Academic journal article Contemporary Economic Policy

What Determines the "Legal" Quality of Bank Regulation and Supervision?

Academic journal article Contemporary Economic Policy

What Determines the "Legal" Quality of Bank Regulation and Supervision?

Article excerpt

I. INTRODUCTION

This article provides an empirical test of the view that institutional changes are equilibrium outcomes that emerge in accordance with the general institutional environment that includes informal rules. Institutional change is said to be adaptive when it conforms with the prevailing institutional environment and socioeconomic realities. North (1990) refers to this type of institutional evolution as exhibiting adaptive efficiency. On the contrary, implantation of formal rules or institutional mechanisms is often ineffective in countries where appropriate market structures and supportive institutional mechanisms do not exist. (1)

This article provides a test of the above view in the context of financial institutions; we hypothesize that the various aspects of the prevailing institutional environment may have an impact on the quality of the banking laws adopted. (2) Banking laws constitute key institutions for the financial sector as they lay out the legal framework for bank regulation and supervision (RS) that is essential for the well functioning of the banking sector. Prudent bank RS help eliminate the potential moral hazard and adverse selection problems financial sectors are prone to. We claim that the adoption of formal rules in regard to bank RS are endogenous to the general quality of the network of prevailing financial institutions.

To test this claim, we use the method of measuring the legal quality (3) of bank RS developed by Neyapti and Dincer (2005, henceforth ND). ND propose an extensive list of criteria, which totals to 98, based on Basel Core Principles (BCP), guidelines, and other documents, as well as the theoretical arguments and best practices. (4) The quantification of these criteria has been made with the viewpoint of measuring the extent of the coverage of bank regulation and its role in limiting or eliminating the potential transaction costs or risks in the banking sector. The methodology for coding each of these criteria has already been detailed in ND and therefore is not going to be repeated here, though in Appendix Table A1, we only report the list of these criteria. Here, we suffice by reporting the eight main clusters of information, which are commonly contained in the banking laws, summarizing the 98 criteria: (A) capital requirements, (B) lending, (C) ownership structure, (D) directors and managers, (E) reporting/recording requirements, (F) corrective action, (G) supervision, and (H) deposit insurance (DI). As in ND, aggregate indices of RS are then formed by using two different methods: (a) the unweighted average of the 98 criteria and (b) principal components (PCs) analysis. These indices enable not only the assessment of the relative positions of countries with regard to legal banking reforms but also the related empirical analyses as we do in the current article. (5)

APPENDIX

TABLE A1

List of Criteria for Measuring RS (Source: Neyapti and Dincer, 2005)

A. Capital requirements

1. Minimum capital at licensing

(a) Minimum capital

2. Capital adequacy

(a) Maximum liability ratio (risky assets/liable capital) of a bank should be

(b) Is liable capital explicitly defined?

(c) Is there any extra capital required to cover losses?

3. Major acquisitions and investments

(a) Maximum aggregate amount of investment

(b) Instead of repayment of a loan, a juridical person's capital may be owned for

(c) Maximum amount of capital of any juridical person a bank may participate is

(d) Maximum aggregate amount of investment on juridical persons

B. Lending

1. Lending to private sector

(a) May supervisors prohibit emergency loans?

(b) Maximum total amount of certain positions of a bank involving price risks at close of business any day

(c) Maximum total amount of certain positions of a bank involving exchange rate risks at close of business any day

(d) Maximum total amount of certain positions of a bank involving interest risks at close of business any day

(e) Is there a defined system to evaluate the creditworthiness of borrowers? …

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