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New Research Shows that Supervision that Relies on Market Monitoring and Transparency Lowers Corruption in Bank Lending

A World Bank Finance Research Feature Story, published March 31, 2006

New World Bank research finds that firms in countries with powerful supervisory agencies—which directly monitor and supervise banks—face greater obstacles to obtaining bank loans because of corruption among bank officials. 

Researchers Beck, Demirguc-Kunt and Levine provide the first assessment of the impact of different bank supervisory policies on firms’ financing obstacles. Their results strongly refute the traditional approach that assumes more powerful supervision will facilitate more efficient corporate finance.

What really does lower corruption among bank officials and help firms raise external finance,” said Asli Demirguc-Kunt, Senior Research Manager at the World Bank, “is a supervisory strategy that empowers private monitoring of banks by forcing them to disclose accurate information to the private sector.”

These findings are particularly important because international financial institutions have until now promoted the development of powerful bank supervisory agencies with the authority to monitor and discipline banks, in the absence of any evidence on the general question of which bank supervisory policy actually facilitates efficient corporate finance.

The research is based on firm-level data from the World Business Environmental Survey of more than 2,500 firms across 37 countries, conducted in 1999. This data provides information on firm characteristics, including the degree to which bank corruption is important in raising capital.

Powerful supervisory agencies tend to lower the integrity of bank lending

The new research supports the view that powerful supervisory agencies are prone to capture and manipulation by politicians, regulators, or both. The authors find that powerful supervisory agencies tend to lower the integrity of bank lending.

For example, estimates show that if Chile had the (relatively much lower) supervisory power of Canada, there would be a distinct decrease in the likelihood that Chilean firms rank corruption as a major obstacle.

However, the authors caution that powerful supervision is so strongly correlated with poor national institutions—such as government ineffectiveness, absence of the rule of law, and high national corruption—that it is difficult to establish an independent relationship between supervisory power and bank corruption when controlling for these institutional traits.

Policies that force banks to disclose accurate information are more effective

The research results also support the “private monitoring” approach, in which supervisory strategies focus on forcing accurate information disclosure and not distorting the incentives of private creditors to monitor banks. This approach appears more likely to facilitate efficient corporate finance.

These findings are consistent with approaches that simultaneously recognize that private agents face substantive information and enforcement costs when monitoring banks, while also recognizing that politicians and regulators will act in their own interests and not necessarily act to reduce market frictions.

Private monitoring has a particularly beneficial effect on the integrity of bank lending in countries with sound legal and bureaucratic institutions,” said Demirguc-Kunt. “Our results support the Basel Committee’s recent emphasis on the importance of private sector monitoring of banks.”

Researchers

Thorsten Beck is a Senior Financial Economist in the Finance Team of the Development Research Group of the World Bank. His recent research has focused on the effects of bank concentration and competitiveness, access to financial services, and the impediments to growth that SMEs face.

Asli Demirguc-Kunt holds the joint appointment of Finance Research Manager, in the World Bank's Development Economics Research Group, and Adviser, Operations and Policy Department in the Bank's Financial Sector Vice Presidency. Her recent research has focused on banking crises, financial regulation, stock markets, corporate finance and the impact of financial structure on economic growth.

Ross Levine is the Harrison S. Kravis University Professor at Brown University and NBER Research Associate. His recent research has focused on financial structures and economic growth, as well as bank regulation and supervision.

References

Thorsten Beck, Asli Demirguc-Kunt, and Ross Levine. Bank Supervision and Corruption in Lending. Forthcoming Journal of Monetary Economics.




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