives: –Avoid: transparency and private monitoring, state banks –Construct: barriers to entry & perhaps restrictions on activities –?: official supervisory power Regimes that are competitive, democratic, constrained executives: –Construct: transparency and private monitoring –Avoid: barriers to entry / restrictions on activities, state banks –?: official supervisory power

Alternative view Govts maximize social welfare, but –… have limited information –… make and inherit mistakes / accidents So, “ what works best”  reform  social welfare. But, Argentina believes this optimism: “The Argentines alter their currency almost as frequently as they change presidents” British Observer, 1899 !!

5. 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). Control for legal origin. Or, simply run reduced form.

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

Qualified Conclusions Until angels govern, need to rethink to bank regulation … –Basel II is likely to be ineffective and may be harmful –Avoid relying excessively on official oversight, restrictions, & ownership –Emphasize private monitoring / incentives (deposit insurance) Confirmation of the private interest theory of regulation. No support for the public interest view Political institutions influence bank regulatory choices –Reform will require customization: F{ political institutions } –Standardized “best practice” recommendations are unlikely to foster socially efficient reform.