Basel and Emerging Markets: Basel and Emerging Markets: A Match Not Made in HeavenA Match Not Made in Heaven

Gerard CaprioGerard Caprio

This presentation draws on a forthcoming volume

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

Cambridge University Press, Fall 2005

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

1. Overview1. Overview

Evidence on supervisory / regulatory policiesEvidence on supervisory / regulatory policies– New dataNew data– Examines what works bestExamines what works best

Evidence on proper role of governmentEvidence on proper role of government– Public vs. Private Interest view of government Public vs. Private Interest view of government

Evidence on determinants of regulatory choicesEvidence on determinants of regulatory choices– Political interests vs. Ignorance / Mistakes Political interests vs. Ignorance / Mistakes

Institutional EnvironmentDemocratic, Political Structure/System

Technology, Information Infrastructure

Judi

cial

, Leg

al,

Reg

ulat

ory

Env

iron

men

tM

arket Structure

Borrowers, counterparties

Med

ia

The Market:Depositors,creditors,

rating agencies

Politicians

Regulators andsupervisors

Corruption

corruption

Banks

A Framework for Bank Regulation and Supervision

1. Our Limitations (some of them…)1. Our Limitations (some of them…)

MeasurementMeasurement– Errors, omissions, Errors, omissions, time-seriestime-series in measuring supervision / regulation? 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?

Gauging Government RoleGauging Government Role– Policies may work differently in different political / institutional regimesPolicies may work differently in different political / institutional regimes– Do we capture these nuances?Do we capture these nuances?

Regulatory choicesRegulatory choices– Does X-C evidence add much?Does X-C evidence add much?

2. Debate about government’s role2. Debate about government’s rolePublic interest viewPublic interest view

Gov’t maximizes social welfareGov’t maximizes social welfare

Gov’t has incentives / ability to Gov’t has incentives / ability to ameliorate market failuresameliorate market failures

If we identify “best practices,” If we identify “best practices,” countries will change.countries will change.

Private interest viewPrivate interest view

Gov’t maximizes Gov’t welfare; so Gov’t maximizes Gov’t welfare; so do regulateesdo regulatees

Gov’t does not necessarily have Gov’t does not necessarily have incentives / ability to fix failuresincentives / ability to fix failures

Need more than “best practices”:Need more than “best practices”:– Combination of incentives for Combination of incentives for

regulators and regulatees will not regulators and regulatees will not maximize social welfaremaximize social welfare

Laissez-Faire : Market failures minor no need for government

2. Basel: Assumes Public Interest2. Basel: Assumes Public Interest

Basel II Pillars – “Best Practices”Basel II Pillars – “Best Practices”

1.1. Capital Capital

2.2. Supervisory oversightSupervisory oversight

3.3. Market DisciplineMarket Discipline

World Bank / IMF – Apply “Best Practices” in DCsWorld Bank / IMF – Apply “Best Practices” in DCs

… … to foster growth & poverty alleviatonto foster growth & poverty alleviaton

… … to reduce fragility & contagionto reduce fragility & contagion

2. Private interest at work2. Private interest at work

1.1. Survival of the sovereignSurvival of the sovereign

2.2. Finance governmentFinance government

3.3. Finance croniesFinance cronies

2. Private vs. Public interest: Different predictions2. Private vs. Public interest: Different predictions

Capital regs, entry restrictions, bank activity restrictions, etc.Capital regs, entry restrictions, bank activity restrictions, etc.– Needed to overcome market failures … Needed to overcome market failures … predictionspredictions..– Used to protect elite … Used to protect elite … predictionspredictions..

Strong official supervisory oversightStrong official supervisory oversight– Needed to overcome market failures …. Needed to overcome market failures …. predictionspredictions..– Used to protect elite … Used to protect elite … predictionspredictions..

Private monitoringPrivate monitoring– Insufficient to overcome market failures … Insufficient to overcome market failures … predictionspredictions..– Necessary to protect against control by elite … Necessary to protect against control by elite … predictionspredictions..

3. Official supervision3. Official supervisionSupervisory powerSupervisory power– Power to take legal action against auditors, director, officersPower to take legal action against auditors, director, officers– Force bank to provision, change organizational structureForce bank to provision, change organizational structure– Power to suspend dividends, bonuses, management feesPower to suspend dividends, bonuses, management fees– Legal power to declare insolventLegal power to declare insolvent– Power to supercede shareholder rights, remove/replace managers, Power to supercede shareholder rights, remove/replace managers,

directorsdirectors

Forbearance discretionForbearance discretion

Loan classification and provisioning Loan classification and provisioning stringencystringency

Diversification: domestically and abroadDiversification: domestically and abroad

Supervisory resourcesSupervisory resources

3. Private monitoring3. Private monitoring

Certified audit requiredCertified audit required

Percent of 10 biggest banks rated by Percent of 10 biggest banks rated by international rating agenciesinternational rating agencies

Accounting disclosure and liabilityAccounting disclosure and liability– accrued but unpaid interestaccrued but unpaid interest– consolidated statements consolidated statements – liability of directorsliability of directors

No deposit insuranceNo deposit insurance

! Private monitoring ≠ Laissez-Faire

Private monitoring involves supervision

4. What Works Best?4. What Works Best?

What “works”What “works”– Bank developmentBank development– EfficiencyEfficiency– IntegrityIntegrity– StabilityStability– Bank governance?Bank governance?

Private monitoring boosts bank developmentPrivate monitoring boosts bank development

Official supervisory power lowers Official supervisory power lowers bank developmentbank development

4. Results on Bank Development4. Results on Bank Development

Basel IIBasel II– Capital requirements: ?Capital requirements: ?– Official supervisory power: hurtsOfficial supervisory power: hurts– Private monitoring: helpsPrivate monitoring: helps

But, official supervisory power is not bad when But, official supervisory power is not bad when – There is a high level of democracy. There is a high level of democracy. – But, need to be a “top 10” country But, need to be a “top 10” country

SOBs are bad. SOBs are bad.

Restrictions hurt bank developmentRestrictions hurt bank development

These results are more consistent with private rather than a public interest view

4. Measuring Bank Corruption4. Measuring Bank Corruption

Bank CorruptionBank Corruption: “How problematic is the : “How problematic is the corruption of bank officials for obtaining corruption of bank officials for obtaining financing?”financing?”

-1 -2 -3 -4 -5 -6 -7 -8

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

Bank Corruption

O fficial Power

0.144*** 0.131*** 0.161*** 0.076*** 0.172*** 0.143*** 0.117*** 0.144***

Private Monitoring

-0.271*** -0.231*** -0.106** -0.174*** -0.298*** -0.232*** -0.136*** -0.295***

GDP Growth

-12.052*** -8.183*** -0.582 -4.153** -13.104*** -9.854*** -5.402** -4.181*

Political Violence

-0.137** 0.674*** 0.632***

Political Voice

-0.403*** -0.674*** -0.735***

Corruption -0.245*** -0.165*** -0.179***

Gov't Banks

0.226* 0.32** 0.499***

Firm O bstacles

0.262*** 0.23*** 0.225***

GDP per Capita

0.16***

firms 2259 2259 2259 2259 2124 2259 2124 2124

countries 33 33 33 33 31 33 31 31

4. Corruption in Lending

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

4. Corruption vs. Supervisory Power4. Corruption vs. Supervisory Power

coef = 1.9073493, (robust) se = .31551212, t = 6.05

e(

corr

up

tion

| X

)

e( official_hat | X )-.656829 .406574

-1.81273

1.48683

GRC

NLD

GBR

CAN NZL

TUR

CYP

FRA

BEL

ISR

LUX

USA

ZAF

ITA

MARJOR

EGY

DEU

MUSBWA

JPN

KOR

ESP

IND

IRLAUS

ISN

JAM

FIN

THA

ARG

CHL

LSO

MLT

SWE

IDN

CHE

DNK

ZMB

BGD

LKA

MEX

MWIGHA

PRT

GUYBOL

TTO

SGP

NGA

AUT

PHL

GTM

GMB

HND

SLV

BRA

MYS

PAN

KEN

PER

VEN

Inconsistent with public interest view.

Very consistent with private interest view.

Madison: If supervisors were angels …

4. Summary4. SummaryBank

DevelopmentEfficiency

Stability/Loan Quality

Lending Integrity

Capital Regulation 0 or + / ++Supervisory Power - 0 / - - - -Private Monitoring ++ ++ 0 / ++ ++Activity Restrictions - - 0 - - / - -Entry Restrictions - - 0 / --Deposit Insurance - - / 0Government Banks - - -Diversification ++

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

5. Choosing policies5. Choosing policies

Q1: Why do some countries choose policies that foster sound Q1: Why do some countries choose policies that foster sound banking, while others choose policies that encourage banking, while others choose policies that encourage

inefficiencies and corruption? inefficiencies and corruption?

Q2: What does the answer imply about the usefulness of Q2: What does the answer imply about the usefulness of identifying what works best?identifying what works best?

5. An example from Stephen Haber5. An example from Stephen Haber

Mexico-Diaz (1876)Mexico-Diaz (1876)– Porfirio Diaz consolidates powerPorfirio Diaz consolidates power– Loans Loans Bank Charter Bank Charter– 2 banks / They write regulations!2 banks / They write regulations!– Directors of Banamex: Directors of Banamex:

President of Congress, Under-President of Congress, Under-Secretary of the Treasury, Senator Secretary of the Treasury, Senator for the Federal District, President’s for the Federal District, President’s Chief of Staff, brother of the Chief of Staff, brother of the Secretary of the TreasurySecretary of the Treasury, etc., etc.

ALL loans ALL loans directors directors

– Self-reinforcing – durable Self-reinforcing – durable

U.S. States post 1789U.S. States post 1789– States short of revenuesStates short of revenues– Loans Loans Bank Charter Bank Charter– Links: federalists-banks!Links: federalists-banks!– But:But:

Political competitionPolitical competition– PhiladelphiaPhiladelphia– NYNY– JeffersonJefferson

Competition for peopleCompetition for people– SuffrageSuffrage– Free bankingFree banking

5. How Do Countries Choose?5. How Do Countries Choose?

Key results Key results – Open, competitive, democratic political institutions:Open, competitive, democratic political 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 political systems:Closed, uncompetitive, autocratic political systems:

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.

6. Qualified Conclusions6. Qualified Conclusions

Until angels govern, the data suggest …Until angels govern, the data suggest …– Avoid relying on official oversight, restrictions, & ownershipAvoid relying on official oversight, restrictions, & ownership– Emphasize private monitoring / incentives (deposit insurance)Emphasize private monitoring / incentives (deposit insurance)– Stress Basel II’s 3Stress Basel II’s 3rdrd pillar (not capital and official oversight) pillar (not capital and official oversight)

Supervisors have crucial roleSupervisors have crucial role– Precommitment model Precommitment model

support market discipline, not supplant itsupport market discipline, not supplant it– Foster / force information disclosureFoster / force information disclosure

Do not fax “best practices to countries!Do not fax “best practices to countries!

Work more on measuring results of supervision.Work more on measuring results of supervision.

ImplicationsImplications

Recommend private monitoring approach Recommend private monitoring approach in Nigeria? Indonesia? in Nigeria? Indonesia? – YesYes

Evidence suggests that empowering official Evidence suggests that empowering official supervisors will work even less well in weak supervisors will work even less well in weak institutional settings! institutional settings!