Supervisory guidance or binding rules? Evidence of the effectiveness of bank oversight in developing countries

The 2007–09 global financial crisis spurred important policy debates on oversight of the banking industry. As discussed in the Global Financial Development Report 2019/2020, after the crisis, bank regulations and supervision became more complex, potentially reducing transparency. This development represents a burden in developing countries, especially low-income countries, where supervisory resources and capacity are limited. In this regard, the recent COVID-19 shock presents an unprecedented challenge for financial authorities as, for example, bank asset quality is expected to deteriorate and policy action is needed to prevent and mitigate the negative effects associated with high and rapid increases in nonperforming loans (NPLs) (see World Development Report 2022, chapter 2, for an in-depth discussion).

What is more effective in affecting bank behavior? How do regulations and supervisory actions interact? What are the conditions under which a binding regulation and effective supervision work best? These questions are especially important for the design and enforcement of prudential regulation in developing countries where the institutional environment is weak (see, for example, Anginer, Demirgüç-Kunt, and Mare, 2018). Yet, the difference between banking regulation and supervision is blurred in the academic literature. The vast majority of empirical studies focus largely on the impact of the former, often not properly articulating the distinction between supervisory and regulatory initiatives and referring to them interchangeably (Hirtle and Kovner, 2020). However, the economic and juridical implications of the issuance of non-legally binding supervisory guidance are materially different from those resulting from the passage of a hypothetically identical regulation.

In a recent study, we provide an empirical assessment of whether banks respond differently to the adoption of supervisory guidance compared to a specular regulatory action. To do so, we study the staggered and distinct supervisory and regulatory implementations of a reform aiming at tackling the issue of persistently high levels of NPLs held by European banks, generally referred to as the European calendar provisioning. This initiative is unique for three main reasons. First, it leaves aside the existing arrangements characterized by a global harmonized effort toward banking regulation as it was introduced as a unilateral regulatory change. As such, the regulatory reform was exogenous to financial policy in developing countries. Second, its underpinning idea subverts the principles established by the Basel capital agreements themselves, introducing a simple and transparent mechanism to reduce NPLs. Indeed, rather than relying on banks’ internal models and capital adequacy assessments, these new rules impose minimum loss coverage requirements to be achieved through write-downs or deductions from regulatory capital, depending mechanically on the time elapsed since the default of the considered loan. Third, the complex process of adoption and enforcement of the European calendar provisioning represents a unique setting to analyze whether banks respond differently to the adoption of supervisory guidance issued under the “comply or explain framework” compared to a specular regulatory action (figure 1).
 

Figure 1: Timeline of the Introduction of the European Calendar Provisioning

Source: Fiordelisi, Lattanzio and Mare 2022.

Note: ECB = European Central Bank; EBA = European Banking Authority.

The staggered supervisory and regulatory actions sparked a heated debate on two major issues. First, the European calendar provisioning brought regulation back in time by foregoing model-based analyses of the risk associated with loan exposures to rely on a simple measure of time elapsed . Second, these interventions called into question the degree to which supervisory guidance issued under the comply or explain framework is perceived to be binding by commercial banks, compared to the legally compulsory nature of regulatory actions.

Building on this discussion, we empirically analyze whether the introduction of the European calendar provisioning is effective in improving the performance of European banks. To address this question within a causal framework, our empirical strategy relies on a dynamic difference-in-differences approach, comparing changes in the riskiness, performance, and loan policies of subsidiaries of European banks operating in developing countries with those of comparable domestic banks. Because European banks consolidate worldwide credit exposures under their domestic regulatory framework, their subsidiaries operating in developing countries are directly affected by the adoption of the calendar provisioning rules. Conversely, matched banks operating in developing countries are not exposed to the effects of these supervisory and regulatory actions.
 

Figure 2: Unconditional Effect of the EU Calendar Provisioning Reform on Nonperforming Loan Holdings

Source: Adapted from Fiordelisi, Lattanzio, and Mare 2022.

Note: The P-values of the two-sample unequal variance t-test of equality of means between domestic banks and EU subsidiaries are 0.38 (2015), 0.51 (2016), 0.07 (2017), 0.03 (2018), and 0.00 (2019).

Our analyses show that European banks reacted to the release of the European Central Bank’s calendar provisioning supervisory guideline by treating it as a binding requirement and decreasing their NPL ratios (figure 2). In our base model, depending on the specification, in 2017, subsidiaries of European banks relatively decreased their NPL ratios by between 1.3 and 2.6 percentage points, or 22% and 44% of the sample mean of European subsidiaries , a sizable reduction. The estimated effect further increased in 2018 and 2019, although by marginally less. The recognition of these losses in banks’ income statements as charge-offs induced an immediate reduction in their regulatory capital (Tier 1 capital) and impaired loan reserves, weakening their capitalization profile. Yet, we document that these persistently higher regulatory costs did not cause a reduction in loan origination. Rather, subsidiaries of European banks appear to have shifted these increased compliance costs to their customers by charging higher interest rates on new loans. Importantly, we further identify that banks primarily target countries featuring weaker definitions of capital requirements and NPLs to implement this form of regulatory cost-shifting, which is consistent with multinational banks exploiting the regulatory leniency of foreign countries to offload at least part of the regulatory costs imposed by domestic regulations and apply lower bank lending standards.
 

Policy implications

These findings suggest that (1) the non-model-based (“risk-adjusted”) supervisory and regulatory interventions achieved the intended goal — which was to reduce the NPL ratios of the subsidiaries of European banks — and (2) supervisory guidance issued under the “comply or explain” framework is perceived by banks as binding while providing supervisors flexibility in the degree to which such actions should be enforced over time and in the cross-section. Overall, the evidence in the paper shows that simple is better and supervisory guidance and enforcement could be useful tools for financial authorities in developing countries to address weak bank performance.