a structural approach to financial stability: on the beneficial role of regulatory governance

Faculty of Economics, Chair of Macroeconomics

A Structural Approach to Financial Stability:

On the Beneficial Role of Regulatory Governance

Benjamin Mohr and Helmut WagnerLjubljana, May 2012


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What are the effects of regulatory governance on financial stability?

Introduction Insufficient banking regulation, government intervention

in regulatory process, and connected lending play central roles in explanation of banking crises during last few decades

Evidence points to governance failures as the key contributing factor in recent global financial crisis (Buiter, 2008; Igan et al., 2009; Levine, 2010; Mian et al., 2010)

Prior to recent financial crisis, many regulatory authorities lacked mandate, sufficient resources, and independence to effectively contain systemic risk and to implement early action


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Introduction While case for central bank independence is well

established, discussion of independence in the sphere of bank regulation is relatively new, but gaining momentum

Independence and accountability are seen as key building blocks of regulatory governance

Need of independence and accountability of regulatory authorities has been recognized by Basel Committee on Banking Supervision (1997; 2006)

Independence from government and financial industry is essential for achieving and safeguarding financial stability (time-inconsistent government policy, industry capture)


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MotivationWhat are the effects of regulatory governance on financial

stability?

Not entirely clear what constitutes good regulatory framework that promotes bank development, efficiency, and stability

Any construction of index that seeks to measure regulatory governance arrangements relies on judgment to some degree

No widely accepted measure, quantification, or time series for measuring financial stability

Recent studies are not sufficiently focused on the macro-prudential dimension of financial stability


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Previous findings Empirical evidence regarding impact of regulatory

governance on financial stability is rather inconclusive two camps

[1] Beck et al. (2003), Das et al. (2004), Ponce (2009): find a positive relationship between regulatory governance and financial stability

[2] Opposing strand does not find that financial stability is associated with regulatory governance (Barth et al., 2004; 2006; Demirgüc-Kunt and Detragiache, 2010)


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Previous findings [1]Beck et al. (2003)

Address concept of financial stability by asking to what degree firms face obstacles in obtaining external finance

Higher degree of regulatory independence seems to reduce likelihood that politicians or financial industry will capture regulatory agency Das et al. (2004)

Proxy banking sector stability by index consisting of a weighted average of CAR and NPLs

Results suggest that regulatory governance has positive impact on banking sector stability


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Previous findings [1]Ponce (2009)

Uses ratio of non-performing loans to proxy financial stability

Regulatory independence significantly reduces average probability of banks defaulting on loans, legal protection and accountability seem to be of even greater importance


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Previous findings [2]Barth et al. (2004; 2006)

Study impact of regulatory practices on development and efficiency of the banking sector, and on the occurrence of banking crises

Supervisory independence is not related to bank development, efficiency, or stabilityDemirgüc-Kunt and Detragiache (2010)

Use Z-Score as a proxy for soundness of banking sector

No relationship between bank soundness and BCP compliance (used as proxy for regulatory governance arrangements)


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Our approach: Structural equation modeling Structural equation model (SEM) describes statistical

relationships between latent (unobservable) variables and manifest (directly observable) variables

We model financial stability and the governance of regulatory authorities as latent variables test whether data patterns can be fitted within data sample provide cross-country evidence of relationship between regulatory governance and financial stability


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Our approach: Structural equation modeling A SEM is often used to estimate size and development

of shadow economy (e.g., Bajada and Schneider, 2005) Other studies treat corruption as latent variable

directly related to its underlying causes (e.g., Dreher et al., 2007)

Recent work of Rose and Spiegel (2009; 2010; 2011) uses structural equation modeling approach, treating the recent financial crisis as a latent variable


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Advantages of our approach Structural equation models can provide information

about relationship between variables that have observable causes and effects but cannot themselves be directly measured(or are difficult to measure)

Fit measures can provide summary evaluation of complex models that involve a large number of linear equations, so that no separate “mini-tests” of model components conducted on an equation-by-equation basis

Methodology allows for a number of indicators that reflect different dimensions of multidimensional variables, enabling a better estimation


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What are the effects of regulatory governance on financial stability?

Financial stability No consensus on what best describes the state of

financial stability, neither theoretical nor conceptual We take a systemic view, emphasizing resilience of

financial system as a whole to financial or real shocks and its ability to facilitate and support the efficient functioning and performance of the economy

To proxy financial stability, we use the IMF’s financial soundness indicators (FSIs)


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IMF’s financial soundness indicators (FSIs) Have a high degree of international comparability Measure the soundness of financial system as a whole Include 5 variables from the core set: regulatory

capital to risk-weighted assets, bank provisions to non-performing loans, return on assets, return on equity, non-performing loans to total loans

Additionally, we include bank capital to assets ratio from the encouraged set


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Determinants of financial stabilityWe use

Regulatory governance Structure of banking sector Macroeconomic conditions Economic freedom


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Determinants of financial stability(1)Regulatory governance We build indices to proxy independence and

accountability of regulatory agency by using data from Barth et al. (2006)

We take two indices from Masciandaro et al. (2008), and

Indicator variables reflecting degree of central bank independence (Arnone et al., 2009)


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Determinants of financial stability(2) Structure of banking sector

comprises openness, competitiveness, and ownership structure of the banking sectorAs indicator variables we consider

Degree of consolidation in banking system Proxy for foreign share of banking sector assets and

degreeof foreign bank entry

Share of bank deposits held in privately owned banks Degree to which banks are allowed to engage in

securities, insurance, and real estate markets


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Determinants of financial stability(3) Macroeconomic conditions

Here several macro variables are considered in the relevant literature:

Rate of inflation, real interest rate, fiscal balance GDP growth and GDP growth volatility Credit and money growth Deposit rate and deposit rate volatility Financial openness


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Determinants of financial stability(4) Economic freedom

Hereinstitutions are regarded as consistent with economic freedom when personal choice, voluntary exchange, freedom to compete, and protection of persons and property are promotedWe use

World Bank’s Good Governance Indicators Indicator variables from the Database of Political

Institutions Democracy measures taken from Polity IV


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Empirical Strategy Sets of manifest variables are used to capture

hypothetical, difficult-to-measure constructs Latent variables are interpreted as hypothetical

constructs (are the “true” variables underlying the measurable indicator variables)

Structural equation model consists of two parts: the structural model and the (exogenous/endogenous) measurement models

Aim of procedure is to obtain values for parameters that produce an estimate for the models’ covariance matrix that will fit the sample covariance matrix of the indicator variables


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Empirical Strategy Wide variety of indicator variables! Testing a range of model specifications, starting from

the most general specification and omitting variables, applying an iterative procedure

Choice of variables based on several criteria: statistical significance of the estimated parameters, parsimony of the model, goodness-of-fit measures


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Empirical Strategy Goodness-of-fit measures considered:

Ratio of chi-square to degrees of freedomComparative Fit IndexRoot Mean Square Error of Approximation

Fit measures based on statistical information theory:Akaike Information CriterionBrowne-Cudeck CriterionBayes Information Criterion


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Model Structural model

Latentvariables


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Model

Exogenousmeasurement

model

Indicatorvariables


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Model

Endogenousmeasurementmodel

Indicatorvariables


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Results (1) Positive relationship between regulatory governance

and variables indicating the degree of independence and accountability of regulatory authorities, as well as indices that proxy the strength of external audits

Positively associated with political independence of central banks; points to a more active role for central banks in banking regulation process

Regulatory governance has a positive influence on the stability of the banking sector

Relationship is robust and positive throughout all model specifications


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Results (2) Positive relationship between structure of the banking

sector and bank concentration Private ownership of banks and foreign bank competition

are positively related to banking sector infrastructure Restrictiveness of bank activities enters with a negative

sign

Positive relationship between the structure of the banking sector and banking sector stability

More open and less restricted banking systems tend to increase safety and soundness of banking system


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Results (3) Negative relationship between macroeconomic

conditions and our inflation indicator, the real interest rate, deposit rate and GDP growth volatility

Signs of coefficients for credit and money growth are negative

Financial openness enters positively

Macroeconomic conditions have a negative influence on banking sector stability

Attributed to the fact that indicator variables considered mainly represent symptoms of an unstable and adverse macroeconomic environment


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Results (4) World Governance Indicators (control of corruption,

rule of law, …) enter with positive signs More democratic and parliamentary systems indicate

greater economic freedom Increasing government size is negatively related to

economic freedom

Economic freedom seems to have a negative effect on the stability of the banking sector

Greater freedoms might imply that banks engage in activities that carry higher risks


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Conclusions Regulatory governance contributes to sound banking

sector Performance of bank regulation could be improved by

providing regulatory authorities with sufficient degree of independence and accountability so that financial stability mandate can be effectively fulfilled

More open and less restricted banking sector is associated with increased soundness of the banking system

Macroeconomic disturbances are negatively related to banking sector stability


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Conclusions Economic freedom seems to have a negative effect on

stability of the banking sector Greater economic freedoms might imply that banks

engage in activities that carry higher risks Institutional environment may induce greater risk-

taking and distort incentive structure in the banking sector so that banking stability could be undermined


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Policy implications Policymakers should provide high degree of

independence to regulatory authorities Regulatory authorities must be accountable to

executive and legislative branches of government and to the financial industry

Anyway, regulatory governance is in critical need of improvement (IMF: Vinals et al., 2010)


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Thank you for your attention !

Paper can be downloaded from my

Webpage: www.fernuni-hagen.de/HWagner

a structural approach to financial stability: on the beneficial role of regulatory governance

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