APPROACH AND CONTEXT

Joseph Schumpeter (1912, p. 74) argued that the banker authorizes the entrepreneur, in the name of society, to innovate. He meant that banks mobilize society's savings and decide who gets to use them. If banks make good decisions, this will maximize the chances that the economy will innovate and thrive. Thus, bank regulation and supervision matter. As illustrated by the differences between the United States and Mexico during the nineteenth century, banking policies can either underwrite growth that benefits society at large, or they can fortify a political fortress that simultaneously enriches the elite while thwarting the aspirations of the many.

To contribute to the understanding of bank regulation and its impact on societies, we construct a new database on banking policies around the world. Within international policy circles, official regulators and supervisors have relied on their experience to formulate best practice recommendations. Clearly, practical experience is essential for designing sound policies.

RECAP AND MOTIVATION

As discussed in Chapter 4, the empirical results are broadly consistent with the private interest view of bank supervisory and regulatory policies and generally inconsistent with the public interest view. For instance, the public interest view suggests that supervisory agencies adopt regulatory restrictions on bank activities and limit the entry of new banks to promote the safety and soundness of the banking system. Yet, we find that these policies do not lower the probability of banking crises. Rather, they increase both net interest margins and bank overhead costs, which is more consistent with the private interest hypothesis that narrow interests will use bank regulations to enrich and protect special interests in society. Similarly, the public interest view suggests that countries will empower official supervisory agencies so that they can more effectively monitor banks and induce banks to behave in a socially efficient manner.

MOTIVATION

When budding entrepreneurs in Brazil, Egypt, Zambia, or Indonesia are turned down for loans or do not even bother to apply because banks instead funnel credit to the rich or politically powerful, this stymies innovation and thwarts economic growth. When households in Georgia, Nigeria, Russia, or Venezuela avoid placing their savings in financial institutions and instead buy foreign currency, physical commodities, or durable goods, this reflects queasiness about domestic banks and advertises the lack of efficient mechanisms for getting savings to productive firms. When bank managers in too many countries simply take deposits with one hand and pass them along to friends and related businesses with the other hand, this discourages business initiative and prevents the poor and unconnected with good ideas from realizing their dreams and improving their economic condition. When bad policies ignite or exacerbate banking crises in Argentina, Indonesia, or Mexico, this yields widespread bankruptcies, rising unemployment, and even soaring street violence.

Although our names appear on the book cover, the contents benefited enormously from insightful conversations with many colleagues, the detailed comments of those who suffered through early versions of the manuscript, seminar and conference participants literally all over the world, and the extraordinary help of many research assistants. At various stages of putting together the database and checking the results, we received excellent assistance from Xin Chen, Dan Goldblum, Andy Kim, and Iffath Sharif; Polly Means assisted with Figure 1.1 and the cover with her usual skill. Daniele Evans kept Jerry organized while he was working on the book and defended him from some bureaucratic demands with great skill, and she and Elena Mehkova helped on parts of the manuscript. We are especially grateful to Cindy Lee and Triphon Phumiwasana for their tireless efforts in assisting us with the database during the past few years. We also benefited from extensive comments from a number of scholars working in this or related areas, and we owe a debt to Thorsten Beck, John Boyd, Charles Calomiris, Maria Carkovic, Stijn Claessens, Asli Demirgüç-Kunt, Bill Easterly, Morris Goldstein, Charles Goodhart, Stephen Haber, Jim Hanson, Patrick Honohan, Ed Kane, George Kaufman, Luc Laeven, Juan Marchetti, Rick Mishkin, Dan Nolle, Larry Promisel, Raghu Rajan, Joao Santos, Augusto de la Torre, Andrei Shleifer, and Greg Udell for comments both general and specific.

GOALS AND BOUNDARIES

Goals

This chapter assesses the book's central question: which bank regulatory and supervisory strategies work best? As stressed in Chapter 1, three inter-related motivations drive this chapter's analyses. First, because banks importantly influence economic growth, poverty alleviation, and economic volatility (Levine, 2005a), it is critical to identify those policies that encourage efficient bank operations. Consequently, this chapter provides the first broad, cross-country assessment of a variety of regulations to determine which ones enhance bank development, stability, efficiency, performance, and the degree of corruption in bank lending. Second, the Basel Committee routinely makes influential recommendations for countries to adopt regarding bank regulatory and supervisory strategies. As described in Chapter 2, it most recently recommended Basel II, which is based on three pillars: capital standards, official supervision, and market discipline, respectively. This chapter provides the first cross-country assessment of the relative merits of these three “pillars.” Third, our inquiry about what works best in bank regulation and supervision bears directly on the epic debate on the proper role of government in an economy. From before the Federalist Papers, philosophers, political scientists, and economists have warned about the adverse repercussions of unchecked power of any branch of government.

Over the course of time and across countries, approaches to bank regulation have varied from extremely light to all encompassing, from highly interventionist regulations and even outright government ownership to episodes of “free” banking. In most countries, the level of regulatory intervention in banking has increased dramatically relative to that in other sectors since the Great Depression (Calomiris, 2003). Before looking in detail in Chapter 3 at current regulatory arrangements around the world, this chapter discusses the ways in which societies approach financial sector regulation, the primary features of regulation and supervision, and how external forces are shaping the regulatory choices that countries make.

The first part of this chapter begins with the broad conceptual foundations for bank regulation. As with government interventions in other sectors, those in banking can be examined from the standpoint of the broader debate on the role of government in an economy. Two mostly opposing camps set the boundaries for this debate.

The public interest view holds that governments regulate banks to facilitate the efficient functioning of banks by ameliorating market failures, for the benefit of broader civil society.

OVERVIEW

How do countries regulate and supervise their banks? Until recently, there was no comprehensive and official database on which one could draw to assess (1) the extent to which bank regulatory and supervisory regimes differ across a wide spectrum of countries, (2) what works best with regard to bank supervision and regulation, and (3) the determinants of different bank supervisory and regulatory choices around the world. Moreover, regulatory officials, especially those from high-income countries, have often taken the view that their choice of how to regulate and supervise their own banks was best for banks everywhere. This “policy hubris” is aided and abetted by a lack of a sufficiently comprehensive and detailed database with which to compare the practices of individual countries. Most importantly, the absence of such data prevents one from empirically testing any advice as to what a country should do to improve bank regulation and supervision and from assessing why countries adopt particular policies toward banks.