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.
BCP compliance ratings can be quite informative since they are available for the 25 core principles that cover all aspects of regulation and supervision, including:
- Availability of legal framework and resources for the agency;
- Powers of supervisors;
- Licensing criteria and permissible activities for institutions;
- All prudential regulations such as capital adequacy and risk management practices;
- Methods of on-going supervision;
- Information requirements; and,
- Supervision of cross-border activities.
Importantly, the assessments are supposed to take into account not only the laws and regulations, but also the extent to which they are implemented in practice. For this purpose, evaluations are conducted by expert supervisors with international experience and are reviewed by internal teams in the Bank and the Fund for consistency.
In two different papers we look at the impact of compliance with BCPs on bank soundness, covering 3000 banks from 86 countries. In the first , we define bank soundness using Moody’s financial strength ratings, which limits our sample significantly only to rated banks. The advantage here is incorporating market information as opposed to only using balance sheet information. We see that for the most part compliance with BCPs is not associated with bank soundness, except for compliance with information provision.* This finding emphasizes the importance of transparency and quality of information, at least for high income and emerging market countries, stressing the need to prioritize such reforms.
In a second paper , when we focus on a larger dataset using accounting measures of bank soundness, the findings are more discouraging. We fail to find any evidence that better compliance with BCPs is associated with sounder banks.
What might explain these poor results? Is it that we cannot properly capture bank soundness using accounting or even market measures? Are the BCP assessments of poor quality or not comparable across countries? Or is it that the rating methodology is not sufficiently granular to be useful? We can’t tell. But these results certainly raise many questions about the Basel Core Principles. Recently, there have been serious efforts to enhance the quality, candor, and comparability of assessments. Hopefully, we can find better ways of capturing and codifying this information as we set out to reform bank regulations once again.
Demirguc-Kunt, Asli, Enrica Detragiache, forthcoming, “Basel Core Principles and Bank Soundness: Does Compliance Matter?” Journal of Financial Stability. (Working Paper version available here .)
Demirguc-Kunt, Asli, Enrica Detragiache and Thierry Tressel, 2008, “Banking on the Principles: Compliance with Basel Core Principles and Bank Soundness ,” Journal of Financial Intermediation, Vol 17, No.4, October.
* Chapter 5, Principle 21 of the BCP defines information provision: “Each bank must maintain adequate records that enable the supervisor to obtain a true and fair view of the financial condition of the bank, and must publish on a regular basis financial statements that fairly reflect its condition.”