Global financial development report 2013Presentation Transcript
Global Financial Development Report 2013Global Financial Development Report 2013 is the first in a new World Bank series. It provides a unique contribution to financialsector policy debates, building on novel data, surveys, research, and wide-ranging country experience, with emphasis onemerging-market and developing economies. Development Report The global financial crisis has challenged conventional thinking on financial sector policies. Launched on the fourthanniversary of the Lehman Brothers collapse—a turning point in the crisis—this volume re-examines a basic question: what is Global Financialthe proper role of the state in financial development? To address the question, this report synthesizes new and existing evidenceon the state’s performance as financial sector regulator, overseer, promoter, and owner. It calls on state agencies to providestrong regulation and supervision and ensure healthy competition in the sector, and to support financial infrastructure, such asthe quality and availability of credit information. It warns that direct interventions—such as lending by state-ownedbanks, used in many countries to counteract the crisis—may end up being harmful. The report also tracks financial systems in more than 200 economies before and during the global financial crisis. Accompany-ing the publication is a website (http://www.worldbank.org/financialdevelopment) that contains extensive datasets, research Rethinking the Role of the State in Financepapers, and other background materials, as well as interactive features. The report’s findings and policy recommendations are relevant for policy makers; staff of central banks, ministries of finance,and financial regulation agencies; nongovernmental organizations and donors; academics and other researchers and analysts;and members of the development community. 2013 Rethinking the Role of the State in Finance ISBN 978-0-8213-9503-5 SKU 19503
Rethinking theRole of the State in Finance
Global Financial Development Report 2013Rethinking theRole of the State in FinanceWashington, D.C.
x o n t e n t s c GLOBAL financial DEVELOPMENT REPORT 2013 2.1 Examples of Weak Supervisory Capacity Identified in the FSAP. . . . . . . . . . . . . . . . 52 2.2 Differences between Crisis and Noncrisis Countries. . . . . . . . . . . . . . . . . . . . . . . . . 57 2.3 Summary of the Basel III Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 2.4 Summary of Selected Proposals for Regulatory Reform. . . . . . . . . . . . . . . . . . . . . . .69 B3.5.1 Competition in MENA and across Regions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 B3.6.1 Cross-Country Determinants of Banking Competition. . . . . . . . . . . . . . . . . . . . . . . 96 B4.4.1 Determinants of the Growth of Total Gross Loans. . . . . . . . . . . . . . . . . . . . . . . . . 110 B4.5.1 Credit Cycles and Government Ownership of Banks. . . . . . . . . . . . . . . . . . . . . . . . 113 5.1 Credit Reporting, Coverage by Region. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 B5.3.1 Bank Concentration and Credit Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 A.1 Countries and Their Financial System Characteristics, Averages, 2008–2010. . . . . 161
ForewordT he Global Financial Development The World Bank Group has been actively Report comes at a time when the engaged in financial sector work for some worldwide financial crisis has starkly time, aiming to help various parts of the insti-highlighted the importance of financial sys- tutional mosaic—including regulation andtems and their role in supporting economic supervision, corporate governance, and finan-development, ensuring stability, and reducing cial infrastructure—ensure that the financialpoverty. sector contributes meaningfully to strong and Finance matters, both when it functions inclusive growth. This report seeks to advancewell and when it functions poorly. Sup- the global financial sector policy debate,ported by robust policies and systems, finance highlighting the important perspective ofworks quietly in the background, contribut- emerging markets and developing economies.ing to economic growth and poverty reduc- It contains a rich array of new financial sectortion. However, impaired by poor sector data that are also publicly available as part ofpolicies, unsound markets, and imprudent our Open Data Agenda.institutions, finance can lay the foundation Sharpening the focus on the central role offor financial crises, destabilizing economies, finance in socioeconomic development andhindering economic growth, and jeopardizing understanding how financial systems can behard-won development gains among the most strengthened are crucial if we are to realizevulnerable. our goal of boosting prosperity and eradi- Fostering sustainable financial develop- cating poverty. The Global Financial Devel-ment and improving the performance of opment Report is an important step in thisfinancial systems depends on numerous insti- process.tutional factors and stakeholders. The policymaker, the regulator, the banker, and the Jim Yong Kimfinancial consumer must all play their part. President The World Bank Group g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 xi
PrefaceT he goal of this inaugural Global Finan- ideological views, instead aiming to develop cial Development Report is to contrib- a more nuanced approach to financial sec- ute to the evolving debate on the role tor policy based on a synthesis of new data,of the state in the financial sector, highlighted research, and operational experiences.from the perspective of development. The The report emphasizes that the state has areport is aimed at a broad range of stakehold- crucial role in the financial sector—it needs toers, including governments, international provide strong prudential supervision, ensurefinancial institutions, nongovernmental orga- healthy competition, and enhance financialnizations, think tanks, academics, private sec- infrastructure. Regarding more direct inter-tor participants, donors, and the wider devel- ventions, such as state ownership of banks,opment community. The report offers policy the report presents new evidence that stateadvice based on research and lessons from involvement can help in mitigating adverseoperational work. effects of a crisis. However, the report cau- This marriage of research and operational tions that over longer periods, direct statework was possible thanks to the engagement involvement can have important negativeof a diverse set of experts inside and outside effects on the financial sector and the econ-the World Bank Group. The report reflects omy. Therefore, as crisis conditions recede,inputs from Bank staff in a broad range of the evidence suggests that it is advisable forunits and collaboration with leading research- governments to shift from direct to indirecters on finance and development. Reflecting interventions.the close links between financial develop- Because the financial system is dynamicment and stability, counterparts at the Inter- and conditions are constantly changing, regu-national Monetary Fund have also provided lar updates are essential. Hence, this reportvaluable contributions. should be seen as part of an ongoing project The report benchmarks financial institu- aimed at supporting systematic evaluation,tions and markets around the world, rec- improving data, and fostering broader part-ognizing the diversity of modern financial nerships. Future reports might address finan-systems. In its analysis of the state’s role in cial inclusion, the development of local cur-finance, the report seeks to avoid simplistic, rency capital markets, the financial sector’s g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 xiii
xiv r e f a c e p GLOBAL financial DEVELOPMENT REPORT 2013 role in long-term financing, and the state’s and sound financial systems for robust eco- role in financing health care and pensions. nomic performance. We hope that this new series of analytical reports will prove useful to all stakeholders in Mahmoud Mohieldin promoting evidence-based decision making Managing Director The World Bank Group
AcknowledgmentsT he 2013 Global Financial Develop- Christova, Margaret Miller, Leora Klapper, ment Report reflects the efforts of a Shalini Sankaranarayan, Alban Pruthi, and broad and diverse group of experts Thilasoni Benjamin Musuku (chapter 5).both inside and outside the World Bank. The The report was prepared under the over-report was cosponsored by the World Bank’s sight of Janamitra Devan, Vice PresidentFinancial and Private Sector Development (FPD and IFC); Justin Yifu Lin, Chief Econo-Vice Presidency (FPD) and the Development mist and Senior Vice President (DEC); andEconomics Vice Presidency (DEC). It reflects Martin Ravallion, Acting Chief Economistinputs from World Bank Group staff across a and Senior Vice President (DEC). Worldrange of units, including all the regional vice Bank Presidents Robert B. Zoellick and Jimpresidencies, the Poverty Reduction and Eco- Yong Kim and Managing Director Mahmoudnomic Management Network, and External Mohieldin provided overall guidance. TheAffairs, as well as staff of the International authors received invaluable advice from theFinance Corporation (IFC). FPD Council (Aslı Demirgüç-Kunt, Augusto Aslı Demirgüç-Kunt was the director of Lopez-Claros, Gaiv Tata, Gerardo Corro- ˇthis project. Martin Cihák led the core team, chano, Janamitra Devan, Klaus Tilmes, Loicwhich included Cesar Calderón, Martin Chiquier, Marialisa Motta, Pierre Guislain,Kanz, Subika Farazi, and Mauricio Pinzon Sujata Lamba, Tilman Ehrbeck, and TuncLatorre. Other key contributors were Erik Uyanik) as well as the World Bank–Interna-Feyen (chapter 1); Maria Soledad Martínez tional Monetary Fund Financial Sector Liai- ˙Pería (chapters 2, 3, and 4); Inci Ötker-Robe, son Committee.Martín Vázquez Suárez, Miquel Dijkman, Peer reviewers of the report were StijnValeria Salomao Garcia, R. Barry Johnston, Claessens, Augusto de la Torre, Ross Levine,and Nicolas Véron (chapter 2); Thorsten Beck Norman Loayza, Roberto Rocha, and Tuncand Klaus Schaeck (chapter 3); Marcin Piat- Uyanik. Luis Servén also reviewed the con-kowski, Eva Gutierrez, José De Luna Mar- cept note. Comments on individual chapterstinez, Carlos Leonardo Vicente (chapter 4); were also received from Aart Kraay, RossOuarda Merrouche, Miriam Bruhn, Mas- Levine, Roberto Rocha, and Sergio Schmuk-simo Cirasino, Marco Nicoli, Maria Teresa ler (chapter 1); Gerard Caprio, Patrick Hono-Chimienti, Froukelien Wendt, Luchia Marius han, Alain Ize, Ross Levine, and Damodaran g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 xv
xvi c k n o w l e d g m e n t s a GLOBAL financial DEVELOPMENT REPORT 2013 Krishnamurti (chapter 2); Franklin Allen, assistance was provided by Hedia Arbi, Gra- Thorsten Beck, Michael Fuchs, and Martha cia Sorensen, and Agnes Yaptenco. Other Martinez Licetti (chapter 3); and Viral Acha- valuable assistance was provided by Benja- rya, Charles Calomiris, Heinz Rudolph, and min Levine and Vin Nie Ong. Sergio Schmukler (chapter 4). Aart Kraay Mauricio Pinzon Latorre and Subika reviewed all chapters for consistency and Farazi were instrumental in compiling and quality multiple times. updating the databases underlying the report. The authors also received valuable sug- In so doing, they benefited from the work of gestions and other contributions at various the current FinStats database team, which stages of the project from Hormoz Aghadey, includes Katie Kibuuka and Diego Sour- Shamshad Akhtar, Deniz Anginer, Mad- rouille, who in turn relied on key efforts from elyn Antoncic, Zsofia Arvai, Steen Byskov, previous FinStats team members, including Kevin Carey, Jeffrey Chelsky, Loic Chiquier, Ed Al-Hussainy, Haocong Ren, and Andrea Gerardo Corrochano, Mariano Cortes, Rob- Coppola. Joanna Nasr, Mariana Carvalho, ert Cull, Stefano Curto, Mansoor Dailami, and Zarina Odinaeva helped with the data Katia D’Hulster, Maya Eden, Tilman Ehr- on the credit information systems used in beck, Matthias Feldmann, Aurora Ferrari, chapter 5. Manuela Ferro, Jose Antonio Garcia, Egbert The work on the 2011 update of the Gerken, Swati Ghosh, David Gould, Neil Banking Regulation and Supervision Survey Gregory, Mario Guadamillas, Pankaj Gupta, started with the collaboration of Maria Sole- Mary Hallward-Driemeier, Darrin Hartzler, dad Martínez Pería, Roberto Rocha, Con- Richard Hinz, Mustafa Zakir Hussain, Sujit stantinos Stephanou, and Haocong Ren. The Kapadia, Isfandyar Khan, Thomas Kirch- survey benefited from contributions from meier, Kalpana Kochhar, Rachel Kyte, Jeffrey numerous banking regulation experts in the Lewis, Samuel Maimbo, Mariem Malouche, World Bank, including David Scott, Krish- Cledan Mandri-Perrott, Claire Louise namurti Damodaran, Katia D’Hulster, Ced- McGuire, Martin Melecky, Dino Merotto, ric Mousset, and others outside the World Sebastian Molineus, Fredesvinda Montes, Bank, in particular, Michael Andrews and Cedric Mousset, Nataliya Mylenko, Makoto Jan-Willem van der Vossen. Insights and Nakagawa, Harish Natarajan, Aloysius Uche encouragement from Gerard Caprio, Ross Ordu, Jorge Patiño, Jean Pesme, Tigran Pog- Levine, and James Barth, who organized hosyan, John Pollner, Daniel Pulido, Hao- the previous rounds of the survey, are grate- cong Ren, Ivan Rossignol, Heinz Rudolph, fully acknowledged. PKF (UK) and Auxilium Consolate Rusagara, Andre Ryba, David helped with compiling and following up on Scott, James Seward, Sophie Sirtaine, Con- the survey responses. Amin Mohseni pro- stantinos Stephanou, Mark Stone, Vijay Tata, vided excellent research assistance on the Marilou Uy, S. Kal Wajid, Juan Zalduendo, survey. Catiana Garcia-Killroy (FPD), Dilek Laura Zoratto, and participants in seminars Aykut and Eung Ju Kim (both DEC), and and briefings organized at the World Bank. Isabella Reuttner (World Economic Forum) The report would not be possible with- provided helpful consultations on data. Tariq out the production team, including Merrell Khokhar, Neil Fantom, Ibrahim Levent, and Tuck-Primdahl and Nicole Frost, as well as William Prince were instrumental in integrat- Stephen McGroarty, Santiago Pombo, Jose ing the report’s data with the World Bank’s De Buerba, Jane Zhang, Ryan Hahn, Mary Open Data Initiative. Donaldson, and Xenia Zia Morales. Aziz The authors would also like to thank the Gokdemir was the production editor, with many country officials and other experts who Debra Naylor as the graphic designer. Roula participated in the surveys underlying this Yazigi assisted the team with the website report, including the Bank Regulation and and communications. Paul Holtz was the Supervision Survey and the Financial Devel- language editor. Excellent administrative opment Barometer.
GLOBAL financial DEVELOPMENT REPORT 2013 c k n o w l e d g m e n t s xvii a Financial support from State Secretariat Change program and the Research Supportfor Economic Affairs (Switzerland) is grate- Budget provided funding for the underlyingfully acknowledged. The latest update of the research program in DEC. Frank Sader hadBank Regulation and Supervision Survey and a key role in FPD’s fundraising efforts for therelated research was financed with financial Global Financial Development Report.support from the U.K. Department for Inter-national Development. The Knowledge forExternal AdvisersViral Acharya CV Starr Professor of Economics, New York University Stern School of Business; Program Director for Financial Economics, Centre for Economic Policy ResearchFranklin Allen Nippon Life Professor of Finance and Professor of Economics at the Wharton School of the University of PennsylvaniaThorsten Beck Professor of Economics and Chairman of the European Banking Center, Tilburg University, NetherlandsCharles Calomiris Henry Kaufmann Professor of Financial Institutions, Graduate School of Business, Columbia UniversityGerard Caprio William Brough Professor of Economics and Chair, Center for Development Economics, Williams CollegeStijn Claessens Assistant Director, Research Department, International Monetary FundPatrick Honohan Governor, Central Bank of IrelandR. Barry Johnston Former Assistant Director, Monetary and Capital Markets Department, International Monetary FundRoss Levine James and Merryl Tisch Professor of Economics; Director, William R. Rhodes Center for International Economics and Finance, Department of Economics, Brown UniversityMonica Rubiolo Head of Macroeconomic Support, State Secretariat for Economic Affairs, SwitzerlandKlaus Schaeck Professor of Empirical Banking, Bangor UniversityNicolas Véron Senior Fellow, Bruegel Institute; Visiting Fellow, The Peterson Institute for International Economics The report also benefited from suggestions and insights from country officials and otherexperts participating in the Financial Development Barometer and the other surveys and dis-cussions underlying this report. The findings, interpretations, and conclusions expressed in thisreport do not necessarily reflect the views of the advisers or institutions with which they areaffiliated.
xviii c k n o w l e d g m e n t s a GLOBAL financial DEVELOPMENT REPORT 2013 Peer Reviewers Stijn Claessens Assistant Director, Research Department, International Monetary Fund Augusto de la Torre Chief Economist, Latin America and the Caribbean Vice Presidency, World Bank Ross Levine James and Merryl Tisch Professor of Economics; Director, William R. Rhodes Center for International Economics and Finance, Department of Economics, Brown University Norman Loayza Lead Economist and Director, 2014 World Development Report: Risks, Vulnerabilities, and the Crisis, World Bank Roberto Rocha Senior Adviser, Financial and Private Sector Vice Presidency, World Bank Tunc Uyanik Director, Financial Systems Global Practice and East Asia and Pacific Region, Financial and Private Sector Vice Presidency, World Bank
Abbreviations and GlossaryATP/TA after-tax profits to assets e-MID Electronic Market for InterbankBANSEFI Banca de Ahorro Nacional y Deposit Servicios Financieros FIRA Fideicomisos Instituidos enBB Banco do Brasil Relación con la Agricultura,BCB Banco Central do Brasil MexicoBCBS Basel Committee for Banking FIRST Financial Sector Reform and Supervision Strengthening InitiativeBIS Bank for International FOGAPE State-Owned Guarantee Fund Settlements for Small Entepreneurs, ChileBNDES Banco Nacional de FSA Financial Sector Assessment Desenvolvimento Econômico e FSAP Financial Sector Assessment Social (state-owned development Program bank, Brazil) FSB Financial Stability BoardBTP/TA before-tax profits to assets FSSA Financial System StabilityCCP central counterparty AssessmentCEF Caixa Econômica Federal GCC Gulf Cooperation CouncilCoCo contingent capital GDP gross domestic productCPSIPS Core Principles for Systemically GOB government-owned bank Important Payment Systems GTS global trading systemCPSS Committee on Payment and HHI Herfindahl-Hirschman index (of Settlement Systems market concentration)CR5 concentration ratio (share of IDB Inter-American Development the five largest banks in total Bank banking system assets) IFC International FinanceDB development bank CorporationDNS deferred net settlement IFRS International FinancialDTAs deferred tax assets Reporting StandardsEAP East Asia and Pacific IMF International Monetary FundECA Europe and Central Asia IOSCO International Organization ofEMDEs emerging markets and Securities Commissions developing economies IRB international ratings-based g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 xix
xx b b r e v i a t i o n s a and glossary GLOBAL financial DEVELOPMENT REPORT 2013 KfW Kreditanstalt für Wiederaufbau, PKO BP PKO Bank Polski Germany PRISM Pakistan Real Time Interbank KOTEC Korean government guarantor Settlement Mechanism LAC Latin America and the PSEFT Payment System and Electronic Caribbean Fund Transfer LIBOR London interbank offered rate PwC Pricewaterhouse Coopers LLP loan loss provisioning RCCP Recommendations for Central M2 M2 measure of money supply Counterparties MENA Middle East and North Africa ROA return on assets MFI microfinance institution RSSS Recommendations for Securities MIC Collateralized Interbank Settlement Systems Market (Italy) RTGS real-time gross settlement MSR mortgage servicing rights RWA risk-weighted assets NAFIN Nacional Financiera, Mexico SAR Special Administrative Region NBFI nonbank financial institution SBP State Bank of Pakistan NBP National Bank of Poland SECO State Secretariat for Economic NI net interest income Affairs, Switzerland NII non-interest income SELIC Sistema Especial de Liquidação NPL nonperforming loan e de Custódia NPS national payment system SIFIs systemically important financial NSFR net stable funding ratio institutions OECD Organisation for Economic SME small and medium enterprise Co-operation and Development SSA Sub-Saharan Africa OLS ordinary least squares STR Sistema de Transferência de OTC over the counter Reservas OV overhead costs TA/A taxes to assets P/E price-to-earnings ratio Glossary of key terms used throughout the report The financial The financial system in a country is defined to include financial insti- system tutions (banks, insurance companies, and other nonbank financial institutions) and financial markets (such as those in stocks, bonds, and financial derivatives). It also includes the financial infrastructure (which includes, for example, credit information–sharing systems and payment and settlement systems). Financial Conceptually, financial development is a process of reducing the costs development of acquiring information, enforcing contracts, and making transac- tions. Empirically, measuring financial development directly is chal- lenging. Instead, the report measures four financial system character- istics (depth, access, efficiency, and stability) for financial institutions and financial markets (“4x2 framework”). The state The state is defined in a broad economic sense, to include not only the country’s government but also autonomous or semiautonomous agen- cies such as a central bank or a financial supervision agency. The roles of the The roles of the state in the financial sector include those of a pro- state moter, owner, regulator, and overseer. The report focuses on areas that were highlighted by the crisis and are of particular relevance for financial development. Country A territorial entity for which statistical data are maintained and pro- vided internationally on a separate and independent basis (not neces- sarily a state as understood by international law and practice).
OverviewO n September 15, 2008, the failure of the U.S. investment banking giantLehman Brothers marked the onset of the larg- Which lessons about the connections between finance and economic development should shape policies in coming decades?est global economic meltdown since the Great On the surface, the main contrast betweenDepression. The aftershocks have severely this global crisis and those in recent decades isaffected the livelihoods of millions of people that developed economies were affected mucharound the world. The crisis triggered policy more strongly and more directly than weresteps and reforms designed to contain the cri- developing economies. But some developedsis and to prevent repetition of these events. financial systems (such as those of Australia, Four years later, with banking woes ongo- Canada, and Singapore) have shown remark-ing in various parts of the world (most nota- able resilience so far, while some developingbly in the euro area), it is a good time to ones have been brought to the brink of col-evaluate these reforms and their likely con- lapse. The bigger point is that the quality oftribution to long-run financial development. a state’s policy for the financial sector mat-The crisis experience is thus an important ters more than the economy’s level of devel-part of the motivation for this inaugural opment. This report reassesses the role of theGlobal Financial Development Report. The state in finance, based on updated data, ongo-crisis has prompted many people to reassess ing research, and World Bank Group experi-various official interventions in financial ences from around the world.systems, from regulation and supervision of Two building blocks underlie the report’sfinancial institutions and markets, to com- view of the role of the state in finance. First,petition policy, to state guarantees and state there are sound economic reasons for theownership of banks, and to enhancements in state to play an active role in financial sys-financial infrastructure. tems. Second, there are practical reasons to But the crisis does not necessarily negate be wary of the state playing too active a rolethe considerable body of evidence on these in financial systems. The tensions inherent intopics accumulated over the past few decades. these two building blocks emphasize the com-It is important to use the crisis experience to plexity of financial policies. Though econom-examine what went wrong and how to fix it. ics identifies the social welfare advantages of g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 1
2 v e r v i e w O GLOBAL financial DEVELOPMENT REPORT 2013 certain government interventions, practical Nevertheless, with ample reservations and experience suggests that the state often does cautions, this report teases out broad lessons not intervene successfully. Furthermore, since for policy makers from a variety of experi- economies and the state’s capacity to regu- ences and analyses (see box O.1 for a sum- late differ across countries and over time, mary of the main messages). the appropriate involvement of the state in The state tends to play a major role in the financial system also varies case by case. the modern financial sector, as promoter, BOX O.1 Main Messages of This Report The report’s overall message is cautionary. The global bility. However, research presented in this report financial crisis has given greater credence to the idea suggests that, for the most part, factors such as poor that active state involvement in the financial sector regulatory environment and distorted risk-taking can help maintain economic stability, drive growth, incentives promote instability, rather than competi- and create jobs. There is evidence that some interven- tion itself. With good regulation and supervision, tions may have had an impact, at least in the short bank competition can help improve efficiency and run. But there is also evidence on potential longer- enhance access to financial services, without neces- term negative effects. The evidence also suggests that, sarily undermining systemic stability. Rather than as the crisis subsides, there may be a need to adjust restricting competition, it is necessary to address the role of the state from direct interventions to less distorted competition, improve the flow of informa- direct involvement. This does not mean that the state tion, and strengthen the contractual environment. should withdraw from overseeing finance. To the con- Lending by state-owned banks can play a positive trary, the state has a very important role, especially in role in stabilizing aggregate credit in a downturn, but providing supervision, ensuring healthy competition, it also can lead to resource misallocation and dete- and strengthening financial infrastructure. rioration of the quality of intermediation. The report Incentives are crucial in the financial sector. The presents some evidence that lending by state-owned main challenge of financial sector policies is to better banks tends to be less procyclical and that some align private incentives with public interest without state-owned banks even played a countercyclical role taxing or subsidizing private risk-taking. Design of during the global financial crisis. However, the track public policy needs to strike the right balance—pro- record of state banks in credit allocation remains gen- moting development, yet in a sustainable way. This erally unimpressive, undermining the benefits of using approach leads to challenges and trade-offs. state banks as a countercyclical tool. Policy makers In regulation and supervision, one of the crisis les- can limit the inefficiencies associated with state bank sons is the importance of getting the “basics” right credit by paying special attention to the governance first. That means solid and transparent institutional of these institutions and schemes and ensuring that frameworks to promote financial stability. Specifi- adequate risk management processes are in place. cally, it means strong, timely, and anticipatory super- However, this oversight is challenging, particularly in visory action, complemented with market discipline. weak institutional environments. In many developing economies, that combination of Experience points to a useful role for the state in basic ingredients implies a priority on building up promoting transparency of information and reducing supervisory capacity. Here, less can mean more: less counterparty risk. For example, the state can facili- complex regulations, for instance, can mean more tate the inclusion of a broader set of lenders in credit effective enforcement by supervisors and better moni- reporting systems and promote the provision of high- toring by stakeholders. quality credit information, particularly when there The evidence also suggests that the state needs to are significant monopoly rents that discourage infor- encourage contestability through healthy entry of mation sharing. Also, to reduce the risk of freeze-ups well-capitalized institutions and timely exit of insol- in interbank markets, the state can create the condi- vent ones. The crisis fueled criticisms of “too much tions for the evolution of markets in collateralized competition” in the financial sector, leading to insta- liabilities.
GLOBAL financial DEVELOPMENT REPORT 2013 O v e r v i e w 3owner, regulator, and overseer. Indeed, eco- that pay off, bank owners reap the profits.nomics provides several good motivations But when such gambles fail, the bank mayfor an active role for the state in finance. not bear the full cost. For example, bail-These motivations reflect the effects of “mar- outs of troubled banks spread the cost ofket imperfections,” such as the costs and failed bets broadly among others in societyuncertainties associated with (a) acquiring who had no connection to the original riskyand processing information, (b) writing and investment decision. This potential for cas-enforcing contracts, and (c) conducting trans- cading events can be a reason for the state toactions. These market imperfections often intervene by imposing “speed limits” on riskcreate situations in which the actions of a few taking by banks.people or institutions can adversely influence Third, limitations on the ability of peoplemany other people throughout society. These to process information, and the tendency ofexternalities provide the economic rationale some people to follow the crowd, can moti-for the government to intervene to improve vate governments to take an active role inthe functioning of the financial system. financial markets. For example, when people A few examples demonstrate how market have difficulty fully understanding compleximperfections motivate government action. investments or do not appreciate the possibil-First, when one bank fails, this can cause ity of rare but extreme events, this can leaddepositors and creditors of other banks to investors to make systematic mistakes, whichbecome nervous and start a run on these can jeopardize the stability of the economy,other banks. This “contagion”—whereby the with potentially adverse ramifications forweakness in one bank can cause stress for people who neither make those investmentsotherwise healthy financial institutions—can nor have any influence over those that do.reverberate through the economy, causing Governments can limit the adverse reper-problems for the individuals and firms that cussions of these market failures. For exam-rely on those otherwise healthy institutions. ple, regulation and supervision can limit riskThis is the classic bank run. taking by financial institutions to avoid the A second example stresses the externali- potential externalities associated with finan-ties associated with risk taking, especially cial fragility. Also, authorities can regulatefor large financial institutions. For the sake information disclosure to facilitate soundof this illustration, imagine a busy road with decisions, and even regulate financial prod-cars and trucks. If a car or truck goes faster, it ucts, similar to how governments regulatecan get to its destination sooner, but there is a the sale of food and drugs. Thus, economicschance that it will be involved in a crash. The provides many reasons for an active role oflikelihood of a crash is small but it increases the state in finance.with speed. Crashes involving large vehicles But just because the state can ameliorateare particularly costly to others involved in market imperfections and improve the oper-the crash and very disruptive to traffic in gen- ation of financial systems does not mean thateral. Nobody wants to be involved in a crash, it will. Designing and enforcing appropriateof course. But when deciding on how fast to policy can be tricky. Returning to the previ-go, a car or truck driver may not fully con- ous analogy with speed limits for cars andsider the costs that a crash might have on oth- trucks, having a single speed limit may noters in terms of injuries, damages, time lost in seem very effective, because some vehiclestraffic jams, and so on. The state can play a have better safety features, such as brakingrole, for example by imposing and enforcing systems, and therefore are less likely to endspeed limits, and perhaps imposing stricter up in a crash. If vehicles with better brakesregulation of vehicles that pose bigger risks, were allowed to go faster, they could spendsuch as large trucks. less time on the road, and traffic could ease Similarly, financial institutions often do up. But brake quality is difficult to monitornot bear the full risks of their portfolios. in real time. So, differentiated speed lim-When a large bank makes risky investments its can be difficult to design and enforce,
4 v e r v i e w O GLOBAL financial DEVELOPMENT REPORT 2013 resulting in more speeding and crashes. The objectives, including less altruistic ones, such state could also intervene directly by pro- as helping friends, family, cronies, and politi- viding government-approved drivers for all cal constituents. When this happens, the gov- cars and trucks. That way, the state can have ernment can do serious harm in the financial more control over safety and soundness, but system. These arguments suggest a sober it can become quite expensive for taxpay- wariness concerning the role of the state in ers. Alternatively, the state could build large finance that will vary according to confidence speed bumps on the road, so that there are in the political system’s ability to promote the almost no crashes; however, traffic would public good. slow down to a crawl. Determining the proper role of the state in The analogy underscores that correct- finance is thus as complex as it is important: ing market imperfections is a complicated one size does not fit all when it comes to pol- task, requiring considerable information and icy intervention. In less developed economies, expertise to design, implement, and enforce there may seem to be more scope for the gov- sound policies. State interventions in finance ernment’s involvement in spearheading finan- need to be risk-sensitive, but measuring risk cial development. However, less development properly and enforcing risk-based regulations is often accompanied by a less effective insti- is far from straightforward. The state can try tutional framework, which in turn increases to run parts of the financial system directly, the risk of inappropriate interventions. And but evidence shows that approach to be very the role of the state naturally changes as the costly. And if the state required banks to hold financial system creates new products, some capital as large as their loans, the risk of fail- of which obviate the need for particular poli- ures would be minimal, but financial inter- cies while others motivate new government mediation would grind to a halt since banks interventions. Reflecting this complexity, would not be able to lend. country officials and other financial sector An important complicating factor is that experts often hold opposing views and opin- the same government policies that ameliorate ions on the pros and cons of various state one market imperfection can create other— interventions—a point illustrated by a recent sometimes even more problematic—distor- informal global opinion poll carried out by tions. For example, when the government the Global Financial Development Report insures the liabilities of banks to reduce the team (box O.2). possibility of bank runs, the insured credi- The Global Financial Development tors of the bank may not diligently monitor Report provides new insights on financial the bank and scrutinize its management. development and the role of the state in finan- This can facilitate excessive risk taking by cial systems, building on the experience from banks. The state can try to limit risk tak- the global financial crisis. Varying economic ing by large, interconnected financial insti- and political circumstances across countries tutions. However, such interventions might imply that financial sector policies require reduce the incentives of private shareholders customization: appropriate policies will dif- to exert strong corporate control over these fer across countries and over time. But there institutions, because they think the govern- are common lessons and guidelines. While ment is already doing it. Thus, state interven- recognizing the complexity of the issue and tions can create even more reliance on the the limits of existing knowledge, this report state. contributes new data and analysis to the pol- An even deeper issue is whether the state icy discussion. always has sufficient incentives to correct for market imperfections. Governments do not Benchmarking Financial always use their powers to address market Systems imperfections and promote the public inter- est. Sometimes, government officials use A growing body of evidence shows that the power of the state to achieve different financial institutions and financial markets
GLOBAL financial DEVELOPMENT REPORT 2013 O v e r v i e w 5 BOX O.2 Views from Some of the World Bank Clients As part of its effort to find out more about client firmed various areas of agreement. For example, country views, the Global Financial Development there is a widespread notion that state-owned Report team carried out an informal global poll— financial institutions and government-backed credit the 2011/12 Financial Development Barometer. This guarantees can in principle play a useful role. The poll, which covered country officials and financial poll also shows many respondents seeing potential sector experts from 78 countries (23 developed and benefits in more stringent supervision of new finan- 55 developing), provides interesting insights into cial instruments in light of the crisis. A majority views about financial development and the role of also see a scope for a more active role of the state the state in finance. in promoting technological innovations in financial Despite the crisis experience, 90 percent of the infrastructure. country officials and experts surveyed in the poll Perhaps more interestingly, the poll also indi- perceive that positive effects of finance (in particular cated many key policy areas where the views for and those on economic growth and poverty reduction) against are almost evenly split. This split includes, outweigh its potential negative effects. A majority for example, opinions on the need for stringency of the respondents therefore see that their country’s and greater scope of regulation and supervision, the financial sector needs to grow, especially in terms pros and cons of greater competition in countries’ of financial markets and nonbank financial institu- financial systems, the possible countercyclical role tions, to better serve its clients and expand to new of state-owned financial institutions, and the role of ones. the state in promoting information sharing—all top- As regards the role of the state in the financial ics that are examined in the current Global Finan- sector, the Financial Development Barometer con- cial Development Report. Selected Responses from the 2011/12 Financial Development Barometer Views were split on important aspects of the state’s role . . . Agree? (%) “In view of the global financial crisis, more stringent financial sector regulation and supervision is needed.” 49 “In view of the global financial crisis, there is a need for broadening the scope of financial sector regulation and supervision.” 54 “More financial sector competition would help financial stability in my home country.” 58 “State-owned financial institutions played an effective countercyclical role during the recent global financial crisis.” 48 “Government-backed credit guarantee schemes do play an important role in promoting financial stability.” 64 “The development of collateral registries can be left, fully or mostly, to the private sector.” 42 Note: The Financial Development Barometer is an informal global poll covering country officials and financial sector experts from 78 economies (23 developed and 55 developing). The response rate was 65 percent. Results are percentages of total responses received.exert a powerful influence on economic the banking industry as a proxy for financialdevelopment, poverty alleviation, and the development. However, size is not a measurestability of economies around the world. Yet of quality, efficiency, or stability. Moreover,measuring the functioning of the financial the banking sector is only one componentsystem has important shortcomings. Indeed, of financial systems. This report, along withempirical work has largely—though not the accompanying public database, assemblesexclusively—relied on measures of the size of and improves cross-country data that can be
6 v e r v i e w O GLOBAL financial DEVELOPMENT REPORT 2013 used to benchmark financial systems. Chap- less deep and also somewhat less efficient and ter 1 addresses questions such as: How can to provide less access, their stability has been one empirically describe different charac- comparable to developed-country financial teristics of financial systems? How can one systems. These measures are then used to compare financial systems across countries characterize and compare financial systems and regions and through time? How have across countries and over time, highlight- financial systems been affected by the global ing the multidimensional nature of financial financial crisis, and what are the key recent development. Country-by-country informa- trends? tion on the key financial system characteris- To measure and benchmark financial sys- tics is presented in the Statistical Appendix, tems, the report develops several measures with more data available through the report’s of four characteristics of financial institu- website. tions (banks, insurance companies, and so on) and financial markets (stock markets and Rethinking the Role of bond markets): (a) the size of financial insti- the State in the Financial tutions and markets (financial depth), (b) the Sector degree to which individuals can and do use financial institutions and markets (access), The report addresses the following key pol- (c) the efficiency of financial institutions icy questions: (a) What is the early postcrisis and markets in providing financial services thinking on transforming regulatory prac- (efficiency), and (d) the stability of financial tices around the world? (b) How should gov- institutions and markets (stability). These ernments promote competition in the finan- four characteristics are measured both for cial sector without planting the seeds of the financial institutions and financial markets, next crisis? (c) When do direct government leading to a 4x2 matrix of the characteristics interventions—such as state ownership and of financial systems. A basic comparison (fig- guarantees—help in developing the financial ure O.1) confirms that although developing- sector, and when do they fail? and (d) What economy financial systems tend to be much should states do to support robust financial Figure O.1 Benchmarking Financial Development, 2008–10 a. Financial institutions b. Financial markets Depth Depth 100 100 75 75 50 50 25 25 0 Stability 0 Access Stability Access Developed economies (%) Efficiency Developing economies (%) Efficiency ˇ Source: Calculations based on Cihák, Demirgüç-Kunt, Feyen, and Levine 2012. Note: Average values are shown for 2008–10 with simple (unweighted) averages across country groups. The 0 corresponds to a historical low of the proxy variable, and 100 corresponds to a historical high calculated for all countries over the period 1960–2010. For the explanation of individual proxy variables for financial depth, access, stability, and efficiency, see chapter 1.
GLOBAL financial DEVELOPMENT REPORT 2013 O v e r v i e w 7 BOX O.3 Navigating This Report In addition to this Overview, the report has two Chapter 4 examines direct state interventions, main parts. The first part (chapter 1) introduces particularly the experience with state-owned banks measures of different characteristics of financial sys- during the financial crisis. It reviews existing and tems that are useful in benchmarking financial sys- new research and reexamines the performance of tems around the world. The second part (chapters 2 state-owned banks during crises. A large part of through 5) examines various aspects of the state’s the discussion focuses on state-owned commer- role in finance. cial banks as opposed to state-owned development Chapter 1 describes financial depth, access, effi- banks; nonetheless, the chapter also presents a new ciency, and stability across countries and regions, data set based on a recent survey of development especially in developing economies. Chapter 1 intro- banks. It also examines the role of credit guarantees. duces a major new database, the Global Financial Chapter 5 relates to the role of the state in finan- Development Database, and discusses how subse- cial infrastructure, with a focus on two topics high- quent editions of the report will revisit the analysis lighted by the crisis: (a) information sharing in credit and benchmarking of financial systems with updated markets, and (b) the role of the state in reducing and expanded data. counterparty risk in payments and securities settle- Chapter 2 examines the role of the state as reg- ment systems. ulator and supervisor. It presents results from a The accompanying website (http://www.world recently updated and substantially expanded World bank.org/financialdevelopment) contains a wealth Bank survey of regulation and supervision around of underlying research, additional evidence includ- the world, explores how crisis countries were differ- ing country examples, and an extensive database on ent from noncrisis countries, and tracks changes that financial development, providing users with interac- governments made after the crisis. The chapter also tive access to information on financial systems. The reviews international regulatory and supervisory website is also a place where users participate in an reforms and discusses proposals for further reforms. online version of the Financial Development Barom- Chapter 3 focuses on the role of the state in com- eter, provide feedback on this Global Financial petition policy. After discussing various measures of Development Report, and submit their suggestions competition, and presenting trends across countries for future issues of the report. and over time based on a new worldwide data set, it The report concentrates on banks. There are reviews the evidence on the implications of banking some references to and data on financial markets competition for bank efficiency, access to finance, and nonbank financial institutions (for example, in a and financial stability. The chapter then analyzes the discussion on the regulatory perimeter and on access policy drivers of competition and highlights the role by nonbank institutions to financial infrastructure). of the state in (a) promoting a contestable banking But to keep the report focused, much of the discus- system and (b) enabling a market-friendly informa- sion is devoted to banks. Future issues of the report tional and institutional environment. It also ana- will cover financial markets and nonbank financial lyzes the impact of government actions during crises institutions in more depth. on bank competition.infrastructure? Box O.3 provides an over- factors, including a country’s level of devel-view of the report’s chapters. opment and the government’s capacity. Two How should public policy be designed themes emerge throughout this report.to address these four key questions? The The first relates to direct and indirectissue of concern in this report is how best interventions. During the recent crisis, directto balance the various roles of the state as state interventions have increased, and earlypromoter, owner, regulator, and overseer. evidence reveals that some of these inter-The right balance depends on a number of ventions worked, at least in the short run.
8 v e r v i e w O GLOBAL financial DEVELOPMENT REPORT 2013 However, there is also evidence on potential Overall, there is broad agreement to longer-term negative effects. Therefore, as the address the “basics” first. This means hav- crisis subsides, there may be a need to rebal- ing in place a coherent institutional and legal ance toward less direct state involvement. framework that establishes market discipline The second important theme is the criti- complemented by strong, timely, and antici- cal role that incentives play in the financial patory supervisory action. In many develop- sector. The challenge for the state’s involve- ing economies, this also means that building ment is to better align private incentives with up supervisory capacity needs to be a top public interest, without taxing or subsidizing priority. Among the important lessons of private risk taking. The design of public pol- the global financial crisis are renewed focus icy needs to strike the right balance in order on systemic risk and the need to pay greater to promote sustainable development. This attention to incentives in the design of regula- leads to different challenges and trade-offs in tion and supervision. answering each of the four questions below. Using a new survey of regulation and supervision around the world (figure O.2), chapter 2 confirms that countries where What are the best ways to reform the global financial crisis originated had regulation and supervision? weaker regulation and supervisory practices The global financial crisis that intensified (for example, less stringent definitions of with the collapse of Lehman Brothers in Sep- capital, less stringent provisioning require- tember 2008 presented a major test of the ments, and greater reliance on banks’ own international architecture developed over risk assessment), as well as less scope for many years to safeguard the stability of the market incentives (for example, lower qual- global financial system. Although the causes ity of financial information made publicly of the crisis are still being debated, there is available, more generous deposit insurance agreement that the crisis revealed major coverage). Tracking changes during the cri- shortcomings in market discipline, regula- sis reveals that countries have stepped up tion, and supervision. The financial crisis efforts in the area of macroprudential pol- therefore has reopened important policy icy, as well as on issues such as resolution debates on financial regulation. After the regimes and consumer protection. However, onset of the meltdown, there was much talk it is not clear whether incentives for market about not wasting the crisis, and using it to discipline have improved. Some elements of push through necessary reforms. Indeed, disclosure and quality of information have many reforms have been enacted or are in improved, but deposit insurance coverage has process. Much has been done, but the system increased during the crisis. This increased was tested further by the more recent euro coverage, together with generous support for area crisis, leading to the questions: Are the weak banks, did not improve incentives for reforms adequate and will they be sufficient monitoring. The survey suggests that there is to reduce the likelihood and severity of future further scope for improving disclosures and financial crises? monitoring incentives. Regulation and supervision represent one Despite the progress made on regulatory area in which the role of the state is not in reform, there are still important areas of dis- dispute. The crucial role of the state is widely agreement. Hence, chapter 2 also presents acknowledged and is well established in the a number of reform proposals that call for economic and financial literature. Hence, the greater emphasis on simplicity and transpar- debate is not about whether the state should ency, as well as a focus on incentive-compat- regulate and supervise the financial sector, ible regulations. Importantly, these proposals but about how best to go about ensuring that warn against growing complexity of regula- regulation and supervision support sound tion, which may reduce transparency and financial development. accountability, increase regulatory arbitrage
GLOBAL financial DEVELOPMENT REPORT 2013 O v e r v i e w 9Figure O.2 Selected Features That Distinguish Crisis-Hit Countries Broader capital definition (Is Tier 3 allowed in regulatory capital?) More sophisticated modeling (Is an advanced internal ratings-based approach offered to banks?) Less strict provisioning I (Are minimum levels of specific provisions for loans and advances set by the regulator?) Less strict provisioning II (Is there a regulatory requirement for general provisions on loans and advances?) Less oversight of external auditors (Are external auditors subject to independent oversight by the supervisor?) Lower standards for public data quality (Do laws or regulations require auditors to conduct their audits in accordance with international standards?) 0 20 40 60 80 100 Crisis Non-Crisis ˇSource: Cihák, Demirgüç-Kunt, Martínez Pería, and Mohseni 2012.Note: Percentage of countries that responded “yes” to the question in parentheses. Based on the World Bank’s 2011 Bank Regulation and SupervisionSurvey. “Crisis” countries are defined as those that had a banking crisis between 2007 and 2011, as identified in Laeven and Valencia (2012).opportunities, and significantly strain regu- other risk-mitigating features. However, iflatory resources and capacity. The propos- the state does not have the capacity to moni-als suggest a regulatory approach that is tor and police such complex rules, the likelymore focused on proactively identifying and result is more speeding and more crashes.addressing incentive problems and making Similarly, complex approaches to calculat-regulations incentive-compatible. This can ing capital requirements are not appropriatehelp to end the continuous need to elimi- if there is limited capacity to verify the cal-nate deficiencies and close loopholes that are culations, do robustness checks, and policeinevitably present in ever more complex sets implementation.of regulations. Other proposals address the One of the positive developments triggeredincentives that the regulators face and either by the crisis is much greater debate and com-propose alternative institutional structures or munication among regulators, policy mak-suggest tools to identify incentive issues on an ers, and academics, who are striving to reachongoing basis. the common goal of designing regulations to In implementing supervisory best prac- minimize the occurrence and cost of futuretices, emerging markets and developing econ- crises. The diverse views and multiple reformomies should focus on establishing a basic proposals in this debate (presented in chapterrobust supervisory framework that reflects 2) are likely to inform the regulatory reformlocal financial systems’ characteristics, and process and improve future outcomes.refraining from incorporating unnecessary(and in several cases inapplicable) complex How should the state promoteelements. Referring back to the earlier anal- competition in the financial sector?ogy with speed limits for cars and trucks,it may be appealing to have a complex rule The global financial crisis also reignited thein which each car has its own speed limit, interest of policy makers and academics independing on the quality of its brakes and the impact of bank competition and the role
10 v e r v i e w O GLOBAL financial DEVELOPMENT REPORT 2013 of the state in shaping competition policies. bank regulatory agencies: survey data reveal Some believe that increasing financial inno- that the majority now have explicit responsi- vation and competition in certain markets, bilities in the areas of competition policy. such as subprime mortgage lending, con- The Global Financial Development tributed to the global financial turmoil, and Report’s analysis (chapter 3) provides guid- they are calling for policies to restrict com- ance on this important issue. Research sug- petition. Others worry that, as a result of gests that bank competition brings about the crisis and the actions of governments in improvements in efficiency across banks and support of the largest banks, concentration in enhances access to financial services, without banking increased, reducing the competitive- necessarily undermining systemic stability. ness of the sector and access to finance, and A cursory look at trends in average systemic potentially also contributing to future insta- risk and bank market power (figure O.3) bility as a result of moral hazard problems indicates that greater market power (that is, associated with “too big to fail” institutions. less competition) is associated with more sys- Hence, the design of competition policy is temic risk (chapter 3 examines this in more challenging because it again involves a pos- detail). Hence, the evidence of a real trade-off sible trade-off between efficiency and growth is weak at best. on one hand and stability concerns on the This analysis suggests that policies to other hand. Another reason why rethinking address the causes of the recent crisis should competition policies is important relates to not unduly restrict competition. The appro- the changing mandate of central banks and priate public policy is (a) to establish a regu- latory framework that does not subsidize risk taking through poorly designed exit poli- cies and too-big-to-fail subsidies and (b) toFigure O.3 Market Power and Systemic Risk remove barriers to entry of “fit and proper” bankers with well-capitalized financial R-squared, log (systemic risk) Lerner index (market power) institutions. –0.5 For competition to improve access to 0.24 finance, the state has an important role to –0.6 play in enabling a market-friendly informa- –0.7 0.22 tional and institutional environment. Policies –0.8 0.20 that guarantee market contestability, timely –0.9 flow of adequate credit information, and –1.0 0.18 contract enforceability will enhance compe- tition among banks and improve access. For –1.1 0.16 instance, evidence across business line data in –1.2 0.14 Brazil shows that competition in the corpo- –1.3 rate segment is higher than in the retail seg- –1.4 0.12 ment. This reflects the existence of a larger pool of credit providers and easier access to –1.5 0.10 2002 2003 2004 2005 2006 2007 2008 information for large corporations. Com- Systemic risk (R-squared, log, left axis) petition in the retail sector can be fostered Market power (Lerner index, right axis) by promoting portability of bank accounts, expanding credit information sharing, andSource: Calculations based on Anginer, Demirgüç-Kunt, and Zhu 2012. increasing payment system interconnection.Note: The systemic risk measure follows Anginer and Demirgüç-Kunt (2001) and builds on In this context, consumer protection lawsMerton’s (1974) contingent claim pricing. Systemic risk is defined as the correlation in the risk-taking behavior of banks and is captured by the R-squared from a regression of a bank’s weekly have been at the forefront of competitionchange in distance to default on country average weekly change in distance to default (excluding policies in many countries. One examplethe bank itself). Higher R-squared means higher systemic risk. Lerner index is a proxy for profitsthat accrue to a bank as a result of its pricing power, so higher values mean less competition. is South Africa, where new legislation pro-The calculations cover 1,872 publicly traded banks in 63 economies (developed and developing). vided a framework to bolster competition by
GLOBAL financial DEVELOPMENT REPORT 2013 O v e r v i e w 11providing a sound information environment often than not serving political intereststo customers and protecting consumers from instead. Nevertheless, the global financialunfair credit and credit marketing practices. crisis underscored the potential countercycli-It established a National Credit Regulator to cal role of state-owned banks in offsettingact as a knowledge platform for credit prac- the contraction of credit from private banks,tices and to ensure compliance with the law. leading to arguments that this is an impor- Competition agencies also play a crucial tant function that can perhaps better justifyadvocacy role in promoting competition. their existence.One example in this regard is Romania’s The crisis and the actions adopted byCompetition Council, which has extended different countries reignited the debate onthe European Union Consumer Credit Direc- the need for direct government interventiontive of 2008. The directive establishes com- in the financial sector. Supporters of state-mon rules on consumer credit over mort- owned banks argue that they provide thegage or real estate guaranteed loans and state an additional tool for crisis manage-eliminates (or sets a low threshold for) early ment and, relative to central banks, may berepayment fees. more capable of providing a safe haven for Finally, state interventions during crises retail and interbank deposits, creating a firemay constitute a barrier to exit that permits break in contagion, and stabilizing aggregateinsolvent and inefficient banks to survive credit. On the other hand, those opposingand generate unhealthy competition. Gov- government bank ownership point out thaternments should be aware that their inter- agency problems and politically motivatedventions during crises may have potentially lending render state-owned banks inefficientnegative long-term consequences on bank and prone to cronyism. Furthermore, pastcompetition and may distort risk-taking experiences of numerous countries suggestincentives. that cronyism in lending may build up large fiscal liabilities and threaten public sector sol- vency and financial stability, as well as mis-When do direct government allocate resources and retard development ininterventions help? the long run.During the global financial crisis, countries During the recent crisis, several coun-pursued a variety of strategies to restart tries used their public bank infrastructuretheir financial and real sectors. As the bal- to prop up the financial sector. For instance,ance sheets of private banks deteriorated and the Brazilian government injected capitalthey curtailed their lending activities, many into its state-owned development bank andcountries used state-owned banks to step up authorized state-owned banks to acquiretheir financing to the private sector. Most equity stakes from private banks and loancountries relied heavily on the use of credit portfolios from financial institutions withguarantee programs. Others adopted a num- liquidity problems. In China, state-ownedber of unconventional monetary and fiscal banks were instructed to boost credit tomeasures to prop up credit markets. specific sectors in order to promote growth. Historically, many state-owned banks In the Russian Federation, Vnesheconom-were created to fulfill long-term develop- bank, the country’s state-owned develop-ment roles by filling market gaps in long- ment bank, received new capital to assistterm credit, infrastructure, and agriculture troubled smaller financial institutions andfinance, and to promote access to finance to invest in Russian financial instruments.to underserved segments of the economy— It also injected money into large state-notably, small and medium enterprises. In controlled banks to increase their loans topractice, however, there is widespread evi- Russian companies. In Mexico, state-owneddence that state banks have generally been development banks extended credit to largevery inefficient in allocating credit, more companies, participated in loan programs
12 v e r v i e w O GLOBAL financial DEVELOPMENT REPORT 2013 for fragile sectors, and extended guarantees Figure O.4 Change in Bank Lending Associated on commercial paper and credit instruments with a 1% Increase in GDP Per Capita Growth issued by specialized nonbank financial insti- tutions. Similar actions were also taken by Percent some developed economies. For example, 2.5 Procyclical lending Germany’s state-owned development bank, 0.021*** 0.020*** Kreditanstalt für Wiederaufbau, increased 2.0 lending to larger companies with short- term liquidity problems, provided additional 1.5 0.013** financing for infrastructure, and helped 0.010*** 1.0 recapitalize regional state banks. And in Finland, the government raised the limits on 0.006*** 0.5 domestic and export financing for the coun- try’s state-owned bank to boost lending to 0.0 small and medium enterprises. Countercyclical lending –0.004*** Chapter 4 highlights that not all state- –1.5 owned banks are alike. They can be classified Full Developing Developed sample economies economies as state commercial banks, state development banks, and development financial institu- Private State tions, depending on whether they aim to maximize profits, are deposit takers, or have Source: Bertay, Demirgüç-Kunt, and Huizinga 2012. Note: The figure shows marginal effects from a regression of bank lend- a clear developmental mandate. State-owned ing on GDP per capita growth and a number of control variables, esti- development banks and financial institutions, mated using a sample of 1,633 banks from 111 countries for the period 1999–2010. in turn, can lend to the public either directly Significance level: ** 5 percent, *** 1 percent. or indirectly through private banks. Most of the evidence discussed on the short-term and long-term effects of state-owned banks The mitigating short-term effect of state- focuses on commercial banks or does not dis- owned banks is illustrated in figure O.4. The tinguish between commercial and develop- figure shows the relationship between lending ment banks. patterns of banks with private and state own- Chapter 4 reviews the historical and new ership and economic growth, measured by research evidence and concludes that lending real GDP per capita growth. Globally, bank by state-owned banks tends to be less procy- lending is procyclical, growing during booms clical than that of their private counterparts. and falling during downturns. Yet the lend- During the global financial crisis, some state- ing pattern of private banks is more procycli- owned banks have indeed played a counter cal compared with their state-owned counter- cyclical role by expanding their lending port- parts. In high-income countries, state-owned folio and restoring favorable conditions in banks even behave in a clearly countercycli- key markets. For instance, the chapter high- cal fashion, increasing in downturns. lights the expansion of the lending portfolio However, because in many cases lend- of state-owned commercial banks (for exam- ing growth continued even after economic ple, PKO Bank Polski in Poland) and state- recovery was under way, and loans were not owned development banks (for example, directed to the most constrained borrowers, BNDES in Brazil) in mitigating the effects the countercyclical benefits of state-owned from the global credit crunch and filling the banks came at the cost of resource misal- gap of lower credit from the private sector. location and worsened intermediation. This Also, Mexican development banks supported mixed view is supported by evidence from the credit channel through the extension previous crises as well. In other words, a tem- of credit guarantees and lending to private porary boom in state bank lending has long- financial intermediaries. term adverse effects by creating a portfolio of
GLOBAL financial DEVELOPMENT REPORT 2013 O v e r v i e w 13bad loans in crises that take a long time to stable systems for large-value financial trans-sort out. actions. Reflecting the focus on the aftermath Ideally, focusing on the governance of of the financial crisis, the report does notthese institutions may help policy makers examine other components of financial infra-address the inefficiencies associated with structure, such as retail payment systems andstate-owned banks. State banks need a clear collateral regimes; it leaves these importantmandate to complement (rather than sub- issues to be covered in future editions.stitute for) private banks, and adopt risk Chapter 5 emphasizes that the transpar-management practices that allow them to ent exchange of credit information reducesguarantee a financially sustainable business. information asymmetries between borrowersHowever, these governance reforms are par- and lenders and is an essential requisite of aticularly challenging in weak institutional well-functioning credit market. However, theenvironments, further emphasizing that the financial crisis has shown that there is muchtrade-off is a serious one for policy makers. room for improvement in this area, especially Credit guarantee schemes have also been in the use of existing credit reporting systemsa popular intervention tool during the recent for prudential oversight and regulation.crisis. However, given their limited scale, they Information sharing in credit markets actsare used not to stabilize aggregate credit but as a public good that improves credit marketto alleviate the impact of the credit crunch on efficiency, access to finance, and financialsegments that are most severely affected, such stability. Nonetheless, for an individual com-as small and medium enterprises. Unfortu- mercial bank, proprietary credit informationnately, rigorous evaluations of these schemes is valuable, so it has incentives to collect theare very few, and existing studies suggest information and keep it away from others.that the benefits of these programs tend to be Information sharing among private lend-rather modest, particularly in institutionally ers thus may not arise naturally, especiallyunderdeveloped settings, and they tend to where banking systems are concentrated (fig-incur fiscal and economic costs. Nevertheless, ure O.5). This creates an important rationalebest practices can be identified. These include for state involvement. In addition, the reportleaving credit assessments and decision mak- highlights that information sharing in crediting to the private sector; capping coverage markets has increasing returns to scale: theratios and delaying the payout of the guar- benefits of credit reporting for financial accessantee until recovery actions are taken by the and stability are greatest when participationlender, so as to minimize moral hazard prob- is as wide as possible and includes banks aslems; having pricing guarantees that take into well as nonbank financial institutions. There-account the need for financial sustainability fore, another important role for the state is toand risk minimization; and encouraging the create a level playing field for the provisionuse of risk management tools. Success again and exchange of credit information, and tohinges on overcoming the challenges of get- facilitate the inclusion of nonregulated lend-ting the design right, particularly in underde- ers into existing credit reporting systems. Inveloped institutional and legal settings. many emerging markets, such as China and South Africa, major initiatives are under way to integrate the rapidly growing microfinanceWhat is the role for the state in and consumer loan markets into the existingpromoting financial infrastructure? credit reporting infrastructure.The global financial crisis has highlighted the Liquidity provision by central banks dur-importance of a resilient financial infrastruc- ing the crisis helped prevent major paymentture for financial stability. It also has led to system disruptions. However, stress emergeda discussion about the role of the state, par- in interbank and over-the-counter derivativesticularly in promoting the provision of high- markets. The state can play an important rolequality credit information and in ensuring in mitigating counterparty risks in interbank
14 v e r v i e w O GLOBAL financial DEVELOPMENT REPORT 2013 Figure O.5 Credit Reporting vs. Banking System money markets by providing robust and Concentration secure infrastructure and, potentially, by promoting the development of collateralized Probability of existence of a credit reporting system interbank markets. The state can also con- 1.0 tribute in the development of a robust infra- 0.92 0.9 structure for security settlement systems and 0.80 the oversight of securities transactions, par- 0.8 ticularly for over-the-counter transactions. 0.7 Increased standardization and transparency 0.6 0.56 0.53 of transactions is needed and can be achieved 0.5 by (a) trading on exchanges or electronic 0.4 0.37 0.39 trading platforms; (b) clearing transactions through central counterparties, that is, enti- 0.3 ties that interpose themselves as counterpart 0.2 to each trade (examples include the Chicago 0.1 Mercantile Exchange’s CME Clearing in the 0.0 United States, Eurex Clearing in Germany, Credit Credit Any credit and London Clearing House’s LCH.Clear- registry bureau reporting net in the United Kingdom); and (c) report- Low bank concentration High bank concentration ing transactions to trade repositories, which are entities that store centralized records of Source: Bruhn, Farazi, and Kanz 2012. transaction data. These policy prescriptions Note: The figure reports the percentage of countries with private (credit bureau), public (credit registry), or any credit reporting institutions for are especially important in many emerging countries with high and low degrees of bank concentration (above and markets, where the development of a modern below the sample mean), respectively. It shows that bank concentration (the asset share of a country’s three largest banks) is negatively asso settlement infrastructure has lagged behind ciated with the development of credit reporting. This relationship is also the rapid growth of emerging equity and conditional on the level of economic development. securities markets.
1 Benchmarking Financial Systems around the World • inancial systems are multidimensional. Four characteristics are of particular interest F for benchmarking financial systems: financial depth, access, efficiency, and stability. These characteristics need to be measured for financial institutions and markets. • inancial systems come in all shapes and sizes, and differ widely in terms of the four F characteristics. As economies develop, services provided by financial markets tend to become more important than those provided by banks. • he global financial crisis was not only about financial instability. In some economies, T the crisis was associated with important changes in financial depth and access.A growing body of evidence suggests that financial institutions—such asbanks and insurance companies—and finan- managerial performance, this boosts the effi- ciency of corporations and reduces waste and fraud by corporate insiders. But that is not all.cial markets—stock markets, bond markets, When equity, bond, and derivative marketsderivative markets, and so on—exert a pow- enable the diversification of risk, this encour-erful influence on economic development, ages investment in higher-return projectspoverty alleviation, and economic stability that might otherwise be shunned. And, when(Levine 2005). For example, when banks financial systems lower transaction costs,screen borrowers and identify firms with the this facilitates trade and specialization—fun-most promising prospects, this is a key step damental inputs to technological innovationthat helps allocate resources, expand economic (Smith 1776).opportunities, and foster growth. When banks When financial systems perform theseand securities markets mobilize savings from functions poorly, they hinder economichouseholds to invest in promising projects, growth, curtail economic opportunities, andthis is another crucial step in fostering eco- destabilize economies. For example, if finan-nomic development. When financial institu- cial systems collect funds and pass them alongtions monitor their investments and scrutinize to cronies, the wealthy, and the politically g l o b a l f i n a n c i a l d e v e l o p m e n t r e p o r t 2 0 1 3 15
16 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 connected, it slows economic growth and across countries and regions and through blocks potential entrepreneurs. And if finan- time; and how financial systems have been cial institutions fail to exert sound corporate affected by the global financial crisis. governance over firms that they fund, that To benchmark financial systems, the failure makes it easier for managers to pursue report measures the following four charac- projects that benefit themselves rather than teristics of financial institutions and mar- the firms and the economy. When financial kets: (a) the size of financial institutions and institutions create complex financial instru- markets (financial depth), (b) the degree to ments and sell them to unsophisticated inves- which individuals can and do use financial tors, it might generate more income for finan- institutions and markets (access), (c) the effi- cial engineers and executives associated with ciency of financial institutions and markets marketing the new instruments, distorting in providing financial services (efficiency), the allocation of society’s savings and imped- and (d) the stability of financial institutions ing economic prosperity. and markets (stability). These characteristics Evidence on the financial system’s role in are measured separately for financial institu- shaping economic development is substantial tions and financial markets (both equity and and varied. But there are shortcomings asso- bond markets), leading to a 4x2 matrix of ciated with assessing financial systems. There financial system characteristics. The report are no good cross-country, cross-time mea- uses these measures to characterize and sures of how they (a) enhance information compare financial systems across economies about firms and hence the efficiency of resource and over time and to assess the relationships allocation; (b) exert sound corporate gover- between these measures and financial sector nance over firms to which they channel those policies. resources; (c) manage, pool, and diversify risk; In focusing on these four characteristics of (d) mobilize savings from savers so that these financial institutions and markets, the report resources can be allocated to the most prom- gives empirical shape and substance to the ising projects in the economy; and (e) facili- complex, multifaceted, and sometimes amor- tate trade. Instead, researchers have largely phous concept of the functioning of financial focused on the size of the banking industry as systems. Financial depth, access, efficiency, a proxy for financial development. But size is and stability might not capture all features of not a measure of quality, efficiency, or stabil- financial systems, and the report does not try ity. And the banking sector is only one part of to construct a composite index of financial financial systems. development. Instead, it uses these four char- Accordingly, a key contribution of this acteristics to describe, compare, and analyze chapter involves data. In recent years, substan- financial systems and their evolution in recent tial efforts have been made to improve these decades. data, which this chapter uses. This report is This chapter, together with the underly- accompanied by the new Global Financial ing data and analysis, highlights the multi Development Database, an extensive world- dimensional nature of financial systems. wide database that combines and updates Deep financial systems do not necessarily several financial data sets (Čihák, Demirgüç- provide broad financial access, highly effi- Kunt, Feyen, and Levine 2012). The data- cient financial systems are not necessarily base is available on the Global Financial more stable than the less efficient ones, and Development Report Web page (http://www so on. Each of these characteristics is asso- .worldbank.org/financialdevelopment). ciated with socioeconomic development, But this chapter goes beyond compiling financial sector policies, and other parts of data. It answers some substantive questions the enabling environment for finance. Finan- using the data, such as how to empirically cial systems differ widely in terms of the 4x2 describe different characteristics of financial characteristics, so it is crucial to measure and systems; how to compare financial systems evaluate each one.
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 17 The chapter also suggests that the global the background, contributing to economicfinancial crisis resulted in more than financial growth and poverty reduction. But wheninstability: in some countries, it also caused things go wrong, the malfunctioning of theproblems along the other dimensions, such as financial system can slow growth, throwmaking people’s and firms’ access to financial more people into poverty, and destabilizeservices more difficult. Finance is about more entire economies. Indeed, financial crisesthan just stability. Having financial systems hurt not only those who work in finance orchannel society’s savings to those with the those who access financial systems. Whenmost promising investment opportunities is the government undertakes costly bailoutsessential for fostering economic growth, alle- of bankrupt financial institutions, this canviating poverty, and enabling people to pur- lead to increases in public indebtedness, thussue their economic goals. undermining governments’ ability to support Finally, this chapter is linked to future key social objectives, including the fund-editions of the Global Financial Develop- ing of education, health, and infrastructurement Report. The report is envisaged as programs. As a result, malfunctioning finan-part of a series, with future reports return- cial systems can also lay the foundations foring to the analysis of financial systems using enduring economic crises, as illustrated quiteupdated and extended data. They will use the dramatically by recent events.measurement framework introduced here to With so much attention focused on sta-examine new topics, such as financial inclu- bility issues following the recent crisis, thesion, capital market development, and oth- powerful linkages between the functioningers. Future editions might expand or improve of the financial system and economic devel-on the framework, which is designed to be opment have been somewhat underempha-flexible to accommodate such adjustments if sized. Although the focus on stability hasneeded—for example, if new types of finan- been understandable, sound financial sectorcial data become available. policies are not only about avoiding crises. Finance is also about the efficient allocation of capital, economic growth, and expandingThe Importance of economic horizons. Therefore, an impor-Financial Systems tant goal is to raise awareness of policies toto Development enhance the operation of financial systems,Finance is central to development. This develop a better understanding, and fostermay seem obvious to financial development debate. To help in framing the debate, thisexperts. It may also seem obvious to bank section clarifies the definition of financialdepositors who just had their entire life sav- development and provides a review of theings wiped out by a financial crisis. But finan- literature on the linkages between financialcial crises get forgotten after a period of time. sector development, economic growth, andAnd when compared with other factors that poverty reduction.are also important—health, the environ-ment, and so on—the case for finance may What is financial development?appear less obvious. Indeed, when panels ofthe world’s leading economists tried to iden- Financial markets are imperfect. Acquiringtify “the 10 great global challenges” in both and processing information about poten-2004 and 2008 as part of the Copenhagen tial investments is costly. There are costsConsensus Project, the list did not include and uncertainties associated with writing,any financial issues.1 interpreting, and enforcing contracts. And This section argues that finance indeed there are costs associated with transactingmatters. It matters both when it functions goods, services, and financial instruments.well and when it malfunctions. When oper- These market imperfections inhibit the flowating effectively, finance works quietly in of society’s savings to those with the best
18 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 ideas and projects, thus curtailing economic At a broader level, financial development development. can be defined as improvements in the quality It is the existence of these costs—these of five key financial functions: (a) producing market imperfections—that creates incen- and processing information about possible tives for the emergence of financial contracts, investments and allocating capital based on markets, and intermediaries. Motivated by these assessments; (b) monitoring individuals profits, people create financial products and and firms and exerting corporate governance institutions to ameliorate the effects of these after allocating capital; (c) facilitating the market imperfections. And governments trading, diversification, and management of often provide an array of services—rang- risk; (d) mobilizing and pooling savings; and ing from legal and accounting systems to (e) easing the exchange of goods, services, government-owned banks—with the stated and financial instruments. Financial insti- goals of reducing these imperfections and tutions and markets around the world dif- enhancing resource allocation. Some econo- fer markedly in how well they provide these mies are comparatively successful at develop- key services. Although this report sometimes ing financial systems that reduce these costs. focuses on the role of the financial systems in Other economies are considerably less suc- reducing information, contracting, and trans- cessful, with potentially large effects on eco- action costs, it primarily adopts a broader nomic development. view of finance and stresses the key functions At the most basic level, therefore, finan- provided by the financial system to the over- cial development occurs when financial all economy. instruments, markets, and intermediaries mitigate—though do not necessarily elimi- Financial development and nate—the effects of imperfect information, economic growth limited enforcement, and transaction costs. For example, the creation of credit registries Economists have long debated the finan- tends to improve acquisition and dissemina- cial sector’s role in economic growth. Lucas tion of information about potential borrow- (1988), for example, dismissed finance as ers, improving the allocation of resources an overstressed determinant of economic with positive effects on economic develop- growth, and Robinson (1952, 86) quipped ment. As another example, countries with that “where enterprise leads finance follows.” effective legal and regulatory systems have From this perspective, finance responds to facilitated the development of equity and demands from the nonfinancial sector: it bond markets that allow investors to hold does not cause economic growth. At the more diversified portfolios than they could other extreme, Miller (1998, 14) argued that without efficient securities markets. This the idea that financial markets contribute to greater risk diversification can facilitate economic growth “is a proposition too obvi- the flow of capital to higher return proj- ous for serious discussion.” Bagehot (1873) ects, boosting growth and enhancing living and others rejected the idea that the finance- standards. growth nexus can be ignored without limit- Defining financial development in terms ing understanding of economic growth. of the degree to which the financial system Recent literature reviews (such as Levine eases market imperfections, however, is too 2005) conclude that evidence suggests a posi- narrow and does not provide much infor- tive, first-order relationship between finan- mation on the actual functions provided by cial development and economic growth. In the financial system to the overall economy. other words, well-functioning financial sys- Thus, Levine (2005) and others have devel- tems play an independent role in promoting oped broader definitions that focus on what long-run economic growth: countries with the financial system actually does.2 better-developed financial systems tend to
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 19grow faster over long periods of time, and business and who cannot, who can pay fora large body of evidence suggests that this education and who cannot, who can attempteffect is causal (Demirgüç-Kunt and Levine to realize his or her economic aspirations and2008).3 who cannot. Furthermore, by affecting the Moreover, research sheds light on the allocation of capital, finance can alter bothmechanisms through which finance affects the rate of economic growth and the demandgrowth. The financial system influences for labor, with potentially profound implica-growth primarily by affecting the alloca- tions for poverty and income distribution.tion of society’s savings, not by affecting the Potentially, finance can have rather com-aggregate savings rate. Thus, when financial plex effects on the income distribution. Itsystems do a good job of identifying and could boost returns to high-skilled work-funding those firms with the best prospects, ers or to low-skilled workers. The mecha-not those firms simply with the strongest nisms are complex and could be good or badpolitical connections, this improves the capi- for the poor and reduce or increase incometal allocation and fosters economic growth. inequality.Such financial systems promote the entry of There is an emerging body of empiricalnew, promising firms and force the exit of research, however, suggesting that in prac-less efficient enterprises. Such financial sys- tice, improvements in financial contracts,tems also expand economic opportunities, markets, and intermediaries actually doso that the allocation of credit—and hence tend to expand economic opportunities andopportunity—is less closely tied to accumu- reduce persistent income inequality. Figurelated wealth and more closely connected to 1.1 provides a basic empirical illustrationthe social value of the project. Furthermore, of the link between financial developmentby improving the governance of firms, well- (approximated here in a simplified way by thefunctioning financial markets and institu- ratio of private sector credit to gross domes-tions reduce waste and fraud, boosting the tic product) and income inequality (approxi-efficient use of scarce resources. By facilitat- mated by changes in the Gini coefficient). Theing risk management, financial systems can graph illustrates that higher levels of financialease the financing of higher return endeavors development are associated with declines inwith positive reverberations on living stan- inequality.dards. And, by pooling society’s savings, More in-depth empirical research is con-financial systems make it possible to exploit sistent with this basic observation. For exam-economies of scale—getting the biggest ple, evidence suggests that access to creditdevelopment boost from available resources. markets increases parental investment in the education of their children and reduces the substitution of children out of schoolingFinancial development and and into labor markets when adverse shockspoverty reduction reduce family income (Belley and LochnerBeyond long-run growth, finance can also 2007). Better-functioning financial systemsshape the gap between the rich and the poor stimulate new firm formation and help small,and the degree to which that gap persists promising firms expand as a wider array ofacross generations (Demirgüç-Kunt and firms gain access to the financial system.Levine 2009). Financial development may Moreover, better-functioning financial sys-affect to what extent a person’s economic tems will identify and fund better projects,opportunities are determined by individual with less emphasis on collateral and incum-skill and initiative, or whether parental bency. Not only do they allow new, efficientwealth, social status, and political connec- firms to enter, they also force old, inefficienttions largely shape economic horizons. The firms to leave, as evidenced by data (Kerr andfinancial system influences who can start a Nanda 2009).
20 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013Figure 1.1 Financial Depth and Income Inequality and accounting systems influence the costs associated with evaluating firms and writ- ing and enforcing contracts and, hence, in Change in Gini coefficient identifying and financing an economy’s most 0.03 UGA promising endeavors. Regulatory, supervi- sory, and tax systems all affect the incentives NGA facing the executives of financial institutions 0.02 and participants in securities markets. Thus, ZMB these components of the enabling environ- ROM ECU GTM CHL 0.01 GHA NER LSO HKG ment for finance also shape the allocation ARG USA and use of capital. And the state often plays SLE a more direct role in shaping the operation 0 IND of financial systems, running state-owned NPL JPN banks, subsidizing agriculture or housing, TZA ITA NOR –0.01 ETH TUR IRL SWE CHE or issuing government securities. Thus, the FIN NLD entire legal, accounting, regulatory, and SEN FRA AUT policy apparatus influences the operation of –0.02 MUS financial systems. Given the importance of finance for eco- –0.03 nomic development and poverty alleviation, –3 –2 –1 0 1 2 it is natural to ask: Why does this chapter Private credit to GDP focus on measuring the functioning of the financial system rather than on examiningSource: Update of Beck, Demirgüç-Kunt, and Levine 2007. the direct impact of financial sector policy,Note: The Gini coefficient is on a scale from 0 (total equality) to 1 (maximum inequality). The chart regulations, and the rest of the enablingis a partial scatter plot, visually representing the regression of changes in the Gini coefficientbetween 1960 and 2005 on the private sector credit–to-GDP ratio (logarithm, 1960–2005 aver- environment on economic growth, povertyage), controlling for the initial (1960) Gini coefficient. Variables on both axes are residuals. The alleviation, and the availability of economicabbreviations next to some of the observations are the three-letter country codes as defined bythe International Organization for Standardization. opportunities? The answer is that to provide guidance to Besides the direct benefits of enhanced policy makers, one needs a detailed under- access to financial services, finance also standing of the mechanisms through which reduces inequality, particularly through the enabling environment for finance influ- indirect labor market mechanisms. Spe- ence the functioning of financial systems. It is cifically, accumulating evidence shows that not enough to assess the associations between financial development accelerates economic financial sector policies and development growth, intensifies competition, and boosts outcomes because these correlations might the demand for labor. Importantly, it usually reflect reverse causality—in which economic brings relatively bigger benefits to those at the development shapes the types of financial lower end of the income distribution (Beck, sector policies that a country adopts—or the Demirgüç-Kunt, and Levine 2007; Beck, correlations might simply reflect the impact Levine, and Levkov 2010). Hence, finance, of some other factor on both economic devel- with good policies, can be both pro-growth opment and financial sector policies. To pro- and pro–poverty reduction. vide more accurate assessments about the enabling environment for finance, it is vital to trace through the channels from particular Financial development and the enabling policies and regulations to the operation of environment for finance financial systems and on to particular eco- Many factors shape the functioning of finan- nomic development outcomes. cial systems and hence their impact on eco- This report contributes to this goal of pro- nomic growth and poverty alleviation. Legal viding more sound advice to policy makers by
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 21Figure 1.2 Socioeconomic Development, Financial Development, and Enabling Environment Socioeconomic Development Social welfare (sustainable long-term growth, poverty reduction) Financial Development Financial sector functions Financial development outcomes Producing information about investments and (empirical proxies, measured separately for allocate capital; monitoring investments and financial institutions and markets) exerting corporate governance; managing risks; – Depth pooling savings; and easing the exchange of – Access goods and services – Efficiency – Stability Enabling Environment Financial sector policies (examples) Other policies and features (examples) – egulation (micro- and macro-prudential, R – acroeconomic policy framework (e.g., M business conduct, etc.) exchange rate regime, monetary policy, – irect interventions (state ownership, D tax policy, capital controls) guarantees, subsidies, liquidity provision) – egal framework, social capital, etc. L – ompetition policy in finance (level playing C – Concentration in the system field, entry/exit, etc.) – Internationalization, dollarization – romotion of financial infrastructure/ P technology ˇSource: Based on the review of literature in C ihák, Demirgüç-Kunt, Feyen, and Levine 2012.(a) developing and analyzing measures of the The Global Financialfunctioning of financial institutions and mar- Development Databasekets (chapter 1) and (b) assembling databases and the 4x2 Measurementon regulations, supervision, and institutional Matrixstructures that shape financial system opera-tions (chapters 2 to 5). Introducing the Global Financial To summarize the discussion in this sec- Development Databasetion, figure 1.2 presents in a visual form therelationships between socioeconomic devel- To measure the functioning of financial sys-opment, financial development, and the tems, country officials, researchers, and oth-enabling environment. It is important to care ers would ideally like to have direct measuresabout the process of financial development of how well financial institutions and finan-because it has a well-documented association cial markets (a) produce information ex antewith economic and social development more about possible investments and allocate capi-generally. It improves sustainable long-term tal; (b) monitor investments and exert cor-growth and reduces poverty, thereby improv- porate governance after providing finance;ing social welfare. One can think about these (c) facilitate the trading, diversification, andas the ultimate developmental objectives. Fig- management of risk; (d) mobilize and poolure 1.2 also highlights that financial systems savings; and (e) ease the exchange of goodsdo not exist in a vacuum. Financial system and services. So if data were not an issue, thecharacteristics depend on the enabling envi- ideal approach to measurement would involveronment, which consists of financial sec- the following determinations: in terms oftor policies and other relevant policies and producing information about possible invest-features. ments and allocating capital, the financial
22 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 sector in Country A, for example, scores 60 figure 1.2). For completeness, the accompa- on a scale from 0 to 100, while Country B’s nying database includes some variables that financial sector scores 75; in terms of moni- measure social welfare (the upper part of toring investments and exerting corporate figure 1.2) as well as financial sector policies governance after providing finance, Country and the other factors that define the enabling A scores 90, while Country B scores only 20 environment for finance (the bottom of fig- on a scale from 0 to 100, and so on. ure 1.2). The following subsections introduce So, instead of the direct measures, empiri- each dimension of this measurement frame- cal studies have focused on proxy variables, ˇ work. The annex to this chapter and Cihák, such as various measures of financial depth Demirgüç-Kunt, Feyen, and Levine (2012) and access. And despite evidence of the cru- provide more detailed information on each cial role of finance for economic develop- component of the measures of the four finan- ment, there is a surprising lack of comprehen- cial system traits in the matrix. sive data on basic aspects of financial systems To obtain a comprehensive characteriza- across countries and over time. For example, tion of financial systems, one must measure there are major gaps in data on trading vol- the four categories for the two key compo- umes in securities markets. Even data on nents of the financial sector, namely financial financial institutions become rather patchy institutions (banks and nonbank financial when one looks beyond the world’s major, institutions) and financial markets (stock publicly listed banks. market, bond market, and other markets). Against this background, one of the key Therefore, to be comprehensive, one needs contributions of the Global Financial Devel- to assemble a 4x2 matrix: four characteris- opment Report is the launch of a new, com- tics for two components. Table 1.1 provides prehensive online database on financial sys- a summary representation of such a 4x2 tems—the Global Financial Development matrix, with examples of variables that can Database, which is made available online be used to fill in each cell of the matrix. The together with the report. The database, same structure is used to organize the under- which will be updated on a regular basis, lying database. The following subsections go compiles and disseminates data on the char- through the individual characteristics in turn. acteristics of financial systems in 205 juris- Box 1.1 focuses on the selection of represen- dictions around world. The database has tative variables within the individual charac- data going back some 50 years (to 1960), teristics. Box 1.2 discusses the challenges of although some measures of financial system aggregating across the four dimensions. traits do not go back that far.4 The data from Critically, this chapter looks beyond the the Global Financial Development Database size of banks and stock markets. Many fac- are integrated with the World Bank’s Open tors shape the mixture of financial interme- Data initiative. Some of the data are new, and diaries and markets operating in an economy. this is the first time such comprehensive data Different types and combinations of infor- are available. The data are made available mation, enforcement, and transaction costs in a Web-friendly form, allowing the users in conjunction with different legal, regula- of the database to interact with the data, for tory, and tax systems have motivated distinct example, by creating their own country peer financial contracts, markets, and intermedi- groups and their own tables and charts. aries across countries and throughout his- tory. Thus, financial institutions and mar- kets can and do look very different across The 4x2 measurement framework countries and over time, but these structural This chapter develops and presents four mea- differences do not necessarily translate into sures of the characteristics of financial sys- differences in the quality of the services pro- tems: depth, access, efficiency, and stability. vided by the financial system to the economy. The focus here is on empirically character- To measure financial systems, this chapter izing financial systems (the middle part of digs deeper into the functioning of financial
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 23table 1.1 Stylized 4x2 Matrix of Financial System Characteristics (with examples of candidate variables in each category) Financial Institutions Financial Markets Private sector credit to GDP Stock market capitalization plus outstanding domestic Financial institutions’ assets to GDP private debt securities to GDP Money (M2 aggregate) to GDP Private debt securities to GDP DEPTH Deposits to GDP Public debt securities to GDP Value-added of the financial sector to GDP International debt securities to GDP Stock market capitalization to GDP Stocks traded to GDP Accounts per thousand adults (commercial banks) Percent of market capitalization outside of top Branches per 100,000 adults (commercial banks) 10 largest companies ACCESS Percent of people with a bank account (from user survey) Percent of value traded outside of top 10 traded companies Percent of firms with line of credit (all firms) Government bond yields (3 month and 10 year) Percent of firms with line of credit (small firms) Ratio of domestic to total debt securities Ratio of private to total debt securities (domestic) Ratio of new corporate bond issues to GDP Net interest margin Turnover ratio (turnover/capitalization) for stock market Lending-deposits spread Price synchronicity (co-movement) EFFICIENCY Noninterest income to total income Price impact Overhead costs (percent of total assets) Liquidity/transaction costs Profitability (return on assets, return on equity) Quoted bid-ask spread for government bonds Boone indicator (Herfindahl, or H-statistic) Turnover of bonds (private, public) on securities exchange Settlement efficiency z-score (or distance to default) Volatility (standard deviation/average) of stock price index, Capital adequacy ratios sovereign bond index STABILITY Asset quality ratios Skewness of the index (stock price, sovereign bond) Liquidity ratios Price/earnings (P/E) ratio Other (net foreign exchange position to capital, etc.) Duration Ratio of short-term to total bonds (domestic, international) Correlation with major bond returns (German, United States) ˇSource: Based on the review of literature in C ihák, Demirgüç-Kunt, Feyen, and Levine 2012. ˇNote: This is a stylized matrix. For details, see Cihák, Demirgüç-Kunt, Feyen, and Levine (2012). Variables that are highlighted in bold are the ones suggested for the benchmarkingexercise. Private sector credit to GDP is domestic private credit to the real sector times deposit money banks to GDP. Accounts per thousand adults (commercial banks) is the num-ber of depositors with commercial banks per 1,000 adults. For each type of institution, this figure is calculated as the (reported number of depositors)*1,000/adult population in thereporting country. The net interest margin is the accounting value of the bank’s net interest revenue as a share of its average interest-bearing (total earning) assets. The z-score(or distance to default) is (ROA + equity)/assets)/sd(ROA), where ROA is average annual return on end-year assets and sd(ROA) is the standard deviation of ROA. Stock marketcapitalization plus outstanding domestic private debt securities to GDP is defined as the value of listed shares to GDP plus amount of outstanding domestic private debt securitiesto GDP. Percent of market capitalization outside of top 10 largest companies is the market capitalization out of the top 10 largest companies to total market capitalization. Turnoverratio (turnover/capitalization) for stock market is the ratio of the value of total shares traded to market capitalization. Volatility (standard deviation/average) of stock price index isthe standard deviation of the sovereign bond index divided by the annual average of that index.systems and does not just look at the size of literature on financial development is privateparticular institutions and markets. credit, defined as credit to the private sector from deposit money banks, as a percentage of GDP. 5 There is a wide literature demon-First characteristic: Financial depth strating the link between financial depth,The most common way to characterize finan- approximated by private sector credit tocial systems is by measuring the size of finan- GDP, on one hand, and long-term economiccial institutions or markets relative to the growth and poverty reduction on the othersize of the economy. “Financial depth” is an hand (for example, Demirgüç-Kunt andanalytically incomplete, though empirically Levine 2008). Private credit varies widelyubiquitous, measure of the functioning of across countries. For example, averagedfinancial systems. over 1980–2010, private credit was less than For financial institutions, the variable that 10 percent of GDP in Angola, Cambodia,has received much attention in the empirical and the Republic of Yemen, while exceeding
24 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 BOX 1.1 Selecting the Representative Variables for Individual Characteristics For every category in the 4x2 matrix, several vari- How should one pick among such competing vari- ables could be used as proxies. Which combination ables? For the purpose of presenting the raw data of these variables should one choose when trying to in the database, it is not necessary to pick. Indeed, compare financial systems? the Global Financial Development Database shows In some cases, the variables in the same dimen- the competing variables, so that users can examine sion are complementary, and some are even additive. the data for themselves. However, for the purpose of For example, the total assets of banks to GDP and characterizing financial systems and for comparisons total assets of nonbank financial institutions to GDP across the dimensions, it is useful to pick one of the are in the same units and complement each other, so competing variables. they can be added up to obtain a proxy of total assets The general approach is to select indicators that of financial institutions to GDP. The result will be are widely available and have a clearly documented a good proxy variable, provided that the underlying link to long-term economic growth or poverty reduc- variables are comprehensive in their coverage and tion in the literature. When two variables capture the that no double counting occurs between them. Other same dimension, and both have a link to economic examples include measures of volatility in the stock development, one would select the variable that— market and volatility in the bond market. If these are even if it is perhaps less sophisticated—has greater measured in a similar way (as standard deviations), country coverage. The more sophisticated variable they can actually be added, using the capitaliza- is still included in the Global Financial Development tions of the two markets, as proxy for their relative Database, and relationships between some of these weights (as well as the covariance between the two), ˇ variables are explored in Cihák, Demirgüç-Kunt, to approximate the general volatility in the financial Feyen, and Levine (2012). For most of the variables, markets. the competing indicators tend to be highly (although In other cases, the variables “compete” to mea- not perfectly) correlated. For example, the correla- sure the similar things in slightly different ways. For tion coefficient for private sector credit to GDP and example, private sector credit to GDP and total assets total banking assets to GDP is 0.98 (figure 1.3). of financial institutions to GDP are both proxies for The chapter’s illustrative comparison of the 4x2 financial institutions’ size. The two variables differ characteristics across countries selects one variable in terms of their comprehensiveness and country cov- from each dimension. The selected variables are erage, with private sector credit to GDP covering a highlighted in bold in table 1.1. smaller set of assets but being available for a large number of countries. 85 percent of GDP in Austria, China, and in the literature on financial development. In the United Kingdom. The annual average any case, the two variables are rather closely value of private credit across countries was correlated, with a correlation coefficient of 39 percent, with a standard deviation of 36 about 0.98 (figure 1.3), so private credit can percent. provide a reasonably close approximation for An alternative to private credit is total total banking assets.6 banking assets to GDP, a variable that is also Despite the literature’s focus on banks, the included in the Global Financial Develop- global financial crisis has highlighted issues in ment Database. Compared to private credit, some nonbank financial institutions (NBFIs). this variable also includes credit to govern- Data coverage of NBFIs is less comprehensive ment and bank assets other than credit. It is than coverage of banks. Nonetheless, recog- arguably a more comprehensive measure of nizing the importance of NBFIs, the Global size, but it is available for a smaller number of Financial Development Database includes countries and has been used less extensively total assets of NBFIs to GDP, which includes
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 25pension fund assets to GDP, mutual fund Figure 1.3 Correlations between Characteristics in Same Categoryassets to GDP, insurance company assets to (example)GDP, insurance premiums (life) to GDP, andinsurance premiums (non-life) to GDP. Private credit versus domestic bank assets For financial markets, the two main seg-ments for which consistent worldwide data Domestic bank assets/GDP (%)can be collected are stock markets and bond 300 CYPmarkets (both sovereign and corporate). Toapproximate the size of stock markets, the ESP IRLmost common choice in the literature is stock HKG NLD 200 PRT GBRmarket capitalization to GDP. For the size of JPN CHE LUXthe bond markets, the mostly commonly used ITA MLT NZL LBNproxy for size is the outstanding volume of KNA FRA ISL SGPMYS LCA BEL VNM AUT DEU AUS GRC CHNdebt securities (private and public) to GDP. 100 MUS KOR SVN THA BHS EST ISR ATG FIN JOR GRD MAR HRV MDV PAN To measure the depth of stock markets, BRA ZAF CPV UKRMNE CHL LTU TURVCT BLZ EGY SVK ABW IND USA BGDDMA ALBSAUNPL VUT TUN BIHthis report primarily uses the stock value SYR KAZ ROM PHL RUS KEN GUY JAM SLV SYC BTN GMBNGA MEXCOL GTMMNG PAKMDA PNG LKANIC DZA GEOSTP PRY BOL AGO KSV MOZ SRB BLR HND FJI WSMMAC CRI TON NAM MKD IDN TGO SEN BEN GHAECUtraded indicator, which equals the value of ARM URY SWZ BDI ARGKHM PER DOM SLB TZABWA VEN AZE CIV UGA MLI BFA MWI ZMB HTI SLE LSO TMP SDN YEM MDG CMR NER GAB CAF AFG GNB MMRstock market transactions as a share of GDP. 0 0 100 200 300This market development indicator incor-porates information on the size and activity Private credit/GDP (%)of the stock market, not simply on the value Source: Calculations based on the Global Financial Development Database.of listed shares. Earlier work by Levine and Note: Correlation = 0.98. A significant correlation coefficient at the 5% level or better.Zervos (1998) indicates that the trading ofownership claims on firms in an economy isclosely tied to the rate of economic growth.There is substantial variation across coun- on the mixture of financial institutions andtries. Although the mean value of stock value markets operating in a financial system.7 Thetraded is about 29 percent of GDP, the stan- degree to which the financial system is rela-dard deviation is about double this value. In tively bank based or market based has beenArmenia, Tanzania, and Uruguay, stock value an important topic in the financial develop-traded annually averaged less than 0.23 per- ment literature. In a recent contribution tocent over the 1980–2008 sample (10th per- this literature, Demirgüç-Kunt, Feyen, andcentile). In contrast, stock value traded aver- Levine (2012) find that as economies develop,aged over 75 percent in China (both mainland services provided by financial markets tendand Hong Kong SAR, China), Saudi Arabia, to become relatively more important thanSwitzerland, and the Unites States (90th per- those provided by banks.centile). Also, this report confirms Levine’sand Zervos’s results using other market devel- Second characteristic: Financial accessopment indicators. In particular, it examines (inclusion)stock market capitalization, which simplymeasures the value of listed shares on a coun- But finance is not just about the size of finan-try’s stock exchanges as a share of GDP and cial institutions and securities; finance is alsosecurities market capitalization, which equals about the ability of individuals and firms inthe capitalization of the stock market plus the an economy to access financial services. Mea-capitalization of the private domestic bond sures of financial access are indeed stronglymarkets, divided by GDP. associated with economic development, a The relative size of banks and markets— relationship that is separate from the associa-called the financial structure ratio—mea- tion between financial depth and economicsures the ratio of private credit to stock mar- development. Besides the direct benefits ofket capitalization and provides information enhanced access to financial services, finance
26 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 also reduces inequality, particularly through financial systems, these individuals and indirect labor market mechanisms. Specifi- enterprises with promising opportunities are cally, accumulated evidence shows that finan- limited to their own savings and earnings. cial access accelerates economic growth, Financial access has been overlooked in tra- intensifies competition, and boosts the ditional literature on financial system char- demand for labor—and it usually brings big- acteristics, mostly because of serious data ger benefits to those at the lower end of the gaps on who has access to which financial income distribution (see, for instance, Beck, services and a lack of systematic information Demirgüç-Kunt, and Levine 2007, and Beck, on the barriers to broader access. The Global Levine, and Levkov 2010). It is important to Financial Development Database contains emphasize that the issue is not only access to both variables that measure the use of finan- any form of finance, but also the quality of cial services (which reflects both supply and financial services available to people. In other demand) as well as variables that focus more words, having a bank account is nice, but it is closely on the supply of financial services. also important to have a competitive interest The main proxy variable in the financial rate, reliable payment services, and so on. access category for financial institutions is the A well-functioning financial system offers number of bank accounts per 1,000 adults. savings, payments, and risk-management Other variables in this category include the products to as large a set of participants number of bank branches per 100,000 adults as possible. It seeks out and finances good (commercial banks), the percentage of firms growth opportunities wherever they may be. with line of credit (all firms), and the percent- Without inclusive financial systems, poor age of firms with line of credit (small firms). individuals and small enterprises need to rely When using these proxies, one needs to be on their personal wealth or internal resources mindful of their weaknesses. For example, to invest in their education, become entre- the number of bank branches is becom- preneurs, or take advantage of promising ing increasingly misleading with the move growth opportunities. Though still far from toward branchless banking. The number of conclusive, the existing body of evidence sug- bank accounts does not suffer from the same gests that developing the financial sector and issue, but it has its own limitations (in par- improving access to finance are likely not ticular, it focuses on banks only). only to accelerate economic growth but also The measure of access in financial markets to reduce income inequality and poverty. relies on various measures of concentration in Access to financial services—financial the market, the idea being that a high degree inclusion—implies an absence of obstacles to of concentration reflects difficulties for access the use of these services, whether the obsta- for newer or smaller issuers. The variables in cles are price or nonprice barriers to finance. this category include the percentage of mar- It is important to distinguish between access ket capitalization outside of the top 10 larg- to—the possibility to use—and actual use of est companies, the percentage of value traded financial services. In some cases, a person or outside of the top 10 traded companies, gov- business has access to services but decides ernment bond yields (3 month and 10 year), not to use them. But in other cases, price ratio of domestic to total debt securities, ratio barriers or discrimination, for example, bar of private to total debt securities (domestic), access. Failure to make this distinction can and ratio of new corporate bond issues to complicate efforts to define and measure GDP. access. Financial market imperfections, such The data for the financial access dimen- as information asymmetries and transaction sion of the Global Financial Development costs, are likely to be especially binding on Database came largely from the IMF’s the talented poor and on micro- and small recently established Access to Finance data- enterprises that lack collateral, credit his- base, based on earlier work by Beck, Demir- tories, and connections. Without inclusive güç-Kunt, and Martínez Pería (2007). 8 In
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 27addition, a part of the financial access data is analysis and other more sophisticated mea-based on the Global Financial Inclusion Indi- sures; for example, Angelidis and Lyroudicators database (Global Findex) that is being (2006) apply data envelopment analysisbuilt at the World Bank (Demirgüç-Kunt and and neural networks to calculate efficiencyKlapper 2012). The Global Findex is the first indexes using bank-by-bank data for the Ital-public database of indicators that consistently ian banking industry. But the data requiredmeasures individuals’ usage of financial prod- for this type of analysis are available only foructs across countries and over time. It can be a small subsample of countries, and thereforeused to track the effect of financial inclu- much additional data-collection work wouldsion policies and facilitate a deeper and more be needed to compile a comprehensive cross-nuanced understanding of how adults around country database. The background paper bythe world save, borrow, and make payments. ˇ Cihák, Demirgüç-Kunt, Feyen, and LevineThe data will be based on interviews with (2012) contains a discussion on data envel-at least 1,000 people per country in up to opment analysis and other examples of more150 countries about their financial behav- sophisticated measures.ior through the Gallup World Poll survey. For financial markets, the basic measureThe survey was rolled out in January 2011. of efficiency in the stock market is the turn-The first data set was made available to the over ratio, that is, the ratio of turnover topublic in April 2012, and the full database capitalization in the stock market. The ratio-will be updated every three years, with head- nale of using this variable is that the higherline indicators of the use of bank accounts turnover relative to capitalization means rela-and formal credit, which are collected on an tively higher volumes of trading in the marketannual basis. and more liquidity. This in turn means more scope for price discovery, better transmission of information in the price, and greater effi-Third characteristic: Financial efficiency ciency of the market. In the bond market, theTo perform its functions well, a financial sec- most commonly used variable is the tightnesstor should be efficient. It should perform its of the bid-ask spread (with the U.S. and West-intermediating functions in the least costly ern European markets showing low spreads,way possible. If intermediation is costly, the and the Dominican Republic, Pakistan, Peru,higher costs may get passed on to households, Qatar, and Vietnam reporting high spreads)firms, and governments. (In)efficiency mea- and the turnover ratio (although the mea-sures for institutions include indicators such surement of the latter often suffers fromas overhead costs to total assets, net interest incomplete data).margin, lending-deposits spread, noninterest A range of other proxies for efficiency inincome to total income, and cost to income financial markets have been used in empiri-ratio (table 1.1). Closely related variables cal literature (table 1.1). One of them is priceinclude measures such as return on assets synchronicity, calculated as a degree of co-and return on equity. While efficient finan- movement of individual stock returns in ancial institutions also tend to be more profit- equity market. The variable aims to captureable, the relationship is not very close (for the information content of daily stock prices.example, an inefficient financial system can It is based on the notion that a market oper-post relatively high profitability if it operates ates efficiently when prices are informativein an economic upswing, while an otherwise about the performance of individual firms.efficient system hit by an adverse shock may When their movements are highly synchro-generate losses). nized, they are less likely to provide such As with the other dimensions, these are individualized information (although onerelatively crude measures of (in)efficiency. For also needs to control for common shocks toa subset of countries, it is possible to calculate economywide fundamentals to establish aefficiency indices based on data envelopment benchmark for this variable). Also, efficiency
28 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 can be approximated by the real transaction has been used extensively in the empirical cost. Based on daily return data of the listed literature. For other indicators, such as the stocks, this variable attempts to approximate regulatory capital to risk-weighted assets and the transaction costs associated with trad- nonperforming loans to total gross loans, ing a particular security. This variable helps the Global Financial Development Database determine the barriers to efficiency in the cross-references the Financial Soundness market. All these indicators are constructed Indicators database available on the IMF by compiling and statistically processing website (http://fsi.imf.org). Variables such as firm-level data from a variety of market the nonperforming loan ratios may be bet- sources. ter known than the z-score, but they are also known to be lagging indicators of soundness ˇ Cihák and Schaeck 2010). Fourth characteristic: Financial stability One of the few reliable forward-looking Last, but not least, the degree of financial sta- indicators of financial instability is excessive bility is an important feature of the financial credit growth. The focus here is on excessive sector. There is a vast literature specifically credit growth. A well-developing financial on measuring systemic risk. Because of the sector is likely to report expansion in credit importance of financial stability for broader growth. Without credit growth, financial macroeconomic stability, the topic is some- sectors would lack depth or would not be times treated as separate from the other three able to provide good access to financial ser- dimensions. 9 But financial stability is an vices. Credit growth is important, and indeed important feature of financial systems, and it may be necessary, even if it is connected with is closely interlinked with the broader process some instability.10 But a very rapid growth of financial development. To illustrate this, in credit is one of the most robust com- imagine a country where banks’ lending stan- mon factors associated with banking cri- dards become very loose, with banks provid- ses (Demirgüç-Kunt and Detragiache 1997; ing loans left and right, without proper risk Kaminsky and Reinhart 1999). IMF (2004), management and loan monitoring. On the for example, estimated that about 75 percent surface, one could observe the rapid growth of credit booms in emerging markets end in as a sign of deepening and increased access banking crises. Typically, credit expansions to finance. Also on the surface, the financial are fueled by overly optimistic expectations sector can seem efficient, for some period of of future income and asset prices, often time: without the loan approval process, such combined with capital inflows. Over time, banks would be able to lower their costs, at households and firms accumulate substan- least until the loans turned bad. And this is tial debt while income does not keep pace. A the problem, of course: the system would decline in income or asset prices then leads be unstable and likely would end in a crisis. to an increase in nonperforming loans and For more on the complex linkages between defaults. If the problem is severe, the coun- financial development, financial fragility, and try experiences a banking crisis. Drehmann, growth, see, for example, Loayza and Ran- Borio, and Tsatsaronis (2011) examine the ciere (2006). performance of different variables as anchors The key variable used here to measure for setting the level of the countercyclical financial stability is the z-score, defined as the regulatory capital buffer requirements for sum of capital to assets and return on assets, banks, finding that the gap between the ratio divided by the standard deviation of return of credit to GDP and its long-term backward- on assets. This variable explicitly compares looking trend performs best as an indicator buffers (capitalization and returns) with the for the accumulation of capital, because this potential for risk (volatility of returns). The variable captures the build-up of systemwide z-score has a direct link with the probabil- vulnerabilities that typically lead to banking ity of default, and for this reason the variable crises.
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 29 BOX 1.2 To Aggregate or Not To provide a rough sense of how financial systems To convert the representative indicator in each of stack up across the 4x2 dimensions, it is helpful to the 4x2 characteristics to a 0–100 scale, each score is convert the individual characteristics to the same rescaled by the maximum for each indicator and the scale. To prepare for this, the 95th and 5th percentile minimum for each indicator. The rescaled indicator for each variable for the entire pooled country-year can be interpreted as the percent distance between data set are calculated, and the top and bottom 5 the worst (0) and the best (100) outcome, defined by percent of observations are truncated. Specifically, all the 5th and 95th percentile of the original distribu- observations from the 5th percentile to the minimum tion. These winsorized and rescaled variables are the are replaced by the value corresponding to the 5th core of much of the analysis presented in this chapter. percentile, and all observations from the 95th percen- To arrive at a more condensed aggregate indica- tile to the maximum are replaced by the value corre- tor, it may be useful to examine the average across sponding to the 95th percentile. In effect, the 5th and the various characteristics; however, a strong caveat 95th percentile become the minimum and maximum applies. An ongoing and rather active debate on mul- of the new (truncated) data set. The main reason tidimensional indices (such as the Multidimensional for truncating the “tails” of the distribution is that Poverty Index, Human Development Index, and sometimes the best and worst scores are very extreme various Unsatisfied Basic Needs indices long used in and may reflect some peculiar (idiosyncratic) features many countries) has focused much criticism on the of a single jurisdiction. However, the top and bot- difficulty of the choice of weights for such an index tom 5 percent of observations are not dropped from (for example, Ravallion 2011). Mindful of the debate the sample completely. If they were dropped, the and the shortcomings associated with creating such calculations would lose too much of the potentially mash-up indices, this report does not explicitly pres- valuable information. Replacing the top and bottom ent such a formal mash-up index. Nonetheless, the 5 percent of observations with the 95th and 5th per- data made available on this report’s website allow centile value, respectively, ensures that much of the interested users to assign different weights to the var- original information is still retained. This so-called ious characteristics and calculate their own aggregate winsorizing is consistent with approaches used in indices. earlier literature. The advantage of the credit growth vari- For financial markets, the most commonlyable is that it is relatively easy to observe and used proxy variable for (in)stability is mar-monitor. Also, unlike some of the other mea- ket volatility, although other proxies are alsosures (for instance, those that include nonper- included in the database (table 1.1). One offorming loan ratios), it is a forward-looking these variables is the skewness, the reasonmeasure of instability. A disadvantage is that being that a market with a more negativethe definition of “excessive” credit growth is skewed distribution of stock returns is likelynot trivial. Also, this measure does not, by to deliver large negative returns, and likely toitself, capture situations where financial sec- be prone to instability.tor problems have already crystallized in a Other variables approximating (in)stabilityfull-blown crisis. In such situations, credit is in the stock market are the price-to-earningsdeclining in real terms rather than growing. ratio (P/E ratio) and duration (a refined ver-It is therefore important to amend the exces- sion of the P/E ratio that takes into accountsive credit growth indicator, as an ex ante factors such as long-term growth and inter-measure of financial instability, by including est rates). These variables are based on thecredit declines as ex post proxies for situa- empirical fact that market prices containtions of financial instability. expectations of future cash flows and growth
30 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 instead of current fundamentals only, and interventions. Finally, another group of indi- therefore stock prices may be more volatile cators relates to the features of the underly- and negatively skewed in the future. ing financial infrastructure. This includes basic indicators on information disclosure, contract enforcement, and other quantitative Measuring the enabling environment for characteristics of financial infrastructure (for finance: A start and an important area example, public registry coverage in percent for further data work of adults, private bureau coverage in percent The focus of the 4x2 matrix is on charac- of adults, procedures to enforce contracts, terizing financial systems (the middle part time to enforce contract, and cost to enforce of figure 1.2). It does not explicitly include contracts). Several other traits of the enabling variables capturing financial sector policy, environment for finance are included in the such as features of financial sector regula- Global Financial Development Database and tion and supervision (the bottom of figure listed in this chapter’s annex. 1.2). The reason for focusing on measures But this is just a start. For policy evalua- of the functioning of financial systems is tion and policy design purposes, it is impor- that those indicators bridge the gap between tant to start collecting more consistent and policy measures and final objectives, such as more comprehensive information on gov- growth, poverty alleviation, and the expan- ernment policies in the financial sector (for sion of economic opportunities. Financial example, on supervision of nonbank financial depth, access, efficiency, and stability func- institutions and financial markets). This is an tion as “intermediate” indicators and targets. important gap in the globally available data; To some extent, this is an analogy with mon- future reports hope to go in more depth into etary policy, where intermediate targets have how this gap might be filled. a relatively clear link to the policy variable (such as a central bank’s interest rate) and an impact on the policy target (such as future Selected Findings inflation rate). Financial system multidimensionality This report, however, has started the pro- cess of assembling comprehensive data on One basic, yet important, observation the enabling environment for finance: finan- derived from the Global Financial Develop- cial sector policies, regulations, supervisory ment Database is that the four characteris- practices, legal and accounting systems, tics of financial systems are far from closely and so forth. As part of the work underly- correlated across countries (figure 1.4). Each ing chapter 2 of this report, a comprehen- characteristic captures a different, separate sive and updated data set on bank regula- facet of financial systems. Capturing only tion and supervision around the world was financial institutions and not financial mar- put together, building on earlier work by kets would be insufficient. Also, looking only Barth, Caprio, and Levine (2004). The data- at financial depth as the only proxy would base also covers policies and issues that go not be sufficient. And similarly, focusing beyond the narrow concept of banking regu- only on financial stability or on access or on lation and supervision, such as deposit pro- efficiency would be insufficient. Stability has tection systems and resolution issues. Also, particularly low correlation with the other the World Bank has recently published a three characteristics. comprehensive update on payment systems and the related policies around the world— Important differences across regions some of these results are featured in chapter and income groups 5. As part of chapter 4, new data are pre- sented on development financial institutions A regional comparison shows major differ- and some other forms of direct government ences in the four characteristics of financial
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 31figure 1.4 Correlations among Financial System Characteristics a. Financial Institutions Depth vs. Access Depth vs. Efficiency Correlation = 0.80* Correlation = 0.47* Private credit to GDP (%) Private credit to GDP (%) MYS GRC ESP ITA AUT NLD PRT MLT LCA HKG AUS VNM CHN JPN CHE NZL CAN MYS 100 THA EST SGP JPN KOR 100 EST BRB SGP KOR SVN ISR ISR THA BHS 80 80 MUS GRD ATG PAN KWT MAR ZAF BHR ZAF LBN HUN CHL HRV HUN KNA CHL LBN JOR MDV VUTLTU 60 MDV 60 BLZ UKR UKR ABW CPV BLZ BIH BIH DMA CZE NPL HND VCT MAC SAU OMN BRA CRI SRB BRN OMN FJI TON NAM 40 WSM 40 NAM RUS MKD BGD KAZ TUR ROM BGD MNG MNG ALB BLR STP NGA TTO IRN KEN KSV GEO MDA PRY GEO NICKEN BOL MDA COL EGY DJI GUY MRT KHMPNG PHL JAM DJI PNG GTM MOZ SUR PHL IDN LKA 20 TGO AGO SYR AZE ETH TZA DZA SWZ PAK PER ARM BWA URY MEX SYC 20 MWI PER GMB SLB ARM SYC TMP AGOAZE TZA SWZ BWA PAK DOM URY DZA MEX SYR VEN LAO UGA GHA COM HTI LSO ARG LAO HTI UGA LBR COM LSO ARG MDG CMR ZMB SLE LBY CAF SLE AFG GAB YEM MDG YEM TCD MMR COG 0 0 0 1,000 2,000 3,000 80 85 90 95 100 Accounts per thousands adults, commercial banks 100 minus lending-deposit spread (%) High income Low income Lower middle income Upper middle income High income Low income Lower middle income Upper middle income Depth vs. Stability Access vs. Efficiency Correlation = 0.02 Correlation = 0.46* Private credit to GDP (%) Accounts per thousands adults, commercial banks IRL GRC LCA DNK NZL AUT MLT HKG DEUCHE CYP GBR JPN ITA NLD FRA SWE PRT AUS LUX VNM ESP CAN CHN MYS 100 EST BEL SVN KOR BRB SGP 3,000 UKR KOR JPN FIN ISR THA BHS 80 GRD PAN MUS HUN BHR MAR KWT ZAF MNEKNA LBN SGP CHL LTU BLZ JOR VUT HRV 2,000 EST BGR 60 UKR USA BIH CZE TUN DMA NPL MYS MAC SYC SAU SRB BRA CRI HND BRN OMN SVK MKD NAM IND WSM MNG 40 KAZ RUS BGD ROM MNG SLV TUR MDA LVA MDV THA MEX 1,000 BTN BLR ALB TTO ISR HUN PRY MDA BOL EGY BLZ OMN ZAF NIC NGA KEN COL BIH LBN GEO MRT GUY PHL KHM SUR ECU JAM QAT SWZ PNG SYC ARM BWA MOZ GTM IDNSEN PER LKA GEO ARG 20 URY AZE GMB TZA TGO BEN VEN MEX PAK MLI ETH BDI AGO SYR CIV DOM BFA PER ARM URY WBG BWA SWZ NAM PHL NOR LAO DZA MWI UGA LSO GHA HTI CMR KEN BGD MDG ARG NER HTI DZA AFG CAF SLE GAB SDN ZMB LBY RWA LSO PAK SYR YEM KGZ UGA SLE PNG MMR TCD AGOAZE TZA DJI COM YEM MDG LAO 0 0 0 20 40 60 80 80 85 90 95 100 Z-score-weighted average commercial bank 100 minus lending-deposit spread (%) High income Low income Lower middle income Upper middle income High income Low income Lower middle income Upper middle income Access vs. Stability Efficiency vs. Stability Correlation = 0.02 Correlation = 0.18 Z-score–weighted average commercial bank Z-score–weighted average commercial bank 80 80 HRV CMR NAM MAR LBN THA FSM WSM COL THA NAM LBY LBN HTI HTI QAT QAT 60 60 JAM MYS MAC MYS CHN SGP DOM SGP CAN GUY BRBCZE PHL ESP PHL BHS 40 IDN 40 JOR BIHVUT KEN GHA BIH OMN TUR KEN GTM LKA NPL OMN VNM KOR TTO MOZ AUS KOR PER PER MRT PNG MUS PNG ALB BLR PRT HND SYR LSO NOR BWA UZB ZAF LSO BHR BRNEGY SYR BWA HKG ZAF NOR AGO PAK ETH SWZ ITA MLT MWI CRI AGO SWZ PAK UGA ARM BLZ ARM BLZ KWT MKD DZA MNG ZAR UGA BOLMNG DZA PAN GNQ AUT JPN SRB YEM JPN YEM ARG BRA SUR ISR ARG 20 ISR 20 RWA TGO SYC NLD BGR SYC RWA BGR ROM KGZ BGD SAU HUN MDA PRY KGZ NGANIC MDA BGD RUS VEN HUN NZL SVN GAB TZA MEX TZA GRD MEX KNA KHM UKR UKR CHE SLE SLE LCA MDG GEO KAZ GRC MDG GEO ZMB GMB TCD TJK EST AZE EST AZE DMA CAF LAO AFG URY LVA LAO LVA URY MMR LTU 0 0 0 1,000 2,000 3,000 80 85 90 95 100 Accounts per thousands adults, commercial banks 100 minus lending-deposit spread (%) High income Low income Lower middle income Upper middle income High income Low income Lower middle income Upper middle income (figure continues next page)
32 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013figure 1.4 Correlations among Financial System Characteristics (continued) b. Financial Markets Depth vs. Access Depth vs. Efficiency Correlation = 0.39* Correlation = 0.47* (Stock market capitalization + outstanding domestic private debt securities)/GDP (Stock market capitalization + outstanding domestic private debt securities)/GDP 200 LUX CHE AUS MYS HKG USA ZAF 200 LUX MYS ZAF CHE DNK AUS USA HKG SGP SGP SWE KOR KOR 150 CHL ESP GBR CAN 150 CHL CAN NLD GBR ESP IRL IRL FRA PNG JOR JOR BEL BRB JPN 100 JPN CHN 100 NOR BRA ISR CHN BHR KNA MNE PRT ISRBRA KWT NOR IND THA THA IND ISL SAU SAU AUT AUT DEU MAR DEU ITA MAR ITA FIN RUS RUS COLPHL COL PHL PER TTO MUS 50 PER MEX GRC MUS 50 FJI JAM HRV KAZ MEX IDN EGY GRC EGY IDN KEN CZE TUR MLT POL NZL PAN MLT NPL LBN OMN POL NZL BWA SVN CIV MWI SRB CYP LKA HUN HUN SVN TUR LKA TUN SLV MKD UKRNGA PAK VNM CYP ARG BOL ARG ZMB UGA LTU EST BGR MNG IRN IRN SVK BGD GEOGHA NAM ECU LVA CRI VEN ARMURY KGZ 0 0 0 20 40 60 80 80 50 100 150 Percent market capitalization out of the top 10 largest companies (%) Stock market turnover ratio (%) High income Low income Lower middle income Upper middle income High income Low income Lower middle income Upper middle income Depth vs. (in)stability Access vs. Efficiency Correlation = 0.09 Correlation = 0.51* (Stock market capitalization + outstanding domestic private debt securities)/GDP Percent market capitalization out of the top 10 largest companies (%) 200 MYS CHE HKG USA DNK ZAF 80 AUS LUX ZAF CAN CHN SGP SWE SGP IND USA KOR CAN GBR KOR 150 CHL NLD MYS JPN ESP HKG GBR ESP IRL 60 PHL LKA IRN IDN EGY AUS FRA THA DEU CHL TUR JOR BEL MUS POL ISR JPN NZL BRA 100 CHN BHR KWT ISR PRT THA IND BRA NOR 40 PER CHE SAU GRC AUT NOR RUS ITA ISL MEX SAU ITA MAR DEU ARG JOR FIN RUS COL PHL MAR MUS PER 50 MEX 20 IRL JAM EGY SVN COL IDN HRV GRC CYP PAN LBN MLT KEN NZL TUR KAZ POL BWA SVN LKA CZE HUN OMN SRB CYP LUX HUN TUN NGA PAK MKD VNM UKR MLT BGR EST ARG MNG LTU SVK LVA NAM CRI 0 0 10 20 30 40 50 0 50 100 150 Asset price volatility Stock market turnover ratio (%) High income Low income Lower middle income Upper middle income High income Low income Lower middle income Upper middle income Access vs. (in)stability Efficiency vs. (in)stability Correlation = 0.21 Correlation = 0.24* Percent market capitalization out of the top 10 largest companies (%) Stock market turnover ratio (%) 80 HKG KOR USA SGP CHN CAN ZAF IND 150 USA CHN ITA TUR VNM GBR KOR RUS JPN MYS HKG ESP ESP 60 PHL LKA IDN AUS JPN THA GBR DEU IND HUN CHL THA EGY DEU TUR NLD FIN ISR MUS 100 SGP AUS SWE NOR POL KWT NZL BRA SAU FRA GRC 40 CHE SAU ITA PER NOR RUS GRC ISR CHE PAK DNK CAN EGY IDN BRA MEX JOR ARG IRL 50 ZAF POL MAR OMN BEL NZL IRL JOR PRT COL 20 SVN CYP MYS PHL LKA MEX CZE TUN CHL NGA LBN MAR KEN COL EST MLT LUX HUN ISL UKR MNG CYP MUS LTU BHR JAM PAN BWA CRI SVN SRB BGR HRV ARG MKD LVA PER KAZ NAM MLT SVK LUX 0 0 10 20 30 40 50 0 20 30 40 50 Asset price volatility Asset price volatility High income Low income Lower middle income Upper middle income High income Low income Lower middle income Upper middle income *Indicates a significant correlation coefficient at the 5% level or better
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 33figure 1.4 Correlations among Financial System Africa on access to finance (table 1.2). ThisCharacteristics (continued) number resonates with the complaints heard during the unrest in the region in 2011.11 c. Financial Sector Depth: Institutions vs. Markets Much of the differences among regions are correlated with differences in income levels. Private credit/GDP (%) 300 Countries that have lower income tend to CYP also show lower values on the 0–100 scale in the 4x2 framework (table 1.2 and figure IRL 1.5). However, the stability indicator is not 200 PRT ESP NLD GBR very correlated with income level—a point LUX CHE HKG highlighted quite dramatically by the global financial crisis. MLT AUS AUT CHN ITA FRA VNM ISL GRC DEU JPN MYS 100 EST SVN FINTHA BEL ISR KOR SGP PAN LTU HRV UKR TUN MUS LBN MAR JOR CHL MNE KNA ZAF Large disparities in financial systems SVKNPL CRI SRBFJI RUS BRA NAM KAZ SAU MKD BGDTUR SLV MNGEGY BOL IND USA across countries GEO KENPHL NGA ECU IDN COL GUY JAM PNG URY LKA MEX ARM BWA PER PAK VENMWI CIV GHA UGA 0 ARG ZMB Behind these regional and peer group aver- 0 100 200 300 400 500 ages are vast differences among individual (Stock market capitalization + outstanding countries, and in some cases also major domestic private debt securities)/GDP differences among different parts of eachSource: Calculations based on the Global Financial Development Database. country’s financial sector. The data fromNote: See table 1.2. the Global Financial Development Database demonstrate rather strikingly the large differ- ences in financial systems around the globe.systems across the key regions as of 2010 For example, the largest financial system in(table 1.2). The results are by and large in the sample is more than 34,500 times theline with what one would expect, with Sub- smallest one. Even if the financial systemsSaharan Africa scoring the lowest on aver- are rescaled by the size of the correspondingage on most of the characteristics, and high- economies (that is, by their GDP), the larg-income countries scoring the highest on most est (deepest) financial system is still somedimensions. A remarkable number is the rela- 110 times the smallest (least deep) one. Andtively low score of Middle East and North even if the top and bottom 5 percent of thistable 1.2 Financial System Characteristics: SummaryFinancialInstitutions East Asia Europe and Latin America Middle East and Sub-Saharan(Mean) High income and Pacific Central Asia and the Caribbean North Africa South Asia AfricaDepth 69 43 37 37 33 32 17Access 43 23 35 30 14 16 10Efficiency 80 70 65 62 83 81 51Stability 42 52 20 35 57 38 32FinancialMarkets East Asia Europe and Latin America Middle East and Sub-Saharan(Mean) High income and Pacific Central Asia and the Caribbean North Africa South Asia AfricaDepth 43 38 12 21 24 17 20Access 46 80 56 40 50 85 77Efficiency 29 40 17 8 24 49 7Stability 66 60 43 64 81 56 54 (table continues next page)
34 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 table 1.2 Financial System Characteristics: Summary (continued) Financial Institutions Upper middle Lower middle (Mean) High income income income Low income Depth 84 44 28 13 Access 55 32 19 5 Efficiency 86 75 61 42 Stability 35 38 40 35 Financial Markets Upper middle Lower middle (Mean) High income income income Low income Depth 51 27 16 10 Access 53 58 69 29 Efficiency 45 19 20 21 Stability 53 60 53 44 Source: Calculations based on the Global Financial Development Database. Note: The summary statistics refer to the winsorized and rescaled variables (0–100), as described in the text. Financial Institutions—Depth: Private Credit/GDP (%); Access: Number of Accounts Per 1,000 Adults, Commercial Banks; Efficiency: Net Interest Margin; Stability: z-score. Under Financial Markets—Depth: (Stock Market Capitalization + Outstanding Domestic Private Debt Securities)/GDP; Access: Percent Market Capitalization Out of the Top 10 Largest Companies (%); Efficiency: Stock Market Turnover Ratio (%); Stability: Asset Price Volatility. Figure 1.5 Financial System Characteristics, by Income Group, 2010 a. Financial institutions b. Financial markets 70 80 60 60 50 Index (0–100) Index (0–100) 40 40 30 20 20 0 Depth Access Efficiency Stability Depth Access Efficiency Stability High income Low income Lower middle income Upper middle income Source: Calculations based on the Global Financial Development Database. Note: The summary statistics refer to the winsorized and rescaled variables (0–100), as described in the text. See also table 1.2. distribution are taken out, the ratio of the examines country-level data, one finds vast largest to the smallest is about 28—a large differences in financial sector depth, as well degree of disparity, considering that these are as in the other characteristics. not raw figures but ratios relative to the size The cross-country differentiation along of the economy. Similar orders of magnitude the key characteristics of financial systems are obtained for the other characteristics of can be seen from the scatter plots in figure financial systems.12 In other words, when one 1.4 as well as from cartograms such as the
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 35one shown for illustration in figure 1.6. The liquidity shocks. In addition, financial insti-scatter plots and the cartogram underscore tutions on average rebounded faster thanthe large cross-country differences. The mea- markets, showing improvements in depthsurement framework underscores that finan- and efficiency after the crisis. This improve-cial sectors in jurisdictions such as the Repub- ment seems to have been the case so far, forlic of Korea and the United States exhibit a example, for Brazil and other Latin Ameri-relatively great financial market depth, as can countries (de la Torre, Ize, and Schmuk-one would expect. The United States has less ler 2011), China (box 1.3), and many Sub-deep financial institutions, reflecting the less Saharan African countries (see, for example,bank-centric (and more market-based) nature World Bank 2012). However, the medium-of the U.S. financial system. Several Euro- term effect of the crisis on financial systemspean countries exhibit relatively great finan- still remains to be seen, and will be examinedcial depth. further in future issues of the Global Finan- Financial systems have changed. As illus- cial Development Report.trated in figures 1.7 and 1.8, the most visiblechange is the observed declines in stability, Increased importance of securitieswhich in turn reflects the increased volatility markets at higher income levelsin returns by financial institutions in somecountries and in most financial markets. The Global Financial Development Database Overall, the data from the Global Finan- allows for an examination of the relative sizecial Development Database suggest that the of financial institutions and financial mar-key disparities among countries in terms of kets around the world. The issue of finan-the nature of their financial systems have cial structure—usually approximated by thesomewhat subsided in the aftermath of the relative size of bank credit and stock marketrecent crisis, as financial sectors in many capitalization—has been an important topicmedium- and low-income countries were in the policy debate.relatively more isolated from the global tur- In a recent paper that used data that aremoil, and therefore less affected by the global part of the Global Financial DevelopmentFigure 1.6 The Uneven Nature of Financial Systems (Illustration)Source: Calculations based on the Global Financial Development Database.Note: The map is for illustration purposes only. Country sizes are adjusted to reflect the volume of financial sector assets in the jurisdiction, measured inU.S. dollars at the end of 2010. The image was created with the help of the MapWindow 4 and ScapeToad software.
36 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013Figure 1.7 Financial Systems: 2008–10 versus 2000–07 (Financial Institutions) a. Depth b. Efficiency Average 2008–10 Average 2008–10 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 0 10 20 30 40 50 60 70 80 90 100 0 10 20 30 40 50 60 70 80 90 100 Average 2000–07 Average 2000–07 c. Access d. Stability Average 2008–10 Average 2008–10 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 0 10 20 30 40 50 60 70 80 90 100 0 10 20 30 40 50 60 70 80 90 100 Average 2000–07 Average 2000–07Source: Calculations based on the Global Financial Development Database. Database, Demirgüç-Kunt, Feyen, and would need to find out if taxes, regulations, Levine (2012) examine empirically the issue legal impediments, or other distortions are of financial structure and find that, as econ- leading to excessive reliance on banks or omies develop, use of services provided by markets. Using policy to facilitate a shift securities markets increases relative to those from a bank-centric system to a more market- provided by banks. This work suggests that based system is never an easy task. Actively policies and institutions should adapt as intervening to develop markets is likely to be countries develop in order to allow financial problematic. Interventions should be more structure to evolve. along the lines of fostering an enabling envi- The existing research and policy work do ronment and reducing impediments. Even not provide enough guidance to justify tar- in systems with a relatively strong state role geting a particular financial structure for a in the economy, shifts in the financial sec- particular country. However, if market or tor structure do not occur overnight. China bank development is too skewed compared (box 1.3) is a case in point: despite policy to what one could expect given their level of intentions and reforms aimed at promot- economic development, the above research ing nonbank financial institutions and mar- findings provide a reason to dig deeper: one kets, the financial system remains very much
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 37Figure 1.8 Financial Systems: 2008–10 versus 2000–07 (Financial Markets) a. Depth b. Efficiency Average 2008–10 Average 2008–10 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 0 10 20 30 40 50 60 70 80 90 100 0 10 20 30 40 50 60 70 80 90 100 Average 2000–07 Average 2000–07 c. Access d. Stability Average 2008–10 Average 2008–10 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 0 10 20 30 40 50 60 70 80 90 100 0 10 20 30 40 50 60 70 80 90 100 Average 2000–07 Average 2000–07Source: Calculations based on the Global Financial Development Database.dominated by large banks, and in some ways in the fourth quarter of 2008, around thehas become even more bank-centric during Lehman failure. On the surface, it may seemthe recent period of rapid credit growth. as if the U.K. financial sector underwent a “productivity miracle” from the 1980s onward, as finance appeared to rise as aThe “bright” and “dark” sides of share of GDP despite a declining labor andfinancial systems capital share. However, a decomposition ofThe data from the Global Financial Devel- returns to banking suggests that much ofopment Database can be used to examine the growth reflected the effects of higherthe notion that growth of financial systems risk taking (Haldane, Brennan, and Madou-may seem explosive. To some extent, this ros 2010). Leverage, higher trading profits,notion reflects the inadequacy of some of the and investments in deep-out-of-the-moneyavailable proxies for financial systems. For options were the risk-taking strategies thatinstance, in the case of the United Kingdom, generated excess returns to bank sharehold-the nominal value-added of the financial sec- ers and staff. Subsequently, as these riskstor (as measured in the System of National materialized, the “miracle” turned into aAccounts) grew at the fastest pace on record mirage.
38 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 BOX 1.3 China Case Study: Large Banks and the Need to Diversify to Markets The 4x2 measurement framework allows country restructured, and a resolution mechanism and inves- officials and analysts to examine financial systems tor protection scheme have been set up. Pension sec- across borders and to put them in a broader interna- tor reform has also progressed, with the establish- tional perspective. The rapid and somewhat uneven ment of a National Social Security Fund in 2000. development of China’s financial system provides for The fixed income market has grown as an alterna- an interesting case study. tive funding channel, but it remains heavily concen- Over the past three decades, China’s economy trated in public sector securities. The equity market has maintained high growth rates. Since the start of mainly meets the needs of large enterprises, in spite reforms in 1978, productivity growth has been rapid of recent progress in establishing a multilayer equity and capacity has been expanded by very high levels market to facilitate funding to small and medium of investment. enterprises (SMEs). Assets under management by China has made progress in moving toward a more the insurance sector corresponded to less than 11 commercially oriented financial system and toward percent of household bank deposits. Trust, financial strengthening of its banks (World Bank 2011c). leasing, and finance companies have all been grow- This progress has been underpinned by reforms that ing rapidly but remain small relative to banks. China included recapitalizing the banking system, upgrad- also has a flourishing informal financial sector, parts ing the prudential regulatory regime, opening the of which provide funding to SMEs and small retail financial system following accession to the World investors. Nonetheless, the large commercial banks Trade Organization, and taking steps to reform inter- make up almost two-thirds of commercial bank est rate and exchange rate policies. Reform of the assets, with the assets of the four largest banks each joint-stock banks has boosted the commercial orien- exceeding 25 percent of GDP (and ranking among tation of the banking system, and reform of the rural the largest banks in the world). credit cooperatives has yielded some initial results. The commercial banking sector has grown very FIGURE B1.3.1 The Chinese Financial Sector rapidly in the past decade. In terms of the 4x2 frame- 100 work, the Chinese banking sector was already rather large, being close to or at the 100 score in terms of 80 the depth indicator (see figure B1.3.1). In this sense, China may seem already “developed” in terms of the Index (0–100) 60 size of its financial institutions. However, the rapid credit growth of the 2000s may have been too rapid 40 and contributed to a somewhat reduced stability score. Perhaps greater increase in depth of the finan- 20 cial markets may have been more warranted. The 4x2 framework underscores that one of 0 the challenges for the Chinese financial sector is to 2000 2002 2004 2006 2008 2010 increase its diversification. Banks, particularly the Depth (institutions) Stability (institutions) largest ones, still dominate financial intermediation. Depth (markets) Stability (markets) Recognizing this challenge, the country authorities Source: Calculations based on World Bank 2011c. have taken steps to diversify the financial sector. Note: For simplicity, the figure shows only four out of the eight variables In the securities sector, key companies have been in the 4x2 framework. See also the note to table 1.2. More examples of the explosive growth They observe that financial systems develop- of financial systems using the data from the ment paths exhibit “convexities,” as rising Global Financial Development Database can participation and interconnectedness gener- be found in de la Torre, Ize, and Schmukler ate positive externalities that promote further (2011) and de la Torre, Feyen, and Ize (2011). participation and interconnectedness. Thus,
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 39much of financial system growth may be to the crisis. For example, the financial stabil-explosive. According to the authors, a counter- ity indicators for many countries show dete-part of such explosiveness is that the associa- rioration several years prior to the crisis (seetion between financial development (approxi- figure B1.3.1 in box 1.3 for an illustrationmated, for example, as private credit to GDP) for China). This finding is consistent withand real development (output growth) exhibits the observation by Anginer and Demirgüç-decreasing returns. In other words, the asso- Kunt (2011), who construct a default riskciation between finance and growth levels off measure for publicly traded banks using theat some point. This result is consistent with Merton contingent claim model, and exam-findings of recent papers that regress output ine the evolution of the correlation struc-growth against financial depth indicators.13 ture of default risk for some 1,800 banks in A different aspect of this convexity has over 60 countries. Based on their measure, ˇbeen brought up recently by Cihák, Muñoz, which is a more sophisticated analogue ofand Scuzzarella (2011). Using a subset of data the z-score used in this chapter, they find afrom the Global Financial Development Data- significant increase in default risk codepen-base, and building on an earlier theoretical dence over the three-year period leading topaper by Nier and others (2007), they exam- the financial crisis. They also find that coun-ine the “bright” and “dark” sides of cross- tries that are more integrated, and that haveborder financial interlinkages. They ask liberalized financial systems and weak bank-whether making a country’s banking sector ing supervision, have higher codependence inmore linked to the global banking network their banking sector. The results support anrenders that country more or less prone to increase in scope for international supervi-banking crises. Their answer, interestingly, is sory cooperation, as well as capital chargesthat it depends on how connected the coun- for “too-connected-to-fail” institutions thattry’s banking sector already is. For banking can impose significant externalities.sectors that are not very connected to the The 4x2 framework also allows examin-global banking network, increases in inter- ing the effects of the global financial crisis.connectedness are associated with a reduced Box 1.4 illustrates this in the case of Roma-probability of a banking crisis. Once intercon- nia, a country whose financial sector seemednectedness reaches a certain value (estimated relatively sound based on conventional ratiosto be at about the 95th percentile of the distri- (such as capital adequacy and nonperformingbution of countries in terms of interconnected- loan ratios) but that was subjected to ratherness), further increases in interconnectedness large shocks during the crisis. Figures 1.7 andcan increase the probability of a banking cri- 1.8 examine the crisis effect in a cross-sectionsis. Also, the analysis suggests that it is impor- of countries.tant to distinguish whether the cross-borderinterlinkages are stemming primarily from Conclusionbanks’ asset side or from their liabilities side:increasing interconnectedness on the liabilities The 4x2 framework presented in this chapter(borrowing) side is more likely to become det- puts a spotlight on the multifaceted nature ofrimental to banking stability than increasing modern financial systems. Focusing only oninterconnectedness on the asset (creditor) side. one dimension—say, financial depth or finan- cial stability—would be shortsighted. Also, focusing only on financial institutions, or justAnalysis of the crisis: Increased on banks, is too much of a simplification andinstability in the run-up, decreased can lead to distorted results and biased policyaccess in the aftermath conclusions.The rich data set in the Global Financial Devel- This chapter illustrates that financialopment Database allows one to examine in sectors come in different shapes and sizes,more depth the developments in the run-up and they differ widely in terms of the 4x2
40 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 BOX 1.4 Romania Case Study: Rapid Growth Enabled by Foreign Funding In the run-up to the global financial crisis, Romania’s FIGURE B1.4.1 Romania’s Financial Sector financial sector has gone through a period of rapid 100 growth, reflected in an increase in the measured financial depth. Similarly to many other countries in the region, the rapid growth of domestic credit 80 was fueled by ample funding provided by parents of foreign-owned banks to their subsidiaries in Roma- Index (0–100) 60 nia. In terms of the 4x2 framework, Romania’s score for financial institutions’ depth grew from only 3 in 40 2000 to 28 in 2007, and its score for financial mar- kets’ depth grew from 1 to 13 over the same period. The Romanian banking system, which dominates 20 the financial sector, entered the crisis with relatively high reported capitalization and liquidity ratios 0 (IMF 2009). Also, the ratios of nonperforming loans 2000 2002 2004 2006 2008 2010 to total loans reported before the crisis were rather Depth (institutions) Stability (institutions) low; however, this finding was mostly just a reflec- Depth (markets) Stability (markets) tion of the high credit growth that masked to some Source: Calculations based on World Bank; IMF 2009. extent the underlying weaknesses in the system. The Note: For simplicity, the figure shows only four of the eight variables z-score, that is, the proxy for stability used in the in the 4x2 framework. See also the note to table 1.2 4x2 framework, suggested that the soundness of Romanian banks was far from perfect in the run-up becoming undercapitalized as the downturn contin- to the crisis. ues. The FSAP therefore called for strengthening of A rapid deterioration in market confidence in capital positions of some banks and for maintain- the Romanian economy has led to bouts of down- ing by parents of foreign-owned banks those lines of ward pressure on the exchange rate, upward pres- credit to their subsidiaries and corporate borrowers sure on interest rates, and a large decline in equity in Romania. In terms of the 4x2 framework, these values (some 80 percent between 2008 and 2009). stability challenges are reflected in major declines These effects led to sharp increases in nonperform- of the stability indicators, both for financial institu- ing loans, putting strains on bank capital positions. tions and financial markets, in 2008 and 2009. Also, Stress-testing analysis performed during the recent the framework highlights that the crisis has halted, Financial Sector Assessment Program (FSAP) (IMF at least temporarily, Romania’s increases in financial 2009) suggested that some banks were at risk of depth. dimensions. More specifically, the chap- with this report, should help country offi- ter also documents developments during cials, researchers, and anybody else with the global financial crisis, not only in terms interest in the matter to better benchmark of financial instability, but also in terms of financial systems. The Statistical Appendix financial depth, access, and efficiency. to the report includes country tables with Despite the remarkable progress in gather- select indicators, as well as aggregates across ing data and information on financial systems regions and income groups. A pocket edi- around the world in recent years, researchers’ tion of the database is also made available as and practitioners’ ability to properly mea- Little Data Book on Financial Development. sure financial systems has been constrained Finally, readers are encouraged to go online by lack of comprehensive data. The data that and explore this large and interesting source are being made publicly available, together of data by themselves.
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 41 Future versions of the Global Financial new trends or observations, and they willDevelopment Report will revisit issues of focus on the relevant theme at hand, such asmeasurement of financial systems around the financial inclusion or capital market develop-world. They will also report on substantial ment, or other issues of policy relevance.Chapter 1 Annex: Overview of the Data SourcesUnderlying the Global Financial DevelopmentDatabaseThis annex is a summary. For more on the The Doing Business database (http://Global Financial Development Database, www.doingbusiness.org/data), a part of theincluding the individual country data and Doing Business project, offers an expansivemetadata, see this report’s Statistical Appen- array of economic data in 183 countries,dix and the Global Financial Development covering the period from 2003 to the pres-Report website at http://www.worldbank ent. The data cover various aspects of busi-.org/financialdevelopment. ness regulations, including those relevant to Database on Financial Development and financial sector development issues, such asStructure (updated November 2010). This enforcing contracts and obtaining credit.database was used a starting point for many IMF’s Access to Finance database (http://of the basic indicators of size, activity, and fas.imf.org/) aims to systematically measureefficiency of financial intermediaries and access to and use of financial services. Fol-markets. Beck, Demirgüç-Kunt, and Levine lowing Beck, Demirgüç-Kunt, and Martínez(2010) describe the sources and construction Pería (2007), the database measures the reachof, and the intuition behind, different indica- of financial services by bank branch network,tors and present descriptive statistics. and availability of automated teller machines, Bankscope (Bureau van Dijk, http:// and does so by using four key financialw w w.bvdinfo.com / Products/Company- instruments: deposits, loans, debt securitiesInformation/International/BANKSCOPE issued, and insurance. The website contains.aspx) was used to obtain and update data on annual data from about 140 respondents forbanks. Bankscope combines widely sourced the six-year period, including data for alldata with flexible software for searching and G-20 countries.analyzing banks. Bankscope contains com- The Global Financial Inclusion Indexprehensive information on banks across the (Global Findex) is a new database of demand-globe. It can be used to research individual side data on financial inclusion, which docu-banks and find banks with specific profiles ments financial usage across gender, age,and analyze them. Bankscope has up to 16 education, geographic regions, and nationalyears of detailed accounts for each bank. income levels. The core set of indicators and Bloomberg (http://www.bloomberg.com/), subindicators of financial inclusion, based onDealogic (http://www.dealogic.com/), and the Global Findex database, includes Use ofThomson Reuters Datastream (http://thom bank accounts (% of adults with an accountsonreuters.com/products_services/financial/ at a formal financial institution, purpose offinancial_products/a-z/datastream/) were accounts, frequency of transactions; % ofused to obtain higher frequency data on adults with an active account at a formalstock exchange and bond markets that were financial institution, mode of access); Savingsaggregate on a country level. (% of adults who saved in the past 12 months
42 e n c h m a r k i n g b financial systems around the world GLOBAL financial DEVELOPMENT REPORT 2013 using a formal financial institution, % of Bank for International Settlements (BIS) adults who saved in the past 12 months using (http://www.bis.org/) statistics were used for an informal savings club or a person outside the aggregate data on bond statistics, includ- the family, % of adults who otherwise saved ing domestic debt securities by residence in the past 12 months); Borrowing (% of and type of instrument (bonds and notes vs. adults who borrowed in the past 12 months money market instruments, issued by finan- from a formal financial institution, % of cial and nonfinancial corporations; based on adults who borrowed in the past 12 months publicly available or country-reported data). from informal sources, % of adults with an Domestic debt securities (Quarterly Review outstanding loan to purchase a home or an Table 16) for a given country comprise issues apartment); Payments (% of adults who used by residents in domestic currency targeted at a formal account to receive wages or govern- resident investors, whereas international debt ment payments in the past 12 months, % of securities (Quarterly Review Table 11) are the adults who used a formal account to receive ones targeted at nonresidents (a) in domes- or send money to family members living else- tic currency on the domestic market, (b) in where in the past 12 months, % of adults domestic and foreign currency on the inter- who used a mobile phone to pay bills or send national market, plus (c) the issues in foreign or receive money in the past 12 months); currency in the domestic market (further Insurance (% of adults who personally pur- information can be found in the Guide to chased private health insurance, % of adults the International Financial Statistics, http:// who work in farming, forestry, or fishing and www.bis.org/publ/bppdf/bispap14.htm). personally paid for crop, rainfall, or livestock Two different collection systems are used insurance). (s-b-s for international debt securities and Financial Soundness Indicators database aggregated data for domestic debt securities), (http://fsi.imf.org/), hosted by the IMF, dis- resulting in some possible overlap (between seminates data and metadata on selected domestic debt securities and international financial soundness indicators provided by debt securities) and inconsistencies (classifi- participating countries. cation of issuers). World Development Indicators (http:// Country authorities’ websites were used to data.worldbank.org/data-catalog/world- reconfirm and fill in some of the gaps in the development-indicators) is the primary World data. Bank collection of development indicators, compiled from officially recognized interna- tional sources. It presents the most current NOTES and accurate global development data avail- 1. See http://www.copenhagenconsensus.com. able, and includes national, regional, and Among the top 30 solutions, microfinance global estimates. was considered as a way to improve liveli- International Financial Statistics (http:// hoods of poor women, but this topic did not elibrary-data.imf.org / FindDataReports. make it to the top 10. aspx?d=33061&e=169393), from the IMF, 2. This is not the only approach to classifying the provides is a standard source of international functions provided by the financial system, statistics on all aspects of international and but it is not dramatically different from other approaches (such as Merton 1992; Merton domestic finance. It reports, for most coun- and Bodie 2004), and it is an approach that tries of the world, basic financial and eco- fits rather well with the large finance litera- nomic data on international banking, money ture, including recent research. and banking, interest rates, prices, produc- 3. In the empirical literature, identifying the tion, international transactions, international impact of finance has sometimes proved liquidity, government accounts, exchange challenging. Some of the early literature on rates, and national accounts. the subject requires the problematic iden-
GLOBAL financial DEVELOPMENT REPORT 2013 b e n c h m a r k i n g f i n a n c i a l s y s t e m s a r o u n d t h e w o r l d 43 tifying assumption that legal origins matter 8. See annex. for development only through their impacts 9. For example, many central banks around the on finance. But subsequent papers have world publish reports focused almost exclu- tried more nuanced and more persuasive sively on financial stability (Čihák, Muñoz, approaches to identification (such as Rajan Teh Sharifuddin, and Tintchev 2012). Simi- and Zingales 1998). larly, the IMF’s Global Financial Stability 4. The database builds on previous work within Report has a clear stability focus. There are, the World Bank Group, in particular the rel- however, many complementarities between evant papers by Beck, Demirgüç-Kunt, and financial stability, depth, access, and effi- Levine (2000, 2010) and Beck and others ciency, as emphasized for instance in the (2006). The database also builds on Finan- World Bank–IMF’s Financial Sector Assess- cial Soundness Indicators database (http:// ment Program. fsi.imf.org/) and the Financial Access Survey 10. Ranciere, Tornell, and Westermann (2008), (http://fas.imf.org/). There are several major for example, find that countries that have sets of data. Chapter 1 annex provides a basic experienced occasional financial crises have, description of the data sources. The Statisti- on average, grown faster than countries with cal Appendix at the end of the report shows stable financial conditions. country-by-country data for 2008–10. In contrast, efficiency seems surprisingly 11. 5. The data source is IMF’s International Finan- relatively high in Middle East and North cial Statistics (see annex). Private credit iso- Africa, as well as in South Asia. This is in lates credit issued to the private sector and part because an important part of bank lend- therefore excludes credit issued to govern- ing goes to large companies and to the public ments, government agencies, and public sector, leading to relatively lower reported enterprises. Private credit also excludes credit margins. issued by central banks. 12. To put this in a more anthropomorphic per- 6. This report includes other measures as well. spective, the tallest adult person on earth is Also relevant are indicators of structure less than 5 times taller than the smallest per- within the individual financial segments, son (http://www.guinessworldrecords.com). such as the concentration ratios (Herfindahl 13. For example, Rioja and Valev (2004) find index, shares of various types of financial (a) no statistically significant relationship institutions in total assets and in GDP, and between finance and growth at low levels of shares of individual markets in total market financial development, (b) a strong positive capitalization). Some of these measures (for relationship at intermediate levels of financial example, the percentage of assets of the three development, and (c) a weaker but still posi- or five largest financial institutions in GDP) tive effect at higher levels of financial devel- are important for the stability dimension, opment. Arcand, Berkes, and Panizza (2011) because they provide a rough approximation find that finance actually starts having a nega- for the potential for impact in the case of a tive effect on output growth when credit to major financial disruption. the private sector exceeds 110 percent of GDP. 7. Financial structure differs markedly across Similarly, Cecchetti and Kharroubi (2012) economies. Over the full sample period, the find that the aggregate productivity growth annual average value of the financial struc- in an economy increases with private sector ture ratio is 279. Countries such as Austra- credit to GDP, but only up to a point; after lia, India, Singapore, and Sweden have this that point, increases in private sector credit ratio at or below 2.35 (10th percentile), while to GDP are associated with lower aggregate Bolivia, Bulgaria, Serbia, and Uganda are productivity growth. examples of countries where this ratio is over 356 (90th percentile).
2 The State as Regulator and Supervisor • inancial sector regulation and supervision are areas where the role of the state is not F in dispute; the debate is about how to ensure that the role is carried out well. • key challenge of regulation is to better align private incentives with public interest, A without taxing or subsidizing private risk taking. Supervision is meant to ensure the implementation of rules and regulations. It needs to harness the power of market dis- cipline and address its limitations. • he financial crisis underscored limitations in supervisory enforcement and market dis- T cipline. It emphasized the importance of combining strong, timely, anticipatory super- visory enforcement with better use of market discipline. It also highlighted the impor- tance of basics—solid and transparent legal and institutional frameworks to promote financial stability. In many developing economies that means that building supervisory capacity needs to be a priority. • seful lessons can be learned by analyzing regulation and supervision in economies U that were at the epicenter of the global financial crisis and those that were not. A new World Bank global survey, presented in this chapter, suggests that economies that suf- fered from the crisis had weaker regulation and supervision practices as well as less scope for market incentives than the rest. • his chapter reviews progress on regulatory reforms at the global and national levels, T and identifies advances made so far. Tracking changes during the crisis reveals that countries have stepped up efforts in the area of macroprudential policy, as well as on issues such as resolution regimes and consumer protection. However, the survey sug- gests that there is further scope for improving market discipline, namely disclosures and monitoring incentives. • he financial crisis has triggered a healthy debate on approaches to regulation and T supervision among regulators, policy makers, and academics, leading to multiple pro- posals for further reforms. These proposals aim to limit regulatory arbitrage and make better use of regulatory resources. Common themes of these proposals are calls for more transparency and simpler regulation to enhance accountability, as well as for more proactive efforts to identify and address incentive problems. g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 45
46 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 F or years, developed economies enjoyed analyses can provide insight to policy mak- stable macroeconomic conditions— ers and regulators designing reforms aimed at often referred to as the Great Modera- making financial systems more resilient and tion—where developments in the financial efficient. sector were often considered major contribu- After the onset of the crisis, there was tors to financial stability and thus to economic much talk about using the crisis to push growth.1 This has been followed by a phase through needed reforms. At the global level, of deep instability, in which major financial the G-20 has mandated the Financial Stabil- institutions collapsed and financial markets ity Board (FSB), after its transformation in malfunctioned. 2009, to promote the coordinated develop- Because of the central role that financial ment and implementation of effective regula- sectors play in market economies, govern- tory, supervisory, and other financial sector ments and major central banks intervened policies. 2 As part of this regulatory reform to avoid the collapse of the economic sys- agenda, the Basel Committee has prepared tem. Massive rescue packages and unortho- new capital and liquidity requirements for dox monetary measures were used to lower banks under the third Basel framework, market participants’ risk aversion to tolerable Basel III. On the national level, many econ- levels and to avert the worst scenarios. This omies have enacted or are considering new frantic activity presented a striking contrast laws and regulations in response to the les- with the sanguine attitude of investors and sons from the crisis. The crisis has also led supervisors in the years before the crisis, to an active policy debate among regulators, when the excesses of financial institutions policy makers, and academics, giving rise to were allowed to grow unhampered. multiple reform proposals. The global financial crisis that began in Much has been done, but is it appropri- 2007 and intensified with the collapse of ate? And will it be sufficient to reduce the Lehman Brothers in 2008 presented a major likelihood and severity of future financial test of the international architecture devel- crises? The key questions addressed in this oped to safeguard the stability of the global chapter are: What is the early thinking on financial system—and the architecture transforming regulatory practices around largely failed. the world? What are the specific issues for Although there is some consensus on emerging markets and developing economies attributing to financial markets an impor- (EMDEs)? What should be the role of the tant component of procyclicality, the reasons state as regulator and supervisor of the finan- behind the absence of decisive preemptive cial sector?3 This chapter reviews some of supervisory action in the run–up to the cri- the lessons from the crisis and the responses sis are still a subject of debate. Some analysts proposed to address them, including those emphasize the weaknesses in policy making. reflected in the World Bank’s updated survey Others blame the trend toward deregulation. of bank regulation and supervision practices Yet others emphasize problems with incen- around the globe. The chapter summarizes tives in the financial markets and the regula- the progress made through recent regulatory tory and supervisory framework. reforms, as well as some promising new ideas Whatever the relative importance of these and reform proposals. factors, the crisis has thrust into the spotlight There is no major debate on whether the major shortcomings in regulation and super- state should be in regulation and supervision. vision, in the capacity of market discipline to Though the benefits of, for example, direct promote financial stability, and in the sound- state ownership of financial institutions are ness of national and international arrange- often disputed, the importance of the state ments for crisis management and surveil- regulating and supervising the financial sector lance, reopening debates and analyses in all is well established in the economic and finan- these areas. The results of these debates and cial literature. The case for financial sector
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 47regulation has been built around the fol- supervision (Laffont and Tirole 1993; Stiglerlowing market failures:4 (a) anticompetitive 1971). According to some authors, that hasbehavior, (b) market misconduct, (c) infor- contributed to the financial crisis (Johnsonmation asymmetries, and (d) systemic insta- and Kwak 2010). So the real question is howbility. These failures can impair the capacity best to ensure that regulation and supervisionof financial markets to deliver efficient out- support sound financial development.comes and justify regulatory intervention if Shortcomings in private and public institu-the benefits outweigh the costs. The first two tions have to be addressed in a comprehen-market failures give rise to inefficiencies that sive way, focusing on the roots of the crisis,need to be resolved through market regula- instead of its consequences. This approachtion, while the last two underpin the case for entails correcting weaknesses prevalent beforeprudential regulation. Regulation aimed at the crisis in many financial markets and insti-curbing anticompetitive behavior is needed tutions, including their supervisory bod-to foster an efficient allocation of resources ies (such as deep information asymmetries,and intermediation of funds. Market miscon- distorted incentives, defective governanceduct regulation is needed to ensure that par- arrangements, and defective accountability).ticipants act with integrity and that sufficient Doing so would improve market discipline byinformation is available to make informed providing information to market participantsdecisions. Information asymmetries have tra- and supervisory bodies if inefficient risk tak-ditionally served as the main justification for ing is sufficiently and timely penalized beforeprudential regulation, but experiences in the the correction of excesses entails prohibitivefinancial crisis have raised the importance costs for the whole economic system. But itattributed to prudential regulation in pre- also implies that, given the limits of marketventing systemic instability. discipline (due to, for example, coordination States’ regulation and supervision (usually problems, fallacy of composition, and herddone via autonomous or semiautonomous behavior), a complementary and equally nec-agencies) can improve welfare by provid- essary role is reserved for well-designed regu-ing the monitoring functions that dispersed latory and supervisory action.counterparts (in particular, depositors, Because of the crisis, much focus has beenshareholders, and bondholders) are unable placed on regulating and monitoring sys-or unwilling to perform (Barth, Caprio, and temic risk. Indeed, using the latest round ofLevine 2006). For example, Dewatripont the World Bank’s survey of regulatory andand Tirole (1994) develop a model of banks’ supervisory practices around the world, thiscapital structure, showing how optimal chapter confirms that countries have steppedregulation can be achieved using a combina- up efforts on macroprudential policy, as welltion of basic capital adequacy requirements as on resolution regimes and financial con-with external intervention when those are sumer protection. All these efforts place moreviolated, with elements of market discipline demands on supervisors, which introducesbeing an important complement (though not greater burden in smaller and lower-incomea substitute) to this regulation. Dewatripont economies where supervisory capacity isand Tirole, as well as other authors, see the already constrained.key challenge for regulation as providing Breakdowns in incentives are a unify-the right incentives to managers of financial ing theme when discussing the roots of theintermediaries. Regulation is seen as a “speed crisis (see Calomiris 2011; Demirgüç-Kuntbump”—a term coined by Joseph Stiglitz— and Servén 2010; Levine 2010, 2011; Rajanmitigating managers’ incentives to gener- 2010). Misaligned incentives in the financialate profits by rapid growth. Politicians and markets and in the regulatory and supervi-regulators are often subject to intense pres- sory framework were among the key factorssure from regulated firms to modify regula- contributing to the crisis. Incentive conflictstions, resulting in suboptimal regulation and help explain how securitization went wrong,
48 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 why credit ratings proved inaccurate, and and exit, healthy competition, and disclosure why the crisis cannot be blamed on mark- of quality information, combined with strong to-market accounting or an unexpected loss and timely supervisory action, are essential of liquidity. Contradictory market, bureau- in getting this balance right. But by revealing cratic, and political incentives undermined limits of market and regulatory discipline, financial regulation and supervision (Caprio, the crisis has led to a policy debate on the Demirgüç-Kunt, and Kane 2010). Insufficient right approach to regulation and supervision. incentives to enforce the existing rules (Barth, This ongoing debate continues to inform reg- Caprio, and Levine 2012a), combined with a ulatory reforms. lack of capacity, resulted in regulations that were not applied and supervisory powers that Some Lessons from the were not used in the years leading to the cri- Global Financial Crisis sis. Reducing the likelihood of future crises therefore requires addressing these incentive The global financial crisis—which began issues; along these lines the chapter discusses in 2007 and intensified with the collapse of reform proposals that emphasize greater Lehman Brothers in September 2008—pro- transparency and disclosure, importance of vided a fundamental test of the international incentive compatibility in reforms, and sim- architecture, developed to safeguard the ple regulation. global financial system (Rajan 2010). Besides Transparency and disclosure of good macroeconomic factors, the main contribut- information, coupled with the right incen- ing factors identified by scholars and policy tives, help make market participants behave makers include major regulatory and super- in ways consistent with the public interest. visory failures, together with failures in other Complicated regulation is not desirable, since parts of the financial system, such as gover- it is harder to implement and supervise, par- nance of private institutions, rating agencies, ticularly in smaller and less developed econo- accounting practices, and transparency. 6 mies with lower supervisory capacity. In most This section concentrates on the shortcom- middle-income and nearly all low-income ings identified by the crisis in micropruden- economies, basic regulations, combined with tial regulation and supervision and market strong supervision and enforcement of trans- discipline. parency, are a better approach. Market disci- The chapter’s focus on shortcomings and pline is not a panacea, but it is an important areas for improvement does not mean that all ingredient in the regulatory and supervisory precrisis regulation failed, or that all super- mix. When regulation is ineffective, market visors performed uniformly badly. Supervi- discipline often breaks down, as illustrated in sion in many jurisdictions has actually per- the recent crisis. formed well. Within advanced economies, This chapter acknowledges the progress Australia, Canada, and Singapore have been made by recent global regulatory reforms, mentioned among examples of countries which include measures to address moral that withstood the global crisis rather well, hazard in too-big-to-fail institutions, abu- in part as a result of their prudent supervi- sive compensation policies, undue activity sory approaches (Palmer and Cerrutti 2009). with over-the-counter derivatives, and biased Also, many emerging markets and develop- credit ratings. It also discusses reform pro- ing economies had limited exposure to the posals that argue for taking these reforms risky behaviors that precipitated the crisis, further, as well as new approaches to regula- and most of these countries averted out- tion and supervision.5 right distress in the financial system partly The challenge of financial sector regula- because of their conservative prudential and tion is to align private incentives with the supervisory practices. Malaysia and Peru are public interest without taxing or subsidizing just two countries that have been praised for private risk taking. Threats of market entry their prudential policies.7 Nonetheless, some
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 49emerging market countries suffered direct management purposes. These risks were espe-impacts of the crisis, especially in Europe and cially great in the case of large and intercon-Central Asia, which need to be seen against nected banks.8 Similarly, many of the credita background of a heavy reliance on par- ratings produced in the run-up to the crisisent bank funding and a buildup of funding failed to properly reflect systemic risk, rais-imbalances in the run-up to the crisis. ing questions about the role for credit ratings in the regulatory framework. These examples underscore the broader point: supervising theWeaknesses in regulation safety and soundness of individual financialand supervision institutions, though very important, does notA major weakness in the precrisis approach necessarily lead to a financial system that isto regulation and supervision was that it robust and stable, thus demonstrating thefocused on risks to individual institutions and importance of following the example of thosedid not sufficiently take into account what a supervisory bodies that have been tradition-confluence of risks implies for the financial ally incorporating systemwide considerationssystem as a whole (systemic risk). Thus the in their supervisory evaluations.crisis raised questions about the effectiveness The second weakness was that the pru-of narrowly focused microprudential policy dential approach suffered from regulatoryin preventing systemic risk. Such approaches “silos” along functional and national lines.seek financial stability by focusing on the The approach focused on the risks in individ-safety and soundness of individual financial ual institutions and in their legal form, withinstitutions, with emphasis on institutions separate approaches for regulation and super-accepting retail deposits. Because questions vision of banks, insurance, and securitieshave been raised on whether this amounts not complemented by strong oversight at theto financial stability, many supervisory bod- financial group level and systemic level. Thisies, in their risk evaluations, take into con- approach allowed transactions to be chan-sideration systemwide developments to assess neled through the entities that were subject totheir potential repercussions for individual weaker regulation, and for transactions to beinstitutions and for the whole system. conducted in the gaps between the regulatory If an institution or market fails, the impact silos to avoid regulation altogether. The rapidon the financial system and economy can growth of the shadow banking system was aexceed the losses sustained by individual case in point. The emergence of the shadowinstitutions or markets. A microprudential banking system in the United States needsapproach that sets regulations and conducts to be seen against the background of differ-supervision to limit the risk in an individual ent regulatory approaches toward deposit-institution does not necessarily limit the risk taking banks and other less-regulated seg-to the financial system. For example, the ments of the financial system. By drawingpush for Basel II implementation led in some a “line in the sand” and separating deposit-jurisdictions to increased emphasis on banks’ taking banks from other entities (includinginternal models and on credit rating agencies investment banks), and by placing risky activ-to evaluate risk. But the implementation of ities in separate legal entities such as special-banks’ internal models focused on the risks in purpose vehicles, policy makers expected thatthe banks’ own balance sheets (private risks), the prudentially regulated segment—primar-and did not adequately take into account the ily the deposit-taking banking sector—wouldrisks posed by individual banks to the finan- be isolated from difficulties in the unregu-cial system as a whole (systemic risk, or pub- lated segment of the financial system thatlic risk). In addition to this regulatory issue, was populated by well-informed professionalmany financial institutions also suffered from investors. In addition to these functionalpoor risk management surrounding the mod- silos, there are also national silos: whereas theels that they used for their own internal risk regulated entities have become increasingly
50 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 global, financial regulation is national, and adequately capture lending concentration, cross-border regulatory cooperation—despite excessive maturity transformation, and— some progress—still faces serious incentive especially in small, open developing econo- problems and broke down in the face of crisis mies—the indirect credit risk associated with pressures (box 2.1). foreign exchange exposures of unhedged bor- Third, some microprudential regulations rowers. Moreover, the rules encouraged risk were poorly designed, contributing to sys- transfers to entities that were legally separate temic risk. The Basel capital adequacy mea- but not separately capitalized. When market sures considerably misrepresented the sol- sentiment with regard to complex, structured vency of banks. There were various reasons products started to deteriorate, parent banks for this, including the use of risk weights that felt compelled for reputational reasons to underestimated the riskiness of assets such shoulder the losses in those entities.10 Risk as mortgages and sovereign debts, the differ- was also transferred in nontransparent ways ent treatment under the Basel rules of assets owing to the rapidly increasing trade in com- held in banking books and those in trading plex, structured financial products, which books, and the definition of capital.9 The often underwent successive repackaging and regulatory framework has also struggled to sale. Because of these layers of opacity, the Box 2.1 Distorted Incentives: Subprime Crisis and Cross-Border Supervision Distorted incentives at various levels were a main cies were aware of the growing fragility of the finan- cause of the financial crisis. For example, the poli- cial system associated with their policies during the cies to promote home ownership in the United decade before the crisis, yet they chose (under pres- States created perverse incentives within official and sure from the industry and politicians) not to modify quasi-official agencies, contributing to the buildup those policies. of exposures in subprime mortgages, and to for- Distorted incentives have also played an impor- bearance in regulation and supervisory oversight tant role in regulation and supervision of financial (Calomiris 2011; Wallison and Calomiris 2009). institutions across several jurisdictions. Supervisory Regulation also played a role in distorting incen- memorandums of understanding and supervisory tives for rating organizations to conduct appropriate colleges have been used to strengthen cross-border due diligence. Other issues included moral hazard supervision. And some of the colleges have been associated with too-big-to-fail policies (Ötker-Robe useful in good times. But in times of crisis, cross- and others 2011), adverse selection associated with border cooperation almost always breaks down, as the rules for assessing the creditworthiness of bor- during the Fortis failure in 2008. This and many rowers, and the principle or agent problems within other examples confirm that the supervisory task financial institutions, related to the nature of own- sharing anchored in the Basel Concordat of 1983 is ership and the structure of executive compensa- not crisis-proof, reflecting misalignments in underly- tion that favored risk taking and higher short-term ing incentives (D’Hulster 2011). Without an agreed returns to the longer-term detriment of shareholders. resolution and burden-sharing mechanism and with Levine (2010) finds that the design, implementa- deteriorating health of the bank, incentive conflicts tion, and maintenance of financial policies in 1996– escalate and supervisory cooperation breaks down. 2006 were primary causes of the financial system’s Thus, good practices for cooperation among super- demise. He rejects the view that the collapse was visors are insufficient to address the incentive con- only due to the popping of the housing bubble and flicts. D’Hulster (2011) calls for rigorous analysis the herding behavior of financiers selling increas- and review of the supervisory task sharing, so that ingly complex and questionable financial products. the right incentives are secured during all stages of Rather, the evidence indicates that regulatory agen- supervision
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 51extent to which individual financial insti- climate dampened incentives for analysts oftutions were exposed to these toxic assets financial stability to dig deeper and ques-became increasingly nontransparent. So tion the adequacy of the information andthough individual banks’ regulatory capital the underlying benign assumptions on whichpositions appeared sound, some were not, their analysis was based. The crisis alsoand the capital adequacy of the financial sys- revealed severe shortcomings in resolutiontem was weakened, increasing systemic risk. frameworks, especially for large financial Fourth, implementation of the rules was institutions active in multiple jurisdictions.constrained by the capacity and incentivesof regulators and supervisors. Supervisory Capacity constraints in regulationresources became stressed as financial insti- and supervisiontutions, instruments, and regulation grewmore complex. Information on exposure and In many developing economies and emerg-risk became harder to compile as financial ing markets, weak supervisory capacity andgroups became more complex and intercon- a lack of regulatory independence are atnected, with operations both locally and least as important as gaps in the regulatoryoverseas, and spanned many business lines. framework in explaining fragility. Nearly allThe regulators also faced conflicts of interest, assessments of developing economies underwith some mandated to promote financial the Financial Sector Assessment Programsystem development as well as supervise it.11 (FSAP) find capacity constraints in regulationSome regulators lacked independence, and and supervision. In many of these economies,even supervisors that were legally indepen- licensing and closure decisions are still vesteddent found it difficult to withstand pressures with ministries of finance rather than bankfrom the industry.12 The “revolving door” regulators, which gives rise to a risk of politi-moving staff between supervisory authorities cal interference in these critical decisions, asand the financial industry—though hard to well as delays in early intervention in the caseavoid completely because having an industry of fragile and weak banks. In many countriesbackground and familiarity with financial in Sub-Saharan Africa, for example, supervi-instruments helps in understanding risks— sory resources are limited, including qualifiedresulted in perceptions of conflicts of interest staff and the availability of analytical toolsfor some supervisors (Kane 2007). It has also and skills. Supervisory processes focus onbeen suggested that supervisors exercised compliance with regulatory standards but areregulatory forbearance on the treatment of not set up to identify and manage the chang-subprime mortgages because of political con- ing risks in banking systems. In addition, thesiderations. Across borders, misalignments in ability to monitor risk at the institutional andincentives between home and host supervi- systemic level is hampered by insufficientsors impede cross-border sharing of supervi- quality in data and reporting processes.sory information (box 2.1). The West African Economic and Mon- Finally, shortcomings in crisis manage- etary Union Banking Commission, for exam-ment and surveillance compounded several of ple, lacks sufficient power to enforce correc-the problems identified above. In particular, tive measures in cases of noncompliance withinformation gaps and asymmetries limited regulations, a situation that has only recentlythe capacity of financial stability assessors to begun to be addressed by political authoritiesmonitor exposures, risk transfers, and threats (Beck and others 2011). Ill-suited regulations,to systemic stability. It was difficult to know such as on preapproval of loan applications,how the failure of one institution would are often ignored, undermining supervisoryaffect others. Systemically important seg- discipline. To ensure certainty and supervi-ments of the financial system were not cov- sory discipline, such outdated regulationsered by surveillance and crisis management should be dropped and the focus shifted toarrangements. The political and economic enforcing meaningful ones. Suggestions to
52 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013Table 2.1 Examples of Weak Supervisory Capacity Identified in the FSAPBangladesh FSA 2010 “Although the government has improved the prudential regulatory and supervisory framework for banks, further improvement would be needed to bring the system up to international standards. Loan classifica- tion, provisioning, rescheduling, and even capital in banks appears uneven and needs strengthening to be brought to international standards.”Barbados FSA 2009 “To assure continued financial stability and competitiveness, important regulatory and remaining super- visory weaknesses in the financial system also should be addressed. The prudential oversight of the banking sector could be strengthened by enhancing supervisory capabilities, accelerating the transition to risk-based banking supervision, tightening supervision of large exposures and exposures to related par- ties, improving the criteria for asset classification and provisioning, improving consolidated supervision for banking groups and regional financial conglomerates, and establishing more active home-host supervisory cooperation arrangements.”Burundi FSA 2009 “The supervisory approach adopted by the [central bank] BRB is still largely based on monitoring compliance with laws and regulations, despite the fact that the international trend favors the risk-based approach. The level of supervision could also be stepped up by developing closer surveillance methods so as to have greater visibility with respect to the major risk areas and fragilities of each establishment.”Haiti FSSA 2008 “Supervisory procedures appear largely adequate, but the capacity of the supervisory function should be improved. Its operational autonomy can be strengthened in the context of greater central bank indepen- dence. The current staffing of the DBS seems insufficient, and its budget needs to be increased in a sustained manner, while supervisory staff skills should be upgraded through training focused on banking and risk management.”Lithuania FSA 2008 “Resolving these issues requires an urgent review of supervisory arrangements for Lithuanian financial markets. Future supervisory arrangements should be designed with the objectives to (i) strengthen capacity to supervise the interactions of banks with their related entities; . . .”Mozambique FSA “(ii) increase capacity of BM’s supervisory staff, especially in the areas of2009 on-site inspections and risk management”Papua New Guinea “Enhance the capacity of the supervisory staff through training, so that the BPNG can move to fullFSSA 2011 risk-based supervision. The BPNG should assert itself more rigorously to ensure full compliance with the supervisory regime. It is good to seek consensus but less desirable to leave necessary prudential statements in draft for over five years (as has happened with the revised large exposures prudential standard). With new tools and the complete suite of regulations recommended above, the BPNG will be in a position to ensure good risk management practices are followed and move to risk-based supervision. It will need further assistance to build capacity to achieve this, so that its committed and professional staff can work in partnership with financial businesses to focus on identifying and managing the key risks in the sector.”Source: World Bank FSAP website (http://worldbank.org/fsap). improve supervisory capacity are among the economy poses significant risks if steps are most common recommendations in FSAPs. taken too fast or not sequenced appropriately, For example, the 2011 FSAP assessment on given “considerable capacity constraints for El Salvador noted that, despite an ambitious qualified personnel in financial institutions project to move toward risk-based supervi- and in financial sector supervision.” (For sion, “it is essential to further upgrade super- additional examples, see table 2.1.) visory capacity, both in quantitative and in These deficiencies weigh increasingly in qualitative terms” and that “the existing a globalized world that is moving toward regulatory framework has significant gaps.” more complex regulations. The survey results In another recent example, the 2011 FSAP show that a move toward Basel II and Basel assessment on Rwanda warns that the ambi- III and the increased complexity of postcrisis tious agenda to improve access to finance regulations are adding pressures on resource and provide more long-term financing to the requirements. In line with these observations,
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 53a recent joint report by FSB, International but also some emerging markets) relied onMonetary Fund (IMF), and World Bank market discipline to safeguard financial(2011), endorsed by G-20 leaders in the soundness and stability. Market disciplineCannes Summit, calls for countries that have requires that markets objectively assess theless internationally integrated financial sys- risks and value of financial instrumentstems or substantial constraints in supervisory and financial institutions, and price themcapacity to focus on reforms to ensure compli- accordingly.ance with the more basic principles of sound The crisis has made it clear that suchregulation before considering a move to the objective market valuation does not alwaysBasel II and Basel III standards. The same occur. For example, in the first half of 2007,report also calls for further development of the stock market valuation of Irish bankssupervisory capacity in developing economies was at or close to their long-term maximum.through targeted and well-coordinated tech- Also, spreads between Greek debt and Ger-nical assistance and other capacity-building man bund were very small for years, as wereactivities. These efforts need to be part of a the spreads of other euro area countries,broader, sustainable strategy to overcome not providing much indication of what wascapacity constraints in regulation and super- to take place. Similarly, credit default swapvision in developing economies. spreads for southern European countries Strengthening of supervisory capacity were negligible for many years comparedand improvements in regulations are areas to their peers in Northern Europe, whichwhere donors can provide help. One of the allowed some countries to go on a lendingtools in this regard is the Financial Sector binge for many years. It was only throughReform and Strengthening (FIRST) Initia- the economic slowdown during the crisis andtive, a multi onor grant facility managed by d escalation of events in Greece that marketthe World Bank. Strengthening supervisory perceptions started to change substantiallycapacity and improving regulations account and credit default swap spreads on govern-for more than a half of FIRST’s recent proj- ment paper shot up (and became more closelyects. Individual donors have also provided correlated with bank risk measures).support directly to various projects aimed at These observations are reminders of thestrengthening capacity in regulatory agencies. tendency of economic agents and the finan-For example, the State Secretariat for Eco- cial system to be overly tolerant of risk innomic Affairs (SECO) in Switzerland has an credit cycle upswings and excessively riskextensive program of banking sector training averse in downswings. Put differently, thein Vietnam, which includes practical train- failure of market discipline needs to be seening for the regulatory body, complemented against the collective tendency of financialby a train-the-trainer project for Vietnam’s markets to underestimate risks in boom timestwo largest universities, management train- and overestimate it in times of bust.ing for bank managers, and technical assis- Still, the failures of market discipline intance in modernizing the central bank and its the run-up to and during the crisis do notstrategy to develop the banking sector. (For mean that financial markets did not pro-information on SECO’s programs in the area vide useful signals. As shown for exampleof capacity building, see the relevant back- by Haldane (2011), equity markets were dif-ground materials at http://www.worldbank ferentiating between banks in trouble and.org/financialdevelopment.) those that were not several years before the financial crisis, when intervention could have vastly reduced the subsequent costs.Weaknesses in market discipline Papers that examined previous crises findand the role of incentives similar relationships. Markets can provideBefore the crisis, financial systems in many useful signals, but the real question is, whenjurisdictions (especially advanced economies, do they provide such signals? And how can
54 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 these signals be caught by market agents and ample evidence that large financial institu- supervisors? tions enjoyed an implicit market subsidy The idea of market discipline rests on prior to the crisis, consistent with the moral the notion that, given the right incentives hazard associated with too-big-to-fail poli- and information, rational market par- cies (Goldstein and Véron 2011; Ötker-Robe ticipants would penalize institutions that and others 2011). They could take on more take on excessive risk. The Basel II capital risk and expand their balance sheets rapidly framework sought to expand the role of to boost short-term profits without having market discipline in the regulatory frame- to increase their capital. Indeed, one long- work. Rating agencies were given a role in known problem that came to the fore dur- the evaluation of the risks in the portfolio ing the crisis was the too-big-to-fail problem under so-called Pillar I (Minimum Capi- (Rajan 2010), in which institutions that are tal Requirements), and an explicit role for too large or too interconnected to be allowed market discipline was introduced under to fail are given more favorable treatment so-called Pillar III (Market Discipline). during crises. This condition severely dis- Reliance on markets to safeguard financial torts their risk-taking incentives during nor- stability was also evident well beyond the mal times by undermining market discipline Basel rules. It was reflected, for example, in to be exercised by their unsecured debtors the limited attention by officials to the risks and transaction counterparts. The implicit posed by unregulated entities in the shadow assumption is that given the prohibitive banking system or to the lack of informa- consequences of failure of these large and tion on risk transfers.13 The assumption was highly interconnected financial institutions, that the regulated financial institutions have policy makers will do whatever it takes to incentives to be prudent in managing expo- prevent these institutions from collapsing. sures to their counterparties. This expectation translates into a fund- But market discipline in the run-up to the ing advantage and skews incentives toward crisis did not work well—mainly because leveraging and risk taking.14 The problems incentives of market players were distorted associated with the too-big-to-fail condition and they did not have access to the needed are often exacerbated by shortcomings in the information. Many institutions and instru- resolution framework for failing financial ments were allowed to grow highly com- institutions, especially when they operate plex and nontransparent. Information on across borders. In most cases, these weak- interconnections and exposures of finan- nesses originate in insolvency frameworks cial institutions was lacking. The increasing that do not distinguish between financial use of over-the-counter financial derivatives companies—especially banks—and nonfi- enabled financial institutions to transfer or nancial corporations. Part of the answer is to to take on risk in nontransparent ways, rap- strengthen bank resolution frameworks and idly and without the necessary capital for to put greater emphasis on resolvability in ultimate risk-taking institutions to be able to the context of ongoing supervision, also by withstand losses when they became appar- demanding that banks establish their resolu- ent. In many cases, assessment of the entities tion plans (also called living wills).15 and instruments was outsourced to special- Executive compensation is one aspect of ized institutions, such as rating agencies and these inadequate governance structures that auditing firms, while the incentives of these attracted close attention during the crisis. agencies to conduct due diligence were often Before the crisis, compensation was gener- compromised by conflicts of interest. As a ally a no-go area for supervisors. Supervisors result, effective market discipline could not rarely had adequate powers to address issues function. related to risk and compensation structures. The lack of effective market discipline The collapse of banks with executives who also resulted from moral hazard. There is were allegedly paid for performance clearly
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 55raised many questions about the link between study by Ellul and Yerramilli (2010) find thatexecutive pay and risk taking. Philippon and commercial banks with a strong commitmentReshef (2009) show that, whereas in 1980 to risk management—as proxied by the ratiobankers made no more than their counter- of the compensation of the chief risk officerparts in other parts of the economy, by 2000 relative to the compensation received by thewages for employees in the financial sector chief executive officer—fared much betterwere 40 percent higher than for those with during the subprime crisis than those withthe same formal qualifications in other sec- weaker commitments to risk management.tors. The last time such a discrepancy was Although risk managers, acting in the inter-observed was just prior to the Great Depres- est of their stockholders, are the first line ofsion—an irony that has not been lost on crit- defense against imprudent investing, pruden-ics of bank compensation, who range from tial regulation and supervision are the secondregulators to the Occupy Wall Street protest- line of defense.17ers. But the level of compensation alone maynot be the real problem. Leading economists, Regulation and Supervisionsuch as Alan Blinder and Raghuram Rajan, in Crisis versus Noncrisishave emphasized that a much more important Countries(and difficult) question to answer is how thestructure of performance pay may encourage How do regulatory and supervisory practicesexcessive risk taking at all levels of the insti- in countries at the epicenter of the globaltution, from traders and underwriters right financial crisis differ from the rest of theup to the firm’s chief executive officer and the world? What can one learn from those dif-board of directors. ferences? And how have the actual national But how exactly the structure of executive regulatory and supervisory practices changedpay affects risk taking is still a topic of heated in recent years as a result of Basel II anddebate. Some have argued—even before the other initiatives and in response to the globalcrisis—that executive compensation at banks financial crisis and its aftermath? To answermust have several features to discourage these questions, this section provides a statusshort-term and excessive risk taking: pay- update and analysis of the regulatory anding bankers with equity or stock options, for supervisory practices around the world. Theinstance, should ensure that if the firm’s mar- section relies on the recently updated dataket value gets wiped out, the same fate awaits from the World Bank’s Bank Regulation andthe paycheck of its senior management. But Supervision Survey (see box 2.2 for an intro-matters may be more complex. Incentive duction to the survey; all the country-levelschemes may unduly emphasize immediate data are publicly available at http://wwwrevenue generation over a prudent long-term .worldbank.org/financialdevelopment).assessment of credit risk (as was likely the case To examine the regulatory and super-in mortgage lending); and bonuses awarded visory differences between crisis and noncri-to managers today may entail risks for the sis countries, this section and the paper byinstitution that do not become apparent until Čihák, Demirgüç-Kunt, Martínez Pería, andmuch later. Both aspects of bank compensa- Mohseni (2012) compare country officials’tion have become the focus of increased regu- inputs from the World Bank’s Bank Regula-lation intended to discourage bank executives tion and Supervision Survey and juxtaposefrom excessive risk taking. But policy mak- them with the countries’ experience duringers’ understanding of how incentives at banks the crisis. Specifically, to distinguish crisistranslated into actual risk-taking behavior is and noncrisis countries, this chapter uses anstill limited, and regulators struggle to come existing and often-used database of bank-up with rules that can rein in reckless risk ing sector crises, last updated in Laeven andtaking without extinguishing banks’ abil- Valencia (2012). Laeven and Valencia use aity to reward actual performance.16 A recent set of well-defined criteria to assess the 143
56 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 Box 2.2 What Is in the World Bank’s Bank Regulation and Supervision Survey? An important input into this chapter was the update supervisors and researchers, and detailed guidelines of the World Bank’s Bank Regulation and Supervi- were drafted by a senior banking regulator to make sion Survey. The survey is a unique dataset of bank the questions more specific and clearer. regulation and supervision around the world. In the Data for 143 jurisdictions (see map B2.2.1) for early 2000s, the World Bank created a database of 2010–11 allow comparisons across countries and bank regulation and supervision around the globe with the previous three rounds. The survey consists (Barth, Caprio, and Levine 2001). The second, of information from over 730 questions and sub- updated iteration of the database was issued in 2003, questions in 14 sections. About half of the questions and the third version was issued in 2007. The survey are the same as in the previous three survey rounds has been widely used in research and policy work. (for reasons of comparability), and about half are The current round of the survey provides compre- new (mostly on macroprudential issues, consumer hensive information on the state of regulation and protection, and Basel II implementation). supervision around the world as of 2011. It is the The survey contains questions in the following first comprehensive look at regulation since 2007. 14 sections: 1. Entry into banking; 2. Ownership; Some of the questions have been kept unchanged 3. Capital; 4. Activities; 5. External auditing from the 2007 survey, for reasons of comparability. requirements; 6. Bank governance; 7. Liquidity and Other questions have been reformulated to result in diversification requirements; 8. Depositor (savings) more precise answers. Several questions were added, protection schemes; 9. Asset classification, provi- in particular on consumer protection and macro- sioning, and write-offs; 10. Accounting/information prudential regulation. The survey involved a major dis losure; 11. Discipline/problem institution exit; c effort to ensure the consistency of responses across 12. Supervision; 13. Banking sector characteristics; countries. Its design involved expertise of both 14. Consumer protection. Map B2.2.1 Coverage of the 2011 Bank Regulation and Supervision Survey Source: World Bank.
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 57Table 2.2 Differences between Crisis and Noncrisis Countries(percent, unless indicated otherwise) Noncrisis Crisis DifferenceQuestion (Yes/No) % Yes % Yes P-valueaIs tier 2 allowed in regulatory capital? 85.3 100.0 0.07Is tier 3 allowed in regulatory capital? 27.5 80.0 0.00Was advanced internal ratings-based approach offered to banks in calculating capital 44.7 94.7 0.00 requirements for credit risk?Are there minimum levels of specific provisions for loans and advances that are set 78.8 30.0 0.00 by the regulator?Can the supervisory agency require commitment/action from controlling 83.2 65.0 0.06 shareholder(s) to support the bank with new equity?Are asset/risk diversification requirements employed to oversee more closely and/or 39.1 13.3 0.07 limit the activities of large/interconnected institutions?Is there a regulatory requirement for general provisions on loans and advances? 69.9 25.0 0.00Do you have an asset classification system under which banks have to report the 89.3 65.0 0.00 quality of their loans and advances using a common regulatory scale?Does accrued, though unpaid, interest/principal enter the bank’s income statement 23.9 50.0 0.02 while the loan is classified as nonperforming?Is there a regulatory limit on related party exposures? 97.3 84.2 0.01Are external auditors subject to independent oversight by banking supervisory 25.9 9.5 0.10 agency?In cases where the supervisor identifies that the bank has received an inadequate 93.6 75.0 0.01 audit, does the supervisor have the powers to take actions against the bank?Question (Quantitative) Median Median P-valueb Risk-based capital ratio of banking system (end of 2008) 14.9 12.8 < .01Risk-based capital ratio of banking system (end of 2009) 16.5 14.6 < .01Risk-based capital ratio of banking system (end of 2010) 16.5 15.9 < .05Tier 1 capital ratio of banking system (end of 2008) 12.9 9.8 < .01Tier 1 capital ratio of banking system (end of 2009) 14.0 11.6 < .01Tier 1 capital ratio of banking system (end of 2010) 14.6 12.0 < .01Source: World Bank’s Bank Regulation and Supervision Survey (database), 2011 data. See also www.worldbank.org/financialdevelopment.Note: The following countries included in the Bank Regulation and Supervision Survey had a systemic banking crisis between 2007 and 2011 according to Laeven and Valencia(2012): Austria, Belgium, Denmark, Germany, Greece, Iceland, Ireland, Kazakhstan, Latvia, Luxembourg, Netherlands, Nigeria, Spain, Ukraine, United Kingdom, and United States.The following countries had borderline systemic crises: France, Hungary, Italy, Portugal, the Russian Federation, Slovenia, and Switzerland.a. For questions with yes or/no responses, Student’s t-test was used to test for the equality of the means (percentage of “yes” responses) between crisis and noncrisis.b. For quantitative questions, Stata’s cendif utility was used to test for the equality of the medians between crisis and noncrisis. See Newson (2002) for more on this utility.countries covered by the World Bank’s Bank • The crisis countries allowed for less strin-Regulation and Supervision Survey. Of those, gent definitions of capital and had lowerthey identify 16 countries—mostly advanced actual tier 1 capital. Whereas 80 percenteconomies, but also some EMDEs—that of crisis countries allowed tier 3 in regula-experienced a systemic banking crisis tory capital and 100 percent allowed tierbetween 2007 and 2011 and 7 countries that 2, only some 28 percent among noncrisisexperienced a borderline systemic crisis in the countries allowed tier 3 and 85 percentsame period (see table 2.2 for a list). All the allowed tier 2.other countries in the database are treated as • The median level of tier 1 capital to assetsnoncrisis countries. was 13 percent for noncrisis countries in When one uses the data from the survey to 2008, compared to 10 percent among cri-compare regulation and supervision in crisis sis countries.countries to the rest of the world (table 2.2), • The share of crisis countries that allowthe following differences stand out:18 banks to calculate their capital require-
58 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 ment for credit risk based on the banks’ efforts to coordinate and monitor progress in internal ratings models is 95 percent, strengthening financial regulation.20 about twice as a large as in the rest of the The expansion of the Financial Stability world (45 percent). Forum and its reestablishment as the FSB, • Regulators and supervisors in crisis coun- with a broader mandate in the area of finan- tries were less able to require bank share- cial stability and the coordination of the holders to support the bank with new global financial sector reform, is the most equity. Although the regulator had this important development in the international power in 83 percent of noncrisis countries, architecture of financial regulation in recent this was true in only 65 percent of crisis years. countries. As part of the regulatory reform package • Although almost 70 percent of noncrisis coordinated by the FSB, the Basel Commit- countries had a regulatory requirement for tee on Banking Supervision (BCBS) intro- general provisions on loans and advances, duced a new global regulatory framework only 25 percent of crisis countries had such for bank capital adequacy and liquidity. provisions in place. Close to 90 percent This new framework, called Basel III, aims of noncrisis countries had an asset clas- to strengthen bank capital requirements and sification system under which banks had introduces new regulatory requirements on to report the quality of their loans using bank liquidity, while limiting bank leverage. a common regulatory scale, while 65 per- This proposal (summarized in table 2.3) con- cent of crisis countries had such systems tains many useful steps that help to address in place. Half of crisis countries allowed the problems highlighted by the crisis. For accrued though unpaid interest and prin- example, the elimination of tier 3 and most cipal to enter the bank income statement of tier 2 capital and other measures should when loans are nonperforming, but only help in raising the quality of banks’ capital, 24 percent of noncrisis countries allowed while the significantly more stringent regula- this. tory treatment of securitizations would result • Crisis countries have relatively less strict in more capital to be held against the credit limited party exposure limits and audit risk of these positions. procedures. In addition to the steps taken by the Basel • Finally, crisis countries also had less scope Committee, the FSB has come up with a for market discipline, in terms both of pro- broad range of proposals that, in some cases, viding incentives to monitor and of ensur- are meant to address certain failures in mar- ing quality of information to enable accu- ket discipline that became strikingly apparent rate monitoring; for example, they had during the crisis. In particular, the FSB has more generous deposit insurance coverage specifically addressed issues relating to com- and lower quality of financial information pensation practices, credit rating agencies, made publicly available. filling of information gaps, and methods to deal with the too-big-to-fail issue. As regards compensation practices, com- pensation at significant financial institu- Global Regulatory tions was recognized by FSB as one factor Reforms19 among many that contributed to the finan- In response to the deficiencies in financial cial crisis that began in 2007. A part of the regulation revealed by the global financial official response was the issuance of FSB’s crisis, leaders of the world’s major econo- Principles for Sound Compensation Practices mies designated the G-20 to be the premier (FSB 2009b) and the related Implementation forum for international economic coopera- Standards (FSB 2009c). The stated aim of tion. They also established the FSB to include these principles and standards is to enhance major emerging economies and welcomed its the stability and robustness of the financial
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 59Table 2.3 Summary of the Basel III FrameworkProposed changes Specific stepsRaising quality, consistency, and The predominant form of tier 1 capital must be common shares and retainedtransparency of the capital base earnings. Tier 2 capital instruments will be harmonized. Tier 3 capital will be eliminated.Strengthening risk coverage of the Promote more integrated management of market and counterparty credit risk.capital framework Add the credit valuation adjustment risk due to deterioration in counterparty’s credit rating. Strengthen the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo and securities financing transactions. Raise the capital buffers backing these exposures. Reduce procyclicality. Provide additional incentives to move over-the-counter derivative contracts to central counterparties. Provide incentives to strengthen the risk management of counterparty credit exposures. Raise counterparty credit risk management standards by including wrong-way risk.Introducing a leverage ratio as a The committee therefore is introducing a leverage ratio requirement that is intendedsupplementary measure to the Basel II to put a floor under the buildup of leverage in the banking sector.risk-based framework Introduce additional safeguards against model risk and measurement error by supplementing the risk-based measure with a simpler measure that is based on gross exposures.Reducing procyclicality and promoting Dampen any excess cyclicality of the minimum capital requirement.countercyclical buffers Promote more forward-looking provisions. Conserve capital to build buffers at individual banks and the banking sector that can be used in stress.Protecting the banking sector from Requirement to use long-term data horizons to estimate probabilities of default.periods of excess credit growth. Downturn loss-given-default estimates, recommended in Basel II, to become mandatory. Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.Promoting stronger provisioning practices Advocate a change in the accounting standards toward an expected loss approach.(forward looking provisioning)Introducing a global minimum liquidity A 30-day liquidity coverage ratio requirement underpinned by a longer-term structuralstandard for internationally active banks liquidity ratio called the net stable funding ratio.Source: Based on Basel Committee on Banking Supervision 2011a.system. They are not to be used as a pretext stability–threatening herding effects that cur-to prevent or impede market entry or market rently arise from credit rating thresholds beingaccess. hardwired into laws, regulations, and market T he reform of credit rating agen- practices, the FSB has drawn up principlescies is another important part of the FSB to reduce reliance on credit ratings in stan-agenda. In an effort to reduce the financial dards, laws, and regulations (FSB 2010b). The
60 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 Box 2.3 Reforming Credit Rating Agencies Credit rating agencies have not met the expectations Though references to risk ratings in regulations placed on them by investors and policy makers. For are undesirable, the alternatives have drawbacks. example, empirical evidence suggests that ratings In particular, bank models of risk assessment have have often been lagging indicators that show at best proved even less reliable than credit ratings, includ- only information already known by the market (see, ing in the largest banks where risk management for example, Afonso, Furceri, and Gomes 2011; was widely believed to be most advanced (see, for Arezki, Candelon, and Sy 2011). instance, UBS 2008). Replacing references to rat- Much of the postcrisis debate on credit rating ings with references to market-based risk indicators agencies has revolved around conflicting interests could sharply increase procyclicality because such because of the commingling of rating and advisory indicators are typically much more volatile than services. The issue is that many larger credit rating credit ratings. As a result, it is to be expected that agencies offer “credit rating advisory services” that ratings will be complemented with other measures essentially advise an issuer on how to structure its of risk. But eliminating references to credit ratings in bond offerings and “special purpose entities” so as regulations is impractical and undesirable given the to achieve a given credit rating for a certain debt lack of proper alternatives. Moreover, contemplating tranche. This creates potential conflicts of interest, such steps given the current period of market stress of course, because credit rating agencies may feel could increase short-term volatility. obligated to provide issuers with those ratings if issu- Véron and Wolff (2012) argue that the role of ers followed their advice on structuring the offering. credit ratings in regulation should be reduced—but Some credit rating agencies avoid this conflict by that eliminating it entirely would have important refusing to rate debt offerings for which its advisory downsides, at least in the short term. Transferring services were sought. This was an important reason the responsibility for ratings to public authorities is why many of the risky, complex structured financial unlikely to be a good alternative because of inherent products had very favorable ratings. conflicts of interest. Goodhart (2008) and Caprio, Credit rating agencies derive some of their impor- Demirgüç-Kunt, and Kane (2010) suggest that credit tance from the fact that the regulatory system relies rating agencies need to bond the quality of their on their assessments. This reliance is observed in work by subjecting it to effective independent review bank regulation, which in some circumstances sets and setting aside some of their fees in a fund from banks’ capital requirements in relation to asset risks which third-party special masters of expedited civil as assessed by the rating agencies. Similar regula- judgments could indemnify investors for provable tions exist for insurance and other financial market harm. participants. Following failures of ratings in the U.S. Reform of credit rating agencies is not just subprime mortgage-based securities market, work an issue for advanced economies. Many EMDEs has been undertaken to reduce regulatory reliance have adopted or have been adopting regulatory on credit ratings. However, this is proving difficult at frameworks that are similar to those of the ad- times, not least because it complicates the adoption of vanced economies, including the reliance on credit global supervisory standards that do refer to ratings. ratings. For illustration, data from the 2011 Bank At the global level, a review of this issue by the Finan- Regulation and Supervision Survey show that 17 cial Stability Board has concluded that it may take a percent of EMDE regulators require their commer- number of years for market participants to develop cial banks to have external credit ratings; the com- enhanced risk management capability to enable parable number for advanced economy regulators is reduced reliance on credit rating agencies (FSB 2010b). 8 percent. principles aim to trigger a significant change risk assessment practices instead. They set out in existing practices that would end mechanis- broad objectives for standard setters and reg- tic reliance by market participants on credit ulators to follow by defining the more specific ratings and establish stronger internal credit actions that will be needed to implement the
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 61changes over time. For a discussion on credit gation capabilities, risk governance, andrating agencies, see box 2.3. internal controls Much work at the FSB level has beendevoted to filling information gaps. In 2009, The FSB, in coordination with the Baselthe G-20 finance ministers and central bank Committee, has come up with a list of 29governors endorsed recommendations to banks considered global SIFIs. These banksaddress information gaps identified by the will need to meet the resolution planningFSB Secretariat and IMF staff. The FSB, in requirements by the end of 2012. Nationalcooperation with the IMF and others, has authorities may decide to extend theselaunched a major initiative to fill existing requirements to other institutions in theirinformation gaps (FSB and IMF 2010). jurisdictions. The group of global SIFIs will To deal with the too-big-to-fail issue, the be updated annually and published by theFSB has developed, in response to requests FSB each November. The methodology andfrom G-20 leaders, a set of policies to address data used by the FSB will be publicly avail-the systemic and moral hazard risks associ- able so that markets and institutions can rep-ated with systemically important financial licate the authorities’ determination.23institutions (SIFIs). 21 The policies—to be The FSB acknowledged that consis-implemented from 2012, with full implemen- tent implementation will be critical to thetation from 2019—basically consist of the effectiveness of these measures. Legislativefollowing:22 changes will be required in many jurisdic- tions to implement the FSB Key Attributes• A new international standard, titled “FSB of Effective Resolution Regimes and to Key Attributes of Effective Resolution strengthen supervisory mandates and capa- Regimes,” setting out the responsibilities, bilities. Other requirements will demand a instruments, and powers that national high degree of cooperation among authori- resolution regimes should have to enable ties, and firms will have to review and change authorities to resolve failing financial their structures and operations. firms in an orderly manner and without exposing taxpayers to the risk of loss National Regulation and• Requirements for resolvability assess- Supervision in Response to ments and for recovery and resolution the Crisis24 planning for global SIFIs, and for the development of institution-specific cross- What is the effect of the global regulatory border cooperation agreements so that reforms so far at the national level? The home and host authorities of the global World Bank survey of bank regulation and SIFIs are better prepared for dealing with supervision is useful in answering this ques- crises and have clarity on how to cooper- tion. The results from the survey underscore ate in a crisis the evolutionary nature of the regulatory and• Requirements for banks determined to be supervisory changes at the national level. To globally systemically important to have illustrate this point, for the qualitative ques- additional loss absorption capacity tai- tions in the survey, 85 percent of yes or no lored to the impact of their failure, rising responses were unchanged between 2007 and from 1.0 percent to 2.5 percent of risk- 2011. Similarly, most of the quantitative indi- weighted assets, to be met with common cators showed relatively little overall move- equity ment throughout the crisis.• More intensive and effective supervision This relatively slow evolution notwith- of SIFIs, including through stronger super- standing, the World Bank survey shows visory mandates, resources, and powers, notable changes in individual countries in and higher supervisory expectations for several areas. For example, in an attempt to risk management functions, data aggre- respond to the crisis, countries introduced a
62 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013Figure 2.1 Introduction of Bank Governance Frameworks The survey also indicates that many juris- (In response to the global financial crisis, dictions resorted to increasing the amount have you introduced new regulations in the following areas?) covered by deposit protection systems as a means to avert the systemic consequences of a widespread mistrust in banking institutions Compensation for executives (figure 2.3). The crisis experience and the survey also Independence of the Board provide a unique opportunity to reexamine the broader framework for regulation and Existence of a direct reporting supervision. One of the most visible devel- line from the chief risk officer to opments in financial sector regulation in the the Board or Board Committee past 20 years has been a shift from the tradi- Existence of a Board or tional sector-by-sector approach to supervi- a risk committee sion toward a greater cross-sector integration of financial supervision Čihák and Podpiera Other 2008). This shift, which was to a large extent 0 10 20 30 40 50 60 70 in response to the growing integration of the banking, securities, and insurance markets, Number of responses has an important impact on the practice of supervision and regulation around the globe.Source: World Bank’s Bank Regulation and Supervision Survey (database), 2011.Note: The figure shows the number of positive responses in each area. A country could respond Box 2.4 discusses the crisis experience withpositively in several areas. the regulatory frameworks. The World Bank’s Bank Regulation and Supervision Survey confirms that macropru-Figure 2.2 New Insolvency Frameworks dential policies received renewed impetus (Have you introduced significant changes to the bank resolution after the crisis, with many new macropru- framework in your country as a result of the global financial crisis?) dential bodies involved (such as the Finan- cial Stability Oversight Council in the United States and the European Systemic Risk Board Introduced a separate bank in the European Union). This involvement insolvency framework led to rapid growth in new financial stabil- Implemented coordination ity reports, with India, Italy, and the United arrangements among States being some of the recent entrants, and domestic authorities it also encouraged a trend toward increased publication of financial sector stress tests (fig- Revisions under ure 2.4). consideration Most developing economy supervisory authorities still use the Basel I capital regime, No revisions though the majority plan on implementing the Basel II capital requirements soon (fig- ure 2.5a). In the survey, some 75 percent of 0 10 20 30 40 50 60 70 80 90 responding jurisdictions, including many Number of responses developing economies, indicated their inten- tion to implement Basel II. Basel II allows forSource: World Bank’s Bank Regulation and Supervision Survey (database), 2011. several approaches, some relatively simple and similar to Basel I, so in principle, for plethora of new requirements on bank gov- developing economies, especially those facing ernance frameworks (figure 2.1), and they important supervisory capacity constraints, have sought or are seeking to strengthen a simplified version of the standardized bank insolvency frameworks (figure 2.2). approach is probably the most appropriate
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 63option. Yet many are aiming to adopt more Figure 2.3 Introduction of Deposit Protection Schemescomplex approaches (figure 2.5b), sometimes (Have you introduced changes to your deposit protection systemwithout justification in terms of the complex- as a result of the global financial crisis?)ity of the institutions that are to be super-vised or the types of transactions in whichthey are involved. Indeed, experience from Increase in amount coveredWorld Bank country work indicates that insome small or lower-income countries, thefull range of options proposed by the BCBS Expansion of coverage (types of exposures, natureis not properly thought through, resulting in of depositor, and so on)the adoption of overly complex regulationsfor the level of economic development and Government guarantee ofcomplexity of the financial system. The sur- deposits and bank debtsvey indicates that introducing Basel II alreadyhad substantial impacts in many countries Only minor changes(figure 2.6), with the implementation being or no changemore challenging for the developing econo-mies than for developed economies. 0 5 10 15 20 25 30 35 40 Developing-economy regulators offer a Number of responsesvariety of reasons why they want to adoptBasel II, although adoption is not manda- Source: World Bank’s Bank Regulation and Supervision Survey (database), 2011.tory outside the member states of the BCBS.Specifically, some are concerned that Basel narrow definitions of capital and without riskI is beginning to be perceived as an inferior weighting) to their minimum requirements.standard by international investors and that This trend is likely to continue as countriesdeveloping-economy financial institutions move toward Basel III.and markets may be penalized by inter- As for the impact of Basel III, recent cal-national market participants or that their culations (such as Majnoni 2012) suggestdomestic banks may eventually be denied that Basel III implementation may, in con-access to foreign markets if they do not com- trast to Basel II, be relatively easier for devel-ply with the latest Basel standards. Accord- oping economies than for developed ones,ing to Financial Stability Institute (2004), the given that the former have built relativelymain driver among nonmember countries of higher capital buffers. Indeed, minimumthe BCBS to move toward Basel II is the fact required as well as actual risk-based capitalthat foreign-controlled banks or local subsid- ratios of banking systems tend to be rela-iaries of foreign banks operating under Basel tively higher in developing economies (figureII expect regulators in low-income countries 2.8). However, higher capital (and liquidity)to adopt the framework as well. Whether or buffers may also be warranted, consider-not these concerns are justified, they have ing that emerging-market and developing-accelerated the diffusion of the Basel frame- economy banks operate in a more volatileworks across the developing world, as docu- economic environment. Also, a commonmented by the World Bank survey. observation from assessments under the The survey results suggest a somewhat World Bank/IMF’s Financial Sector Assess-increased emphasis on higher-quality capital ment Program and other diagnostic work isin regulatory capital relative to earlier sur- that high reported capital buffers overstateveys. For example, respondents in the more the true resilience of financial institutions inrecent survey were less likely to include sub- light of deficiencies in accounting and regu-ordinated debt in regulatory capital (figure latory frameworks, especially as regards loan2.7). Also, since the 2007 survey, seven coun- classification, provisioning, and consolidatedtries have added basic leverage ratios (with supervision. To examine the likely impact
64 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 Box 2.4 Institutional Structures for Regulation and Supervision Regarding the broader architecture for regulation the twin peak model and against the sectoral model and supervision, three broad models are being used ˇ (Cihák and Podpiera 2008). Indeed, during the around the world: a three-pillar or “sectoral” model global financial crisis, some of the twin peak juris- (banking, insurance, and securities); a two-pillar or dictions (particularly Australia and Canada) have “twin peak” model (prudential and business con- been relatively unaffected, while the United States, a duct); and an integrated model (all types of super- jurisdiction with a fractionalized sectoral approach vision under one roof). One of the arguably most to supervision, has been at the crisis epicenter. How- remarkable developments of the past 10 years, con- ever, the crisis experience is far from black and firmed by the World Bank’s Bank Regulation and white, with the Netherlands, one of the examples of Supervision Survey, has been a trend from the three- the twin peaks model, being involved in the Fortis pillar model toward either the two-pillar model or failure, one of the major European bank failures. It the integrated model (with the twin peak model is still early to make a firm overall conclusion, and gaining traction in the early 2000s). isolating the effects of supervisory architecture from In a recent study, Melecky and Podpiera (2012) other effects is notoriously hard. examined the drivers of supervisory structures for There is one area where the postcrisis policy con- prudential and business conduct supervision over sensus is rather clear, though, and that relates to the the past decade in 98 countries, finding among other role of the central bank in the supervisory frame- things that countries advancing to a higher stage of work. Recent policy papers on the subject (such as economic development tend to integrate their super- Nier and others 2011) emphasize the importance of visory structures, small open economies tend to opt central banks playing an important role in macro- for more integrated supervisory structures, financial prudential policy. Indeed, the World Bank’s bank deepening makes countries integrate supervision pro- regulation survey underscores the growing role of gressively more, and the lobbying power of the con- central banks in the supervisory framework and the centrated and highly profitable banking sector acts as growing emphasis on macroprudential policy. The a negative force against business conduct integration. emphasis here is on macroprudential, as views differ (The related data on the structure of supervision are on the appropriate involvement of central banks in available on the website accompanying this report, microprudential supervision. In a recent study on the http://www.worldbank.org/financialdevelopment.) subject, Masciandaro, Pansini, and Quintyn (2011) How do these various institutional structures used empirical evidence from the crisis to make a compare in terms of crisis frequency and the limit- case for keeping macro- and microprudential super- ing of the crisis impact? Cross-country regressions vision institutionally separate to allow for more using data for a wide set of developing and devel- checks and balances and thus reduce the probability oped economies provide some evidence in favor of of supervisory failure. of Basel III on developing economies, World Finally, the survey suggests there is further Bank staff have undertaken in-depth analy- scope for improving disclosures and incen- sis of individual bank data. The results (box tives for stakeholders to monitor financial 2.5) suggest that the impact of the new capi- institutions, hence the need to address mar- tal regulations may be broadly manageable, ket discipline. The findings in this area are whereas the liquidity regulations may be somewhat mixed. Deposit insurance coverage more challenging, given the difficult exter- has increased during the crisis and, coupled nal funding environment, as well as the rela- with too-big-to-fail policies, is further erod- tively undeveloped local financial markets. ing incentives to monitor. Although the sur- However, there are important differences vey suggests that some elements of disclosure across regions, as well as within each region and quality of information have improved, and across financial institutions. it is not clear whether market discipline has been strengthened overall.
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 65How to Strengthen the Figure 2.4 Financial Stability Reporting and Stress TestCrisis Response Publication, 1995–2011Are the global and national regulatory andsupervisory responses sufficient to address Percentthe issues highlighted by the crisis? Is any- 90thing missing in the crisis response so far? 80As illustrated in this chapter, the financial 70crisis has triggered much discussion and 60many regulatory reform initiatives on the 50global level as well as on the national level. 40Economists have been following this reformprocess, and have voiced concerns that the 30reforms are only going halfway (Beck 2011; 20Shadow Regulatory Financial Committee 102011; Squam Lake Group 2010; London 0School of Economics 2010). Economists, 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20regulators, and policy makers agree thatthe challenge is to design regulations to Countries that publish financial stability reportsminimize the occurrence and cost of future Countries that publish stress test resultscrises; however, there is less agreement onthe proposed approaches to regulation and ˇ Source: Cihák, Muñoz, Teh Sharifuddin, and Tintchev 2012.supervision. Table 2.4 provides a summaryof selected proposals. reflect issues of regulatory complexity as well One common theme emerging from these as the capacity of the regulatory approach tostudies involves concerns about the effective- address systemic risk that can lead to financialness and efficiency of the regulatory approach crises. The trend toward regulating more andadopted by the official sector. The concerns the growing complexity of regulation distortsFigure 2.5 Push to Implement New Basel Rules a. Year of Basel II adoption b. Selected approach to calculate minimum capital requirements Countries adopting Basel II (%) 100 90 Developing 80 countries 70 60 50 40 Developed 30 countries 20 10 0 2000 2005 2010 2015 2020 Standardized Foundation IRB Advanced IRB approach approach approach Median Deviation 2007 survey 2011 surveySource: World Bank’s Bank Regulation and Supervision Survey (database).Note: IRB = international ratings-based.
66 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013Figure 2.6 Impact of the Move to Basel II Figure 2.7 Quality of Capital (What was the impact of moving to Basel II on (Is subordinated debt included in regulatory capital?) the overall regulatory capital level in the banking system?) Respondents (%) Respondents (%) Percent 100 100 Is the following included in 40 90 90 regulatory capital? 35 80 80 70 Is subordinated debt included in 70 30 regulatory capital? 60 60 25 50 50 20 40 40 30 30 15 20 20 10 10 10 5 0 0 Tier 2 Tier 3 2007 2011 0 Increased Increased Neutral/ Decreased Decreased substantially slightly little change slightly substantially Source: World Bank ’s Bank Regulation and Supervision Survey (database), 2011. All Developed Developing regulation that may limit innovation and hin-Source: World Bank’s Bank Regulation and Supervision Survey (database), 2011. der the ability of the financial system to per-Note: Percentage of countries responding in each category (of all countries that implemented Basel II). form its role in supporting growth and devel- opment. Overall, these reforms emphasize (a)Figure 2.8 Capital Adequacy Ratios: Minimum and Actual the importance of greater transparency and disclosure, (b) closer attention to incentives, so that regulations are “incentive-robust,” Actual risk-based capital ratio of the banking system as of end-2010, % and (c) simplicity, that is, keeping regulatory 40 38 rules as simple as possible to make it more 36 difficult for market participants to circum- 34 vent rules and easier for supervisors to moni- 32 tor and enforce them. 30 28 26 24 Asymmetric information, transparency, 22 and disclosure 20 18 Further enhancing the disclosure of infor- 16 mation should be a key component of regu- 14 latory reform. Asymmetric information—a 12 situation in which one party to the financial 10 8 transaction, usually the debtor, has access to 6 information material to the valuation of the 6 7 8 9 10 11 12 13 14 15 16 transaction that is not available to the other Minimum required risk-based regulatory capital ratio as of the end of 2010 (%) party, usually the creditor (Bebczuk 2003; Stiglitz and Rothschild 1976)—is a centralSource: World Bank’s Bank Regulation and Supervision Survey (database), 2011. problem in financial systems because it lim- its the capacity of the investors, lenders, and incentives by facilitating regulatory arbitrage analysts to monitor effectively and to price and undermining the ability of supervisors correctly the risks in financial institutions to monitor and enforce these regulations. and instruments. The problems of asymmet- The concerns also reflect the risk of excessive ric information have increased as financial
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 67 Box 2.5 Impact of the Basel III Implementation in Developing Economies This box examines implications of the Basel III mon equity component of capital. The definition of regulatory measures for developing economies. The capital will contain only a limited amount of certain analysis, which closely follows Ötker-Robe, Paz- intangibles and qualified assets (for example, banks arbasioglu, and others (2010), focuses on the impact can count up to 10 percent of DTAs resulting from of Basel III capital requirements for banks to have timing differences, MSRs, and significant invest- higher and better quality capital with greater loss ments in unconsolidated subsidiaries, capped at 15 absorption characteristics, taking into account the percent for the sum of DTAs, MSRs, and significant Basel Committee on Banking Supervision (BCBS) investments in unconsolidated subsidiaries). Analy- rules on capital deductions and the market risk sis follows the BCBS indication that market risk framework agreed to in July 2010. It also covers the capital requirements will increase by an estimated impact of the new liquidity requirements in the form average of three to four times for large, internation- of the so-called net stable funding ratio (NSFR). ally active banks. Because of data constraints, this analysis does not Overall, the analysis suggests that the share of include the short-term liquidity coverage ratio and assets with less loss-absorbing characteristics to be the leverage ratio. The sample covers 127 banks in deducted from core tier 1 capital is relatively small 42 countries over six regions. on average for EMDE banks, except in the Latin The calculations are based, in large part, on com- America and Caribbean region (figure B2.5.1). The pany reports and data from the Bankscope database. proportion of core tier 1 capital to be deducted varies An array of assumptions common to all banks are greatly across banks, reflecting their business char- made, given the lack of access to more granular acteristics and differences in tax systems; hence, the country-specific data on the various components of needed increase in capital to meet the new require- Percent Percent banks’ capital bases on a consistent basis. The find- ments28.0% be large for some banks. Other intan- 30 can 100 10% ings should hence be interpreted with caution. Since gible assets form the core of items to be deducted 25 80 regional averages are affected by the sample, they (more than 30 percent), followed by net DTAs due 20 60 may not fully represent the actual vulnerability of a to loss carry forwards (23 percent) and invest- 15 90% given region to the new requirements. ments in unconsolidated 8.0% 10.1% subsidiaries (20 percent). 40 10 9.4% According to the new capital standards, banks Net DTAs seem particularly important for Latin 5 6.2% 4.0% 20 3.3% will be required to deduct most of their assets with America and the Caribbean (LAC), East Asia and 0 0 less loss-absorbing characteristics—such as minority Pacific (EAP), and Southern Africa, and investment be ca L Af and l A nd ac sia sia Af aran L AL AL rib eri ra a dP tA hA an a sia c a interests, goodwill, net deferred tax assets (DTAs), in unconsolidated subsidiaries is relatively high in ifi ric ric rth st nt pe h Ca m Sa an Eas No le Ea ut he in A Ce Euro So b- Su investment in unconsolidated subsidiaries, and Europe and Central Asia (ECA) and EAP. If applied d t Lat idd M mortgage servicing rights (MSRs)—from the com- immediately, the proposed deductions and market an Figure B2.5.1 EMDEs: The Impact of Basel III Capital and Liquidity Requirements a. % of core tier 1 to be deducted b. Impact of Basel regulation on core capital ratio by end-2012 Percent Percent Percent Percent 30 10 100 9.11% 4% 3% 12 28.0% 10% 8% 9% 6% 25 28% 8.22% 10 8 80 7.58% 9.1% 8 20 8 7.6% 6 60 15 90% 92% 91% 94% 96% 97% 6 4 40 10.1% 9.4% 72% 4 10 8.0% 6.2% 2 5 4.0% 20 0.92% 2 3.3% 0.61% 0.64% 0 00 0 ur A r 1 be cans sa n ur r 1 ut1– ed Af 0a1r2ne L tAR i edi be ca L Af and l A nd ac sia sia Af aran re LL tio frie d ing veci ia sia , 2h r AL rib ertiio S2o01 ain , c Tie , c ca ie tio a co AL nt rrke eaasn se le E A ra Aor an ea mulnad ast Ant h A12 ric a rn tiPa s rib eri ra a T W dP tA hA an a sia c a an s, reitc a Ca muc a E e rab- III ifi ric ric rth st nt pe mnat cpre rtIhI c st h r tio e f Ca m he in Ad Sa ra Cor an Eas No le Ea Nol a Su l ut e he in A Ce Euro Ce EuIrno se S d t at D al So b- Ba I Su d t at idd Ba idd L an L an L M M Cu an Remaining core Tier 1 ratio (%) Deduction items according to BCBS proposalnext page) (box continued (%) Percent Percent 10 12 9.11% 11.3% 10.9% 10.7% 8.22% Percent 10.6% 10.0% 10.6% 9.8% Net stabl
10% 8% 9% 6% 880 7.58% 9.1% 9.5% 20 28% 8.2% 80 8 7.6% 660 7.0% 6.3% 15 90% 92% 91% 94% 96% 97% 6 60 440 10.1% 9.4% 72% 10 90% 92% 8.0% 91% 94% 96% 97% 4 40 72% 6.2% 220 5 4.0% 3.3% 0.92% 2 0.61% 0.64% 20 0 00 0 3.3% 68 t h0e GLOBAL financial DEVELOPMENT REPORT 2013 ur A r 1 be cas RW in ur a r 1 ou – d s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 2 h a re L ea a biedd ca LL ra a ric d rth st al A and d P t A ac sia sia ia h a Af a ra n nt L t As e d tio Afe nd ing eac sia ia Af 012an rib eriion L b e ca S011 ine re L AiLbb eric n t p e Af a n krel as n AL , c Tie , c ricTie tioS co h A As As se dle A ea muaa East nt th 1 2 A a a ra rth o r a r rib eri an s P A rn l ntdivP A n l A nd a Af and sia ac sia ific a an ia s, reiftic a an Ca mct 2 a re Af ran ric ric Ce Euro orth ast No E a tr e nrt ee I c st h r b II Ca m E a a n d a st th u Ca m tio e le en rop ma crp Sa a Sau l I No II Ea in ed ra Cor he in A he A Ce EIunro he in A ou Af a ra n N E -, se aE C r b- idd C ia u d t at D Eu anle cS rib eri r E Ba Su a a d t La t d t La t ifi ric ric ric ah s Ca m Ba id an L l Sa ut he in A M M -S So b- b CuSu Su d t at an an an L M Remaining core Tier 1 ratio (%) Core Tie Remaining core Tier 1 ratio (%) Deduction items according to BCBS proposal (%) New Ba Deduction items according to BCBS proposal (%) Box 2.5 Impact of the Basel III Implementation in Developing Economies (continued) Percent c. Current and adjusted core tier 1 ratios Percent d. Net stable funding ratio (available stable 10 12 funding/required stable funding) Percent 9.11% 11.3% 10.9% 10.7% 10.6% 10.6% 8.22% Percent 10 9.1% 10.0% 9.8% Net stable funding ratio 12 8 11.3% 7.58% 9.5% 9.0% 9.5% 10.6% 10.6% 10.9% 10.7% 160 8.2% 8.2% 8.3% 7.9% 180 8.22% 10 10.0% 9.8% 8 7.6% 7.6% 6 9.1% 9.5% 9.0% 9.5% 140 7.0% 7.2% 7.4% 160 8.2% 8.2% 8.3% 7.9% 6.3% 8 7.6% 7.6% 7.2% 7.4% 6 140 4 7.0% 120 6.3% 120 6 4 100 100 2 4 0.92% 0.61% 0.64% 80 2 80 02 60 60 0 L ren 1 s W n anCuEas urre r 1 h A 1 ed Af ariaon, 2 core ion 40 L be ca l A nd Af a n d ac sia sia Af aran tR ei A,Lcur ier AL ut 01 ain c ie t A ea a la s nt sia –12 2 0 rib eri ra a siake as dP tA hA an sia a c a be ca ct 01 40 T o, T ifi ric ric nt pe rth st So gs, 2 ret ht I h rib eri du l A a nd re Ca m Sa ra l II tio e tia e 20 Sa an s No le Ea ut ra Cor rraic or he in A Ce ro , 2 re ra m a nc Ea Ca m De Af IIand rn ci tivia b- se in fic e So b- Ic Eu tio co nt pe I 2 Su Ba 20 0 d Pmu t A Su an a 01 d t Lat r idd ric rth esl tra l III No lBaEsa 0 50 he in A Ce Euro M se 0 eBa d t at idd ifi an an L M Core Tier 1 ratio Basel III core ratio, 2010 ac sia Af and Af aran sia ca l A nd rib eri ra a dP tA hA c a a an sia East Asia and Pacific ric ric rth st nt pe h Ca m be Sa an Eas New Basel III core ratio, 2012 No Ea ut he in A Ce Euro Core Tier 1 ratio Basel III core ratio, 2010 Europe and Central A b- So le Su d t at idd an L New Basel III core ratio, 2012 Latin America and th M e. NSFR vs. share of wholesale funding f. NSFR vs. loan to deposit ratio Percent Net stable funding ratio Net stable funding ratio (%) 160 180 180 Net stable funding ratio (%) 160 140 180 160 140 140 120 160 120 120 140 100 100 100 120 80 80 100 80 60 80 60 60 40 40 40 60 20 40 20 20 0 0 20 0 10 20 30 40 50 60 70 80 90 0 50 100 150 200 250 300 0 0 0 Share of wholesale 150 50 100 funding in200 funding total 250 300 Loan to deposit ratio ac sia Af and Af aran sia be ca l A nd rib eri ra a dP tA hA c a a an sia East Asia and Pacific Loan to deposit ratio Middle East and North Africa East Asia and Pacific Middle East and North Africa ifi ric ric rth st nt pe h Ca m Sa an Eas No Ea ut he in A Ce Euro l A nd Europe and Central Asia South Asia b- So Europe and Central Asia South Asia le ra a Su sia East Asia and Pacific Middle East and North Africa dt t idd La nt pe Europe and Centralthe Caribbean Latin America and Asia South Asia Africa Sub-Saharan Latin America and the Caribbean Sub-Saharan AfricaCe Euro M an Latin America and the Caribbean Sub-Saharan Africa risk adjustments would lower the core tier 1 ratio by dependence on parent funding and underdeveloped about 1–3 percentage points on average. The overall local capital markets) or loan-to-deposit ratios are impact on the core tier 1 ratio is the largest for LAC, high (ECA and some LAC countries). However, Middle East and North Africa (MENA), and ECA other factors may also affect the level of NSFR (for regions, but most banks in the latter two regions still example, low levels of government securities in asset pass the required 7 percent level comfortably after portfolios may result in low NSFRs). Moreover, fur- the adjustments. ther challenges may be ahead in meeting the NSFR There is also wide variation in banks’ ability to requirement: for example, upcoming rollover needs meet the required 100 percent level for the net stable of European banks and sovereigns may raise the cost funding ratio (NSFR). The calculations suggest that of term funding that may spill over to EMDEs and the NSFR may have varying degrees of impact on result in competition for deposits. There are also EMDEs across regions, with wide variations within challenges associated with holding high levels of (liq- a given region. The ECA and LAC regions seem to uid) government securities; this would help in meet- be the most vulnerable to the NSFR, where depen- ing the NSFR target but expose the bank to higher dence on wholesale funding (ECA, given the high sovereign risk. Source: World Bank staff calculations based on Bankscope data for 127 banks in 42 countries.
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 69Table 2.4 Summary of Selected Proposals for Regulatory ReformProposal by Specific StepsAdmati and Hellwig 2012; Replace risk-weighted capital ratios by (significantly higher) leverage ratios,Hellwig 2010 combined with strong disclosures about risk exposures.Barth, Caprio and Levine Rather than focusing on the regulations themselves, focuses on how to better2012a oversee the regulators. Establishment of a “sentinel” agency, watching over the regulators on behalf of the taxpayers.Bartlett 2012 Redesign bank disclosures to facilitate credit modeling by market participants. (Illustrates that basic credit risk modeling, combined with appropriate bank disclosures, could have enhanced investors’ ability to detect the portfolio risk leading to recent banking crises, without revealing sensitive position-level data.)Brunnemeier and others Develop more “prompt corrective action”-types of rules to facilitate “leaning2009 against the wind.”Calomiris 2011 Proposes “incentive-robust” reform proposals to address mortgage risk subsidization, regulators’ inability to measure risks ex ante and losses ex post, the too-big-to-fail problem, liquidity risk, macroprudential regulations that vary over the cycle, prudential regulations to encourage the greater use of clearinghouses in clearing over-the-counter transactions, and design of appropriate guidelines to constrain government assistance to banks during crises.Caprio, Demirgüç-Kunt, and Make oversight more adaptive to changes (innovations) and hold supervisorsKane 2010 accountable for their adaptiveness. Regulators should disclose information on the value and measurement of potential claims that institutions make on the government’s safety net. Establishing the right incentive structure for supervisors requires a chain of reforms.ˇCihák, Demirgüç-Kunt, and Reorient the approach to financial regulation to have at its core the objective ofJohnston 2012a addressing incentives on an ongoing basis. As part of this, consider conducting regular “incentive audits.”Claessens and others 2010 Recognize mitigation of systemic risks as an explicit objective of all agencies involved in supervision, to enhance accountability: Clear mandates and tools commensurate with these mandates to preserve financial stability; sufficient resources; clear allocation of responsibilities among agencies; Clear communication among agencies.de la Torre and Ize 2011 Establish strong and independent supervisory agencies, populated by highly skilled civil servants.Demirgüç-Kunt 2011; Scale back explicit deposit insurance from large banks as an additional measureRajan 2010 to claw back implicit guarantees and remove the too-big-to-fail subsidies.Enriques and Hertig 2010 Strengthen internal and external governance of supervisors: (a) strong CEOs with boards’ and commissions’ powers limited to basic policy-making decisions and monitoring, (b) increased line responsibilities for staff, (c) requirement subjecting supervisors to stronger disclosure requirements.FSA (The Turner Address the need for more intrusive supervision, more outcomes-orientedReview) 2009 supervision, and more risk-based supervision, more systemic supervision, and international coordination of supervision.Masciandaro, Pansini, Make a clearer organizational distinction between macro- and microprudentialQuintyn 2011 supervision to allow for more checks and balances to improve supervisory governance. (table continues next page)
70 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 Table 2.4 Summary of Selected Proposals for Regulatory Reform (continued) Proposal by Specific Steps Palmer and Cerutti 2009 Summon the “will to act” by (a) leaning more against the wind; (b) strengthening the context of supervision (independence, leadership, accountability); (c) strengthening supervisory processes by making them more intensive, result-oriented, risk-based, and proactive; (d) strengthening macroprudential surveillance and mitigating procyclicality; and (e) improving cross-border supervisory cooperation. Viñals and others 2010 Implement more intrusive supervision—“skeptical but proactive supervision” that is comprehensive, adaptive, and conclusive. Achieve changes through (a) enabling legislation and budgetary resources; (b) clear strategy; (c) robust internal organization; and (d) effective coordination with other agencies. Create revisions through (a) clear mandate, (b) independence and accountability, (c) skilled staff, (d) healthy relationship with industry, and (e) partnership with board. Weder di Mauro 2009 Establish more independence and accountability for supervisors to address time-inconsistency issues; offer higher compensation levels for supervisors; and set up supervision at supranational levels (Europe) to eliminate local industry capture. Wellink 2011 Address the need for “intrusive supervision.” instruments, structures and interconnections, supervision. These initiatives, which focus regulatory and accounting rules, and institu- primarily on ensuring better information for tions’ risk control and assessment techniques supervisory purposes, go some way toward have become more complex. addressing the weaknesses highlighted by the Asymmetries of information and principal- crisis. agent issues abound between buyers and sell- The focus on collecting better data for ers of financial services and products, as evi- supervision should not detract from the need denced by the malpractices in the U.S. for much better public disclosure of informa- mortgage sector in the run-up to the crisis. tion. The value of transparency and disclo- Professional bankers possess expert knowl- sure has been emphasized by many observers edge, and obtaining such knowledge is time- as well as by recent research (Bartlett 2012; consuming and costly. This puts the client at Demirgüç-Kunt, Detragiache, and Tressel a disadvantage, notably when monitoring 2008). Greater disclosure would allow credi- compliance with contractual arrangements. tors, investors, and analysts to assess directly In principle, disgruntled consumers can seek the solvency of the financial institutions. The legal recourse, but the legal process is time- financial crisis illustrated that financial insti- consuming, costly, and uncertain. These con- tutions are rather opaque organizations for ditions highlight the general case for detailed investors in capital markets. Although bank disclosure requirements and conduct of busi- regulatory policy has long sought to promote ness regulation. Moreover, information asym- market discipline of banks through enhanced metries are an important rationale for pru- public disclosure, bank regulatory disclosures dential regulation and supervision of banks are notoriously lacking in granular, position- accepting deposits from retail clients, as these level information concerning their credit nonprofessional consumers are ill-equipped investments, largely because of conflicting to evaluate the safety and soundness of banks. concerns about protecting the confidentiality As part of the crisis response, the FSB and of a bank’s proprietary investment strategies others have launched useful initiatives on and customer information. data and information gaps. At the national When particular market sectors experi- level, many regulators have started collect- ence distress, investors are thus forced to ing additional data to allow for strengthened speculate as to which institutions might be
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 71exposed, potentially causing significant dis- Further improvements in transparencyruptions in credit markets and contributing and disclosures are seriously needed, both onto systemic risk. Bartlett (2012) argues that the systemwide level and on the level of indi-redesigning bank disclosures to facilitate vidual financial institutions. As regards thecredit modeling by market participants has disclosures on systemic risks, many countriesthe potential to meaningfully increase mar- have been publishing so-called financial sta-ket discipline while minimizing the disclo- bility reports. Recent research on the subjectsure of sensitive bank data. He illustrates suggests that simply publishing a financialhow even basic credit risk modeling, when stability report seems to have no impact oncombined with appropriate bank disclosures, financial stability (Čihák, Muñoz, Teh Shari-could have significantly enhanced investors’ fuddin, and Tintchev 2012). The effective-ability to detect the portfolio risk leading to ness of such reports in signaling and address-two recent severe banking crises. Moreover, ing systemic risk has, however, been affectedbecause such an approach leverages the same by a number of factors. In the absence of aaggregate metrics banks themselves use to unifying analytical framework for assessingmonitor their risk exposure, the proposed systemic risk, most financial stability reportsdisclosure regime would impose a limited were rather descriptive and refrained fromdisclosure burden on banks while avoiding explicit statements about the level of systemicthe need to reveal sensitive position-level risk present in the financial system. Datadata. gaps, particularly in the nonbank sector, led It would be naive, of course, to think that many reports to focus on the banking sec-all creditors, investors, and analysts have the tor, impeding a true systemwide perspective.resources and capacity to understand, assess, Also, the articulation of financial stabilityand identify these increasingly more complex analysis into remedial policies, aimed at curb-structures, institutions, and instruments. ing the buildup of systemic risk, was prob-Indeed, the collective tendency of financial lematic. There is thus substantial scope forfirms, nonfinancial corporations, and house- improving such reports (as well as the asso-holds to overexpose themselves to risk in the ciated information on systemic-level risks) inupswing of a credit cycle, and to become terms of clarity, consistency over time, andoverly risk-averse in a downswing, has been coverage. The ongoing work on good prac-well documented. These tendencies raise tices in macroprudential surveillance (such assome questions about the capacity of finan- Nier and others 2011) could usefully addresscial markets and investors to instill discipline transparency and disclosures of systemic risk.on the behavior of financial entities, and they At the level of individual financial institu-underscore the importance of having both tions, further reforms are needed to ensure astrong supervision and market discipline. higher quality of disclosures. Much reliance One of the important advantages of com- has been placed on the external auditors, aplementing strong supervision with market sector that came to be dominated by the “Bigdiscipline is that, with sufficient disclosures Four” (KPMG, PwC, Ernst & Young, andand proper incentives, investors and analysts Deloitte). In the run-up to the financial crisis,would be more likely to develop their own many financial institutions were given a cleanassessments of capital adequacy and liquidity, bill of health by the external auditors, onlyand there could be scope for competition and to be bailed out a few months later as theevolution in the design of the most appropri- financial crisis unfolded. In the wake of theate measures. This approach would limit the crisis, the European Union has proposed alikelihood of “groupthink” and focusing too draft law to tighten supervision of the exter-much on a single and possibly flawed proxy nal auditors. At the global level, the FSB hasor rating system. Ultimately, the approach requested action from several global bodieswould help in limiting the buildup of risk that to ensure greater international consistency inoccurred prior to the financial crisis. audit practices, and to provide more specific
72 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 guidance for external audits. The focus of source of financial instability in finan- these reforms is on ensuring higher-quality cial systems. Modern financial systems information for supervisors, but it is impor- with limited liability encourage risk-tak- tant to use the momentum also for improving ing incentives in financial institutions, 25 the quality of information that investors get and these incentives can be exacerbated from the audits. by badly designed regulations and safety Finally, a further push is needed to nets. The literature has identified a number strengthen global accounting standards. of market failures that are relevant to finan- Many observers have recently awakened cial stability and that result from incentive to the importance of accounting because problems. 26 of the controversy over the mark-to-market Of course, most regulations affect incen- principle (or more appropriately, “fair value tives in one way or another, and the impor- accounting”) and its impact during the finan- tance of designing regulations in a way that cial crisis. In late 2007 and early 2008, sev- is incentive-compatible is being increasingly eral prominent financiers and analysts pro- recognized in international forums. The tested that the rapid decreases in the market recent regulatory reforms at the global level, prices of U.S. mortgage-based securities and as well as at the country level, have included other assets were meaningless and caused by measures on systemically important financial liquidity shortfalls. According to them, mark- institutions, compensation policies, a reduced ing these assets to reduced amounts in bal- role of credit ratings, initiatives on data, and ance sheets would precipitate an unnecessary information gaps, all of which go some way crisis. With hindsight, this analysis was not toward addressing the weaknesses high- completely correct. It is widely accepted that lighted by the crisis. financial markets can overshoot in their cor- Reconciling private incentives with pub- rections, which in a mark-to-market environ- lic interest by regulation is key, but far from ment could create contagion effects; however, trivial. Addressing one incentive issue by a for the most part, the reason for the reduced new or amended regulation often only leads market prices was a permanent loss of value to creating incentive breakdowns elsewhere. rather than a temporary effect resulting from And some of the existing incentive issues lack of liquidity in the markets. In this case, (for example, lack of incentives of supervi- the transparency that fair value accounting sors from different jurisdictions to share provided played a key role in pushing these relevant information in situations of stress) institutions’ management through the recog- have not really been fully addressed, in spite nition of losses. Box 2.6 provides a viewpoint of the efforts made at the international level on this topic. under the coordination of the FSB. As dem- Greater transparency and better infor- onstrated, for example, in Barth, Caprio, and mation would not have the desired positive Levine (2012a), regulators have often failed effect on sustainable financial development if to implement the regulations and exercise the market participants did not have incentives powers that they already had. They point out to monitor performance. The next section that among other factors, psychological bias therefore turns to the issue of incentives. in favor of the industry—similar to that pre- vailing in sports, where referees regularly call games in favor of home teams—also operates Incentive issues in finance. In the authors’ view, therefore, the The identification and correction of incen- key issue to address is not necessarily more tive problems that create systemic risk regulations (although some additional regula- should be at the center of any framework tions may be appropriate), but it is how to get that seeks to maintain financial stabil- regulators to enforce the rules. So, how are ity. Many economists believe incentive governments to ensure that addressing the problems are perhaps the most important incentive breakdowns is indeed central to the
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 73 Box 2.6 Accounting Standards (Viewpoint by Nicolas Véron) Sometimes it takes a narrow lens to distinguish the community, and setting incentives for individual true features of big objects. The future of financial jurisdictions to adopt and enforce standards to globalization, whatever one’s perspective on its foster genuine cross-border comparability of finan- dangers or merits, is one of the biggest questions cial statements. At this point, it is still too early to of the moment. By contrast, accounting has often judge whether the attempt to make IFRS the domi- been perceived as boring. But the policy debate on nant global accounting language can succeed on an accounting, and especially on International Finan- enduring basis. But there are already important les- cial Reporting Standards (IFRS), entails large sons that have wide significance beyond the com- stakes and important lessons for global financial munity of accounting professionals. integration. First, global financial rules are not a utopian As is so often the case, the policy debate is vision but a reality. The initial success of IFRS has obscured by the weight of special interests. Most been remarkable. Their adoption has been smooth notably, financial industry executives and their lob- and has generally improved financial reporting byists were able to convince many policy makers and quality, starting in the European Union in 2005 but non–accounting experts that fair value accounting increasingly now in other countries as well. Given had been a major aggravating factor in the initial the right conditions, financial regulatory harmoni- phase of the crisis, in late 2007 and early 2008, zation can work across continents. even as later developments clearly demonstrated that Second, the crisis has increased the need for pub- there had been no excessive undershooting of mar- lic oversight of financial rules, but it is not yet clear ket prices during that period. A similar sequence had how this can be done effectively and consistently. A happened a few years earlier in the United States, monitoring board of public entities was created in when corporate advocates managed to delay the 2009 to oversee the IFRS Foundation, but its con- accounting recognition of the cost of stock options struction is awkward and raises concerns about its for nearly a decade. In accounting, as in most other legitimacy and future effectiveness. For the foresee- areas of financial regulation, the issues are technical able future we will have to rely on trial-and-error and jargon-ridden, and the potential financial conse- experimentation for international financial regula- quences are large, so that public debates and policy tory bodies, which in most cases cannot take exist- decisions are easily captured. Therefore, governance ing national arrangements as a direct model. arrangements are crucial. Third, those global bodies that exist have yet to The governance of accounting standard setting adapt to the ongoing rebalancing of the financial has widely varied over time and across countries. world. The IFRS Foundation is registered in the The general trend of the past few decades has been United States; its staff is in London; its monitor- toward standard setters that are more independent ing board gives permanent seats only to the United vis-à-vis governments and special industry interests. States, European Union, and Japan; and it still But the challenges related to the IFRS are unprece- caters largely to audiences in the developed world, dented because these standards are set at the global even as large emerging economies represent a rap- level. There is no global government to oversee the idly increasing share of global finance. We don’t IFRS Foundation, the organization that sets the stan- know whether or how China, India, and others dards, or to enforce consistent IFRS implementation will take responsibility at the global level for trans- across countries. Nor is there any coherent global parency and integrity in financial reporting. But if representation of investors, whose information needs efforts to empower them in formal global institu- the standards are primarily meant to serve. tions are not accelerated, it is hard to see how such Answers may lie in the IFRS Foundation mak- institutions can fulfill their potential. ing more efforts to organize the global investor
74 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 regulatory framework? One suggestion, pro- approaches to assessing financial stability, in posed by Barth, Caprio, and Levine (2012a), particular, stress testing and use of supervi- instead of focusing on the regulations them- sory codes and standards. The incentive audit selves, focuses on how to better oversee the would focus on the key elements that moti- regulators. Specifically, they propose a senti- vate and guide financial decision making. nel agency, which would watch the regulators A focus on correcting incentive issues and on behalf of taxpayers. The agency would putting them front and center does not mean have no regulatory powers, but it would have discarding the existing regulatory and super- the ability to obtain all the information avail- visory frameworks. In other words, what is able to regulatory agencies, along with the needed is an evolutionary change, not a revo- duty to report on the key systemic risks and lution. The effort would involve a reorienta- on what the regulators are doing to address tion toward a regulatory and supervisory those risks. framework that is more focused on the suf- Going in a similar direction, Masciand- ficiency of information disclosures, factors aro, Pansini, and Quintyn (2011) emphasize that influence the incentives to monitor activ- the distinction between macro- and micro- ities within financial firms, corporate gover- prudential supervision. Using empirical evi- nance and compensation practices, conflicts dence from the crisis, they make a case for of interest, and explicit and implicit guar- keeping macroprudential supervision insti- antees. A greater focus on incentives, which tutionally separate from microprudential could be achieved by extending or improving supervision. In other words, it seems better existing efforts, would support the regula- for macroprudential supervisors not to have tory approaches by identifying the underlying direct microprudential supervisory powers, distortions that can give rise to systemic risk, as long as they have the ability to obtain all including in the design and application of the the relevant information to assess the key regulations themselves. The effort would also systemic risks and the steps to address those help to prioritize the regulatory response on risks. Such an arrangement allows for more a systemwide basis and increase the attention checks and balances and thus reduces the on bolstering effective market discipline in probability of supervisory failure. support of regulation. Many countries have recently been put- ting in place committees or new agencies to Keeping regulatory rules as simple carry out macroprudential regulation and as possible, and promoting strong supervision. In some cases, these agencies or enforcement bodies maintain a clear separation between macro- and microprudential supervision. In It is important to keep the rules as simple as other countries, however, macroprudential needed for their effective monitoring, and to committees or agencies are also involved in promote strong enforcement. 27 This point microprudential supervision. This is different relates closely to the previous two points on from the sentinel agency, which cannot have asymmetric information and incentive prob- any direct regulatory or supervisory powers, lems: complexity can make it difficult for to limit the risk of conflicts of interest. supervisors, investors, and others to distill How are governments and agencies to the relevant information about soundness increase the focus on incentives in prac- of financial institutions and about systemic tice? ˇ Cihák, Demirgüç-Kunt, and Johnston risk. Also, combined with bad incentives for (2012a, 2012b) propose that the identifica- financial institutions’ managers, complexity tion of incentive problems be based on a can make it easier for financial institutions to specific analysis of incentives, an “incen- bypass regulatory rules and use obfuscation tive audit” (box 2.7). Such audits, building to their advantage. on a methodology proposed in an earlier However, finance is not a simple busi- paper by Johnston, Chai, and Schumacher ness. Imposing simplicity through draconian (2000), could be used to complement other measures would be either too costly or not
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 75 ˇ Box 2.7 Incentive Audits (Viewpoint by Martin Cihák, Asli Demirgüç-Kunt, and R. Barry Johnston) Introducing incentive audits could strengthen finan- to address incentive issues by adapting regula- cial sector policy. The basic idea of such audits is to tion, supervision, and other measures. In Iceland, more regularly and systemically evaluate structural the analysis was done as a postmortem, benefiting factors that affect incentives for risk taking in the from hindsight. But it is feasible to do such analy- financial sector. The key issues that audits would sis ex ante. Indeed, much of the information used need to cover include contract design, banking pow- in the commission’s report was available (read- ers, banking relationships, structure of ownership ily, or with moderate data-gathering effort) even and liabilities, industrial organizations, existence of before the crisis. Also, the commission had relatively guarantees, and the adequacy of safety nets. modest resources (three members and small sup- How would incentive audits look in practice? To port staff), illustrating that incentive audits need get a clearer idea, one can take a 2010 report by a not be very costly or overly complicated to per- parliamentary commission examining the roots of form. As the commission’s report points out, “it the 2007 financial crisis in Iceland. The report notes should have been clear to the supervisory authori- the overly rapid growth of the three major Icelandic ties that such incentives existed and that there was banks as a major contributor of the crisis, and docu- reason for concern,” but supervisors “did not keep ments the underlying “strong incentives for growth,” up with the rapid changes in the banks’ practices,” which included the banks’ incentive schemes as well and instead of examining the underlying reasons for as the high leverage of the major owners (Special the changes, they took comfort in the banks’ capital Investigation Commission 2010). The report maps ratios exceeding a statutory minimum and appear- out the network of conflicting interests of key bank ˇ ing robust in narrowly defined stress tests (Cihák owners, who were also the largest debtors of these and Ong 2010). banks. Existing approaches do not entirely overlook This illustration captures the basic notion of issues related to incentives. Many reports on finan- an incentive audit. There are other examples (such cial stability focus very narrowly on a quantitative as Calomiris 2011, who uses an incentive-based ˇ description and analysis of trends (Cihák, Muñoz, approach to propose a reform of the U.S. regulatory Teh Sharifuddin, and Tintchev 2012), but some do ˇ framework). Cihák, Demirgüç-Kunt, and Johnston mention the misalignments between private sector (2012b) provide a more detailed description of the incentives and public interests. So this area could audit, going from a top-level examination of the key be usefully extended and made a more permanent elements of the financial environment in an econ- feature of the reporting. Also, in the context of the omy—market structure and financial instruments, World Bank/IMF Financial Sector Assessment Pro- government safety net, legal framework, and quality gram, when assessments collect information on own- of enforcement—to a more detailed and prioritized ership of financial institutions, they look into issues assessment of incentives, mindful of the likely effect such as safety nets. The idea of incentive audits, on the behavior of the main agents in the system. therefore, is not to build a new assessment from The checklist of key features would be accompanied scratch, but to raise the profile of incentive-related by guidance with evaluation methodology for con- issues and bring more structure to the assessments. sistent application across countries. Incentive audits should be seen not as a replacement To be effective, incentive audits would have to of other parts of the overall assessment of vulner- be performed regularly, and their outcome used abilities, but as a complement.feasible. For example, requiring all banks have been circulated—for example, thoseto move from limited to unlimited liability that suggest directly constraining financialcould bring banks’ size down substantially, institutions’ size or substantially narrowingbut it would not be feasible in contemporary the range of permissible activities—wouldfinancial systems. 28 Other proposals that potentially have serious side effects and
76 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 weaknesses, such that their implementation critical of the risk-weighted asset concept should be subject to careful analysis before as a proxy for actual exposures, and sug- their actual adoption. One possible way to gested replacing risk-weighted capital ratios keep institutions from becoming systemically with (significantly higher) leverage ratios, important, as noted, for example, in Rajan combined with strong disclosures about risk (2010), may not be through crude prohibi- exposures. Their argument is based on the tions on size or activity, but through collect- observation that the system of risk-calibrated ing and monitoring of information about capital requirements, in particular under the exposures among institutions and risk con- model-based approach, played a key role in centrations in the system. allowing banks to be undercapitalized prior An important aspect of the debate on com- to the crisis, with strong systemic effects for plexity relates to issues of capital adequacy deleveraging multipliers and for the function- and leverage. Empirical evidence suggests ing of interbank markets. The issue is not that when faced with uncertainty, markets trivial, of course, partly because of the short- tend to pay more attention to more basic indi- and medium-term adverse effects such high cators that are more difficult to bypass. For ratios could have on financial intermediation example, Demirgüç-Kunt, Detragiache, and and financial development. Merrouche (2012) used a multi ountry panel c Another alternative approach to current of banks to study whether better-capitalized risk-based capital regulation would be to banks experienced higher stock returns dur- have a simple leverage ratio (which is simple ing the financial crisis. They found that a enough to monitor and enforce) adjusted stronger capital position was associated with upward by the loan spreads banks charge better stock market performance, and that their customers. As discussed in Calomiris the relationship is stronger when capital is (2011), using loan spreads to measure loan measured by the leverage ratio rather than the default risk is desirable because these spreads risk-adjusted capital ratio, and that higher- are accurate forecasters of the probability quality forms of capital, such as tier 1 capi- that a loan will become nonperforming (Ash- tal and tangible common equity, were more craft and Morgan 2003). This would be an relevant. These empirical findings, of course, example not only of a simple regulation but do not imply that using leverage as the only also of an incentive-robust one, since banks tool is a complete solution; nonetheless, the clearly would not have an incentive to lower authors use these results to make a case for their interest rates just to reduce their capi- relatively greater reliance on simpler capi- tal budgeting against a loan, because doing tal ratios, such as the leverage ratio, that are so would reduce their income and defeat the more difficult to circumvent. purpose of circumventing the regulation. 29 Of course, a sole reliance on the lever- An added advantage of this approach would age ratio, which is not risk-sensitive, could be that monitoring interest rates is fairly become problematic, as it could give banks uncomplicated even in the least developed of an incentive to shift to riskier activities to emerging markets. boost returns. Therefore, it is important to Other approaches focus on complement- take into account the relative riskiness of ing basic capital ratios (such as a common the various assets; however, views differ as equity requirement) by so-called contingent to who should do it and how. Basel III has capital (CoCo) requirements. These authors recognized the usefulness of basic leverage provide evidence that seems to imply that a ratios and narrower (high-quality) measures CoCo requirement, complementing common of capital and has combined them with the equity, would be an effective prudential tool. risk-based ratios. CoCos can help the prompt recapitalization Several authors have proposed to move of banks after significant losses of equity even further. For example, Hellwig (2010) but before the bank has run out of options and Admati and Hellwig (2012) have been to access the equity market. That dynamic
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 77 Box 2.8 Regulatory Discipline and Market Discipline: Opposites or Complements? In a major precrisis study of banking regulation T he global financial crisis has highlighted fail- around the world, Barth, Caprio, and Levine (2006) ures both in regulatory and supervisory discipline have used the data from the earlier versions of the as well as in market discipline. It has thrown a World Bank’s Bank Regulation and Supervision Sur- particularly unflattering light on market discipline, vey to examine the various regulatory approaches and highlighting its intrinsic limitations, especially when compare them to the outcomes that countries care key assumptions are not met. At the same time, the about. They concluded that the standard features of crisis has also highlighted the serious regulatory and banking supervision and regulation do not reduce— supervisory failures that contributed to the crisis. and may even increase—the chance that countries In a recent paper, Barth, Caprio, and Levine experience banking crises. Nor do these rules and (2012b) follow up on this analysis, using the crisis regulations lead to more developed banking sectors or observations as well as data from the 2011 Bank more efficient banks. These findings are, according to Regulation and Supervision Survey database. The the authors, consistent with private interest views and results of their analysis support a complementary the fact that “few countries have highly developed role for regulation and market discipline, as high- democratic institutions” (13). In contrast, policies lighted recently by Haldane (2011). Market disci- that enable private markets to better monitor banks pline and state-imposed regulatory and supervisory and that encourage private actors to “discipline” discipline are complementary, since each has its own banks are associated with desirable outcomes. But limitations, and market failures often have their critically, they found no link between market moni- roots in regulatory failures. toring and the likelihood of a bank crisis.incentive feature of a properly designed The debate on these proposals is still ongo-CoCo requirement would encourage effective ing, so this is unlikely to be the last word.risk governance by banks, provide a more But most proposals argue that the regula-effective solution to the too-big-to-fail prob- tory framework should include well-definedlem, reduce forbearance risk (supervisory capital and liquidity measures that are moni-reluctance to recognize losses), and address tored and enforced by a strong supervisoryuncertainty about the appropriate amount of body, which should be held accountable forcapital banks need to hold (and the changes its activities. This need for strong enforce-in that amount over time). Calomiris and ment of regulatory rules should also includeHerring (2011) examine this proposal in transparency and disclosure requirementsdetail, concluding that if a proper CoCo (as pointed out, for example, by the Shadowrequirement had been in place in 2007, the Financial Regulatory Committee 2011). Indisruptive failures of large financial institu- other words, proposals suggest market dis-tions, and the systemic meltdown after Sep- cipline should become an important comple-tember 2008, could have been avoided. They ment to the supervisory discipline providednote that, to be effective, (a) a large amount by an independent but accountable supervi-of CoCos relative to common equity should sory body (box 2.8).be required, (b) CoCo conversion should be The issue of regulatory complexity is,based on a market value trigger, (c) all CoCos of course, much broader than the capitalshould convert if conversion is triggered, and requirements and the issue of risk weighting.(d) the conversion ratio should be dilutive of The U.S. Shadow Regulatory Committee haspreexisting equity holders. However, how long advocated simpler and more transpar-these untested instruments would actually ent regulations (Shadow Financial Regula-perform in case of need remains to be seen. tory Committee 2011). However, the broader
78 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 trend, confirmed also by the Bank Regula- that did not have a banking crisis in 2007 tion and Supervision Survey, is toward more through 2009—had more stringent defini- complex regulations, not only in developed tions of capital, higher capital levels, and less economies but also in developing economies. complex regulatory frameworks. They had Various observers have pointed out the bur- stricter audit procedures, limits on related den of this new complexity for the industry;30 party exposures, and asset classification stan- but in many countries, especially the smaller dards; and their supervisors were more likely and lower-income ones, this also adds sub- to require shareholders to support distressed stantially to the already existing capacity banks with new equity. Noncrisis countries constraints. This complexity makes it more were also characterized by better quality of difficult for supervisors to ensure that regula- financial information and greater incentives tions are actually and effectively implemented to use that information—among other rea- and, importantly, for taxpayers to see what sons, because they have relatively less gener- is being done to keep the system safe and to ous deposit insurance coverage. hold supervisors accountable. The global financial crisis has also trig- gered a healthy policy debate on approaches to regulation and supervision. This ongoing Conclusion debate among regulators, policy makers, and Although the overall role of the state in academics has led to multiple reform propos- finance is an open question, there is clearly als, highlighting the diversity of views. This an important role for the state in financial is likely to inform the regulatory reform pro- sector regulation and supervision. This is the cess and improve future outcomes. one area where the role of the state is not in This chapter reviewed the progress with dispute; the real debate is over how to ensure regulatory reforms at the global level as well that the role is performed well. as in individual countries, and identified the Good regulation needs to better align pri- advances made so far in many areas. It also vate incentives with public interest, without recognized a number of reform proposals taxing or subsidizing private risk taking. that suggest improvements on the current Supervision is meant to ensure implementa- approaches to regulation and supervision. tion of rules and regulations and to address These proposals aim to limit regulatory arbi- limitations of market discipline. trage opportunities and better employ regu- The global financial crisis underscored latory resources and capacity. Among the limitations in both regulatory and market common themes of these proposals are calls discipline. It emphasized the importance of for greater regulatory simplicity and trans- combining strong, timely, and anticipatory parency as a way to enhance accountability, supervisory enforcement with a better use as well as for more proactive identifying and of market discipline. It also highlighted the addressing of incentive problems. importance of the basics, that is, solid and transparent legal and institutional frame- Notes works to promote financial stability. In many developing economies, the conclusion is that 1. For example, Greenspan (2005, para. 17–19) building up supervisory capacity needs to be remarked that “regulatory reform, coupled with innovative technologies, has stimulated a top priority. the development of financial products, such Lessons can be learned by analyzing regu- as asset-backed securities, collateral loan lation and supervision in economies that were obligations, and credit default swaps that at the epicenter of the global financial crisis facilitate the dispersion of risk. . . . These and those that were not. The World Bank’s increasingly complex financial instruments new global survey, presented in this chap- have contributed to the development of a far ter, suggests that noncrisis countries—those more flexible, efficient, and hence resilient
GLOBAL financial DEVELOPMENT REPORT 2013 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r 79 financial system than the one that existed just poses. For example, U.S. supervisors did raise a quarter-century ago.” alarms about the risks of subprime lending, 2. See FSB Charter, article 1. but a significant tightening of the pruden- 3. This report uses a broad concept of “the tial practices did not occur before the crisis, state” that includes not only government but reflecting pressures from the industry and also autonomous or semiautonomous agen- lawmakers (Levine 2010). Reviews of com- cies such as a central bank or financial super- pliance with the Basel Core Principles find vision agency. that some of the weakest areas relate to the 4. For example, Carmichel and Pomerleano operational independence of the regulators, (2002) and de la Torre, Ize, and Schmukler and that—despite some progress in recent (2011). years—this is still an issue in many develop- 5. In addition to regulation, another state inter- ing economies (Čihák and Tieman 2011). vention that can also have an impact on finan- 13. For more on shadow banking and FSB-related cial sector risk taking is financial taxation. It response see FSB (2012). has received some policy attention during the 14. Demirgüç-Kunt and Huizinga (2011), using crisis (see, for example, IMF 2010c). None- a wide international sample of banks, present theless, the regulatory approach is likely to evidence that casts doubts on the need for sys- remain central for practical policy in the fore- temically large banks even from the narrower seeable future, and is therefore the focus of this perspective of bank shareholders. It suggests chapter (for a discussion of the pros and cons that bank growth has not been in the interest of regulation and taxation, see Keen 2011). of bank shareholders in small economies, and 6. Masciandaro, Pansini, and Quintyn (2011) it is not clear whether those in larger econo- provide an overview of the literature on the mies have benefited. Inadequate corporate causes on the crisis, focusing on supervisory governance structures in financial institutions and regulatory failures. have enabled managers to pursue high-growth 7. See the respective IMF country reports (IMF strategies at the expense of shareholders, pro- 2010a; IMF 2012). viding support for greater government regula- 8. Data on larger and more interconnected tion (as also argued, for example, in Barth, financial institutions show that they have Caprio, and Levine 2012a). been taking on more risk and have been more 15. The work of the FSB in this area is meant to likely to experience financial stress than oth- make credible to all counterparts of a finan- ers (Ötker-Robe and others 2011). cial institution the possibility of its failure, so 9. Many banks, especially in advanced econo- they exercise due monitoring on management mies, held a relatively small part of capital and control of shareholders. as equity, with the remainder being in capital 16. Another related, although less explored, facet with weak loss-absorbing characteristics that of market discipline is the forced departure had little value during the crisis. Given the of managers from underperforming financial large differences and lack of transparency in institutions. Schaeck and others (2011) find the definition of capital, it was hard to assess that when banks take on too much risk and and compare the adequacy of capital across get into trouble, their managers do get forced institutions. out. But it is often too late for the banks,10. Banks could reduce their risk capital require- which tend to remain in trouble for years ments through shifts in assets to legally remote after the turnover. entities excluded from asset definitions, 17. For more on this subject, see also a recent through credit default swaps that reduced the debate between Rene Stulz of Ohio State regulatory risks in their portfolio, or through University and Lucian Bebchuk of Harvard credit enhancements that improved the rat- Law School and others at the “All About ings of assets and thus the need to hold regu- Finance” blog on the World Bank’s website. latory capital. (http://blogs.worldbank.org/allaboutfinance/11. For example, the mandates of the United the-aaf-virtual-debates). Kingdom’s Financial Services Authority and 18. Gaps and weaknesses in regulation and Switzerland’s Federal Banking Commission. supervision were not the only factors con-12. Even supervisors that are independent in tributing to the crisis, as discussed earlier in principle can be overruled for political pur- this chapter, though they are expected to have
80 t h e s t a t e a s r e g u l a t o r a n d s u p e r v i s o r GLOBAL financial DEVELOPMENT REPORT 2013 played an important role. Also, although the pros and cons of returning to unlimited systemic crisis prevention is not the only liability for banks. Although such a move objective of regulation and supervision (for would almost certainly bring banks’ size example, some regulations focus on customer down “with a bang” (as noted by Charles protection, anti–money laundering, and so Goodhart in his March 1, 2012, debate on), crisis prevention is usually seen as a with Robert Pringle at centralbanking.com), key objective, so juxtaposing regulation and it would not be feasible in a contemporary supervision in crisis and noncrisis countries financial system. does offer interesting insights. Nevertheless, 26. For a broad overview of the underlying fac- users should note that these findings are cor- tors of financial crises, see de la Torre and Ize relations, and do not imply causality. (2011). In addition to incentive breakdowns 19. This section does not aspire to be an all- and asymmetric information, they also men- inclusive compendium of all reforms. More tion issues of collective cognition (“nobody work is ongoing or contemplated, for really understands what is going on”) and instance on accounting standards, shadow costly enforcement (“crises are a natural part banking, financial supervision, and mar- of the financial landscape”). ket infrastructures. For more on these, see 27. The long-running debate on rules versus http://www.financialstabilityboard.org/ principles in supervision (Mersch 2007) has publications/r_111104.pdf. been intensified by the crisis. In the context of 20. See the Leaders’ statement after the Pittsburgh this debate, for example, the incentive audits Summit in September 2009 (G-20 Leaders, proposal calls for a greater emphasis on well- 2009). defined principles. Specifically, the principles 21. See FSB (2011b). SIFIs are financial institu- need to address the various misalignments in tions whose distress or disorderly failure, incentives, both among market participants because of their size, complexity, and inter- and among regulators. But emphasizing well- connectedness, would cause significant dis- defined principles does not mean that one can ruption to the wider financial system and do away with rules. Similarly, the proposal to economic activity. focus on incentives does not mean abolishing 22. In addition to the four steps listed here, stron- microprudential supervision. Effective rules ger international standards for core financial and efficient principles are both essential to market infrastructures are to be finalized in promote financial integration and reinforce early 2012, aiming to reduce contagion risks financial stability. It would be naive to think when failures occur. that principles applied on a stand-alone basis 23. On May 31, 2012, the International Asso- can eliminate the need for rules. ciation of Insurance Supervisors released for 28. The intrinsic desirability of such a measure public consultation its assessment method- for financial stability purposes is far from ology for identifying globally systemically undisputed, since the solvency analysis that important insurers (see http://www.iaisweb. creditors are expected to make would shift its org/view/element_href.cfm?src=1/15384. focus from the bank per se to the personal pdf). wealth of the bank proprietors, which would 24. This report focuses on global trends. Recent probably prove to be a quite challenging task. regional reports of the World Bank provide 29. Interest rates on deposits could also be used related updates on regulatory and supervisory because these too are associated with bank trends in individual regions, such as Latin risk (Acharya and Mora 2012). However, America and the Caribbean (de la Torre, deposit rates tend to be sensitive to bank risk Ize, and Schmukler 2011) and Middle East only very close in time to bank insolvency and North Africa (Rocha, Arvai, and Farazi because of explicit and implicit deposit insur- 2011). ance. 25. Banks have not always operated with limited 30. For the United States, see for example, the liability, pre-19th-century England being a Economist 2012; for the European Union, case in point. Several authors have discussed see, for example, Wall Street Journal 2011.
3 The Role of the State in Promoting Bank Competition • ompetition in the banking sector promotes efficiency and financial inclusion, with- C out necessarily undermining financial stability. • ven if the recent crisis is perceived as an episode where competition exacerbated E private risk taking and helped destabilize the system, the correct public policy is not to restrict competition. What is needed is a regulatory framework that ensures that private incentives are aligned with public interest. • he state can play a role in enhancing banking competition by designing policies that T guarantee market contestability through healthy entry of well-capitalized institutions and timely exit of insolvent ones and by creating a market-friendly informational and institutional framework. • overnments should be mindful of the consequences of their intervention during G c rises and limit negative consequences on bank competition and risk taking.T he recent crisis reignited the interest of to future instability as a result of moral haz- policy makers and academics in assess- ard problems associated with too-big-to-fail ing bank competition and rethinking the institutions. Box 3.1 presents a recent debaterole of the state in shaping competition policies on the relationship between competition and(that is, policies and laws that affect the extent financial stability.to which banks compete).1,2 Some believe that Another reason why competition mat-increases in competition and financial inno- ters is related to the changing mandate ofvation in markets such as subprime lending central banks and bank regulatory agen-contributed to the recent financial turmoil. cies. Although traditionally the primary goalOthers worry that the crisis and government of bank regulators has been to ensure banksupport of the largest banks increased bank- stability, this is changing. According to theing concentration, reducing competition and World Bank’s Bank Regulation and Supervi-access to finance, and potentially contributing sion Survey, updated in 2011, 71 percent of g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 81
82 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 Box 3.1 Two Views on the Link between Competition and Stability In a recent debate held by The Economist magazine, were weakened by banks’ off balance sheet vehicles, two banking professors expressed contrasting views which were used to hold securitized assets.” about the role of bank competition in promoting On the other hand, Thorsten Beck, Professor of stability. Economics and Chairman of the European Banking According to Franklin Allen, Nippon Life Pro- Center at Tilburg University, argues that “compe- fessor of Finance and Economics, Wharton School, tition in banking is not dangerous per se; it is the University of Pennsylvania, “more competition does regulatory framework in which banks operate and make banking more dangerous.” But he also cautions which sets their risk-taking incentives that drives that “competition is only one of the factors contribut- stability or fragility of banking. Competition can ing to instability.” He goes on to say that “the experi- be a powerful source of useful innovation and effi- ence of a number of countries in the past and dur- ciency, ultimately benefitting enterprises and house- ing the recent crisis provides some insights into the holds; competition can also foster stability through relevant issues. Historically, the comparison that has improved lending technologies; competition, how- often been made is between the stability of the Cana- ever, can also endanger stability if mixed with the dian banking system compared to the United States’ wrong kind of regulation.” experience. In the late 19th and early 20th century, “Risks and dangers in banking arise primarily the United States had many banking crises, while from a regulatory framework that is not adapted Canada did not. The standard explanation for this is to the market structure. Large financial institutions that Canada had a few large banks, while the United turn too-big-to-fail because the regulator does not States had many small banks. In the recent crisis, the have any means to properly discipline and resolve banking system in Canada and also that in Australia them. Similarly, competition results in herding and were very resilient. Six banks dominate the Canadian increased fragility risk in the absence of macro-pru- financial system, while there are four major banks dential tools to counter asset price and credit booms together with a few small domestic banks in Austra- and take into account co-variation between banks’ lia. However, the United Kingdom, whose banking risk profiles. The experience from the last crisis has system has a broadly similar structure to Australia’s, led to reform attempts exactly in these two areas: with four major banks and a few other small domes- resolution, especially of systemically important tic and foreign banks, had a very different experience. financial institutions, and macro-prudential regula- The lesson of this comparison is that competition is tion. It is thus not market structure or competition only one of the many factors that are important. In per se, that drives fragility, but a regulatory frame- addition to the competitive nature of the industry, work that sets the wrong incentives.” funding structure and the institutional and regulatory “The challenge is to maintain competition in the environments are important. These factors are well market to the benefit of the real economy, while at illustrated by the recent experience of Canada, Aus- the same time creating a regulatory framework that tralia, and the United Kingdom. Canadian and Aus- minimizes the negative implications that competi- tralian banks mainly relied on depositary funding. tion can have for stability. Such a framework would This funding source proved stable through the crisis. include additional capital charges for size, com- In contrast, British banks increasingly used wholesale plexity and systemic importance of banks, macro- funding from financial markets. Canada and Aus- prudential regulations that take into account the tralia also have much more conservative regulatory interaction between financial institutions, and— environments than the UK. For example, in Canada, most critically—a resolution framework that allows capital regulation is stricter than the Basel agreements resolving even the largest financial institutions, thus require. Banks’ foreign and wholesale activities are reducing the perverse incentives stemming from a limited. The mortgage market is also conservative in too-big-to-fail status.” terms of the products offered, with less than 3 percent This discussion suggests that both sides share being subprime and less than 30 percent being securi- more in common than they disagree with, but see tized. In the UK a ‘light touch’ regulatory framework Economist 2012 http://www.economist.com/debate/ was implemented. An illustration is that capital ratios days/view/706 for more. Source: The Economist 2012 (reprinted with permission).
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 83bank regulators report that their mandate and bank pricing behavior. It then reviewsalso includes promoting financial inclusion the evidence on the implications of bankingand economic development. Also, 65 percent competition for bank efficiency, access tomention issues of market conduct, and nearly finance, and financial stability. After that, the25 percent mention competition policy. chapter analyzes the policy drivers of compe-Hence, either directly or indirectly—because tition and highlights the role of the state ascompetition influences market conduct and a regulator and enabler of a market-friendlyaccess to finance—competition is an impor- informational and institutional environment.tant issue for regulators.3 It also examines the impact on competition This chapter presents measures of bank of government actions during crises. Thecompetition and describes basic trends across chapter concludes by summarizing the policyeconomies and over time. By illustrating implications.various approaches to measuring competi-tion and discussing factors that drive it, the Bank Competition:chapter seeks to provide guidance to policy Measurement andmakers. Stylized Facts The chapter conveys four main messages: There are three main approaches to assess-• Bank competition improves efficiency ing bank competition: measures of bank across banks and enhances access to finan- concentration under the “structure-conduct- cial services, while not necessarily eroding performance” paradigm, regulatory indica- the stability of the financial system. tors that measure the contestability of the• Policies to address the causes of the recent banking sector, and direct measures of bank crisis should not restrict competition. The pricing behavior or market power based on correct public policy should establish a the “new empirical industrial organization” regulatory framework that supervises and literature. ensures the alignment of private incentives An alternative approach used by some with public interest. studies to analyze bank competition is based• The state should promote competition on interest spread decomposition (box 3.2). both as a regulator and as an enabler of a But spreads are outcome measures of effi- market-friendly informational and institu- ciency, and in addition to the competition tional environment. Policies that improve environment, cross-country differences in market contestability—through healthy spreads can reflect macroeconomic perfor- entry of well-capitalized institutions and mance, the extent of taxation on financial timely exit of insolvent ones, opportune intermediation, the quality of the contractual flow of adequate credit information, and and judicial environment, and bank-specific contract enforceability—will enhance factors such as scale and risk preferences. So competition among banks. this chapter instead presents direct measures• State interventions during crises may cre- such as the Panzar-Rosse H-statistic, the ate barriers to exit that permit insolvent Lerner index, and the so-called Boone indica- and inefficient banks to survive and gener- tor. Box 3.3 summarizes these measures.4 ate unhealthy competition. Governments Competition may vary within economies should take steps to eliminate distortions and across products (for example, by type of in risk taking and limit their negative con- loan, such as corporate or consumer). Ideally, sequences on bank competition. competition should be measured by business line for different markets (box 3.4). But such The chapter first discusses alternative disaggregated data are often not available,measures of competition and presents trends and most measures cannot be computed sep-across economies and over time, using mea- arately for these submarkets. Accordingly, insures of market concentration, contestability, what follows, country and regional measures
84 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 Box 3.2 Decomposing Bank Spreads to Make Inferences about Bank Competition Bank interest spreads are frequently used as an indi- Demirgüç-Kunt and Huizinga (1999) and Beck cator of the efficiency of the banking system (Beck and Fuchs (2004) follow the identities above to con- and Fuchs 2004; Demirgüç-Kunt and Huizinga duct an accounting decomposition and an economic 1999; Demirgüç-Kunt, Laeven, and Levine 2004). analysis of the determinants of bank net interest An accounting decomposition of bank spreads or margins using data for 80 countries between 1988– of interest margins (the value of a bank’s net inter- 95, in the first case, and focusing on 38 banks in est income divided by assets) can be derived from a Kenya for the year 2002, in the second case. straightforward accounting identity: To the extent that high spreads are explained by high profit margins, these studies infer that lack of Before-tax profits to assets (BTP/TA) = After-tax competition could be a factor. In the economic anal- profits to assets (ATP/TA) + taxes to assets (TA/A) ysis of spreads, Demirgüç-Kunt and Huizinga (1999) From a bank’s income statement, before-tax profits regress spreads and profits on measures of concen- must satisfy the accounting identity: tration (as an indicator of competition) and conclude that, aside from other factors, lack of bank compe- BTP/TA = NI/TA + NII/TA – OV/TA – LLP/TA tition drives bank spreads and profits across coun- where NI is net interest income, NII refers to non- tries. Similarly, Beck and Fuchs (2004) conclude that interest income, OV stands for overhead costs, and the high profit margins that explain part of the high LLP refers to loan loss provisioning. The identities spreads in Kenya are due to lack of competition in above allow for a decomposition of net interest mar- the banking sector. gins (NI/TA) into its components: NI/TA = ATP/TA + TA/A − NII/TA + OV/TA + LLP/TA are used to illustrate different approaches to region have the largest CR5 concentration assessing bank competition. ratios (figure 3.2). The structure-conduct-performance para- Concentration measures are not good pre- digm assumes that there is a stable, causal dictors of competition.5 The predictive accu- relationship between the structure of the racy of concentration measures on banking banking industry, firm conduct, and perfor- competition is challenged by the concept of mance. It suggests that fewer and larger firms market contestability. The behavior of banks are more likely to engage in anticompetitive in contestable markets is determined by behavior. In this framework, competition is threat of entry and exit. Banks are pressured negatively related to measures of concentra- to behave competitively in an industry with tion, such as the share of assets held by the low entry restrictions on new banks and easy top three or five largest banks and the Her- exit conditions for unprofitable institutions— findahl index. even if the market is concentrated. Figure 3.1 depicts the asset share of the Figure 3.3 depicts two (admittedly imper- five largest banks (CR5) in developed and fect) proxies of regulatory indicators that developing economies, showing that banking capture entry conditions into the banking systems are more concentrated in developing industry: an index of barriers to entry and than developed economies. Across regions, the share of banking licenses denied. These banking systems in Sub-Saharan Africa and two indicators are from the World Bank’s the Gulf Cooperation Council (GCC) coun- Bank Regulation and Supervision Survey, tries of the Middle East and North Africa and they capture entry restrictions into the
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 85 Box 3.3 Measuring Banking Sector Concentration and Competition Banking concentration can be approximated by the Higher values of the H-statistic are associated concentration ratio—the share of assets held by the k with more competitive banking systems. Under a largest banks (typically three or five) in a given econ- monopoly, an increase in input prices results in a rise omy—or the Herfindahl-Hirschman index (HHI), in marginal costs, a fall in output, and a decline in the sum of the squared market share of each bank in revenues (because the demand curve is downward the system. The HHI accounts for the market share sloping), leading to an H-statistic less than or equal of all banks in the system and assigns a larger weight to 0. Under perfect competition, an increase in input to the biggest banks. Instead, concentration ratios prices raises both marginal costs and total revenues completely ignore the smaller banks in the system. by the same amount (since the demand curve is per- The concentration ratio varies between nearly 0 and fectly elastic); hence, the H-statistic will equal 1. 100. The HHI has values up to 10,000. If there is A frequently used measure of markups in bank- only a single bank that has 100 percent of the mar- ing is the Lerner index, defined as the difference ket share, the HHI would be 10,000. If there were a between output prices and marginal costs (relative large number of market participants with each bank to prices). Prices are calculated as total bank revenue having a market share of almost 0 percent, the HHI over assets, whereas marginal costs are obtained would be close to zero. from an estimated translog cost function with The Panzar and Rosse (1982, 1987) H-statistic respect to output. Higher values of the Lerner index captures the elasticity of bank interest revenues to signal less bank competition. input prices. The H-statistic is calculated in two steps: The Boone indicator measures the effect of effi- ciency on performance in terms of profits. It is calcu- 1. Running a regression of the log of gross total rev- lated as the elasticity of profits to marginal costs. To enues (or the log of interest revenues) on log mea- calculate this elasticity, the log of a measure of prof- sures of banks’ input prices. its (such as return on assets) is regressed against a 2. Adding the estimated coefficients for each input log measure of marginal costs. The elasticity is cap- price. Input prices include the price of depos- tured by the coefficient on log marginal costs, which its (commonly measured as the ratio of interest are typically calculated from the first derivative of a expenses to total deposits), the price of personnel translog cost function. The main idea of the Boone (as captured by the ratio of personnel expenses to indicator is that more-efficient banks achieve higher assets), and the price of equipment and fixed capi- profits. The more negative the Boone indicator is, tal (approximated by the ratio of other operating the higher the level of competition is in the market, and administrative expenses to total assets). because the effect of reallocation is stronger.banking industry. The first indicator, an The competitive environment of theoverall index of barriers to entry, summa- banking system can also be affected byrizes the information needed to obtain a the strategic reactions of banks. The newbanking license. Higher index values indicate empirical industrial organization literaturemore stringent requirements for bank entry. provides three indicators of banks’ pricingThe second indicator of contestability is the behavior.6share of applications for bank licenses that First, the H-statistic measures the elastic-were denied. Regulations concerning entry ity of banks’ revenues relative to input pricesto the banking sector are, on average, more (Panzar and Rosse 1982, 1987). Under per-stringent in developing economies than in fect competition, an increase in input pricesdeveloped ones. Between 2001 and 2010, the raises both marginal costs and total revenuesshare of denied banking licenses declined for by the same amount, and hence the H-statis-both groups of countries. tic equals 1. Under a monopoly, an increase
86 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 Box 3.4 nalyzing Bank Competition Using Disaggregated Business Line Data: A Evidence from Brazil Urdapilleta and Stephanou (2009) use disaggregated existence of more substitute providers (like capital business data for banks in Brazil to analyze the driv- markets or overseas banks) in the corporate sector ers of bank revenues, costs, and risks in the retail keeps loan rates and fees lower. Similarly, the study and corporate segments. The study allocates rev- cites easier access to credit information for large cor- enues, costs, and all other line items in the financial porations as another reason why competition in this statements of the banking system into different busi- segment is higher. ness lines. This approach results in financial state- Among the policies that can foster competition ments and ratios by business line. Other public data in the retail segment, the study mentions promoting sources were used and assumptions made to estimate the portability of bank accounts, permitting positive notional financial statements for each business line. credit information sharing, and expanding payment Interviews with senior management served as a con- system interconnection. All these allow customers to sistency check on the overall methodology. switch banks more easily and, therefore, force banks A key finding of the analysis is that the retail to compete more actively. banking segment has significantly higher returns (39 The study illustrates how differences across mar- percent) than the corporate segment (16 percent), ket segments, which tend to be averaged out in an despite being riskier and costlier. In particular, aggregate analysis, need to be taken into account higher lending rates and fees more than compensate when designing public policy in banking. The study for additional expenses. also highlights that a great deal of in-depth knowl- The study argues that one of the reasons for edge of the banking sector is required to be able to lower profitability in the corporate sector is the use the practitioner approach to obtaining profitabil- higher degree of competition among providers in the ity measures by business line and to be able to assess segment. In particular, the study mentions how the bank competition across market segments. Figure 3.1 Five Bank Concentration Ratio (CR5): in input prices results in a rise in marginal Developed and Developing Economies costs, a fall in output, and a decline in rev- enues, leading to an H-statistic less than or Median asset share of 5 largest banks, % equal to 0. Panzar and Rosse (1987) show 90 that when H is between 0 and 1, the system 80 operates under monopolistic competition. 70 In general, the H-statistic is interpreted as a measure of the degree of competition in the 60 banking market.7 50 Second, the Lerner index captures the dif- 40 ference between output prices and marginal 30 costs of production—that is, the markup of 20 output prices over marginal costs (Lerner 10 1934).8 0 Finally, the Boone indicator is based on 1996–2010 2000–07 2000–10 the association between firm performance Developed economies Developing economies and efficiency (Boone 2001; Boone, Griffith, and Harrison 2005; Hay and Liu 1997). See Source: Calculations based on Bankscope (database). box 3.3 for further details on the calculation
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 87Figure 3.2 Five Bank Concentration Ratio (CR5): Developing Regions, Median Values, 1996–2010 Median concentration 100 90 80 70 60 50 40 30 20 10 0 East Asia Europe and Latin America GCC Middle Non-GCC Middle South Asia Sub-Saharan and Pacific Central Asia and the East and East and Africa Caribbean North Africa North AfricaSource: Calculations based on Bankscope (database).of these pricing indicators of banking indicator, a measure of the effect of effi-competition. ciency on performance in terms of profits. Figure 3.4 depicts the H-statistic for An increase in the Lerner index or the Boonedeveloped and developing economies. Bank indicator indicates a deterioration of the com-pricing behavior was more sensitive to petitive conduct of financial intermediaries.changes in the price of inputs among devel- Banking competition in developed economiesoped compared with developing economies deteriorated initially (1996–2003), increasedin 1996 –2007, indicating that banking in the run-up to the global financial crisissystems in developed economies behave (2004–08), and worsened afterward (2009–more competitively. But bank competition 10). The initial deterioration could be associ-declined in 2008–10 for developed econo- ated with the drop in competition observedmies, while it improved for developing econ- in the euro area after the adoption of theomies. It can be argued that the declining European Monetary Union (Sun 2011) and intrend in developed economies may be attrib- line with findings of less competitive behav-uted to the implications on industry struc- ior of banks in large and integrated financialture and competitive conduct of the recent markets (Bikker and Spierdijk 2008).9systemic banking crisis and its associated It is important to note that the simplelarge-scale policy responses. observation that competition increased Figure 3.5 examines the competitive before the crisis does not necessarily suggestbehavior of banking systems across develop- that greater competition in itself spurred theing regions. Latin America has the systems crisis. Recent studies suggest the problem waswith the highest sensitivity of output to input that the increase in competition occurred inprices, whereas those in the Middle East and an environment where regulation and super-North Africa appear to be the least competi- vision were too lax and incentives for ade-tive (see box 3.5 for further details). quate risk management were missing (Barth, Figure 3.6 shows the evolution of the Caprio, and Levine 2012; Caprio, Demirgüç-Lerner index, a measure of market power Kunt, and Kane 2010).that compares output pricing and marginal On the other hand, the financial cri-costs (that is, markup), as well as the Boone sis—and the subsequent policy responses by
88 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 Figure 3.3 Regulatory Indicators of Market Contestability a. Entry barriers: b. Share of denied licenses: Developed versus developing economies Developed versus developing economies Average of region Average of region, % 8 25 7 20 6 5 15 4 3 10 2 5 1 0 0 Developed economies Developing economies Developed economies Developing economies 2001 2010 2001 2010 c. Entry barriers across developing regions d. Share of denied licenses across developing regions Average of region Average of region, % 8 80 7 70 6 60 5 50 4 40 3 30 2 20 1 10 0 0 sia sia sia ic sia GC bbe ica GC Afr ast ric t ca ic GC bbe ica GC Afr ast ric t ca Af as Af as cif cif fri fri hA hA lA ri er lA ri er an C M an an C M ica So a an C M an an C M ica So a h E th E h E th E Pa Pa nA nA Ca m No ort dle or ddle Ca m No ort dle or ddle tra ra ut ut he in A h e in A d d t ra ra d d an en an en dN i dN i dN i dN i ha ha d t Lat d t Lat dC dC ia ia Sa Sa As As an an b- b- st st n- Su n- Su pe pe Ea Ea an an ro ro Eu Eu 2001 2010 2001 2010 Sources: Calculations based on Bank Regulation and Supervision Survey (database), World Bank, 2007 data; Barth, Caprio, and Levine 2001, 2004, 2006; ˇ Cihák and others 2012. Note: The index of entry into banking requirements captures whether various types of legal submissions are required to obtain a banking license. Higher scores indicate greater restrictions on entry into banking. On the other hand, the share of denied licenses is the ratio of denied to total license requests. governments—may have affected the com- and Spain). The Lerner index and the Boone petitive conduct of financial intermediaries indicator for developing economies evolve in in developed economies.10 Sun (2011) finds a similar fashion, with a smoother trend in that bank competition in developed econo- the Boone indicator than the Lerner index. mies deteriorated during this period, espe- Deterioration of bank competition may cially in countries that had large credit and have taken place in spite of financial reforms housing booms (such as the United States across developing economies—especially in
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 89Figure 3.4 Bank Competition: Developed vs. with variability across geographical regionsDeveloping Economies (figure 3.7). Though GCC countries in the Middle East and North Africa display the H-statistic (OLS regional estimates) least competitive banking systems, Latin 0.65 American banking systems have the most 0.60 competitive systems in developing regions. 0.55 0.50 0.45 The Impact of Competition 0.40 on the Banking System 0.35 0.30 Competition affects the banking industry 0.25 along three dimensions: efficiency, access to 0.20 finance, and stability. 0.15 0.10 0.05 Competition and banking efficiency 0.00 1996–2007 2000–07 2000–10 There are two views on the direction of cau- Developed economies Developing economies sality between competition and efficiency. The “quiet life” hypothesis argues thatSource: World Bank staff, based on Bankscope (database). monopoly power allows banks to relax theirNote: OLS = ordinary least squares. efforts and increases their costs, predicting a positive link from competition to efficiency (Hicks 1935). Alternatively, the “efficientcountries with weak institutions (low bureau- structure” hypothesis predicts a negativecratic quality and low transparency) and low relationship between competition and effi-levels of economic development (Delis 2012). ciency, where causality runs from efficiency The Lerner index and Boone indicator in to competition (Demsetz 1973). Accordingdeveloping country regions mimic the aver- to this view, better managed, more efficientage for developing economies—although firms can secure the largest market shares,Figure 3.5 Bank Competition across Developing Regions, 1996–2007 H-statistic (OLS regional estimates) 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 East Asia Europe and Latin America GCC Middle Non-GCC Middle South Asia Sub-Saharan and Pacific Central Asia and the East and East and Africa Caribbean North Africa North AfricaSource: Calculations based on Bankscope (database).Note: H-statistic figures are calculated following the methodology described in Demirgüç-Kunt and Martínez Pería 2010.
90 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 Box 3.5 Banking Competition in the Middle East and North Africa Banking sectors in the Middle East and North Third, the paper compares the extent of banking Africa region (MENA) are among the deepest in sector competition in the region to that observed in the developing world (see table B3.5), but are they other regions of the developing world. Finally, the competitive? paper analyzes the factors that explain differences Anzoategui, Martínez Pería, and Rocha (2010) in competition between MENA and other regions. analyze bank competition in the region in four dif- The estimations of the H-statistic and the Lerner ferent ways. First, the study analyzes two distinct index show that banking sectors in MENA operate measures of competition, the H-statistic and the under monopolistic competition. Comparisons over Lerner index, over a longer period of time, 1994– time indicate that competition within MENA, both 2008. Second, the paper examines the behavior of among Gulf Cooperation Council (GCC) countries competition in the region and tests for differences and non-GCC economies, has not improved and, in across two subperiods: 1994–2001 and 2002–08. many cases, worsened. Table B3.5.1 Competition in MENA and across Regions H-statistics Lerner index Regions (1994–2008) (2002–08) (1994–2008) (2002–08) Middle East and North Africa 0.520 0.482 0.320 0.373 GCC countries 0.497 0.470 0.360 0.435 Non-GCC countries 0.528 0.508 0.241 0.258 p-value GCC = non-GCC 0.640 0.640 0.050 0.010 East Asia and Pacific 0.614 0.584 0.230 0.265 p-value East Asia and Pacific = GCC 0.070 0.120 0 0 p-value East Asia and Pacific = non-GCC 0.020 0.140 0.810 0.890 Eastern Europe 0.685 0.694 0.182 0.196 p-value Eastern Europe = GCC 0 0 0 0 p-value Eastern Europe = non-GCC 0 0 0.240 0.240 Latin America and the Caribbean 0.743 0.765 0.215 0.234 p-value Latin America and the Caribbean = GCC 0 0 0 0 p-value Latin America and the Caribbean = non-GCC 0 0 0.580 0.630 Former Soviet Union 0.659 0.669 0.271 0.266 p-value Former Soviet Union = GCC 0.010 0 0 0 p-value Former Soviet Union = non-GCC 0 0 0.520 0.860 South Asia 0.710 0.677 0.244 0.272 p-value South Asia = GCC 0 0.010 0.020 0 p-value South Asia = non-GCC 0 0 0.970 0.800 Sub-Saharan Africa 0.521 0.518 0.223 0.169 p-value Sub-Saharan Africa = GCC 0.700 0.510 0.040 0.020 p-value Sub-Saharan Africa = non-GCC 0.830 0.850 0.810 0.450 Note: GCC = Gulf Cooperation Council, MENA = Middle East and North Africa. Relative to other regions, MENA is lagging suggests that a worse credit information environ- behind in terms of bank competition. The evaluation ment and stricter regulations and practices govern- of the factors explaining differences in banking sec- ing bank entry are at least partly to blame. tor competition between MENA and other regions
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 91leading to more concentration and less Figure 3.6 Bank Competition: Developed vs. Developingcompetition. Economies Although studies that examine the linkbetween concentration and efficiency find a. Lerner index, 1996–2010mixed results,11 the overwhelming major- Median across banksity of recent empirical studies conclude that 0.30competition brings about improvements inefficiency in both developed and developing 0.25economies. Using data for more than 14,000 0.20banks operating in Europe and the UnitedStates, Schaeck and Čihák (2008) find a 0.15positive effect of competition on profit andcost efficiency. Similarly, using a technique 0.10to obtain joint estimates of efficiency and 0.05market power among banks in the EuropeanMonetary Union, Delis and Tsionas (2009)find a negative relationship, which is in line 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20with the quiet life hypothesis. Comparable findings are obtained when Developed economies Developing economiesthe sample of economies is extended to b. Boone indicator, 1997–2010include developing economies. Using data on Median across banksnet interest margins and overhead costs for 0.000over 1,400 banks in 72 developed and devel-oping economies, Demirgüç-Kunt, Laeven, –0.005and Levine (2004) find that tighter regula- –0.010tions on bank entry and bank activities leadto higher costs of financial intermediation. –0.015Lin, Ma, and Song (2010) find a similarresult for 2,500 banks operating in 74 econ- –0.020omies. Finally, focusing on 60 developing –0.025economies, Turk-Ariss (2010) finds a signifi-cant negative association between bank mar- –0.030ket power (as measured by the Lerner index) 97 98 99 00 01 02 03 04 05 06 07 08 09 10 19 19 19 20 20 20 20 20 20 20 20 20 20 20and cost efficiency.12 Overall, the literature examining the link Developed economies Developing economiesbetween direct measures of competition andefficiency suggests that more bank competi- Source: Calculations based on Bankscope (database). Note: Lerner index estimations follow the methodology described in Demirgüç-Kunt and Martíneztion increases bank efficiency in both devel- Pería (2010). The regional estimates for the Lerner index are based on the median of bank esti-oped and developing economies. mates within the region. Boone indicator estimations follow the methodology used by Schaeck ˇ and Cihák (2010a) with a modification to use marginal costs instead of average costs. Data are pooled by region in order to estimate the regional Boone indicator. Boone indicator data are not shown for Sub-Saharan Africa because of a lack of adequate dataCompetition and access to financeTheory makes ambiguous predictions regard-ing the effect of competition on access to asymmetries and agency costs, competitionfinance. The conventional market power can reduce access by making it more dif-hypothesis argues that competition in the ficult for banks to internalize the returnsbanking market reduces the cost of finance from investing in lending, in particular, withand increases the availability of credit. On opaque clients.13the other hand, the information hypothesis Most of the empirical studies on thisposits that in the presence of information question used concentration as a measure
92 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013Figure 3.7 Bank Competition across Developing Regions banking sectors.15 Using data on growth in value added from 1980–90 for 16 countries, and measuring competition at the country- a. Lerner index, 1996–2010 level (using the Panzar and Rosse H-statistic), Median across banks 0.55 Claessens and Laeven (2005) find that com- 0.50 petition is positively associated with indus- trial growth. They suggest that competi- 0.45 tive banking sectors are better at providing 0.40 financing to financially dependent firms. 0.35 Exploiting a rich dataset on small and 0.30 medium-sized enterprises in Spain, Carbó- 0.25 Valverde, Rodríguez-Fernández, and Udell 0.20 (2009) also find evidence that competition 0.15 promotes access to finance, using the Lerner 0.10 index.16 In sum, similar to the findings on 0.05 the link between competition and efficiency, 0.00 the evidence that measures bank competition 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 directly suggests that competition is ben- 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 eficial for the banking sector. In particular, b. Boone indicator, 1997–2010 bank competition enhances access to credit. Median across banks 0.55 Competition and banking stability –0.01 Competing theories explain the link between –0.02 competition and stability.17 The traditional view predicts that competitive banking sys- –0.03 tems are less stable because competition reduces bank profits and erodes the char- –0.04 ter value of banks, consequently increasing –0.05 incentives for excessive risk taking (Chan, Greenbaum, and Thakor 1986; Keeley 1990; –0.06 Marcus 1984). Furthermore, in more com- –0.07 petitive environments, banks earn lower informational rents from their relationship 97 98 99 00 01 02 03 04 05 06 07 08 09 10 19 19 19 20 20 20 20 20 20 20 20 20 20 20 with borrowers, reducing their incentives to East Asia and Pacific Non-GCC Middle East properly screen borrowers, again increasing Europe and Central Asia and North Africa the risk of fragility (Allen and Gale 2000, Latin America and the Caribbean South Asia 2004; Boot and Greenbaum 1993). Competi- GCC Middle East and North Africa Sub-Saharan Africa tion can also destabilize the banking sector through its impact on the interbank marketSource: Calculations based on Bankscope (database). and the payments system.Note: Lerner index estimations follow the methodology described in Demirgüç-Kunt and MartínezPería (2010). The regional estimates for the Lerner index are based on the median of bank esti- For example, if all banks are price-takersmates within the region. Boone indicator estimations follow the methodology used by Schaeck in a competitive market, banks have no incen- ˇand Cihák (2010a) with a modification to use marginal costs instead of average costs. Data arepooled by region in order to estimate the regional Boone indicator. Boone indicator data are not tives to provide liquidity to a troubled bank,shown for Sub-Saharan Africa because of a lack of adequate data. leading to bank failure, and creating negative repercussions for the entire sector (Allen and Gale 2000). A somewhat different argument of competition, obtaining mixed results.14 in support of the competition-fragility view But studies that focus on direct measures is that more concentrated banking systems of competition and contestability show that have larger banks, which in turn allow them access to finance is easier in more competitive to diversify their portfolios better. A final
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 93argument refers to the number of banks to be 2007a) find that more competitive bankingsupervised. Given that a more concentrated systems (defined as those with fewer regula-banking system typically implies a smaller tory restrictions on bank entry and activities)number of banks, this might reduce the are less likely to suffer systemic banking dis-supervisory burden and enhance the overall tress. This finding is confirmed by Schaeck,stability of the banking system. Čihák, and Wolfe (2009), who find a negative The competition-stability view argues relationship between bank competition andthat market power in banking boosts prof- systemic bank fragility using the H-statisticits and stability, yet ignores the potential to measure competition. Schaeck and Čihákimpact of market power on borrower behav- (2010b) identify bank capitalization as oneior (Boyd and de Nicoló 2005). Because of the channels through which competitionbanks in less competitive sectors can charge fosters stability. Using data for more thanhigher interest rates, this may induce firms 2,600 European banks, they show that banksto assume greater risk—resulting in a have higher capital ratios in more competitivehigher probability that loans become non- environments. This is consistent with Berger,performing. Similarly, higher interest rates Klapper, and Turk-Ariss (2009), who findmight attract riskier borrowers through the that banks in more competitive banking sys-adverse selection effect. Thus, in contrast tems take greater lending risks, but compen-to the charter-value hypothesis, the com- sate with a higher capital-asset ratio, result-petition-stability view predicts that bank ing in an overall lower level of bank risk, asactions will result in more risk taking and measured by the z-score.greater fragility in more concentrated and Measures of bank risk, such as theless competitive banking systems. Advo- z-score, ignore systemic stability, but regu-cates of the competition-stability view also lators are concerned with systemic stabil-disagree with the notion that concentrated ity much more than the absolute level ofbanking systems are easier to monitor than risk of individual banks. In a recent paper,less concentrated banking systems with Anginer, Demirgüç-Kunt, and Zhu (2012)many banks, since larger banks can be more introduce a new measure of systemic riskcomplex and, hence, harder to supervise. taking by banks. Using Merton’s 1973 con- The early empirical literature on the link tingent claim pricing framework, they cal-between competition and stability is mixed. culate the default probability for each bankSome country studies have shown that in the system. They measure systemic riskincreasing competition leads to greater indi- as the codependence in default probabilityvidual bank risk taking.18 In the context of across banks. After controlling for variousthe U.S. subprime crisis, Dell’Ariccia, Igan, bank- and country-level variables, Anginer,and Laeven (2012) document that the rapid Demirgüç-Kunt, and Zhu (2012) find a posi-growth of credit in U.S. mortgage markets tive relationship between competition andin the run-up to the crisis was accompanied systemic stability. They also show that lackby a reduction in lending standards (lower of competition (as measured by the Lernerloan application denial rates), which they index) has a more adverse effect on systemicargue was in part explained by the entry of stability in countries with low levels of for-new and large lending institutions. How- eign ownership, weak investor protection,ever, some previous studies failed to find that generous safety nets, and weak regulationlarger banks are less likely to fail as would be and supervision.predicted by the competition-fragility view The advantages of competition in an effi-(Boyd and Graham 1991, 1996; Boyd and cient and inclusive financial system are sig-Runkle 1993; De Nicoló 2000). nificant. Recent studies provide evidence On the other hand, studies using cross- questioning the conventional view that com-country, time-series data sets offer evidence petition is bad for stability. Importantly,supporting the competition-stability view. policy bodies such as the OECD CompetitionBeck, Demirgüç-Kunt, and Levine (2006, Committee have suggested that to promote
94 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 banking stability, policy makers should practices, the state can shape the information design and apply better regulations and environment and influence the extent of bank supervisory practices rather than limit bank competition. competition (OECD 2010). The institutional environment can also have an impact on bank competition. For example, to the extent that corruption is ram- Drivers of Bank Competition pant in the economy, there will be less scope The main drivers of competition are entry for a level playing field in the financial sector, and exit policies, underlying information and and competition will suffer as a result. Simi- institutional environment, and competitive larly, to the degree that creditor rights are not pressures in the financial sector.19 The state protected, there will be less incentive for new can directly influence all three. The state banks to enter the banking sector. The state can also affect bank competition by owning directly influences the institutional environ- banks. Box 3.6 analyzes the determinants of ment by the laws that it promotes and the banking competition across economies. extent to which it upholds compliance. Entry and exit policies in banking are All else being equal, the entry of foreign important for competition because they keep banks and the presence of nonbank interme- incumbents on their toes. The threat of entry diaries are likely to affect bank competition. and exit to the industry forces banks to worry Foreign banks often bring new technologies about providing good, affordable products and new products to banking sectors, creat- and limits their ability to exercise market ing an incentive for local banks to compete. power. Entry policies include regulations on Similarly, the presence of a liquid stock mar- licensing, as well as the practice by regulators ket or other financial intermediaries that can of approving new licenses. Exit policies refer provide financing to firms is likely to foster to regulations as well as the measures taken competition in the banking sector, because by regulators to close insolvent banks. The banks will have to compete to provide finan- state can directly affect bank competition by cial services to firms. Once again, the state promoting policies and practices that facili- has a role to play here by introducing regula- tate bank entry and exit. A delicate balance tions and practices that foster the entry and needs to be struck where regulators foster operation of nonbank competitors. contestability (to streamline requirements for Finally, government ownership of banks bank licensing, speed up the licensing pro- can also affect bank competition. On the cess, and implement efficient bank resolution) one hand, government banks can spur com- without jeopardizing bank stability (that is, petition if (because they typically do not maintaining a licensing process that keeps maximize profits) they push other banks to out unfit bankers). lower prices. On the other hand, if govern- Access to credit history information about ment banks dominate the system and other potential borrowers also facilitates compe- banks are crowded out, competition falls. tition in the banking sector. Dell’Ariccia, Box 3.6 shows that banking systems are Friedman, and Marquez (1999) show that to more competitive in countries with lower the extent that access to credit information entry barriers, greater foreign bank par- is restricted, incumbent banks are better able ticipation, and more developed capital mar- to exercise market power and limit competi- kets (which are also associated with greater tion. At the same time, greater disclosure of development of nonbank financial interme- information regarding the terms of banking diaries). 20 Greater information disclosure, products will generate greater awareness by as captured by depth of credit information, bank clients and promote bank competi- also promotes competition. Box 3.7, on the tion. By promoting the establishment and other hand, highlights the importance of operation of credit bureaus and by having in consumer protection measures to enhance place consumer protection regulations and banking competition.
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 95 Box 3.6 An Econometric Analysis of Drivers of Bank Competition The Lerner index is used as the summary measure institutional framework is measured by the index of of competition across 83 countries and is regressed control of corruption, which measures the degree to against variables capturing the following: which public power is exercised for private benefit— such as state capture by elites and private interests 1. Entry and exit policies in the banking sector. (Kaufmann, Kraay, and Mastruzzi 2009). 2. The information and institutional environments. Competitive pressures from within and outside 3. Competitive pressures from within and outside the the banking sector are captured by indicators of banking sector. Bank-level Bankscope data for the market structure, presence of foreign banks, liquid- period 2000–10 are used to compute the Lerner ity of the stock market, and importance of nonbank index for all countries with at least five banks. intermediaries such as insurance companies and pension funds. Market structure is measured by the The first group of barriers to entry comprise mea- share of assets held by the top five banks in the sys- sures such as the number of documents and proce- tem. To the extent that there is some validity to the dures required to obtain a banking license, the per- structure-conduct-performance paradigm, this vari- centage of denied applications for banking licenses, able is expected to be positive and significant. Cross- and the minimum entry capital required for banks. border banking as captured by the share of banking The second group includes a synthetic indicator of assets held by foreign banks may reflect a greater activity restrictions that captures a bank’s ability to degree of market contestability. To the extent that engage in activities other than banking (say, securi- this is the case, promoting foreign bank participa- ties, insurance, or real estate). Higher values of this tion may increase competition in the industry. On index represent greater restrictions. Both indexes are the other hand, if foreign bank entry is associated constructed with data from the World Bank 2006 with mergers and acquisitions, it might not enhance Bank Regulation and Supervision Survey. competition. Finally, a more competitive banking The availability of credit history information is system may arise from greater interindustry compe- captured by the depth of credit information index tition. In short, the development of nonbank finan- gathered from Doing Business (see http://www. cial intermediaries may affect the market power doingbusiness.org). This index takes values from 0 of the banking sector. The relative importance of to 6, and higher values indicate greater availability such intermediaries is approximated by the value of of information. The extent to which the government shares traded to gross domestic product (GDP), the requires that financial institutions disclose informa- value of life insurance premiums to GDP, and the tion about financial contracts to potential users of share of pension fund assets to GDP. this service is measured by an index on the strict- The table below suggests that the banking sec- ness of financial contract disclosure requirements, tor is more competitive (the Lerner index is lower) which was constructed based on questions from in countries with greater contestability (lower entry the World Bank Regulation and Supervision Sur- barriers), greater information disclosure, better vey. This contract disclosure index is also a measure institutions, more foreign bank participation, and of consumer protection. The quality of the overall more liquid stock markets. (Continued on next page)State Interventions holidays, provide blanket guarantees, injectduring Crises and Banking capital, increase deposit insurance coverageCompetition limits, and extend liquidity support to banksDuring crises, governments, central banks, on an unprecedented scale (Laeven and Valen-and other authorities in charge of the super- cia 2008, 2010). During tranquil periods, thevision and regulation of financial institu- competitive effects of rescue operations ontions introduce deposit freezes, declare bank individual banks (such as capital injections,
96 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 Box 3.6 An Econometric Analysis of Drivers of Bank Competition (continued) Table B3.6.1 Cross-Country Determinants of Banking Competitiona Variable       State as regulator: Market contestability Entry barriers 0.0401* 0.0376 0.013 0.0279 0.0242 0.0537** [0.024] [0.023] [0.028] [0.021] [0.019] [0.021] Share of bank licenses denied –0.0025 0.0229 –0.0616 –0.0132 –0.0589 [0.038] [0.037] [0.049] [0.042] [0.043] Restrictions on bank activities –0.0074 –0.0049 –0.01 –0.0087 –0.009 [0.005] [0.005] [0.008] [0.006] [0.006] Minimum entry capital required (ln) 0.0025** 0.0022* 0.0011 0.0006 0.0005 0.0031** [0.001] [0.001] [0.001] [0.001] [0.001] [0.001] State as enabler of market-friendly environments Depth of credit information –0.0110* –0.0130** [0.006] [0.006] Strictness of financial contract –0.0074 disclosure requirements (0-4) [0.010] Control of corruption –0.0291** –0.0172 –0.0299* –0.0318*** –0.0235* –0.0193 [0.011] [0.013] [0.017] [0.011] [0.012] [0.015] State as bank owner Government bank participation –0.0417 –0.0793* –0.0854 –0.044 –0.0394 –0.0734 [0.046] [0.044] [0.064] [0.047] [0.047] [0.048] Competitive pressures within the banking sector and from other parts of the financial sector Foreign bank participation –0.0594** –0.0677 –0.0614 –0.0859*** –0.0715** –0.0822** [0.028] [0.034] [0.050] [0.029] [0.030] [0.034] Concentration (CR5) 0.1119** 0.0816 0.0191 [0.055] [0.063] [0.065] Stock market value traded –0.0371* –0.0616** (ratio to GDP) [0.020] [0.023] Life insurance premium 0.3105 (ratio to GDP) [0.445] Pension fund assets 0.0448 (ratio to GDP) [0.031] Constant 0.0178 0.0195 0.2706 0.0503 0.1403 –0.0858 [0.191] [0.189] [0.221] [0.176] [0.152] [0.158] Observations 83 71 38 72 64 42 R-squared 0.189 0.231 0.369 0.273 0.355 0.399 Note: GDP = gross domestic product. a. A countrys Lerner index is the median estimate across banks over the period 2000–10. Robust standard errors are in brackets. ***p < 0.01 **p < 0.05 *p < 0.1 emergency liquidity facilities, and assisted affect large numbers of institutions, with mergers) tend to be relevant only for a limited potential implications for industry structure number of distressed institutions and their and competitive conduct in financial systems competitors (Gropp and others 2011; Hak- over longer periods of time. enes and Schnabel 2010). However, episodes An emerging body of research exam- of systemic banking crises frequently result ines the effects of bank bailouts and other in large-scale, repeated policy responses that policy responses on risk taking at the bank
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 97 Box 3.7 Consumer Protection and Competition in South Africa Among emerging markets, South Africa has a well- ments and barriers to entry in the payments systems, developed financial sector and one of the largest cap- but the inquiry put special emphasis on measures of ital markets. In 2010, the outreach of the banking consumer protection. sector, as measured by its credit to the private sector, Advances in consumer protection are justified totaled 145 percent of GDP, while stock market cap- on the grounds that they can promote competition italization to GDP amounted to 278 percent of GDP. and depth. Providing better information to custom- In recent years, major South African banks have also ers can lead to rising price and product competi- expanded throughout the region—notably, Absa and tion among banking intermediaries. In this context, Standard Bank (Beck and others 2011). However, South Africa established a series of mechanisms the banking sector is heavily concentrated, with the and institutions that promoted a more sound infor- five largest banks accounting for over 90 percent of mation environment. The National Credit Act 34 total assets and deposits in the system in 2010. Esti- (enacted in 2005), for instance, provides a general mates of market power in the South African banking framework to promote responsible lending practices, industry show that there is evidence of monopolis- protect South African consumers from unfair credit tic competition (Greenberg and Simbanegavi 2009; and credit marketing practices and, more generally, Mlambo and Ncube 2011), which is consistent with establish norms and standards on consumer credit. the fact that large banks tend to avoid competition It also created the National Credit Regulator to among themselves, as reported by the Competition ensure the law’s compliance, investigate complaints, Commission on Banking (OECD 2008). promote financial literacy, and provide a knowledge The lack of competition in the South African platform on credit practices. On the other hand, banking sector has been documented in several cases of noncompliance and appeals to decisions reports prepared for the National Treasury and the of the regulators were allowed to be presented and South African Reserve Bank (Falkena and others solved by the National Consumer Tribunal. 2004; Competition Commission of South Africa In spite of the advances on abusive lending prac- 2006). As manifested by high prices and poor qual- tices, the mechanisms established by the National ity of financial services, low rates of innovation, Credit Act to restructure consumer debt have been and financial exclusion, the lack of competition was slow. For instance, Beck and others (2011) point attributed partly to high concentration and profit- out that as few as 5 percent of the 150,000 applica- ability in retail banking and payments (OECD tions made by overly indebted consumers have been 2010). This led to the Banking Enquiry launched by finalized by courts. Finally, better use of consumer the Competition Commission in August 2006. The protection networks requires financially aware con- result of this inquiry led to several recommendations sumers. Efforts to raise the effectiveness of financial to address problems of restrictive interbank arrange- literacy programs are required. Sources: Beck and others 2011; Greenberg and Simbanegavi 2009; Mlambo and Ncube 2011; OECD 2010.level (Berger and others 2010; Duchin and entrenchment of the supported institutions;Sosyura 2011; Farhi and Tirole 2012; Gropp, assisted mergers of large financial institutionsHakenes, and Schnabel 2011; Hakenes and increase concentration, presumably reducingSchnabel 2010; Hoshi and Kashyap 2010; competition in retail markets and reinforcingRichardson and Troost 2009). However, how the perception that these banks are too bigthese actions affect competition has received to fail (Beck and others 2010; Hakenes andless attention. This issue is of vital impor- Schnabel 2010).tance because of the unintended (and pos- More research is clearly needed in thissibly detrimental) effects for consumer wel- area, though a number of studies suggestfare. For example, guarantees can result in that state interventions that favor some bank
98 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 services (such as guarantees, liquidity sup- number of banks in the system can easily lead port, recapitalizations, and nationalizations) to lower levels of bank competition (OECD force competitors to behave more aggres- 2009). In that case, governments should pro- sively, leading to decreased margins and mote the entry of deserving institutions to increased competition (Gropp, Hakenes, and mitigate the negative impact of mergers. Schnabel 2011; Hovakimian and Kane 2000; Overall, it is clear that state interven- Kane 1989). Using data for 138 countries that tions during crises can have an impact on witnessed a variety of policy responses dur- bank competition and potentially on future ing 46 banking crises, Calderón and Schaeck banking stability. Governments should avoid (2012) find that Lerner indexes and net inter- insolvency resolution policies that not only est margins drop as a result of state interven- distort risk-taking incentives and jeopardize tions such as guarantees, liquidity support, future stability, but also have implications for recapitalizations, and nationalizations. the level of competition in the banking sector. This apparent increase in competition should be interpreted with caution—espe- Implications for the Design cially if the type of state intervention under of Competition Policies consideration delays the exit of inefficient and insolvent banks. Kane (2000) argues Bank competition increases efficiency and that some state interventions can constitute financial inclusion. Recent evidence suggests a barrier to exit by allowing these banks that bank competition can even enhance sys- to survive beyond their “natural death.” temic financial stability. Hence, bank com- State support to these zombie banks—a petition should not be restricted with the term coined by Kane (1989)—would allow hope of promoting stability. Instead, the state these institutions to bid up deposit rates and should design and enforce regulations that accept low interest rates on high-risk loans create the right incentives to safeguard stabil- and investments, thus reducing profit mar- ity, while at the same time promote competi- gins in the industry (Kane 2000; Kane and tion and efficiency. Rice 2001). In sum, states can create zombie The state can shape bank competition banks by distorting risk-taking incentives of through its actions as a regulator and an the system and generating unhealthy com- enabler of a market-friendly and information- petition. Calderón and Schaeck (2012) show rich environment. In particular, banking that the increase in competition that might sectors are more competitive in economies result from state interventions during crises where the state designs, implements, and is also accompanied by other negative conse- enforces regulatory frameworks that ensure quences. Despite the evidence that the cost of greater contestability. More specifically, poli- borrowing is reduced and credit is restored as cies designed to ease the entry of deserving a result of these state interventions, access to institutions (those that can pass fit and proper credit by opaque borrowers such as small and tests) and promote timely exit may prevent medium enterprises is reduced. incumbent banks from exercising market To avoid the distorting effects of state power and lead to a more competitive envi- interventions, sunset clauses and exit plans ronment. Related to the less stringent barriers are important (Beck, Coyle, and others 2010). to entry, foreign bank penetration may also By providing credible signals that interven- be conducive to greater competition. tions are temporary, governments can reduce The state can also promote competition the negative repercussion for competition. in the banking sector by ensuring banks’ Similarly, addressing governance deficien- and consumers’ access to information as cies in the supported institutions can also be well as by building up a sound institutional important in reducing incentives for excessive framework that levels the playing field. Free risk taking. Finally, measures such as gov- flow of credit information among banks and ernment-sponsored mergers that reduce the transparency of financial products offered
GLOBAL financial DEVELOPMENT REPORT 2013 t h e r o l e o f t h e s t a t e i n p r o m o t i n g b a n k c o m p e t i t i o n 99by banks to potential consumers should be and full integration—as opposed to differ-ensured by the state. A sound institutional ent types of partial integration supervisoryframework that ensures the enforcement of models.contracts, property rights, and the rule of law Competition can bring important benefitsthat limits the exercise of public power for to the financial sector and should not be sac-private benefit is conducive to greater com- rificed for the sake of stability. Instead gov-petition in the banking sector. Finally, poli- ernments should implement the measures dis-cies to promote deeper and more diversified cussed in this chapter to monitor competitionfinancial markets—especially the develop- and strengthen the information and institu-ment of nonbanking financial institutions— tional frameworks to promote competition,also appear to increase the level of competi- while ensuring that regulations and super-tion in the banking sector. visory practices are in place that safeguard Government interventions during crises banking stability.that prevent the exit of insolvent institutionsand increase market power through mergerscan also affect competition and bank risk notestaking. In trying to mitigate the impact of 1. The chapter focuses on competition in thefinancial crises, governments should be aware banking sector rather than the broader finan-of the potentially negative consequences of cial sector. But it does touch on the impact oftheir actions on bank competition and future nonbank intermediaries on bank competition.bank stability. See Motta (2004) for a broader discussion on Finally, implementation of competition the theory and practice of competition policy.policies depends on the institutional arrange- 2. For example, in February 2010, the OECDment in place. The increased integration Competition Committee held a discussion onacross different parts of the financial industry competition, concentration, and stability inhas led to a shift in financial supervision from the banking sector.a sector-based approach to more integrated 3. Several developed and developing economiesapproaches, including (a) a fully integrated have competition agencies that have mandatessupervisory model with one agency (a Finan- or that can influence market outcomes in banking. Competition agencies enforce anti-cial Supervision Authority) carrying out all trust laws (for example, assess the competitivesupervisory roles (such as microprudential, harm of mergers, deter anticompetitive behav-business conduct, and competition policy), or ior, and minimize distortions from state aid)(b) a so-called functional or objective-based and promote measures to enable firm entryapproach in which sectorally integrated agen- and rivalry (that is, competition advocacy).cies undertake different supervisory roles.21 4. In general terms, the view of competition An example of the latter is the twin peaks presented here and discussed in the litera-model. One agency is responsible for pruden- ture is based on the notion that banks pri-tial supervision in the financial system, and marily compete in deposit and loan markets.another one oversees market conduct, con- However, in practice, especially in developedsumer protection, and corporate governance economies, banks offer a variety of servicesin all sectors.22 The effectiveness of the twin (such as market making, asset management,peaks approach, as argued by its advocates, is and underwriting) where market power may arise. Payment systems are another area inguaranteed by having a clear focus and divi- which there might be significant deviationssion of roles, to minimize turf battles between from marginal cost pricing.agencies, as well as strong collaboration, to 5. See Cetorelli (1999), Claessens and Laevenwork together in overlapping areas (Kremers (2004), and Demirgüç-Kunt, Laeven, andand Schoenmaker 2008, 2010). Evidence so Levine (2004), among others. Nevertheless,far suggests that regulatory quality is stron- concentration measures are presented firstger in systems with objectives-based super- because they are the most widely used and eas-vision—in favor of the twin peaks model iest to compute of measures of competition.
100 t h e r o l e o f t h e s tat e i n p r o m o t i n g b a n k c o m p e t i t i o n GLOBAL financial DEVELOPMENT REPORT 2013 6. There is a growing literature on measuring tration facilitates access credit, whereas Beck, and explaining bank competition using direct Demirgüç-Kunt, and Maksimovic (2004) measures of competition: Anzoategui, Mar- and Chong, Lu, and Ongena (2012) find the tínez Pería and Melecký (2010); Anzoategui, opposite result using data for 74 countries Martínez Pería, and Rocha (2010); Beck, de and for Chinese small and medium enter- Jonghe, and Schepens (2011); Berger, Klap- prises, respectively. per, and Turk-Ariss (2009); and Delis (2012); 15. At the same time, using bank-level data, Beck, Demirgüç-Kunt and Martínez Pería (2010); Demirgüç-Kunt, and Martínez Pería (2008) Schaeck and Čihák (2008, 2010a, 2010b); find that barriers to banking (minimum bal- Schaeck, Čihák, and Wolfe (2009); Turk- ances to open deposit accounts and to obtain Ariss (2010), among others. loans, as well as documentation require- 7. Note that the H-statistic can only be used to ments to access financial services) are higher test the hypothesis of perfect competition if in countries with greater entry restrictions for the market is in long-run equilibrium (returns banks. on bank assets are not related to input prices). 16. At the same time, the authors find that their However, tests using the H-statistic for the results for the Lerner index are not consistent null of monopoly are still valid, since the with results using concentration as a measure long-run profit condition does not apply in of competition. They conclude that “research- the case of a monopoly. ers and policymakers need to be very careful 8. Measuring marginal costs is difficult and in drawing strong conclusions about market requires certain assumptions about the cost power and credit availability based on analy- function of banks. Typically, studies that cal- ses that rely exclusively on concentration as a culate the Lerner index assume a translog cost measure of market power.” function. 17. See Beck (2008) for a thorough review of the 9. Bikker and Spierdijk (2008) argue that banks theoretical and empirical literature on bank in large and integrated financial markets (such competition and stability. as in Europe after establishing the European 18. See, for example, Keeley (1990) and Dick Monetary Union) are pushed by rising capi- (2006), in the case of the United States; tal market competition and tend to shift from Jimenez, Lopez, and Saurina (2007) in the traditional intermediation to more sophisti- case of Spain. cated and complex products associated with 19. See Anzoategui, Martínez Pería, and Rocha less price competition. 2010; Claessens and Laeven 2004; Delis 2012; 10. In recent work, Calderon and Schaeck (2012) Demirgüç-Kunt and Martínez Pería 2010. use data for 138 countries, of which 43 expe- 20. Rocha, Arvai, and Farazi (2011) find that the rienced banking crises. Their analyses show lack of competition in the Middle East and that government interventions (such as North Africa banking sectors is the outcome blanket guarantees, liquidity support by the of barriers to entry and lack of competition central bank, recapitalizations, and nation- from nonbanking financial intermediaries, alization of banks) during crises significantly among other factors. increase competition in banking systems, and 21. Čihák and Podpiera (2008) discuss the differ- the distortionary effects cannot be reversed ent types of supervisory arrangements. easily. Countries with a twin peaks supervisory 22. 11. See Berger (1995), Goldberg and Rai (1996), structure are Australia (Australia Prudential and Berger and Hannan (1998), among Regulation Authority and the Australian others. Securities and Investments Commission) and 12. One exception is Casu and Girardone (2009), the Netherlands—with the Netherlands Bank who find a positive causation between market (DNB) in charge of prudential supervision power and efficiency for 2,701 banks operat- and the Authority for the Financial Mar- ing in France, Germany, Italy, Spain, and the kets supervising market conduct (Čihák and United Kingdom from 2000 to 2005. Podpiera 2008; Kremers and Schoenmaker 13. See Petersen and Rajan (1995) and Marquez 2008). (2002). 14. Using U.S. data, Petersen and Rajan (1995) and Zarutskie (2006) find that bank concen-
4 Direct State Interventions • ending by state-owned banks is less procyclical than lending by private banks, and L some state banks played a countercyclical role during the global financial crisis. How- ever, this lending did not always target the most constrained borrowers and contin- ued even after economic recovery ensued, questioning the effectiveness of the policy. Furthermore, the evidence based on previous episodes of downturns and recoveries is mixed. • oreover, research finds that efforts to stabilize aggregate credit by state-owned banks M come at a cost, particularly through the deterioration of the quality of intermediation and resource misallocation. This effect undermines the benefits of using state banks as a countercyclical tool. • The empirical evidence largely suggests that government bank ownership is associated with lower levels of financial development and slower economic growth. Policy makers need to avoid the inefficiencies associated with government bank ownership by pay- ing special attention to the governance of these institutions and ensuring, among other things, that adequate risk management processes are in place, which is particularly chal- lenging in weak institutional environments. • Another popular form of intervention during the recent crisis was through credit guar- antee programs. Rigorous evaluations of these programs are rare, but existing studies suggest that the benefits are modest and costs are often significant. Success hinges on overcoming the challenges of getting the design right, particularly in underdeveloped institutional and legal settings.S tate-owned banks were typically cre- underserved segments of the economy—nota- ated to fulfill long-term development bly, small and medium enterprises (SMEs).1 In roles by filling market gaps in long- practice, however, widespread evidence showsterm credit, infrastructure, and agriculture that state banks have generally been very inef-finance, and to promote access to finance for ficient in allocating credit, more often than g l o b a l f i n a n c i a l d e v e l o p m e n t R EPO R T 2 0 1 3 101
102 i r e c t d s tat e i n t e r v e n t i o n s GLOBAL financial DEVELOPMENT REPORT 2013 not serving political interests. Nevertheless, discusses public credit guarantees that were the recent global financial crisis underscored also widely used to offset the credit crunch the countercyclical role of state-owned banks and mentions other policies adopted by in offsetting the contraction of credit from central banks to deal with the recent crisis. private banks, leading to arguments that this The main messages from this chapter are as function is an important one that can poten- follows. tially better justify their existence. First, lending by state-owned banks is During the recent global financial crisis, less procyclical. During the recent global countries pursued a variety of strategies to financial crisis, state-owned banks in some restart their financial and real sectors. As the countries expanded their lending portfolios balance sheets of private banks deteriorated and were credited with assisting in the eco- and they curtailed their lending activities, nomic recovery. However, it is unclear that many countries used state-owned banks to the recent crisis illustrates that state-owned step up their financing to the private sector banks can effectively play a countercyclical (for example, Brazil, China, and Germany).2 role. Lending growth continued even after Some economies relied heavily on the use economic recovery was under way, and loans of credit guarantee programs. For exam- were not directed to the most constrained ple, Canada, Chile, Finland, Germany, the borrowers. Furthermore, the evidence from Republic of Korea, Malaysia, and the Neth- previous crises on this issue is also mixed. erlands extended new and special schemes or Any benefits of credit stabilization that may refueled existing ones to alleviate the impact arise from countercyclical lending by state- of the credit crunch on SMEs. Finally, other owned banks come at a cost. The state faces countries, such as the United States, United a direct cost to the extent that outlays to the Kingdom, and those of the euro area, adopted financial sector (such as state treasury pur- a number of unconventional monetary and chases of securities, recapitalization, and so fiscal measures to prop up credit markets.3 forth) and public debt burdens are piling up.5 The crisis and the actions adopted by Perhaps more important, financial interme- different countries reignited the debate on diation by state-owned banks is subject to whether there is a need for direct government the risk of political capture and often leads intervention in the financial sector. Support- to a deterioration of the quality of loans and ers of state-owned banks argue that these misallocation of resources in the medium to institutions provide the state an additional long term. The bulk of the empirical evidence tool for crisis management and, relative to suggests that state ownership of banks tends central banks, they may be more capable of to be associated with lower financial devel- undertaking the role of safe haven for retail opment, greater financial instability, and and interbank deposits, creating a fire break slower rates of economic growth. Hence, the to mitigate contagion, and stabilizing aggre- trade-off between the potential benefits of a gate credit. countercyclical role of state banks and the On the other hand, those who oppose long-term adverse impact on credit allocation government bank ownership point out that requires careful consideration. agency problems and politically motivated Second, focusing on the governance of lending render state-owned banks breed- state-owned banks ideally may help policy ing grounds for corruption. Furthermore, makers address the inefficiencies associated rewarding political cronyism may build up with these institutions. Policy makers need to large fiscal liabilities and threaten public sec- design a clear mandate, allow the institutions tor solvency and financial fragility, as well as to work as a complement to (rather than a misallocate resources and retard development. substitute for) the private banks, and adopt This chapter reevaluates the merits of risk management practices that allow them government bank ownership in the wake of to guarantee a financially sustainable busi- the global financial crisis.4 The chapter also ness. However, these governance reforms are
GLOBAL financial DEVELOPMENT REPORT 2013 d i r e c t s t a t e i n t e r v e n t i o n s 103particularly challenging in weak institutional Figure 4.1 Trends in Government Ownershipenvironments. of Banks Third, credit guarantee schemes were alsoa popular intervention tool used during the Asset share of government-owned banks in therecent crisis. However, because these pro- financial system (%)grams are small scale, they are not likely to 25have a large macroeconomic impact. Fur-thermore, research suggests that the benefits 20of these programs in terms of financial andeconomic “additionality” are rather mod- 15est, and they may bring along significant fis-cal and economic costs.6 The effectiveness of 10these programs relies on their design. Bestpractices include (a) leaving credit assess- 5ments and decision making to the privatesector, (b) capping coverage ratios and delay- 0 Developed economies Developing economiesing the payout of the guarantee until recov- 2001–07 2008–10ery actions are taken by the lender so as tominimize moral hazard problems, (c) pricing Sources: Calculations based on Farazi, Feyen, and Rocha 2011; Bankguarantees so they take into account the need Regulation and Supervision Survey (database), World Bank 2003, 2007, 2011; Barth, Caprio, and Levine 2001, 2004, 2008).for financial sustainability and risk minimi-zation, and (d) encouraging the use of riskmanagement tools. be attributed to the recent bailouts, mergers, The rest of the chapter is organized as fol- recapitalizations, and nationalization of dis-lows. It first presents data on bank ownership tressed financial institutions that were morestructure worldwide, highlighting the regions common among developed economies thanwhere state-owned bank presence is signifi- developing economies.cant. Next, it analyzes the countercyclical Though government bank ownership isnature of government bank lending during more prevalent in the developing world, it hasthe recent crisis and in previous episodes. It declined considerably over time (figure 4.2).also discusses the evidence on the longer-term Since the 1970s, the share of state-ownedimplications of government bank ownership banks relative to the total assets of the bank-and then turns to credit guarantee schemes. ing system declined sharply in all emerging regions, from an average of 67 percent in 1970 to 22 percent in 2009. The retrench-Ownership Structures ment of government participation has beenaround the World dramatic in the Eastern European and Cen-State-owned banks account for less than 10 tral Asian region. The massive privatizationpercent of banking system assets in devel- program in transition economies launchedoped economies and double that share in in the early 1990s reduced the governmentdeveloping economies (figure 4.1). In a com- stake in the banking system from almostparison of the periods 2001–07 and 2008– full ownership (88 percent in 1985) to inter-10, the recent global crisis brought about a mediate levels of government participationsmall surge in government bank ownership (20 percent in 2009).7 Finally, the Worldin developed countries (6.7 percent to 8 Bank report Financing Africa illustrates thepercent, respectively), while the opposite is dramatic transformation of the ownershiptrue in developing economies (government structure in African banks over the last 50bank ownership declined from 20.5 to 17.3 years (Beck and others 2011). From a systempercent). The uptick in the share of state- mostly dominated by state-owned banks, theowned banks in developed countries may region now has the second highest share of
104 i r e c t d s tat e i n t e r v e n t i o n s GLOBAL financial DEVELOPMENT REPORT 2013 Figure 4.2 Government Ownership across Developing Regions, 1970–2009 Asset share of government-owned banks in the financial system (%) 100 80 60 40 20 0 East Asia Europe and Latin America Middle East and South Asia Sub-Saharan and Pacific Central Asia and the Caribbean North Africa Africa 1970 1985 1995 2002 2009 Sources: Calculations based on Farazi, Feyen, and Rocha 2011; Bank Regulation and Supervision Survey (database), World Bank 2003, 2007, 2011; Barth, Caprio, and Levine 2001, 2004, 2008. foreign-owned banks—trailing only the tran- have an asset market share between 20 and sition economies of Eastern Europe and Cen- 50 percent. While the average market share tral Asia.8 of government-owned banks is negligible The retrenchment of state-owned banks in in Eastern European nations, it is still large the financial sector can be attributed to their among countries in Central Asia.10 Almost poor financial performance as well as their half of the countries that responded to the lat- less than stellar contribution to financial and est round of the World Bank’s Bank Regula- economic development—especially in coun- tion and Supervision Survey report a market tries where they dominated the banking sys- share for state-owned banks below 5 percent. tem. This trend also reflects retrenchment of the public sector and fiscal consolidation in Role of Government Bank some countries.9 Lending in Mitigating Despite the fact that the activity and Economic Cycles and Crises importance of state-owned banks declined sharply over time, they still play a substantive The recent global financial crisis has brought role in some countries. For instance, state- to the fore the potential role of state-owned owned banks still dominate the process of banks in stabilizing aggregate credit.11 His- financial intermediation in Algeria, Belarus, torical evidence shows that the failure of China, the Arab Republic of Egypt, India, credit flows to recover may drag down the and the Syrian Arab Republic, where the asset recovery of real economic activity (Biggs, market share of these banks exceeded half the Mayer, and Pick 2010). In other words, a pre- assets of the banking system in 2010. In other condition for the recovery of the corporate countries, state-owned banks do not lead the sector may be the recovery of the financial process of credit creation but still play an sector.12 Though a strand of the empirical lit- important role. For example, state-owned erature argues that recoveries in real output banks in Argentina, Brazil, Indonesia, Korea, without a recovery in credit flows—credit- Poland, the Russian Federation, and Turkey less recoveries or “Phoenix miracles”—are
GLOBAL financial DEVELOPMENT REPORT 2013 d i r e c t s t a t e i n t e r v e n t i o n s 105not rare events, and become more frequent banks. Governments injected capital intoafter a banking crisis or credit boom (Abiad, their state-owned banks to roll over exist-Dell’Ariccia, and Li 2011; Bijsterbosch and ing loans or provided new credit to SMEs orDahlhaus 2011; Calvo, Izquierdo, and Talvi exporting firms (this has been the case, for2006a, 2006b), the evidence at the macro- example, in Canada, Chile, Korea, and Tuni-economic level is far from conclusive and sia), raised credit ceilings of their state-owneddisplays a great deal of heterogeneity. Fur- banks (in Finland and Korea, among others),thermore, firm-level evidence (Ayyagari, and established credit facilities for banksDemirgüç-Kunt, and Maksimovic 2011a) (for example, in India and Tunisia). In Bra-shows that real sector recoveries are not cred- zil, a state-owned development bank (Bancoitless, and that firms substitute short-term Nacional de Desenvolvimento Econômicocredit with long-term external finance, either e Social, BNDES) played an important rolethrough long-term borrowing or capital issu- in expanding credit during the recent cri-ance. In sum, Phoenix miracles are not sup- sis. However, the fact that most loans seemported by firm-level data either in the United to have gone to large firms and that creditStates or among emerging markets. continued to expand even after the economy The global recession in 2008–09 involved recovered in 2010–11 calls into question theunprecedented conditions: real output fell ability of this bank to behave countercycli-sharply and in a synchronized fashion across cally (box 4.1). State-owned developmentthe world (with more than 80 percent of the banks in Mexico expanded their loan portfo-countries sharing a recessionary phase in the lios and also supported key markets throughperiod from the third quarter of 2008 to the special guarantee programs (box 4.2). Non-first quarter of 2009). In addition, real credit performing loans (NPLs) and profitabilityalso fell in a synchronized manner across seem stable so far, perhaps because most ofcountries. Aisen and Franken (2010) show the lending was through tier II operations inthat 95 percent of countries experienced which credit decisions are left to private inter-a contraction in bank credit in at least one mediaries.13 However, because credit keptmonth between September 2008 and May growing even after the economy recovered,2009. The dire financial conditions in the it is still unclear whether state-owned devel-world economy reignited the debate on the opment banks in Mexico will be able to playcountercyclical role of government banks. an effective countercyclical role rather than The fact that recoveries may not take place crowd out private banks.without credit growth may be reason enough In Poland, state-owned bank PKO Bankfor the state to use their government bank Polski has played a role in credit stabiliza-infrastructure in order to keep the credit flow- tion by lending to the corporate and SMEing. State-owned banks may facilitate credit sectors (box 4.3). Though so far the bankstabilization for several reasons. First, stabi- has remained profitable and NPLs have notlization of credit markets may be a part of changed dramatically, time will tell whetherstate-owned banks’ mandate. In this context, the bank’s credit allocation was efficient.state-owned banks may fill the gap of credit The case of Poland is not representative ofcaused by underprovision by their private all countries in Eastern Europe. Researchcounterparts in times of crisis (Rudolph 2009, comparing the behavior of state-owned and2010). Second, state-owned banks could be foreign-owned banks in relation to privateperceived as safer during recessions or crises, domestic banks in Eastern Europe and Latinand their more stable deposit base could allow America before and after the 2007–09 crisesthem to have more stable lending activity dur- (box 4.4) shows that in Eastern Europe, state-ing crises (Micco and Panizza 2006). owned banks in general did not play a coun- During the recent crisis, many countries tercyclical role. On the other hand, state-deployed their state-owned banks to counter- owned banks in Latin America increasedact the credit contraction by privately owned loan growth during the crisis relative to their
106 i r e c t d s tat e i n t e r v e n t i o n s GLOBAL financial DEVELOPMENT REPORT 2013 Box 4.1 Intervention Using State-Owned Banks in Brazil The Brazilian government actively used its state bank cent of GDP. The continued expansion of credit by infrastructure to engineer a rapid countercyclical public banks, and especially BNDES, in 2010 and response to mitigate the contagion effects from the 2011 illustrates the difficulties of behaving counter- global financial crisis. New liquidity assistance lines cyclically during upswings in real economic activity. were created by the Central Bank of Brazil (BCB) to BNDES played an important role: it extended enable the country’s state commercial banks, Banco special credit facilities thanks to a generous capital do Brasil (BB) and Caixa Econômica Federal (CEF), injection by the government (R$100 billion in 2009). to acquire ownership interest in private and public Loans from BNDES were extended at a subsidized financial institutions—including insurance compa- rate—the long-term interest rate was set at 6 percent, nies, social welfare institutions, and capitalization which is 7.5 percentage points lower than the market companies—with or without the acquisition of the rate (Lazzarini and others 2011). In fact, credit by capital stock control. Moreover, the government used BNDES surged from R$160 billion (at 2005 prices) in its public bank infrastructure—BB, CEF, and Banco September 2008 to R$277 billion in December 2010. Nacional de Desenvolvimento Econômico e Social The fact that most of this credit is being extended to (BNDES), the state-owned development bank—to large firms that are likely to get loans elsewhere (Laz- play a countercyclical role in credit markets during zarini and others 2011) indicates that private banks this period of global financial turmoil. Figure B4.1.1 are crowded out in credit markets. illustrates the expansion of credit by Brazilian state- The portfolio expansion of BNDES was accompa- owned banks from 13.4 percent of GDP in Septem- nied by a shift in the composition of its funding. Fig- ber 2008 to 18.1 percent of GDP by end-2009. As ure B4.1.2 shows that resources channeled from the of December 2011, credit extended by public banks national treasury rather than those coming from the represented 21.4 percent of GDP, while overall credit Workers’ Assistance Fund became the main source of operations in the financial system totaled 49.1 per- funding beginning in 2009. The transfer from Trea- Figure B4.1.1 Ownership and Credit in Brazil Credit as percentage of GDP 60 50 40 30 20 10 0 20 ary 20 ary 20 ary 20 ary 20 ary 20 ary 20 ary 20 ary 20 ary 20 ary uly uly uly uly uly uly uly uly uly uly u u u u u u u u u u -J -J -J -J -J -J -J