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Regulation

Reforming Bank Regulations

Asli Demirgüç-Kunt's picture

It is no surprise that the recent financial crisis has sparked a new round of regulatory reform all around the world. The crisis has certainly exposed significant weaknesses in the regulatory and supervisory framework and led to a debate about the role these weaknesses may have played in causing and propagating the crisis. As a result, reform of regulation and supervision is a top priority for policymakers, and many countries are working to upgrade their frameworks. But there are more questions than answers: What constitutes good regulation and supervision? Which elements are most important for ensuring bank soundness?  What should the reforms focus on?

The Basel Committee – a forum for bank supervisors from around the world – has been trying to answer these questions since 1997. The Committee first got together that year to issue the Core Principles for Effective Bank Supervision (BCPs), a document summarizing best practices in the field. Since then many countries have endorsed the BCPs and have undertaken to comply with them, making them an almost universal standard for bank regulation. Since 1999, the IMF and the World Bank have conducted evaluations of countries’ compliance with these principles, mainly within their joint Financial Sector Assessment Program (FSAP). Hence the international community has made significant investments in developing these principles, encouraging their wide-spread adoption, and assessing progress with their compliance.

In light of the recent crisis and the resulting skepticism about the effectiveness of existing approaches to regulation and supervision, it is natural to ask if compliance with this global standard of good regulation is associated with bank soundness. This is what I have tried to do with Enrica Detragiache and Thierry Tressel, two of my colleagues from the Fund. Specifically, we test whether better compliance with BCPs is associated with safer banks. We also look at whether compliance with different elements of the BCP framework is more closely associated with bank soundness to identify if there are specific areas that would help prioritize reform efforts to improve supervision.

Deals vs. Rules: Capturing Regulatory Burdens

Mary Hallward-Driemeier's picture

The costs of excessive regulatory burdens can stifle incentives for firms to innovate, invest and grow. In recent years, aid agencies and developing countries have been stepping up efforts  to reduce numerous and lengthy regulatory procedures. However, the focus on aggregate measures of regulatory burden for a country and relying on measures of formal requirements misses a lot of the action.

The World Bank has interviewed over 100,000 entrepreneurs and senior managers in over 100 countries as part of its Enterprise Surveys project. Among the measures collected is the de facto time it takes businesses to complete various interactions with the government (e.g., the time to get goods through customs, get a construction permit, or get an operating license). In the chart below, each vertical line represents a country, and the length of the line represents the distribution of time for firms to clear goods through customs. The first thing to notice is just how much variation there is – within individual countries. There are favored firms for whom it takes a couple of days to obtain permits or clear customs – and disfavored firms, for whom the wait can be weeks or even months. The variation within most countries is considerably larger than the differences in averages across countries.

The Pitfalls of Financial Regulatory Reform

Ryan Hahn's picture

On May 25 we invited Professor Charles Calomiris of Columbia University to come speak at the World Bank as part of our FPD Chief Economist Talk series. Professor Calomiris discussed the on-going process of regulatory reform, particularly in the U.S., and was, to put it mildly, less than sanguine about the legislation that is currently making its way through the U.S. Congress. Watch a video of his talk (below the jump). The talk itself runs about 46 minutes, and a Q&A session follows.

Bailing Out the Banks: Reconciling Stability and Competition in Europe

Thorsten Beck's picture

The relationship between market structure, competition and stability in banking has been a policy-relevant but controversial one (see Beck, 2008 for a pre-crisis survey).  The current crisis has put the topic back on the front-burner, and particularly so in Europe, where competition concerns about the effect of national bail-out packages on competition across Europe rank high.  Together with four other European economists, I have tackled this question in a recent CEPR report: Bailing out the Banks: Reconciling Stability and Competition.

The crisis has provoked two common but quite different reactions concerning the role of competition policy in the banking sector.  One reaction has been to jump to the conclusion that financial stability should take priority over all other concerns and that therefore the "business as usual" preoccupations of competition regulators should be put on hold.  Another reaction has been to fear that intervention to restore financial stability will lead to massive distortions of competition in the banking sector, and therefore to conclude that competition rules should be applied even more vigorously than usual, with the receipt of State aid being considered presumptive grounds for suspecting the bank in question of anti-competitive behavior.  We endorse neither of these points of view. 

Thoughts on the Financial Crisis and Improving Financial Regulation

Editor’s Note: The following post was contributed by Ross Levine, the James and Merryl Tisch Professor of Economics at Brown University.  This post summarizes a presentation Professor Levine gave at the World Bank on April 28 entitled An Autopsy of the Financial System: Suicide, Accident, or Negligent Homicide?  The presentation from the event is available here and video of the event will be made available soon on the All About Finance blog.  

In this blog entry, I address three issues: (1) The causes of the cause of the financial crisis, (2) Core approaches to financial regulation, and (3) Systemic improvements.  I also direct readers to longer treatments of each of these issues.

Causes

In a recent paper, An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide, I show that the design, implementation, and maintenance of financial policies by U.S. policymakers and regulators during the period from 1996 through 2006 were the primary causes of the financial system’s collapse.  I study five important policies (1) Securities and Exchange Commission (SEC) policies toward credit rating agencies, (2) Federal Reserve policies that allowed banks to reduce their capital cushions through the use of credit default swaps, (3) SEC and Federal Reserve policies concerning over-the-counter derivatives, (4) SEC policies toward the consolidated supervision of major investment banks, and (5) government policies toward the housing-finance giants, Fannie Mae and Freddie Mac.

Let me be blunt—time and again, U.S. regulatory authorities and policymakers (1) were acutely aware of the growing fragility of the financial system caused by their policies during the decade before the crisis, (2) had ample power to fix the problems, and (3) chose not to.  This crisis did not just fall from the sky on the heads of policymakers; policymakers helped cause this crisis.  While Alan Greenspan (former Chairman of the U.S. Federal Reserve) depicts the financial crisis as a once in a “hundred years flood” and a “classic euphoric bubble,” the evidence is inconsistent with these overly simple characterizations.  More importantly, this focus on “irrational exuberance” self-servingly deflects attention from the policy determinants of the crisis.

Regulators were not simply victims of limited information or a lack of regulatory power. Rather, the role of regulators in the five policies I mention above demonstrates that the crisis represents the selection—and most importantly the maintenance—of policies that increased financial fragility.  The financial regulatory system failed systemically.  To fix it, we need more than tinkering, we need systemic change. 

What Does the Financial Crisis Teach Us about the Feasibility of Different Banking Models?

Asli Demirgüç-Kunt's picture

The recent financial crisis has seen the demise of large investment banks in the U.S.  This major change in the financial landscape has also rekindled interest in discussion of optimal banking models.  All over the world, perceived costs and benefits of combining bank activities of various kinds have given rise to a wide variation in allowed bank activities.  Should banks operate as universal banks, a model which allows banks to combine a wide range of financial activities, including commercial banking, investment banking and insurance; or should their activities be restricted?

To some policymakers the universal banking model may appear to be a more desirable structure for a financial institution due to its resilience to adverse shocks, particularly after the crisis.  However, others have called for the separation of commercial and investment activities (along the lines of the Glass-Steagall Act of 1933 in U.S. which was repealed by Gramm-Leach-Bliley Act in 1999) to minimize the crisis-related costs imposed on taxpayers through the financial safety net.  So which model is more desirable?

Theory, as usual, provides conflicting predictions about the optimal asset and liability mix of an institution.  On the one hand, banks gain information on their customers in the provision of one financial service that may prove useful in the provision of other financial services to these same customers.  Hence, combining different types of activities – non-interesting earning, as well as interest-earning assets – may increase return as well as diversify risks, therefore boosting performance.  This argues for the merits of universal banks.

On the other hand, if a bank becomes too complex, bank managers may actually start taking advantage of this complexity for their own private benefit (what are sometimes known as “agency costs”) at the expense of the bank.  So, too much diversification may actually not be optimal, increasing bank fragility and reducing overall performance.  This tends to support the separation of commercial and investment activities. 

The Disastrous Consequences of Weak Financial Sector Policies

Asli Demirgüç-Kunt's picture

What is the role of the financial sector in development?  Does it really contribute, or does it merely respond to the demands of the real sector?  Are markets simply casinos for betting, or do they perform some productive role?  Shouldn’t the development community just focus its attention on more important issues, such as health, education, and the real sector?

I hear these questions all the time.  It is not surprising because prominent economists also hold conflicting views.  Many development economists do not even bother to discuss the role of the financial sector in development.  Joan Robinson famously stated “Where enterprise leads, finance follows,” and Robert Lucas has argued that the role of finance in the literature on growth has been “over-stressed.”

But at the other extreme, Joseph Schumpeter observed “The banker…authorizes people in the name of society…to innovate” and Merton Miller stated: “That financial markets contribute to economic growth is a proposition almost too obvious for serious discussion.”  This debate is crucial since it affects the decisions of policymakers to prioritize financial sector reforms, and the attention they pay to identifying and adopting appropriate financial sector policies.  Where do we come out?

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