This paper uses our new database on bank regulation and supervision in 107 countries to assess the relationship between specific regulatory and supervisory practices and banking-sector development, efficiency, and fragility. The paper examines: (i) regulatory restrictions on bank activities and the mixing of banking and commerce; (ii) regulations on domestic and foreign bank entry; (iii) regulations on capital adequacy; (iv) deposit insurance system design features; (v) supervisory power, independence, and resources; (vi) loan classification stringency, provisioning standards, and diversification guidelines; (vii) regulations fostering information disclosure and private-sector monitoring of banks; and (viii) government ownership. The results, albeit tentative, raise a cautionary flag regarding government policies that rely excessively on direct government supervision and regulation of bank activities. The findings instead suggest that policies that rely on guidelines that (1) force accurate information disclosure, (2) empower private-sector corporate control of banks, and (3) foster incentives for private agents to exert corporate control work best to promote bank development, performance and stability

Existing regulatory capital requirements are often criticized for only being loosely linked to the economic risk of the banks' assets. In view of the attempts of international regulators to introduce more risk sensitive capital requirements, we theoretically examine the effect of specific regulatory capital requirements on the risk-taking behavior of banks. More precisely, we develop a continuous time framework where the banks' choice of asset risk is endogenously determined. We compare regulation based on the Basel I building block approach to value-at-risk or ‘internal model’-based capital requirements with respect to risk taking behavior, deposit insurance liability, and shareholder value. The main findings are: (i) value-at-risk-based capital regulation creates a stronger incentive to reduce asset risk when banks are solvent, (ii) solvent banks that reduce their asset risk reduce the current value of the deposit insurance liability significantly, (iii) under value-at-risk regulation the risk reduction behavior of banks is less sensitive to changes in their investment opportunity set, and (iv) banks' equityholders can benefit from risk-based capital requirements

Although domestic mergers and acquisitions (M&As) in the financial services industry have increased steadily over the past two decades, international M&As were until recently relatively rare. Moreover, the share of cross-border mergers in the banking industry is low compared with other industries. This paper uses a novel dataset of over 3000 mergers that took place between 1985 and 2001 to analyze the determinants of international bank mergers. We test the extent to which information costs and regulations hold back merger activity. Our results suggest that information costs significantly impede cross-border bank mergers. Regulations also influence cross-border bank merger activity. Hence, policy makers can create environments that encourage cross-border activity, but information cost barriers must be overcome even in (legally) integrated markets

We study optimal enforcement in credit markets in which the only threat facing a defaulting borrower is restricted access to financial markets. We solve for the optimal level of exclusion, and link it to observed institutional arrangements. Regulation in this environment must accomplish two objectives. First, it must prevent borrowers from defaulting on one bank and transferring their resources to another bank. Second, and less obviously, it must give banks the incentive to make sizeable loans, and to honour their promises of future credit. We establish that the optimal regulation resembles observed laws governing default on debt. Moreover, if debtors have the right to a “fresh start” after bankruptcy then this must be balanced by enforceable provisions against fraudulent conveyance. Our optimal regulation is robust, in that it can be implemented in a way that does not require the regulator to have information about either the borrower or lender. Our results isolate the way in which specific institutions surrounding bankruptcy—namely rules governing asset garnishment and fraudulent conveyances—support loan markets in which borrowers have no collateral

In some countries, banks are firms' key source of financing. In others, firms look mainly to financial markets to meet their financial needs. Why should this be so? This paper provides an explanation tied to legal traditions. Civil-law courts are less effective than their common-law counterparts in resolving conflicts because they have less flexibility in interpreting the laws and creating new rules. Banks emerge in these economies as primary contract enforcers, leading to bank-oriented financial systems. Furthermore, because common-law courts enforce laws effectively, providing them with more detailed creditor and shareholder protection laws has a greater impact on the development of financial markets compared with civil-law systems

We build a simple model of banking in the presence of macroeconomic shocks where the comparative roles of private and public monitors can be analyzed. This model provides endogenous justifications for prudential regulation (capital requirements) and emergency liquidity assistance by the Central Bank (lender of last resort). We show that market discipline can be helpful, but does not solve the fundamental problem of regulatory forbearance. We propose some directions of reform of the regulatory system that could improve the management of banking crises

This paper presents a dynamic model of imperfect competition in banking where the banks can invest in a prudent or a gambling asset. We show that if intermediation margins are small, the banks' franchise values will be small, and in the absence of regulation only a gambling equilibrium will exist. In this case, either flat-rate capital requirements or binding deposit rate ceilings can ensure the existence of a prudent equilibrium, although both have a negative impact on deposit rates. Such impact does not obtain with either risk-based capital requirements or nonbinding deposit rate ceilings, but only the former are always effective in controlling risk-shifting incentives

Most financial risk regulations assume that asset returns are exogenous, where risk is estimated from historical data. This assumption fails to take into account the feedback effect of trading decisions on prices. We investigate the consequences of risk constrained trading by means of simulations of a general equilibrium model with a value-at-risk constraint and compare the results to the case when risk constraints are not present. Prices are lower on average in the presence of risk regulation, while volatility is higher. Risk regulation may have the perverse effect of exacerbating price fluctuations

The paper provides a critical review of the Financial Services Agency (FSA) of Japan since its establishment in June 1998 (as the Financial Supervisory Agency) to June 2004. During the six year period, the FSA faced the challenge of addressing severe insolvency problems in banking as well as life insurance industries. The paper argues that the initial separation of the supervisory role (in the Financial Supervisory Agency and the Financial Reconstruction Commission) and the policy planning role (in the Ministry of Finance) was useful in the sense it allowed the FSA to have a firm stance on the insolvency problem that was partially created by the failure of the past financial regulatory policy. Even after the creation of the FSA, the Bank of Japan remained as another bank supervisor. This seems have made the central bank reluctant in relaxing monetary policy out of the fear that such loose monetary policy would actually discourage re-organization of banking industry. This suggests a problem of having the central bank as a bank supervisor. For the life insurance companies, the FSA (both old and new) has not been successful in intervening (using prompt corrective action) before the failures. Finally, the paper also points out the important role of the leadership at the FSA that shapes the financial regulation, and suggests a problem of appointing a politician to this role