October 6, 2006 The proper design of bank regulation and supervision has been debated throughout modern history. Over the past few years, important aspects of this discussion have included Basel II—a new regulatory framework aimed at ensuring the solvency and viability of banks—and the roles of capital requirements, supervisory powers, and market discipline.
These and other issues were the focus of a recent conference on bank regulation and corporate finance. The World Bank and the Journal of Financial Intermediation (JFI) hosted the event in Washington, D.C. Eleven papers were presented, some of which will appear in a special issue of the JFI next fall. All papers and presentations are available online.
Beyond the traditional debate
“An important message we heard during the conference was that market players should be empowered to curb the incentives that could lead banks to take aggressive or imprudent risks,” said Thorsten Beck, Senior Economist, Finance Research, at the World Bank. “The right monitoring tools must be put in place because these will eventually ensure the stability of the entire financial system.”
“These topics are not just technical or academic, but often at the center of the policy dialogue between the World Bank and client countries,” said Asli Demirgüç-Kunt, Senior Research Manager, Finance and Private Sector Development, at the World Bank.
Governor Randall Kroszner from the Federal Reserve Board stressed the importance of political economy in financial sector reforms in his keynote address, quoting the example of the U.S., where states opened their banking systems at different points over the 1970s and 1980s depending on the strength of different lobby groups.
Transparency and market discipline are important
Several papers showed the importance of giving market participants the tools and motivation to keep banks’ risk-taking behavior within reasonable limits. These findings are important for the debate on Basel II, under which market discipline is relatively underdeveloped.
They are also critical for assessments by the IMF and World Bank of the regulatory and supervisory structures of client countries. While these assessments are multi-faceted, research presented at the conference suggests that those related to market discipline could be more important than others.
However, the political interests and constraints of regulators matter too, especially in times of widespread distress. Bank regulators are less likely to close failing banks if there is already widespread distress in the banking system. Such constraints can even result in situations where banks impose regulations on regulators rather than vice versa.” said Ed Kane.
How concentration, competition, and stability play out
The relationship between inter-bank competition and the stability of the financial system is not simply linear, concluded conference participants. Their interaction depends on the health and the contestability—the possibility to challenge incumbents through new entrants—of the banking system, which has implications for regulatory policies and foreign bank entry.
The evolution of the regulatory process of reviewing mergers from purely supervisory concerns into evaluating them from the viewpoint of efficiency and competition is a positive development. But this might require an authority outside the supervisory agency to avoid intra-agency conflict of interest, experts felt.
The discussants also emphasized that concentration, as defined by market structure, is not the same as competition. The relevant market, switching costs incurred by customers, and market contestability must be taken into account when making inferences from market structure to competition.
Analyzing entry and exit costs can offer insights into market contestability. For example, contestability can be reduced by a too-generous financial safety net that prevents ordered exit, and by lobbying efforts to keep non-financial companies from offering banking services.
The relationship between banks and borrowers
Several papers presented at the conference shed new light on the relationship between banks and borrowers.
Financial intermediaries such as banks play an important role in mitigating asymmetric information (available without costs to borrowers, but not to outsiders) and the resulting agency problems between firms and investors. New results suggest that there is a trade-off. A closer, more exclusive relationship between banks and borrowers, possibly including holding equity in trust by the bank, can reduce agency problems between banks and borrowers. But this can hurt the stock market liquidity of the borrower’s stock.
Spotlight on Basel II
As in many conferences on bank supervision, Basel II was much discussed, especially by the panel comprising Gary Stern, President of the Federal Reserve Bank of Minneapolis, Eric Rosengren, Executive Vice President of the Federal Reserve Bank of Boston, Ed Kane from Boston College, Charles Calomiris from Columbia University, and Arnoud Boot from University of Amsterdam.
The lack of prompt corrective action and the limited role for market discipline under Basel II were criticized. While Basel II and the risk-based capital requirements it postulates might be a step toward encouraging more sophisticated risk modeling by banks, Charles Calomiris from Columbia University expressed concerns about potential manipulation of these models by banks and subsequent under-capitalization.
Given asymmetric information between banks and supervisors, this might come to light too late. While it is still early to call for Basel III, Ed Kane, Boston College, suggested that Basel be viewed as a process rather than an end- point.