Do bank regulation, supervision and monitoring enhance or impede bank efficiency?

TLDR: In this paper, a panel analysis of 4050 banks observations in 72 countries over the period 1999-2007 was conducted to examine whether bank regulation, supervision and monitoring enhance or impede bank operating efficiency.

Abstract: The recent global financial crisis has spurred renewed interest in identifying those reforms in bank regulation that would work best to promote bank development, performance and stability. Building upon three recent world-wide surveys on bank regulation ( Barth et al., 2004 , Barth et al., 2006 , Barth et al., 2008 ), we contribute to this assessment by examining whether bank regulation, supervision and monitoring enhance or impede bank operating efficiency. Based on an un-balanced panel analysis of 4050 banks observations in 72 countries over the period 1999–2007, we find that tighter restrictions on bank activities are negatively associated with bank efficiency, while greater capital regulation stringency is marginally and positively associated with bank efficiency. We also find that a strengthening of official supervisory power is positively associated with bank efficiency only in countries with independent supervisory authorities. Moreover, independence coupled with a more experienced supervisory authority tends to enhance bank efficiency. Finally, market-based monitoring of banks in terms of more financial transparency is positively associated with bank efficiency.

Figures

Table 4. Correlation matrix

Table 3: Bank efficiency scores for countries

Table 7. Change Regression Results

Figure 2: Changes in overall capital stringency in countries (2006 vs. 1999)

Table 6. Instrumental variables regression results

Table 1: Variable definitions and data sources

Full text

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Electronic copy available at: http://ssrn.com/abstract=1579352
1
Do Bank Regulation, Supervision and Monitoring Enhance or Impede Bank
Efficiency?

March 21 2010
James R. Barth
a
, Chen Lin
b
, Yue Ma
c
, Jesús Seade
c
and Frank M. Song
d
a) Department of Finance, Auburn University and Milken Institute, USA
b) Department of Economics and Finance, City University of Hong Kong
c) Department of Economics, Lingnan University, Hong Kong
d) School of Economics and Finance, University of Hong Kong
Abstract
The recent global financial crisis has spurred renewed interest in identifying those reforms in
bank regulation that would work best to promote bank development, performance and
stability. Building upon three recent world-wide surveys on bank regulation (Barth et al.,
2004, 2006, and 2008), we attempt to contribute to this assessment by examining whether
bank regulation, supervision and monitoring enhance or impede bank operating efficiency.
Based on an un-balanced panel analysis of more than 4,050 banks observations in 72
countries over the time period 1999-2007, we find that tighter restrictions on bank activities
are negatively associated with bank efficiency while greater capital regulation stringency is
marginally and positively associated with bank efficiency. In addition, we find that a
strengthening of official supervisory power is positively associated with bank efficiency only
in countries with independent supervisory authorities. Moreover, independence coupled with
a more experienced supervisory authority tends to enhance bank efficiency. Finally,
market-based monitoring of banks in terms of more financial transparency is positively
associated with bank efficiency.
.
Keywords: Bank regulation, Supervision, Operating efficiency
JEL Classifications: G21, G28.

We thank Charles Calomiris, Dong He, David Parsley, Joshua Aizenman, and participants at
HKMA/Columbia/Lingnan Conference on the Global Financial Turmoil and the Evolving Financial
Interdependence in Asia, 2009, for helpful comments. Funding under Lingnan University's Competitive
Public Policy Research Grant (No. 3002-PPR-5) from the RGC of Hong Kong SAR Government is
gratefully acknowledged.

Electronic copy available at: http://ssrn.com/abstract=1579352
2
1. Introduction
Well-functioning banking systems exert a first-order impact on economic growth and
development (e.g., see Levine 1997 and 2005). Banking systems, however, do not always
function in a beneficial manner and thus at times fall short of achieving this important goal.
The recent global financial crisis only serves to well as a reminder of this unpleasant fact.
The response of policymakers to this and similar situations in the past is typically an
assessment of what went wrong and what regulatory reforms can be made to promote better
functioning banking systems. The breadth and depth of the most recent crisis certainly
underscores the importance of such assessments.
The purpose of this paper is to contribute to the assessment of the types of reforms in
bank regulation that work best to achieve well-functioning banking systems. Our assessment
specifically focuses on the extent to which regulation enhances or impedes the ability of
banks in countries everywhere to operate efficiently. While this is just one aspect of a well-
functioning banking system it is certainly an important one. Policymakers can surely make
more informed decisions about the regulation of banks when they know the likely affect of
those decisions on the performance of banks. Despite the extensive literature on bank
efficiency (see Berger and Humphrey, 1997, and Berger, 2007, for thorough reviews of the
literature), a comprehensive study on whether bank regulation, supervision and monitoring
enhance or impede efficiency remains scarce. This is mainly due to limited data availability
so as to obtain concrete measures on various aspects of international bank regulation and
supervision schemes.
This data limitation has been recently addressed by the three worldwide surveys on
bank regulation and supervision conducted by Barth, Caprio and Levine (2004, 2006 and
2008) under the auspices of the World Bank over the past decade. The relevant bank
regulation and supervision databases are compiled from the answers provided by the official
regulatory and supervisory authorities to the surveys. The original survey, Survey I, provides
information for the year 1999 and covers 117 countries. The second survey, Survey II,
characterizes the regulatory environment for 2002, and covers 152 countries. Survey III is for
2005/2006 and covers 142 countries. The surveys contain more than 300 questions regarding

3
a wide range of bank regulations and supervisory practices, such as capital regulation, entry
regulation, activities restrictions, supervisory power and independence, external governance
and private-sector monitoring. Overall, the three surveys provide a very comprehensive and
detailed picture of differences in bank regulation and supervision in countries around the
world over the past decade, thereby providing an excellent opportunity to examine whether
bank regulation, supervision and monitoring enhance or impede bank efficiency.
From a theoretical perspective, the predictions about the effects of regulation and
supervision on banks are not clear. There are two general views that provide conflicting
predictions, as explained more fully by Barth et al. (2006), among others. The ―public interest
view‖ holds that the government acts in the interests of the public and regulates banks to
promote efficient banking and ameliorate market failures. In contrast, the ―private interest
view‖ holds that regulation is often used to promote the special interests of the few, not the
broader public. According to the ―public interest view‖, well-structured regulation can
enhance efficiency by fostering competition among banks and by encouraging effective
governance of bank managers. But according to the ―private interest view‖, one would expect
regulation to impede efficiency since it would constrain banks to cater to the politically
favored or well connected. This implies that bank regulation will not play an active role in
improving bank efficiency, but rather constrain banks to channel resources to special interest
groups, such as politicians or their cronies. Given these two opposing views, and with similar
conflicting predictions based on economic theory about the impact of specific regulations like
capital requirements on bank performance, empirical studies become all the more important
in helping inform policy decisions.
Building on these recently available bank regulation datasets, we examine an
extensive and changing set of regulations and supervisory practices on bank efficiency using
data for more than 4,050 banks in a broad cross-section of 72 countries over the time period
1999-2007. The efficiency measures for the banks are constructed based on a widely adopted
and non-parametric method to gauge the extent to which the performance of the individual
banks deviates from that predicted for the ―best practice‖ banks (i.e., efficiency frontier). We
then use these measures to examine whether regulation, supervision, and monitoring enhance

4
or impede bank efficiency.
Briefly, we find the following main results. First, with respect to bank regulation,
we find that tighter restrictions on bank activities are negatively associated with bank
efficiency while greater capital regulation stringency is marginally and positively associated
with bank efficiency. One should therefore be aware that when tightening bank activities
restrictions and strengthening bank capital requirements, which are mainly designed to reduce
bank risk, there may be some potential efficiency loss. Second, regarding bank supervision,
strengthening official supervisory power is positively associated with bank efficiency only in
countries with independent supervisory authorities. Furthermore, greater independence of the
supervisory authority itself tends to enhance bank efficiency. This result is important as it
suggests that greater independence of supervisory agencies from both politicians and banking
firms enhances supervision effectiveness and bank efficiency. It also suggests that putting
official supervisory power in the hands of independent supervisors might be helpful in
improving the overall efficiency of banking systems. Finally, increased market-based
monitoring of banks in terms of more financial transparency and better external audits is
positively associated with bank efficiency, suggesting that the third pillar of Basel II can play
an important and positive role in helping to improve bank efficiency. We obtain similar
results in a dynamic setting, where we explore the impacts of changes in bank regulation and
supervision schemes on the change of bank operating efficiency. Focusing on these changes
is important to account for potential time-invariant unobservable factors that might affect
both the regulation schemes and bank efficiency. Furthermore, as a check on potential
endogeneity issues, we find our results to be robust to an instrumental variable analysis.
In addition to these major findings, we also obtain some other interesting results. We
find that greater bank competition, as measured by an asset (deposit) concentration ratio,
enhances bank efficiency. The results echo previous findings in the literature (e.g., Berger
and Hannan, 1998). The existence and generosity of a deposit insurance system seems to be
associated with lower bank efficiency, however. We also find that greater government
ownership of the banking industry is associated with lower bank efficiency. Large banks,
moreover, tend to have higher efficiency. In addition, we find that a better institutional

Frequently asked questions

Q1. What contributions have the authors mentioned in the paper "Do bank regulation, supervision and monitoring enhance or impede bank efficiency?" ?

Barth et al. this paper conducted an unbalanced panel analysis of more than 4,050 banks observations in 72 countries over the time period 1999-2007, and found that tighter restrictions on bank activities are negatively associated with bank efficiency while greater capital regulation stringency is marginally and positively associated with the bank efficiency. 

Q2. What is the effect of the HHI on bank efficiency?

As for the control variables, less bank competition, as measured by the HHI, is indeednegatively and significantly related to bank efficiency. 

Q3. What are the effects of the Kaufmann indexes on bank efficiency?

Regarding bank regulation, the authors find in particular that tighter bank activity restrictions exert negative impacts on bank efficiency while the greater capital regulation stringency exerts marginally positive effects on bank efficiency. 

Q4. What is the effect of a strong external auditor requirement on bank efficiency?

The authors find that an external auditor requirement, the strength of external auditor, and bank information disclosure are positively associated with bank operating efficiency while generous deposit insurance coverage is negatively associated with bank operating efficiency. 

Q5. What is the effect of a country‘s inflation on bank efficiency?

A country‘s inflation is negatively associated with bank efficiency, suggesting that a lower inflationary environment is more conducive to efficient bank operations. 

Q6. What is the role of supervisory independence in the development of a well functioning banking system?

As Barth et al. (2006) point out, supervisory independence enables the supervisors to be insulated from, or able to resist, pressure and influence to modify supervisory practices in order to cater to narrow political or business interests. 

Q7. Why do the authors include ethnic fractionalization as an instrumental variable?

The authors also include the ethnic fractionalization as an instrumental variable because it has been found that economies with greater ethnic diversity tend to choose institutions that facilitate expropriation (Easterly and Levine, 1997). 

Q8. What is the advantage of using data averaged over the three-year period?

One advantage of using data averaged over the three-year period is that the authors smoothvariables that vary over time (Demirguc-Kunt et al., 2004). 

Q9. What is the way to examine how international bank flows have responded to these changes?

Since these reforms arguably have had a meaningful effect on the regulatory environment, it is interesting to explore how international bank flows have responded to these regulatory changes. 

Q10. What is the role of the supervisory agency in promoting the private interests of banks?

As Beck et al. (2006) point out, if bank supervisory agencies have the power to discipline non-compliant banks, the supervisors may use this power to induce or force banks to allocate credit so as to generate private or political benefits. 

Q11. What is the first principal component indicator of the bank supervisory power?

The first principal component indicator of these variables is used, with higher values indicating broader and greater authority for bank supervisors. 

Q12. What is the importance of loan loss provisions in the study of bank efficiency?

As Drake et al. (2006) point out, it has long been argued in the literature that the incorporation of risk/loan quality is vitally important in studies of bank efficiency. 

Q13. Why do the authors include the percentage of years that the country has been independent since 1776?

the authors follow Beck et al. (2006) and include the percentage of years that the country has been independent since 1776 as an additional instrumental variable because countries that gained their independence earlier had more opportunity to modify colonial institutions and adopt policies more conducive to economic development.. 

Q14. What are the effects of bank regulation and supervision on bank efficiency?

Based on an analysis of a sample with more than 8,000 bank-year observations in 72 countries over the time period 1999-2007, the authors find bank regulation, supervision and market monitoring all exert significant impacts on bank efficiency.