Bank regulation and supervision.

• Author: Levine, Ross
• Position: Research Summaries

A large body of research suggests that banks matter for human welfare. Most noticeably, banks matter when they fail. Indeed, the fiscal costs of banking crises in developing countries since 1980 have exceeded $1 trillion, and some estimates put the cost of Japan's banking problems alone over this threshold. (1) Recent research also finds that banks matter for economic growth. (2) Banks that mobilize and allocate savings efficiently, allocate capital to endeavors with the highest expected social returns, and exert sound governance over funded firms foster innovation and growth. Banks that instead funnel credit to connected parties and the politically powerful discourage entrepreneurship and impede economic development. Recent work further shows that banks matter for poverty and income distribution. (3) Well-functioning banks that extend credit to those with the best projects, rather than to the wealthy or to those with familial, political, or corrupt connections, exert an equalizing affect on the distribution of income and a disproportionately positive impact on the poor by de-linking good ideas and ability from past accumulation of wealth and associations.

The important relationship between banks and economic welfare has led researchers and international institutions to develop policy recommendations concerning bank regulation and supervision. The International Monetary Fund, World Bank, and other international agencies have developed extensive checklists of "best practice" recommendations that they urge all countries to adopt. Most influentially, the Basel Committee on Bank Supervision recently revised and extended the 1988 Basel Capital Accord.

Data

Until recently, the absence of data on bank regulation and supervision made it impossible to conduct broad cross-country studies of which regulations and supervisory practices promote sound banking. While analysts used models, country-studies, and the experiences of supervisors to make policy recommendations, there were simply insufficient data with which to conduct extensive international comparisons and to test the validity of Basel II or other proposals for reform. Clearly expert advice and evidence from individual countries should inform banking policies; but just as clearly, cross-country econometric evidence can provide a valuable input.

Consequently, James Barth, Gerard Caprio, and I assembled an international database on banking policies. We conducted two surveys. The first was conducted in 1998-9 and involved over 100 countries and included information on almost 200 regulations and supervisory practices. The second covered 2003-4 and included 50 more countries and 100 additional questions, many of which were recommended by users of the first survey. (4)

Using these data, I am working with others to assess which banking sector policies promote sound banking around the world. In terms of defining "sound banking," many take for granted that stability is the primary objective of bank regulation. While we study stability, my co-authors and I also examine the impact of banking policies on bank development, efficiency, corruption in lending, and corporate governance of banks. Banks are not simply safe places to stash funds. Banks play pivotal roles in mobilizing and allocating resources, monitoring firms, and providing liquidity and risk management services. Thus, bank regulation and supervision should be judged by more criteria than stability alone.

A Political Economy Approach

Consistent with research on the political economy of banking policies, the patterns we observe in the data suggest that countries do not choose individual regulations in isolation; rather, individual choices reflect broad approaches to the role of government in the economy. (5) Some governments choose an active, hands-on approach, where the government owns much of the banking industry, restricts banks from engaging in non-lending...