How do regulation and ownership affect banking sector performance and stability? Budapest 2006

Introduction Regulation environment of banking system capital requirements restrictions on bank activities: securities insurance real estate mixing banking and commerce: banks own non-financial firms bank entry Ownership structure of banks government ownership

How does regulation affect banking sector performance and stability?

Capital Requirements Positive views: serves as a buffer against losses and hence failure (Dewatripont and Tirole, 1994) reduces incentives for banks to engage in higher risk activities, especially generated by deposit insurance (Berger, Herring, Szego, 1995) Negative views: may cause bank to reduce its lending (Brealey, 2001) may encourage banks to take more credit risk (Kim and Santomero, 1988; Blum 1999)

What is Basel Accord? Basel Accord I - In 1988 the Basel Committee of Banking Supervision in Basel, Switzerland published a set of minimal capital requirements for internationally active banks based on credit risk; updated in 1996 to cover market risk Basel Accord II - was issued by BCBS in 2004; addressed shortcomings in the treatment of credit risk and incorporated operational risk. It is based on three pillars: minimum capital requirements supervisory review practices market discipline

Capital adequacy ratios Tier I capital > Tier II capital, where Tier I capital - shareholders equity and disclosed reserves Tier II capital - undisclosed reserves and subordinated term debt instruments Total capital = Tier I capital + Tier II capital credit risk = sum of risk-weighted asset values market risk = VaR/8% VaR - category that describes probabilistically the market risk

Deficiencies in Basel Accord II ignore the degree to which the bank portfolio is diversified unlikely to incorporate differences in loan maturity or to provide solution to better quantified measures of risk and economic capital no consideration of the probability and cost of bank failures and their impact on the system as a whole

Finding: the relationship between stringency of regulation of capital ratios and bank development, performance and stability is weak, but still positive * Imposition of capital standards have not prevented banking crises Does regulation of capital adequacy actually achieve its desired result?

Why to regulate bank activities and mixing banking and commerce? conflict of interests arise when banks engage in non-traditional activities (John, John and Saunders, 1994; Saunders, 1985) may provide more opportunities for risky behavior ( Boyd, Chang, Smith 1998) complex banks are difficult to monitor financial conglomerates may reduce efficiency and competition

Why not to regulate bank activities and mixing banking and commerce? enables banks to exploit economies of scale and creates more diversified, hence more stable banks ( Claessens and Klingebiel, 2000) increases the franchise value of banks and thus incentives to behave prudently creates more stability enables banks to adapt and hence provide more efficiently the changing financial services

Argentina 2.50 Australia 2.00 Austria 1.25 Belgium 2.50 Brazil 2.50 Canada 2.25 Chile 2.75 Denmark 1.75 Egypt 2.50 France 2.00 Germany 1.75 Greece 2.25 India 3.00 Indonesia 3.50 Israel 1.00 Italy 2.25 Japan 3.25 Mexico 3.25 Republic of Korea 2.25 Spain 1.75 Sweden 3.00 Switzerland 1.50 turkey 3.00 United Kingdom 1.25 United States 3.00 Country data on bank regulation * index equals the average of the four indicators (1-4) of the regulatory restrictions imposed on banks, specifically on securities, insurance, real estate and banks owning non financial firms

The empirical evidence: Restrictions on non-traditional activities of banks and mixing banking and commerce are: negatively associated with bank development positively with greater financial fragility and a likelihood of crises

Regulation on bank entry Theoretical views: positive: effective regulation of bank entry can promote stability banks with monopolistic power possess greater franchise value, which enhances prudent risk behavior (Keeley, 1990) negative: competition is beneficial because it eliminates inefficient banks (Shleifer, Vishny, 1998) Finding: restrictions on bank entry are associated with greater bank fragility

How does ownership affect banking sector performance and stability?

Average equity of top 10 banks owned by the government, % Types of laws Common French German Scandinavian Socialist Average 59 42

Views of government ownership of banks Development - projects financed by the government are socially desirable. It encourages development of the institution of lending (Gerschenkron, 1962) Political - projects are not necessarily socially efficient, but politically desirable. It politicizes resource allocation and thus slows down financial development (Shleifer, Vishny, 1994)

Empirical Evidence: The empirical evidence is consistent with political view: government ownership of banks reduces efficiency and subsequent development of banking sector is associated with greater financial instability

Conclusion: Both the practice and empirical findings show that: countries with greater regulatory restrictions have less developed, less efficient banking systems and higher probability of banking crises countries with greater government ownership have less developed, less efficient and more unstable banking systems

Thank you!