Arnold Kling  

Better Regulation Fails To Strengthen Banks

More Matt Ridley... Liberty in the Long Run...

That is the conclusion of Asli Demirgüç-Kunt and Enrica Detragiache, two economists with the International Monetary Fund.

All in all, we do not find support for the hypothesis that better compliance with BCPs [Basel Core Principles] results in sounder banks as measured by Z-scores [the number of standard deviations by which bank returns have to fall to wipe out bank equity]. This result holds after controlling for the macroeconomic environment, institutional quality, and bank characteristics. We also fail to find a significant relationship when we consider different samples, such a sample of rated banks only, a sample including only commercial banks, and samples including only the largest financial institutions. In an additional test, we calculate aggregate Z-scores at the country level to try to capture the stability of the system as a while rather than that of individual banks, but also this measure of soundness is not significantly related to overall BCP compliance.

Thanks to a pointer from Olaf Storbeck, recommended by a Tim Harford tweet.

This is an unusual sort of paper, in that it tries to look for evidence that regulation works. Ordinarily, economists proceed directly from the observation that market results are imperfect to the conclusion that regulation is the solution. Faith-based regulation, as opposed to evidence-based regulation.

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COMMENTS (9 to date)
david writes:

There've been other papers considering the idea before. Here's another IMF working paper, dating from 2004, with a different conclusion:

Using BCP assessment results for 65 countries and 1998–2002 panel data for other variables, we find a significant positive impact of higher compliance with BCP on banking sector performance, as measured by nonperforming loans and net interest margin, after controlling for the level of development of the economy and the financial system and macroeconomic and structural factors.

I wonder what would happen if we plugged 1998-present panel data into it.

I reiterate that your insinuation that existing economics is "faith-based" is patently false. Here's a quote from a 2008 paper by Demirgüç-Kunt and Detragiache - the two authors of the paper you quote - and a third author, Thierry Tressel:

5. Conclusions

Strong regulation and supervision plays an essential part in ensuring a safe and sound banking system. [...]

Using bank-level investor ratings for 39 countries, we have explored whether countries that comply more closely with the Basel Core Principles (BCPs)—the universally accepted standard of best practices in bank supervision—have sounder banks, as measured by Moody's financial strength ratings. [..]

We find a significant and positive relationship between compliance with information provision and bank soundness ratings. This relationship is robust to controlling for broad indexes of institutional quality, macroeconomic variables, sovereign ratings, and reverse causality. Specifically, countries that require their banks to regularly and accurately report their financial data to regulators and market participants have more highly rated banks, as timely disclosure of high quality information strengthens monitoring by regulators and markets alike. [...]

Our results suggest that countries aiming to upgrade banking regulation and supervision should consider giving priority to information provision over other elements of the core principles. Because information provision is a necessary condition for effective discipline, this policy recommendation is consistent with the approach to regulation and supervision recommended by Barth et al. (2006), who stress the importance of mechanisms to empower market discipline and are skeptical of structures that assign too much power to regulators.

The 2010 paper uses a different set of metrics for soundness.

In short: the idea of testing regulatory approaches is not new and you aren't the heroic heterodox revolutionary that you seem to think you are. Sorry.

Bruce N. Stein writes:

This is a *fantastic* read. Thank you.

Bruce N. Stein writes:

To david:

1: The 2004 paper you cite talks about *results* as measured by non-performing loans, etc which is related to, but not necessarily proportionally correlated, to overall soundness. And in fact higher returns can often indicate riskier activities, as we've very well seen recently. So to compare "performance" and use it to indicate "better" is somewhat disingenuous.

Further, certain aspects of the BCPs could have increased returns while increasing future risk. In fact, in the conclusions on page 11 of the 2010 paper in the original post (as well as on pages 5-6) you'll find this gem:

If anything, we find that compliance with a specific group of principles, those giving supervisors powers to regulate bank licensing and structure is associated with riskier banks, potentially suggesting that such powers may be misused in practice.

2: The 2008 paper you cite is specifically addressed in the new paper as having a very restricted sample set and of using a different metric which the authors believe to be suspect to fault. From page 4:

Using rating information to proxy bank risk significantly limited the sample size in that study, making it necessary to exclude many smaller banks and many banks from lower income countries. Furthermore, after the recent crisis, the credibility of credit ratings as indicators of bank risk has also diminished, questioning the merit of using these ratings in the analysis.

So while I think it is very, very wise to proceed with caution, and while I do think that Mr. Kling was being a bit hyperbolic, there is important information to digest here that indicates a 0 correlation, and even a possible negative correlation, between bank regulatory structure and soundness. The issues you've raised do not dismiss this.

Doc Merlin writes:

Although not as scientific as this paper, I generally find that regulations just lead to regulatory arbitrage which increases brittleness due to complexity.

beezer writes:

Sorry for my ignorance. And I can't even cite where I read the information, but the Basel Accords, it is alleged, greatly increased leverage in banking.

Ergo, adherence to Basel requirements increased leverage and risk. Would it follow that strict regulatory regimes requiring strict adherence to the accords would insure participation in a debt meltdown? That would pretty much indicate strong regulations are worse than light ones, or none at all.

david writes:

@Bruce N. Stein,

Yes, I agree that the paper contains important information; it does not straightforwardly endorse naive regulation. Neither does the 2008 paper I quoted (see the section I bolded!). I do not dispute the point on regulatory soundness.

I was disputing Kling's last paragraph, where he asserts that (1) the paper is unusual (2) that 'ordinary' economics behind regulation is 'faith-based'. He stated so in a straightforward non-hyperbolic manner and I think both assertions are bluntly false.

Kling has in past posts presented a narrative where he claims to have understanding of some idea he invented that the mainstream not; he supports this by bringing up concepts which he suggests are generally unexamined elsewhere. This is wrong and misleading - the effectiveness of financial regulation is heavily-studied topic; it merely has much more ambiguous conclusions than what he wishes were the case.

Bruce N. Stein writes:

@ david:

You are a gentleman and a scholar. *bow*

dWj writes:

The thing that passed the Senate today, that's going to change how mortgage securities count for regulatory capital purchases, right? Or are the government screw-ups that fed the problem to be left in place?

I think I know which way to guess. Sigh.

Mike Rulle writes:

To David

Your emotional outburst appears omnidirectional. I don't understand what is frustrating you. Is it that AK has a skeptical outlook toward certain claims about the effectiveness of some forms of regulation or that he claims originality without merit? If the latter, it might mean you too are skeptical of regulation. If the former, then not. What was your point?

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