The importance of banks for the economic growth and the fact that banks are vulnerable to systematic risk lead governments to regulate banks widely and intensively (Levine, 2004). Sound regulation restrains excessive bank risk-taking and reduces financial fragility; however, failures in the regulation of banks can jeopardize the financial system. The ongoing financial turmoil which started in the US subprime mortgage market and spread out internationally highlights the critical role of bank regulation, and leads to heated debates on the regulatory overhaul of the financial system around the world. The policy makers and economists recommend more powerful official regulator and require greater transparency of financial institutions.
Recent years have seen several cross-country studies on national regulation of banks (e.g., Barth, Caprio, and Levine, 2004, 2006, BCL hereafter; Beck, Demirguc-Kunt, and Levine, BDL hereafter, 2006; Laeven and Levine, 2009). These studies suggest that the regulation policies which encourage private monitoring work best to promote bank development and economic growth; while the regulation policies which empower direct official supervision have no positive effects on bank development and sometimes even undermine financial stability. Specifically, BDL (2006) examine the relationship between bank regulation policies and corruption in bank lending.
They find that encouraging private monitoring of banks through the disclosure of accurate and timely information reduces lending corruption; however, strengthening traditional official supervision has no positive impacts on the integrity of bank lending. BCL (2004) examine the relationship between bank regulation policies and banking sector development. They show that regulation policies which force accurate information disclosure and promote private agents to exert market discipline foster bank development and stability; however, regulation policies which rely excessively on direct supervision and regulation of bank activities are negatively associated with bank development and stability.
In addition to official regulation, corporate governance is also important for banks. Banks themselves are corporations. Corporate governance affects bank performance. Sound corporate governance boosts bank valuation. The impacts of corporate governance on bank valuation persist even when controlling for the possible effects of regulation policies (Caprio et al., 2007; Li and Song, 2009). Moreover, banks are major sources of external finance for other firms, especially in developing and emerging economies. Banks are also primary sources of corporate governance of other firms (Frank and Mayer, 2001) as creditors, and in many countries, as equity holders. Sound corporate governance of banks is essential for bank managers to allocate social capital efficiently and to exert effective governance over the firms they fund.
Shortcomings in corporate governance of banks, if widespread, can destabilize the financial system and even cripple the real economy (OECD, 2006). It is claimed that, to an important extent, the current financial crisis can be attributed to the failures and weaknesses of corporate governance arrangements. For example, information about risk exposures sometimes did not reach the boards or even senior levels of management, risk management was often activity-based rather than enterprise-based, and the compensation system encouraged excessive short-term thinking (OECD, 2009).
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Bank Regulation and Board Independence: A Cross-country Analysis
