New Measures of Bank Regulation and Supervision

1. New Measures of Bank Regulation and Supervision Jim Barth, Jerry Caprio and Ross Levine Workshop on Measuring Bank Regulation and Supervision World Bank Washington, DC October 26,2007

2. Why Measure Regulation? “[The idea] that financial markets contribute to economic growth is a proposition too obvious for serious discussion.” Nobel Laureate Merton Miller 1988

3. Why Measure Regulation? To identify policies that promote welfare, which means: • Data and testing are important • Requires collection and measurement • Requires assessing competing hypotheses • Requires using different methods and datasets • Measures provide benchmarks

4. Our New MeasuresAre Based Upon Such Factors As …1. Structure, scope, and independence of regulation and supervision ... 2. regulations on bank activities and mixing banking-commerce ... 3. regulations on competition ... 4. regulations on capital adequacy ... 5. deposit insurance system design ... 6. supervisory powers and resources ... 7. regulations fostering private sector monitoring of banks

5. How the New Measures AreObtained and Constructed

6. Data Obtained From Surveys of Regulatory and Supervisory Officials • 3 Surveys • 1st: 1998-1999-2000 • 107 countries • 175 questions • 2nd: 2003 • 152 countries • 275 questions • 3rd: 2006 • 142 countries - 214 submitted forms and follow-ups to 60 countries • 300+ questions – 176 yes/no Surveys represent a compromise between obtaining useful information and asking so much that they are too burdensome. They also reflect feedback from banking experts on questions to ask and consultations with authorities on interpretation of questions, including extensive comments from supervisors at the Bank of Spain, Basel Committee, and International Monetary Fund.

7. Reliability of Data • Extensive cleaning of the data, including back and forth with officials and checking of websites • Earlier data on the web for years, rarely in need of correction (only 4-5 times for thousands of entries) • Analysis of reversals, I-II-II (typically 5%) • Response rate varies over time and by question (some data confidential) • Should be verified and extended by World Bank and International Monetary Fund employees on missions.

8. Measurement Limitations • Errors and/or omissions in measuring supervision / regulation? • Impact of regulation and supervision “on the ground” (only have proxies). Are the proxies reasonable or not? • Better aggregate indexes of approaches to supervision / regulation? • Solution: workshops like this should seek to improve upon the survey so as to get better data that can be examined by outside, third parties rather than simply arguing that regulation and supervision are so complex that trusting a relatively few authorities in individual countries alone to possess the knowledge to know and then to do what’s best for their countries is all that can be done. • Note that research is frequently being conducted without taking into account regulations and supervisory practices. Research that does is usually forced to rely on “unofficial” regulatory and supervisory data.

9. Most Data Are Quantitative andDescribe Important Characteristics of the Banking Sector in Countries Can be used to compare to other datasets.

10. Database Includes Such Quantitative Information As … • Size of banking system (number and assets) • Ownership of banks (government and foreign) • Foreign-currency denominated assets and liabilities • Number of supervisors and budget for supervision • Applications for banking licenses and rejection rates (domestic and foreign) • Concentration ratios (deposits and assets) • Utilization of some enforcement powers

11. Two Possible Approachesto the Measurement of Regulations and Supervisory Practices Involving both Quantitative and Qualitative Data • “Every rule” vs. “Broad index”? • No correct answer. • We started with “Every rule” approach, but … • Countries choose strategies, not a smorgasbord of rules • Aggregation and selectivity also involved in measuring such things as CAMELS scores and the Consumer Price Index • Note that the United Kingdom’s Financial Services Authority (FSA) has an 8,500-page rulebook to accompany the eleven principles it has laid out for financial regulation.

12. Structure, scope, independence of regulation and supervision Bank activities Entry requirements Capital requirements Deposit Insurance Supervisory powers Private monitoring External governance Ownership characteristics Some Data Are Grouped and Aggregated to Obtain Broad Measures of… All the data is online in the hopes of lowering the entry barriers to conducting better research. This also aids in obtaining feedback to improve the scope and accuracy of the information.

13. How Many Bank Supervisory Authorities Do Countries Have?

14. Is the Central Bank a Supervisory Authority?

15. Who Funds Supervision in Countries?

16. What Is a Bank? Regulatory Restrictions on Activities and Mixing of Banking and Commerce Unrestricted Permitted Restricted Prohibited Percent 100 4 7 9 31 18 80 32 41 46 60 21 40 33 26 40 42 34 20 20 36 31 13 11 7 0 Securities Insurance Real estate Bank ownership of nonfinancial firms Nonfinancial firm ownership of banks

17. Measuring Restrictions on Activities 1. Unrestricted – A full range of activities in the given category can be conducted directly in the bank. 2. Permitted – A full range of activities can be conducted, but all or some must be conducted in subsidiaries. 3. Restricted – Less than a full range of activities can be conducted in the bank or subsidiaries. 4. Prohibited – The activity cannot be conducted in either the bank or subsidiaries. One can construct equally weighted and/or principal component indices or any others that one wishes.

18. Measuring Entry • Foreign • Limitations on foreign entry/ownership • % of entry applications denied (foreign & domestic) • Domestic • Summary indicator of rules to obtain a license • Draft by-laws, organizational chart, financial projections, financial background information on major owners, background of directors/managers, sources of capital, etc. One can construct equally weighted and/or principal component indices or any others that one wishes.

19. Measuring Capital • Summary measure of initial and general capital stringency • Basel C/A • Capital varies with market risk • Loan, securities, FX losses deducted from capital • Initial capital only with cash and government securities • Borrowed funds for initial capital • Verify capital sources One can construct equally weighted and/or principal component indices or any others that one wishes.

20. Are Countries Planning on Adopting Basel II?

21. Which Approach Do Countries Plan to Adopt? Standardized Approach Advanced IRB Approach Foundation IRB Approach

22. Do Countries Require a Simple Capital Leverage Ratio?

23. Do Countries Have Explicit Deposit Insurance Schemes? Survey III 143 Countries Survey II 152 Countries Countries recently adopting deposit insurance: Armenia, Hong Kong, Malaysia, Moldova, Russia, Singapore, Tajikistan, Uruguay, and Zimbabwe

24. Measuring Deposit Insurance Generosity • Explicit • Level of coverage • Coinsurance • Coverage (e.g., foreign currency deposits, interbank deposits) • Funding (source; flat or risk based) • Management • Membership One can construct equally weighted and/or principal component indices or any others that one wishes.

25. Measuring Official Supervision • Supervisory power • Power to take legal action against auditors, director, officers • Force bank to provision, change organizational structure • Power to suspend dividends, bonuses, management fees • Legal power to declare insolvency • Power to supercede shareholder rights, remove/replace managers, directors • Forbearance discretion • Loan classification and provisioning stringency • Diversification: domestically and abroad • Supervisory resources One can construct equally weighted and/or principal component indices or any others that one wishes.

26. What Powers Do Supervisors Possess?

27. What Powers Do Supervisors Possess?

28. Are Courts Supervisory Authorities Too?

29. Measuring Private Monitoring • Certified audit required • Percent of 10 biggest banks rated by international rating agencies • Accounting disclosure and liability • Accrued but unpaid interest • Consolidated statements • Liability of directors • No deposit insurance Private monitoring ≠ Laissez-Faire Private monitoring involves supervision One can construct equally weighted and/or principal component indices or any others that one wishes.

30. Remember… “If you can not measure it, you can not improve it.” Lord Kelvin